Proposed Regulations Under IRC Section 2704 May Significantly Change Valuation Discounts for Transfers of Family-Owned Businesses

The Treasury and IRS recently issued proposed regulations intended to affect the valuation of closely held business interests transferred to family members.

Specifically, the proposed regulations: 1) treat the lapse of voting or liquidation rates as a transfer subject to estate, gift and GST tax in certain circumstances; and 2) provides new rules which would value transfers of interests in a closely held business without considering certain restrictions placed on those interests. These rules may significantly reduce valuation discounts for gift, estate and generation-skipping tax purposes.

Under IRC Section 2704(b), where one transfers an interest in a corporation or partnership to or for the benefit of a member of the transferor’s family and the transferor and family members hold (immediately before the transfer) control of the entity, then an “applicable restriction” must be disregarded in determining the value of the transferred interest. For this purpose an “applicable restriction” is one which limits the right of the transferee to liquidate or redeem the transferred interest if this restriction: a) terminates in the future; or b) can be removed by the transferor or the transferor’s family member, acting either alone or collectively. Typical examples of these restrictions involve the right of an owner to cash-out, which is made subject to: i) approval of a high percentage of other owners or unanimous consent; or ii) approval of the entity manager or general partner. Additionally, a partnership or limited liability company agreement might limit the rights of transferees to become full partners or members (the “Assignee” rule found in the laws of most states). While these restrictions may mirror provisions found in a typical business arrangement, the IRS sees them, in the family context, as merely providing a justification for discounting the value for transfer tax purposes.

The current regulations contain two exceptions where a restriction is allowed to affect the value of a transferred interest. A commercially reasonable restriction imposed by an unrelated person in a financing transaction does not need to be disregarded. A more significant “state law exception” exists under which a restriction which is no more restrictive than that found under the default rules of state law for the entity is allowed for valuation purposes. Since many states have changed their limited partnership and limited liability company laws after the passage of IRC section 2704 to provide for more restrictive default provisions, the Service believes that this “state law exception” needs adjustment.

Under the proposed regulations:

• The current “state law exception” is changed. A restriction can be considered for valuation purposes where it is “imposed or required to be imposed by any federal or state law” IRC section 2704(b)(3)(B). The Service clarifies that this refers only to the laws of the United States or any state, including the District of Columbia. It does not include any other jurisdiction. Furthermore, a restriction is considered imposed or required to be imposed by law only if the restriction cannot be removed or overridden, is mandated by the applicable law, and is required to be included in the governing document or is otherwise made mandatory. Consequently, the right to draft an agreement with a less restrictive provision will cause the term not to be considered as mandatory and to be disregarded for valuation purposes.
• The change to the State Law Exception will cause restrictions imposed on transferees treated as assignees to be disregarded to valuation purposes.
• The proposed regulations contain new classes of restrictions which must be disregarded (referred to as “disregarded restrictions”). They include redemption terms for less than “minimum value” or receipt of certain deferred payments.
• Where non-family members own interests in the entity, the Proposed Regulations disregard such interests that have been held less than three years before the date of transfer, that constitute less than 10% of the value of all equity interest, and that when combined with the interests of other nonfamily members constitute less than 20% of the value of all the equity interests, or which lack a right to put the interest to the entity and receive a minimum value.

Certain provisions of the proposed regulations will be effective upon issuance of final regulations and others are effective 30 days after that. Since there is a 90-day comment period and a public hearing scheduled December 1, final regulations will be issued no sooner than December 2016 and possibly not until 2017. This gives taxpayers a limited period of time to plan under the current rules, which provide the maximum valuation discount benefits.

• Gifting programs should be accelerated to be completed before finalization of the regulations.
• Estate plan should be reviewed to consider the impact of these rules on potential estate tax obligations. Life insurance needs may need to be reconsidered.
• Partnership and LLC agreements should be reviewed and amended to accommodate future transfers.

Contact your Marcum tax professional to discuss how this new IRS position may affect you.