The Latest IRS Attack on Family Business Succession

November 4, 2016 Alerts and Newsletters

Proposed Regulations to Code Section 2704 Would Significantly Impact use of Valuation Discounts for Family-Controlled Businesses

The Internal Revenue Service ("IRS") has issued Proposed Regulations under Internal Revenue Code ("Code") Section 2704, which, if made final in present form, would significantly reduce the benefit of valuation discounts in the context of intra-family transfers of interests in family-controlled entities.

While the new rules may largely diminish discounts for lack of control, it is unclear how much they will affect discounts for lack of marketability. For some family-owned businesses, however, planning in anticipation of these Proposed Regulations might be the difference between family ownership surviving into the next generation or not.

Under current law taxpayers are able to reduce the amount of transfer tax (i.e., estate or gift tax) ultimately paid on intra-family asset transfers by obtaining discounts in valuing family business interests to reflect lack of control and lack of marketability.

  • Discounts for lack of control are primarily obtained by transferring voting interests in the entity to other (typically younger generation) family members, so that the older generation family member does not have a controlling share. Each gift is valued separately for discounted valuation purposes, and the value of the interest in the hands of the recipient determines the amount of gift tax due. Therefore, by making multiple small, separate gifts of voting interests, a transferor will pay substantially less gift tax than if the transferred interest was transferred all at once.
  • Discounts for lack of marketability are generally obtained (or magnified) by including in the entity's governing instruments provisions that limit the ability of interest holders to liquidate the entity or redeem their interests.

Discounts Permitted Under Current Rules: If certain rights held by the transferor lapse when he or she transfers interests in the family enterprise to other family members, the value of those interests is determined as if those rights had not lapsed. Certain important exceptions apply. The scope of these exceptions is best demonstrated by the following examples.

  • Lapse of Liquidation or Voting Rights: If a transfer of an interest in a family-controlled entity from one family member to another results in the transferor losing his or her right to liquidate the entity (for example, because the transferor no longer holds the percentage interest required to force liquidation) or losing his or her controlling voting interest in the entity, that liquidation right or voting right is not deemed to have lapsed so long as the interest passing to the family-member transferee retains the right to participate in a liquidation vote or retains its proportional share of voting rights, as the case may be.
  • Certain Restrictions on Liquidation are Ignored: The governing instruments of family-controlled entities often contain provisions that limit the ability of interest holders to liquidate. Under the current regulations, only a liquidation restriction that is more restrictive than the state law default rule will be ignored for valuation purposes. Otherwise such a liquidation restriction will be honored.

Proposed Regulations: When and if made final, the regulations will significantly reduce both the availability and the effectiveness of valuation discounts used in valuing intra-family transfers of interests in family-controlled entities.

  • New Three-Year Lookback for Lapse of Liquidation Rights and Voting Rights: Taxpayers with controlling interests in family businesses often transfer to family members enough of their interests to bring them below the control threshold. A primary purpose of such transaction(s) is a reduction in the estate tax valuation of the taxpayer's retained position in the entity upon his or her subsequent death.

    Under the Proposed Regulations an intra-family transfer resulting in the transferor losing his or her right to liquidate or control the entity will be treated as a lapse in liquidation or voting rights if the transferor dies within three years after the transfer, even though the voting rights themselves still attach to the transferred interests.

    The value attributable to the "lapsed rights" would be included in the transferor's gross estate for estate tax purposes, and would not qualify for a marital or charitable deduction against such estate tax—therefore this "phantom value" would be subject to estate tax on the transferor's death.
  • Expanded Definition of "Applicable Restrictions": Some state legislatures have made their state default rules (respecting liquidation) more rigorous since Section 2704 was enacted. Families then tightened liquidation restrictions in governing agreements, thereby reducing the value of interests in family enterprises. Under the Proposed Regulations, restrictions on liquidation that are not mandated by state or federal law will be ignored for purposes of valuing a transferred interest. Commercially reasonable restrictions (e.g., those applying in connection with bank financings) will continue to be honored.
  • New "Disregarded Restrictions": The Proposed Regulations include a new class of restrictions, called "Disregarded Restrictions," to be ignored for valuation purposes in the context of intra-family transfers.
    • Restrictions that Limit a Transferee's Right to Liquidate or be Redeemed on up to Six Months' Notice are Disregarded: Disregarded Restrictions appear to include any restriction that (i) limits the ability of an interest holder to compel redemption or liquidation on six months' (at most) notice (ii) for the interest's proportionate share of the entity's net value (iii) payable in cash or other property, and not payable in promissory notes issued by the entity or related parties, unless the entity is an active trade or business.

