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The Reality of Politics of the Family/ Small Business Enterprises In America.
Oct 10, 2016
Sept 20, 2016
Aug 23th, 2016
The Reality of Politics of the Family/ Small Business Enterprises In America.
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Steven A. Horowitz, Esq.
Partner, Horowitz and Rubenstein, LLC
By: Steven A. Horowitz
A Bill to nullify the recently Proposed Regulations under Section 2704(b) highlights both the political and economic realities of the significance of small businesses/family owned business to the U.S. economy. H.R. 6042 authored by Representative James Sensenbrenner seeks to highlight that significance by nullifying or voiding those Regulations if they are ever finalized, ab initio. Perhaps fantasy will not overwhelm the transfer tax system, this time.
In a move that was likely designed either as a last minute attempt to win votes within the business community in his district, or as a shot across the bow of the Treasury Department, Representative James Sensenbrenner, R-Wisconsin has introduced a nullification Bill consisting of two full sentences (including the title). The Bill is a rare move and is most likely politically motivated, notwithstanding its accuracy from a tax perspective. It is designed to let the Treasury Department know that they should withdraw the Proposed Regulations issued on August 4, 2016; and to let the closely held business community and the legion of its advisors know that he believes that they are far too important to the U.S. economy to let passage from one generation to another, be impaired based upon Regulations issued under Section 2704(b) which go beyond congressional mandate in their issuance. (See H.R. 6042, Sept. 15, 2016).
The Sole Provision of H.R. 6042
The sole provision of the bill introduced by Representative Sensenbrenner reads as follows:
“Section 1. Nullification of certain proposed regulations relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes.
Regulations proposed for purposes of section 2704 of the Internal Revenue Code of 1986 relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes, published on August 4, 2016 (81 Fed. Reg. 51413), and any substantially similar regulations hereafter promulgated shall have no force or effect.”
Many tax practitioners, estate planners, and commentators were quick to condemn the validity of proposed regulations based upon issues ranging from the denial of economic realities, the failure to respect state property rights upon which the transfer tax is determined and governed, and the addition back to the Code of a three-year rule without the amendment of section 2035. It appeared that the regulations may in fact have been designed to govern deathbed transfers of interest in family business enterprises (corporations, partnerships and limited liability companies) for estate, gift and generation-skipping transfer tax purposes. The upshot was a denial of discounts for any transfers of business interests, such as lack of marketability and minority interest discounts any time an interest in a family business enterprise was transferred between members of the same family. The Service has long been searching for a mechanism to combat the taking of such discounts and the cottage industry of business valuation, which has evolved since the issuance of Rev. Rul. 93 – 12, 1993-2 C.B. 202 in 1993. The nature of the proposed regulations indicated that the Treasury Department was intent on reestablishing the family attribution concept which had previously existed under Rev. Rul. 81-253, 1981-1 C.B. 107. The proposed regulations were exceedingly complex, almost certainly impossible to administer, and in this author’s opinion well beyond the treasury’s authority to issue regulations under section 2704 (b).
As currently issued, the proposed regulations would allow the service to disregard restrictions in the value of business interests caused by limitations on a shareholder’s ability to liquidate the enterprise which may be provided for in organization and formation documents, Operating Agreements, shareholder agreements, partnership agreements, etc. Moreover, if the transfer is one which had taken place within three years before death, the Service can “deem” the restrictions not to exist and to disregard them, accordingly. The rules would also introduce a class of “disregarded restrictions” that would not be considered at all, such as limitations on the time and manner of the payment of proceeds.
What many fail to realize, is that these proposed regulations could have resulted in the inability to utilize private annuities, sales for Self-Cancelling Installment Notes (SCINs) or straightforward installment note sales. The reason being, that the question would always arise as to whether or not “full and adequate consideration” had been paid for the assets acquired in each and every transaction, because fair market value would no longer be readily determinable. The effect of this would be that every transaction done on an intra-family basis would carry with it section 2036 risk of estate includibility. One can only imagine the uncertainty within the small business community of such a situation, and the problematic effect of how to engage in succession planning for the owners – senior generation family members, of such businesses.
It appears that Representative Sensenbrenner is both politically savvy and well aware of the effect that these Proposed Regulations will have on the business owners within his constituency, as well as being among the few who realize that Chapter 14 (2701-2704) was not designed to reinstate the family attribution argument of Revenue Ruling 81-253” (See Dees, “Parsing the Proposed Regulations under IRC Section 2704: A new Valuation Regime, or the Return of Family Attribution?”, September 12, 2016 @www.mwe.com).
