Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 2 of 3

Portions of these materials were initially prepared for the 58th Annual Heckerling Institute on Estate Planning, sponsored by the University of Miami School of Law. They are reproduced with the permission of the Heckerling Institute.

“Family-Owned Business and Internal Revenue Code Chapter 14 – Part 2 of 3,” that is the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is ACTEC Fellow John Challis of St. Louis, Missouri.

Understanding Chapter 14: IRS Rules for Family Business Transfers

Chapter 14 is a provision in the Internal Revenue Code that deals with special valuation rules for transfers of interest and family-owned businesses. These rules were designed to prevent families from undervaluing business interests when transferring them to the next generation, particularly for gift and estate tax purposes.

ACTEC Fellow Todd Angkatavanich of New York City will join us for a special three-part series to help business owners and their wealth management and estate planning teams better understand Chapter 14, identify pitfalls, and share recommendations. In part two, Todd will build on what was discussed in part one and discuss in more detail how Chapter 14 creeps into your practice in different transactions. Welcome, Todd.

Todd Angkatavanich:  Thanks very much, John. Continuing our discussion from the first session, the provisions of Chapter 14 can be quite confounding and really not so intuitive, right? They sort of layer on top of a number of wealth transfer transactions – almost like this mystical Hogwarts layer -with some surprising results.

Deemed Gifts and Valuation Pitfalls Under Section 2701

Now, Chapter 14, as I mentioned, came into play in October of 1990, and it consists of four different sections: 2701, 2702, 2703, and 2704. And these different provisions are designed to attack different family transactions in order to prevent what were considered to be perceived abuses. There are two broad approaches under Chapter 14: the so-called deemed gift approaches and then the disregarding provisions.

The deemed gift provisions are contained in Section 2701 and 2702, as well as Section 2704. The disregarding provisions are contained under Section 2703 and 2704(b). These different provisions are all designed to sort of attack different transactions that might take place from different vantage points. But the underlying presumption with all of these provisions, if you look at the legislative history, appears to be that there’s a presumption that when senior family member and junior family member generally get together to do any number of transactions, there is a presumption that they are working in concert to sort of manipulate values so as to reduce the value of the asset for transfer tax purposes and, in so doing, cutting the government out of its share.

And as I mentioned last time, sometimes there might be a motivation for that kind of shifting of value or manipulation of value, but oftentimes that’s not the case. And there are certain safe harbors that are built into these various provisions to take into account that it’s not always going to be the case that those are the intended results.

Discretionary vs. Mandatory Structures in Preferred Interests

So, let’s talk about Section 2701 a little bit. 2701 is what I think most would say, and I would certainly agree, the most complex provision under Chapter 14.  It is a deemed gift provision that was designed to really sort of prevent perceived abuses with respect to pre-1990 discretionary preferred and common family partnerships. And the real key there is the word “discretionary” because one of the common misconceptions is that: “Well, you can no longer do a preferred and common partnership in the family context.”  And that’s not true. You can indeed do a preferred and common partnership in the family context today, it’s just that it needs to be Section 2701 compliant.

And the big difference between a Section 2701 compliant preferred partnership that you can do today is that it is not going to be discretionary in nature, rather it needs to be structured so that it is mandatory and quantifiable in nature. But the perceived abuse that gave rise to the enactment of Section 2701 had to do with discretionary preferred and common partnerships. And the discretionary part of it was the part that was considered to be problematic and abusive in the eyes of Congress.

Well, what were people doing? Pre-1990, a family might, let’s say, have a partnership. Let’s say it’s a single economic, all common partnership or an LLC, and then they would enter into some kind of restructuring transaction or maybe create a brand-new entity whereby the entity would be capitalized with two distinct economic interests. There would be the frozen preferred class that would be entitled to, let’s say, a preferred return or preferred coupon, but would not be entitled to growth beyond that preferred interest. And then there would be a common growth class that would be entitled to all the upside growth above the preferred interest.

What families would do – would be – that they would either create a new partnership or they would recapitalize the old one into preferred and common, and they would eventually make a gift of the common, let’s say, to the kids or trusts for the benefit of the kids. But pre-1990, the preferred was often structured so that it had all sorts of discretionary rights. And again, discretionary is key; so maybe the preferred interest would be paid out if there was enough cash flow. On top of that, maybe the parents holding the preferred interest would be given all sorts of discretionary rights that they could exercise or not exercise.

And then they would give away the common to the next generation. But in determining the value of the common interest on the parent’s gift tax return, they would say: well, look, my preferred interest that I’m going to continue to retain, it has all these discretionary rights associated with it. Almost like a Christmas tree – it was hung with all these different discretionary ornaments, and it was said that that would ascribe most of the value to the parent. And because the parent was not giving away the preferred interest, rather they would only give away the common interest, they would say for gift tax purposes: “Well, the gift of that common must be very low since I’ve held on to the preferred interest and the preferred interest was loaded with all these discretionary bells and whistles.”

