Estate Planning Regulation Impacts Small Business And Estate Tax Planning Strategies

new estate planning regulations

The government lost estate and gift tax cases that attracted headlines. In response, the Department of Treasury (“Treasury”) proposed new regulations in early 2016 that would amend definitions in the 1992 regulations that were problematic in the court cases. In addition, Treasury it added requirements designed to defeat valuation discounts in the estate and gift tax areas.

The 1992 Regulation

The 1992 regulation gave IRS the right to disregard certain provisions in shareholder partnership and operating agreements for purposes of estate and gift tax valuation. The 1992 regulations defined an applicable restriction, however, it applied only to a transferor and members of his or her family. An applicable restriction effectively limits the ability to liquidate the entity (in whole or in part) and is more restrictive than a limitation imposed by state law. The law in many states limits the ability of a partner in a partnership or a member in a limited liability company to liquidate the entity. The result was that one could rely upon state law to avoid any problem. A second aspect of the regulation was the definition of a lapse. A liquidation right would lapse when it was eliminated or restricted, so the mere transfer of an interest that held such a right was not a lapse. These rules provided a clear framework for planning and were an obstacle for the government.

The Proposed Regulations

The proposed regulations created a new class of restrictions called disregarded restrictions which are focused on impacting valuation. The first disregarded restrictions is any provision that limits or permits liquidation can be disregarded. Second, any amount received on liquidation or redemption is disregarded if it is less than minimum value. Minimum value is the pro rata share of the enterprise and this prevents discounts. Third, payment is deferred beyond six months after notice of liquidation is given may also be disregarded. Fourth, the agreement permits payment to be in any manner other than cash or property. Debt obligations of the entity are not property for this purpose unless the entity is engaged in an active trade or business.

The proposed regulations address state law restrictions. Only a state or federal law restriction that cannot be changed by the governing documents will not be an applicable restriction. In most states, the statute is the default rule so it is expected that any restrictions would have to be imposed by the written agreement. This change would impact discounts for lack of control and was intended as such.

The 1992 rules only applied to families while the proposed rules would expand coverage beyond the prior definition of family. An interest owned by a non-family member would be disregarded unless: (i) it was held for three years before the transfer under examination; (ii) the interest constituted 10% or more of the equity; (iii) nonfamily members must own 20% or more of the equity; and (iv) the nonfamily member has a put right on the terms specified in the proposed rules.

Additional Changes

There are additional changes, such as an assignee’s interest would be treated as a lapse in order to reduce or eliminate discounts which have haunted the IRS in the past. Finally, there are inconsistencies in the application of the effective date or dates. For example, if the new regulations are effective upon adoption or 30 days thereafter, then how can the rules require that an interest of a non-family member be held for three years? In effect, a blackout period is created by regulation.

What is clear is that Treasury and the IRS want to end discounts. The public hearing on the regulations attracted many negative comments from small business owners and professional organizations. This outcry and a change in the administration may put these regulations on hold. Succession planning faces a major hurdle if these rules are ever adopted in the present form.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, James McDonough, at 201-806-3364.

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James F. McDonough, Jr. concentrates on wealth preservation and estate planning for high net worth individuals, closely held business matters and ownership succession, estate administration and income tax planning. He worked for three years for the public accounting firm, then known as Touche Ross, where he obtained his license as a Certified Public Accountant in 1983. In 1984, he was employed as a tax attorney by Union Camp Corporation where he engaged in planning for corporate income deferred compensation, qualified plan and tax-free exchanges. In 1986, Mr. McDonough was employed as Tax Manager for Monroe Systems For Business, Inc. Thereafter, he was employed as a tax attorney for five years where he engaged in corporate and estate tax planning and estate administration and litigation. For more information, please visit James McDonough's full biography at Scarinci Hollenbeck

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