Valuation of family-owned entities for estate and gift tax purposes under Sec. 2704

Family-controlled corporations and partnerships are frequently part of an estate plan to transfer wealth from one generation to another, particularly for closely held businesses gifted or bequeathed from owners to their children or grandchildren. Such entities are especially attractive because of the ability to employ discounts for lack of marketability or control in valuing the transfer for gift, estate, or generation-skipping transfer tax purposes.¹ However, with the recent release of proposed regulations under Sec. 2704, the IRS is substantially curtailing the use of such valuation discounts. If and when these regulations become final, they will in many instances disregard certain restrictions on a shareholder’s or partner’s rights to participate in management, receive distributions or force liquidation, and/or sell or transfer interests in family limited partnerships or closely held corporations, thereby negating valuation discounts that for decades have been a basic component of many estate plans.

This article describes the general rules of Sec. 2704 that disregard lapses or other restrictions of certain voting or liquidation rights in the context of measuring the value of gratuitous transfers of family-controlled entities where such lapses or restrictions are intended to impact the tax value of a transferred interest but not its ultimate economic value to a recipient family member. The proposed regulations limit certain exceptions in the regulations to this general rule and offer additional limitations for valuing “deathbed” transfers. The regulations also clarify the meaning of “control” in entities, as well as modify what constitutes an “applicable restriction” by adding a new concept of “disregarded restrictions.” These proposed rules addressing the valuation of closely held enterprises transferred among family members may significantly restrict discounts for lack of control and marketability that have been the driving force for the creation of many family limited partnerships.

Sec. 2704: Lapses

For wealth transfer tax purposes, Sec. 2704 has for more than two decades prescribed rules for disregarding certain lapsing rights and liquidation restrictions in valuing transferred interests among family members in family-controlled corporations and partnerships.² With respect to lapses, the legislative history to Sec. 2704³ states that it is intended to overturn the holding of Estate of Harrison,⁴ which considered the valuation of partnership interests held by a decedent where the decedent’s general partnership interest had the right to liquidate the partnership, but his limited partnership interest had no liquidation right. Upon his death, the partnership agreement required the decedent’s partnership interest to be sold to his children, providing at the same time that his right to have his interest liquidated lapsed upon his death. The court held that the lapse of the liquidation power at death resulted in a sizable reduction in the value of both the general and limited partnership interests for estate tax purposes.

To reverse this result, Sec. 2704(a)(1) provides that a lapse of any voting or liquidation right⁵ where the individual⁶ with such right and members of his or her family⁷ hold, both before and after the lapse, control⁸ of the entity shall be ignored in valuing the interest for wealth transfer tax purposes.

Example 1: A father and daughter have controlling interests in a corporation. If the father’s stock has voting rights that lapse on his death and his stock is bequeathed to his daughter, Sec. 2704(a)(1) would include the value of the lapsed rights in the father’s estate. If the father’s stock has voting rights that lapse upon the gift of the shares to the daughter, the father is treated as making a taxable gift to the daughter on the date of the lapse.

For this purpose, Sec. 2704(a)(3) grants broad regulatory authority to the IRS to define rights that are similar to voting or liquidation rights.

Example 2: X and members of his family own all the stock of Corporation Z. Under the terms of the share certificates, X has the power to cause Z to liquidate, but that power lapses upon X’s death, and his shares are bequeathed to his family. Under Sec. 2704(a)(1), the shares are valued for estate tax purposes as if the lapse had never existed.

Thus, if the lapse occurs during the life of the owner of an entity, it is treated as a gift, and if it occurs at the owner’s death, it is treated as a transfer includible in the gross estate.

Meaning of ‘lapse’

A lapse for this purpose occurs only when the voting or liquidation rights associated with the transferred interest are themselves restricted or eliminated as a result of the transfer.⁹

Example 3: X owns 100% of Y Corporation, the bylaws of which provide that Y can be liquidated only upon the consent of shareholders holding 80% of the stock. X transfers a 30% interest to a family member. There is no lapse under Sec. 2704(a)(1) because the liquidation right of the transferred interest was not restricted or eliminated.¹⁰

Example 4: Assume the same facts as in the previous example, except X holds two classes of Y stock, transferring one class to a family member and retaining the other, which has a liquidation right subordinate to the right of the transferred interest to approve or deny the liquidation of the retained stock. Because the family member holding the transferred interest can deny X the ability to liquidate the retained subordinate interest, a lapse of that right has occurred.¹¹

A lapse of a voting or liquidation right may arise in the same manner as the creation of such a right, i.e., by reason of a state statute, a corporate charter, a partnership agreement, or other private arrangement agreed to among the owners.¹²

Example 5: The bylaws of Corporation Y provide that the voting rights of any transferred shares of Y’s single class of outstanding stock are reduced by half following a transfer but are fully restored after five years. X dies with 60% of the stock, which is bequeathed to his children. The temporary reduction of voting power to the transferred shares does not reduce their value for estate tax purposes.¹³

Finally, if a lapse is not permanent but may be restored only by an action or event beyond the control of the interest’s holder and the holder’s family, no lapse occurs.¹⁴

Example 6: X and his two children are equal general and limited partners in Partnership Y. Each general partner has the right to liquidate the partnership. The partnership agreement provides that incompetency of a partner does not terminate the partnership, but an incompetent partner cannot exercise the rights of a general partner. A partner’s full rights are restored if the partner regains competency. If X is incompetent, the lapse of voting rights is not subject to Sec. 2704(a) because X may later regain rights upon his regaining competency. However, if X dies while incompetent, a lapse subject to Sec. 2704(a) occurs because the lapsed right can no longer be reclaimed.¹⁵

Exceptions

The general rule of Sec. 2704(a) that disregards restrictions of voting and liquidation rights that lapse in valuing an interest transferred among family members has exceptions. Thus, where the holder’s family cannot liquidate the interest after the lapse of a liquidation right, the lapse is not ignored in valuing the interest.

