Texas State Bar Suggests Changes to Proposed Estate Tax Regs

On behalf of the Tax Section of the State Bar of Texas, I am pleased to submit the enclosed response to the request of the Department of Treasury ("Treasury") and Internal Revenue Service ("IRS") in the Notice of Proposed Rulemaking (REG-163113-02) issued on August 4, 2016 (the "Proposed Regulations"). The Proposed Regulations provide rules concerning the valuation of interests in certain business entities for estate, gift, and generation-skipping transfer tax purposes, specifically including the treatment of certain lapsing rights and liquidation restrictions in determining the value of intra-family transfers of interests in corporations, partnerships, and other entities.

THE COMMENTS ENCLOSED WITH THIS LETTER ARE BEING PRESENTED ONLY ON BEHALF OF THE TAX SECTION OF THE STATE BAR OF TEXAS.

THE COMMENTS SHOULD NOT BE CONSTRUED AS REPRESENTING THE POSITION OF THE BOARD OF DIRECTORS, THE EXECUTIVE COMMITTEE OR THE GENERAL MEMBERSHIP OF THE STATE BAR OF TEXAS. THE TAX SECTION, WHICH HAS SUBMITTED THESE COMMENTS, IS A VOLUNTARY SECTION OF MEMBERS COMPOSED OF LAWYERS PRACTICING IN A SPECIFIED AREA OF LAW. THE COMMENTS ARE SUBMITTED AS A RESULT OF THE APPROVAL OF THE COMMITTEE ON GOVERNMENT SUBMISSIONS OF THE TAX SECTION AND PURSUANT TO THE PROCEDURES ADOPTED BY THE COUNCIL OF THE TAX SECTION, WHICH IS THE GOVERNING BODY OF THAT SECTION. NO APPROVAL OR DISAPPROVAL OF THE GENERAL MEMBERSHIP OF THIS SECTION HAS BEEN OBTAINED AND THE COMMENTS REPRESENT THE VIEWS OF THE MEMBERS OF THE TAX SECTION WHO PREPARED THEM.

We commend Treasury and the IRS for the time and thought that has been put into preparing the Proposed Regulations, and we appreciate being extended the opportunity to participate in this process.

David E. Colmenero, Chair

Although members of the Tax Section who participated in preparing these Comments have clients who would be affected by the principles addressed by these Comments or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

Contact Persons:

Celeste C. Lawton

These Comments are in response to the Proposed Regulations regarding the rules concerning the valuation of interests in certain business entities for estate, gift, and generation skipping transfer tax purposes, specifically with respect to the treatment of certain lapsing rights and liquidation restrictions in determining the value of intra-family transfers of interests in corporations, partnerships, and other entities.

We recognize the time and thoughtful work invested by Treasury and the IRS in preparing the Proposed Regulations and the accompanying explanatory preamble to the Proposed Regulations (the "Preamble"). It is our intent to present items for consideration that may help support Treasury and the IRS to provide clear regulatory guidance.

For ease of discussion, we have opted to address our concerns with regard to the Proposed Regulations in a limited partnership context. However, we have identical concerns with regard to the application of the Proposed Regulations in corresponding corporate and limited liability company contexts.

II. COMMENTS REGARDING PROPOSED REGULATIONS UNDER CODE¹§ 2704

We believe the IRS and Treasury have no intention of taking this position, given that they clearly state in the preamble to Prop. Reg. § 1.1014-10 that Code § 1014(f) is intended to ensure consistency between the income tax basis of property acquired from a decedent and its estate tax value. Accordingly, we respectfully request the IRS and Treasury clarify that lapsing rights and liquidation restrictions disregarded pursuant to Code § 2704 and the Proposed Regulations for establishing the estate tax value of an interest acquired from a decedent in an entity described in Code § 2704 are also to be disregarded in establishing its income tax basis so that its initial basis will be equivalent to its final value determined for estate tax purposes (or as otherwise reflected in a Form 8971 and accompanying Schedule A).

We recognize that the suggested clarification may be more appropriate in conjunction with Prop. Reg. § 1.1014-10, particularly in light of an arguably similar need for clarity with regard to the impact of Code § 2703 and its regulations on the valuation, for both estate tax and income tax basis purposes, of entity interests transferred by a decedent. Consequently, we respectively request clarification and defer to the IRS in determining the manner in which this clarification may be best addressed.

