IRS Proposes Regulations That Would Remove Valuation Discounts in Estate & Gift Tax Transfers

By Mark Gehrig, Managing Director

In early August, the Department of the Treasury and the Internal Revenue Service (“IRS” or “the Service”) released proposed changes to Internal Revenue Code (“IRC”) Section 2704.  These are the regulations that pertain to the use of discounts in the valuation of transferred fractional ownership interests for gift and estate tax purposes.

While the release of the proposed regulations may have gone unnoticed by many, the potential new Section 2704 guidelines have been eagerly awaited by those who provide estate and gift tax services (legal, accounting, tax, and valuation) to the owners of closely held businesses controlled by members of a family.  Legal entity forms included in the new rules include taxable C corporations and flow-through entities such as S corporations, partnerships, and limited liability companies.  Importantly, in addition to family limited partnerships (i.e., asset pooling vehicles) operating businesses are also the subject of the proposed regulations.

If adopted as proposed, the regulations will make it more costly to accomplish intra-family transfers of fractional ownership interests of a family-controlled business.

Current Status

To emphasize, the new Section 2704 regulations are currently proposed and, as such, are subject to a 90 day comment period which will end on November 2, 2016.  After receiving comments from the public, the IRS will hold a hearing at 10 a.m. on December 1, 2016 in the auditorium of the Internal Revenue Building on Constitution Avenue in Washington DC.  The public can attend the hearing and, with advance planning, a ten minute oral presentation can be made to the IRS by any interested party.  As would be expected, building security will reportedly be tight that day; admission requires a photo I.D.

What might result from all of this?  The proposed regulations could go into full effect as currently written as quickly as 30 days after the publication of the final ruling, which could theoretically occur in the first quarter of 2017.   However, the proposed regulations may also be modified or abandoned, the latter allowing the current regulations to continue.  Further, any new regulation may ultimately be challenged in court or modified by new legislation.

If history is any guide, the more controversial the nature of a proposed regulation (and these proposed regulations are very controversial) the longer it will take for the fray to resolve itself.  As such, a final determination could take 12-24 months or several years.

In any event, modifications to Section 2704 will apply only to transfers that occur after any changes are finalized and go into effect; any new rules will reportedly not be applied retroactively.

A Very Brief History

For many decades, various techniques were available to maximize valuation discounts for transferred ownership interests as a means of reducing estate and gift taxes.  Then, in 1990, Chapter 14 of the IRC was enacted to prevent, or at least limit, the reduction of taxes owed through the use of “abusive” freeze (i.e., the exchange of assets that benefit from value appreciation for those that don’t) and other techniques designed to decrease the value of intra-family transfers by imposing artificial restrictions on voting and liquidation rights that serve to reduce value without reducing the economic rights inherent in the transferred asset.

Stated differently and more broadly, Section 2704(b)(4) currently provides that “The Secretary [of the Treasury] may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest…but does not ultimately reduce the value of such interest to the transferee.”

Reportedly, the Service wanted to issue revised regulations to further curb what it perceived as abuses as far back as 2003.  Approximately thirteen years later, on August 2, 2016, the proposed revisions to the regulations finally appeared.

What Are Some of the Implications?

Most of the discussion resulting from the proposed regulations has focused on IRC Section 2704.  This section currently provides special valuation rules for valuing the intra-family transfer of interests subject to lapsing voting or liquidation rights and restrictions on liquidation.  Section 2704(a) ignores certain lapses of voting or liquidation rights if the family controls the entity both before and after the lapse.  IRC Section 2704(b) sets forth that certain “applicable restrictions” (i.e., restrictions that might otherwise merit valuation discounts) are to be ignored for purposes of valuing interests in family-controlled entities if those interests are transferred in a gift or estate tax context for the benefit of other family members.  Stated differently, an applicable restriction is one that restricts the ability to liquidate in a way that is more restrictive than state law and/or that either goes away after the intra-family transfer or can be removed by the family operating collectively.

Section 2704 currently asserts that if the shareholder agreement controlling the operations of a family-owned business stipulates that an owner’s shares may be redeemed by the entity at book value, such a provision will typically be ignored for purposes of determining fair market value in a gift and estate tax context.  However, a restriction that is generally applicable under state law could merit a supportable discount for estate and gift tax valuation purposes.  Under current regulations, if business conditions exist that cause a minority shareholder’s interest to be subject to lack of control and/or lack of marketability factors, even in the absence of business and owner agreements restricting the rights of shareholders, discounts would be appropriate.

As proposed, the new Section 2704 would eliminate most valuation discounts for family-controlled businesses in an estate and gift tax context.  In the attempt to further eliminate the validity of restrictions that lead to valuation discounts, the proposed regulations introduce an additional category of restrictions, referred to as “disregarded restrictions.”  Disregarded restrictions, aptly termed, are ignored in the valuation of an interest in a family-controlled entity if, after the transfer, the restriction will lapse or may be removed by the transferor or the family of the transferor.  A disregarded restriction would also include any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity.  Further, the proposed regulations shine a light on attempts to avoid the application of Section 2704 by involving a charity or another non-family member; the proposed regulations would disregard such interests unless certain conditions are met.  The proposed regulations also address the “deathbed transfer” of an interest for the purpose of creating a valuation discount.  If a transfer is made within three years of the death of the transferor and effectively dilutes the ability to liquidate the transferred interest as a result of fractionalizing and transferring the interest among multiple family members, the transfer would be deemed to have occurred at the date of death and will be valued for transfer tax purposes as though the liquidation right was not diminished.  Although many uncertainties exist with regards to how the proposed provisions will ultimately affect appraisal practice, discounts for lack of control seemingly will be subject to the greatest degree of scrutiny and pressure to disregard.

A foundational element of the proposed Section 2704 regulations appears to be the IRS’s assumption that the members of a family that own a business act as a single, cohesive unit; that family members always cooperate.  The perspective of the Service is seemingly that discounts that might otherwise be appropriate in non-family member situations are not applicable to family-controlled business.  Other aspects of the proposed regulations are equally imaginary, but are beyond the scope of this discussion.  Some contend that the Service has overreached as the original intent of Chapter 14 was to uncover artificial and non-economic restrictions.  The proposed regulations, however, seem to have the scent of the family attribution test.

Anecdotally, in a recent meeting with the lead attorney of the estate and gift tax practice at a noted local law firm, a general inquiry regarding the level and composition of current business activity at the law firm was made.  The response was that the attorney’s firm was extremely busy with litigation work, particularly engagements arising from disputes between family members resulting from, or related to, the intra-family transfer of ownership interests.  The assumption of family unity can be tenuous for some, if not many, family-owned businesses.

The Road Forward

Many seem to believe there will be a significant challenge to the Section 2704 regulations as proposed.  This will likely come from a variety of stakeholders including, most notably, family-owned businesses and providers of estate and gift tax advisory services.  Likely challenges to the positions taken by the IRS reportedly will revolve around misalignment of the proposed regulations with the legislative grant of regulatory authority and applicable statutes, not to mention reality.  As always, informed guidance is the safest route to choose.