Estate Tax Law

By Jill S. Dodd

Proposed 2704 Regulations Attack Valuation Discounts

The IRS has expanded the scope of IRC Section 2704 by issuing proposed regulations that seek to limit the availability of valuation discounts for transfers of interests in family-controlled entities. In general, the purpose of Section 2704 is to eliminate valuation discounts for gifts and bequests of interests in a business entity to or for the benefit of the transferor’s family member if, before and after the transfer, the transferor and his or her family members control the business entity. The statute was enacted to prevent wealthy families from forming entities and “manufacturing” discounts by drafting restrictions in the entity’s governing documents for the sole purpose of avoiding or lowering payment of transfer tax. If the proposed regulations are adopted, they will significantly reduce (or eliminate) such minority interest discounts.

Some of the changes to the regulations should not come as a surprise to tax planners. First, the proposed regulations expand the definition of the types of family-controlled entities that fall within the reach of Section 2704. The proposed regulations clarify that Section 2704 covers S corporations, general and limited partnerships, and limited liability companies. Moreover, the proposed regulations provide that the IRS will look through any entity or trust that holds an interest in an entity to determine if it is controlled by the family. In other words, family members cannot avoid the regulations by holding their interests indirectly through a trust, corporation or other business entity. Most planners who are risk-averse have assumed this to be the case and have structured previous transactions with this in mind.

Disregarded Restrictions. Under the proposed regulations, restrictions that limit a transferee’s ability to redeem or liquidate his or her own interest in a family-controlled entity will be disregarded when valuing an interest for gift or estate tax purposes, or in the context of a sale of an interest to a trust for the benefit of the next generation. In effect, intra-family transfers of family-controlled entities will be valued under the assumption that the transferee of the interest will have a six-month option to “put” the interest to the entity (that is, to be redeemed out at the transferee’s option) for a purchase price that is essentially the pro rata net value of the company, which price will be paid in cash. If paid for with a note (as most buyouts are), the note will be taken into account only for valuation purposes if it is at a “market rate” of interest, requires periodic payments and relates to the purchase of an active trade or business. In other words, restrictions that limit the holder’s ability to liquidate his or her interest, defer payment or require payment with a note at the applicable federal rate (historically very low) will be disregarded when valuing the interest.

Applicable Restrictions. Under the current regulations, a restriction in a partnership agreement that is not more restrictive than state law would be respected and taken into account when calculating the value of a partnership interest. For example, if the default state law provides that it takes 100 percent of the partners to dissolve a limited partnership, and if the family limited partnership agreement of a partnership formed under this state law also so provided, this restriction would be taken into account in valuing the partnership interest. This provision led to a host of states revising their uniform statutes to provide favorable default laws. Under the proposed regulations, these state law restrictions are only effective to discount value if they are mandatory and cannot be varied by the parties. In other words, unless the states revise their statutes to require certain provisions (such as 100 percent consent to dissolve a partnership), notwithstanding any provision in the entity’s governing documents, these provisions in partnership or LLC agreements will be ignored for purposes of establishing valuation.

Assignee Interests. The value of an assignee interest is typically discounted because it does not carry the right to vote. The proposed regulations provide that, essentially, the assignee interest will be treated as though the transferor had gifted a voting interest. Thus, even where there are legitimate business reasons to retain a voting interest (indeed, there are situations in which business owners are required to retain voting rights even if transferring the economic interests), the transferor will be treated for transfer tax purposes as though he or she transferred a voting interest. It is unclear under the proposed regulations whether the assignee would receive basis credit for income tax purposes for the transfer tax paid by the transferor on the phantom voting right that the transferee never received and/or if the transferor would get some kind of credit against potential estate tax for the retained voting control in his estate that was already taxed when the assignee interest was transferred.

Three-Year Rule. Another notable change is a bright-line rule imposing a tax, at death, on transfers of minority interests made within three years of the transferor’s death. Here’s an example of how this would work: Under the current regulations, if Dad owns 100 percent of a family business whose operating agreement requires a 51 percent vote to liquidate, and Dad gifts 30 percent of the company each to his son and daughter, there will be valuation discounts for lack of control and discounts for lack of marketability for each of the 30 percent gifts. In the words of the statute, there is no “taxable lapse” of Dad’s liquidation rights that would be subject to gift tax. Under the current regulations, that would be the end of the story in terms of valuing these gifts. Under the proposed regulations, however, if Dad dies within three years of transferring the interests to his children, the IRS would tax Dad’s estate on the value of the lapse of Dad’s liquidation at the time of death (in other words, on the value of the discount). Even though the interests themselves are out of the estate, Dad’s estate will have an estate tax liability for the phantom value of the lapse of liquidation rights that purportedly happened at his death.

What Is a Family-Controlled Entity? For purposes of determining whether a company is family-controlled, family members are defined as parents, children, grandchildren and grandparents, but not siblings or cousins. Nonfamily holders of interests will be disregarded if any one of the following conditions is present: a nonfamily interest constitutes less than 10 percent of the entity; an aggregate of less than 20 percent or more of the entity is owned by nonfamily members; every nonfamily holder of an interest has held the interest for less than three years before the date of the transfer; or each nonfamily holder does not have a put right to redeem the entirety of the holder’s interest on six month’s notice.

Any Exceptions? There are only narrow exceptions to Applicable and Disregarded Restrictions. Any restriction on an active trade or business that is “commercially reasonable” and imposed by a nonfamily member and/or any restriction that is mandated by state or federal law may be considered when valuing an interest.

Effective Date. These proposed regulations will not become effective until after they become final, although if the new three-year rule survives, it will pull in any gifts made before they become effective if the transferor dies within three years of the gift, but after the regulations are finalized. Further, the Disregarded Restrictions rules will not apply until 30 days after the regulations become final. A hearing is scheduled for December 1, 2016, and most commentators do not think they will become final until mid-2017 at the very earliest.



pursuant to New York DR 2-101(f)

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