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

Chapter 14 is a provision of 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 this third and final installment, Todd will focus on unique issues and pitfalls under Chapter 14 as it relates to family-limited partnerships. Welcome, Todd.

Understanding Section 2704 of Chapter 14: A Focus on Estate and Gift Tax Implications

Todd Angkatavanich:  John, thanks so much for having me. In this third session, we are going to focus on Section 2704(a) and 2704(b) of Chapter 14. I’m going to focus quite a bit on some of the implications that can be quite tricky to think through under 2704(a) as they relate to your valuation of family-limited partnerships and some of the so-called “decontrol measures” that we may think about in order to address 2036 concerns.

2704 is comprised of two different provisions, 2704(a) and 2704(b). It always seemed to me like they were different provisions, so 2704(b), I almost think that it should be like a 2705. And interestingly enough, there have been proposals last year for a new Section 2705 to be introduced, which would have to do with eliminating valuation discounts with respect to family entities. But what we have currently is 2704(a), which is either a deemed gift provision in the gift tax context or an increase in the gross estate in the estate tax context related to lapses or disappearance of either liquidation rights or voting rights. And we’ll focus probably more in the gift tax context.

But the application of 2704(a) can be to either cause a deemed gift in the gift tax context or to cause an increase in the value of the estate for gross estate purposes when you have such a lapse. A lapse is defined as “a restriction or elimination of either a voting right or a liquidation right.” Basically a disappearance of that right. The origins of this go back to a case called Harrison, where you basically, it was an estate tax case where basically, you know, Parent died with, you know, a large limited partnership interest in a family partnership coupled with a general partner interest. And the general partner interest allowed the general partner to compel the dissolution of the partnership. And in so doing, they’d be able to take back their assets they had in the partnership.

Well, Parent died and under the partnership arrangement, Parent – the GP basically lapsed at that point. So the position was taken for estate tax purposes that, well, the value included in the estate should be the LP interest without the GP withdrawal because at the time of death, that lapsed and that went away. The estate was successful in securing that argument and basically securing a much lower value for the interest because the GP interest went “poof” at death.

2704(a) was enacted in order to prevent that. Sometimes it’s referred to as the “Anti-Harrison Rule”. And it does that by saying: “Look, if for estate tax purposes, you have something that lapses or is restricted or eliminated, either a voting right or a liquidation right – if that happens at death, we are going to increase back the value in the estate to what it would be before that lapse.”

Similarly, if the lapse happens in a gift tax context during lifetime, the amount of the deemed gift is going to be determined by saying: “Look, day one before the lapse, what is the interest worth? Day two after the lapse, what is that worth?” You subtract out the day two amount and the difference is going to be the amount of the deemed gift. That’s one of the deemed gift provisions or deemed gift approaches that exist under Chapter 14, in addition to section 2701 and section 2702.

Section 2704(b): Disregarding Restrictions Beyond State Law

2704(b), similarly to 2703, is a disregarding provision. Basically, 2703 says that: “We, for transfer tax purposes, are going to disregard certain restrictions on the ability to liquidate an entity if those restrictions are more restrictive than those rights that would otherwise be provided under state law.“

In other words, if state law says that: “Well, 75% of the members of a partnership can liquidate it, and then the family puts in place a partnership agreement that says: ‘Well, you need 85% to liquidate.’” And so Parent dies, let’s say, with something less than the 85%, let’s say 80%. 2704(b) is going to say: “Well, you can’t say that you didn’t have the right to liquidate under the partnership agreement because you only had 80%, but you needed 85% to liquidate because state law would say: ‘Well, if you have 75%, that is enough to compel liquidation.’” 2704(b) will sort of ignore that provision that’s more restrictive than what rights would otherwise be given under state law.

Those are those two provisions, which again, I view them as like different provisions.

Where I want to go with this – one area in particular that I think is a place where we really need to be mindful of 2704, and particularly 2704(a) – is in the context of family limited partnerships or family LLCs. All of us as planners are well aware of the ongoing challenges that have been happening with family limited partnerships over the past 20 plus years or so. And the IRS’ most effective argument to date has been under section 2036 – either 2036(a)(1), the retained enjoyment string, or section 2036(a)(2), the retained control string – and either one of those two theories can cause the assets that Parent contributed into a family partnership to come back into their estate if there’s either retained enjoyment under 2036(a)(1) or there’s retained control under 2036(a)(2). The IRS only needs to be successful with one of those theories, although in certain cases they are successful in both (a)(1) and(a)(2) theories.

