HOW THE SECTION 2704 PROPOSED REGULATIONS BECAME SUCH A BIG DEAL
A deep look at the Proposed Regulations provides insights into divergent interpretations.
Dear Readers Who Follow Washington Developments:
Capital Letter Number 40 discussed the current attention to the Proposed Treasury Regulations under section 2704, generated by the President’s Executive Order to identify recent unduly burdensome or complex regulations. This Capital Letter Number 41 will look at the history of the Proposed Regulations in a depth and detail perhaps uncharacteristic of most Capital Letters. It will then compare the divergent interpretations of the Proposed Regulations, will choose the interpretation it prefers, will explain that choice, will offer some views about how the Proposed Regulations became so muddled, and will conclude by acknowledging some opportunities for the future.
1987: Section 2036(c)
Section 2704 is part of chapter 14 of the Internal Revenue Code, which can be traced in large part to the ill-fated section 2036(c), enacted by the Revenue Act of 1987. Section 2036(c), entitled “Inclusion Related to Valuation Freezes,” provided that certain transferors of an “interest in an enterprise” would be treated as retaining the enjoyment of the transferred property under section 2036(a)(1) for estate tax purposes if the transfer carried what the statute called “a disproportionately large share of the potential appreciation in such person’s interest in the enterprise.”
Section 2036(c) was immediately criticized for being way too broad and vague. A widely-heard criticism was that it seemed aimed mostly at undervaluation of transfers for gift tax purposes, but tried to rectify such undervaluations indirectly with an estate tax assessment that could occur many years or decades after the transfer.
A joint task force, formed of representatives of the ABA Section of Real Property, Probate and Trust Law (now Real Property, Trust and Estate Law), the ABA Section of Taxation, and ACTEC, recommended that section 2036(c) be repealed and replaced by what it called a “valuation assumption.” This “valuation assumption” would be that in valuing “nonpublic stock and partnership interests” for gift tax purposes “any discretionary liquidation, conversion, dividend or put rights retained by the donor or the donor’s spouse will not be exercised by them in a manner adverse to the donee’s interest if the donee is a member of the donor’s family.” The task force report summed up its proposal, in the context of common and preferred corporate stock, by stating that “the proposed gift tax valuation assumption rule is intended to value the transferred common stock interest without lowering that value with the discretionary ‘bells and whistles’ often placed on the preferred.” While the task force did not use the word “disregarded,” its proposed “valuation assumption” somewhat foreshadowed section 2704(b) by providing in effect that certain features of the nonpublic entity’s capital structure would be disregarded to the extent they could adversely affect the donee’s interest. In the final legislation, the task force’s “valuation assumption” is explicitly retained in the rules for the valuation of certain qualified payments in section 2701(a)(3)(B).
The task force also proposed what it called a “safe harbor,” allowing any retained senior interest to be valued at no less than its liquidation value, if
“(a) such preferred interest is entitled to a cumulative dividend or preferred income right not less than the liquidation amount multiplied by the applicable Federal rate on the date of such gift determined under IRC §1274 compounded semiannually; and
“(b) in the event of any failure of the corporation or partnership to pay dividends or make cash distributions in the amount stipulated in (a) above for 36 months, the preferred interest shall be entitled to voting control of the corporation or partnership; and
“(c) the sum of all such preferred interests does not exceed 80% of all of the equity interest in such corporation or partnership.”
In the final legislation, the task force’s paragraph (a) is roughly reflected in the “qualified payment” rule in section 2701(c)(3), its paragraph (b) in the four-year grace period in section 2701(d)(2)(C), and its paragraph (c) in the minimum 10% junior equity value in section 2701(a)(4).
1990: The Development of Chapter 14
Congress tried to rescue section 2036(c) in the Technical and Miscellaneous Revenue Act of 1988 by adding a number of specialized exceptions drawn from the business world. The criticism did not abate, and on March 22, 1990, the House Ways and Means Committee published a “Discussion Draft” retroactively repealing section 2036(c) and prospectively replacing it with new “special valuation rules.” Those rules very roughly foreshadowed what eventually became sections 2701, 2702, and 2703. Notably, the Discussion Draft did not contain an analog of section 2704. The Committee announced a public hearing on the Discussion Draft, to be held on April 24, 1990.
