Proposed Regulations Under IRC Section 2704

By:
Kevin Matz, Esq., CPA, LLM (Taxation)
Published Date:
Oct 1, 2016

On Aug. 2, 2016, the U.S. Department of the Treasury and the IRS issued proposed regulations under IRC Section 2704 (the “Proposed Regulations”) that, if enacted in its present form, might significantly curtail the ability of taxpayers to claim valuation discounts for both lack of control and lack of marketability in family-controlled entities. 

In this context, “control” generally means at least 50% ownership of a corporation, partnership, or limited liability company, taking into account certain complex family attribution rules. Except in certain limited circumstances, the Proposed Regulations would blur the distinction between (i) active trades or businesses and (ii) entities that are holding companies for passive assets, such as publicly-traded securities. A three-year “clawback” could also apply in certain contexts to valuation discounts attributable to lapsed voting or liquidation rights of a senior family member who dies within three years of making a gift of an interest in a family-controlled entity.

Under the Proposed Regulations, valuation discounts would likely be unimpaired for most tenancy-in-common interests in real property, except perhaps where the tenancy-in-common interest would be regarded as a partnership interest for federal income tax purposes. (See Revenue Procedure 2002-22.)  In the context of nontaxable estates for estate tax purposes, the Proposed Regulations—if enacted—might have the paradoxical effect of decreasing total taxes because they will often serve to increase basis for income tax purposes, thereby reducing beneficiaries’ income tax liabilities when inherited property is later sold or depreciated from a higher basis peg-point. 

Nevertheless, the overall impact of the Proposed Regulations might be very severe in many client contexts. Notwithstanding the presumption of deference generally accorded to agency regulations, there has been significant concern of vast overreach in the rulemaking grant that Congress conferred upon the Department of the Treasury—particularly in the case of active trades or businesses. Specifically, certain of the Proposed Regulations purport to establish “disregarded restrictions” under the authority of IRC section 2704(b)(4). That section provides that Treasury may issue regulations regarding certain restrictions only “if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.” 

It is difficult to imagine that a court would conclude that real-world limitations on the ability to participate in the management of a closely-held entity, or to compel the liquidation of either the entity itself or the transferor’s interest in such an entity, will always fail to reduce the value of such interest to the transferee. This is particularly the case where an active trade or business is involved, and—depending upon the facts and circumstances—might also apply where an active trade or business is not involved, especially if nonfamily ownership comprises the remaining 50% of the entity’s equity interests. Accordingly, a number of professional organizations are anticipated to submit comment letters that will fiercely attack this conclusive presumption as legally invalid for exceeding permissible rulemaking authority—in addition to creating significant ambiguities warranting further IRS guidance.   

There is a hearing scheduled on the Proposed Regulations in Washington, D.C. on Dec. 1, 2016. It is conceivable, however, that the Proposed Regulations might be enacted in its final form by early 2017, with the IRS then leaving it up to the courts to resolve issues of rulemaking validity and ambiguities in construction. In the meantime, there is a window of opportunity for individuals to engage in estate planning involving interests in closely-held entities with methods that might soon effectively be lost by early 2017. 

Disregarded Restrictions

The cornerstone of the Proposed Regulations is Proposed Regulations section 25.2704-3, which establishes a new category of restrictions known as “disregarded restrictions.” Section 25.2704-3(a) provides that “if an interest in a corporation or a partnership (an entity), whether domestic or foreign, is transferred to or for the benefit of a member of the transferor’s family and the transferor and/or members of the transferor’s family control the entity immediately before the transfer, any restriction described in paragraph (b) of this section is disregarded, and the transferred interest is valued as provided in paragraph (f) of this section” (emphasis added).           The Proposed Regulations clarify that these rules apply to limited liability companies—in addition to partnerships and corporations—and that the detailed family attribution rules of Treasury Regulations section 25.2701-6 apply as well.           

What restrictions are described in paragraph (b) and therefore constitute “disregarded restrictions”?  Proposed Regulations section 25.2704-3(b)(1) states that, in general, “[t]he term disregarded restriction means a restriction that is a limitation on the ability to redeem or liquidate an interest in an entity that is described in any more or more of paragraphs (b)(1)(i) through (iv) of this section, if the restriction, in whole or in part, either lapses after the transfer or can be removed by the transferor or any member of the transferor’s family (subject to paragraph (b)(4) of this section), either alone or collectively” (emphasis in original). The Proposed Regulations list the following restrictions.

            1. The provision limits or permits the limitation (such as through amendment) of the ability of the holder of the interest to compel liquidation or redemption of the interest.       

