• Proposed regulations under Internal Revenue Code Section 2704 significantly reduce valuation discounts—The Treasury has released proposed regulations (REG-163113-02) under IRC Section 2704 regarding lapses of voting and liquidation rights and transfers of interests in closely held entities. The regulations expand the types of restrictions that will be ignored when valuing a transfer and therefore eliminate the justification for various discounts. Section 2704 generally applies to interests in corporations and partnerships—the proposed regulations clarify that they would also apply to limited liability companies.
Section 2704(a) currently treats the lapse of a voting or liquidation right as a taxable transfer only if the rights are restricted or eliminated with respect to the transferred interests. Therefore, Section 2704(a) wouldn’t apply if a transferor gave an interest away and the voting or liquidation rights attendant to the interest remained (so that the donee received the interest with those rights) even though after the transfer, the transferor no longer had a presently exercisable right because of his reduced ownership interest. The proposed regulations expand the reach of Section 2704(a) so that it will apply to transfers by a transferor within three years of the date of the transferor’s death, subject to certain conditions. As a result, the proposed regulations will treat certain transfers occurring within three years of death that reduce the transferor’s voting and liquidation control (even if the voting or liquidation rights aren’t restricted or eliminated with respect to the transferred interest) as taxable lapses occurring at death. The proposed regulations give an example. If a taxpayer transfers 30 shares of common stock to his child more than three years before his death, there’s no lapse of a liquidation right because the voting rights aren’t restricted or eliminated. But, if the taxpayer dies within three years of the transfer, it would be treated as a lapse of a liquidation right occurring on his death.
Section 2704(b) disregards applicable restrictions when valuing an interest in a closely held entity. Currently, an “applicable restriction” is defined to be a limitation on liquidation of an entity that’s more restrictive than those that would be applicable under local law or one that the family can’t remove. In response to the statute, many states have heightened the default restrictions on liquidation by statute, so that any restriction in a partnership agreement that matches the default restrictions would meet the exception and not be considered an applicable restriction. The proposed regulations, for all practical purposes, remove the applicable law exception and therefore broaden the definition of “applicable restrictions” that are ignored for valuation purposes.
In general, any restriction on a member’s right to liquidate his interest will be disregarded if the restriction will lapse at any time after the transfer or if the transferor, or the transferor and his family members, without regarding non-family members, can remove the restrictions. In addition, the proposed regulations create a new class of restrictions (disregarded restrictions) that would also be disregarded for valuation purposes. These are restrictions that: (1) limit the holder’s ability to liquidate his interest (as opposed to the entire entity), (2) limit the liquidation proceeds to less than a minimum value, (3) defer payment of the liquidation proceeds for more than six months, and (4) permit non-cash payment of the proceeds (except for certain promissory notes).
There are exceptions for these new disregarded restrictions. There’s an exception if each holder of an interest in the entity has an enforceable put right to receive cash or value equal to the minimum value within six months notice. In addition, when determining whether the family can remove a disregarded restriction, a non-family member’s interest will be disregarded if: (1) the non-family member has held it for less than three years, (2) the interest is less than 10 percent of all of the equity (or capital and profits) interests in the entity, (3) all non-family members’ interests in the entity are less than 20 percent of the total capital and profits interests, or (4) the non-family member doesn’t have an enforceable right to receive a minimum value within six months notice.
The proposed regulations apply to operating businesses and family limited partnerships (FLPs) with liquid assets alike, if they’re controlled by the family. “Control” is defined as either: (1) 50 percent or more of the capital or profits interests, or (2) holding any equity interest with the ability to cause the full or partial liquidation of the entity.
These regulations will greatly impact lifetime and testamentary transfers of interests in FLPs and operating businesses that are controlled by the transferor’s family.
These regulations will be effective when final regulations are issued. A public hearing on the proposed regulations is scheduled for Dec. 1. Before then, practitioners should advise clients considering making transfers of discounted assets to do so soon.
• Internal Revenue Service rules that reformation doesn’t have effect for purposes of determining designated beneficiary—In Private Letter Ruling 201628004 (March 30, 2016), the IRS ruled that an individual retirement account beneficiary designation reformed under state law wasn’t recognized for income tax purposes, ultimately holding that the IRA was payable to the decedent’s estate and therefore had no designated beneficiary. The decedent had designated three trusts as beneficiaries of his IRA. The three trusts were described as “look through trusts.” The decedent later moved the IRA to a new custodian and, in the process, inadvertently designated his estate as the IRA beneficiary.
After his death, the error was discovered, and the trustees of the trusts petitioned a local court to modify the beneficiary designation to carry out the original estate plan. The court ordered the three trusts as the beneficiaries of the IRA. Then, the trustees requested a ruling that the minimum required distributions (MRDs) could be paid out over the life expectancy of a trust beneficiary.
However, the IRS ruled that the order from the state court didn’t affect IRC Section 401(a)(9) and therefore, there was still no designated beneficiary. As a result, the MRDs had to be paid out over the life expectancy of the decedent.
• IRS rules that generation-skipping transfer (GST) tax exemption was automatically applied to gifts even though they weren’t properly reported on gift tax return as indirect skips—In PLR 201628007 (released July 8, 2016), the settlor reported various gifts to trusts over several years on Schedule A, Part 1, of Form 709 as gifts subject only to gift tax. The settlor and his spouse elected to split the gifts. Because the gifts were reported on Part 1 (and not on Part 3, as indirect skips), no allocation of GST tax exemption was made or shown on Schedule C.
The settlor sought a ruling to determine if GST tax exemption was automatically allocated to these transfers. The IRS ruled that the trusts met the definition of GST trusts. Therefore, the transfers were indirect skips. The improper reporting of the gifts as transfers subject only to gift tax didn’t change this conclusion. The automatic allocation is effective whether or not a Form 709 is filed and as of the date of the transfer. As a result, GST tax exemption was automatically allocated to each of the transfers as of the date of the transfer.
• Massachusetts Supreme Judicial Court rules that trusts are subject to Massachusetts fiduciary income tax even though corporate trustee had domicile outside of the state—The Supreme Judicial Court of Massachusetts upheld a decision by the Appellate Tax Board, which ruled that Bank of America was an inhabitant of the state even though it wasn’t domiciled there. Massachusetts imposes a fiduciary income tax on resident trusts, and to be considered a resident trust, several requirements must be met. One of those requirements is that at least one trustee must be an inhabitant of the state.
In Bank of America v. Commissioner, 474 Mass. 702 (July 11, 2016), Bank of America filed abatement claims relating to 34 trusts of which it served as trustee, claiming that it wasn’t an inhabitant of Massachusetts. Although the statute relating to the residency of trustees was initially drafted to relate to natural persons, another section of the statute provides that corporations acting as trustees are subject to the law in the manner of, and under the same conditions as, individuals. The question was how to determine whether the bank was an inhabitant. The Appellate Tax Board held that a corporation will be an inhabitant if it maintains a permanent place in the Commonwealth, continues to be present for the required period of time (183 days a year) and conducts trust administration activities in Massachusetts, which include, in particular, material trust activities relating specifically to the trusts at issue. Under this rule, Bank of America was an inhabitant of the Commonwealth, causing the trusts to be considered resident trusts and subject to Massachusetts tax.
The bank didn’t raise any constitutional issues, and the court deemed them to have been waived. So, the court didn’t have the opportunity to rule on the dormant commerce clause.