We do not believe that an inclusion window is appropriate. However, we believe that if one is to be adopted, it should more precisely address the concerns with "deathbed" transfers noted by the IRS and Treasury in the Preamble. We understand the practical benefits of incorporating a bright-line test to address the perceived abuses of deathbed transfers that are motivated solely by a desire to avoid inclusion of a controlling interest in a family entity in the transferor's estate for estate tax purposes. However, a strict application of the proposed three year inclusion window will invariably produce a punitive tax result for a transferor who dies unexpectedly after transferring an entity interest without any "deathbed" motivations.

We propose instead that a lapse of a voting or liquidation right resulting from a gift be treated as occurring at the transferor's death only if he or she was "terminally ill" at the time of the gift, as determined in accordance with Treas. Reg. §§ 1.7520-3(b)(3), 20.7520-3(b)(3), and 25.7520-3(b)(3). Admittedly, an adoption of the "terminally ill" test will not provide in many instances the bright-line result otherwise achievable with the proposed three-year inclusion window. However, the "terminally ill" standard provides a workable and balanced approach to addressing the IRS's and Treasury's concerns with abusive deathbed transfers while avoiding penalizing transferors who are engaging in lifetime planning without deathbed objectives but die unexpectedly within a relatively short time thereafter.

Treasury and the IRS have historically provided effective dates for proposed regulations based in part upon their appreciation of planners' duties to their clients and the need to counsel them on the risks associated with different planning techniques based upon laws in effect at the time those techniques are implemented. We accordingly believe Prop. Reg. § 25.2704-1(c)(1) is intended to apply solely to lapses of voting or liquidation rights associated with lapses actually occurring after the Effective Date. If that belief is correct, then we propose that the last sentence of Prop. Reg. § 25.2704-1(c)(1) be revised to include the underlined text as follows: "The lapse of a voting or liquidation right as a result of the transfer of an interest after the Effective Date set forth in § 25.2704-4(b)(1) and within three years of the transferor's death is treated as a lapse occurring on the transferor's date of death, includible in the gross estate pursuant to section 2704(a)."

We would also appreciate guidance with regard to the manner in which the "applicable restriction" and "disregarded restriction" rules will be applied, or not applied, in the event that Prop. Reg. § 25.2704-1(c)(1) requires the inclusion of the "phantom asset," so that a double taxation of value is avoided.

An interest's minimum value is effectively calculated based upon its holder's deemed ownership of a proportionate share of the entity's underlying assets (if assigned a Net Asset Value) or its operating business (if appropriately valued by consideration of the expanded list of factors). Given that, we request that if an interest's minimum value is in part derived from a proportionate share of an illiquid interest owned by an entity (e.g., real estate or an operating business) then that interest's value is to be determined by also taking into consideration any valuation discounts that would be appropriately considered in valuing an undivided interest held directly in such an illiquid interest.

For an example of why this proposed modification is suggested, assume that family members A, B, C, and D each own outright a 25% fractional interest in real property with a fair market value of $1,000,000. By its very nature, the interest each of A, B, C, and D owns in the real property is not worth $250,000. Instead, the value of each person's interest should take into account discounts for lack of control and lack of marketability and consequently be valued at some amount less than $250,000.

Further assume that A, B, C, and D transfer their interests in the real property to an entity, resulting in the entity owning the real property in its entirety. Thus, the minimum value of each individual's interest in the entity is $250,000, or $1,000,000 (the property's fair market value) multiplied by 25% (each individual's interest in the property). Pursuant to Prop. Reg. § 25.2704-3(b)(1)(ii), the minimum value of each person's interest is deemed to be $250,000 upon contribution of the property to the entity. We believe that the Proposed Regulations in this regard unduly penalize for transfer tax purposes individuals who include restrictions in business arrangements to secure creditor protections and other nontax benefits provided by owning real estate and operating businesses via an entity rather than co-owning those assets directly.