There were 40 witnesses at the hearing. Eight of them were ACTEC Fellows, including three who appeared on behalf of ACTEC – President Waller Horsley, Vice President Tom Sweeney, and Estate and Gift Tax Committee and 2036(c) Task Force Chairman Jim Gamble. ACTEC’s statement shared the Ways and Means Committee’s concerns about abusive valuation freezes, supported the repeal of section 2036(c), agreed with the Discussion Draft’s focus on valuation rather than estate inclusion, but viewed the Discussion Draft as broader and more complex than necessary to solve the acknowledged valuation problem. Jim Gamble’s oral testimony highlighted three concerns with the Discussion Draft – that it would apply to persons who do not control the entity, that it would ignore readily available market values in some cases, and that it would treat some nonfamily donees as members of the family. Ironically, although the contexts are different, the themes of the first and third points in Jim’s 1990 testimony are reprised in some of the most important criticisms of the 2016 Proposed Regulations. The point about application to persons who do not control the entity is similar to the criticism in Part 18 on page 26 of ACTEC’s initial October 27, 2016, Comments on the Proposed Regulations and in Part 4 on page 8 of ACTEC’s Letter of August 1, 2017, reiterating its most serious criticisms in response to Notice 2017-38. The point about the treatment of some nonfamily members as members of the family is similar to the criticism in Part 22 on pages 31-34 of ACTEC’s October 27 Comments and in Part 2 on pages 5-6 of its August 1 Letter.
Chapter 14 was enacted as part of the Omnibus Budget Reconciliation Act of 1990 on November 5, 1990. The effective date was October 9, 1990, the reported date of relevant Senate Finance Committee action. In addition to what became sections 2701, 2702, and 2703, the Senate version included a provision that would have (1) determined the value of property without regard to any restriction other than a restriction which by its terms will never lapse and (2) provided that, in valuing property for estate tax purposes, any right held by the decedent with respect to the property would be deemed exercisable by the estate even if it lapsed on the decedent’s death. The House-Senate Conference Report modified this provision to the current content of section 2704.
The Proposed Regulations
The Proposed Regulations were released on August 2, 2016, and published in the Federal Register on August 4. They were immediately and severely criticized as being way too broad, as overthrowing the willing-buyer-willing-seller standard of “fair market value,” as exceeding Treasury’s statutory authority, and as destroying family-owned businesses. I believe the criticism has largely missed the mark and that both the scope and the tone of the criticism have been unfair. Nevertheless, the climate in which this discussion has occurred makes the criticism understandable. This climate includes the vocabulary of the Proposed Regulations themselves, the suspicion that they exceed Treasury’s statutory authority, the concern that they will destroy family-owned operating businesses, and awkward timing in a broader environment of harsh rhetoric and distrust.
THE MEANING OF “DISREGARDED RESTRICTION”
The core of the Proposed Regulations is the addition of a new category of “disregarded restrictions.” And the heart of the divergence of interpretations of the Proposed Regulations has been disagreement over the identification and effect of a “disregarded restriction.”
The Narrow View
The narrow view notes that a “disregarded restriction” is defined in Proposed Reg. §25.2704-3(b) only as a “provision” of the governing documents or applicable law that limits the ability of the holder to compel liquidation or redemption of an interest on no more than six months’ notice for cash or property (generally not a promissory note) equal at least to what the proposed regulations call “minimum value.” A “provision” is words on a page – artificial words on a page – in effect, “bells and whistles,” as the 2036(c) task force put it.
Proposed Reg. §25.2704-3(f) follows up with the reassurance that
“if a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise.”
The preamble to the proposed regulations confirms that
“the fair market value of the interest in the entity is determined assuming that the disregarded restriction did not exist, either in the governing documents or applicable law. Fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums, subject to the assumptions described in this paragraph.”
Thus, the answer to the appraiser who is worried about coping with a new standard of valuation called “minimum value” is to advise the appraiser to just ignore certain words on the pages of the governing documents. After all, nearly every appraiser of an interest in an entity, at the beginning of the engagement, receives – often from lawyers like ACTEC Fellows – the effective and relevant governing documents. The lawyer would now simply tell the appraiser to proceed as if those words were not there, but otherwise in the same way as before. The appraiser’s professional standards would require disclosure of this “extraordinary assumption” or “hypothetical condition” in the appraisal report, but that should be the only noticeable impact on the appraiser’s assignment.