Section 2036(a)(2), Retained Control and the Doctrine of External Standards

Now, where there’s been a decent amount of development over the past several years, the past decade or more, has been the retained control issue under section 2036(a)(2). And, in my mind, there’s kind of what I call, there’s two applications of it. There’s the first application of 2036(a)(2) retained control, which is the Strangi case from 20 years ago plus now. But that’s essentially – if Parent dies owning some or all of the general partner interest in a family partnership or dies owning the managerial interest or holding the managerial interest in an LLC, that there is a risk that the assets that Parent put into that partnership could come back into their estate under 2036(a)(2) retained control theory because Parent, either alone or perhaps in conjunction with other GPs or other managers, has the right to control the disposition of the assets in that partnership. That’s what I refer to as the first application of 2036(a)(2).

Then there’s also what I refer to as the second application of 2036(a)(2) – which is aside from whether Parent holds any GP or managerial interest, the right of the parent as let’s say a limited partner in the partnership to cast a vote, yea or nay, towards liquidation. Because that, under the Strangi case, under the Powell case, and under the more recent Fields case, has also been said to constitute the right alone or in conjunction with others to control the disposition of the assets. Why? Because if Parent has the right to cast their vote in connection with the other partners of the partnership, it’s been held in those cases that that is a right to control the ultimate disposition of it. And if they collectively vote to liquidate the partnership, then Parent will get their assets back.

Because of the evolution of this, and now that you’ve got a handful of cases that address and determine that 2036(a)(2) retained control existed in the family partnership context – you have the Strangi case, Turner, Powell and the Fields cases. It’s for a long time been an issue of discussion when you are sort of kicking the tires and evaluating the relative strength or lack of strength of a family limited partnership.

And so really going back as far as the Strangi case in 2003, where the tax court said that dad’s ability as a 47% general partner in the family partnership – that ability in connection with the other general partners to sort of liquidate the partnership and control the disposition of the assets – that was a right in conjunction with the others that would cause inclusion under 2036(a)(2).

Since then, there has often been evaluation of family partnerships. And if Parent has too much control either as a general partner or as a manager of the partnership, and there’s a concern that there was a risk of inclusion under 2036(a)(2), then professionals discuss and think about what we’ll call “decontrolling measures” in order to rid Parent of that tainted control interest, ideally before three years or outside of three years before the parent’s passing. It involves trying to figure out how you can get rid of that interest so Parent doesn’t have that interest that can be problematic at the time they die.

That’s all well and good from a 2036(a)(2) standpoint. However, there are very important issues that you need to think about under 2704(a) to make sure that in your quest to cleanse Parent of their 2036(a)(2) control interest, which could be problematic down the road – several years down the road – when Parent dies, you have to be careful to not trip over a more immediate gift tax issue by causing a deemed gift perhaps under section 2704(a) due to the disappearance or the lapse of either a voting right that Parent might have or perhaps the lapse of a liquidation right that Parent might have.

It’s very important that when you are trying to think of ways to rid Parent of that tainted interest that you don’t just take it away. Because remember what we talked about – 2704(a) in the gift tax context will say: “Hey, if I have a right to liquidate the entity and we do some kind of transaction whereby that right to liquidate is restricted or eliminated so it lapses, it disappears.” The gift tax consequence is going to be, there is going to be a deemed gift and the measure of that deemed gift is going to be what are the bundled rights that Parent had day one and subtract out the remaining bundled rights Parent has on day two after the disappearance of this value and the difference between those two is going to be a deemed gift under section 2704(a) lapse.

Section 2704(a) and Voting Interests in an LLC

Now I’ll mention that aside from 2704(a), there’s also a similar concept that was applied in the Bosca Tax Court case where Parents and Children all owned voting interest in an LLC and then they restructured it so that Parents took back non-voting interest in the LLC and the kids got all the voting interest. And the Tax Court noted that 2704(a) was not raised, but nonetheless the Tax Court came to the conclusion that there was a deemed gift under traditional gift tax principles and the measure of that gift was basically measured the same way that you would determine that gift under section 2704(a).

I think the takeaway with 2704(a) in the family limited partnership context is: “Yes, it’s very important to stress test your family partnership on a regular basis because the evolution of these cases is ongoing, but be very careful when you are thinking about moves to decontrol and rid the parent of their control interest to not just simply eliminate it, because you could end up with a more immediate gift tax issue as opposed to the solve of an estate tax issue that could come up in 10 or 15 years.”

