United States: Proposed Regulations Under Section 2704

On August 2, the United States Treasury Department issued proposed regulations under Section 2704 of the Internal Revenue Code of 1986, as amended from time to time (the "Code"). These proposed regulations, if finally adopted in their current form, would have a substantial negative effect on the ability of owners of interests in family-controlled entities (including domestic and foreign corporations, partnerships, and LLCs) to take advantage of valuation discounts for gift, estate and generation-skipping transfer tax purposes when transferring interests in such entities to family members. The proposed regulations would apply to both lifetime gifts and transfers at death, as well as to sales for consideration.

A hearing on the proposed regulations is scheduled to be held on December 1. Most of the new rules would become effective on the date the regulations become final, and others will become effective 30 days thereafter. Although it is probable that the final regulations will not take effect until the first quarter of 2017 at the earliest, it would be wise for clients to consider making gifts of interests in family-controlled entities prior to the end of this calendar year.

Under Section 2704(a) of the Code, the lapse of any voting or liquidation right in an entity, such as a corporation, partnership or LLC, is treated as a taxable transfer by gift or at death if the transferor, immediately before the lapse, and members of the transferor's family, both before and after the lapse, hold control of the entity. For purposes of Section 2704, a lapse of a voting or a liquidation right occurs when a presently exercisable voting or liquidation right is restricted or eliminated.

Under Section 2704(b) of the Code, if an interest in a corporation or partnership is transferred to or for a member of a transferor's family, certain restrictions are disregarded in valuing the transferred interest, if the transferor and members of the transferor's family hold control of the entity immediately before the transfer. For purposes of Section 2704(b), such a restriction includes any restriction that effectively limits the ability of the entity to liquidate and (1) the restriction lapses, in whole or in part, after the transfer, or (2) the transferor or any member of the transferor's family (either alone or collectively) has the power after the transfer to remove, in whole or in part, such restriction. In other words, if, after the transfer, a restriction that would have the effect of reducing the fair market value of a transferred interest (such as a restriction that limits the ability of the entity to liquidate) lapses by its terms or could be removed by the transferor or any member of the transferor's family, such restriction will be disregarded for valuation purposes.

The proposed regulations are long and complex and a detailed analysis is beyond the scope of this Client Alert. In brief, however, the proposed regulations target the following perceived taxpayer valuation reduction strategies:

1. Deathbed Transfers Resulting in Loss of Voting or Liquidation Power

The proposed regulations would treat the lapse of a voting or liquidation right as a result of a transfer of an interest in a family-controlled entity within three years of the transferor's death as a lapse occurring upon the transferor's death, and thus includible in the transferor's estate pursuant to Section 2704(a). For example, if a parent holding 51% of the voting stock of a family-controlled corporation makes a gift to a child of a 2% block of voting stock less than three years prior to the parent's death, the difference between the fair market value of a 51% block of the corporation's voting stock and a 49% block of such stock will be included in the parent's estate for estate tax purposes, as well as the fair market value of the 49% block of voting stock that the parent in fact owned at death. By contrast, if the parent's death were to occur more than three years after the date of the gift, the fair market value of only the 49% voting block would be included in the parent's estate for estate tax purposes.

The effect of this rule would be to eliminate or reduce significantly the otherwise available minority discount in valuing such a transfer.

2. Nominal Power of Non-Family Interest Holders to Prevent Liquidation of the Entity

The proposed regulations would disregard the power of non-family interest holders to prevent the liquidation of the family-controlled entity (for purposes of determining whether the transferor, the transferor's estate, or any member of the transferor's family, singly or collectively, possesses the power to remove a restriction on liquidation of the entity after the transfer), unless on the date of the transfer all of the following conditions are satisfied: (a) the interest has been held by the non-family member for at least three years immediately prior to the transfer, (b) the interest constitutes at least a 10% equity or capital or profits interest in the entity, (c) the aggregate non-family equity interests in the entity amount to at least 20%, and (d) each non-family interest holder possesses a put right enforceable under local law that meets specified minimum value and payment conditions contained in the proposed regulations. (See paragraph 5 below.) In other words, the proposed regulations would disregard the presence of relatively recent, insubstantial non-family equity holders in a family-controlled entity when determining whether the transferor or members of the transferor's family have the power to remove a restriction. These provisions are consistent with the Treasury's and IRS's view that the ownership interest of a non-family member should be recognized for valuation purposes only where the interest is economically substantial and longstanding, and that a bright-line test will avoid an otherwise fact-intensive inquiry as to whether the non-family ownership interest effectively constrains the family's ability to liquidate the entity.

