General Background:  

On August 2, 2016, the Treasury Department released the much anticipated proposed Treasury Regulations under Code Section 2704, providing clarification and imposing further limitations on the use of valuation discounts for transfers of interests in family controlled entities for transfer tax purposes.  The Proposed Regulations will thus create higher valuations for transfer tax purposes, which will result in higher transfer tax liabilities but also larger basis step-ups.  The Proposed Regulations, if enacted in their current form, among other things, would essentially eliminate discounts for minority control and lack of marketability in transfer tax valuations of interests in closely held entities (e.g., family limited partnerships, closely held corporations, and other family controlled entities).

A hearing with respect to the Proposed Regulations is scheduled for December 1, 2016, and comments are welcome by November 2, 2016.  It is important to note that these regulations are proposed only. The regulations will become effective with respect to "lapsing voting and liquidation rights" and transfers subject to "applicable restrictions" that occur on or after the date of final publication.  With respect to transfers subject to newly defined "disregarded restrictions," the regulations will become effective 30 days following the date of final publication.  

Section 2704 is part of the Special Valuation Rules meant to address the planning tool of the "estate freeze."  An estate freeze is a technique that attempts to limit or reduce the value of an interest in a business or other property for estate tax purposes.  In many cases, this is accomplished by having the older generation transfer the appreciating interest in a business to the younger generation while retaining a non-appreciating interest.  

Section 2704 was enacted in 1990 to provide special valuation rules to apply to intra-family transfers of interests in corporations and partnerships subject to lapsing voting or liquidation rights and to restrictions on liquidation.  According to the legislative history, one of the purposes of its enactment was to overrule the decision in Estate of Harrison v. Commissioner, T.C. Memo 1987-8.  

In Harrison, a Texas decedent and his two sons held general partnership interests in a partnership while the decedent also held a limited partnership interest.  Any general partner had the right to liquidate the partnership during his life and cause each general partner to obtain the full value of his partnership interests.  When determining the estate tax value of the decedent's limited partnership interest, the Tax Court "pinpoint[ed] [its] valuation at the instant of death" and concluded that a discount should be given on the value of the limited partnership interest due to the lack of a right to liquidate (that right having lapsed at death).  The result was that the value of the limited partnership interest was found to be less than its value in the hands of the decedent immediately before his death and less than the value in the hands of his family members immediately after his death.  

In order to hinder the use of lapsing rights as was found in Harrison, Section 2704 was enacted.  Section 2704(a) in general treats lapses of voting or liquidation rights in a corporation or partnership as a transfer subject to US federal transfer taxes where the individual holding such right before the lapse, and the members of such individual's family after the lapse, control the entity.  The amount subject to transfer tax is the decrease in value of all the interests held by the holder of the right as a result of the lapse.  If the right lapses at death, it increases the holder's gross estate.  If it lapses while the holder is alive, it creates a taxable gift.  

To discourage the use of artificial restrictions, such as the inability to force the liquidation of a partnership to decrease the estate or gift tax on transfers of closely held business interests, Section 2704(b) requires that such restrictions be ignored in certain cases.  These are so-called "applicable restrictions."  If a taxpayer transfers stock or a partnership interest to a family member, and such corporation or partnership is controlled by the family immediately before the transfer, any restriction that limits the ability of the corporation or partnership to liquidate (in whole or in part) will be ignored for estate and gift tax purposes if the restriction lapses after the transfer or if the transferor and the transferor's family have the power to remove it.  

Explanation of Changes:  

Entities Covered and Classifications.  Current rules indicate that Section 2704 applies to corporations and partnerships.  The Proposed Regulations state that Section 2704 continues to apply to corporations and partnerships, but clarify that included within the meaning of partnership is any other business entity regardless of how the entity is classified under the check–the-box rules (e.g., LLCs), and regardless of whether it is US or foreign.  Also, in analyzing control of an entity and state law restrictions, the Proposed Regulations look to local law (where the entity was created) to determine such rights, regardless of how such entity is classified for federal tax purposes (e.g., as an entity disregarded from its owner).  

Lapse of Voting or Liquidation Rights and Death Bed Transfers (Three-Year Rule).   Under current regulations, a lapse of a liquidation right occurs at the time such right is restricted or eliminated, and lapses that occur as a result of a transfer of an interest in the family controlled entity are excluded (the exception).  For example, a father transfers his 100% interest in a family company to each of his four children, 25% to each.  Each of these transfers could theoretically be seen as a lapse because no one child could exercise voting control as the father did before the transfer.  Provided that none of the liquidation rights were changed as a part of the transfer, the exception applies and this is not a lapse under current law.     