Example 7: D owns 100% of Y Corporation, holding the right to liquidate Y. D dies, leaving the stock to D’s children. Y’s charter provides that at D’s death the right to liquidate lapses, such that the children may not liquidate Y. Thus, the lapsed right may be considered in valuing D’s stock for estate tax purposes.

Sec. 2704(a) also does not apply if neither the holder of the interest (or the holder’s estate) nor members of the holder’s family can, immediately after the lapse, liquidate an interest that the holder could have liquidated prior to the lapse.¹⁶

Example 8: D and his children hold both limited and general partnership interests. Only the general partnership interests have liquidation rights. D dies leaving his limited, but not his general, interest to his spouse. Because of a general partner’s right to liquidate the partnership, a limited interest has a greater fair market value (FMV) when held in conjunction with a general interest. Because D’s children could liquidate D’s limited interest left to his spouse, its value is not reduced merely because the spouse cannot liquidate the partnership; i.e., the lapse of D’s right to liquidate the partnership does not affect the value of the interest passing to the spouse.¹⁷

Example 9: The facts are the same as in the previous example, except D is the only general partner, and, under state law, the children may liquidate the partnership. Again, the lapse of D’s liquidation right is disregarded in valuing the interest passing to the spouse.¹⁸

Finally, Sec. 2704(a) does not apply to a lapse of a liquidation right if it occurs solely due to a change in state law.¹⁹ Thus, if X owns an interest in a corporation that confers upon him voting or liquidation rights, but pursuant to state law, such rights do not carry over to those receiving gifts of shares from X or to those who inherit the shares upon X’s death, such lapses are not disregarded for valuation purposes.

Value of transfer

If Sec. 2704(a) applies to the transfer of an interest among family members, the amount of the gift or the inclusion in the gross estate is the excess (if any) of the value of all interests in the entity held by the transferor before the lapse (determined as if the voting and/or liquidation rights were nonlapsing) over the value of such interests after the lapse.

Example 10: D owns all the preferred stock of Corporation Y (60% of the voting power), and D’s children own all of its common stock (40% of the voting power). Under Y’s bylaws, the voting rights of the preferred stock terminate upon D’s death. The value of D’s interest immediately prior to his death was $100 (determined as if the voting rights were nonlapsing). Immediately after death, the interest would be $90 if the voting rights were nonlapsing, i.e., the decrease in value resulting from D’s no longer being a key factor in Y’s profitability. Applying Sec. 2704(a) to the lapse of voting rights on D’s death, D’s gross estate includes an amount equal to the excess of $90 over the FMV of the preferred stock after the lapse of the voting rights.²⁰

Applying the facts in the Harrison case, the following example based on Regs. Sec. 25.2704-1(f), Example (5), illustrates the inclusion in the gross estate in a typical family limited partnership when a family member dies.

Example 11: X and his two children each hold both general and limited partnership interests. State law provides that only general partners may participate in management or cause the partnership to liquidate. Pursuant to the partnership agreement, the partnership must upon the death or withdrawal of a general partner redeem the general partnership interest for its FMV. A limited partner’s interest may be redeemed only when the partnership liquidates. X dies leaving his limited partnership interest to his spouse and, as required by the partnership agreement, X’s general interest is redeemed. X’s gross estate includes an amount equal to the excess of X’s interests in the partnership held immediately prior to death, determined after X’s death but not considering the lapsed interest, over the FMV of X’s interests in the partnership after death. Because the value of a limited partnership interest is greater when held with a general interest in the partnership that gives the partner the right to liquidate the partnership and participate in management, the value of the limited interest passing to the spouse will be increased as a result of Sec. 2704(a).

While the lapse of a voting or liquidation right may cause a taxable gift or increase the transferor’s gross estate, the amount of the gift or increase in value may be negligible. For example, if a general partner in a limited partnership has no liquidation right and transfers a portion of his or her general partnership interest to a family member and, under the partnership agreement, the transferred general interest is converted to a limited interest, the value of the lapse may be negligible in that the only difference between a general and limited interest is the ability to participate in the partnership’s daily affairs.