3. Statutorily Imposed Restrictions on Liquidation of the Family-Controlled Entity

Since the enactment of the current regulations in 1992, many states have enacted statutes that are designed to provide elective restrictions on liquidations that are as restrictive as those that possibly could be imposed in a partnership agreement under applicable law. Such a statutorily imposed restriction would include, for example, a provision that prohibits the withdrawal of a limited partner from a partnership unless the partnership agreement provides otherwise, or prevents the liquidation or redemption of a partnership interest until the partnership is dissolved and fully liquidated. For purposes of determining the fair market value of the transferred interest, the proposed regulations would disregard any restriction on the liquidation of the entity that is not required under applicable federal or state law. By contrast, the current Treasury Department regulations under Section 2704 except from the definition of a restriction that is to be disregarded for valuation purposes any restriction that is no more restrictive than that which state law would apply in the absence of such a restriction.

4. Low Valuation of Assignee Interests

The proposed regulations provide that a transfer that results in the restriction or elimination of the transferee's ability to exercise voting or liquidation rights that were associated with the interest prior to the transfer constitutes a lapse of such rights. Thus, a transfer of a partnership interest to an assignee who is given a non-voting interest (with the intent that such a non-voting interest would be entitled to a discounted fair market value) would constitute a lapse of the voting and liquidation rights associated with the transferred interest, thus resulting in a taxable transfer within the meaning of Section 2704(a) of the Code.

5. Restrictions Relating to the Ability to Compel Liquidation of an Interest in the Entity and the Payment of Property to Be Received in Exchange for a Liquidated Interest

The proposed regulations create a new class of restrictions relating to an interest in a family-controlled entity – called "Disregarded Restrictions" – which would be disregarded in valuing such an interest for transfer tax purposes. Such disregarded restrictions include provisions that would:

  1. limit or permit the limitation of an interest holder's ability to compel the liquidation or redemption of the interest;
  2. limit or permit the limitation of the amount that may be received by the interest holder on liquidation or redemption of an interest in the entity to an amount that is less than "minimum value" (as such term is defined in the proposed regulations);
  3. defer or permit deferral of the payment of the full amount of the liquidation or redemption proceeds for more than six months after the date the holder gives notice to the entity of the holder's intent to have his or her interest liquidated or redeemed; and
  4. authorize or permit the payment of any portion of the full amount of the liquidation or redemption proceeds in any manner other than in cash or property. With one exception relating to entities engaged in an active trade or business, a promissory note issued directly or indirectly by the entity, or by one or more holders of interests in the entity, or by a person related to either the entity or a holder of an interest in the entity is deemed not to be property.

The proposed regulations provide an exception to the applicability of the Disregarded Restrictions where, among other conditions, each holder in the entity has an enforceable put right to receive, on liquidation or redemption of the holder's interest, cash or other property having a value that is at least equal to "minimum value," as such term is defined therein. This provision undoubtedly will be highly controversial because of its likely impact on the availability of minority interest and lack of marketability discounts in connection with a transfer of an interest in a family-controlled entity.

These proposals make clear the intent of the Treasury Department and the IRS to strengthen the current regulations under Section 2704 of the Code in order to eradicate perceived taxpayer valuation abuses permitted by the current regulatory scheme. It is, in our view, quite possible that, in the hearing scheduled for December 1, taxpayers and their representatives will argue that the proposed regulations exceed the regulatory authority granted to the Treasury Department under Section 2704, and that congressional action is required to effectuate the objectives of the proposals. In addition, taxpayers and their representatives likely will argue that it is inappropriate for the proposed regulations to apply to a family-controlled operating business as opposed to an entity holding passive assets such as investment portfolios. The introduction by the proposed regulations of the new concept of "disregarded restrictions" almost certainly will be attacked by taxpayers and their representatives as inappropriately limiting or eliminating both lack of control and lack of marketability discounts.

In any event, clients who otherwise are considering making transfers (whether by gift or sale) of interests in family-controlled entities to family members should focus on that planning now. It would be wise to implement such a transaction prior to December 1, but certainly before year end, in order to take advantage of currently available minority interest and lack of marketability discounts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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