IRS Proposed Regulations to Chart New Course for Gift and Estate Tax Valuations

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estate planning, gift tax, valuation, proposed regulations, Grossman Yanak & Ford LLP

After an extended period of threatening to do so, the Internal Revenue Service issued proposed regulations affecting the valuation of closely-held business interests for gift and estate tax purposes. The proposed regulations, under Internal Revenue Code (IRC) Section 2704(b)(4), concern restrictions on valuation discounts pertaining to the transfer of family-owned entity interests.

Specifically, the proposed regulations deal with the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes and the treatment of lapsing rights and restrictions on liquidation in determining the value of transferred interests. Such lapsing rights and restrictions on liquidations often serve as a basis for increasing valuation discounts, as those attributes are deemed to increase investment risk associated with holding the transferred interest.

Valuation of equity interests subject to such lapsing rights and restrictions on liquidation is governed by IRC Section 2704, under which lapses of voting or liquidation rights are treated as a transfer in excess of the fair market value (FMV) of all interests held by the transferor (determined as if the voting or liquidation rights were non-lapsing) over the FMV of those interests after the lapse.

There is, however, an important exception to this treatment set forth under Treasury regulations Sec. 25.2704-1(c)(1), which provides that 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 exception has the effect that an inter vivos transfer of a minority interest by the holder of an interest with the aggregate voting power to compel the entity to acquire the holder’s interest is not treated as a lapse, even though the transfer results in the loss of the transferor’s presently exercisable liquidation right.

The Internal Revenue Service takes issue with this exception in the instance of deathbed transfers, where the Service argues an inter vivos transfer that results in a loss of power to liquidate occurs on the decedent’s deathbed generally has “minimal economic effects,” but results in a lower value for estate tax purposes.

The Internal Revenue Service has also noted that the current Treasury regulations issued under Section 2704 have been made ineffective by changes in state laws, court decisions, and various estate planning techniques that avoid the application of Sec. 2704(b), under which certain liquidation restrictions are disregarded.

The proposed regulations would amend the current regulations to address what constitutes control of a limited liability company or other entity or arrangement that is not a corporation, partnership, or limited partnership. This change would be effective when the rules are adopted as final.

The proposed regulations would also amend the current rules to address deathbed transfers that result in the lapse of a liquidation right and to clarify the treatment of a transfer that results in the creation of an assignee interest. This change would apply to lapses of rights created after Oct. 8, 1990, occurring on or after the date the regulations are published as final.

The proposed rules would also amend the current rules to refine the definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations of state law. This change would apply to transfers of property subject to restrictions created after Oct. 8, 1990, occurring on or after the date the regulations are published as final.

Finally, the proposed regulations would add a new section to 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.  This change would apply to transfers of property subject to restrictions created after Oct. 8, 1990, occurring 30 or more days after the date the regulations are published as final.

Adding the proposed changes to the current tax regime will likely serve as a means of lowering valuation discounts due to the elimination of certain rights and restrictions traditionally considered in the valuation of these closely-held business interests.

Questions and comments may be directed to Bob Grossman or Melissa Bizyak at 412-338-9300.