Even if provisions that restrict redemption are disregarded, there are many factors that will still support significant discounts in the valuation of transferred interests in entities, including (1) the risk that the buyer of the interest may be unable to negotiate a favorable buyout, (2) the risk a hypothetical willing buyer would incur in dealing with an unrelated family, and (3) the lack of ability to control or influence the investments and activities of the entity as a going concern. And in the case of a family-owned operating business, the appraiser should be expected to take into account many more relevant economic and business factors, including (4) the business plan, business environment, competition, illiquidity and the need for capital, unpredictability, or other obstacles to the business’s redemption of the interest, (5) the fact that partial liquidation (redemption) makes a business not just smaller, but weaker and less competitive, and (6) the fact that the managers or majority owners of the business therefore may not consider a partial liquidation to be in the best interests of the business or the other owners to whom they owe a fiduciary duty.
The Broad View
The broad view of a “disregarded restriction” requires anything that restricts or prevents an interest-holder’s realization of “minimum value” on six months’ notice to be disregarded. Thus, the valuation of that interest must assume that nothing restricts or prevents such realization, and if everything that prevents such realization is removed, such realization is therefore permitted. The form of the entity, the composition of the ownership and management of the entity, the activities of the entity, the market or other economic environment in which a business entity functions – all is ignored. The holder of an interest in the entity is treated as the direct owner of a pro rata share of the net fair market value of the entity, valued as such, with perhaps only a discount for the time value of money over a deferral period of six months. The entity, in effect, is disregarded. And, assuming that the use of entities to depress transfer tax values is what the Proposed Regulations are aimed at, then the objectives of the Proposed Regulations are served. Some have described the broad view as the valuation of an interest in a family-owned entity as if the holder could put the interest to the entity (or other owners) for its “minimum value” – in other words a “deemed put right.”
It follows, under the broad view, that the lawyer and the appraiser cannot just ignore the words on the pages of the governing documents that explicitly prohibit redemption, or limit redemption to book value, or allow redemption only for a long-term promissory note, or require an extraordinary vote to approve a redemption. They must also ignore the words, whether in the governing documents or in applicable law, that could affect redemption, including for example a state law that says a limited partnership is controlled by the general partner, or that a three-fourths vote is required to amend the corporate bylaws, or that a unanimous vote is required to dissolve a limited liability company.
Further, the broad view would disregard the economic and business factors described above, if those factors impede redemption and marketability and reduce fair market value, as the transferor’s family presumably could remove those factors by changing or selling the business.
Taken even a step further, the broad view might say that if the transferor’s family can theoretically amend the governing documents to give every owner a put right, then their failure to do so must itself be treated as a disregarded restriction and the put right is deemed to exist.
The result is that the Proposed Regulations’ use of the term “minimum value” is taken literally and makes “minimum value” the “minimum value” for transfer tax purposes.
Providing some support for the broad view is the statement in Proposed Reg. §25.2704-3(f) that “if a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise.” Even the failure to amend governing documents to give every owner a put right could be viewed to be a restriction existing “otherwise,” which must be disregarded.
Capital Letters’ View
Almost all of the criticism of the Proposed Regulations has seemed to stem from the broad view. I believe that that criticism largely misses the mark because I take the narrow view. Disregarded restrictions are limited to targeted provisions (“bells and whistles”) in governing documents that artificially try to “put a thumb on the scale” of valuation. The Proposed Regulations would affect only aggressive uses of such provisions. And, because of the economic and business factors outside of the entity structure described above, the Proposed Regulations would not affect family-owned operating businesses very much, if at all.
I initially came to the narrow view mainly because it interprets the scope of the Proposed Regulations in light of the statutory limits on Treasury’s regulatory authority, as described below. Since then, notably in the public hearing on December 1, 2016, persons at Treasury and the IRS who participated in drafting the Proposed Regulations have confirmed that the narrower application was their intent.
Section 2704(b)(4) states:
“The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”
The Meaning of “Other”
The word “other,” of course, means that regulations could provide for the disregard of restrictions beyond what the statute provides directly. It has been suggested that the regulatory authority might extend only to restrictions on activities other than liquidation, not to other restrictions on liquidation, and therefore the regulations are impermissibly broad because all subdivisions of the definition of “disregarded restriction” in Proposed Reg. §25.2704-3(b)(1) refer to both liquidation and redemption. The point is hard to understand, because the “liquidation” in view in Proposed Reg. §25.2704-3(b)(1) is clearly the liquidation (or redemption) of an individual owner’s interest (as the “deemed put” model suggests), not “the ability of the corporation or partnership to liquidate,” which section 2704(b)(2)(A) includes in the definition of an “applicable restriction” that is disregarded directly by the statute. But in any event it seems most logical to construe “other” as applying to “restrictions” (the word it precedes) and as authorizing regulatory disregard of restrictions that are merely different from the “applicable restrictions” defined in the immediately preceding paragraphs (2) and (3) of section 2704(b).