            2. The provision limits or permits the limitation (such as through amendment) of the amount that may be received by the holder of the interest on liquidation or redemption of the interest to an amount that is less than a “minimum value.” The term “minimum value” means the interest’s share of the net value of the entity determined on the date of liquidation or redemption. The net value of the entity is the fair market value, as determined for federal estate or gift tax purposes, as the case may be, of the property held by the entity reduced by the outstanding obligations of the entity. Solely for purposes of determining minimum value, the only outstanding obligations of the entity that may be taken into account are those that would be allowable (if paid) as deductions under IRC section 2053 if those deductions instead were claims against an estate. (IRC section 2053 governs the deduction of debts and administration expenses for estate tax purposes, and the implications of this cross-reference within the Proposed Regulations are not entirely clear.)    

            3. The provision defers or permits the 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 the holder’s interest liquidated or redeemed. 

            4. The provision authorizes or permits the payment of any portion of the full amount of the liquidation or redemption proceeds in any manner other than in cash or property. Solely for this purpose, except as provided in the following sentence, a note or other obligation issued directly or indirectly by the entity, by one or more holders of interests in the entity, or by a person related to either the entity or any holder of an interest in the entity, is deemed not to be property. The exception to this non-treatment of a note or other obligation as property arises in the case of an entity that is engaged in an active trade or business, at least 60% of whose value consists of the non-passive assets of that trade or business, in which case to the extent that the liquidation proceeds are not attributable to passive assets, such proceeds may include such a note or other obligation if such note or other obligation is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds.               

For purposes of determining whether the restriction either lapses after the transfer or can be removed by the transferor or any member of the transferor’s family either alone or collectively, Proposed Regulations section 25.2701-3(b)(4) provides that the interests of nonfamily members are themselves “disregarded” unless (1) the interest has been held by the nonfamily member for at least three years immediately before the transfer; (2) the nonfamily member holds at least a 10% equity interest in the entity; (3) the total of the equity interests held by all nonfamily members constitutes at least 20% of all equity interests in the entity; and (4) each nonfamily member has a “put right” to obtain a pro rata share of the entity’s “minimum value” within six months of providing notice of an intent to withdraw. As a practical matter, no one will effectively meet this exception requirement.

Proposed Regulations section 25.2701-3(b)(5) provides that the following types of restrictions will not be considered “disregarded restrictions” and therefore can potentially be considered in valuing the transferred interest: 

  • an “applicable restriction” as defined in Proposed Regulations section 25.2704-2 (to be discussed later in this article)
  • “a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity’s trade or business operations in the form of debt or equity” (whether a person is considered “unrelated” is generally determined by reference to IRC section 267(b)
  • certain restrictions imposed or required to be imposed by federal or state law
  • an “option, right to use property, or agreement that is subject to section 2703” (the scope of this exception is unclear, particularly in the case of buy-sell agreements that might be subject to review under IRC section 2703 but withstand scrutiny under such provision)
  • certain rights to put interests to the entity that are described in Proposed Regulations section 25.2704-3(b)(6)

According to the Proposed Regulations, “the term ‘put right’ means a right, enforceable under applicable local law, to receive from the entity or from one or more other holders, on liquidation or redemption of the holder's interest, within six months after the date the holder gives notice of the holder's intent to withdraw, cash and/or other property with a value that is at least equal to the minimum value of the interest determined as of the date of the liquidation or redemption.” For this purpose, the term “other property” does not include a note or other obligation issued directly or indirectly by the entity, by one or more holders of interests in the entity, or by one or more persons related either to the entity or to any holder of an interest in the entity, except in the case of certain entities engaged in trades or businesses that meet certain criteria. As a practical matter, these put rights will not exist.

What is the effect of a “disregarded restriction”?  According to Proposed Regulations section 25.2704-3(f), if a restriction is disregarded under section 25.2704-3, “the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law or otherwise.  For this purpose, local law is the law of the jurisdiction, whether domestic or foreign, under which the entity is created or organized.”

Some commentators have speculated that the implication of the Proposed Regulations is to actually read “deemed put rights” into the governing documents and local law for valuation purposes, as if the interest holder were granted the affirmative right to withdraw its interest in exchange for a pro rata share of the entity’s “minimum value” upon six months’ notice. It does not appear, however, that the Proposed Regulations indicate such an interpretation: They instead call for the fair market value of the transferred interest to be “determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law or otherwise.”

The new rules of Proposed Regulations section 25.2704-3 governing “disregarded restrictions” are proposed to apply to “transfers of property subject to restrictions created after October 8, 1990, occurring 30 or more days after the date these regulations are published as final regulations in the Federal Register.”

