Proposed 2704 Regulations: Commercially Reasonable Restriction Exclusion” – What Might it Mean?
The Proposed 2704 Regulations prevent taxpayers from considering a range of restrictions that could otherwise reduce the value of an interest in an entity for transfer tax purposes. These restrictions include those denominated “applicable restrictions” that had been in prior law but are made much tougher by the Proposed Regulations and a new category of restrictions referred to as “Disregarded Restrictions.” The Proposed Regulations throw taxpayers a bone, a rather small one, in terms of permitting at least one type of restriction on value to be respected. This leniency permits consideration of restrictions a lender or other financial partner may place on the entity or transaction. If the restriction applies then the valuation of an interest in a family entity might qualify for a valuation discount, e.g. for a lack of control.
The Proposed Regulation reads as follows:
Commercially reasonable restriction. An applicable restriction does not include a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity’s trade or business operations, whether in the form of debt or equity. An unrelated person is any person whose relationship to the transferor, the transferee, or any member of the family of either is not described in section 267(b), provided that for purposes of this section the term fiduciary of a trust as used in section 267(b) does not include a bank as defined in section 581 that is publicly held.
By way of example, a commercially reasonable restriction imposed by a bank, co-venturer providing capital, etc. appears to be an exception to the comprehensive list of “applicable restrictions” and “disregarded restrictions” that cannot be factored into a valuation analysis. It would appear that a commercially reasonable restriction could result in the reduction of the minimum value required to be imputed under the put right rule.
Examples to Explain, Understand, and Apply the Exception
Example 1: A real estate developer obtains financing from a local bank. The bank, as a condition of financing the project insisted on the Matriarch of the project serving as manager of the LLC owning the project, and placed restrictions on the transfer of any equity interests during the term of the loan, or the liquidation of the property LLC. Since these restrictions have been used by other lenders for many similar development deals these restrictions would appear to be respected when the appraiser values the LLC borrowing funds for transfer tax purposes. It is not clear whether the requirement of the Matriarch serving as manager, is a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity. Will these be permitted to be considered in the valuation? Since this is a real estate development will the lending restriction actual fall within the ambit of this new rule? That may turn on whether the project arises to the level of a “trade or business operations.” Will the same determination noted above, i.e. reference to IRC Sec. 6166(b)(9)(B) for the definition of a passive asset which is “any asset other than an asset used in carrying on a trade or business apply?
Example 2: A real estate developer owns and operates an apartment complex and seeks to refinance the property with a local bank. The developer, who is a substantial real estate entrepreneur with significant equity in the project request the bank to require, as a condition of refinancing the project that the developer serve as manager of the LLC owning the project, and place restrictions on the transfer of any equity interests during the term of the loan. The bank sees no issue in complying with the developer’s request since these terms add to its security. The lender is also not concerned about complying with the request, understanding that the developer has made the request to support valuation discounts. Since these restrictions have been used by other lenders the bank is not concerned that the IRS could accuse it of being complicit in manufacturing discounts. The issue as to whether the size or net equity of this particular developer would negate the need for customer restrictions is one of fact that might vary by lender, and the quantum of capital to obviate the need for restrictions is a judgement call by any lender. So the question remains to be seen whether this is just another example of how the Proposed Regulations will force business owners to find other avenues to reflect the reality of valuations in their planning.
Example 3: A real estate developer leases 35% of a strip shopping center to a major chain as the anchor tenant. Securing that tenant will assure bank financing essential to the development proceeding, and will also be the magnet to attract local stores to rent the rest of the project. The anchor tenant as part of all of its leases with shopping center developers insisted on a list of restrictions on the operations of the entity owning the shopping center, including restrictions on transfer, liquidation, financing, etc. These are all commercially reasonable and the developer could not sign the anchor tenant without agreeing to them. But since the tenant does not fall within the ambit of “person providing capital to the entity” the restriction will not come under the exception provided by this provision.
Example 4: Assume the same facts as in the preceding example. However, the tenant loans $100,000 to the developer. Will that suffice to characterize the anchor tenant’s restrictions, now replicated in a loan document in addition to the lease, within the ambit of the exception? What if the developer increased the tenant allowance for tenant improvements by $100,000 in the negotiations? The net economic result might be the same but would the discount be substantially different? So long as the tenant allowance is reasonable how could the IRS, or any third party for that matter, discern what result from the negotiation process? The exception does not appear to include a de minimus rule.
How many commercial transactions will be modified to address the onerous and unrealistic valuation provisions of the Proposed Regulations?
The proposed Treasury Regulations under Code Section 2704 are scheduled for a public hearing December 1st, 2016. Hopefully, the lack of clarity and unreasonable narrowness of the commercial borrowing exception will be addressed before the final Regulations are issued. In their present form issues are legion.
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