That makes the regulatory authority very broad indeed. An “applicable restriction” is defined (using the numbering and lettering of the actual subdivisions of section 2704(b)) as (2) any restriction that (A) limits the ability of the entity to liquidate and (B) either (i) lapses after the transfer or (ii) can be removed by the transferor’s family, (3) except (A) certain commercial restrictions or (B) “any restriction imposed, or required to be imposed, by any Federal or State law.” A regulatory disregarded restriction might actually satisfy the condition of being “other” by altering any of the foregoing elements of the definition of “applicable restriction,” including, for example, abandoning the exception for a restriction imposed and made unavoidable by state law. But even if that change is regarded as technically authorized, it is hard to see how it would ever be prudent. (Proposed Reg. §§25.2704-2(b)(4)(ii) and -3(b)(5)(iii) would limit the exception for restrictions imposed by law to restrictions that cannot be avoided, not including mere default state law rules that governing instruments can override. This change basically aligns the regulations with the wording of section 2704(b)(3)(B) quoted above and reverses the more lenient position of the 1992 regulations. But going further and removing the exception even for unavoidable requirements of state or federal law would seems to never be appropriate.)
The Meaning of “Ultimately”
The next limitation on the regulatory authority granted by section 2704(b)(4) is the requirement that a new disregarded restriction “has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.” Reducing the value of the transferred interest for transfer tax purposes is not hard to understand. Intuitively it is what all of chapter 14 – some might say all of estate tax planning – is about.
But what does “ultimately” mean? Besides section 2704, the word “ultimate” or “ultimately” is used in 25 sections of the Internal Revenue Code. The common feature that all 25 examples share is the context of a single activity or transaction of limited duration – natural resource depletion, movement of funds, sales, consumption, determination of tax liability, or litigation. The inevitable question then is: What activity or transaction is the context for the use of “ultimately” in section 2704(b)(4)? It has to be “reducing the value of the transferred interest for purposes of this subtitle.” That is done by filing a return, avoiding or surviving an audit or resolving any issues raised in an audit, and seeing the three-year statute of limitations run. That is what makes it so easy to see a temporal element in the last clause of section 2704(b)(4). In the absence of any other source of insight, section 2704(b)(4) contemplates regulations that will go after ephemeral restrictions that there is little reason for the family not to undo once the gift or estate tax exposure is past and those restrictions have served their purpose.
The Meaning of What Isn’t There
Even clearer is the fact that section 2704(b)(4) does not authorize “new” valuation standards, conventions, or assumptions. It does not authorize regulations that substitute new parameters for the “disregarded restrictions.” Not even “minimum value” as a standard of transfer tax value. Certainly not a “deemed put right.” As Mickey Davis has put it, section 2704(b)(4) gives Treasury an eraser, but not a pencil. Regulations can eliminate, but they can’t rewrite.
That limitation on the scope of the regulatory authority is clear, and there has been no doubt or disagreement about that.
Public and Private Legislative History
Some have found evidence beyond the text of section 2704(b)(4) that the Proposed Regulations violate congressional intent. The most obvious and oft-cited example is the statement in the 1990 House-Senate Conference Report about section 2704 that “these rules do not affect minority discounts or other discounts available under present law.” H R. Rep. No. 101-964, 101st Cong., 2d Sess. 1137 (Conference Report, Oct. 27, 1990). But of course section 2704 is entirely pointless if it does not increase tax liability in some cases by increasing the value of a transferred interest for gift or estate tax purposes. That almost inevitably means that some discount – a minority discount or at least some “other” discount – will be denied or reduced. So it is hard to tell what that statement in the Conference Report ever meant as a textual matter, although it is likely if not certain that it was inserted at the request of, or to accommodate the interests of, some of those advocates who had been active in combatting section 2036(c) and had been represented at the April 24, 1990, Ways and Means Committee hearing.