The Proposed Regulations alter this rule by requiring that the transferor (in the example above, the father) survive for three years.  Thus, this exception will only apply to such transfers which occur more than three years before the death of the transferor.  In other words, transfers within three years of death will be treated as transfers under Section 2704 on the transferor's date of death and the minority valuation discount will be includable in the transferor's gross estate, thereby essentially eliminating the minority discount in this case.  

Of course, the three-year "look-back" rule of the Proposed Regulations does not eliminate the ability to apply a minority interest discount at the time of the transfer, so long as the transferor survives the three-year period and the voting/liquidation rights are not changed as part of the transfer.  However, the inclusion of the minority valuation discount in the gross estate should the transferor die within the three-year period will create a "phantom asset" for the estate and a question about who should bear the estate taxes.  For those with Wills that require all estate taxes to be paid from the residuary estate (which may pass to beneficiaries other than those who received the interests during the transferor's lifetime), consideration should be given to either including a formula estate tax clause in the Will or providing that the estate bears estate taxes on assets passing under the Will, and that the donees of all other assets passing outside of the Will and by lifetime gifts bear the estate taxes with respect to those assets.  

Elimination of Discounts on Transfers to Assignees.  In general, a partnership interest (or membership interest in an LLC) may be assigned without the consent of the entity. However, such assignee will not be admitted as a partner or member of the entity absent the entity's consent.  Thus, an assignee generally has no control or management rights, or the level of control is at least uncertain.  For example, a father passes away owning a 30% partnership interest.  His son inherits the interest as an assignee.  For these reasons, under current rules, assignee interests may be discounted for lack of control and the uncertainty or lack of rights under state law.  The Proposed Regulations would treat a transfer to an assignee as a lapse of the rights associated with such interest (regardless of whether or not the transferor retained such rights) and essentially eliminate the lack of control discount.   

Ability to Liquidate.  Current rules provide that Section 2704 does not apply to the lapse of a liquidation right where the interest can be liquidated immediately after the lapse.  Local law, as modified by the governing documents of the entity, determines whether an interest can be immediately liquidated after the lapse.  The Proposed Regulations clarify that (1) the manner in which an entity may be liquidated is irrelevant (i.e., whether by vote, local law, or other action permitted under the governing documents), and (2) an interest held by a non-family member may be disregarded under the rules of Treas. Reg. § 25.2704-3(b)(4) of the Proposed Regulations (described below).  

Disregard of "Applicable Restrictions" - Discounts Related to Restrictions on Liquidation . The Proposed Regulations seek to curb the reduction of the transfer tax value of ownership interests involved in intra-family transfers where the interest holder's ability to liquidate the entity (whether completely or partially) is restricted or limited.  

These "applicable restrictions" include any limitation to liquidate the entity (whether arising from governing documents, agreements, or local law) where the limitation will lapse or could be removed by any one or more of the transferor, the transferor's estate, and the transferor's family members following the transfer.  The lapse or removal can occur at any time following the transfer, and the specific manner in which the lapse occurs is irrelevant. Ownership interests held through corporations, partnerships, estates, trusts, or other entities are aggregated with the interests held directly by the transferor, the transferor's estate, and the transferor's family members for purposes of determining their ability to remove the restriction.  

A limitation would only be disregarded if both of the following conditions are met:

  • the interest is transferred to or for the benefit of a member of the transferor's family; and
  • the transferor, members of the transferor's family, or both control the entity immediately before the interest is transferred.

If the limitation is disregarded, then the transferor would use normal valuation principles (excluding any discounts that might have been applicable due to the limitation) to determine the fair market value of the transferred interest.

An example of the application of the regulations that disregard applicable restrictions is the following. Assume a mother owns 76% of the interests of a partnership and two of her three children each own 12% of the interests in the partnership. Further, assume that the partnership agreement requires the consent of all partners to liquidate. The mother dies and bequeaths her 76% interest to her third child. The requirement that all of the partners consent to liquidation is an applicable restriction, since it can be removed by the transferor's family (the three children) following the transfer. Since the transferor and members of her family controlled the entity before the transfer, the 76% interest passing to the third child will be valued without regard to the applicable restriction (i.e., it will be value as if the 76% interest was sufficient to liquidate the partnership). This essentially prevents a discount for lack of marketability.

