Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 1 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 1 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.

Introduction to Chapter 14 – Why It Matters for Estate Planners

Chapter 14 is a provision in the Internal Revenue Code that deals with special valuation rules for transfers of interests in 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 one, Todd will introduce Chapter 14 through his “Hogwarts Mystical Rules’” and discuss how Chapter 14 is contextualized through its basic presumptions, and the four sections applied to attack perceived abuses. Welcome, Todd.

Todd Angkatavanich: Well, thanks very much, John, for having me. These next three sessions, we’re going to try to cover from a big picture perspective – Chapter 14 and the various places where you may see it in your practice.

I always like to try to conceptualize things with different analogies, and that’s no different certainly with the Chapter 14 sort of digestion of the issues. And the way I like to think about it is through a Hogwarts analogy; this was something that I spoke about at the Heckerling Institute last year on Chapter 14.

The Hogwarts Analogy – Understanding the Mystical Nature of Chapter 14

But, if we think of the city of London and the city of London in this analogy represents our base wealth transfer objective, what would a parent typically like to maybe do from a wealth transfer planning perspective? They may want to transfer assets, they may want to try to take some valuation discounts, they may want to get assets into some kind of structure that’s going to be more tax-efficient from a transfer tax perspective and let those assets grow outside of parent’s estate. And there’s all sorts of variations and techniques that we as estate planners get involved with, of course. And that’s, in this analogy, the city of London.  That is our base wealth transfer planning objective. Seems kind of straightforward enough, right? We want to get from point A to point B.

But where sort of the Chapter 14 sort of “mystical rules” come into play, that is like this kind of Hogwarts kind of ethereal layer, this sort of invisible layer with these confounding kind of rules that just lies on top of the city of London. But it’s kind of invisible in many cases. And sort of to take this analogy a little further – in this sort of mystical Hogwarts layer, there are all sorts of different rules that don’t really make intuitive sense to muggles like us. And perhaps you have some things that maybe defy the laws of gravity – floating candles and floating cars – or the one that I like to really kind of think about with this analogy is the moving staircase analogy.

Where are we going with this? Because there is a point here with this Hogwarts analogy. And if we stick with the moving staircases theme for a second, perhaps with this analogy, there may have been way back when some kind of rationale, some kind of abuse that Hogwarts was trying to sort of prevent. Say for instance, maybe students were taking a shortcut and going through a restricted area and they didn’t want the students to do that. To prevent that abuse, they said, “I know, we’ll come up with these rules, and we’ll move the staircases, we’ll make the staircases move so the students can’t go take the shortcut and do this abuse.”

But unfortunately, you could end up with some very draconian responses or draconian consequences put in place to prevent an abuse. And, as a consequence, you can have some consequences that could be much more draconian than perhaps the perceived abuse might justify.

Now with Chapter 14, there are a bunch of different provisions that address different family transactions and perceived abuses with those family transactions from different perspectives. And, as we’ll get into it, sometimes some of the consequences of Chapter 14 are truly draconian. But other times, the consequences of Chapter 14 may only be, let’s say, potentially draconian. And in certain cases, they may be less severe or less draconian. And that’s really going to depend upon the facts and circumstances and the particular rules that we’re talking about.

But that’s kind of a big picture perspective. And that’s the way I like to kind of conceptualize why we have these kind of not-so-intuitive rules that don’t really make sense. They’re sort of like this mystical layer of confounding rules that can frustrate our sort of base wealth transfer objective; It can frustrate the city of London through this invisible layer on top. And so that’s kind of the analogy, and that’s the context through which I’ll be talking about these things for the next couple of sessions.

Special Valuation Rules

What is Chapter 14? Well, you know, Chapter 14, these rules have now been in place for some 35 years. They are a set of rules that came into place effective October of 1990 and they are referred to as the “special valuation rules.” And, despite the fact that they’ve been in place for 35 years or so now, they still are not very well understood by many practitioners. Or perhaps there are certain parts of Chapter 14 that are understood; other parts that practitioners sometimes will try to avoid like the plague, quite frankly. And that can be really problematic if you don’t have a good handle on these rules or at least a sensitivity to know where the red flags are.

Overview of IRC Chapter 14 – Sections 2701, 2702, 2703, and 2704

Chapter 14 consists of Sections 2701, 2702, 2703, and 2704 of the Code. And these different provisions, like I mentioned before, are broadly designed to attack certain family transactions in order to prevent what was perceived to be abuses in connection with some of these family transactions. And they will kind of attack different transactions from a different perspective or different vantage points.