It should be noted that the resulting statutory language of 2704(a) and (b) has worked very well for the better part of the past twenty-five (25) years. It is a workable statutory and regulatory framework which serves to limit the amount of revenue loss of the public fisc, etc., while enabling the smooth transition of family business enterprises and family real estate holding and other family wealth from one generation to the next without too much depletion for transfer taxes and without the need to reject the economic realities of minority and marketability discounts which are inherently present anytime an entity is owned by multiple parties, whether they are related or unrelated. There is nothing inherently sinister about a shareholder agreement, partnership agreement or operating agreement which prohibits dissolution/ liquidation of a business enterprise without a majority vote. In fact, to do otherwise would encourage anarchy in business and provide the minority with significantly disproportionate rights if they could threaten dissolution or liquidation of the business enterprise anytime they did not get their way. Likewise, the Legislative History to Section 2704(b) makes it clear that the statute was not intended to bring back the theory of “Family Attribution” set forth in Rev. Rul. 81-253, 1981 C.B. 107 which was by that time already thoroughly rejected by the Tax Court and the Circuit Courts of Appeal in cases ranging from Estate of Lee v. C.I.R., 69 T.C. 860 (1978), nonacq., 1980-2 C.B. 2. Estate of Bright v. U.S., 658 F.2d 999 (5th Cir. 1981); Propstra v. U.S. 680 F.2d1248 (9th Cir. 1982), Estate of Minihan v. C.I.R, 88 T.C 492 (1987) and Estate of Edgar A. Berg v. Commissioner, T.C. Memo 1991-279 (1991), Reversed and Remanded Berg v. C.I.R, 976 F.2d 1163 (8thCir. 1992). In the latter two cases, not only was family attribution ruled to be an invalid estate and gift tax doctrine, the Courts awarded the taxpayers litigation fees and expenses and issued a stern warning to the service that they would summarily reject the argument and award costs out of hand in the future if this type of attribution based valuation case was brought before them. Thereafter the Treasury Department implemented the ultimate acquiescence by issuing Rev. Rul. 93-12, 1993-1 C.B. 202 which revoked Rev. Rul. 81-253, 1981-1 C.B. 107 and embracing the validity of minority discounts in situations like those set forth therein and eliminated its reliance on the use of the family attribution argument.
In 1994, the Treasury Department amended the originally issued Final 2704(b) regulations to take out certain examples that were known as the disregarded partnership examples. Moreover, in TAM9449001 (3/11/04) the IRS held that the value of a donor’s gift of 100% of the stock of a closely held corporation in equal shares to each of his 11 children was determined by considering each gift separately and not by aggregating all of the donors holdings. In this way, the treasury was accepting the fact that in reality the gift tax is not based upon what the donor owns at the time of gift, or what he and his family owned collectively following the gift, rather it is based upon what each donee receives and has in his possession following the gift.
It is important to note that proposed regulations do not provide substitute for alternative provisions, but they are still subject to challenges of the validity of traditional valuation discounts. Since 1990 various commentators and educators have been of the belief that any regulations which the service would issue with regard to family limited partnerships, would be based upon an elimination of the concept of discounting interests and family limited partnerships which held passive investment assets such as stock or real estate which was not actively managed. However, there is nothing in either Chapter 14, original section 2036(c), or any other valuation provision of the code which causes active or passive business interests, or holding company interests to be taxed differently. In 1990 section 2704(b), as originally written, disregarded restrictions on the ability of a partnership or corporation to those restrictions lapse by the family. As a result of the outcry of business groups and technical experts at the time, Congress acknowledged that IRC 2704(b) was not intended to affect minority and lack of marketability discounts: rather, it was only designed to ignore “bells and whistles” which are added to an entity agreement in the hopes of expanding or enhancing the nature of the discounts when measured against those available under state law (in other words state law provides the default guidance for the taking of discounts).
As a result of this fact, the proposed regulations of 2704(b) not only violate the statutory enabling language of Chapter 14, IRC §2704, they are not constitutionally valid under the Due Process Clause as an improper taking of the property and property rights of an individual. Likewise, these proposed regulations are both over-reaching and an evisceration of the doctrine of economic reality principles of both state property law rights and their governance of the treatment of assets for transfer tax purposes. Moreover, they decry the principles of economic reality used in business valuation set forth in Rev. Rul. 59-60 (1959-1 C.B. 237), the mother of all business valuation rulings and the deciding point of every business valuation case from the Estate of Daniel Harrison, (T.C. Memo 1987-8), to Estate of Mandelbaum, (T.C. Memo 1995-255) to the Estate of Paul Mitchell, (T.C. Memo 1997-461) to Rev. Rul. 93-12 (1993 C.B. 202).
