Friday, September 16, 2016

Proposed Treasury Regulations Would Significantly Limit Valuation Discounts for Transfers of Interests in Family Controlled Entities

In early August, the IRS released proposed regulations regarding §2704 of the Internal Revenue Code.  Section 2704 was enacted in 1990 in an attempt by Congress to limit valuation discounts on intra-family transfers of family controlled corporations and partnerships for gift and estate tax purposes. 

Section 2704(a) treats the lapse of voting or liquidation rights in family controlled corporations or partnerships as a transfer by gift or as a transfer included in the transferor’s gross estate.  Section 2704(b) generally provides that “applicable restrictions” are disregarded in valuing intra-family transferred interests.  Applicable restrictions are those that (i) limit the ability of the entity to liquidate and (ii) lapse or can be removed by members of the family. 
However, based on a combination of favorable tax court rulings and changes in state law since 1990, estate planners have sought significant tax savings for their clients ranging from 30-50 percent of the value of the pre-transfer interest despite the restrictions imposed by §2704. 
Summary and Impact of Proposed Regulations
The proposed regulations would impose a three year look-back rule; if the transferor dies within three years of making a transfer, the value of the lapsed voting or liquidation right would be included in the transferor’s gross estate.  The three year look-back rule would significantly eliminate “deathbed transfers” designed to achieve valuation discounts. 
In addition to the three year look-back rule, to close what the IRS perceived as loopholes in the current §2704 regulations, the proposed regulations add the concept of “disregarded restrictions” and have also added LLCs to the types of entities covered by the regulations.  Interestingly, rather than defining specific types of restrictions, disregarded restrictions are defined by their effect.  Subject to certain limited exceptions, the proposed regulations would disregard most restrictions unless the interest holder has the ability to put its interest to the entity on six months’ notice for at least its pro rata share of the net value of the entity in cash or property. 
In sum, if the proposed regulations are enacted in their current form, they would significantly restrict transferors’ abilities to achieve lack of control and lack of marketability discounts in connection with transfers of interests in family controlled entities. 
Planning Considerations
There is significant uncertainty with respect to both the validity and interpretation of the proposed regulations.  Despite the uncertainty, clients contemplating transferring non-controlling interests in family controlled entities should consider completing such transfers prior to the date the regulations become effective (generally, the date when the regulations become final).
If the regulations are finalized, individuals may continue to achieve tax savings by transferring appreciating assets out of their estate. However, they will no longer be able to leverage the tax savings by taking many traditional discounts on the value of the transferred asset.
Effective Dates
The regulations generally will become effective on the date they become final, which could be before the current presidential administration ends.