Sometimes you may have a couple of different provisions under Chapter 14 that can come into play to frustrate a transaction. But, basically, with all of Chapter 14, if you read through the legislative history, there seems to be an underlying assumption that whenever family members – typically senior and junior family members – are getting together to do some sort of transaction, whether that’s a partnership transaction, a sale transaction, a gift transaction and trust, or some other types of transactions, whenever the family members are getting together to do that, there appears to be a presumption under Chapter 14 that the family is working in concert in order to transfer value at artificially low valuations for transfer tax purposes. And, in so doing, trying to cut the government out of its share of taxes.

Now that underlying assumption that appears to kind of be a common thread through the various provisions of Chapter 14 – sometimes perhaps that’s correct, but oftentimes, that’s not the case. And I think one of the problems with Chapter 14 is there’s just this presumption that when family members are entering into transactions that they are necessarily trying to pull a fast one. And, as a consequence, Chapter 14 will impose some consequence that may be draconian in certain circumstances, other times perhaps not as draconian, but still some consequences. So that is sort of the underlying assumption that really sort of is a common thread through all these provisions.

Deemed Gift Provisions – Understanding IRC Section 2701, 2702, and 2704(a)

Now let’s just talk about what these different approaches are, right? Again, like I said, Chapter 14 comprises of Sections 2701, 2702, 2703 and 2704. And I like to categorize these into what we’ll call the deemed gift provisions as one kind of broad approach. And then the other ones we’ll call the disregarding provisions. The deemed gift provisions are contained under Sections 2701, 2702 and 2704(a). And they broadly attack certain transactions by saying: “okay, we are going to impose some deemed gift upon, let’s say the parent, in connection with some kind of transaction that was perceived to be abusive.”

Section 2701 can result in a deemed gift in connection with transfers of subordinate equity interests while the parent holds on or retains a senior equity interest. And, as we’ll talk about in the next section, 2701 is quite broad in its application. And, even though it was really designed to address perceived abuses with discretionary, abusive preferred and common partnerships, the language of that provision can spread beyond that. And so, Section 2701 comes into play when we’re doing things such as carried interest estate planning with interest in private equity funds or hedge funds, preferred and common partnerships when you want to do those kinds of structures, possibly family office, profit center structures and possibly sales to intentionally defective grantor trusts.

The other type of deemed gift provision is under Section 2702. Most people think about 2702 as the statutory basis for a GRAT or for a QPRT (Qualified Personal Residence Trust).  And while that is certainly correct, I think the origin of this statute is really intended to be sort of a punitive provision for transfers and trusts where a parent retains an interest and can lead to a deemed gift. Now, the GRAT (Grantor Retained Annuity Trust) and the QPRT provisions under 2702 are really safe harbor provisions that come into play.

IRC Section 2704(a) – Deemed Gifts from Lapsed Voting and Liquidation Rights

The third kind of deemed gift approach is under Section 2704(a), which deals with a deemed gift or in the estate tax context – an increase in the value of the gross estate in connection with lapses of either voting rights or lapses of liquidation right. And when we say “lapse”, what that basically means is when that right disappears, when it goes poof. So if you have some kind of transaction whereby either a voting right or a liquidation right disappears or lapses, then 2704(a) will come into the situation and cause a deemed gift.

Disregarded Restrictions – IRC Section 2703 Explained

Broadly, the other kinds of provisions are disregarding provisions. That’s under Section 2703 and 2704(b). Section 2703 is basically going to say, either for gift tax purposes or for estate tax purposes, certain provisions that are in some sort of governing agreement or certain other types of provisions that might sort of cause the value of something to be valued less than fair market value will generally be disregarded for gift tax purposes and estate tax purposes. And that can lead to some real frustrations.

IRC Section 2704(b) – Family Entity Restrictions and Valuation Impact

The other disregarding provision is under Section 2704(b), which is something that often comes into play perhaps with family limited partnerships or family LLCs, whereby certain restrictive provisions that might be included in a governing instrument that would impose restrictions on the ability to liquidate the entity.  If those restrictions are more restrictive than might otherwise be provided anyway under state law, then those more restrictive provisions are going to be disregarded for gift or estate tax purposes.

Final Thoughts – Why Estate Planners Must Understand Chapter 14

That’s the broad sort of overview of Chapter 14, what it’s designed to sort of do, why we end up with these crazy confounding mystical Hogwarts-type rules, and where we might see it in our practices. And, in the next session, we’ll go into some more practicality of the session of the different provisions of where we might see them in our practice. Thanks very much, John. I appreciate it.

John Challis: Thank you, Todd, for your discussion of Part I, and we look forward to your second and third installments in this series.

You may also be interested in:

 

Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 1 of 3 — THIS PODCAST

Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 2 of 3 — How do Sections 2701–2704 impact family wealth planning? Discover key traps, safe harbors, and IRS challenges in this expert ACTEC discussion.

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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