IRS Aims to Stop Undervaluation Of Transferred Interests
The IRS proposed new rules on August 3, 2016, which are intended to prevent the undervaluation of transferred interests in corporations and partnerships for estate, gift and generation-skipping transfer tax purposes. The proposed regulations, affecting the transfer tax liability of individuals who transfer an interest in certain closely held entities but not the entities themselves, address deathbed transfers that result in the lapse of a liquidation right, clarify how transfers creating an assignee interest will be treated, and add a new section to address restrictions on the liquidation of an individual interest in an entity.
Under the new rules, which the IRS is seeking comments on before finalization, the form of an entity would be determined under local law, regardless of how the entity is classified for other federal tax purposes and regardless of whether it is disregarded as an entity separate from its owner under federal tax laws. A transfer which results in the restriction or elimination of any of the rights associated with the transferred interest is treated as a lapse, and the proposed rules will narrow the exception to the definition of a lapse of a liquidation right to transfers occurring at least three years before the transferor’s death. This three year no-lapse restriction provision which would otherwise result in the asset being deemed to lapse solely for transfer tax purposes should actually be more aptly placed, if at all, in the provisions of IRC §2035, an action which would require an act of Congress.
The preamble to the post regulations offers three reasons for their promulgation in the current fashion:
1. Kerr Estate limited to a liquidation restriction to a restriction on the liquidation of the entity and not the liquidation of an owner’s interest in the entity.
2. Changes in state law that are designed to make default provisions more apt to restrict liquidation.
3. Use of nominal interests to avoid the application of IRC Section 2704(b).
The treasury blog from August 2, 2016, offered an additional reason: “it is common for wealthy taxpayers and their advisors to use certain aggressive tax planning techniques to artificially lower the taxable value of their transferred assets. By taking advantage of these techniques, certain taxpayers or their estates on closely held businesses or other entities can end up paying less than they should in estate or gift taxes. Treasury’s action will significantly reduce the ability of these taxpayers and their estates to use such techniques solely for the purpose of lowering their estate and gift taxes.”
Since 1993 it has been noted by many practitioners that a variety of states have implemented limited liability company and partnership statutory restrictions on dissolution and liquidation which are primarily designed for the sole purpose of enhancing the use of that state’s limited partnership or limited liability company laws to form entities within those states which bear little or no relationship to the taxpayer’s business operations, residence, or the location of their real property. It is believed that taxpayers are availing themselves of these states solely for the purpose of enhancing the level of discount available for valuation purposes for both gift and estate tax purposes.
However, no one really knows what the future application of these regulations would be in the event that they are finalized in their current form, to wit: Prop. Reg. Section 25.2704-3(f) “Effect of disregarding a restriction. 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. For this purpose, local law is the law of the jurisdiction, but the domestic or foreign, under which the entity is created organized.” If no right to withdraw or liquidate an entity is provided under state law or entity documents, the entity will continue without liquidating all withdrawals (except for a general partner). Under state law, liquidation of any entity is authorized not restricted. Because section 2704 (b) does not authorize the Treasury Department to provide alternative terms for disregarded restrictions the proposed regulations may have sought to avoid this limitation by merely implying the existence of a right to liquidate.
Perhaps Congressman Sensenbrenner was merely trying to win votes from his business constituents, but it is possible that he was trying to prevent the Treasury Department from embarrassing itself in situations where the absence of a right of liquidation or dissolution would lead to a higher value for an interest in an enterprise than might otherwise be the case if the right or restriction were recognized for tax purposes and valuation purposes. For example, if a GRAT were to be created with an interest in an enterprise, and under current law the restrictions result in a low valuation per unit, the implementation of the proposed regulations might result in the use of higher value units of the enterprise for the payment of the GRAT’s obligatory annual payment to the grantor. In such a case, the regulations would serve to whipsaw the treasury and benefit the estate plan of the grantor and an overall context. Whatever his justification for this unique Bill designed to nullify the proposed regulations if implemented, it is possible that it was either for the protection of the government, the belief that the provisions are outside the authority of the Treasury Department to promulgate, or the desire to maintain the status quo rather than to have these ill-conceived regulations invalidated at some later point. The last statement being based upon the fact that it is likely that any challenge to the validity of the regulations is most likely to take place in a high dollar value case.