Sec. 2704(b): Liquidation restrictions

In determining the value of a transferred interest in a corporation or partnership, certain “applicable restrictions” on the ability of the corporation or partnership to liquidate are disregarded in measuring the value of the interest for wealth transfer tax purposes.²¹ The applicable restriction is disregarded only where the transfer by gift or bequest of the interest in the corporation or partnership is to (or for the benefit of) a member of the transferor’s family, and the transferor and members of his or her family control the entity immediately before the transfer. Thus, a liquidation restriction is ignored and the value of the interest in the entity is determined as if the right to liquidate, including any rights under state law to liquidate, were exercisable at the time of gift or death.²²

An “applicable restriction” is defined as one that limits the ability of the corporation or partnership to liquidate;²³ is more restrictive than any restriction imposed by federal or state law;²⁴ and either lapses, in whole or in part, after the transfer²⁵ or can be removed, in whole or in part, by the transferor or any member of his or her family, either alone or collectively.²⁶

Example 12: X owns 76% and his two children each own 12% of a partnership. The partnership agreement requires the consent of all the partners to liquidate, but state law requires only 70% of total partnership interests. Upon X’s death the requirement of unanimous partner consent to liquidate is an applicable restriction, because the children acting together can remove the restrictions. Therefore, X’s interest is valued without regard to the restriction, i.e., as if X’s interest alone is sufficient to cause liquidation.²⁷

The regulations declare that an absolute restriction on liquidation for a set period that cannot be changed by family members will still be an applicable restriction and ignored for valuation purposes.

Example 13: X owns all the preferred stock in Corporation Y, which carries a right to liquidate Y in 20X9. In 20X4, when X’s children own all the common stock of Y, X transfers the preferred stock to one of his children. The fact that X cannot liquidate Y until 20X9 is disregarded in valuing the 20X4 transfer.²⁸

An applicable restriction, however, does not include a commercially reasonable restriction resulting from a financing by the corporation or partnership with a person who is not related to the transferor or transferee or a member of the family of either.²⁹ This is an important exception, in that banks will often require restrictions on redeeming owners’ interests as a condition of making loans to businesses. Specifically, the restriction must be imposed by an unrelated party advancing capital in the form of debt or equity for the entity’s trade or business operations.³⁰ A “related party” for this purpose includes members of the individual’s family, i.e., spouse, siblings, ancestors and lineal descendants, a corporation owned more than 50% by the individual, and the grantor and fiduciary of a trust.³¹

Example 14: A partnership owned by D and his children borrows money from a party related to D. The loan agreement requires that the partners not liquidate the partnership without the lender’s consent, i.e., an applicable restriction. If D transfers all or part of his partnership interest to any or all of his children, the transfer is valued as if the lender’s consent were not required.

Closely held businesses often deny a limited partner or shareholder the right to cash in his or her interest at FMV, at least during the enterprise’s startup phase, due to the financial disruption it would cause. Therefore, a restriction on a limited partner or shareholder to liquidate his or her interest should be commercially reasonable and not constitute an applicable restriction.

Finally, and most importantly in light of the proposed regulations described below, Sec. 2704(b)(4) gives the IRS the authority to provide in regulations that other restrictions may similarly be disregarded in valuing transfers of interests in an entity to a member of the transferor’s family if the restriction merely reduces the value for transfer-tax purposes but does not ultimately reduce the value of the interest in the hands of the transferee.

Proposed regulations

Pursuant to the authority of Sec. 2704(a)(3) to expand the meaning of voting or liquidation rights subject to a lapse and of Sec. 2704(b)(4) to describe other restrictions that may be disregarded for determining the value of an interest in an entity, the Treasury Department and the IRS in August 2016 issued proposed regulations that address valuation discounts for transfers of closely held businesses among family members.³² While not eliminating all valuation discounts, they introduce significant changes that will affect almost all planning options in this area. If the regulations are made final in the same form as proposed, all estate plans involving transfers of interests in family limited partnerships will need to be examined to determine whether valuation discounts are still viable.

Reasons for new regulations

The preamble to the proposed regulations declares that Sec. 2704 and its current regulations have been ineffective in fulfilling the statute’s intent to curtail lapses and restrictions on transfers of interests in closely held businesses among family members. First, courts have held that Sec. 2704(b) applies only to restrictions on the ability to liquidate an entire entity and not to restrictions on the ability to liquidate a transferred interest in that entity.³³ Thus, under current law, a restriction on the ability to liquidate an individual interest is not an applicable restriction.

Second, the current regulations provide that a restriction on liquidation that is no more restrictive than that of the state law governing the entity’s activity and would apply in the absence of the restriction is not an applicable restriction.³⁴ A liquidation right means the power to compel the entity to acquire all or a portion of the holder’s equity interest in the entity including by reason of aggregate voting power, whether or not its exercise would result in the entity’s complete liquidation.³⁵

The preamble points out that after the promulgation of the current regulations, many states amended their law to impose additional restrictions on the right of partners to liquidate their interests, so that many partnership agreements restricting liquidation now fall within the regulatory exception to Sec. 2704(b) for restrictions that are no more restrictive than those under state law and thus are not applicable restrictions.³⁶

Finally, the preamble notes that taxpayers have avoided Sec. 2704(b) by means of transferring partnership interests to an assignee³⁷ or a nominal interest to a non—family member such as a charity or employee to ensure the family alone does not have the power to remove the restriction.³⁸

As a result of these and many other concerns described below, the proposed regulations substantially revise and clarify the rules governing lapses and applicable restrictions in Sec. 2704. The remaining discussion explains these changes and their impact on the valuation of closely held businesses gifted or bequeathed to members of a transferor’s family.