Valuation Manipulation and IRS Rebuttals: The Subtraction Method Explained

And so, Parent would make a gift of the common, take this low value approach based upon what’s called the “subtraction method of valuation”, which would involve them saying: “Well, the whole entity was worth X, and my preferred interest was worth Y, and Y was very big. And so the remaining or the resulting gift of the common, which is Z, must be worth very little.” Parents would do that, and they transferred out for less gift tax value.

But then later on, maybe Parent would actually exercise or not exercise some of those discretionary rights, and you had a shift of value into the common interest held by the kids at a much lower gift tax value. So 2701 came into play in order to prevent that kind of abuse. And the way 2701 does that is to say: “Look, whenever you have one of these post-1990 transactions with a subordinate equity interest – let’s say a common interest – and Parent holds on to the senior equity interest, we are going to say that Parent’s senior retained interest is going to be valued at zero, or certain components of Parent’s senior equity interest is going to be valued at zero.”

What does that do? That inflates artificially the value of the subordinate common interest that’s going to the next generation. And so, what 2701 essentially does is it looks to address evaluation manipulation fiction that families were perceived to be doing, and it replaces it with a different kind of fiction. The different kind of fiction is that it replaces it by saying:  “We are going to artificially increase the value of the subordinate equity interest that’s going to the next generation, and perhaps inflate in it much higher than the fair market value.”

With that backdrop, and the rationale behind the enactment of Section 2701 that it’s a deemed gift provision, where are we now with it? Well, there are different places where we might see 2701 come into your practice. Certainly, with the preferred and the common type arrangement. Like I mentioned before, you can do a preferred and common partnership, and we do them indeed quite a bit. Because you are dividing the economics of a family entity into two distinct economic classes. So it’s very similar to, let’s say, a balance in between sort of fixed income and equity.

Now, the thing is, if you’re going to do it now, the preferred interest needs to be crafted in a way that is mandatory and quantifiable nature as opposed to discretionary. But in the right circumstance, it can still be very powerful. So, if you have the common interest that has the upside growth potential, maybe that can go into a GST exempt trust (Generation-Skipping Trusts). Parent holds on to that preferred interest that satisfies Section 2701. In other applications, sometimes maybe you’ll have a GST non-exempt trust that will hold the preferred interest. And maybe a GST exempt trust will hold the common interest, and it’s a way to sort of contain the growth in the less efficient bucket – let’s say that being the GST non-exempt trust – and shift in the future growth with a longer sort of investment horizon into a GST exempt trust, for instance.

Vertical Slice Safe Harbor: Planning with Carried Interests Under Section 2701

Now, because the rules of 2701 are drafted so broadly and they can be sort of not so easy to understand sometimes because of that combination, it’s not limited to just a preferred and common scenario, even though that was sort of the underpinning of the motivation to enact the statute. But there are other places where we see it. Let’s say perhaps the most kind of typical way you might see it now is in the context of wealth transfer planning with fund principals of a hedge fund or a private equity fund or a venture capital fund, the so-called “vertical slice”. And this usually sort of arises when there’s a desire to transfer, let’s say, just some portion of fund principles carried interest down to the kids or a trust for the kids but perhaps they have a significant amount of capital invested in the fund as a limited partner. So if you had your druthers, you would just give away the carried interest because that has the most upside, supercharged potential. But the rules of 2701 can come into play because if I transfer a subordinate equity interest, let’s say the carried interest, to a junior family member, and I retain a senior equity interest, which might be my LP interest in the fund – now we have a potential deemed gift under Section 2701.

There are safe harbors that are usually brought into play when we’re doing that kind of planning. The most typical of which is known as the “vertical slice,” which basically says: “Look, if I reduce my interest, go to the kids in a proportional way, like a slice of cakes, if I give away 10% of my interest in the carry and 10% of my interest as a limited partner in the fund, that is going to satisfy a safe harbor to 2701.”

Non-Vertical Alternatives: Navigating Complex 2701 Compliant Structures

Beyond the scope of this, there are other applications that we often use in this kind of planning that are called “non-vertical alternatives” that don’t involve the vertical slice, but other kinds of ways to comply with Section 2701 when doing this planning. Sometimes we might see these issues creep up, perhaps in the context of family offices and the so-called “lender profits interest structure”. The concern there being that, well, if I have a profits interest, you know, that’s put in place for, you know, these so-called lender structures that are sort of created for Section 162 purposes, do you somehow have some 2701 potential exposure if the profits interest is subordinate and it goes down to the next generation?

Now there are ways to try to position around that, the so-called “proportionality approach”, or perhaps the profits interest is not structured as a subordinate interest or other types of variations of those approaches. But just know that in these different kinds of situations, you need to be mindful of these issues and sort of carefully digest them before you go forward with the transaction.

Profits Interests and Family Offices: Avoiding 2701 Traps in Lender Structures

Now one of the things that I think – to go back to that analogy of the moving staircases before (the Hogwarts analogy in Part I) – and sort of the draconian nature of some of these rules, in some cases the consequences can indeed be draconian, in others it may potentially be draconian – but it may not be. Another analogy, or the mixed metaphors here, is sort of an infection. And I think that kind of conventional wisdom with 2701 is that if you catch this infection, it’s necessarily going to be fatal. And I think it’s fair to say that that’s not really the case, despite the fact that that’s kind of the bad reputation that it has – but that’s not to say that the infection is nothing to worry about.

