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Proposed IRS Sec. 2704 Regulations May Close Door on Certain Estate Valuation Discounts

Nov 7th 2016
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On Aug. 2, 2016, the US Treasury Department and the IRS issued proposed regulations under Code Section 2704 that are designed to significantly curtail the ability of taxpayers to claim valuation discounts for lack of control and lack of marketability in intra-family transfers of interests in family-controlled entities, such as corporations, partnerships, or LLCs.

The IRS has long considered the ability of taxpayers to apply these discount strategies a tax loophole. Through the issuance of the proposed regulations, the IRS seeks to modify the valuation rules to prevent what the IRS asserts is an undervaluation of such transferred interests.

While an in-depth analysis of the proposed regulations is beyond the scope of this article, the crux of the regulations is to establish a new category of restrictions referred to as “disregarded restrictions.

These restrictions, following the enactment of the proposed regulations, would essentially result in the transfer of interests in family-controlled entities being valued as though the recipient of the interest has a right to sell that transferred interest back to the entity for a “minimum value,” which generally is the fair market value of the entity’s underlying net assets.

In addition to creating the class of disregarded restrictions, the proposed regulations also:

  • Create a rule to remove the ability to use transfers made within three years of the transferor’s death as a means of obtaining a discount for certain lapses of voting or liquidation rights.
  • Prevent the interests of unrelated parties from being considered in assessing whether a family has the ability to remove certain disregarded restrictions and thus avoid the application of those rules, unless it can be shown that the third-party-owned interest is “economically substantial” based on a bright-line test.
  • Specify “applicable restrictions” (those that limit the ability of a business to liquidate) as being disregarded for purposes of valuing an interest where the transferor or family has the ability to remove those restrictions.
  • Restrict the use of certain state law default restrictions from being used to support valuation discounts where the family can remove or override those restrictions.
  • Provide a safe harbor to permit valuation discounts for certain “commercially reasonable restrictions” imposed by unrelated persons (e.g., banks).
  • Clarify that buy-sell agreements that impose restrictions on transfers of interests and meet certain conditions can still be considered in determining if a valuation discount is appropriate.

Timing of Enactment
The IRS has scheduled a public hearing on the proposed regulations for Dec. 1, 2016. Substantial and varied comments on the proposed regulations will undoubtedly be provided, and given the level of comments expected, it is possible that the proposed regulations will be modified before enacted.

Importantly, the proposed regulations will become effective 30 days after they are enacted into law, making the earliest possible effective date on the final regulations early January 2017, but it is likely that the effective date will occur further out into 2017.

Implications for Accounting and Valuation Professionals
Accounting professionals whose practices include the preparation of valuation reports and appraisals, or the preparation of tax returns that include such information, will need to have a working knowledge of the proposed regulations and how they impact valuation analysis.

In their current form, the proposed regulations would substantially alter the status quo in the transactions where they are implicated. Coordination with legal counsel on the impact of the proposed regulations in performing valuations of family-controlled entities and what restrictions constitute disregarded restrictions, as well as other provisions, will likely be essential in the near to midterm once the proposed regulations are finalized.

What to Do Now: Estate Planning Before the Proposed Regulations Are Finalized
Because the proposed regulations become effective 30 days after enactment, there remains a window of opportunity for individuals to engage in estate planning techniques involving interests in family-controlled entities that may be lost as soon as early 2017, depending upon when the proposed regulations are finalized and in what form.

Accordingly, taxpayers and their family-controlled entities still have some time to undertake transfer planning now before the new rules become effective. This may include initiating or accelerating current gifts of interests in family controlled entities – while lack of control and marketability discounts still hold under the current valuation regime.

However, if the proposed regulations are finalized in their current form, it is likely that taxpayers will move quickly to accelerate gifting and other transfers in advance of the effective date reminiscent of what occurred at the end of 2012, when the possibility of a lower estate tax exemption in 2013 prompted many taxpayers to make sizable gifts before year end.

While timing is an issue, due to the irrevocability of gifts and other transfers, a thoughtful approach in view of a client’s unique situation and goals is still recommended.