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Proposed 2704 Regulations – Considerations for Valuation and Estate Tax Planning

November 9, 2016 | Patrick McFarlen

The proposed 2704 regulations concerning the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes warrant significant planning considerations. Specifically, these proposed regulations concern the treatment of certain lapsing rights and restrictions on liquidation in determining the value of the transferred interests. These proposed regulations affect certain transferors of interests in corporations and partnerships and are necessary to prevent the undervaluation of such transferred interests.1

The Treasury’s proposed 2704 regulations could be finalized any time after December 1 (public hearing date). If unchanged from the proposed status, the regulations would disallow the application of discounts for lack of control and lack of marketability to family members in certain situations. In addition, it would include a new three-year look-back rule for transfers that took place within three years of death.

Proposed Regulations

The proposed regulations are as follows:
  • §25.2701-2: Expansion of definition of controlled entity
  • §25.2704-1: Expansion of definition of lapse and adds new three-year rule
  • §25.2704-2: Expansion of explanations regarding applicable restrictions
  • §25.2704-3: New disregarded restrictions
  • §25.2704-4: Effective date
Treasury Reg. §2704-1 expands lapses of voting and liquidation rights, newly excludes transfers within three years of death, provides explicitly that transfer of interests to an assignee is a lapse, and adds disregard of certain non-family interests. 

Treasury Reg. §2704-2 removes safe harbor with respect to applicable restrictions. 

Treasury Reg. §2704-3 adds “disregarded restrictions.” If a family member, no discounts are allowed.

Definitions

The regulations include specific definitions of “family,” “control,” and “disregarded restrictions.” 
  • Member of the family. The term “member of the family,” with respect to any individual, means:

a. Such individual’s spouse,
b. Any ancestor or lineal descendant of such individual or such spouse,
c. Any brother or sister of the individual, and
d. Any spouse of any individual described in b or c above.

Corporate control means holding either 50% of total voting power or 50% of fair market value. Partnership control means holding at least 50% interest in profits or capital, disregarding guaranteed payments of a fixed amount. Other entities or arrangements (business entities under Treasury Reg. §301.7701-2(a)) control means holding 50% of profits or capital or holding equity interest with power to cause liquidation of entity or arrangement.

“Disregarded restrictions” are defined as follows:
  • “[R]estriction that is a limitation on the ability to redeem or liquidate an interest in an entity” described in at least one of the following:
    • Provision limits or permits limitation of ability of interest holder to compel liquidation or interest redemption.
    • Provision limits or permits limitation of amount holder may receive on liquidation or redemption to less than “minimum value.”
    • Provision defers or permits deferral of payment of full amount of liquidation or redemption proceeds for more than six months after notice of holder’s intention of having interest liquidated or redeemed.
    • Provision authorizes or permits payment of any portion of full amount of liquidation or redemption proceeds other than in cash or property (excluding certain notes for operating businesses).
  • Source of limitation does not matter: organizational documents, buy-sell, redemption agreement, deed of transfer or sale, OR local Jaw whether mandatory or may be superseded by governing documents.
  • Restriction is a “disregarded restriction” if, after transfer:
    • Restriction lapses OR
    • May be removed by transferor, transferor’s estate, and members of transferor’s family, individually or collectively.

Recommendations for Planning

The following recommendations include actions that can be taken pre-effective date and gift techniques to preserve discounts post-effective date. 

  • Complete gift, sale, GRAT, and freeze transactions already underway if discounts may be involved.
  • Consider creating entities for gift, sale, GRAT, and freeze transactions already underway to capture current law discounts with possibility of unwinding at higher values later.
  • Consider paying gift tax.
  • Consider implications if proposed regulations never become final.
  • Consider impact of three-year rule. Does it apply to transfers before proposed regulations become final?

For additional information about EKS&H’s business valuation services, contact Patrick McFarlen at pmcfarlen@eksh.com or 303-740-9400.

1 https://www.regulations.gov/document?D=IRS_FRDOC_0001-1487

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