Brief Summary Of §2704 Proposed Regulations On Discounts In Family Entities

Written by: Wills, Trusts, & Estate Administration

On August 2, 2016, the Treasury Department issued long awaited (or long feared) proposed regulations under IRC §2704 regarding the valuation of family owned businesses.

Valuation discounts are a major tax planning tool to reduce or eliminate federal estate and gift taxes as part of a comprehensive estate plan. Clients have used valuation discounts to transfer substantial amounts of their wealth tax-free, or at significantly reduced tax cost, from one generation level to the next. Discounts for lack of marketability (meaning the inability to quickly sell or monetize an asset) and for a minority interest (meaning the inability to control the liquidation of an entity’s assets, the entity’s  distributions, the timing of the distributions and the management of the entity) have enabled clients to discount the values of gifts to family members and to discount an estate’s value at the client’s death. Valuation discounts generally range between 25% and 55% of the entity’s underlying property values, depending on various factors.

By way of background, Section 2704 was enacted in 1990 to address perceived abuses in estate and gift tax planning.  In oversimplified terms, 2704 provided, among other things, that if a restriction in a governing document (LLC operating agreement, partnership agreement, corporate Articles, bylaws or buy-sell agreement) is more restrictive as to transfer or liquidation requirements than default state law provisions, the restriction is ignored for purposes of valuation for estate and gift tax purposes if the transferor, or members of his family, control the entity immediately before the transfer.  This is referred to as an Applicable Restriction– defined as a limitation on the ability to liquidate the entity in whole or part– which is more restrictive than default state law provisions.

Notwithstanding §2704, discounts have been consistently upheld by courts in every circuit for in excess of 20 years, for several reasons, including:

1. Many (if not most) states have over time modified their default state law provisions to provide greater restrictions which have enhanced and supported valuation discounts.

2. Discounts, in fact, are market reflective and legitimate! (e.g. a 20% non voting interest in a closely held family partnership is simply, actually and commercially not worth 20% of the entity’s assets in an arm’s length transaction!)

In fact, with very limited exceptions, nearly the only time discounts failed in court challenges by the IRS were due to significant formation or operational flaws, usually through being overly aggressive – e.g. such as, placing all assets in an FLP to the point of personal insolvency; not respecting the entity (paying personal living expenses out of entity); placing significant personal use assets in the entity [e.g. the residence]; and similar issues that were clearly abusive in nature.

Granted, the regulations are not a per se complete elimination of discounts.  But they will, if finalized, result in a significant reduction in discounts.  Case law and course of practice over the last 20 years have regularly sustained discounts in the 30-45% range, with some even exceeding 50%.  Under the new regulations, a range of 5-15% may be much more likely to be the best case scenario.

Effectively, what the regs do is virtually completely eliminate discounts for minority interest or lack of control, as well as significantly impact marketability discounts.  Discounts under other theories, such as (i) a liquidation cost discount; (ii) an undivided interest discount; (iii) a blockage discount [for very significant  holdings in a single stock] should potentially all remain available.  However, these have always been relatively minor discounts, all or any two or three of which, if exist in a given situation, might only achieve a 5-15% discount.

How the regulations accomplish their result is quite complex, but it boils down to four major changes, summarized as follows:

(1)        changes in §2704(a) as relates to the lapse of a “liquidation right” upon a transfer

(2)        changes in 2704(b) which provides for certain (most) restrictions on the right to liquidate or demand full value to be disregarded in a valuation setting

(3)        a three year bright line test, such that if a transfer is made within three years of death, any lapse of a liquidation right is deemed to occur at the time of death

(4)        creation of a “Deemed Minimum Value” concept, such that in valuing an interest, it would be valued as if it had a right to “put” that value for sale at a value determined as the net asset value multiplied by the percentage interest, and without the old traditional discounts.

The provisions addressing the disregard of restrictions is very broad.  Previously, in valuing an interest, the appraisal could consider  restrictions that were provided in the default state law.  (An example is common provisions in most LLLP statutes that provide a limited partner cannot withdraw and demand fair value.)  Under the proposed regs, these type provisions will be ignored unless it is a “mandatory” provision, and even then, it is ignored if there are other state law provisions that could be used and are not as restrictive (e.g. assuming there are greater restrictions in an LLLP statute vs. in the traditional LP statute, the LLLP specific restrictions would be ignored).

These regs apply to family entities: partnerships, LLCs and corporations.  Thus, in addition to the obvious impact on family partnerships and family LLCs, they will have an identical impact on closely held corporations, directly impacting the transfer tax benefits of re-capitalizing a corporation to provide voting and non-voting stock.

Effective Date

Public comments/hearing on Dec. 1.  Expected to become final regs very soon thereafter.

Outlook

–Hope (but don’t expect) the public comments result in meaningful change to the proposed regs;

–Court challenge? (But does us no good from a planning perspective);

–States revise laws further? (some states likely will, but probably not significantly enough to overcome the language in the regs, and in any event, this presents no short term solution).

Action item

Act now, or likely lose the opportunity.