Treasury Department Issues Proposed Regulations Limiting Valuation Discounts on Transfers of Interests in Family-Controlled Entities


On August 2, 2016, the U.S. Treasury Department released proposed regulations under Section 2704 of the Internal Revenue Code of 1986, as amended. If adopted in their current form, the proposed regulations would significantly reduce or eliminate valuation discounts for estate, gift and generationskipping transfer (GST) tax purposes on transfers of interests in family-controlled entities. The new rules generally would become effective only after they are adopted as final regulations, which is expected to occur perhaps as early as the first quarter of 2017.


The use of a family-controlled entity such as a family limited partnership (FLP) to hold, manage and control family assets has long been a popular estate planning tool because of the potential to transfer interests in the FLP to family members at a reduced transfer tax cost using valuation discounts. Under general valuation principles, a minority interest or lack of control discount reflects limitations on a minority owner’s ability to participate in the management of the entity, to withdraw from the entity or to compel a distribution or redemption with respect to the minority owner’s interest. An illiquidity or lack of marketability discount reflects the absence of a readily available market, which limits the owner’s ability to monetize the investment.

Section 2704 was enacted in 1990 to limit valuation discounts on intra-family transfers of family-controlled interests, and the current regulations thereunder were adopted in 1992. The notice announcing the proposed new regulations states that “the Treasury Department and the Internal Revenue Service have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute,” citing judicial decisions limiting the scope of Section 2704, revisions to state statutes that enhanced an exception to the application of Section 2704, and the use of planning techniques that effectively permitted taxpayers to avoid application of the rules. The proposed regulations would implement the provisions of a legislative proposal that was included in the Obama administration’s annual budget for a number of years but was never introduced as legislation.


The proposed regulations include new rules that would:

  • Introduce a new category of restrictions (“disregarded restrictions”) on interests in familycontrolled entities that would be disregarded for transfer tax valuation purposes, including provisions that (i) limit the ability of the holder of an interest to liquidate such interest, (ii) limit the liquidation proceeds to less than a “minimum value,” (iii) permit the payment of the liquidation proceeds other than in cash or property (except for certain qualifying notes), or (iv) defer the payment of the liquidation proceeds for more than six months;
  • Effectively eliminate the statutory exception from the application of Section 2704 for restrictions that are imposed under federal or state law;
  • Prevent taxpayers from avoiding the application of Section 2704 by having a non-family member, such as a charity or an employee, own a nominal blocking interest in the family-controlled entity; and
  • Treat the assignment of a partnership interest to an assignee who does not have the rights of a partner as a lapse of such rights that is a taxable transfer for estate, gift and GST purposes.

The proposed regulations would apply to both passive investment entities, as well as to active operating entities.

The following example in the proposed regulations illustrates the impact of the new rules. Assume a parent makes a gift of an interest in an FLP to a child. The partnership agreement of the FLP provides that the partnership may be liquidated only upon the unanimous consent of all partners, and does not permit withdrawals by limited partners. The prohibition on withdrawals would be considered a “disregarded restriction” because it imposes a restriction on the ability of the partner to compel a liquidation of the partner’s interest and the restriction is not mandated by federal or state law. Accordingly, because family members could remove the restriction after the transfer, the interest must be valued without taking into account the provision in the partnership agreement that prevents the partner from compelling a liquidation or redemption of the interest. This has the effect of disallowing any discount for minority interest or lack of control and also would appear to reduce or eliminate a discount for illiquidity or lack of marketability to the extent the underlying assets of the partnership are marketable.


There is a 90-day public comment period for the proposed regulations and a public hearing is scheduled for December 1, 2016. With limited exceptions, the new regulations would be effective no earlier than the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register, which could be as early as the first quarter of 2017. The most significant provision of the proposed regulations – the introduction of so-called “disregarded restrictions” – would be effective no earlier than 30 days after the publication of the final regulations.


The proposed regulations, if adopted in their current form, are expected to be challenged by taxpayers as going beyond what was intended by Congress in enacting Section 2704. It is unclear to what extent such a challenge would be successful. Accordingly, it would be prudent for clients who are considering transferring interests in their family-controlled entities to do so as soon as possible and, in any event, before the adoption of the final regulations.