Locke Lord QuickStudy: Disappearing Discounts?: IRC 2704 Proposed Regulations Threaten Valuation Discounts for Transfers of Interests in Family-Controlled Entities

Purpose of Section 2704
Internal Revenue Code Section 2704 was originally passed to restrict certain types of valuation discounts on transfers of ownership interests in family-owned businesses among family members. While the Section itself is fairly short, it contains complicated provisions that generally deal with the right of an owner of the entity to control the liquidation of the entity.  Purpose of Proposed Regulations
Estate planners developed strategies to minimize application of Section 2704 and courts have generally approved those structures. Treasury sought legislation that would restrict those strategies. When the legislation failed to gain traction, Treasury issued the proposed regulations (released on August 2, 2016) to try to address the same issues.

What do the Proposed Regulations Do?
The proposed regulations may significantly reduce the discounts that are applied to intra-family transfers of ownership interests in certain family-controlled entities. For example, if Dad owns 100% of a family limited partnership (“FLP”) that holds $100 million worth of assets (corporate stock, land or other assets) and transferred 25% of the FLP to his son, the “transfer tax value” of the gift would currently only be $16-17 million because lack of control and minority interest discounts could be applied since son could not control a liquidation of the entity. This is a good result for families because they can pass more value to their children with smaller transfer tax consequences. It also recognizes that many such FLPs are highly restricted and family harmony is not always present.

The proposed regulations require that any restrictions on liquidation of a partner’s interest in the entity be disregarded. What that means in terms of ultimate valuation is not yet clear, but one result may be that the interest is valued at its pro rata portion of the net value of the assets in the FLP (which would be $25 million in the example above). However, it is still very uncertain as to: (i) exactly how the proposed regulations are applied and (ii) if they will be upheld in court since some aspects of the regulations may go beyond the Section 2704 statute itself.

Rules Generally Not Effective Until Final
These proposed regulations are not effective until they are finalized, and they won’t be finalized until sometime after the public hearing scheduled on December 1, 2016. There has already been and will be numerous comments pointing out problematic provisions in the proposed regulations, and some legislators have become incensed and have proposed laws to prohibit the changes. While it could be months – or even years – before the regulations are final, it is equally clear that this is an area of high priority to Treasury.

Ultimate Concern
The ultimate concern is that these proposed regulations would eliminate or greatly restrict valuation discounts for transfers of interests in certain family-controlled entities. Families interested in capitalizing on these discounts should contact their estate planning attorneys as soon as possible to determine how these proposed regulations could apply to them, and to determine whether transfers should be made before the regulations are finalized.