Tax Certainty Restored to Wealth Transfers Involving Family-Controlled Entities

Valuation practitioners, wealth advisors, estate tax attorneys and their clients can breathe a sigh of relief.  Onerous proposed changes to the treatment of the transfer of interests in family-controlled entities will not be enacted.  On October 2, the Treasury issued its final decision not to adopt the proposed changes to IRC Section 2704.

Background

IRC Section 2704 addresses certain tax-related valuation issues in the transfer of interests in family-controlled entities.  Since its enactment in 1990, the goal (and effect) of Section 2704 has been to limit the applicability of certain valuation discounts – mainly lack of control and marketability – that decrease the fair market value of such transfers.  Specifically, it treats the lapse of voting and liquidation rights as deemed transfers if the family controls the entity both before and after such transfers.  For example, if a decedent owned all of the limited partnership interests and a small general partnership interest in a limited partnership, their ability to liquidate the partnership technically ended upon their death.  However, Section 2704 recognized that the ability to liquidate simply passed to the decedent’s family heirs.  Therefore, there would be no discount for the lack of control.

Proposed Changes

Proposed changes to Section 2704 would have expanded the restrictions on the use of discounts for lack of control and marketability, which would have had far-reaching, negative tax consequences for transferees.  Specifically:

• State law default restrictions would no longer be considered.  In short, any restrictions imposed by state law on the ability of a partner or shareholder to dissolve the entity (that can be made more restrictive by family members via by-laws) would be disregarded.  Eliminating restrictions eliminates the discount for lack of control, and hence increases the fair market value of the interest for tax purposes.

• A new group of disregarded restrictions would be created.  Generally speaking, the holder of an interest has a put option on that interest that allows them to sell it back to the entity for an amount at least equal to their pro-rata share of the net value of the entity in exchange for cash or property.  The reality is that such liquidity within a family-controlled entity does not typically exist.  This provision would have resulted in a “phantom” value, which would have increased the fair market value of the interest for tax purposes.

• Deaths within three years would have expanded the requirement to disregard certain transfer restrictions.  This would have essentially expanded the original provision of Section 2704, from “upon the death of the decedent” to “within three years of the death of the decedent”.  The phantom value of the ability to liquidate the entity would have been added back to the value of the decedent’s estate.  In addition to the higher taxable value, consider the practical difficulty in estate administration and the residual risk to the estate and heirs.

• Covered entities would have been defined more broadly.  Limited liability companies, regardless of whether they were disregarded entities for tax purposes, would have been included (corporations and partnerships were included as part of the original provisions).

• The ability of nonfamily members to restrict the transferability of interests would no longer be considered, unless certain, very stringent conditions exist.

An Alternate Reality

Equally important, while the proposed changes outlined the effect of new regulations, they fell far short with respect to their practical implementation.  Ultimately, this is what doomed their enactment.  We valuation practitioners would have faced too much uncertainty with respect to the phantom value created by a reality that does not exist.  Lack of control and marketability in family interests indeed result in very real economic restrictions – restrictions that must be reflected in the applicable fair market value interest.

Related:  Treasury’s Decision to Withdraw Proposed Regulations Entirely