Last year, the IRS proposed regulations to stem abusive practices related to the use of family limited partnerships (FLPs) and other family-controlled businesses.
The regulations would have eliminated (or substantially reduced) the valuation discounts for lack of control and marketability that have made these gift and estate planning vehicles attractive to large family businesses. The IRS estimates that valuation discounts average 37% (combined) for these entities. So, significant dollars were at stake.
But the IRS entirely withdrew this proposal. Here's why the IRS dropped the proposal, along with other possible changes to the tax laws that could have major implications for estate planning.
Controversy over Section 2704
In April, President Trump ordered the U.S. Treasury Department to review major Obama-era tax regulations and identify those that are particularly complex or burdensome to taxpayers. One of the projects under Treasury scrutiny was proposed regulations under Section 2704 on liquidation restrictions for gift, estate, and generation-skipping transfer taxes.
The proposed regulations included provisions to:
- Amend existing rules on what constitutes control of a limited liability company or other entity or arrangement that isn't a corporation, partnership or limited partnership,
- Address death-bed transfers (made within three years of the transferor's death), and
- Modify what's considered an "applicable restriction" by eliminating a comparison to the liquidation limitations of state law.
The proposal also would have added various types of "disregarded restrictions" to the regulations to rein in valuation discounts.
If approved, the regulations would have had far-reaching and severe economic effects according to a report published in May by Sonecon, a financial consulting firm founded by Robert Shapiro, former U.S. Under Secretary of Commerce. The report estimates that the proposal would increase estate taxes for large family businesses by 60% or $633.3 billion (in present dollars) over the next 46 years.
Furthermore, the report concludes that, if family businesses reduced their capital budgets by an amount equal to the additional tax they would owe, they would:
- Invest less money in equipment and machinery, reducing gross domestic product (GDP) by nearly $2.5 trillion (in present dollars) over the next 46 years, and
- Hire fewer employees, eliminating roughly 106,000 jobs over the next decade.
Major opponents of the Sec. 2704 proposal include the Real Estate Roundtable, the Private Investor Coalition, the Independent Community Bankers of America, the S Corporation Association, and the Associated Builders and Contractors. Together with family business owners and conservative lawmakers, these business groups told the Treasury that these rules were simply too broad and onerous to family businesses.
In October, the Treasury announced that it would withdraw the proposal. So, FLPs (and similar entities) remain viable estate planning tools . . . for now.
However, congressional Republicans have proposed a tax reform framework that calls for the elimination of the estate tax. The framework doesn't address gift tax or whether assets would be inherited on a stepped-up basis. If not, heirs could incur substantial capital gains when inherited assets are eventually sold.
As of this writing, neither the U.S. House of Representatives nor the Senate has introduced any tax reform legislation based on this framework. So, the details are uncertain and elimination of the estate tax isn't a sure thing.
Dos and Don'ts
In the meantime, if you already have an FLP in place or would like to add an FLP to your estate plan, don't be lulled into a false sense of complacency. Just because the Treasury has withdrawn its recent proposal, that doesn't mean the IRS won't continue to scrutinize FLPs, especially those that engage in certain estate planning faux pas.
Partnership Best Practices
Here's a list of some best practices when it comes to setting up and administering your partnership:
- Do set up your partnership for a bona fide, nontax business purposes, such as efficient asset management and protection from creditors.
- Don't engage in deathbed transfers (within a few years of the donor's death or when the donor is in poor health).
- Do respect partnership formalities, such as having a partnership agreement, annual meetings, and separate bank accounts.
- Don't comingle personal and FLP assets or retain ongoing economic benefits from the partnership's assets.
- Do hire a credentialed business valuation professional to appraise private business interests and quantify valuation discounts for lack of control and marketability.
Valuation pros consider a variety of factors when quantifying valuation discounts, such as the nature and composition of the partnership's underlying assets, historical and expected income distributions, current market conditions, partnership agreement rights and restrictions, and state laws. Do-it-yourself valuations are unlikely to pass IRS muster.
Check with your valuation advisor before making any year-end estate planning decisions. Although the IRS had withdrawn its proposal to eliminate FLP valuation discounts under Sec. 2704, many uncertainties remain. The valuation community is watching congressional tax reform efforts and can help you manage any major developments.
LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA, CVA
Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters.