In yesterday’s post, we considered the context in which the recently proposed regulations under Section 2704 of the Code will eventually be applied. Today, we will discuss Section 2704 and the valuation of an interest in a closely-held business. We will also review the failed legislative efforts to address the issues covered by the regulations.

Valuation Principles

Both the courts and the IRS have defined the “fair market value” of property as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.

According to the IRS, shares of stock of a closely-held corporation should be valued based upon a consideration of the factors affecting its fair market value, including the size of the block of stock to be valued. Indeed, the IRS has concluded in a public ruling that a minority interest in a closely-held corporation is more difficult to sell than a similar block of publicly-traded stock.

The IRS’s regulations echo this point, providing that the fair market value of shares of stock is to be determined by taking into consideration the degree of control of the business represented by the block of stock to be valued. Thus, a willing buyer may not pay a willing seller a proportionate share of the value of a closely-held business when purchasing a minority interest in the business.

Among other factors to be considered in the valuation of closely-held stock, the IRS has noted, is whether the stock is subject to an agreement restricting its liquidation, sale or transfer. The IRS has observed that it is always necessary to consider the relationship between the parties to the agreement, the relative number of shares held by the taxpayer, and other material facts, to determine whether the agreement represents a bona fide business arrangement or a device to pass the taxpayer’s shares to his family for less than an adequate and full consideration in money or money’s worth.

Section 2704 Is Born

The year is 1990. By that time, many courts had held that, because the fair market value of an interest in a family-held business was determined at the moment of death, the value attributable to a voting or liquidation right that lapsed under the terms of a partnership or shareholders’ agreement upon the death of an owner, could not be taken into account in valuing the interest and, thus, was not subject to estate tax.

As a result, the value for transfer tax purposes of the decedent’s equity interest in the business was determined by the courts to be less than its value either in the hands of the decedent immediately before death (i.e., before the lapse) or in the hands of his family immediately after his death (when the family could restore the “lapsed” right).

Congress moved to prevent this result and to tax the “lost” value attributable to the lapsed right, by providing, in new Section 2704 of the Code, that the lapse of a voting or liquidation right in a family-controlled entity results in a transfer by gift or an inclusion in the gross estate.

Example 1. Parent and Child control a corporation. Parent’s stock has a voting right that lapses on Parent’s death. Parent’s stock is valued for Federal estate tax purposes as if the voting right of the parent’s stock were non-lapsing.

Example 2. Father and Child each own general and limited interests in a partnership. The general partnership interest carries with it the right to liquidate the partnership; the limited partnership interest has no such right. The liquidation right associated with the general partnership interest lapses after ten years. There is a gift at the time of the lapse equal to the excess of (1) the value of Father’s partnership interests determined as if he held the right to liquidate over (2) the value of such interests determined as if he did not hold such right.

However, Congress also stated that this new rule regarding lapsing rights would not affect “minority discounts or other discounts” available under the law. In other words, the IRS’s public ruling and regulations described above, that identified the size of one’s holding in a business as a factor to consider in the valuation of such holding, would continue to apply. In other words, Congress did not seek the elimination of valuation discounts by enacting Section 2704.

In addition to the issue of lapsing rights, Congress also addressed restrictions agreed to among the owners of a family business that effectively limited the ability of the family-owned entity to liquidate. Such a restriction, it said, would be ignored in valuing a transfer among family members if (1) the transferor and family members control the business, and (2) the restriction can be removed by the transferor or members of his family, either alone or collectively.

Example 3. Mother and Son are partners in a two-person partnership. The partnership agreement provides that the partnership cannot be terminated. Mother dies and leaves her partnership interest to Daughter. As the sole partners, Daughter and Son acting together could remove the restriction on partnership termination. The value of Mother’s partnership interest in her estate is determined without regard to the restriction.

Recognizing that other situations may present similar valuation issues or potential abuses, Congress authorized the IRS to identify other restrictions that should be disregarded for valuation purposes; specifically, restrictions that reduced the value of the transferred interest for transfer tax purposes but which did not reduce the value of the interest to the transferee.

The First Set of Regulations

Shortly after its passage, in 1991 the IRS proposed regulations under Section 2704.

The IRS explained that the lapse of a voting or liquidation right was a transfer for estate and gift tax purposes only if the holder of the lapsing right and members of his family controlled the business both before and after the lapse; for example, the holder and his family can, immediately after the lapse, liquidate an interest the holder could have liquidated prior to the lapse.