      Disregarding more stringent restrictions may increase materially the value ascribed to family business interests for gift tax and estate tax purposes.

      Is a safe harbor created? Presumably the converse is true—a restriction will not be disregarded if (i) every interest holder has a six month (or less) "put right" to compel redemption or liquidation, (ii) for the interest's proportionate share of net value, (iii) payable in cash or other property (other than promissory notes issued by the entity or related parties, unless the entity is an active trade or business).
    • Disregarding Nominal Interests of Non-Family Members: Because the provisions of Section 2704 are intended to apply only to family-controlled enterprises, in the past some advisors have suggested that giving a non-family member (such as a charity or an employee) the right to participate in the removal of a liquidation restriction may make Section 2704 inapplicable even to the interests which are held by family members.

      The Proposed Regulations impose grave restrictions (unlikely to be palatable to most families) on the sorts of interests held by non-family members that will allow the family to escape application of Section 2704.
  • Clarification of Scope of Covered Entities: Although Section 2704 refers expressly only to corporations and partnerships, the Proposed Regulations make clear that limited liability companies and other entities and business arrangements are also covered. The regulations also make clear that the rules apply to passive investment entities as well as to operating entities. Apparently, gifts of fractional interests in real estate are not covered.
  • Elimination of Discounts Based on Assignee Status: The Proposed Regulations will eliminate any discount based on the transferee's status as an assignee and not a full owner of the transferred interest.

Effective Dates:

  • Lapses of Voting and Liquidation Rights: The Proposed Regulations applicable to voting and liquidation rights of individual interests will apply to transfers occurring on or after the date the regulations are published as Final Regulations.

    Open Question: It is not clear from the Proposed Regulations whether the new three-year lookback will apply only to gifts made after the regulations are finalized, or if it will apply to deaths which occur after the regulations are finalized (in which case gifts made before the effective date could be subject to the lookback).

    A senior Treasury Department official, speaking at the most recent meeting of the American College of Trust and Estate Counsel, announced, however, that Final Regulations should clarify that transfers made prior to issuance of Final Regulations will not be subject to the three-year rule in any event.
  • Restrictions on Liquidation and Redemption Rights: The Proposed Regulations applicable to restrictions on liquidation or redemption of interests in the business entity will not take effect until 30 days after the date the regulations are published as final regulations.


  • Action by Year End 2016: Clients considering transferring interests in family-controlled entities that are controlling interests and have liquidation rights should consider making the transfers as soon as possible, and preferably before year end (it is highly unlikely that any of the Proposed Regulations would take effect before the end of 2016).
    • Possible Transfer Methods:
      • Outright gifts to younger generation family members
      • Gifts in trust (to benefit younger generation family members)
      • Installment sales to "Grantor" Trusts
      • Longer Term GRATs (Grantor Retained Annuity Trusts)
  • Long Term Planning: Attention should be given to the application of these new regulations with respect to the provisions of existing and future operating agreements, buy-sell agreements, and other governing documents.

    Consideration will also need to be given to the source of cash to pay any estate taxes due with respect to the value of any lapsed right which may be re-included in a transferor's gross estate.
    • Possible Sources of Liquidity:
      • Life Insurance
      • IRC § 303 Redemptions (permitting essentially tax free access to cash held in qualifying corporations to raise funds needed to pay federal and state estate taxes, and estate administration expenses)

Please call your lawyer in the Private Clients Group or Business Law Group at Verrill Dana LLP to discuss how any change in the applicable law may affect you and your family, and what steps you might consider to mitigate any adverse consequences to your family business.

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