Thus, we respectfully request that Treasury and the IRS revise the Proposed Regulations to provide a look-through rule in the following suggested new last sentence to Prop. Reg. § 25.2704-3(b)(1)(ii): "Notwithstanding the preceding, if the entity holds an operating business, real estate, or other property with regard to which the value of an interest therein would typically be affected by the degree of control of such business or property that interest represents (an "Illiquid Asset"), then the "minimum value" of an interest in such entity shall be equal to (i) the fair market value, as of the date of liquidation or redemption, of such interest's share of the property held by the entity (as determined pursuant to section 2031 or 2512 and the applicable regulations), provided that any value attributable to such interest's share of an Illiquid Asset shall be determined by taking into consideration any discounts that would otherwise be appropriately applied in establishing the value of an undivided interest in such Illiquid Asset if it were held directly by an individual, reduced by (ii) such interest's proportionate share of the outstanding obligations of the entity meeting the criteria set forth above, if the net value of the entity is determined based upon its Net Asset Value."

The Preamble and Prop. Reg. § 25.2704-3(b)(ii) initially seem to suggest that for purposes of determining minimum value, the fair market value of an operating business held via a subsidiary should be valued by considering the expanded list of factors for consideration outlined in Treas. Reg. §§ 20.2031-2(f)(2), 20.2031-3, 25.2512-2(f)(2) and 25.2512-3. However, the last sentence of Prop. Reg. § 25.2704-3(b)(ii) provides that if the property held by the entity directly or indirectly includes an interest in another entity (which could be an operating business) with regard to which transfers by the transferor would trigger an application of Code § 2704(b), the parent entity will be treated as owning a share of the property held by the other entity "determined and valued in accordance with the provisions of section 2704(b) and the regulations thereunder." It is therefore not entirely clear if the minimum value of a parent entity's interest in an operating business held via a subsidiary entity should be based strictly on the value of the operating business's underlying property in accordance with the last sentence of Prop. Reg. § 25.2704-3(b)(ii) or whether its value should be determined after valuing the subsidiary based upon a consideration of the expanded list of additional factors referred to above.

We respectfully request that Treasury and the IRS clarify which of the preceding interpretations is the intended result under the Proposed Regulations and provide examples that would clearly identify how minimum value should be determined with respect to operating businesses held by a family-controlled entity via a subsidiary entity.

Existing Treas. Reg. § 25.2704-2 references Treas. Reg. § 25.2701-2(b)(5) as providing the definition for the term "control." However, Prop. Reg. §§ 25.2704-2 and 25.2704-3 reference Treas. Reg. § 25.2701-2(b)(5) (also modified pursuant to the Proposed Regulations) as providing the definition of the term "controlled entity" but do not direct that it or any other regulation define the term "control." Curiously, "controlled entity" does not appear to be a term of consequence in either of those Proposed Regulations, although each uses the term "family controlled entities" in a seemingly descriptive manner and not as a term with any apparent technical significance. The reference to Treas. Reg. § 25.2701-2(b)(5) in each of Prop. Reg. §§ 25.2704-2 and 25.2704-3 for a definition of "controlled entity" and not simply "control" has created confusion as to the individuals who are required to possess control of an entity in order for transfers of interests in it to be subject to Code § 2704(b).

The confusion stems from the two-part manner in which Prop. Reg. § 25.2701-2(b)(5) defines "controlled entity." It outlines the type and level of interests for determining "control" of each type of entity. However, in Treas. Reg. § 25.2701-2(b)(5)(i), it also lists the individuals whose ownership of those interests "count" for purposes of characterizing an entity as a "controlled entity," and those individuals are not identical to those defined as "members of the transferor's family." For determining what constitutes a controlled entity, "applicable family members" must be considered. Specifically, spouses of the transferor's descendants are "members of the transferor's family," but any interests they hold in an entity do not "count" in determining whether it is a "controlled entity" for purposes of Code § 2701. Conversely, neither (i) descendants of the transferor's siblings nor (ii) siblings or descendants of siblings of the transferor's spouse are to be considered "members of the transferor's family" but any interests they hold in an entity do "count" in determining whether it is a "controlled entity" because they are applicable family members.

