Section 2704 Proposed Changes

September 16, 2016

By Samir B. Dahman

On August 2, 2016, the IRS released proposed regulations to Internal Revenue Code Section 2704.  The regulations are aimed at limiting the use of valuation discounts in interests in family-owned and closely held entities.

Under current law, Section 2704(a) provides that the lapse of liquidation or voting rights is taxed as a transfer and subject to gift/estate tax if an individual and that individual’s family hold voting or liquidation control over the entity.  Under Section 2704(b), if there is a restriction in place that limits the ability of the entity to liquidate and that restriction can be lifted by the family, then that restriction is disregarded when valuing the transferred interest for gift/estate tax purposes when that interest is being transferred within the family.

The proposed changes dramatically alter the impact of the statute.  The changes could include:

  • When determining the fair market value of transferred interests, disregard restrictions on liquidation that are not mandated by federal or state law;
  • Eradicate any discounts available when the transferee is solely an assignee and not a full owner in the entity;
  • Eliminate – or at least substantially limit – the lack of control and minority discounts in family-controlled companies by treating as an additional transfer the lapse of voting and/or liquidation rights for transfers made within three years of death of the transferor;
  • Clarification on the descriptions of entities governed, which will now include LLCs, corporations, partnerships, and other entity types; and
  • Remove the ability of most nonfamily members owners to block the removal of restrictions, unless that member:
    • Held the interest for more than three (3) years;
    • Owns a substantial interest; and
    • Has the right to be bought out for cash or property upon six (6) months notice.[1]

In essence, these changes assume that transferees receiving interests will be able to liquidate those interests, thus eliminating the ability of transferors to use valuation discounts (minority, lack of marketability, lack of control, etc.).  These proposed changes are significant to family-owned companies because, if enacted as is, an important estate planning technique will be lost.

Public comments on these proposed changes are due on November 2, 2016, with a final hearing occurring on December 1, 2016. If passed as is, these changes are expected to be challenged as they are inconsistent with the legislative history of the section, which indicates that this section was not intended to impact minority discounts.

Nonetheless, clients with family-owned businesses and other closely held entities should begin planning for these changes immediately and meet with counsel to determine the best way to move forward, incurring as little negative impact as possible.

[1] Not including promissory notes issued by the owners, entity, or anyone related to the owners or entity.

For more information please contact Samir B. Dahman at sbd@kjk.com or (614) 427-5750.