Proposed Section 2704 Regulations Would Severely Limit Discounts on Transfers of Ownership Interests in Family-Controlled Entities

The proposed regulations are exceedingly complex and broad in scope, but suffice to say that if implemented, they would significantly curtail the discounts that can be applied to the value of family-controlled business interests for transfer tax purposes. Family members with these types of assets should act quickly if they want to take advantage of the favorable valuation discounts that apply under current law.

Background

Affluent families frequently hold a portion of their wealth in a closely-held entity, such as a limited partnership, LLC, or corporation. Some of these entities are active operating businesses, while others own passive investments, such as marketable securities. Family members often transfer all or a portion of their ownership interests in these entities to younger generations as part of their estate planning to reduce estate, gift, and generation-skipping transfer tax exposure. This type of transfer is advantageous for two reasons: (i) it removes the asset from the transferor’s taxable estate; and (ii) any future appreciation in value of the asset will accrue in the hands of the transferee and will not be part of the transferor’s estate for estate tax purposes.

When interests in these closely-held entities are transferred to other family members, the value of the transferred interest is usually subject to a “lack of control discount” and a “lack of marketability discount.” The “lack of control discount” reflects a minority owner’s limited ability to control the entity, while the “lack of marketability discount” reflects an owner’s limited ability to convert the investment to cash by way of a liquidation, redemption, or sale of the interest. These valuation discounts, which typically exceed 30% of the net asset value, lower the tax cost of transferring interests in closely-held entities to other family members, such as children and grandchildren. 

It has long been the position of the IRS that these valuation discounts are not a true reflection of value when applied to interests in family entities. The IRS and the Treasury Department tried for years to persuade Congress to enact legislation to tighten Section 2704 of the Internal Revenue Code to lessen perceived abuses in valuation discounts for family entities. When it became apparent that no legislation would be forthcoming from Congress, the IRS announced earlier this year at the ABA’s Tax Section meeting in May that it would take matters into its own hands by proposing new regulations.

Proposed Regulations

On August 2, 2016, the IRS made good on its word and released proposed regulations under Section 2704 of the Internal Revenue Code. If implemented, the proposed regulations will severely limit valuation discounts on transfers of interests in family-controlled entities (including family limited partnerships, LLCs, and corporations). This loss of valuation discounts will result in a significantly greater transfer tax liability than would occur if the interest in the family-controlled entity were transferred under the current regulations.

The proposed regulations are not effective immediately. They must first go through a 90-day public comment period, followed by a public hearing on December 1, 2016. We anticipate there will be extensive comments from valuation experts and professionals in the estate planning community. If the regulations are finalized, the most far-reaching portions of the regulations would become effective 30 days after finalization, while other portions of the regulations would become effective immediately upon finalization. Given this time table, the earliest the regulations could become final would be early 2017.

Importance of Planning Now

At this time, no one knows when or if the regulations will be finalized, whether changes will be made before the regulations are finalized, or whether there will be litigation challenging the validity of the regulations. If the proposed regulations are finalized in their present form, most of the restrictions that have historically justified discounts for transfers of interests in family-controlled entities would be disregarded for valuation purposes. The end result is that a significant estate planning technique will be lost, and the tax cost of transferring interests in family-controlled entities will increase substantially. 

Clients who are over the Federal estate tax exemption threshold (for 2016, $5.45 million per individual or $10.9 million for married couples) and who are considering transferring interests in family-controlled entities should act quickly to make the transfers as soon as possible, while the planning window is still open.