Leaving aside the conundrum about what that statement in the Conference Report might have meant in 1990, the context, “these rules,” is clearly the conference agreement modification of the Senate rules that became section 2704. Six paragraphs later, the Conference Report states that “the provision also grants to the Treasury Secretary regulatory authority to disregard other restrictions which reduce the value of the transferred interest for transfer tax purposes but which do not ultimately reduce the value of the interest to the transferee.” Id. at 1138. There is no suggestion whatsoever that the regulations would be limited by the concern for discounts that may have guided what Congress itself directly provided in 1990. Indeed, if Congress did not fully intend and expect that Treasury’s regulations under the authority of section 2704(b)(4) would do more than the statute alone did, it would have had no reason to include the regulatory authority at all.
Similarly, again in response to some of the advocates who had been working with congressional staffs to replace section 2036(c), there is no question that some of those staff members, and some Members of Congress and Senators themselves, gave assurances both about how the statute would be limited and about how Congress would insist Treasury administer the statute. Even representatives of Treasury may have added their assurances regarding the anticipated first round of implementing regulations. But those private discussions were not legislative history. The only authoritative expression Congress left us of its intention in enacting section 2704(b)(4) was section 2704(b)(4) itself (with an almost word-for-word recital in the Conference Report that adds nothing).
In short, the only substantive limitations imposed by section 2704(b)(4) on the Proposed Regulations as a practical matter are that the additional disregarded restrictions are ephemeral – that is, they do not “ultimately reduce the value of such interest to the transferee” – and that they only disregard, and do not seek to replace, the targeted restrictions.
Rereading the Proposed Regulations
Guessing the meaning of the Proposed Regulations, with their references to “minimum value” and “otherwise” and the like, is clearly a challenge. But reading them through the lens of their statutory authority confirms that the only effect the Proposed Regulations can have is to ignore certain limitations that are temporary and for that reason may not be real. In this reading the Proposed Regulations do not have much effect, if any, on family-owned operating businesses, because families do not make the sacrifices and take the risks and put in the effort needed to build a family business just to survive a transfer tax audit. And this reading rules out any new standard of transfer tax value like “minimum value,” because that would require adding, not just disregarding.
As Capital Letter Number 40 reported, ACTEC Fellow and Treasury Department attorney-adviser Cathy Hughes offered assurances at the public hearing on the Proposed Regulations that their intended scope is much narrower than many critics had assumed. She said that “we will absolutely make that clear in the final regulations.” Apparently she and her colleagues had also reread the Proposed Regulations in light of the statutory authority, or at least in light of the storm of criticism they had stirred up, and agreed that some of the wording needed to be fixed to clearly communicate their intent.
There is more to the background of why the Proposed Regulations were received with such skepticism. We cannot overlook the effect of the quarter-century build-up from the enactment of the statute in 1990 to the publication of the Proposed Regulations in 2016.
The regulation project was formally launched in 2002. But from May 2009 until April 2013, the anticipated regulations were analyzed and discussed in light of a revenue proposal in the Treasury Department’s annual “General Explanations of the Administration’s Revenue Proposals” (popularly called the “Greenbook”) entitled “Modify Rules on Valuation Discounts.” The 2009, 2010, 2011, and 2012 Greenbooks stated:
“This proposal would create an additional category of restrictions (‘disregarded restrictions’) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family.”
These “additional” restrictions sounded like the “other” restrictions contemplated by Congress in section 2704(b)(4). But the Greenbooks went on to state:
“Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.”
As discussed above, section 2704(b)(4) says nothing about substituting affirmative assumptions for the “other restrictions” that may be disregarded. So it seemed likely that one of the reasons Treasury was asking for legislation was to expand section 2704(b)(4) to authorize such regulatory assumptions, although we never had an opportunity to verify that because no bill was introduced that included statutory language to fulfill this Greenbook request.
The Greenbooks added:
“Regulatory authority would be granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of section 2704 if certain standards are met.”
It was never clear what kind of “safe harbors” could be enjoyed simply by drafting documents in a certain way. The exceptions Congress added to section 2036(c) in 1988 could be viewed as “safe harbors,” and they satisfied no one. But the very notion of safe harbors made it clear that, even with enhanced legislative authority, the section 2704 regulations were not expected to swallow up all valuation discounts.
