Could New Section 2704 Regulations Eliminate Discounts Applicable to Transferred Interests in Family Owned Entities?

Demystifying Valuation, Economic Damages + Forensic Accounting

Section 2704(b)

Internal Revenue Code Section 2704(b) provides that certain “applicable restrictions” that would typically justify the application of lack of control and/or lack of marketability discounts to transferred interests in closely-held family entities such as limited partnerships or limited liability companies are to be ignored for the purpose of valuation, if those interests are transferred either by gift or upon death to or for the benefit of other family members.

Applicable Restrictions

An applicable restriction is one that restricts the ability of an entity to liquidate with terms that are more restrictive than under applicable default state law and that either disappears after the transfer to a family member or when the family collectively is vested with the authority to eliminate it.

To preclude a restriction from being applicable, statutes have been changed to ensure that the default rules under state law restrict the ability of the entity to liquidate.

Statutory Proposal and Regulations

There has been a proposal to amend Section 2704 to create an additional category of restrictions that would be disregarded when valuing an interest in a family controlled entity. It would apply to a transfer of an interest to a family member, if after the transfer the restriction will lapse or may be removed by the transferor or the transferor’s family. These disregarded restrictions would essentially include limitations on a holder’s right to liquidate its interest, which are more restrictive than a specified standard to be identified in the regulations.

Status of Proposed Amendment to Section 2704

On May 10, 2015 Cathy Hughes of the U.S. Treasury’s Office of Tax Policy spoke at the ABA’s Tax Section Meeting. She commented on proposed Section 2704 regulation which might have a dramatic impact on the valuation of interests in closely-held limited partnerships and limited liability companies transferred to family members.

Ms. Hughes suggested that the 2704 regulations might be issued later this summer or fall prior to the ABA Tax Section meeting which is September 17-19.

Treasury regulations are typically effective on the date final regulations are issued. At least several years typically lapse from the time proposed regulations are issued until the regulations are finalized. In very limited situations, proposed regulations provide they will be effective when finalized retroactive back to the date of the proposed regulations.

Possible Responses to the Proposed Amendment

Many practitioners believe that if enacted, an amendment to Section 2704 would ultimately be rejected by the Tax Court in a manner analogous to Kerr v. Commissioner in 1999. In that case, as well as Jones v. Commissioner, Knight v. Commissioner, and Harper v. Commissioner, the IRS argued that the term “applicable restriction” in Code § 2704(b) includes any restriction that limits the ability of a partner/member to liquidate his interest in the partnership/LLC that is more restrictive than state law. In support of its argument, the IRS cited Regulation § 25.2704-2(b), which provides that an “applicable restriction” includes any restriction to liquidate the entity “in whole or in part”. In all four cases, the Tax Court rejected the IRS’s argument.

Another important consideration is whether the elimination of lack of control and lack of marketability discounts will ultimately squash the Treasury’s plan to amend Section 2704 because the instructions to Form 706 (United States Estate Tax Return) and Form 709 (United States Gift Tax Return) instruct the preparer to determine the fair market value of the decedent’s assets or the gifted assets.

Since fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts, it is our opinion that the business valuator must take lack of control and lack of marketability discounts into consideration unless the instructions to the forms are revised.

By Gary Ringel, CGREA