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Proposed Changes to IRC Section 2704

Posted in Business Valuation, on Oct 2016, By: Mark S. Gottlieb

Introduction

MarketWatch recently published an article outlining a report written by the global wealth consultancy, Wealth-X, and the insurance brokerage and consulting firm, NFP, which predicts that ultra-high-net-worth individuals will transfer $3.9 trillion to the next generation by 2026.The article writes that this massive global transfer, which it describes as the largest wealth transfer in history, has already begun. It states that, as of last year, ultrahigh-net-worth individuals 80 years of age or older are, on average, seven times wealthier than those 30 years of age or younger. These older, extremely deep-pocketed individuals are now in a position to transfer wealth to their family members. As the article writes, a recent survey conducted by Knight Frank found that the biggest concerns for these individuals are “succession and inheritance issues,” which likely derive in part from the complicated regulations imposed by the Internal Revenue Service. These concerns were likely amplified in the beginning of August 2016 by the official IRS release of the proposed changes to Internal Revenue Code § 2704, which handles rules for valuation discounts that affect transfers of family-owned equity interests or partnerships.

The recently proposed changes to Internal Revenue Code § 2704 would affect not only the superrich, but anyone planning to transfer an interest in a family-owned corporation or partnership to a family member. These regulations would eliminate valuation discounts for transfer interests and likely limit the financial benefit of these transfers. The best strategy for an individual planning to transfer interests in a family business to his or her family members would be to complete the transfer before the proposed regulations take effect as expected in late 2017.

Background

Section 2704, which was enacted in October of 1990, outlines the treatment of certain lapsing rights and applicable restrictions with the intended purpose of limiting the use of discounts in transfers or gifts of interests in family businesses, specifically those organized as a family limited partnership (FLP).

An FLP, which is a type of intra-family partnership that typically includes a variety of properties, is attractive to a high-net-worth individual because it allows for the transfer of wealth to family members based on a fair market value which is, in theory, subject to valuation discounts for lack of marketability and lack of control. Internal Revenue Code § 2704 was imposed to prevent estate and gift tax strategies that are designed to use these discounts to artificially reduce the value of a taxable transfer without lowering its economic value.

The first part of the rule, Section 2704(a), defines a lapse in liquidation or voting rights as a taxable event based on the individual’s rights before the lapse occurs. This is to prevent an individual from structuring a transfer that would allocate his or her

controlling interest or power to liquidate among various transferees, therefore making each minority interest subject to minority discounts and lowering the tax value of the transfer. The current regulation offers an exemption, however, for transfers where the rights of the transferred interest are not restricted or eliminated. The proposed regulations would employ stricter measures for what transfers qualify for this exemption, mostly eliminating eligibility for such an exemption by redefining the threshold of control.

The second part of the rule, 2704(b), states that certain “applicable restrictions” on an entity’s ability to liquidate should be disregarded during valuation. These “applicable restrictions” refer to discounts that would typically reduce the transfer tax value of an entity. Disregarding these certain restrictions prevents individuals from using discounts to reduce the value consensus of the interests they are transferring.

Section 2704(b)(3) explains that an “applicable restriction” to be disregarded does not include the following:

  1. Any commercially reasonable restriction which arises as part of any 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, or
  2. Any restriction imposed, or required to be imposed, by any Federal or State law.

This component of the rule is one of the focal points of the proposed regulations. In some cases, under the current regulations, courts have re-characterized restrictions so that they are no longer considered “applicable restrictions,” effectively decreasing the number of restrictions which are disregarded. The IRS regards this as an unjust loss of revenue.

Proposed Regulations

To begin their summary of the proposed regulations, the IRS states the following:

“The Treasury Department and the IRS have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments.”

Essentially, the IRS has recognized that there is flexibility in the current regulations that reduce impact. The proposed regulations would be stricter.

The proposed regulations would affect the impact of Section 2704(a) by redefining control of an entity and changing how a lapse in voting rights should be handled. The proposed changes examine aggregate ownership interests or voting rights of the whole family, rather than those of each individual. On top of that, the new regulations lower the minimum ownership that constitutes control. Under the new regulations, anyone holding at least 50% interest in an entity is attributed control of that entity. These changes of definitions would result in fewer instances of lapsing voting rights. In terms of valuation, this means that, more often, a person’s interest, if transferred, would not be eligible for minority discounts.

The proposed changes also handle liquidation rights as they relate to Deathbed Transfers. If enacted, these regulations would deny the exemption of transfers that occur within 3 years of the transferor’s death. Additionally, if transfers that include a surrender of rights to liquidate or control occur within 3 years of the transferor’s death, the transfers are treated as if the lapse of liquidation rights occurred at the time of the individual’s death. This effectively includes the transfer as an additional asset in the transferor’s gross estate, often making it ineligible for various deductions.

The proposed regulations would affect the impact of Section 2704(b) by calling for a re-characterization of an “applicable restriction.” The proposed regulations would define a restriction based on the effect it would have on tax value, rather than on the type of restriction it is independently. This would greatly limit the number of restrictions that could be disregarded. In addition, the new regulations would essentially eradicate the function of 2704(b)(3)(B) by allowing the new regulations to overrule state laws that increase the number of restrictions to be regarded. This new regulation would greatly increase the restrictions which are to be disregarded and limit consideration for discounts.

The bottom line is that these proposed regulations, if enacted, would essentially eliminate minority and lack of control discounts for the intra-family transfer of interests in a family-owned business. This would often result in greater tax expense for these transfers and lowered financial benefit. It would also change the appraiser’s relationship to fair market value.

Effects on Fair Market Value

Fair market value (FMV) is the most widely accepted standard of value used by appraisers. FMV is defined in the ASA Business Valuation Standards as the follows:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

The “relevant facts” included at the end of this definition include any applicable physical, legal, or economic attributes of the subject property and the market in which it exists that may affect each party’s willingness to buy or sell. In a typical valuation, certain characteristics of the subject property and its role in the market, which may make the property less valuable, will be reflected by relevant valuation discounts.

Under the proposed regulations, appraisers would be required to conduct valuations assuming hypothetical circumstances that often do not coincide with the market.  In other words, appraisers would be expected to assume that all disregarded restrictions do not exist. This would cause them to determine a fair market value that ignores otherwise applicable valuation discounts, resulting in a value determination that may not match what the market is realistically ready to receive.

Moving Forward-How To Prepare For These Changes

The proposed changes would affect anyone who plans to transfer equity interests to family members. It is essential to approach this process in the company of a seasoned business valuation expert who is adept at navigating the complex authorities in action during these transfers.

Conclusions

If these regulations are enacted in December 2017 as planned, valuation discounts for transfer interests will essentially be eliminated. This will redefine how these interests are valued and most likely limit the financial benefits of these transfers.

It is essential to approach these changes with a business valuation expert at your side. Please feel free to contact our office of specialists to assist you or your clients navigate through this expected change by the IRS.