The IRS’s Proposed 2704 Regulations Aim to Place Restrictions on Valuation Discount Planning

Last summer, the IRS proposed regulations that would amend § 25.2701-2. This change would impact the definition of what constitutes control of an LLC or other entity or arrangement that isn’t a corporation, partnership, or limited partnership.

These regulations would clarify section 2704’s application to corporations, partnerships, LLC’s, and other business organizations that are business entities within the meaning of § 301.7701-2(a), regardless of whether the entity is domestic or foreign, how it’s classified for other federal tax purposes, and whether the entity or arrangement is disregarded as an entity separate from its owner for other federal tax purposes.

Effect on Estate Planning

If the proposed regulations wind up being the final form, taxpayers will lose a significant estate planning vehicle; plus, the tax cost of transferring interests in family-owned entities will increase. The new rules would amend § 25.2704-1 to contemplate deathbed transfers that end up in the lapse of a liquidation right and to clarify the treatment of a transfer that results in the creation of an assignee interest. They would refine the definition of “applicable restriction” and eliminate the comparison to the liquidation limitations of state law.

The proposed 2704 regulations would also add a new section with restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who aren’t family members.

Potential Changes

The proposed regulations would bring about these changes, if and when finalized:

  • Treat a lapse of voting and liquidation rights for transfers made within three years of death of interests in a family-controlled entity as an additional transfer, thereby eliminating or limiting the lack of control and minority discounts for the transfers;
  • Get rid of discounts based on the transferee’s status as an assignee and not a full owner and participant in the entity;
  • Abandon the ability of most nonfamily member owners to block the removal of covered restrictions, unless that owner had held the interest for more than three years, owns a substantial interest, and has the right—with six months’ notice—to be redeemed or bought out for cash or property, not including a promissory note issued by the entity, its owners, or anyone related to the entity or its owners;
  • Disregard restrictions on liquidation that aren’t required legally in determining the fair market value of the transferred interest; and
  • Clarify the description of entities covered to include LLCs, corporations, partnerships, and other entities and business arrangements.

The Latest

The IRS held a hearing on the 2704 proposed regulations in December, where valuation experts, business advisors, and taxpayer advocacy groups commented on potential issues that would result if the 2704 proposed regulations were finalized in their current form. A representative of the Treasury Department confirmed that the government didn’t intend to include a “deemed put right” in the 2704 proposed regulations that would eliminate the use of all discounts when valuing transfers of business interests.

The Treasury planned to clarify this when the regulations were finalized. Given this development, it’s possible that the proposed regulations—if finalized—would still impact the way in which family business interests are valued for gift and estate tax purposes, but the effect on these valuations may not be and great as originally anticipated.

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