Then the 2013, 2014, 2015, and 2016 Greenbooks omitted that legislative request. This evidently made some observers anxious that the IRS would try to do by regulatory fiat what Congress so far had declined to authorize. Indeed, a true “minimum value” for transfer tax purposes or a corresponding “deemed put right” may very well have been the kind of substituted valuation assumption for which, along with certain safe harbors, the Greenbooks had unsuccessfully sought legislative cover. But without such legislation, it should have been clear, as discussed above, that Treasury couldn’t provide an assumption like a “deemed put right” that would exceed the limited authority granted by section 2704(b)(4). The Greenbooks might have been requesting statutory cover for precisely what the “deemed put” view assumes, but Congress never granted that request, and in 2013 Treasury withdrew it.
Even after Treasury dropped the Greenbook recommendation but continued the active regulation project, the Greenbook continued to be consulted and cited for what the Proposed Regulations might eventually look like. It was assumed that Treasury had reflected its view of the regulations that were needed in its requests for legislation in the Greenbooks, and that its view would not dramatically change just because it chose to go it alone without additional authority – a very natural and logical assumption. That led almost inevitably to the assumption that the anticipated regulations might look exactly like the Greenbook proposals, which would be impossible, or in any event illegal, without the additional congressional cover the Greenbooks seemed to admit Treasury knew it needed.
Still the build-up continued. Chapter 14 was enacted in November 1990. Regulations were proposed in March and September 1991 and finalized in January 1992. Then this new regulation project was launched in 2002. The Greenbook proposal appeared in 2009 and disappeared in 2013. Then reports circulated in the spring of 2015 that the section 2704 Proposed Regulations would be out by fall. They weren’t. The enactment of the consistent basis rules on July 31, 2015 (about which Capital Letter Number 42 will comment) may have been an important obstacle.
Meanwhile, the rumor of a fall release of the Proposed Regulations rekindled the anticipation. ACTEC Fellow Richard Dees sent a public 29-page letter to Treasury and the IRS on August 31, 2015. The letter recounted, from Richard’s first-hand experience, much of the history recounted in this Capital Letter. But the thesis and purpose of his letter was captured in the opening paragraph, where he wrote that he
“is concerned by a report that Treasury and the Internal Revenue Service will propose in the near future new regulations under Internal Revenue Code Section 2704(b) similar to those titled ‘Rules to Modify Valuation Discounts,’ which the Administration last proposed in 2013 (the ‘Greenbook Proposal’). The author believes for the many reasons set forth below that such regulations, if issued in that form, would be invalid.”
When the Proposed Regulations were released on August 2, 2016, that thesis (which I believe is absolutely correct) was remembered. But, rather than reading the Proposed Regulations through the lens of the statutory authority, many held to the assumption made in 2015 that the Proposed Regulations would be the same as the Greenbook proposal and therefore would be very broad and undoubtedly illegal. It was that view that was heard first and most persistently, fueled by the lack of clarity in the actual text of the Proposed Regulations.
How It Happened: Reprise and Speculation
As pointed out in Capital Letter Number 38 of July 20, 2015, the 10-year revenue estimates for the Greenbook proposal, from 2009 through 2012, respectively, were $19.038 billion, $18.667 billion, $18.166 billion, and $18.079 billion. Thus the estimates were rounded to the nearest $1 million, representing fine-tuning to the nearest $100,000 per year. Another way of looking at it is that, at a 40 percent transfer tax rate, these estimates were fine-tuned to the nearest $250,000 of disallowed discounts per year. In contrast, on June 11, 2009, shortly after the proposal first appeared, a set of Joint Committee on Taxation revenue estimates related to the Administration’s budget proposals skipped this proposal, because of its lack of specificity that made it impossible to tell what it would accomplish and therefore what revenue effect it would have. But the revenue estimators at Treasury obviously had no such handicap, and the annual fine-tuning suggested that they knew exactly what the contemplated regulations would provide.
As a result, Capital Letters speculates – without the benefit of any inside information whatsoever – that by the time the 2009 Greenbook was published the regulations had already been drafted, or at least the substance of the proposed regulations had been very specifically outlined. Then when Treasury and the IRS decided to omit the proposal for additional regulatory authority under section 2704 from the 2013 Greenbook and draft those regulations without that additional authority, it stands to reason that it made changes to that draft to moderate it. Perhaps the changes included deletion of the originally contemplated “certain assumptions” that would “substitute for the disregarded restrictions” in the Greenbook proposal. And maybe those “certain assumptions” included a version of “minimum value.”
