Adequate Disclosure of Position on IRC Section 2704 Proposed Regulations

On August 2, 2016, the IRS released proposed regulations under IRC Section 2704.  The proposed regulations are intended to limit the use of certain types of discounts in the valuation of interests in family-owned businesses for transfer tax purposes.  See prior posts on this news feed for more information on the details of these proposed regulations.  At present, there are strong indications that these proposed regulations will be either amended prior to final issuance or scrapped altogether.  Treasury is currently in the process of review of the Section 2704 regulations in response to Executive Order 13789.

If a taxpayer is taking a position that is contrary to proposed regulations, the position must be disclosed on the return.  IRS Form 709 – U.S. Gift (and Generation-Skipping Transfer) Tax Return requires the filer to provide adequate disclosure of the gift.  The AICPA has released a recommended statement to be included with IRS Form 709, disclosing the transfer of an interest in a family partnership or family controlled entity made on the same date or after the issuance of the IRC Section 2704 proposed regulations.  The suggested disclosure statement may be found here:

https://www.aicpa.org/interestareas/personalfinancialplanning/resources/taxplanning/downloadabledocuments/suggested_disclosure.pdf

Basis Consistency Rules

Valuation professionals are frequently retained to perform appraisals of property for estate tax purposes.  IRC Section 1014 contains rules for property that is acquired from a decedent. The Highway Bill of 2015 amended section 1014 to provide that anyone who inherits property may not treat the property as having a basis higher than that reported for estate tax purposes.

In addition, it creates a new IRC section 6035 stating that executors that are required to file an estate tax return must furnish payee statements to any person acquiring an interest in property from the estate and must also provide information returns to the IRS. These statements identify the value of each interest in property acquired from the estate as reported on the estate tax return. The basis reporting provisions apply to property with respect to which an estate tax return is filed after the date of enactment, July 31, 2015.

Valuation Discount Regulations under Review

The valuation and estate planning community breathes a collective sigh of relief that the Proposed Regulations under 2704 regarding use of certain discounts in valuing family-owned business interests were one of the areas identified in IRS Notice 2017-38 as imposing undue financial burdens on taxpayers and/or adding “undue complexity” to federal tax laws. Valuation professionals had made these assertions in Fall 2016 in response to the August 2016 issuance of the proposed regulations. In fact, certain commenters had opined that the regulations as proposed also exceeded the IRS’s Grant of Authority from Congress under IRC Section 2704, a view apparently not shared by Treasury.

The four areas addressed in the Proposed Regulations were as follows:

  1. Rules for what constitutes control of an LLC or other entity or arrangement that is not a corporation, partnership, or limited partnership are defined.
  2. So-called “deathbed” transfers are limited, and there is clarification of what occurs if a transfer results in the creation of an assignee interest.
  3. The definition of “applicable restriction” under Reg. Section 25.2704-02 is amended to eliminate the tie-in to local law.
  4. A new section is added to address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not family members.

I expect that Treasury will roll back the elimination of the use of minority discounts in the valuation of family-owned business interests on the basis that it imposes undue financial burdens on taxpayers. The nature of the undue burden is the disparity of treatment between business owners who are family members versus those who are not. My expectation is not a guarantee, however. Family business owners are advised to do estate planning as soon as possible.

Treasury Secretary issues Response to Executive Order 13789

On July 7, 2017, the IRS issued Notice 2017-38 outlining recent regulations that it identified as requiring review pursuant to Executive Order 14789 (April 21, 2017).  Of 105 sets of regulations that have been issued since January 1, 2016, 53 were deemed minor or technical and not required to be addressed under EO 13789.  The remaining 52 issuances were reviewed by the IRS and Treasury Department.  Eight (8) sets of regulations were identified as warranting further review in order to comply with the EO.  The eight areas identified were as follows:

  1. Proposed Regulations under Section 103 on Definition of Political Subdivision (REG-129067-15; 81 F.R. 8870)
  2. Temporary Regulations under Section 337(d) on Certain Transfers of Property to Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs) (T.D. 9770; 81 F.R. 36793)
  3. Final Regulations under Section 7602 on the Participation of a Person Described in Section 6103(n) in a Summons Interview (T.D. 9778; 81 F.R. 45409)
  4. Proposed Regulations under Section 2704 on Restrictions on Liquidation of an Interest for Estate, Gift and Generation-Skipping Transfer Taxes (REG-163113- 02; 81 F.R. 51413)
  5. Temporary Regulations under Section 752 on Liabilities Recognized as Recourse Partnership Liabilities (T.D. 9788; 81 F.R. 69282)
  6. Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness (T.D. 9790; 81 F.R. 72858)
  7. Final Regulations under Section 987 on Income and Currency Gain or Loss With Respect to a Section 987 Qualified Business Unit (T.D. 9794; 81 F.R. 88806)
  8. Final Regulations under Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations (T.D. 9803; 81 F.R. 91012)

These eight sets of regulations were deemed to potentially be in conflict with the first two requirements of EO 13789; that is, they may pose an undue financial burden on taxpayers, and/or they may add “undue complexity” to federal tax laws.  The IRS and Treasury apparently did not identify any regulations that exceeded its authority – the third requirement of the EO.

A further report is due September 18, 2017, outlining recommendations for remediation to bring the regulations into compliance with the requirements of EO 13789.

