SEPTEMBER 2016 NEWSLETTER

TAX ALERTS:

New Regulations May Limit Or Eliminate Valuation Discounts For Transfers Of Interests In Family Held Entities

The use of Intentionally Defective Grantor Trusts (IDGT), Limited Liability Companies (LLCs) and Family Limited Partnerships (FLPs) are clever and efficient ways to transfer family wealth to your children or future generations, remove assets from your estate, and reduce potential federal estate taxes. However, proposed IRS Treasury Regulations may severely limit or eliminate part of the benefits of using these advanced estate planning techniques.

Benefits of Using IDGTs, LLCs and FLPs

Two reasons a grantor would intentionally create an IDGT is to remove the assets he/she transfers to the trust from his/her federal taxable estate and to allow the assets in the trust to grow income tax free. If structured properly, IDGT’s are useful for transferring wealth because for estate tax purposes, the grantor is not considered as owning the IDGT, however, for income tax purposes the grantor is still the owner. Therefore, when income taxes are paid by the grantor rather than from the trust fund, more money is removed from the grantor’s taxable estate and kept in the trust to be distributed to the beneficiaries outside of the grantor’s taxable estate. In all, the grantor will have removed from his/her estate the value of the trust assets, any future appreciation on those assets, and the amount of money used to pay income taxes on the earnings of the trust assets.

Similar to an IDGT, a parent often uses a LLC or FLP to remove property from his/her taxable estate. There are two basic steps taken when using a LLC or FLP as part of an estate plan. The first step is to transfer property to a newly-formed limited liability company or family limited partnership in exchange for a membership or partnership interest. Next, the parent can make gifts of the LLC or FLP interests to his/her children and grandchildren, which can be done gift/estate tax free using part of the Lifetime Gift and Estate Tax Exemption Credit and Annual Exclusion against Gift Tax. By using the exemption/exclusions against Federal Gift and Estate tax, a substantial amount of property can be transferred to lower generations entirely free of gift/estate tax.

Valuation Discounts of Family Business Interests

IDGTs, LLCs and FLPs are especially useful tax saving vehicles where the transferor has a family owned, privately held business and/or real estate and desires to transfer it to his/her children and/or grandchildren.. In addition to all the benefits described above, the transferor can take advantage of valuation discounts of family business interests and/or real estate. The value of the non-controlling interest of the privately held business/real estate can be significantly discounted because of the lack of control over the business/real estate, minority interest, restrictions on transferability and the lack of marketability of the business interest/real estate. The lack of marketability is due to the generally unattractive nature of the interest to outside investors. For LLCs or FLPs it is because minority membership or limited partnership interests are transferred to the lower generations and the members or limited partners do not participate in control and management of the business/real estate and lack 4 liquidation or dissolution rights. . For IDGTs, generally only non-voting stock is transferred to the IDGT thereby precluding the trustee, as owner of that interest, from having any control over the business/real estate. Furthermore, the LLC and/or FLPs’ Operating Agreement usually contain restrictions on transfers which further curtail the value of such interest. There are few potential investors who would be willing to pay full price to buy an interest in a business or real estate wherein they cannot control, liquidate or dissolve their investment, force liquidation, or freely sell his/her interest to a willing buyer.

Proposed Treasury Regulations

The IRS Treasury has recently proposed regulations pertaining to Section 2704 of the Internal Revenue Code. Section 2704 is applied to closely held family entities and basically provides that a taxable event occurs when liquidation or voting rights lapse and that, in valuing property for federal estate and gift tax purposes, certain restrictions on an entity’s ability to liquidate are disregarded. This Section further grants the Treasury the authority to issue regulations to cause certain other restrictions that reduce valuation discounts are to be disregarded which is the purpose of the currently proposed regulations.

Regarding a lapse in voting and liquidation rights, the only persons who would be affected by the proposed regulations are those who transfer an interest within three years of his or her death. Under the current law, if an interest in a closely held family entity is transferred from one family member to another, and the original holder of the interest thereby loses the right to liquidate the entity, there is no lapse of a liquidation right as long as the right to participate in a liquidation vote was transferred along with the interest to the other family member. The same applies to voting rights; as long as the interest passing to the family member still has a voting right attached to it, no taxable lapse has occurred. The proposed regulations governing these transfers are meant to attack transfers within three years of death.

The most important valuation discount that may be eliminated is that valuation discounts for minority interest in closely held entities, which can easily range from 15 to 40%. Essentially, the regulations would ignore any restrictions in the governing documents and any applicable state laws governing minority interests and value the interest as though there were no restrictions. Under the current law, the only restrictions ignored for valuation purposes are those that are more restrictive than applicable default state laws. Examples include the ability of a limited partner to withdraw from a partnership or to force a liquidation of the partnership.

Instead of referring to applicable state laws, the proposed regulations create a new category of restrictions that will be ignored for valuation purposes called “Disregarded Provisions”. Disregarded Provisions includes any provision that limits or permits the limitation of the holder of an interest to compel liquidation or redemption. In other words, under the proposed regulations, the IRS will value all interests transferred between family members in closely held entities as though the transferee of the interest has the right to liquidate or redeem the interest for its proportionate share of the entity’s net asset value in cash or other property regardless of whether the transferee could actually compel such an action in a state court.

The public comment period is still open but if the Proposed Regulations go into effect as written on January 1, 2017, they will have a significant effect on advanced estate planning and the ability of owners of closely held family entities to receive a valuation discount when transferring minority interest to family members or trusts for the benefit of family members. 5

We strongly advise you to contact your local Congressman immediately to protest these proposed regulations.

For Pennsylvania residents, contact:

Pat Toomey at https://www.toomey.senate.gov/ and Bob Casey at https://www.casey.senate.gov/. Patrick Meehan at https://meehan.house.gov/ Robert Brady at https://brady.house.gov/ Brendan Boyle at https://boyle.house.gov/

For New Jersey residents, contact:

Robert Menendez at https://www.menendez.senate.gov/ Corey Booker at https://www.booker.senate.gov/. Michael Fitzpatrick at https://fitzpatrick.house.gov/