We believe that the individuals who are required to hold control of an entity in order for transfers of interests in it to be subject to Code § 2704(b) are solely those referenced in the definition of "member of the family." We believe that any attempt by the Treasury and the IRS to expand that list of individuals to include those additional individuals referenced in the definition of "controlled entity" would be an inappropriate exercise of the authority provided to them pursuant to Code § 2704(b)(4) to issue the Proposed Regulations. If Treas. Reg. § 25.2702-2(a)(1) is confirmed as providing the appropriate listing of those individuals, then we propose that the first sentence of each of Prop. Reg. § 25.2704-2(c) and Prop. Reg. § 25.2704-3(c) be revised to read: "For the definition of control, see § 25.2701-2(b)(5)(ii), (iii), or (iv), as applicable."

However, Treasury and the IRS have now proposed a narrower interpretation of the Exception in Prop. Reg. § 25.2704-2(b)(4)(ii) (for applicable restrictions) and § 25.2704-3(b)(5)(iii) (for "disregarded restrictions"). Together, those sections direct that a provision of state or federal law that may be overridden in the partnership agreement or otherwise superseded (whether by the partners or otherwise) is not a restriction that is "imposed or required to be imposed by federal or state law." As explained in the Preamble, Treasury and the IRS feel this narrower interpretation is now appropriate because the "current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws" that may on their face substantiate the need for valuation discounts but in Treasury's and the IRS's estimation are likely to be circumvented by the other partners' willingness to accommodate a family member's request that those restrictions be removed.

Effectively, Treasury and the IRS now seem to interpret "impose" as a reference to a non waivable state or federal restriction, which begs the question of what is to be considered a restriction "required to be imposed" by state or federal law. Some practitioners have speculated that this second prong of the Exception may refer to a state or federal law requiring the actual incorporation in the partnership agreement of a specific restriction on a limited partner's withdrawal right or the right of a limited partnership to liquidate.

We are unaware of any state law provision restricting a limited partner's withdrawal right or the right of a limited partnership to liquidate that cannot be overridden in the partnership agreement. We are also unaware of any state or federal law that requires such a non-waivable provision be incorporated in a partnership agreement. Thus, it seems unlikely that any restriction in a partnership agreement on a limited partner's withdrawal right or the right of a limited partnership to liquidate will qualify for the Exception, as interpreted in the Proposed Regulations. We are concerned that Treasury and the IRS have consequently narrowed the Exception to the extent it will have little or no effect and thus will have been rendered meaningless, which suggests that the Treasury and the IRS have exceeded their Congressional authority in adopting this interpretation. The Proposed Regulations appear to have broadened the application of family attribution principles beyond the few instances in which Congress intended that it be assumed that family members will unite to disregard actual lapses of voting or liquidation rights or restrictions on an entity's liquidation to substantiate an artificially higher value for a transferred (or deemed transferred) limited partnership interest than would otherwise apply.

Congress indicated in the legislative history to Chapter 14 its awareness of the courts' refusal to consider familial relationships among co-owners in valuing transferred interests in family entities and its intent that Chapter 14 not affect discounts available under then present law. 136 Cong. Rec. 15679, 15681 (October 18, 1990); H. Conf. Rept. 101-964, at 1137 (1990), 1991-2 C.B. 560, 606. We believe this effective invalidation of the Exception and corresponding expansion of family attribution principles conflicts with Congress's intent in enacting Chapter 14 and case law of continuing precedential value and may only be undertaken by Treasury and the IRS pursuant to an explicit Congressional directive.

In light of the foregoing, we respectfully suggest that Treasury and the IRS revise Prop. Reg. §§ 25.2704-2(b)(4)(ii) and 25.2704-3(b)(5)(iii) to retain the "no more restrictive standard" set forth in § 25.2704-2(b) of the current regulations. Alternatively, if the Treasury and the IRS will not return to the standard of the current regulations, we respectfully request that Treasury add additional examples to the Proposed Regulations that illustrate circumstances under which the Exception will have effect under the new standard contained in Prop. Reg. §§ 25.2704-2(b)(4)(ii) and 25.2704-3(b)(5)(iii).

III. CONCLUSION

We greatly appreciate the opportunity to work with your office on these significant tax issues and hope these comments provide relevant analysis for your review. Thank you for your consideration.