Applicable Restrictions

In addition to creating a new class of restrictions called “disregarded restrictions,” the Proposed Regulations also expand the scope of the previously existing category of restrictions known as “applicable restrictions.”

Proposed Regulations section 25.2704-2(a) provides that if an interest in an entity, “whether domestic or foreign, is transferred to or for the benefit of a member of the transferor’s family, and the transferor and/or members of the transferor’s family control the entity immediately before the transfer, any applicable restriction is disregarded in valuing the transferred interest.” The Proposed Regulations clarify that these rules apply to limited liability companies—in addition to partnerships and corporations—and that the detailed family attribution rules of Treasury Regulations section 25.2701-6 also apply.

Proposed Regulations section 25.2704-2(b)(1) defines the term “applicable restriction” as a limitation on the ability to liquidate the entity in whole or in part (as opposed to a particular holder’s interest in the entity) if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor’s estate, or any member of the transferor’s family, either alone or collectively. As noted above, Proposed Regulations section 25.2704-3 instead governs restrictions on the ability to liquidate a particular holder’s interest in the entity. The applicable restriction may be imposed under the entity’s governing documents or by local law.

Proposed Regulations section 25.2704-2(b)(4) provides that the following restrictions on the ability to liquidate an entity are excluded from the definition of an applicable restriction:

  • a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity’s trade or business operations, whether in the form of debt or equity (an “unrelated person” is defined by reference to IRC section 267(b))
  • certain restrictions imposed by federal or state law
  • an option, right to use property, or agreement that is subject to review under IRC section 2703 (as in the case of disregarded restrictions, the scope of this exception is unclear, particularly in the case of buy-sell agreements that might be subject to IRC section 2703 but withstand scrutiny under such provision)
  • a “put right” as defined in section 25.2704-3(b)(6), which would prevent the restriction from being treated as an applicable restriction (as noted above, as a practical matter, no one is likely to be conferred such a put right)

The provisions of the Proposed Regulations dealing with applicable restrictions apply to transfers of property subject to restrictions created after Oct. 8, 1990, occurring on or after the date these regulations are published as final regulations in the Federal Register.

Lapses Of Certain Rights And The Three-Year Clawback Upon Death

The Proposed Regulations also expand the lapse provisions of section 25.2704-1 and create a bright-line rule that can potentially produce estate tax inclusion of the value that is attributable to lapsed voting or liquidation rights if a person transfers an interest in a family-controlled entity and dies within three years of such transfer. As currently written, the Proposed Regulations could cause this “clawback” to apply to transactions occurring up to three years before the date that the Proposed Regulations are published as final regulations in the Federal Register. This means that this clawback could potentially apply to transactions occurring before the date that the Proposed Regulations were issued.

Proposed Regulations section 25.2704-1(a)(1) provides that “the lapse of a voting or liquidation right in an [entity], whether domestic or foreign, is a transfer by the individual directly or indirectly holding the right immediately prior to its lapse to the extent provided in paragraphs (b) and (c) of this section. This section applies only if the entity is controlled by the holder and/or members of the holder’s family immediately before and after this lapse.” Once again, the term “entity” for this purpose includes corporations, partnerships, and limited liability companies, and the detailed family attribution rules of Treasury Regulations section 25.2701-6 apply as well.

In the case of a limited liability company, the right of a member to participate in company management is a voting right. A voting right or a liquidation right may be conferred by—or lapse by—reason of local law, the governing documents, an agreement, or otherwise.  For purposes of testing the ability of the holder’s family to liquidate, an interest held by a person other than a member of the holder’s family may be disregarded when applying the analysis under Proposed Regulations section 25.2704-3(b)(4) (which applies to “disregarded restrictions”), as if such section also applies to the question of whether the holder (or the holder’s estate) and members of the holder’s family may liquidate an interest immediately after the lapse.

Proposed Regulations section 25.2704-1(a)(5) also addresses the issue of “assignee interests” and states that “[a] transfer that results in the restriction or elimination of the transferee’s ability to exercise the voting or liquidation rights that were associated with the interest while held by the transferor is a lapse of those rights.” The Proposed Regulations give the example of transferring a partnership interest to an assignee that neither has nor may exercise the voting or liquidation rights associated with the transferred interest.

