August 23, 2016
Proposed Section 2704
On August 2, 2016, the Treasury Department released proposed regulations amending and expanding upon the current regulations to Internal Revenue Code section 2704. The proposed regulations, if adopted, would affect the valuation of interests in family-owned businesses transferred among family members by eliminating certain discounts currently recognized under the law.
Appraisers have long recognized that interests in closely held entities that are subject to certain restrictions are valued at a discount over liquidation value. Such discounts have been applied and upheld in valuing interests in family-owned entities as well as nonfamily private entities. The proposed regulations, if adopted, make those discounts largely unavailable to family-owned entities.
In 1990, Congress enacted section 2704 to limit the scope of available valuation discounts for transfer tax purposes in valuing interests in family-owned entities. Section 2704(a) provides that a lapse of voting or restriction rights upon a transfer of an interest in a family-owned entity will be treated as an additional transfer of the lapsed right; however, there is a broad exception to this rule in the existing regulations when the right is still in existence after the transfer, even if the right is no longer exercisable solely by the transferor.
Section 2704(b) provides that certain restrictions shall be disregarded for valuation purposes. Such disregarded restrictions include the ability to liquidate an entity but only to the extent the liquidation right exceeds the rights available under State law and if the liquidation right will automatically lapse or can be removed by the transferor or the transferor’s family after the transfer.
Thus section 2704 as enacted placed boundaries on the use of valuation discounts, but it did not eliminate them. The proposed regulations further curtail the availability of valuation discounts with a bright line rule.
Timeline to Adoption
The proposed regulations will be subject to public comment for the next 90 days, and a public hearing will be held on December 1, 2016. We anticipate significant commentary to be submitted. After the hearing, the proposed regulations may be further revised or may be published as final. The effective date for adoption will be 30 days after the regulations are published as final.
The Proposed Regulations
The proposed regulations would affect the taxation of transfers by limiting the valuation discounts judicially recognized under existing law in several ways, including the following:
- The lapse of voting and liquidation rights in the hands of the transferor pursuant to a transfer of an interest in a family-held business that is made within three years of a transferor’s death (i.e., deathbed transfers) would be deemed an additional transfer potentially subject to transfer tax (but would not be eligible for the marital deduction or charitable deduction); and
- The proposed regulations would expand the disregarded restrictions that may not be included in the valuation of an interest in a family-owned business by providing that:
- The transferee’s status as an assignee of an economic interest, as opposed to a full voting member in the family-owned business, would not afford the transferred interest any valuation discount;
- The ability of a nonfamily member owner to block the removal of “covered restrictions” would be disregarded for valuation discount purposes unless the nonfamily member has held the interest for more than 3 years, owns a substantial interest in the entity, and has the right to be redeemed or bought out for cash or property upon 6 months’ notice; and
- Restrictions on liquidation that are provided as default rules under Federal or State law but are not mandated by Federal or State law would not be recognized if the transfer of the interest is to a family member.
At this time, the full impact of the section 2704 proposed regulations is unknown, but if the proposed regulations are published as final without further revisions, they will make the value of interests in certain family-owned businesses or closely owned businesses higher for transfer tax purposes. We will continue to monitor the situation closely. In the meantime, we recommend that any client who is interested in moving forward with a transfer of an interest in a family-owned business or other closely held entity consider acting quickly, as the proposed regulations will only apply to transfers on or after the date that the final regulations are published in the Federal Register. Please contact us as soon as possible if you would like to discuss the proposed regulations further.
For further information please contact
Micah J. Miller (Palo Alto),
Melinda B. Barker (Palo Alto),
Jennifer Jordan McCall (Palo Alto),
Kim T. Schoknecht (Palo Alto) or
Elizabeth H.W. Fry (New York).
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