How Proposed Regulations Under IRC Section 2704 Could Impact Gift & Estate Tax Valuations
The IRS recently proposed regulations under IRC Section 2704 that could have a significant impact on the treatment of intra-family transfers of closely held business interests. The proposed regulations are intended to curtail the application of valuation discounts in valuing valuations of ownership interests in family-controlled entities for gift and estate tax reporting purposes.
In this article, we provide some background information on section 2704 and outline the major provisions of the newly proposed regulations from a valuation perspective. The following discussion is not meant to provide tax or legal advice, but rather to inform business owners and their advisors on changes that could will impact valuations performed for gift and estate tax purposes.
Gift and Estate Tax Planning and Valuation Discounts
Taxpayers often gift interests in family-controlled entities to transfer wealth to their heirs prior to or upon death. When an interest in a privately held company is transferred to a family member, a valuation is generally required to determine gift or estate tax liability. When performing valuations of minority interests for gift and estate tax purposes, appraisers often apply valuation discounts to account for lack of control and lack of marketability.
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Applying valuation discounts effectively reduces the taxable value of an interest. As such, it has been common practice for the IRS to scrutinize and sometimes challenge the application of valuation discounts to curb the potential abuse of tax loopholes used by some high-net worth families to reduce their tax obligations.
In issuing the proposed regulations under section 2704, Mark Mazur, assistant secretary for tax policy at the U.S. Treasury Department, said the following:
“It is common for wealthy taxpayers and their advisors to use certain aggressive tax planning tactics to artificially lower the taxable value of their transferred assets. By taking advantage of these tactics, certain taxpayers or their estates owning closely held businesses or other entities can end up paying less than they should in estate or gift taxes. Treasury’s action will significantly reduce the ability of these taxpayers and their estates to use such techniques solely for the purpose of lowering their estate and gift taxes.” 1
Existing Regulations under IRC Section 2704
IRC Section 2704 was originally introduced in 1990 with the goal of limiting the use of valuation discounts for intra-family transfers of certain interests in family partnerships and LLCs. Below, we outline the key provisions of section 2704 as it currently exists.
IRC Section 2704(a) addresses the tax treatment of lapses in voting or liquidation rights in family-controlled entities. Under Section 2704(a), the lapse of voting or liquidation rights in an entity is deemed a transfer if the transferor or the transferor’s family controls the entity both before and after such lapse. In such cases, the transfer is subject to gift or estate taxes.2
IRC Section 2704(b) defines “applicable restrictions,” which refer to limitations on the ability of the transferred interest to force the whole or partial liquidation of the corresponding entity. An applicable restriction is any restriction that effectively limits the ability of the entity to liquidate, but which, after the transfer, will lapse or may be removed by the transferor or the transferor’s family, whether in whole or part. Section 2704(b) provides that an applicable restriction is to be disregarded for valuation purposes if the transfer is subject to §2704, as established previously.3
Also included in section 2704(b) are exceptions clarifying what does not constitute an applicable restriction. An applicable restriction does not include the following:
- Commercially reasonable restrictions on liquidation imposed by unrelated individuals providing capital by means of debt or equity;
- Restrictions imposed by federal or state law; or
- Options, rights to use property, or agreements subject to IRC Section 2703
IRC Section 2704(b)(3)(B) provides that any restriction “imposed, or required to be imposed, by any Federal or State law” is not considered an applicable restriction.4
26 CFR §25.2704-2(b), which provides clarity on IRC Section 2704(b), states that an applicable restriction “is a limitation on the ability to liquidate the entity (wholly or partially) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction.” 5
Reasons for the Proposed Regulations
According to the IRS and the Treasury Department, changes in State laws and other developments have rendered the current regulations under section 2704 ineffective. We outline the factors that influenced the proposed regulations below.