Significantly, the Proposed Regulations will cause certain transfers of entity interests within three years of death to trigger this new, expanded rule. Proposed Regulations section 25.2701-1(c)(1) states that “[e]xcept as otherwise provided, a transfer of an interest occurring more than three years before the transferor’s death that results in the lapse of a voting or liquidation right is not subject to this section if the rights with respect to the transferred interest are not restricted or eliminated”; however, “[t]he lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor’s death is treated as a lapse occurring on the transferor’s date of death, includible in the gross estate pursuant to section 2704(a).” The Proposed Regulations give the following examples to illustrate this point:

  • More than three years before D’s death, D (who had held an 84% interest in an entity known as “Y,” the by-laws of which require a 70% vote by interest to liquidate) transfers one-half of D’s stock in equal shares to D’s three children (14 percent each).  Section 2704(b) does not apply to the loss of D’s ability to liquidate Y because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had the transfers occurred within three years of D’s death, the transfers would have been treated as the lapse of D’s liquidation right occurring at D’s death.
  • More than three years before D’s death, D transfers 30 shares of common stock to D’s child.  The transfer is not a lapse of a liquidation right with respect to the common stock because the voting rights that enabled D to liquidate prior to the transfer are not restricted or eliminated, and the transfer occurs more than three years before D’s death. However, had the transfer occurred within three years of D’s death, the transfer would have been treated as the lapse of D’s liquidation right with respect to the common stock occurring at D’s death.

Proposed Regulations section 25.2704-1 applies to lapses of rights created after Oct. 8, 1990, occurring on or after the date these regulations are published as final regulations in the Federal Register. Proposed Regulations section 25.2704-1(c)(1), in turn, states that “[t]he lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor’s death is treated as a lapse occurring on the transferor’s date of death, includible in the gross estate pursuant to section 2704(a).” This would seem to indicate that transactions occurring as far back as three years prior to the date of death of a decedent who dies subsequent to the finalization of these regulations might be subject to this clawback—even though the transactions causing these transfers might have occurred prior to Aug. 2, 2016, and thereby preceded the issuance of the Proposed Regulations. It is hard to imagine that Treasury intended such an unfair result. Nevertheless, pending clarification by Treasury, the “phantom asset” for estate tax inclusion purposes that may be created by this section of the Proposed Regulations poses a risk for those desiring to engage in transactions involving interests in family-controlled entities, particularly where both spouses are living and the family’s estate planning objective is to defer all estate taxes until the death of the surviving spouse.

Estate Planning Before The Proposed Regulations Are Finalized

As noted above, there is a window of opportunity for individuals to engage in estate planning methods involving interests in closely-held entities that may soon be lost in early 2017, depending upon when these regulations are finalized. In evaluating the urgency of encouraging clients to gift interests in family-controlled entities before the Proposed Regulations are finalized, keep in mind that the Proposed Regulations state that disregarded restrictions and applicable restrictions are to be treated as though they do not exist, either in the governing instrument or under applicable state law, and that “generally applicable valuation principles” will govern the valuation of the interest transferred, determined without regard to the stricken provisions. An entity’s practical inability to comply with owner withdrawal and liquidation requests—particularly in the case of active trades or businesses, or where there is 50% ownership by unrelated parties—may well lead some appraisers to conclude that significant discounts for lack of control and lack of marketability may still be warranted, notwithstanding that the appraisers are required to disregard restrictions on liquidation and withdrawal that are contained in the entity’s governing instruments or under local law. How this ultimately plays out in IRS audits and in litigation is anyone’s guess.

That being said, those who are considering making gifts or other transfers of family-controlled interests before the Proposed Regulations are finalized should be wary of the potential perils of estate planning with entities that could be posed upon the transferor’s death under IRC sections 2036(a)(1) and (2), where the senior family member retains too much control over the assets contributed to the entity either as a result of (1) a retained right (express or implied) to enjoy the property contributed to the entity or the income derived therefrom or (2) the transferor’s continued ability to participate in directing entity distributions. Planning with tenancy-in-common interests that are not considered partnership interests for federal income tax purposes may become in vogue (see, for example, Revenue Procedure 2002-22). A thoughtful balancing of factually intensive concerns that also takes into account potential income tax consequences—as opposed to a “mad rush” to make gifts of entity interests to “beat the clock”—will be warranted here.

 

Kevin Matz, Esq., CPA, LLM, is the managing attorney of the law firm of Kevin Matz & Associates PLLC, with offices in New York City and White Plains, N.Y. His practice is devoted principally to domestic and international estate and tax planning and he is a fellow of the American College of Trust and Estate Counsel (ACTEC). Mr. Matz is also a certified public accountant and a past chairman of the estate planning committee of the NYSSCPA. He writes and lectures frequently on estate and tax planning topics. He can be reached by email at kmatz@kmatzlaw.com or by phone at 914-682-6884.

 
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