Estate Valuation Discounts Would Be Prohibited Under Proposed Regulations

Editor: Sally P. Schreiber, J.D.

The IRS issued long-awaited proposed regulations designed to prevent taxpayers from lowering the estate and gift tax value of transferred assets. The regulations (REG-163113-02) will “close a tax loophole that certain taxpayers have long used to understate the fair market value of their assets for estate and gift purposes,” in the words of Mark Mazur, assistant secretary for tax policy at the Treasury Department.

Editor’s note: These regulations were identified as burdensome by the Treasury Department in July 2017 and are being reviewed for possible modification or withdrawal. See “Treasury Identifies 8 Regulations as Burdensome.”

The proposed regulations specifically deal with the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes and the treatment of lapsing rights and restrictions on liquidation in determining the value of transferred interests. Valuation of those interests is governed by Sec. 2704, under which lapses of voting or liquidation rights are treated as a transfer in excess of the fair market value (FMV) of all interests held by the transferor (determined as if the voting or liquidation rights were nonlapsing) over the FMV of those interests after the lapse.

However, an exception under Regs. Sec. 25.2704-1(c)(1) provides that a transfer of an interest that results in the lapse of a liquidation right generally is not subject to this rule if the rights with respect to the transferred interest are not restricted or eliminated. This exception has the effect that an inter vivos transfer of a minority interest by the holder of an interest with the aggregate voting power to compel the entity to acquire the holder’s interest is not treated as a lapse, even though the transfer results in the loss of the transferor’s presently exercisable liquidation right. The IRS believes that this exception should not apply when the inter vivos transfer that results in the loss of the power to liquidate occurs on the decedent’s deathbed. Such transfers, the IRS says, “generally have minimal economic effects, but result in a transfer tax value that is less than the value of the interest either in the hands of the decedent prior to death or in the hands of the decedent’s family immediately after death.”

The IRS also believes that the current regulations under Sec. 2704 have been made ineffective by changes in state laws, court decisions, and various estate planning techniques that avoid the application of Sec. 2704(b), under which certain liquidation restrictions are disregarded. The proposed regulations would amend Regs. Sec. 25.2701-2 to address what constitutes control of a limited liability company or other entity or arrangement that is not a corporation, partnership, or limited partnership. This change would be effective when the rules are adopted as final.

They would also amend Regs. Sec. 25.2704-1 to address deathbed transfers that result in the lapse of a liquidation right and to clarify the treatment of a transfer that results in the creation of an assignee interest. This change would apply to lapses of rights created after Oct. 8, 1990, occurring on or after the date the regulations are published as final.

The proposed regulations would amend Regs. Sec. 25.2704-2 to refine the definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations of state law. This change would apply to transfers of property subject to restrictions created after Oct. 8, 1990, occurring on or after the date the regulations are published as final.

Finally, the proposed regulations would add a new section to address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not members of the family. This change would apply to transfers of property subject to restrictions created after Oct. 8, 1990, occurring 30 or more days after the date the regulations are published as final.