President orders Treasury to Review Recent Regulations

On April 21, 2017, President Trump issued Executive Order No. 13789, ordering the Secretary of the Treasury to

immediately review all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016, and, in consultation with the Administrator of the Office of Information and Regulatory Affairs, Office of Management and Budget, identify in an interim report to the President all such regulations that:

(i) impose an undue financial burden on United States taxpayers;

(ii) add undue complexity to the Federal tax laws; or

(iii) exceed the statutory authority of the Internal Revenue Service.

The interim report is due June 21, 2017.  A report recommending specific actions is due September 18, 2017, with actions to be taken within 180 days thereafter.  The reason for the issuance of Executive Order 13789 is stated therein as follows:

The Federal tax system should be simple, fair, efficient, and pro-growth. The purposes of tax regulations should be to bring clarity to the already complex Internal Revenue Code (title 26, United States Code) and to provide useful guidance to taxpayers. Contrary to these purposes, numerous tax regulations issued over the last several years have effectively increased tax burdens, impeded economic growth, and saddled American businesses with onerous fines, complicated forms, and frustration. Immediate action is necessary to reduce the burden existing tax regulations impose on American taxpayers and thereby to provide tax relief and useful, simplified tax guidance.

Update on Status of IRS Regulations on Valuation Discounts

In August 2016, the IRS issued Proposed Regulations under IRC Section 2704. These regulations are intended to curb the ability of taxpayers to claim valuation discounts in the transfer of interests in family-owned businesses for estate, gift, and generation-skipping transfer tax purposes.

Valuation professionals formed tax forces to examine the proposed regulations and respond. The result was that the IRS received many comments regarding the expected impact of the regulations. Three main areas of concern emerged from the response to the IRS, as follows:

  1. The proposals interfere with a valuation professional’s ability to evaluate the economic reality of a particular situation.
  2. Two classes of small business owners are created:  those who have family relationships and those who do not. Under the new regulations, these two classes of business owners are treated differently.
  3. The IRS exceeded its Grant of Authority under IRC Section 2704, and the resulting proposed regulations are unsupported by adequate agency fact-finding.

At a public meeting that was held on December 1, 2016, a Treasury representative stated that it is not the intent of the IRS to do away with valuation discounts in their entirety. It is anticipated that the proposed regulations will be reworded before final issuance (expected in 2017).

IRS issues Proposed Regulations regarding Valuation Discounts

The IRS has long given the side-eye to certain discounts taken in the transfer of interests in family businesses for estate and gift tax purposes.  Fractional interests of a family-controlled business are often transferred at deep discount because the fair market value standard is applied to the interest being transferred, without consideration of who owns the other interests in the business.

On August 2, 2016, the Treasury Department issued long-awaited proposed regulations under IRC Section 2704 designed to limit the ability of taxpayers to claim valuation discounts for transfer tax purposes.  The proposed regulations are scheduled to become final in early 2017.

REG-163113-02 contains a four-pronged approach to limiting valuation discounts, summarized as follows:

  1. Rules for what constitutes control of an LLC or other entity or arrangement that is not a corporation, partnership, or limited partnership are defined.
  2. So-called “deathbed” transfers are limited, and there is clarification of what occurs if a transfer results in the creation of an assignee interest.
  3. The definition of “applicable restriction” under Reg. Section 25.2704-02 is amended to eliminate the tie-in to local law.
  4. A new section is added to address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not family members.

The deadline for submission of comments to the IRS is November 2, 2016.

R&D Credit – New Developments

The R&D credit was made permanent in the Tax Extender Bill of 2015. It was also made more accessible to start-up businesses that have not yet generated taxable income.

Credit may be used against AMT:  A business with less than $50 million in gross receipts is now able to use the R&D credit to offset AMT. This helps a business that has qualifying expenditures, but was formerly barred from getting a benefit due to AMT limitation.

Start-ups may use R&D credit against payroll tax liability:  A start-up may have significant R&D expenditures, but no taxable income. Now, these companies may offset up to $250,000 per year in payroll tax liabilities with the R&D credit. The company must be in the first five years in which it has gross receipts, and those gross receipts must be less than $5 million.

Status of Valuation Discount Regulations

In April 2015, an IRS official indicated that regulations were being developed that would impact the ability of a taxpayer to use discounts in the valuation of an interest in a family-owned business that is being transferred within the family group. Proposed regulations were expected in Fall 2015. As of December 31, 2015, those regulations have not been issued by the IRS.

Valuation professionals are unsure what to make of the nonappearance of the proposed regulations. It is possible that the IRS is still working on the project. On the other hand, practitioners have raised serious questions on two fronts: 1) does IRC Section 2704(b)(4) grant the IRS the authority to issue regulations of this type? and 2) might not such regulations be effectively sidestepped in the valuation process by building a risk factor that gives rise to a valuation discount into another aspect of the methodology, such as the cost of capital? Another result of regulating discounts in this manner is that it places a minority owner in a family owned business in a less-advantageous position than a minority investor in a similar non-family business. The fairness of such a result has been questioned.

A taxpayer who wishes to transfer an interest in a family-owned business that is legitimately subject to a discount is advised to act without delay. It seems likely that such regulations, once issued, will attract much attention. It would be better to avoid the uncertainty surrounding what will undoubtedly be a learning curve for all involved—practitioners as well as the IRS.

Become a CPA

Being an accountant is a challenging and rewarding career. Like all careers, it takes patience and persistence to reach your goal. Earning a CPA license is a major achievement and will almost surely advance your accounting career. Here is a youtube video produced by the NJ Society of Certified Public Accountants explaining the process of becoming a CPA:  Become a CPA