If so – and again this is only speculation – perhaps some of the troublesome vocabulary and wording in the Proposed Regulations is left over from that earlier Greenbook-based draft and just wasn’t completely cleaned up. The Proposed Regulations are 50 pages long and contain over 15,000 words, and the shortcut of not reinventing previous drafting is not hard to understand.
FEAR OF DESTROYING FAMILY-OWNED BUSINESSES
Under the narrow view of the Proposed Regulations, they should not have much effect on family-owned operating businesses. Indeed, that is a reason argued for simply adding an explicit exception for operating businesses to the Proposed Regulations to allay the fear business owners have expressed.
In defining a “disregarded restriction” to include a provision for paying a withdrawing owner with a promissory note, Proposed Reg. §25.2704-3(b)(1)(iv) provides an explicit exception “in the case of an entity engaged in an active trade or business, at least 60 percent of whose value consists of the nonpassive assets of that trade or business, and to the extent that the liquidation proceeds are not attributable to passive assets within the meaning of section 6166(b)(9)(B).” We might ask why an exception for entities engaged in an active trade or business is needed if such entities are not the target of the Proposed Regulations. The answer might be that this exception is a carryover from a previous draft, as discussed above. Or the answer might be that the issue was not really thought through.
In any event, family business owners quickly and sincerely assumed that their businesses were being targeted, and they and their representatives and trade associations became very outspoken about it. This outspokenness has naturally generated a lot of press coverage, and references to the Proposed Regulations in the press have been quite often explained in terms of the valuation, not of interests in family-owned “entities,” but of interests in “family businesses.”
Then of course the concerns of those vocal business owners came to the attention of members of Congress. Representative Warren Davidson (R-OH) and Senator Marco Rubio (R-FL) introduced the “Protect Family Farms and Businesses Act” on September 21 (H.R. 6100) and September 28, 2016 (S. 3436), respectively, and reintroduced them on January 2, 2017, the first day of the new Congress (H.R. 308 and S. 47). (They did not call their bills the “Protect Investment Entities Act.”) Their efforts were perpetuated in section 115 of the Fiscal Year 2018 appropriations bill reported out of the House Appropriations Committee on June 29, 2017, which provides:
“None of the funds made available by this Act may be used to finalize, implement, or enforce amendments to Treasury Regulations proposed in the Notice of Proposed Rulemaking in the Federal Register on August 4, 2016 (81 Fed. Reg. 51413) (relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes under section 2704 of the Internal Revenue Code of 1986), or any substantially similar amendments to such regulations.”
Ironically, because these legislative efforts have been provoked by the “broad view” of the Proposed Regulations (discussed above), it is conceivable that the Proposed Regulations themselves, read with the “narrow view,” are not “substantially similar” to the regulations this bill would defund. Now that would be an interesting outcome.
ENVIRONMENT OF HARSH RHETORIC AND DISTRUST
Many forces in the political and social environment have aligned to make the reception of the section 2704 Proposed Regulations so negative. Obviously we live in times of increasingly harsh and sometimes baffling polarity and cynicism. But the particular focus of that polarity and cynicism and the timing of the Proposed Regulations have made it particularly difficult for the Proposed Regulations to have a calm and reasoned reception, and perhaps unreasonable to expect that they could.
First, we have seen decades of concerted effort to repeal the federal estate tax, with successes limited to the enactment of lower rates and the unlimited marital deduction in 1981, the vetoed “Death Tax Elimination Act of 2000,” the one-year (2010) repeal in 2001, and recent substantial increases in the exemption and modest reductions in the rate. Some are frustrated by these hollow victories and frustrated that the IRS would fiddle with regulations when they want the “immoral” “death tax” totally repealed.
Second, there is great distrust of the IRS and its motives, aggravated by some revelations and greater allegations in 2013 of politically-motivated mishandling of exemption applications of section 501(c)(4) tax-exempt organizations.
Third, release of the Proposed Regulations was anticipated in the last two years of the Obama Administration and occurred in the last six months of the Obama Administration. This encouraged rumors of a plan to push the final regulations out before President Obama left office. That was never a very realistic view, but, like the suspicion that family businesses were being targeted by the Proposed Regulations, it too was genuine.