Just like any kind of infection, there are ways that you can fight that infection with different types of antibiotics or treatments or things like that. Those are all the damage control arguments that can come into play in the event of a 2701 infection. It’s not something that is nothing to worry about, but there are these kind of damage control arguments and it is not automatically fatal.

Section 2702 and GRATs: Mandatory Interest as a Safe Harbor from Zero Valuation

In contrast, under Section 2702, as I mentioned in the prior session about 2702, most people think of that as the statutory basis for GRATs and QPRTs. And while that certainly is true, the sort of underpinning to the statute was more to prevent perceived abuses with respect to pre-1990 transfers in trust where someone retained back an income interest, as opposed to what you can do today with a GRAT where what you’re taking back is a set annuity interest.

And the perceived abuse there was: “Well, pre-1990, if I put in assets into a trust, a million dollars of assets into a trust and I retain the income interest, and I try to say, well, for gift tax purposes, I’m going to subtract out the value of my income interest and I’m going to assume a rate of return for that income interest and say that that’s going to be the amount that’s going to reduce my taxable gift.” The concern was that, well, if I did that, but then my trustee simply invested it for growth and did not actually pay me back that income return, now there was a sort of manipulation of value.

So 2701 was enacted to say: “Hey, going forward, if you make a gift into a trust and you retain an income interest, which is subject to manipulation, we are going to slap you on the wrist on that and we are going to value your retained interest, Parent, at zero.” Even though Parents’ income interest might actually give them some cash flow, the draconian result under 2702 was to say: “We’re going to give you credit of zero, Parent.”  And the GRAT and the QPRT are statutory safe harbors to this zero-valuation rule. So you can do a GRAT today, but the intention of the GRAT was not to give taxpayers a freebie. It was to say: “Look, if you structure your retained interest so that it is mandatory and quantifiable and annual in nature, then we are going to actually give you some credit for it, Parent.”

Now 2702 is indeed fatal if you violate it. If you’ve put a million dollars into a trust and you take back something that does not satisfy the requirements of the safe harbor for, let’s say, a GRAT under 2702, you are indeed going to have a gift of the whole thing. From a tax perspective, it is indeed fatal in contrast to, let’s say, 2701, where if you sort of make a gift of interest to the next generation that violates 2701, there are going to be some deemed gift consequences, but it is not automatically going to be fatal.

Section 2703: When Buy-Sell Agreements Are Ignored for Gift and Estate Tax Purposes

Where else do we see some of the Chapter 14 issues come into play? Well, we see it come into play with family limited partnerships, and we’ve seen that under Section 2703. As I mentioned before, 2703 is a provision that can apply for gift tax purposes or estate tax purposes to say, the statute is going to say: “Look, if there is an agreement between family members that’s going to artificially reduce the value, 2703 is going to ignore that agreement for purposes of the transfer tax.”

Importantly, 2703 does not impact the enforceability for contract law purposes. All 2703 cares about is how it’s going to be valued for gift or estate tax purposes. So there’s a real risk that you could have a mismatch or disconnect between the value for gift or estate tax purposes versus the legally enforceable contractual provisions. So you have to be really careful there because there could be some tripwires there.

2703 in Action: Family Limited Partnerships and Split-Dollar Life Insurance Structures

The other things we’ve seen 2703 apply are in the context of family limited partnerships. Sometimes the IRS has been successful, sometimes they have not been. When the IRS has been successful in applying the 2703 argument in the context of family limited partnerships, it’s been in the context of being able to say: “We think certain provisions within the partnership agreement, let’s say for instance, a right of first refusal that might otherwise result in a valuation discount, should be disregarded under Section 2703 because the various different requirements to accept 2703 have not been satisfied.” We’ve also seen 2703 applied in the multi-generational split dollar context. There are a number of different places where 2703 and other Chapter 14 provisions can really come into play to frustrate a transaction.

In the last session that we’re going to do, we’re going to talk about the 2704 provisions that can come into play, really in unexpected ways sometimes, and particularly some implications with when you’re evaluating a family limited partnership and some of the restructuring that you might consider. John, thanks very much for that.

John Challis:  I appreciate it. Thank you, Todd, for your discussion of Parts 1 and 2 and we look forward to your final installment in this series.

You may also be interested in:

Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 1 of 3 — Understand IRC Chapter 14 rules, Sections 2701–2704, and key estate planning strategies to avoid tax pitfalls in family wealth transfers.

Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 2 of 3 — THIS PODCAST

Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 3 of 3 — Explore Sections 2704(a) & (b) and their impact on family-limited partnerships, valuation, and estate planning under Chapter 14.

Estate Planning Insights for Business Owners — Business owners must carefully plan for succession, taxes, and the ever-changing economic landscape. Stay informed about the latest trust and estate developments with ACTEC Fellows.

Experts Analyze Tax Law and Guidance — ACTEC Fellows provide IRS guidance and the impact of tax regulatory changes and proposed legislation.

 

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