By: Tim Gulbranson
On May 6, the Treasury Department Office of Tax Policy announced that it plans to issue proposed regulations for Internal Revenue Code Section 2704, which regulates property valuation held by a “Family Limited Partnership” (FLP) or “Family Limited Liability Company” (FLLC). Because of the current regulatory language’s inability to successfully execute the underlying law, the IRS has been expressing its intention to amend Section 2704 regulations for a number of years, including as recently as May 2016. Because the last few years have shown waning interest on the part of the President and Congress to change Section 2704, the IRS’s priority to amend the underlying regulations has risen, and therefore, the release of proposed regulations by the Treasury Department seems certain to become a reality. This potential shift in FLP treatment provides a welcome opportunity to discuss the FLP’s place within an individual’s overall estate plan and allows us to answer the questions: “What is an FLP?”, “How could it be used in my estate planning?”, and “Will the IRS pass new regulations rendering them ineffective?”
For the better part of 40 years forming an FLP has been a significant part of estate planning techniques for individuals with enough assets to potentially incur federal estate tax liability at death. While the utility of forming FLPs has lessened due to the rising threshold of individual net worth required to incur federal estate taxes (currently at $5.45 million), the FLP is still an effective estate planning tool for high-net worth individuals and families.
FLP’s in Estate Planning
The FLP strategy begins by a person creating a business entity in the form of a limited partnership or limited liability company, into which ownership of the person’s assets are transferred. Shares of the business are then transferred to family members or other loved ones either during life or after death. The key to the usefulness of the FLP technique, however, is in the amount of shares each individual receives and the restrictions placed on the transferee’s ability to sell those shares. By providing each transferee with only a minority stake in the business and placing certain restrictions on the shareholder’s ability to liquidate or sell the share, the transferee is able to discount the value of the shares due to the shareholder’s inability to control the business and or sell the shares on the open market. These “lack of control” and “lack of marketability” discounts on the shares’ valuation—each amounting to between 15–30 percent—allow a person to gift the assets held by the business at a far-reduced valuation, thereby shrinking the overall value of the estate and reducing or eliminating the estate’s federal tax burden.
Changes to FLP’s: Coming soon?
Unsurprisingly, the IRS has attempted to regulate this practice due to the significant tax savings realized by those using the technique. In 1990, Congress enacted Internal Revenue Code Sections 2701–2704 to limit the ability to discount values of FLP shares whether given during life or after death. Relevant to FLPs as part of an estate plan, Section 2704 aims to limit lack of control and lack of marketability discounts when an individual bequeaths FLP shares to family members by “disregarding” restrictions placed on the ability to liquidate ones shares that eventually lapse after death. In other words, section 2704 prohibits the recognition of shares’ valuation discount when a marketability restriction expires after death, thereby valuing the shares without the discount and raising the decedent’s federal estate tax burden. Without Section 2704’s limitation, the conflicting principles of a valuation discount and family members’ realization of fair market value for their shares would be realized, which the IRS would argue, is not the original intent of the law.
However, the law’s regulatory language ultimately led to Section 2704’s enforceability problems. While 2704 itself is fairly straightforward, the IRS created regulations that muddied the waters by defining an “applicable restriction” as one that is more restrictive than allowable limitations under state law. Almost immediately, states began passing amendments to their business entity laws allowing LLC and partnership agreements to contain provisions that are restrictive of liquidation rights, thereby severely limiting what would be considered a disregarded restriction and rendering 2704 ineffective.
The Bottom Line
Though the IRS has indicated its intention to amend 2704 regulations, it has yet to announce the content of the regulations; however, given 2704’s foundation, instead of pegging the definition of “applicable restrictions” to state law, the IRS will likely seek to increase and enumerate the number of restrictions that are “disregarded” for tax purposes. Finally, although rarely done, the IRS has the ability to retroactively enforce any new regulations, requiring existing estate plans using FLPs to be updated and conform to the new standards or else lead to an unexpected and unplanned estate tax burden at one’s death.
While the timing, content, and retroactivity of any amendments to Section 2704 or its regulations are unknown, it is recommended that everyone regularly engage with one’s attorney to discuss financial and estate planning goals and update one’s estate plan after every major life event or every five to 10 years.
Tim practices on our Corporate & Transactional Law team, focusing on estate planning, trust and probate administration, and real estate. Learn more about Tim at https://l-wlaw.com/attorneys/tim-b-gulbranson/.