Fourth, President Obama was particularly viewed by some as likely, if not eager, to take action without regard for congressional authorization. For example, in an oft-quoted portion of his State of the Union Address to Congress on February 12, 2013, he stated:
“Now, the good news is we can make meaningful progress on this issue while driving strong economic growth. I urge this Congress to get together, pursue a bipartisan, market-based solution to climate change, like the one John McCain and Joe Lieberman worked on together a few years ago. But if Congress won’t act soon to protect future generations, I will.”
The context was environmental regulation, not tax policy. But owners of small businesses, typically family-owned businesses, are very sensitive to environmental regulation. They noticed President Obama’s willingness to go it alone. Then, less than two months later, on April 10, 2013, with “if Congress won’t act … I will” still echoing, the Fiscal 2014 Greenbook was published with the proposal to “Modify Rules on Valuation Discounts” omitted. The 2013-2014 Treasury-IRS Priority Guidance Plan, with the section 2704 project ominously retained, followed on August 9, 2013, “proving” that the President was going to act without congressional authority.
Fifth, when the Proposed Regulations finally were issued, they were accompanied by somewhat unusual political statements that some, especially those already prepared to dislike the Proposed Regulations, saw as triumphal gloating at the expense of family businesses. Assistant Secretary of the Treasury for Tax Policy Mark Mazur released a “Note” stating:
“Today, the U.S. Department of the Treasury announced a new regulatory proposal to close a tax loophole that certain taxpayers have long used to understate the fair market value of their assets for estate and gift tax purposes.”
The White House seemed to those observers to be even more boastful:
“The Obama administration has made considerable progress over the past eight years to make our tax code fairer. This week, the Treasury Department is building on that progress through proposed new rules closing a loophole that allows some wealthy families to avoid paying their fair share in estate taxes.”
This was an odd boast to make about a regulation project launched in one Bush Administration under a statute enacted in another Bush Administration. In any event, it infuriated those who were already in a mood to be infuriated.
Given that climate, there has been little inclination to give the drafters the benefit of any doubt or to work with them constructively to make improvements, as Jim Gamble and his colleagues worked with Congress and congressional staffs in 1990 to improve the Discussion Draft. This translated into haste to read the Proposed Regulations as violating the statutory authority rather than interpret them in light of the statutory authority, which fueled the “broad view.” It evolved into an unwillingness even to trust the assurances offered at the December 1 hearing that the “narrow view” was intended after all.
Drafters of regulations should try to do a better job, especially of anticipating the confusion that terms like “minimum value” are apt to create. They should remember the example of the Ways and Means Committee in inviting dialogue about a Discussion Draft in 1990. If possible, they should try to find a way to make proposed regulations seem less like a threat of imminent finalizing and more like a “draft” to be discussed and probably improved. Perhaps, when regulations might be as unpopular, or in any event as scrutinized, as the section 2704 Proposed Regulations, Treasury and the IRS could find a way to soften the initial impact. For example, they might announce in the Notice of Proposed Rulemaking itself that if there are substantial suggestions for change, then, after making the changes they think would be responsive, they expect to keep the dialogue open by re-proposing the regulations and not going straight to finalizing them. That could be especially appropriate in cases like section 2704 where a regulation project has already been open for a long time.
As an aside, reflection on the 1990 Discussion Draft and the bad experience with section 2036(c) that prompted it might remind the IRS of the limitations of section 2036 as an open-ended enforcement tool. That could and should lead to reconsideration of the aggressive invocation of section 2036 to rectify simple valuation disputes that we see from time to time in unsettling fact-specific case law. It might even encourage Treasury and the IRS to find a way to explicitly make regulations like the section 2704 regulations, after appropriate public input, the exclusive tools for addressing the perceived abuses that are within their scope.
For its part, the estate planning community should appreciate and welcome the opportunity for regulations to bring clarity and predictability, which benefit everyone, into the estate tax law. And we should appreciate and welcome our own role in bringing practical experience and judgment to that process. We should try not to commit to a view of proposed regulations years before they are issued, and we should view it as okay to give the drafters the benefit of the doubt. Like Jim Gamble and his colleagues in 1990, we can set an example of moderation, courtesy, and constructive contribution, even when disagreeing.
In that spirit, in the context of the section 2704 Proposed Regulations, we may yet have a once-in-a-generation opportunity to achieve better clarity and certainty about an important area of the transfer tax law, including the status of family-owned operating businesses, by working collaboratively and trustingly with those whom ACTEC’s Government Submissions Policy (Exhibit B, paragraph 2) rightly calls “our friends in government service.”