2704 Regs May Eliminate Discount: Practitioners Must Plan Now

Most practitioners are aware by now that the Treasury has proposed regulations under Code Section 2704 that would generally eliminate valuation discounts on transfers of interest in family entities. This means that practitioners should advise all wealthy clients to review planning options before year-end when these new rules might become effective.

The AICPA will examine the regulations and offer comments at the Dec. 1 IRS hearing; however, to be safe, advisers should proceed with the assumption they will take effect as is. Outlined below are four practical planning steps practitioners should address with their clients before year-end.

Step 1: Identify Clients Affected

Clients who own large real estate or valuable family businesses that can currently be discounted for transfer tax valuation purposes, but which may not be able to be discounted after the effective date of the regulations, should focus on planning for the new regulations. In 2012, when the estate tax exemption was modified from $5 million to $1 million, many clients rushed to modify their plans in advance of this change. We will likely experience similar activity this year, as clients strive to complete planning to address the discount rush before year-end.

Step 2: Identify and Address Legal Impediments to Planning

Although a client might benefit significantly from consummating transfers (by gift or sale) to family members or trusts for family or other heirs before year-end, practitioners should discuss with their clients whether those transfers can actually be made. If the client owns interests in real estate LLCs, it might be critical to secure a discount to make planning successful. However, the threshold issue might be whether the approval of a lender, anchor tenant or co-owner is required before those transfers can be made.

Since this might take time, practitioners should advise potentially affected clients to have their attorneys review all governing legal documents and obtain any approvals necessary to transfer. This is much more restrictive and time sensitive than 2012 planning, when any asset or even cash borrowed on an asset could have been given to accomplish planning objectives. In 2016, if the actual equity interests cannot be transferred, gifts or sales to lock in discounts may not be feasible. If a modification to a shareholder’s agreement or other type of approval needs to be obtained to permit gifts or sales of equity interests, that process should be undertaken now. The time delays and possible costs of obtaining third-party approvals could be significant.

Step 3: Determine Interests to be Transferred and Receptacles to Receive those Interests

Practitioners need to determine which business entity interests are advisable to transfer, and to whom they should be transferred (e.g., a child or a particular type of trust). This step is an interrelated step. In most cases, transfers should be made to trusts and not directly to heirs in order to ensure control of the family business interests and protect those interests from possible divorce or other legal actions against the recipient. If equity interests are sold, it may be a good planning opportunity to designate a grantor trust as recipient, if the value exceeds the client’s remaining gift tax exemption. This will avoid current capital gains on the sale of the discounted equity interests. Thus, for larger transfers, a grantor trust might be the default approach.

Determine whether those trusts should be formed in trust-friendly jurisdictions (e.g., Alaska, Nevada, South Dakota or Delaware). The manner in which the receptacle trust and the mechanism of consummating the transfer to that trust (or trusts) will depend on a number of factors: client age and health, client need for cash flow or access to funds transferred, tax status of the entity (e.g., S corporation or not), etc. For example, if the client will need cash flow from the entity in retirement, selling rather than gifting interest might be advisable so that note payments can provide cash flow.

Step 4: Value the Interests to be Transferred

Undertake the value of the underlying assets and non-controlling interests in the business to be transferred. The fact that after the regulations become effective, discounts might be eliminated does not mean that the IRS will not challenge discounts on transactions consummated before the effective date. Appraisal reports should be prepared meeting all requirements necessary to be respected by the IRS.

For more information on this topic, the AICPA’s Personal Financial Planning Division has created a resource page containing multiple podcasts and articles on how advisers can plan for the proposed regulations.

Martin Shenkman, CPA, MBA, PFS, AEP, JD, Shenkman Law. Martin focuses on estate and tax planning. He is the author of more than 42 books and 1,000 articles, and is a quoted expert on tax matters. Martin is also known for his active charitable work, which has been profiled in Forbes.

Family business image courtesy of Shutterstock

2704 Regs May Eliminate Discount: Practitioners Must Plan Now

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