IRS regulations anticipated for release as early as this September may further restrict valuation discounts. The exact scope of the regulations is unknown, but the regulations will likely make it more difficult for taxpayers to discount the value of family business interests.

Valuation Discounts Generally

Valuation discounts in family business interests are often utilized in connection with “estate freezes” that deflect future asset growth from the estate of a senior family member to a younger generation member. Families place restrictions—such as restrictions on the owner’s ability to become a full-fledged voting member or partner of the entity—on interests given to junior family members. Splitting interests and dividing control in this way considerably reduces the value of the transferred interests. The most significant valuation discounts arising from such mechanisms are lack of marketability and lack of control discounts. Thus, when appraisals are done for family business interests with such restrictions placed on them, the transferred interests are valued at significant discounts, and the tax on a transfer may be correspondingly reduced. However, the interests still retain economic benefits for the transferees.

Section 2704 Restrictions Background

In 1990, Internal Revenue Code Section 2704 was enacted to curb the use of such techniques that reduce the value of assets in a taxable transfer. Section 2704 ignores certain “applicable restrictions” when valuing interests in family-controlled entities, such as restrictions that effectively limit the ability of the entity to liquidate and that lapse (or that the family has the power to eliminate) after a transfer is made. However, an exception to Section 2704 provides that restrictions imposed by state or federal law continue to be respected, rather than disregarded, for valuation purposes. In response, many states have changed their laws to provide restrictions that might otherwise be ignored for valuation purposes under Section 2704.

New Regulations on the Way

Section 2704(b) gives the Secretary of the Treasury the power to issue new regulations disregarding additional restrictions if the restrictions reduce the value of the transferred interest but not the value of the interest to the transferee. The IRS has interpreted this grant of power broadly and has long maintained its authority to further restrict valuation discounts.

Since 2003, new regulations under Section 2704 have been on the IRS-Treasury Priority Business Plan, and for several years the Administration included a section in its statement of revenue proposals (commonly known as the “Greenbook”) calling for additional legislation to strengthen the Treasury’s authority to disregard restrictions under Section 2704. However, these revenue proposals were noticeably dropped from the Greenbook in 2014, prompting many to conclude that regulations are now imminent. To confirm this, Cathy Hughes, an Estate and Gift Tax Attorney Advisor at the Treasury Department, spoke at a conference in late April this year, and indicated that new regulations may be released in September of this year.

What might the new regulations look like? The 2013 Greenbook, which was the most recent Greenbook to contain the Section 2704 revenue proposals, provides some clues. The 2013 Greenbook proposed several changes, including the following:

  • The addition of “disregarded restrictions” which are “to be specified in regulations” and may extend beyond the scope of the liquidation restrictions currently addressed by Section 2704.
  • The attribution of the voting power of certain minority interests held by charities or non-family members (to be specified in regulations) to the family for purposes of assessing family control.
  • The addition of safe harbors to permit taxpayers to prepare governing documents for a family-controlled entity so as to avoid the application of Section 2704.

Commentators have also considered a variety of other possibilities for the new regulations. For example, some commentators suggest that the new regulations might distinguish between holding and operating companies and apply more restrictive regulations to the former. Still other commentators believe that the regulations may limit the availability of minority and marketability discounts for transfers involving family-controlled entities, notwithstanding legislative history that clearly indicates that Section 2704 was not intended to affect such discounts.

If you are considering a transfer with valuation discounts, now is the time to act. While the effective date of the looming Section 2704 regulations is unknown, regulations are typically effective prospectively. In the normal course, regulations are issued in proposed form, comments are invited for a period of time, and final regulations are issued thereafter. The effective date of the regulations is typically the date of the final regulations; however, in some cases, regulations have been deemed effective as of the date of the proposed regulations. (Notwithstanding the foregoing, even a transaction completed before the release of the Section 2704 regulations is not guaranteed to avoid scrutiny under the regulations because the IRS could attempt to treat the regulations as interpretive of existing law.)