The IRS has at last issued long-anticipated proposed regulations under Code §2704.  We perceive the proposed regulations as an attempt by the IRS to curtail the use of discounts – such as minority interest and lack of marketability discounts – in valuing transfers of interests in family-controlled entities for gift and estate tax purposes.

“Family limited partnerships” – that is, family investment entities usually structured as LLCs or limited partnerships – have been a popular estate planning technique for years.  Generally speaking, a client can transfer non-voting, non-marketable interests in these types of entities to children or a trust, and claim a valuation discount due to the restrictions that apply to the interest transferred.

Code §2704 provides that certain “applicable restrictions” on ownership interests in family entities, ie, entities where the transferor and family members control the entity, should be disregarded for valuation purposes.  The statute also permits the IRS to issue regulations providing for other restrictions (as determined by the IRS) to be disregarded in determining the value of a transfer to a family member, if a restriction has the effect of reducing the value of the transferred interest but does not ultimately reduce the value of such interest to the transferee.

The proposed regulations make two overarching changes.  First, changes under Code §2704(a) create new rules relating to a lapse of a liquidating right.  These changes are less relevant, at least in our practice, as we generally do not structure entities to include liquidation or other rights that lapse.

Second, changes under Code §2704(b) create a new concept of “Disregarded Restrictions.”  Under the proposed regulations, a restriction that will lapse at any time after the transfer, or a restriction that may be removed or overridden by the transferor (or the transferor and family members acting together) will be disregarded for gift and estate tax valuation purposes.  This is the case even if the restriction on the interest is pursuant to state law rather than a governing business agreement.  There are certain exceptions – for example, an owner’s right to liquidate or “put” his or her interest to the entity and receive cash within six months is not considered a “disregarded restriction.”

The effect of this rule appears to be that it would eliminate minority interest discounts, because the holder of any interest would be deemed to be able to liquidate his or her interest in the entity without restrictions.  The effect of the proposed regulations on lack of marketability discounts is unclear, although it seems the IRS similarly could argue for a small or zero lack of marketability discount on the theory that the holder of the interest is deemed to be able to liquidate the interest.

Thus, if the proposed regulations are adopted in their current form, they likely will increase the value for gift and estate tax purposes of transfers of interests in family-controlled entities.

The proposed regulations are controversial.  Commentators already have questioned whether the Treasury has exceeded its statutory authority in issuing the proposed regulations.  The proposed regulations are (at least in this author’s opinion) complicated and ambiguous, and perhaps unfair.  For example, if a client creates an LLC to purchase and manage a commercial property, and the client transfers an interest in the LLC to his or her child, and the interest is subject to typical restrictions on sale of the interest or the ability of a member to liquidate (largely because the asset owned by the LLC is illiquid and perhaps leveraged), then it seems that the true value of the interest transferred to the child would be reduced due to these restrictions (think about what a willing buyer would really pay the child for the LLC interest); however, under the proposed regulations, the value of the LLC interest transferred would be artificially inflated for gift tax purposes.

The proposed regulations are not effective until they are finalized.  Treasury has requested written comments by November 2, 2016 and a public hearing on the regulations is scheduled for December 1, 2016.

The Supreme Court has recently struck down state bans on same-sex marriage as unconstitutional in Obergefell v. Hodges, 576 US ___ (2015), after previously striking down the federal exclusion of same-sex couples from marriage-related laws in US v. Windsor, 570 US ___ (2013).  The Internal Revenue Service (IRS) has now followed suit to recognize same-sex marriage for all federal tax purposes, including income, estate, gift, generation-skipping, and employment tax.

On October 23, proposed regulations were published in the Federal Register, which redefine the terms “husband” and “wife” under Section 7701(17).  Both terms will now mean an individual lawfully married to another individual, and the term “husband and wife” will mean two individuals lawfully married to each other. These definitions would apply regardless of sex.  Prop Reg § 301.7701-18(a).  The IRS is accepting comments for a limited time.

However, the proposed regulations redefining marriage will not apply to domestic partnerships, civil unions or other relationships. Prop Reg § 301.7701-18(c).  The couples’ choice to remain unmarried is respected by the IRS as deliberate, for example, for purposes of preserving eligibility for government benefits or avoiding the tax marriage penalty.  Preamble to Prop Reg 10/21/2015.  In addition, a marriage conducted in a foreign jurisdiction will be recognized for federal tax purposes only if the marriage would be recognized in at least one state, possession, or territory of the United States.  Preamble to Prop Reg 10/21/2015.

Experts have started to calculate the inflation adjustments to key estate and gift exemption amounts for 2016. Note that these are not the official figures to be released by the IRS, but should be used as a guide. The IRS will officially release the numbers later this year.

For an estate of any decedent dying during calendar year 2016, the applicable exclusion is increased from $5.43 million to $5.45 million. This change increases not only the applicable exclusion amount available at death, but also a taxpayer’s lifetime gift applicable exclusion amount and generation skipping transfer exclusion amount. This means a husband and wife with proper planning could transfer $10.90 million estate, gift and GST tax free to their children and grandchildren in 2016.