LLCs and their control

With the promulgation of the check-the-box regulations, whereby a business entity’s status for tax purposes as a passthrough may differ from its classification under local law, limited liability companies (LLCs) have become a popular choice of entity for small businesses.³⁹ To address this new form of entity, the proposed regulations clarify that Sec. 2704 applies to transferred interests of LLCs, including single-member disregarded entities, regardless of how the LLC is classified under local law.⁴⁰

The proposed regulations also clarify the meaning of what constitutes control of an LLC or other entities that are not corporations or partnerships, defining the term to be at least 50% of either the capital or profit interests in the business, or the holding of an equity interest that has the power to cause full or partial liquidation.⁴¹

Example 15: Before death, D owned all the preferred equity interests in Entity Y. The preferred and common interests each carry 50% of the total voting power of Y. D’s children own 40% of the common interests, and unrelated parties own the remaining 60%. If, upon D’s death, the voting rights of the preferred interests lapse, Sec. 2704(a) does not apply because members of D’s family do not controlY.

Example 16: D and D’s children, A and B, organize X, an LLC under the laws of State Y. D, A, and B each contribute cash to X. X’s operating agreement calls for X to maintain capital accounts for each member that are adjusted to reflect each member’s contributions to and distributions from X, as well as each member’s share of X’s profits and losses. Upon liquidation, distributions are determined by the members’ capital account balances. Profits and losses are allocated on the basis of units issued to each member, which are not in proportion to capital. D holds 98 units; A and B each hold one unit. D is designated in the operating agreement as the manager of X with the power to liquidate X. D and D’s family have control of X because they hold at least 50% of the profit interests (or capital interests) of X. Further, D and D’s family have control of X because D holds an interest with the ability to cause the liquidation ofX.

Example 17: The facts are the same as in the preceding example except that, under the operating agreement, all distributions are made to members based on the units held. Further, X elects to be treated as a corporation for federal tax purposes. D and D’s family have control of X because they hold at least 50% of the capital interests in X. Further, D and D’s family have control of X because D holds an interest with the ability to cause the liquidation ofX.

Technically, this clarification of the meaning of the term “control” applies only to transfers of interests in entities and not assets such as undivided interests in real estate. However, the proposed regulations’ expansion of the types of business relationships to which Sec. 2704 applies could be interpreted to include undivided interests in business assets themselves. While probably not the intent of the proposed regulations, their liberal definition of the kinds of interests in property that create control leaves open an interpretation that would extend to interests in assets themselves.

Deathbed transfers

Generally, a liquidation right is considered to lapse when it is restricted or eliminated.⁴² Thus, where the liquidation right is also transferred with the interest, there is no lapse, and the transferor is not subject to Sec. 2704(a).⁴³ This has led to majority owners’ gifting interests in closely held businesses to family members shortly before death to convert the controlling interest into a minority interest for a valuation discount.⁴⁴ But because transfers shortly before death create a disparity between a minimal economic effect of the transfer and its substantial tax effect, the proposed regulations adopt a three-year rule for transfers of interests subject to lapsing liquidation rights. Thus, if an individual transfers an interest with a lapsing voting or liquidation right within three years of the individual’s death, the right is considered to lapse at the individual’s death, and the value of the lapsed right is included in the individual’s gross estate.⁴⁵

Example 18: Within three years before her death, X gifts 1% stock interests in a family-owned corporation to each of her two children, thereby reducing her interest from a controlling 51% to a noncontrolling 49%. The value of X’s remaining interest will not be discounted to reflect a minority interest in the corporation.⁴⁶

Example 19: D owns 84% of the single class of stock of Corporation Y, the bylaws of which require 70% of the vote to liquidate. More than three years before D’s death, D transfers one-half of D’s stock in equal shares to D’s three children (14% each). Sec. 2704(a) does not apply to the loss of D’s ability to liquidate Y because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had the transfers occurred within three years of D’s death, under the proposed regulations, the transfers would have been treated as the lapse of D’s liquidation right occurring at D’s death.⁴⁷

Example 20: D owns all the stock of Corporation X, consisting of 100 shares of nonvoting preferred stock and 100 shares of voting common stock. Under its bylaws, X can be liquidated only with the consent of at least 80% of the voting shares. More than three years before D’s death, D transfers 30 shares of common stock to D’s child. The transfer is not a lapse of a liquidation right with respect to the common stock because the voting rights that enabled D to liquidate prior to the transfer are not restricted or eliminated, and the transfer occurs more than three years before D’s death. However, had the transfer occurred within three years of D’s death, under the proposed regulations, the transfer would have been treated as the lapse of D’s liquidation right with respect to the common stock.⁴⁸

The effect of this “deathbed” transfer rule, however, may not be critical in light of other proposed regulations under Sec. 2704(b) creating “disregarded restrictions,” discussed below, that reduce or eliminate minority discounts regardless of whether interests are transferred within three years of death.

Transfers to assignees

The proposed regulations clarify the treatment of transfers that create an assignee interest. Under state law, an assignee is someone who receives an interest in an entity but is not considered a partner or shareholder in the entity. Generally, an assignee may receive items of income and loss but has no rights to participate in management. As a result of this loss of management control that eliminates significant rights and power associated with the interest, the valuation of a transfer of an interest from a partner to an assignee has been discounted.

