IRS Finally Issues Long-Anticipated Proposed Regulations Restricting the Use of Valuation Discounts

By: Jennifer J. Conley, JD

On August 2, 2016, the IRS issued long-anticipated proposed regulations under Section 2704 of the Internal Revenue Code restricting the use of valuation discounts associated with family- controlled entities.  The use of family-controlled entities, such as limited liability companies and limited partnerships, has been a traditional way for high-net worth families to transfer wealth downstream at a reduced value for transfer tax (i.e. estate, gift and generation-skipping taxes) purposes while maintaining the full economic value of the assets for the next generation.  The reduced value has been partially based on discounts for restrictions associated with the family-entity interests such as the inability to participate in management (“lack of control”) or to sell or transfer the interest (“lack of marketability”). 

For example, imagine you own a 30% non-controlling minority interest in a family-controlled entity with a fair market value of $1,000,000, and you cannot transfer the interest to a third-party without the consent of all the members and the governing documents do not require the family-controlled entity to purchase this interest upon a transfer.  Because you own a minority interest burdened by transfer restrictions, the value of your interest would be discounted (usually between 20%-35%) for gift tax purposes such that you only have to use about $700,000 of your lifetime exemption from gift tax to transfer an interest worth $1,000,000. This discounted value for gift tax purposes applies even though the underlying fair market value of the family-controlled entity’s assets do not change with a transfer of an interest in the entity.

The IRS has threatened the viability of valuation discounts for years now, and these proposed regulations appear to be the first concrete step toward strictly limiting their use on a broad scale basis.  The proposed regulations are quite complex, but the following summarizes some of the most significant changes.

First, Section 2704(a) prescribes special valuation rules on intra-family transfers of interests in closely-held entities for transfers of interests with certain lapsing liquidation or voting rights.  The proposed regulations seek to treat the transfers that result in these lapses of liquidation or voting rights as an additional transfer at the transferor’s death if the transfer was made within 3 years of the transferor’s death and if the entity is controlled by the transferor or the transferor’s family members.  Under such circumstances, the entire fair market value related to the lapse of the liquidation or voting right will be includible in the decedent’s estate for estate tax purposes.

Second, Section 2704(b)(1) governs the valuation of transfers in closely-held entities subject to restrictions on redemptions or liquidation by disregarding certain of such restrictions (called “applicable restrictions”) when the interests are transferred to family members. Under the proposed regulations, even though a non-family member interest holder may prevent the removal of these restrictions, such non-family member’s interest is disregarded for valuation purposes unless (1) the interest has been held for at least three (3) years, (2) the interest is more than 10% of the value of all of the equity interests, (3) the interest, when aggregated with all non-family member interests, totals at least 20% of the value of all of the equity interests, and (4) the interest can be redeemed by the non-family member on no more than 6-months’ notice.  Even if the above four requirements can be satisfied, there are further restrictions on the ability to use this exception.

Third, Section 2704(b)(3)(B) clarifies the above rule by providing that applicable restrictions do not include “any restriction imposed, or required to be imposed, by any Federal or State law.” The proposed regulations curtail the use of this exception by providing that restrictions that are more restrictive under the entity’s governing documents than those under the default State law applicable to the entity are not restrictions “imposed, or required to be imposed” by Federal or State law.  This is significant because most states allow the governing documents of an entity to provide for restrictions outside of the default law and most governing documents do in fact provide additional restrictions.

Finally, the proposed regulations clarify that Section 2704 also applies to limited liability companies and other entities, even though it currently only refers to partnerships and corporations.

Although it appears that the IRS has reached beyond the congressional intent of Section 2704 with these proposed regulations, it is likely that they will be made final in the next 180 days, following a 90-day public comment period and a public hearing scheduled for December 1, 2016.  Based on the comments and hearing, the final regulations may look different from what is outlined here and in the proposed regulations.  However, until the proposed regulations are made final, they are not binding on taxpayers or the IRS, so there is currently a window of opportunity available to facilitate planning under the existing rules.  

Please contact us to discuss and review how the proposed regulations will affect your family-controlled entity and long-term estate planning goals, and whether there are some opportunistic steps to take before the proposed regulations are made final.  Given the time it takes to facilitate planning and any necessary business valuations, timing is of the essence to begin these discussions.