Transfer of assets & business interests: Proposed Treasury Regulations Under IRC Section 2704 Would All But Eliminate Valuation Discounts

by Paul McGloin

Client Considering Planning Transfers May Wish to Implement Them Prior to December 1st

It is rare that a proposed Treasury Regulation gets much attention from estate planning practitioners, especially ones issued during the vacation month of August. However, on August 4th the IRS issued proposed Treasury Regulations under a little-used section of the Internal Revenue Code that may represent one of the biggest changes in estate planning law in the past thirty years. Planners around the country have spent much of the past month huddled in discussion groups and on conference calls to try to understand what these far-reaching changes mean for their clients.

For decades, when making transfers of interests in family-owned businesses, planners have relied on valuation discounts to reduce the value of transferred interests during lifetime or at death. These valuation discounts are usually based on transferring minority, non-controlling interests in business entities to family members or to trusts for their benefit. Discounts are claimed due to the fact that the interests transferred are subject to multiple restrictions --- for example, the inability to influence business decisions or to force distributions (lack of control) or the inability to sell the transferred interest to a third party (lack of marketability). These claimed discounts are argued to reduce the value of assets transferred --- in some cases very dramatically.

Over the years the IRS has been largely unsuccessful in challenging these claimed discounts in audits and in court, except in the most extreme cases where structures were created immediately prior to a family member’s death with the obvious intent of claiming a discount. The debate about discounts is usually about the magnitude of the discount that will be allowed in a given case, rather than whether a discount is permitted at all. For decades, lawyers have understood how to build restrictions into family-owned business entities (corporations, partnerships and limited liability companies), and valuation experts have provided clients with appraisals that document the amounts of the discounts resulting from these restrictions. As gift and estate tax exemptions have increased in recent years, clients have been able to shift more and more wealth out of their estates through these claimed discounts.

The provision of the tax law that addresses the valuation of interests in businesses that are subject to restrictions is Internal Revenue Code Section 2704, enacted by Congress in 1990. On its surface, Section 2704 has the stated intent of requiring certain restrictions on family-controlled entities to be disregarded for valuation purposes if they prevent a business entity from being liquidated. Discounts for minority interests and lack of marketability would appear to be restrictions of this type. However, Section 2704 also contains an important exception --- it does not apply to restrictions that are “imposed, or required to be imposed, by any Federal or State law.” This language has been interpreted by the IRS, courts and practitioners to mean that if a particular state’s “default provisions” on liquidation of a business entity impose certain requirements absent contrary language in the governing documents, those default provisions under state law make Section 2704 inapplicable. Thus, for example, if a business entity is created in a particular state that requires the unanimous consent of the members, partners, shareholders, etc. to liquidate the entity, and the organizational documents of the entity do not impose a different requirement, such a restriction is outside the scope of Section 2704 and the restrictions can be taken into account in valuing the interests transferred. Many states in recent years (with an eye no doubt to competing for entity-creation business or keeping business in-state) have enacted default restrictions on liquidation of entities that have had the practical effect of nullifying Section 2704. With competent planning advice, owners of private companies and family businesses could entirely avoid the impact of Section 2704 and transfer restricted interests in entities at deep discounts.

Since its earliest years, the Obama Administration has had the stated goal of modifying rules about valuation discounts for family businesses, and the original hope of the Administration was to change the rules via legislation. However, the Administration’s legislative proposals have not won support in Congress, and this lack of support has led to a change in tactics. Section 2704 broadly authorizes the IRS to put into effect Regulations to disregard restrictions that reduce the estate or gift tax value of an interest but that do not ultimately reduce the value of the interest to the transferee. Rather than changing Section 2704 by statute, the Administration through the IRS is imposing new Treasury Regulations that will broaden the application of the statute.

What do the proposed Treasury Regulations under Section 2704 do?

• Restrictions on liquidation must be mandated by Federal or State law in order to be taken into account for valuation purposes. Restrictions that are simply allowable under state law or a governing document are disregarded for the purpose of valuing transferred interests. Most restrictions that planners have traditionally used to support valuation discounts will no longer be viable.

• The proposed Treasury Regulations clarify that Section 2704 applies to corporations, partnerships, limited liability companies and all other business arrangements. The view that a particular form of business entity is excluded from the scope of Section 2704 is rejected.

• Ownership of interests in business entities by non-family members to create discounting opportunities are drastically reduced. Third-party owners are required to meet minimum holding periods and levels of ownership, and third party ownership interests must have minimum “put rights”.

• When interests are transferred within three years of death, restrictions are ignored in most cases in valuing the interests.

Commentators have remarked that on their face the breadth and scope of the proposed Treasury Regulations under IRC Section 2704 may make it difficult or impossible for clients to create entities that qualify for the kinds of valuation discounts seen in past decades.

The proposed Regulations under Section 2704 state that they will take effect thirty days after they are published as “Final Regulations.” A public hearing is scheduled on the proposed Regulations for December 1, 2016, so publication of “Final Regulations” may not occur until some time in 2017. Due to uncertainty over the effective date of the proposed Regulations, many planners are advising clients considering transfers to implement their plans prior to the December 1st hearing date.

The proposed Regulations under Section 2704 leave many important questions unanswered. For example, if a family attempts to make a gift or sale of an interest at a discount due to a restriction, and the restriction is later disregarded by the IRS under Section 2704, who is to pay the gift tax or estate tax on the value that has “disappeared” with the restriction? In other words, just as we have “phantom income” for income tax purposes, might we have “phantom assets” for gift and estate tax purposes due to these new rules? Even more fundamentally, is it permissible for a government agency (the IRS) to “reinterpret” a statute twenty-six years after its enactment to have a significantly different meaning than how it has been interpreted by the IRS, the courts and practitioners over the intervening time period (and indeed by the Congress that enacted it)? These points and others will certainly be raised with the IRS in the December 1st hearing.

The main take-away for clients who own interests in closely-held or family businesses should be to sit down with their estate planning attorney or advisor before the proposed Treasury Regulations come into effect. This is a very complex area, but the message is simple: discounts on transfers of restricted interests that are readily available now may not be available in the future. Making transfers now of these interests may result in more wealth being transferred to your heirs, and less gift and estate tax being owed to the IRS. Ignore this opportunity at your own risk!

September 2016