The proposed regulations reverse this result, stating that if a transfer results in the restriction or elimination of any of the rights or powers associated with the interest, the transfer is treated as a lapse under Sec. 2704(a).⁴⁹ For example, the transfer of a partnership interest to an assignee that neither has nor may exercise the voting or liquidation rights of the transferor partner is a lapse of the voting and liquidation rights associated with the transferred interest. As a result, a transfer of an interest to an assignee may be treated as a lapse of liquidation rights associated with the interest and thus treated as a taxable gift.⁵⁰

Liquidation restrictions and state law

The proposed regulations attempt to reverse what the IRS regards as the evisceration of Sec. 2704(b) by estate planners and the courts with rules that simply disregard restrictions that, in its view, do not meaningfully impact the interest’s economic value. First, the proposed regulations would remove from the current regulations the exception limiting the definition of “applicable restriction” to limitations that are more restrictive than state law restrictions.⁵¹ Removing this exception will result in many restrictions’ being disregarded for valuation purposes although they simply reflect a state or local law.

Second, the proposed regulations define the meaning of “federal” and “state” for purposes of determining whether a restriction is “imposed, or required to be imposed, by any Federal or State law” under Sec. 2704(b)(3)(B), to refer only to the United States, any of its states, and the District of Columbia, but not the law of any other jurisdiction, i.e., the law of a foreign country.⁵² A restriction is considered imposed by law if it cannot be removed or overridden and is mandated by statute to be included in governing documents or is otherwise made mandatory.

A provision of law that applies only in the absence of a contrary provision in the governing documents or that may be superseded with regard to an entity by vote of the partners or shareholders is not a restriction imposed by federal or state law. Restrictions that may not be removed or overridden may still be considered applicable restrictions if the state law applies to a narrow class of entities such as family-controlled entities that would otherwise be subject to Sec. 2704(b). Finally, a restriction is not considered imposed by law where state law imposes a mandatory restriction but provides an alternative provision for the same type of entity that does not mandate the restriction.⁵³

These regulatory revisions are important in that, as the preamble to the regulations states, the laws of many states now provide that limited partners have no withdrawal rights (unless allowed in the partnership agreement) until the partnership terminates and allow liquidation of the entity only upon unanimous vote of the partners. Consequently, limited partnerships and LLCs structured in accordance with these state default rules are valued taking these restrictions into account. Under the proposed regulations, because the state law restriction on withdrawal is not a mandatory requirement, it would be ignored for valuation purposes.

Disregarded restrictions

Perhaps the most far-reaching provision in the proposed regulations is the creation of a new regime of “disregarded restrictions” in connection with the valuation of transfers under Sec. 2704(b). Employing the broad authority of Sec. 2704(b)(4) to describe other restrictions in determining the value of closely held entity interests transferred among family members, the proposed regulations create four categories of liquidation restrictions that will be disregarded for valuation purposes if the restriction, in whole or in part, either lapses after the transfer or can be removed by the transferor or any member of the transferor’s family, either alone or collectively:

1. Provisions that limit or permit the limitation of the holder of the interest to compel liquidation or redemption of the interest.⁵⁴

Example 21: D and D’s children, A and B, are partners in limited partnership X, which was created on July 1, 2016. D owns a 98% limited partner interest, and A and B each own a 1% general partner interest. The partnership agreement provides that the partnership will liquidate on June 30, 2066, or by the earlier agreement of all the partners but otherwise prohibits the withdrawal of a limited partner. Under applicable local law, a limited partner may withdraw from a limited partnership at the time, or on the occurrence of events, specified in the partnership agreement. Under the partnership agreement, the approval of all partners is required to amend the agreement. None of these provisions is mandated by local law. D transfers a 33% limited partner interest to A and a 33% limited partner interest toB.

By prohibiting the withdrawal of a limited partner, the partnership agreement imposes a restriction on a partner’s ability to liquidate the partner’s interest in the partnership that is not required to be imposed by law and that may be removed by the transferor and members of the transferor’s family, acting collectively, by agreeing to amend the partnership agreement. Therefore, the restriction on a limited partner’s ability to liquidate that partner’s interest is disregarded in determining the value of each transferred interest.⁵⁵

2. Provisions that limit or permit the limitation of the amount that may be received by the holder of the interest on liquidation or redemption of the interest to an amount that is less than “minimum value.” Minimum value means the interest’s share of the “net value” of the entity determined on the date of liquidation or redemption. The net value of the entity is the FMV of the property held by the entity, reduced by the entity’s outstanding obligations, if any.⁵⁶ Only obligations that would be deductible (if paid) for estate tax purposes may be taken into account.⁵⁷

3. Provisions that defer or permit the deferral of the payment of the full liquidation or redemption proceeds for more than six months after the date the holder gives notice to the entity of the holder’s intent to have the holder’s interest liquidated or redeemed.⁵⁸

4. Provisions that authorize or permit the payment of any portion of the full liquidation or redemption proceeds in any manner other than in cash or property. “Property” does not include a note or other obligation issued directly or indirectly by the entity or issued by other owners of the entity or parties related to either.⁵⁹ However, notes of an entity are property if the entity is engaged in an active trade or business and at least 60% of the entity’s value consists of nonpassive assets.⁶⁰ The notes must be adequately secured, require periodic payments on a nondeferred basis, carry a market rate of interest, and have an FMV on the date of liquidation or redemption equal to the liquidation proceeds.⁶¹

If a restriction upon the interest is described in any of the above categories, the FMV of the interest in the entity is determined as if the restriction did not exist, either in the governing documents or applicable law. The proposed regulations make clear that a disregarded restriction does not require the individual to be able to cause a liquidation of the entity but only to be able to redeem his or her own interest.⁶²

Presumably, the governing documents of the partnership or corporation would not need to explicitly state that owners do not have these rights, so long as default provisions of the state law under which the entity is organized do not confer them upon owners.