The estate, gift and GST tax rate remains the same at 40% and the gift tax annual exclusion remains at $14,000.

While the New Jersey state exclusion amount remains unchanged at $675,000, the New York exclusion amount was changed as of April 1, 2014. Beginning April 1, 2014, the exclusion is as follows:

• $2.0625 million for decedents dying between April 1, 2014 through March 31, 2015;
• $3.125 million for decedents dying between April 1, 2015 through March 31, 2016;
• $4.1875 million for decedents dying between April 1, 2016 through March 31, 2017;
• $5.25 million for decedents dying between April 1, 2017 through December 31, 2018. Beginning in 2019, the exclusion would be indexed for inflation, and equal to the Federal exclusion.

The gift tax annual exclusion to a non-citizen spouse has been increased from $147,000 to $148,000. While gifts between spouses are unlimited if the donee spouse is a United States citizen, there are restrictions when the donee spouse is not a United States citizen.

“Family limited partnerships” – that is, family investment entities usually structured as LLCs or limited partnerships – have been a popular estate planning technique for years. Generally speaking, a client can transfer non-voting, non-marketable interests in these types of entities to children or a trust, and claim a valuation discount due to the restrictions that apply to the interest transferred. It appears, however, that the IRS will soon release proposed regulations under Code §2704 that are expected to limit the use of valuation discounts in these situations.

Code §2704 governs certain “applicable restrictions” that may apply to ownership interests in family entities. The law provides that certain restrictions are disregarded for valuation purposes. The law also permits the IRS to issue regulations providing for other restrictions (as determined by the IRS) to be disregarded in determining the value of a transfer to a family member, if a restriction has the effect of reducing the value of the transferred interest but does not ultimately reduce the value of such interest to the transferee.

After including new Code §2704 regulations on its list of priority guidance for the past 11 years, it appears (based on comments made by an IRS spokesperson to the ABA Tax Section) that the IRS will soon issue these regulations. While the scope and specifics of the regulations are unknown, it is expected that the proposed regulations will restrict the use of discounting by defining new restrictions that are to be disregarded when valuing a transfer of an interest in a family entity. The effective date of the proposed regulations and possible “grandfathering” opportunities are also currently unknown.

Accordingly, if you have been considering this type of estate planning transaction, it would be prudent to contact us and discuss with one of the attorneys in our group.

The New York State Legislature passed the Executive Budget for 2014-2015 on March 31, 2014, which brings about important changes to New York estate and gift tax laws.  These include:

Estate tax exemption increase.  Effective April 1, 2014, the New York State estate tax exemption increased to $2,062,500 for New York residents dying between April 1, 2014 and April 1, 2015 and will increase to $3,125,000 on April 1, 2015, $4,187,500 on April 1, 2016 and $5,250,000 for taxpayers dying between April 1, 2017 and January 1, 2019.  Beginning on January 1, 2019, the exclusion will be indexed for inflation taking into consideration cost-of-living adjustments.  In 2019, the New York exemption is scheduled to equal the federal estate tax exemption.

The top tax rate will remain at 16% rather than a reduction to 10% as proposed by Governor Cuomo.

New York has not adopted the concept of “portability,” which would permit a surviving spouse to utilize any estate tax exemption unused by the decedent spouse.  For this reason, estate planning tools such as qualified disclaimers should continue to be used to capture the decedent’s exemption absent portability.

Estate tax cliff.  The New York estate tax exclusion increase will benefit those estates equal to or below the estate tax applicable exclusion amount at the time of a decedent’s death while those estates that are between 100% and 105% of the exclusion amount will rapidly lose the benefit of the exclusion due to a phase-out computation.  However, no credit is allowed for New York taxable estates exceeding 105% of the basic exclusion amount.  Instead, these estates will be taxable in their entirety.

For example, assume an applicable estate tax exclusion amount of $2,062,500 at the time of a decedent’s death.  Under the new laws, if the decedent’s estate is valued at $2,062,500, the entire estate escapes New York estate tax.  However, if the estate is instead valued at $2.2 million, which represents more than 105% of the basic exclusion amount of $2,062,500, then the entire estate is subject to taxation, resulting in a tax of $114,800.

Pursuant to the new brackets, an estate exceeding 105% of the New York exclusion amount that is fully subject to New York estate tax will effectively owe the same amount that was owed under prior law.

Lifetime gifts added back to estate.  The new law also provides that all taxable gifts not otherwise included in the Federal gross estate and that were made during the three years ending on the decedent’s date of death will be included as part of the New York gross estate for purposes of calculating the New York estate tax.  This significant change in law does not apply to gifts made while the decedent was not a resident of New York State nor to gifts made prior to April 1, 2014 or on or after January 1, 2019.