The Proposed Regulations would continue to allow transferors to take into account two types of restrictions when determining the fair market value of an ownership interest transferred intra-family. The two exceptions from the definition of applicable restrictions are (1) a restriction imposed by federal or state law, and (2) a "commercially-reasonable" exception. In addition, restrictions where all owners hold a "put right" (discussed further below) do not constitute applicable restrictions.

The current regulations provide an exception for restrictions on liquidation that are imposed by federal or state law, including where a restriction imposed by the governing documents is "no more restrictive" than the default state law. Since the current regulations were promulgated, many state legislatures have enacted statutory restrictions on the ability of limited partners to withdraw or liquidate their interests in a limited partnership. Often, these statutory restrictions provide the ability to circumvent the restriction through other statutory provisions or via the entity's governing documents. The Treasury Department believes that these statutes allow taxpayers to treat nearly all restrictions found in governing documents as "no more restrictive" than state law, which, in turn, results in valuation discounts when the interests are transferred within a family, since the restrictions would not be considered "applicable restrictions."

The Proposed Regulations limit the exception to only those federal or state law restrictions that do not provide for an option to remove, supersede, override, or opt-out. For purposes of this exception, federal or state law includes only the laws of the Untied States, the District of Columbia, and any US state but does not include the laws of any other jurisdiction.  There are few, if any, state laws that do not provide for an option to remove, supersede, override, or opt out, so the effect of the Proposed Regulations is to essentially eliminate the "imposed by federal or state law" exception. If the provisions do not meet the exception, the restrictive provision will be deemed an applicable restriction, and therefore will be "disregarded" for valuation purposes.

The second exception to the definition of applicable restrictions is a "commercially reasonable" restriction imposed by an "unrelated person" who injects capital for the entity's trade or business. This exception is unchanged from the current regulations, which require that a capital infusion (equity or debt) must be from a person who is not related to the transferor, transferee, or any of their family members. Related persons include, but are not limited to, an individual's family members, trustees (other than banks) of trusts established by the individual, and corporations controlled by the individual. Neither the current regulations nor the Proposed Regulations define "commercially reasonable."

New Disregarded Restrictions. Having concluded there are additional restrictions that adversely affect the transfer tax value of an interest but do not reduce the value of the interest to the family-member transferee, the IRS has promulgated in the Proposed Regulations a new category of "disregarded restrictions", which will be ignored for valuation purposes similar to the aforementioned "applicable restrictions."  The implementation of these "disregarded restrictions" is intended to avoid, among other things, the outcome of Kerr v. Commissioner, 292 F.3d 490 (5th Cir. 2002). In Kerr, the Fifth Circuit Court of Appeals held that since an unrelated minority partner, the University of Texas, in the family limited partnership that was the subject of the case, had to consent to remove the restriction on the right to liquidate an interest in the partnership, the restriction was not an applicable restriction (as family members could not remove the restriction). 

Under the Proposed Regulations, if an interest in an entity (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, then any "disregarded restriction" on the right to liquidate the interest in the entity that lapses or that can be removed or overridden by the transferor, the transferor's estate and/or any member of the transferor's family (without regard to certain interests held by nonfamily members) will be disregarded.  

Specifically, a "disregarded restriction" under the Proposed Regulations includes any provision that: (i) limits the ability of the holder of the interest to compel liquidation or redemption of an interest; (ii) limits the liquidation proceeds of such interest to an amount that is less than "minimum value"; (iii) defers the payment of the liquidation proceeds for more than six months after the date the holder gives notice of intent to have the holder's interest liquidated or redeemed; or (iv) permits the payment of the liquidation proceeds in any manner other than in cash or property, subject to the limitations set forth in the following paragraph.  A disregarded restriction includes any restriction imposed under the terms of the governing documents, any other document, assignment, agreement or arrangement, and with the exception of specified US federal or state law restrictions, includes any restriction imposed under local law regardless of whether the restriction may be superseded by the governing documents or otherwise. 