Restrictions on liquidating individual interests
In Kerr v. Commissioner, the U.S. Tax Court concluded that applicable restrictions under section 2704(b) apply only to restrictions on the ability to liquidate an entire entity, and that a restriction on the ability to liquidate an individual interest is not an applicable restriction under current regulations.6
Changing state laws
Since section 2704 was introduced, many states have revised their statutes governing limited partnerships so that the statutes are at least as restrictive as the maximum liquidation restrictions that could be imposed in a partnership agreement. Since partnerships and LLCs are often structured to correspond with state law, the provisions of partnership agreements restricting liquidation typically fall within the regulatory exception provided under section 2704(b)(3)(B) and 26 CFR 25.2704-2(b): that they are no more restrictive than those under State law, and therefore do not constitute applicable restrictions.
In an effort to reduce their tax liability, some taxpayers have tried to avoid the application of section 2704(b) by transferring a partnership interest to an assignee instead of a partner. These taxpayers reason that as long as partnership income, gains, losses, etc. are allocated to the assignee, they do not have, nor can they exercise, the rights or power of a partner. They also reason that the assignee’s inability to liquidate its partnership interest is no more restrictive than the constraints imposed under State law, concluding that the assignment should not be considered an applicable restriction.
Transfers to non-family members
A common strategy among such taxpayers is to transfer a minority interest of a family-controlled entity to a non-family member (e.g., an unrelated charity or employee) to ensure the family would not have the power to remove a restriction, thereby avoiding the application of Section 2704(b).
Proposed Changes to Section 2704
On August 2, 2016, the IRS introduced the currently proposed changes to Section 2704.7 The proposed changes include the following:
- Clarification of covered entities to include corporations, partnerships, LLCs, and other entities and/or business arrangements.
- Modification to the definition of control so as to reference the holding of at least 50% of either the capital or profit interest in an entity by the transferor’s family in aggregate, or having the ability to cause liquidation of the entity.
- Addition of new language that applies to transfers of interests to assignees, which states that transfers resulting in the restriction or elimination of the transferee’s ability to exercise the voting or liquidation rights, as associated with the interest prior to the transfer, will be considered a lapse of those rights.
- Inclusion of a three-year rule that applies to transfers of family-controlled entities made within three years of the transferor’s death by which certain transfers that resulted in a lapse of liquidation rights are included in the transferor’s taxable estate.
- Revision to 26 CFR 25.2704-2(b) to provide that an applicable restriction does include restrictions that are imposed under the terms of the governing documents, as well as restrictions that are imposed under a local law, regardless of whether a restriction may be superseded by, or pursuant to, the governing documents.
- Creation of a class of “disregarded restrictions” that refer to restrictions on the ability of the entity to liquidate or redeem individual interests in family-controlled entities.
As noted above, the proposed regulations introduce a new class of “disregarded restrictions.” The IRS introduced disregarded restrictions within the proposed regulations based on its conclusion that there are additional restrictions that adversely impact the transfer tax value of an interest in a family-controlled entity without reducing the value of the interest to a member of that family. In other words, the inclusion of disregarded restrictions is meant to avoid situations similar to that of Kerr v. Commissioner.
According to the proposed regulations, a disregarded restriction is one that:8
- Limits the ability of the interest’s holder to liquidate the interest in the entity;
- Limits liquidation proceeds to less than a minimum value; 9
- Defers payment of the liquidation proceeds for more than 6 months; and/or
- Permits payment of the liquidation proceeds in form(s) other than cash or certain forms of property.
In transfers involving interests in family-controlled entities, any of the above restrictions on an individual’s right to liquidate his or her interest will be disregarded for valuation purposes if the restriction will lapse at any time following the transfer, or if the transferor or transferor’s family may remove the restriction.