Ownership by non-family members

Believing that transfers of less than a substantial amount in an entity to a non-family member should not preclude the application of Sec. 2704(b), Treasury and the IRS set out in the proposed regulations specific circumstances where such an ownership interest will count in measuring whether the transferor or his or her family can remove the restriction. In determining whether the transferor or the transferor’s family can remove a disregarded restriction, any interest in the entity held by a non-family member is disregarded if, at the time of the transfer:

• The interest has been held less than three years before the date of the transfer;⁶³
• The interest constitutes less than 10% of the value of all of the equity interests in a corporation or capital and profits interest in a partnership;⁶⁴
• When combined with the interests of other non-family members, the interest constitutes less than 20% of the value of all of the equity interests in a corporation or capital and profits interests in other business entities (as defined in Regs. Sec. 301.7701-2(a));⁶⁵ or
• Each non-family member, as owner, lacks a right to “put” the interest in the entity and receive a minimum value.⁶⁶

The term “put right” means a right enforceable under local law to receive from the entity or from one or more holders on liquidation or redemption of the holder’s interest, within six months after the date the holder gives notice of the holder’s intent to withdraw, cash and/or other property with a value at least equal to the minimum value of the interest determined at the date of liquidation or redemption.⁶⁷

Example 22: D owns a 1% general partner interest and a 74% limited partner interest in limited partnership X, which in turn holds a 50% limited partner interest in limited partnership Y. D owns the remaining interest in Y. B, an unrelated individual, has owned a 25% limited partner interest in X for more than three years. The governing documents of the partnerships permit liquidation of the entity upon agreement of owners holding 90% of the interests but, with the exception of B’s interest, prohibit the withdrawal of a limited partner. B may withdraw on six months’ notice and receive his share of the minimum value of X, which includes a share of the minimum value of Y. Under the governing documents of the partnerships, the approval of all partners is required to amend the documents. D transfers a 40% limited interest in Y to D’s children.

For purposes of determining whether D and/or D’s family members can remove a restriction after the transfer, B is treated as owning a 12.5% (0.25 × 0.50) interest in Y—thus, more than a 10% interest but less than a 20% interest. B’s interest is disregarded in determining whether D and D’s family hold the right to remove a restriction after the transfer, resulting in D and D’s children being deemed to own 100% of Y for this purpose.⁶⁸

Example 23: The facts are the same as in the preceding example, except that D transfers a 40% limited interest in X to his children. B’s ownership of 25% of X is not disregarded, so that D and D’s family cannot remove a restriction after the transfer.⁶⁹

Example 24: D owns 85 of the outstanding shares of X, a corporation, and A, an unrelated individual, owns the remaining 15 shares. Under X’s governing documents, the approval of the shareholders holding 75% of the outstanding stock is required to liquidate X. With the exception of non-family members, a shareholder may not withdraw from X. Non-family members may withdraw on six months’ notice and receive their interest’s share of the minimum value of X. D transfers 10 shares to C, a charity. Four years later, D dies. D bequeaths 10 shares to B, an unrelated individual, and the remaining 65 shares to trusts for the benefit of D’s family.

The prohibition on withdrawal is a restriction that limits redemption. In determining whether D’s estate and/or D’s family may remove the restriction after the transfer occurring on D’s death, B’s interest is disregarded because it was not held by B for at least three years prior to D’s death. The interests of A and C, however, are not disregarded, because each held an interest of at least 10% for at least three years prior to D’s death, the total of those interests represents at least 20% of X, and each had the right to withdraw on six months’ notice and receive his or her interest’s share of the minimum value of X. As a result, D and D’s family hold 65 of the deemed total of 90 shares in X, or 72%, which is less than the 75% needed to liquidate X. Thus, D and D’s family are not able to remove the restriction after the transfer, and Sec. 2704(b) does not apply in valuing D’s interest in X for federal estate tax purposes.⁷⁰

If the non-family-owned interest is disregarded, the determination of whether the family can remove the restriction will be made as if the remaining interests are the sole interests in the entity.⁷¹ As a practical matter, almost no family business will have a non-family member meet these requirements.