The rules introduced by the IRS will ultimately raise estate taxes by making people report a much higher value for their company than they would under current law. The agency said the rules were needed because existing regulations have been largely rendered ineffective by changes in state laws and court rulings, and it wanted to stop family-owned businesses from being able to make transfers with discounts and restrictions that it deemed unreasonable. Experts say the proposed regulations are complex and will require more time to parse through to truly understand their full scope, but their early analyses suggest the rules are overly broad, fail to provide clarity and may instead be adding confusion to the tax treatment of these transfers. The immediate impact of the rules is that they put family-owned businesses under a great deal of pressure to complete affected transactions before the end of the year when the rules may get finalized, experts say. A public hearing on the proposals is scheduled for Dec. 1.
There are professionals who have explained the obvious, to wit: that the agency is really trying to do away with the practice of senior generations restructuring a business while allowing the future value to go to the younger generation in the family while escaping estate and gift taxes. For people who try to use various restrictive and entity based techniques such as FLPs and FLLCs in an attempt to discount their assets so they can get more out of their estates, the IRS is clearly, and without appropriate authority, trying via these proposed regulations to reduce or eliminate the ability to do so. If you’re unable to get as much value out of your estate by doing this kind of planning, then you would have more value left in your estate that is subject to estate tax. The proposed regulations also disregard provisions that individual states allow, contrary to what the Internal Revenue Code provides, and as such the rules are both unenforceable and likely unconstitutional, if enacted in their current form.
It is the opinion of this author and more than one other, that the Service has clearly and markedly exceeded its regulatory authority by changing the Congressionally-imposed “and” to an IRS-imposed “and/or.” (See Blaise, Source URL: http://wealthmanagement.com/estate-planning/portions-proposed-2704-regulations-exceed-irs-authority; and Versprille, IRS Expected to Face Pushback Against New Estate Tax Rules; Practitioners warn the new regulations are a court case waiting to happen. Trusts & Estates. Copyright 2016 by The Bureau of National Affairs, Inc. Source URL: http://wealthmanagement.com/taxes/irs-expected-face-pushback-against-new-estate-tax-rules.
Congress granted the IRS certain regulatory authority in IRC § 2704(b)(4):
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. Congress thus gave the IRS authority to disregard other restrictions, which the IRS clearly has done by proposing new Treasury Regulations Section 25.2704-3, but Congress didn’t grant the IRS authority to make other unilateral changes to the Internal Revenue Code, which it clearly has also done by changing the key concurrent word “and” to the concurrent or disjunctive phrase “and/or.” (See Blasé, Supra). Evidence that Congress knew how to employ the concurrent and disjunctive “and/or” concept can be found in the separate IRC §2704(b)(2)(B)(ii), which deals with the situation after the transfer: “The transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.” The IRS itself has also demonstrated that it understands the difference between the “immediately before” and “after” sections and the use of the word “and” versus the phrase “and/or,” by choosing to employ the following language in proposed regulation Section 25.2704-2(b)(1): “. . . if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor’s estate, and/or any member of the transferor’s family, either alone or collectively.” (See Blasé and Versprille). Moreover, It is clear from the language of 2704(b)(3) that the very definition of an “applicable restriction” “shall not include: (A) any commercially reasonable restriction which arises as part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either, or (B) or any restriction imposed, or required to be imposed, by any Federal or State Law.” (Emphasis Added). The fact is that there are no legal rights to liquidate to be read into Common Law, or into any state’s business corporation law, or any version of ULPA, RULPA or the ULLCA, or any state’s LLC act. The Treasury Department seems to believe that by setting out the wording of the Regulations backwards, there will be a cleansing of the erroneous construction thereof.
It is my sincere belief that the release of this bill and its timing and limited language are proof that it was primarily politically motivated. After all when and why does Congress ever pass legislation which is designed to target and invalidate a series of Treasury Regulations that have not yet even been finalized as of the point of introduction of the legislation? Whatever the real motivation, the belief among most practitioners is that these Proposed Regulations are so overly defiant of the realities of the economics of business and so devoid of the consideration of state law property rights and its control over the valuation of property/ assets for gift and estate tax purposes, that the maxim holds no water in this situation. While the Secretary of the Treasury may be empowered under the Statute to promulgate regulations in the context of Chapter 14, they MUST, nevertheless be consistent with the intention of the statute. The intention of Congress in enacting IRC §2704(b) in 1990 was not to change state law property rights and create a regime whereby fantasy once again overwhelms the transfer tax system. After all, that was why they repealed IRC §2036(c) and replaced it with Chapter 14 twenty-six (26) years ago, in the first place. Economic reality and state law property rights must be more appropriately represented in any set of regulations that the Treasury Department is going to put forward. Smart move Rep. Sensenbrenner.
Oct. 10, 2016 / by Steve Horowitz
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