The proposed regulations also address how to determine whether the transferor, or transferor’s family, has the ability to remove a disregarded restriction when any interest in the entity is held by a non-family member. According to the new rules, for the purpose of determining the ability of the transferor or transferor’s family to remove a restriction, an interest held by a non-family member should be disregarded unless each of the following criteria are met:
- The interest has been held by the non-family member for more than three years immediately before the transfer;
- The non-family member holds at least a 10% of either the equity or profit interest in the company;
- The aggregate interest held by all non-family members is at least 20% of the equity or profit interest in the company; and
- Each non-family member has an enforceable put right to receive, from the entity or from one or more of the shareholders, the minimum value of the interest, as of the date of the liquidation, within six months of providing notice of the intent to withdraw.
The proposed changes stipulate that the existing exceptions, which currently apply to applicable restrictions under Section 2704(b), also apply to disregarded restrictions. Further, another exception is introduced under the proposed changes, stating that a restriction does not constitute an applicable restriction or disregarded restriction if each holder of an interest in the entity has a conforming put right.10
Impact on Valuation
Under the proposed changes to Section 2704(a), if a transfer results in a lapse in the voting or liquidation rights of the transferor, and the transfer occurs within three years of the transferor’s death, then the value of the lapse is added to the transferor’s estate. The value of the lapse is the excess, if any, of the fair market value of the interests in the entity held by the transferor immediately before the transfer determined as if the lapse did not occur, over the fair market value of such interests valued as if the transfer occurred on the date of the transferor’s death and as if the lapse did occur.
Under Section 2704(b), an interest transferred for gifting purposes may have an applicable restriction, a disregarded restriction, or neither. If the transferred interest has neither an applicable restriction nor a disregarded restriction, it will be valued no differently than it otherwise would be under the current regulations. If the transferred interest has either an applicable restriction or a disregarded restriction, then the transferred interest will be valued as if the provision, or lack thereof, resulting in the restriction did not exist. For example, removing a disregarded restriction does not grant a right to the transferred interest to redeem within six months of notice. It only means that if there were a provision in the governing documents or local law that restricted such ability, the restriction is ignored and the governing document or local law is considered silent on the issue. We expect this will cause a slight reduction in the discounts for lack of control and lack of marketability applicable to relevant transfers as compared to the existing regulations; however, we do not believe it will come close to eliminating such discounts.
It should be noted that some attorneys and valuation professionals have interpreted the new regulations as effectively granting rights to a transferred interest, such as a put right. If this interpretation were supported by case law, the proposed regulations could create larger reductions in the discount for lack of control and lack of marketability than our interpretation above.
Regardless of the interpretation, the proposed regulations will make valuations of intra-family transfers for gift and estate tax purposes more complex and time consuming (i.e., more expensive). Your valuation expert must be familiar with both new and existing regulations, your company’s ownership structure and governing documents, and the applicable laws within your jurisdiction. Any discounts that are be applied must be carefully determined and thoroughly supported.
Given the proposed changes, and the level of scrutiny already applied by the IRS to the use of valuation discounts, it is highly important to select a qualified appraiser with extensive experience in providing valuations for tax reporting purposes. Failing to adhere to new regulations as they go into effect can result in a challenge by the IRS, which may involve costly and time-consuming litigation.
1 U.S. Department of the Treasury. Treasury Issues Proposed Regulations to Close Estate and Gift Tax Loophole. Mark J. Mazur. Treasury Notes Blog: August 2016.
2 “Treatment of Certain Lapsing Rights and Restrictions,” Title 26 U.S. Code, Sec. 2704 et seq. 2006 ed. Supp. III, 2009.
5 “Lapse of Certain Rights,” Title 26 Code of Federal Regulations, Pt. 25. 2016 ed.
6 Kerr v. Commissioner, 113 T.C. 449, 473 (1999), aff’d, 292 F.3rd 490 (5th Cir. 2002).
7 Internal Revenue Service. Estate, Gift, and Generation-skipping Transfer Taxes; Restrictions on Liquidation of an Interest: Notice of proposed rulemaking and notice of public hearing (August 2, 2016).
9 Minimum value: Pro rata share of fair market value of entity only including obligations allowed under 26 U.S.C. § 2703.
This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.