Extending Sec. 2704’s reach

The rules of Sec. 2704 dealing with lapses of voting or liquidation rights and the disregard of certain restrictions on liquidation rights have a substantial impact on the valuation of intrafamily gifts and bequests of family-owned partnerships, corporations, and LLCs. With the promulgation of the proposed regulations, the impact of these rules on valuation discounts on transferred interests will only increase. If the rules are finalized in their proposed form, taxpayers will likely challenge the regulations as exceeding the scope of authority in Secs. 2704(a)(3) and (b)(4)—a difficult but perhaps not insurmountable burden.⁷²

Many of the thousands of comment letters the IRS received in response to the proposed regulations urged they be withdrawn or withdrawn and reproposed.⁷³ In addition, in the public hearing on the proposed regulations in December 2016, over 30 witnesses from across the country spoke against the proposed regulations or particular provisions. Thus, practitioners should also be aware that these proposed regulations could be withdrawn or at least substantially modified.In any event, the earliest the final regulations will be effective is upon their publication in the Federal Register,⁷⁴ permitting taxpayers an opportunity to plan.  

Footnotes

¹See, e.g., Williamson, “Family Limited Partnership Regs Target Valuation Discounts,” 152 Tax Notes 1559 (Sept. 12, 2016), discussing the traditional use of family limited partnerships in an estate plan.

²Sec. 2704, including Sec. 2704(a) (lapsing interests) and Sec. 2704(b) (liquidation rights), was added to the Code by the Omnibus Budget Reconciliation Act of 1990, P.L. 101-508.

³136 Cong. Rec. S15629 (daily ed. Oct. 18, 1990); H.R. Conf. Rep’t No. 964, 101st Cong., 2d Sess. 1028, 1137 (1990).

⁴Estate of Harrison, T.C. Memo. 1987-8.

⁵A voting right is defined as the right to vote with respect to any matter of the entity, including the right to participate in management (Regs. Sec. 25.2704-1(a)(2)(iv)). A liquidation right is the ability to compel the entity to acquire all or a portion of the holder’s interest in the entity but not necessarily the power to liquidate the entire entity (Regs. Sec. 25.2704-1(a)(2)(v)).

⁶For this purpose, an individual is deemed to hold an interest that is held by a corporation, partnership, trust, or other entity in which the individual holds an interest (Secs. 2704(c)(3) and 2701(e)(3)).

⁷An individual’s family includes the person’s spouse, ancestors, and lineal descendants (and their spouses), as well as brothers and sisters (and their spouses) (Sec. 2704(c)(2)).

⁸See Sec. 2704(c)(1), cross-referencing Sec. 2701(b)(2). In the case of a partnership, “control” for this purpose means holding at least 50% of the capital or profits interest and in the case of a limited partnership, the holding of a general partnership interest (Sec. 2701(b)(2)(B)). In the case of a corporation, control is the holding of at least 50% (by vote or value) of the corporation’s stock (Sec. 2701(b)(2)(A)).

⁹Regs. Sec. 25.2704-1(c)(1).

¹⁰See Regs. Sec. 25.2704-1(f), Example (7).

¹¹Regs. Sec. 25.2704-1(c)(1).

¹²Regs. Sec. 25.2704-1(a)(4).

¹³See Regs. Sec. 25.2704-1(f), Example (3).

¹⁴Regs. Sec. 25.2704-1(a)(3).

¹⁵Regs. Sec. 25.2704-1(f), Example (9).

¹⁶Regs. Sec. 25.2704-1(c)(2)(i). But see Regs. Sec. 25.2704-1(f), Example (5), where the decedent partner and his children owned both general partnership interests with liquidation rights and limited interests without liquidation rights.

¹⁷Regs. Sec. 25.2704-1(f), Example (5).

¹⁸Regs. Sec. 25.2704-1(f), Example (6).

¹⁹Regs. Sec. 25.2704-1(c)(2)(iii).

²⁰Regs. Sec. 25.2704-1(f), Example (1).

²¹Sec. 2704(b).

²²See Regs. Sec. 25.2704-2(c).

²³Sec. 2704(b)(2)(A).

²⁴Sec. 2704(b)(3)(B).

²⁵Sec. 2704(b)(2)(B)(i).

²⁶Sec. 2704(b)(2)(B)(ii).

²⁷See Regs. Sec. 25.2704-2(d), Example (1).

²⁸Regs. Sec. 25.2704-2(d), Example (2).

²⁹Sec. 2704(b)(3)(A).

³⁰Regs. Sec. 25.2704-2(b).

³¹Id. See also Sec. 267(b).

³²REG-163113-02.

³³Kerr, 113 T.C. 449, aff’d, 292 F.3d 490 (5th Cir. 2002). Specifically, the dispute centers upon the first sentence of Regs. Sec. 25.2704-2(b) referring to “the ability to liquidate the entity (in whole or in part).” The court interpreted the phrase to refer to a complete or partial liquidation, i.e., a pro rata distribution of property to shareholders or partners, not the ability to liquidate one owner’s equity interest in a non-pro rata liquidation. The Service contends that the provision applies to the non-pro rata liquidation of an owner’s equity interest. See Regs. Sec. 25.2704-2(d), Example (5).

³⁴The Tax Court in Kerr, 113 T.C. 449, 472, held that Regs. Sec. 25.2704-2(b) expanded the statutory exception to Sec. 2704(b) that excepts “any restriction imposed, or required to be imposed, by any Federal or State law” (Sec. 2704(b)(3)(B)).

³⁵Regs. Sec. 25.2704-1(a)(2)(v).

