Are Family Limited Partnership Discounts About to End for Newly Formed FLPs?

Is There a Reason to Act Soon? Will the IRS Prevail this Time?

The IRS is considering issuing proposed Section (SEC) 2704(b)(4) regulations to limit the availability of discounts for lack of control and lack of marketability. The article highlights the need to communicate with estate and gift tax attorneys that have discussed forming a FLP. While practitioners do not know what is being proposed, the §2704 legislative proposal (last included in the Fiscal Year 2013 Greenbook dated February 2012) includes items considered eight years ago, which includes adding additional disregarded restrictions and restrictions on assignee interests.

It is reported that at a recent ABA Tax Section meeting, Catherine Hughes, an Estate and Gift Tax Attorney Advisor in the Office of Tax Policy of the U.S. Treasury Department, said the IRS will soon (later this Summer or Fall) release proposed SEC 2704(b)(4) regulations to “restrict or eliminate” discounts for transfers of family owned entities.  (The consensus amongst tax practitioners is that the proposed regulations will be issued before the fall ABA Section of Taxation meeting scheduled for September 17-19, 2015.)

The newly proposed regulations may impact family entities formed after the regulations are released.  So there is reason to consider forming FLPs soon, before the proposed regulations are issued.  In its current form, SEC 2704(b) reads as follows:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

By way of background, SEC 2704 was enacted to limit the use of valuation discounts in connection with gifts of interests in family owned entities.  The concern then was that business owners/transferors were imposing restriction on the transferred interests that had the effect of reducing the value for gift tax purposes even though the economic value of the transferred interest was not affected.  SEC 2704(b) ignore certain “applicable restrictions” on liquidation that would normally justify a value discounted for lack of control and/or marketability in valuing interests in family-controlled entities if those interests are transferred to other family members.

For business valuators that appraise FLPs in their practice, this is a development that needs to be monitored.

Over the years, the IRS has unsuccessfully battled FLP discounts.  The addition of new proposed regulations, if sustained against inevitable court challenges, may eliminate discounts for estate and gift filings.  As valuators, we have repeatedly argued successfully the value of partnership units is less than direct ownership of the underlying assets.  Steve Akers, in a June 2015 release on this subject, observed that while there is reason for concern, “a regulation disallowing discounts in certain situations may actually be advantageous for many decedent’s who do not owe estate tax but would benefit from a stepped-up basis at death to the undiscounted value of the assets” [assuming the value determined under 2704 is recognized for purposes of SEC 1014, see Reg. §1.104-1(a)].

In a recent Practice Alert directed to clients and friends of the firm, Joel Crouch, a well respected tax attorney with Meadows, Collier, Reed, Cousins, Crouch & Ungerman in Dallas wrote: “Current law allows taxpayers to transfer minority interests in family entities to family members at a significantly reduced transfer tax cost with the use of valuation discounts.”  Section 2704 of the Internal Revenue Code provides that if an interest in a family-controlled entity is transferred to a family member, any “applicable restriction” is disregarded in valuing the transferred interest.  An “applicable restriction” is defined as a restriction that limits the ability of the entity to liquidate, and the restriction lapses after the transfer, but excludes “any restriction imposed, or required to be imposed, by any Federal or State law.”  In a separate Practice Alert, KPMG notes that the budget proposal “provided the disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest” and that the proposed regulations may disregard restrictions that limit “a transferee’s ability to be admitted as a full partner or to hold an equity interest in [an] entity.”

Mr. Crouch adds that “[t]he new regulations may add an additional category of restrictions that may be disregarded in determining the value of interests in family controlled entities transferred to family members.  The regulations may limit the availability of minority ownership and lack of marketability discounts and revive the concept of the family attribution under the pretext of limiting liquidation and other restrictions.  In addition, the application of the new rules may be limited to holding entities, with an exemption for operating entities.”

As for more detail, we will all have to wait to read the proposed regulations when issued, but expect a bumpy ride ahead with higher transfer costs if these proposed regulations are finalized and sustained by the courts.

Joseph D. Brophy, MBA, CPA/ABV, CVA, ABAR, CM&AA is President of Joseph D. Brophy, CPA, PC, a Dallas, Texas based accounting, business valuation, and financial consulting firm. Mr. Brophy has over 25 years of professional experience providing individuals and small businesses information, strategies, and systems to succeed. Mr. Brophy can be reached at: (214) 522-3722 or by e-mail at: jdbrophy@jdbrophycpa.com.