Proposed regulations under Section 2704

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Many articles have been written in recent months on the proposed regulations under Section 2704 of the Internal Revenue Code, which was released on Aug. 2. In case you have missed the many summaries, synopses and opinions on this very broad and impactful proposal, I am providing a brief, high-level summary of both the proposed regulations and issues that have been raised concerning them.

Section 2704 was enacted in 1990 and titled “Treatment of Certain Lapsing Rights and Restrictions.” The goal was to limit discounts for certain family partnerships or LLC interests that are transferred to family members. Over the years, the IRS has argued that FLP and other family-controlled holding entity ownership interests are constructed solely to avoid intergenerational wealth transfer, gift, estate, and generation-skipping transfer taxes.

The major provisions of the long-awaited proposed regulations include:

Covered entities

Although section 2704, when it was enacted, referred only to corporations and partnerships, the proposed regulations would clarify that they also apply to limited liability companies and other entities and business arrangements, as well as corporations and partnerships.

Death within three years/lapse of liquidation rights

Section 2704(a) treats the lapse of a voting or liquidation right in a family-owned entity as a transfer by the individual holding the right immediately before its lapse. The current regulations exempt such a transfer if the rights with respect to the transferred interest are not restricted or eliminated.  The proposed regulations would deny that exemption for transfers occurring within three years before the transferor’s death if the entity is controlled by the transferor and members of the transferor’s family immediately before and after the lapse, eliminating minority or lack of control discounts in some cases.

This example illustrates its impact of the provision: An individual owning 84 percent of the stock in a corporation, whose bylaws require at least 70 percent of the vote to liquidate, gives one-half of his stock in equal shares to his three children. The individual in this example gave up his right to liquidate or control the corporation by making the gift. If these transfers occurred within three years of his death, the transfers would be treated as if the lapse of the liquidation right occurred at the individual’s death. His gross estate now includes an additional “phantom asset” (the amount that was previously taken in discounts) that will not qualify for the estate tax marital or charitable deduction.

Disregarded restrictions

The effect of Section 2704(b) is that interests in a family-controlled entity that are subject to restrictions on redemption or liquidation are disregarded in valuing such an interest for gift or estate tax purposes when that interest is transferred to a family member.

Rather than describing the kinds of such lapsing or removable restrictions that will be disregarded in making such valuations, the proposed regulations define those restrictions with reference to the effect they would have on gift or estate tax value.  If the effect of a restriction on an interest in an entity is to limit the ability of the holder of that interest to compel liquidation or redemption of that interest on no more than six months’ notice for cash or property equal at least to what the proposed regulations call “minimum value,” then the restriction is disregarded.

“Minimum value” is defined as the pro rata share of the net fair market value of the assets of the entity – that is, the fair market value of those assets reduced by the debts of the entity, multiplied by the share of the entity represented by that interest. The regulations go on to say that these rules do not mean that all interests in entities will necessarily be valued on a “look-through” basis at their pro rata share of the net value of the assets of the entity, but the proposed regulations would move much closer to such a model.

State law default restrictions not considered

Most states allow the governing documents of an entity to override any restrictions on transfer. If the proposed regulations become final, there will be few if any applicable restrictions that will reduce the value of an interest in a family-controlled entity for transfer tax purposes.

Assignees

Transfers to assignees may result in lapsed liquidation or voting rights under §2704(a) and will be subject to the “disregarded restrictions” rules.

There are a few reasons for applying valuation discounts for FLPs and other privately held, family-controlled entities.

 Market considerations

• When valuing a privately held business interest, valuation analysts look to public and private market transactions of securities with the same or a similar set of restrictions to identify similar securities that assist in creating a proxy of risk. These risk factors are often represented as a price discount from the net asset value of the underlying assets of the FLP.
• Discounts provide the investor a greater level of assurance that their investment will yield a suitable rate of return upon selling. Important considerations include:

1. FLP investments are typically not especially unique investments; and
2. From an arms-length transaction perspective, the transferee cannot expect to sell its interest to all buyers at a price not substantially discounted from the aggregate fair market value of the FLP’s underlying assets. Otherwise, the buyer would simply use his or her own capital to buy similar investments (if not the same investments) as the FLP, retaining control of the investments and having the ability to liquidate on his or her own terms.

• Generally, lack of control and lack of marketability issues of privately held, family controlled FLPs create negative characteristics which support valuation discounts.

A public hearing on proposed Section 2704 regulations is scheduled for Dec. 1.  Because of the broad sweep of the proposed regulations, there will likely be challenges to their adoption in their present form. Attention should be given to the provisions in current and future operating agreements and other governing documents. Potential tax consequences should also be considered.

Kristin S. Coffey, CVA, MBA, is the director of business valuation services with Mengel, Metzger, Barr & Co. LLP. She can be reached at [email protected].