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Prop. Regs Aim to Close Loopholes on Valuation of Certain Transferred Interests

(Parker Tax Publishing August 2016)

The IRS has issued proposed regulations under Code Sec. 2704 relating to the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes. The regulations (1) attempt to close certain loopholes, which closely held businesses have used to avoid transfer taxes, by addressing the treatment of certain lapsing rights and restrictions on liquidation in determining the value of transferred interests, and (2) update the current regulations to reflect developments in state and case law. REG-163113-02 (8/4/16).


Code Sec. 2704 provides special valuation rules, for purposes of estate, gift, and generation-skipping transfer taxes, for valuing intra-family transfers of interests in corporations and partnerships subject to lapsing voting or liquidation rights and restrictions on liquidation. A "liquidation right" is the right to compel an entity to acquire all or a portion of a taxpayer's equity interest in the entity, and a lapse of such right generally occurs when that right is restricted or eliminated. Generally, lapses of voting or liquidation rights are treated as a transfer of the excess of the fair market value of all interests held by the transferor over the fair market value of those interests after the lapse.

Under Code Sec. 2704(a)(1), if there is a lapse of a taxpayer's voting or liquidation right in a corporation or a partnership and the taxpayer and members of his or her family hold, both before and after the lapse, control of the entity, the lapse is generally treated as a gift by the taxpayer, or as a transfer includible in the taxpayer's gross estate (whichever is applicable).

Code Sec. 2704(b)(1) provides generally that, if a taxpayer transfers an interest in a corporation or partnership to a member of his or her family, and together they have control of the entity, any "applicable restriction" (i.e. a restriction that effectively limits the entity's ability to liquidate, but that will lapse or may be removed after the transfer) is disregarded in valuing the transferred interest.

Citing concerns over certain transactions taxpayers have used to avoid the application of Code Sec. 2704, the IRS has issued proposed regulations that seek to eliminate these loopholes. The proposed regulations address deathbed transfers that result in the lapse of a liquidation right, refine the definition of the term "applicable restriction," add a new class of disregarded restrictions, and address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not members of the family.

The proposed regulations are generally effective when finalized.

Deathbed Transfers Resulting in Lapse of Liquidation Rights

Reg. Sec. 25.2704-1(c)(1) provides that a lapse of a liquidation right occurs at the time a presently exercisable liquidation right is restricted or eliminated. However, a transfer of an interest that results in the lapse of a liquidation right generally is not subject to this rule if the rights with respect to the transferred interest are not restricted or eliminated. The effect of this exception is that the inter vivos transfer (i.e. the transfer during a taxpayer's lifetime) of a minority interest by the holder of a liquidation right is not treated as a lapse even though the transfer results in the loss of that taxpayer's presently exercisable liquidation right.

The IRS stated that this exception should not apply when the inter vivos transfer that results in the loss of the power to liquidate occurs on the decedent's deathbed, noting that such transfers generally have minimal economic effects, but result in a transfer tax value that is less than the value of the interest either in the hands of the decedent prior to death or in the hands of the decedent's family immediately after death. Accordingly, the proposed regulations treat transfers occurring within three years of death that result in the lapse of a liquidation right as transfers occurring at death for purposes of Code Sec. 2704(a).

Applicable Restrictions under Code Section 2704(b)

Reg. Sec. 25.2704-2(b) provides that an "applicable restriction" is a limitation on the ability to liquidate an entity that is more restrictive than the limitations that would apply under the state law generally applicable to that entity. The IRS stated that the current regulation has been rendered substantially ineffective by changes in state laws and by case law.

The IRS noted that since the issuance of the current regulations, many state statutes governing limited partnerships have been revised to be at least as restrictive as the maximum restriction on liquidation that could be imposed in a partnership agreement. The result is that the provisions of a partnership agreement restricting liquidation generally fall within the regulatory exception for restrictions that are no more restrictive than those under state law, and thus do not constitute applicable restrictions under the current regulations.

The proposed regulations remove the exception in Reg. Sec. 25.2704-2(b) that limits the definition of "applicable restriction" to limitations that are more restrictive than the limitations that would apply in the absence of the restriction under the local law generally applicable to the entity. If an applicable restriction is disregarded, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction does not exist, and thus, there is deemed to be no such restriction on liquidation of the entity.

New Class of Disregarded Restrictions Added

The proposed regulations add a new class of restrictions that would be disregarded for purposes of Code Sec. 2704. Exceptions that apply to applicable restrictions under the current and proposed regulations also apply to this new class of disregarded restrictions.

Under Prop. Reg. Sec. 25.2704-3, in the case of a family-controlled entity, certain restrictions on a shareholder's, partner's, member's, or other owner's right to liquidate his or her interest in the entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor, or the transferor and family members may remove or override the restriction (disregarded restrictions). Such disregarded restrictions include a restriction that:

(1) limits the ability of the holder of the interest to liquidate the interest;

(2) limits the liquidation proceeds to an amount that is less than a minimum value;

(3) defers the payment of the liquidation proceeds for more than six months; or

(4) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.

In determining whether the transferor and/or the transferor's family has the ability to remove a disregarded restriction, any interest in the entity held by a person who is not a member of the transferor's family is disregarded if the interest:

(1) has been held by such person for less than three years;

(2) is less than 10 percent of the value of all equity interests in a corporation, or is less than 10 percent of the capital and profits interests in a non-corporate entity; or

(3) when combined with the interests of all other non-family members, is less than 20 percent of the value of all of the equity interests in a corporation, or is less than 20 percent of the capital and profits interests in a non-corporate entity.

The interest is also disregarded if a nonfamily member does not have an enforceable right, on no more than six months' prior notice, to receive in exchange for the interest the minimum value of the interest.

If a restriction is disregarded under Prop. Reg. Sec. 25.2704-3, the fair market value of the interest in the entity is determined assuming that the disregarded restriction did not exist.

Entities to Which the Proposed Regulations Apply

The proposed regulations clarify that Code Sec. 2704 applies to corporations, partnerships, LLCs (including disregarded entities), and other entities and arrangements that are business entities within the meaning of Reg. Sec. 301.7701-2(a). In the case of any business entity or arrangement that is not a corporation, the form of the entity or arrangement is determined under local law.

In addition, the proposed regulations provide that that control of an LLC or of any other entity or arrangement that is not a corporation, partnership, or limited partnership means the holding of at least 50 percent of either the capital or profits interests of the entity or arrangement, or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity or arrangement.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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