For the above purposes, "minimum value" means the interest's share of the net value of the entity on the date of liquidation or redemption, which value consists of the fair market value of the property held by the entity reduced only by outstanding obligations of the entity that would be allowable (if paid) as deductions for US federal estate tax purposes if those obligations instead were claims against an estate.  In determining whether a provision permits the liquidation or redemption payment in a manner other than in cash or property, the Proposed Regulations provide that a note or other obligation issued directly or indirectly by the entity, by any interest holder in the entity, or by any person related to either the entity or any interest holder, is not considered property.  The Proposed Regulations do allow for a limited exception in the case of certain entities engaged in an active trade or business, whereby a note or other obligation may be considered property if the liquidation proceeds are not attributable to passive assets of the entity, and the note itself is adequately secured, paid on a periodic, non-deferred basis at market interest rates, and has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds. 

The exceptions that apply to "applicable restrictions" under the Proposed Regulations, which include those in the current regulations plus an additional "put right" exception, also apply to this new category of "disregarded restrictions." The "put right" exception applies if each interest holder has a "put" right to receive on liquidation of their interest, cash and/or other property at least equal to the minimum value paid, within six months after the holder gives notice of intent to liquidate, provided that any such "other property" does not include a note or other obligation issued directly or indirectly by the entity, by any interest holder in the entity, or by any person related to either the entity or any interest holder.  An active trade or business exception similar to the one described above applies to this definition of "other property" within the Proposed Regulations.

The following is an example of the new disregarded restrictions at work. A father and his two children are partners in a limited partnership where the father owns a 98% limited partner interest and each child owns a 1% general partner interest. Under the partnership agreement, the partners cannot withdraw from the partnership, and the partnership cannot be liquidated unless all of the partners agree (all must also agree to amend the partnership agreement). Local law would permit withdrawal. The father transfers a 33% interest to each of his two children.  Since the restriction here limits the ability of the holder of the interest to compel liquidation, members of the transferor's family may remove or override the restriction. In addition to the family's ability to remove or override the restriction, the entity was controlled by the family before the transfer, and, therefore, it is a disregarded restriction. Accordingly, the 33% interest is valued for gift tax purposes under general valuation rules as if the restriction on liquidation did not exist.

To combat the use of a non-family member "straw-man" to circumvent the application of Section 2704(b), as was done in Kerr discussed above, the Proposed Regulations disregard certain interests held by non-family members when determining whether the transferor, the transferor's estate, and/or the transferor's family members may remove or override a potential disregarded restriction. Specifically, the Proposed Regulations disregard any interest held by a non-family member that: (i) has been held less than three years before the date of transfer; (ii) constitutes less than 10 percent of the value of all the equity interests; (iii) when combined with the interests of other non-family members, constitutes less than 20 percent of the value of all the equity interests; and (iv) where the non-family holder of such interest lacks a put right in the interest as described above.  Therefore, in order for a case like Kerr to succeed under the Proposed Regulations, the charity (or other non-family partner) must have a significant interest in the entity that can be liquidated in short order.

The overall impact of the Proposed Regulations, including the disregarded restrictions among the restrictions that cannot be taken into account for gift and estate tax valuation purposes, is that the ability to consider a lack of marketability discount when giving or bequeathing an interest in a closely-held family entity is significantly reduced, if not fully eliminated.  The reason for this is that the inability to liquidate one's interest in the entity is one of the essential components of the lack of marketability discount.  There may still be some ability to argue that a lack of marketability discount is appropriate even though the inability to liquidate will be disregarded, since the hypothetical willing buyer will still pay more for publicly traded securities than for an interest in a private company, but this discount is greatly diminished.

Conclusion

The Proposed Regulations will significantly hinder the ability to use restrictions on liquidation or voting rights to reduce the transfer tax value of intra-family transfers of ownership interests in entities. Put another way, the traditional valuation discounts for lack of marketability, lack of control, and minority interests, are significantly reduced (if not eliminated in some cases) by the propose regulations. If the Proposed Regulations are enacted and apply to a transferred interest, then the interest will be valued under the generally applicable valuation rules. Accordingly, families may need to consider the appropriateness of past appraisals and valuations of closely-held entities prior to any future transfers of the same assets (e.g., further interests in a partnership).  Such appraisals should be revised to take into account the increased valuations under the Proposed Regulations.  Failure to do so could result in larger gift and estate taxes than may have been anticipated.  Once a family obtains new appraisals under the Proposed Regulations, they can plan for the greater transfer taxes that will be due.  In addition, families may want to consider accelerating gifts of closely-held family business interests before the regulations become final (keeping in mind that the new three-year rule discussed above may still result in lapsed rights being included in the transferor's estate).