Now there are ways that you can try to work around that. One of the exceptions importantly to 2704(a) is that if I make a transfer of an interest, rather than a restriction or elimination of that interest, that is not going to be a lapse that will be a deemed gift under section 2704(a). Some of the different pathways that we might think about to do a proper decontrol is to transfer an interest rather than just simply having that interest go “poof”.

The other thing is that a 2704(a) lapse can cause a deemed gift with respect to a lapse of a liquidation right or a lapse of a voting right. Now arguably if I have the right to liquidate and that goes away, so that’s a lapse, that’s going to result in a more substantial gift as opposed to – look, if I’m a limited partner in a partnership and I’m concerned that, you know, under the second application of 2036(a)(2) that I mentioned before, that if my right just as a limited partner of the partnership to cast a vote yay or nay could be considered to be a 2036(a)(2) control string – like was just recently mentioned in the Fields case and was mentioned in the Powell case – there might be a concern or desire to rid my limited partner interest of that right to cast a vote on liquidation.

But it’s sort of a mini-version of the same issue. If I have a limited partner interest that is currently entitled to cast a vote on liquidation and we restructure it so that my limited partner interest no longer has the right to cast yay or nay towards a vote on liquidation – if that right disappears, there’s a real risk that that’s going to be a 2704(a) lapse. However, in that case, it’s a lapse of not a liquidation right, but it’s a lapse of a voting right.

Accessing Options and Stress Testing Family Partnerships

So my question to you, John, is: “If you are one of 50 partners in a partnership or one of 10 partners in a partnership, how much value should be ascribed to your right to cast a vote yay or nay when it’s one of 10 people as opposed to the right to liquidate the partnership?”  I think the answer to that is that perhaps on a percentage basis, the deemed gift from a lapse of a right to cast a vote towards liquidation, so it’s a lapse of a voting right, should be a lot less than a lapse of the right to compel the liquidation.

Now, that’s ultimately going to be a matter for the valuation folks to get involved. But I think suffice it to say that whenever you are analyzing your family limited partnerships and you’re doing your stress testing, which is beyond the scope of today, you want to really think carefully about the more immediate gift tax issues in your quest to try to decontrol Parent to avoid an estate tax issue down the line.

The one other thing I’ll say is as you do these family partnership stress tests, I think perhaps the most important factor is going to be analyzing to see how compelling of an argument may or may not exist that the formation and the capitalization of the partnership in the first place satisfies, or we hope satisfies, the bona fide sale exception to 2036. Although I would note that that’s not a bright line test, rather it’s one like sort of like a stress test to use another analogy here. It’s like a stress test where you get on the stress test of the doctor’s office and it’s going to give you a decent sense of your relative health, or lack of health, but it’s not like a bright line kind of test.

With that, I think we’re going to wrap things up. Overall, be mindful with a number of different family transactions of the different sort of implications and issues that can arise under Chapter 14, the so-called sort of Hogwarts kind of ethereal mystical layer of these rules that lie on top of your city of London, which is your wealth transfer objectives.

And so, John, thank you very much for having me for this. I really appreciate it.

John Challis:  And thank you, Todd, for taking the time to present all three of these discussions on Chapter 14.

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 — How do Sections 2701–2704 impact family wealth planning? Discover key traps, safe harbors, and IRS challenges in this expert ACTEC discussion.

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.

 

This podcast was produced by The American College of Trust and Estate Counsel, ACTEC. Listeners, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The material in this podcast is for information purposes only and is not intended to and should not be treated as legal advice or tax advice. The views expressed are those of speakers as of the date noted and not necessarily those of ACTEC or any speaker’s employer or firm. The information, opinions, and recommendations presented in this Podcast are for general information only and any reliance on the information provided in this Podcast is done at your own risk. The entire contents and design of this Podcast, are the property of ACTEC, or used by ACTEC with permission, and are protected under U.S. and international copyright and trademark laws. Except as otherwise provided herein, users of this Podcast may save and use information contained in the Podcast only for personal or other non-commercial, educational purposes. No other use, including, without limitation, reproduction, retransmission or editing, of this Podcast may be made without the prior written permission of The American College of Trust and Estate Counsel. If you have ideas for a future ACTEC Trust & Estate Talk topic, please contact us at ACTECpodcast@ACTEC.org. © 2018 – 2025 The American College of Trust and Estate Counsel. All rights reserved.