Conversely, if the holder’s family cannot recover the value lost as a result of the lapse, the lapse is not of the type to which Section 2704 is directed.

The IRS explained that a lapse of a right occurs when the right is reduced or eliminated.

This last factor was important because it provided the basis for the following provision of the existing regulations: the transfer of an interest conferring a right is not treated as a lapse of that right if the right was not reduced or eliminated, but simply transferred to another.

For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control; the voting right associated with the transferred interest continues to exist.

Consistent with Section 2704, the regulations provided that, in valuing a transfer of an interest in a business to a family member, certain restrictions on the ability to liquidate the business are to be disregarded if (1) the transferor’s family controls the business entity immediately before the transfer, and (2) the transferor and members of his family can remove the restriction immediately after the transfer.

Importantly – and notwithstanding the general theme of “family control” under Section 2704 (and its assumption that a family could add or remove a restriction at will) – when the regulations were finalized in 1992, the IRS provided that a restriction would not be disregarded if it was not more restrictive than the default rule under the applicable state law. The fact that the family could agree to a less restrictive provision was not relevant.

“Family Attribution”

In 1993, the year following the issuance of final regulations under Section 2704, the IRS issued a public ruling in which it held that, if a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family would not be considered in valuing each transferred interest for purposes of the gift tax.

For estate and gift tax valuation purposes, the IRS stated that it would not assume that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest.

Consequently, a minority discount would not be disallowed, the IRS stated, solely because a transferred interest when aggregated with interests held by family members, would be part of a controlling interest.

It should be noted that the above ruling made no mention of then-recently enacted Section 2704 and the concept that the taxpayer’s family could, if it controlled the entity immediately after the taxpayer’s transfer of an interest in the entity, either restore the lapsed right or remove the restriction. Indeed, it seems reasonable to conclude that the IRS recognized Congress’s intent that Section 2704 did not affect otherwise available “minority discounts or other discounts.”

The Green Books: 1999 through 2001

The IRS’s 1993 ruling opened the flood-gates to the gifting of interests in family-owned business entities. Many advisers and their clients sought to leverage the opportunity for valuation discounting, not only as to family operating businesses and real estate investments but also with respect to liquid investment assets. They prepared partnership and operating agreements with restrictive provisions that literally did not run afoul of Section 2704 and its regulations, and that supported lower values for the business interests being transferred.

According to the Clinton administration’s budget proposals from 1999 through 2001:

Under current law, taxpayers making gratuitous transfers of fractional interests in entities routinely claim discounts on the valuation of such interests.

The concept of valuation discounts originated in the context of active businesses, where it has long been accepted that a willing buyer would not pay a willing seller a proportionate share of the value of the entire business when purchasing a minority interest in a non-publicly traded business.

Without legislation in this area, tax planners have carried this concept over into the family estate planning area, where a now common planning technique is to contribute marketable securities to a family limited partnership or LLC and to make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.

This disappearing value is illusory because family members are not minority interest holders in any meaningful sense.

The Clinton administration’s proposal sought to eliminate valuation discounts except as they applied to active businesses.

The Green Books: 2010 through 2013

The Clinton administration failed in its efforts. The Obama administration then took a different approach to curbing what it saw as valuation abuses in family gift tax planning.

According to its budget proposals from 2010 through 2013:

Section 2704 was enacted to prevent the reduction of taxes through the use of techniques designed to reduce the value of the transferor’s taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor when the economic benefit to the beneficiaries is not reduced by these techniques.

Generally, section 2704(b) provides that certain ‘applicable restrictions’ (that would normally justify discounts in the value of the interests transferred) are to be ignored in valuing interests in family-controlled entities if those interests are transferred (either by gift or on death) to or for the benefit of other family members.

Without referring to the regulations under Section 2704, it went on to say:

Judicial decisions and the enactment of new statutes in most states have, in effect, made section 2704(b) inapplicable in many situations, specifically by re-characterizing restrictions such that they no longer fall within the definition of an ‘applicable restriction’.

In addition, the IRS has identified additional arrangements to circumvent the application of section 2704.

This proposal would create an additional category of restrictions (‘disregarded restrictions’) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction may be removed by the transferor and/or the transferor’s family.

Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.
Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations.

For purposes of determining whether a restriction may be removed by members of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family.

After failing to convert any of these proposals into legislation, the Obama administration ceased including them in its budget proposals from 2014 thru 2017.

However, during this period, the IRS indicated that it was working on proposed regulations under Section 2704 – the regulations that were issued last month.

In next week’s post, we will consider these proposed regulations in some detail.