³⁶See, e.g., Tex. Bus. Orgs. Code §153.110 (limited partner may withdraw pursuant to terms of partnership agreement); Uniform Limited Partnership Act (2001) §601(a), 6A U.L.A. 348, 448 (Supp. 2015) (limited partner has no right to withdraw before completion of the winding up of the partnership).

³⁷See Kerr, 292 F.2d 490, 463-64 (5th Cir. 2002), and Estate of Jones, 116 T.C. 121, 129-30 (2001), finding that an assignee’s inability to cause the partnership to liquidate his or her interest is no more of a restriction than that imposed upon assignees under state law, so that it is not an applicable restriction.

³⁸See Kerr, 292 F.2d at 494.

³⁹Regs. Sec. 301.7701-2(a).

⁴⁰Prop. Regs. Sec. 25.2701-2(b)(5)(i).

⁴¹Prop. Regs. Sec. 25.2701-2(b)(5)(iv). For this purpose, existing attribution rules apply to treat an individual, the individual’s estate, and members of the individual’s family as holding interests held through a corporation, partnership, trust, or other entity (Regs. Sec. 25.2701-6).

⁴²Regs. Sec. 25.2704-1(c)(1).

⁴³Id.

⁴⁴See, e.g., Estate of Murphy, T.C. Memo. 1990-472.

⁴⁵Prop. Regs. Sec. 25.2704-1(c)(1). While the effective date of the proposed regulations is generally the date they become final, a deathbed inclusion might arise before that date if a transfer occurs within three years of the regulations’ being finalized, followed by the transferor’s death.

⁴⁶See Murphy, T.C. Memo. 1990-472.

⁴⁷Prop. Regs. Sec. 25.2704-1(f), Example (4).

⁴⁸Prop. Regs. Sec. 25.2704-1(f), Example (7).

⁴⁹Prop. Regs. Sec. 25.2704-1(a)(5).

⁵⁰Although not referred to in the proposed regulations, an interest transferred to an assignee will most likely also be ignored under the new “disregarded restriction” rules in Prop. Regs. Sec. 25.2704-3(b)(1) because the assignee does not have a redemption, i.e., “put,” right.

⁵¹Prop. Regs. Sec. 25.2704-2(b).

⁵²Prop. Regs. Sec. 25.2704-2(b)(4)(ii).

⁵³Id.

⁵⁴Prop. Regs. Sec. 25.2704-3(b)(1)(i).

⁵⁵See Prop. Regs. Sec. 25.2704-3(g), Example (1).

⁵⁶See Prop. Regs. Sec. 25.2704-3(b)(1)(ii), cross-referencing Regs. Secs. 20.2031-2(f)(2) and 20.2031-3 (testamentary transfers) and Regs. Secs. 25.2512-2(f)(2) and 25.2512-3 (inter vivos transfers) for guidance in valuing interests in operating businesses. These regulations make clear that minimum value is not merely the value of a business’s physical assets but also takes into account the entity’s earning capacity, its position in the industry, and the economic outlook for the industry as a whole.

⁵⁷If only obligations actually paid for estate tax purposes under Sec. 2053 are allowed, contingent or uncertain obligations will be excluded.

⁵⁸Prop. Regs. Sec. 25.2704-3(b)(1)(iii).

⁵⁹See Sec. 267(b) for parties considered related to the entity or other holders of interests in the entity.

⁶⁰For this purpose, generally, an asset is passive if it is not used in a trade or business (Sec. 6166(b)(9)(B)(i)).

⁶¹Prop. Regs. Sec. 25.2704-3(b)(1)(iv).

⁶²Prop. Regs. Sec. 25.2704-3(b)(1).

⁶³Prop. Regs. Sec. 25.2704-3(b)(4)(i)(A).

⁶⁴Prop. Regs. Sec. 25.2704-3(b)(4)(i)(B).

⁶⁵Prop. Regs. Sec. 25.2704-3(b)(4)(i)(C).

⁶⁶Prop. Regs. Sec. 25.2704-3(b)(4)(i)(D).

⁶⁷Prop. Regs. Sec. 25.2704-3(b)(6).

⁶⁸Prop. Regs. Sec. 25.2704-1(g), Example (10).

⁶⁹Id.

⁷⁰Prop. Regs. Sec. 25.2704-1(g), Example (11).

⁷¹Prop. Regs. Sec. 25.2704-3(b)(4)(ii).

⁷²Despite the broad grant of authority in Secs. 2704(a)(3) and (b)(4) to issue regulations, the Conference Report to the Omnibus Budget Reconciliation Act of 1990, P.L. 101-508, that enacted Chapter 14 of the Code, of which Sec. 2704 is a part, states that it was not intended to affect minority discounts or other discounts available under the law at that time. See 136 Cong. Rec. S15679, S15681 (Oct. 18, 1990). Perhaps this is why President Barack Obama’s 2010-2013 revenue proposals (“green books”) called for legislation making the changes offered in the proposed regulations.

⁷³See, e.g., comments by the AICPA, Jan. 13, 2017, available at www.aicpa.org.

⁷⁴Regs. Sec. 25.2701-8(b); Prop. Regs. Sec. 25.2704-4. In the case of “disregarded restrictions,” the final regulations are effective 30 days after their publication in the Federal Register (Regs. Sec. 25.2704-4(b)(3)).