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Without Further Ado, The Proposed Regulations Under Section 2704

By Christopher C. Weeg on August 4, 2016

Two days ago, the Treasury released the much-awaited proposed regulations under § 2704. If finalized in their current form, they will likely drastically change the landscape of estate planning with family controlled entities by severely curtailing (if not eliminating) minority and marketability discounts largely predicated on liquidation restrictions. Some of the major changes include the closing of perceived loop holes in § 2704’s definition of applicable restrictions; namely, state law restrictions, assignee interests, and interests held by nonfamily members. Specifically, the regulations do the following:

1.  Amend § 25.2701-2 to address what constitutes control of an LLC or other entity or
     arrangement that is not a corporation, partnership, or limited partnership;
2.  Amend § 25.2704-1 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;
3.  Amend § 25.2704-2 to refine the definition of the term “applicable restriction” by
     eliminating the comparison to the state law liquidation restrictions; and
4.  Add new § 25.2704-3 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 family members.

A few of the most impactful changes will be discussed in further detail below. A background to § 2704, which applies special valuation rules to intra-family transfers of interests in family controlled entities, is also provided at the end of this post.

State Law Exception Eliminated

Formerly, the expanded definition of an applicable restriction in the regulations excepted a liquidation restriction that was less restrictive than that of the state law which would apply in the absence of the restriction. Accordingly, if a liquidation restriction in an entity’s governing documents was not more restrictive than default state law, such restriction was taken into consideration for valuation purposes and discount planning. In response to the Tax Court’s decision in Kerr v. Comm’r upholding and applying this exception, the proposed regulations remove the exception in §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. The result is the state law exception is severely narrowed to only mandatory rules under state law, not default rules. This narrowed state law exception also applies to the newly added disregarded restrictions, discussed below.

New “Disregarded Restrictions”

The proposed regulations add additional “disregarded restrictions” that “may affect adversely the transfer tax value of an interest but that do not reduce the value of the interest to the family-member transferee and thus should be disregarded for transfer tax valuation purposes.”

A “disregarded restriction” includes any one of the following restrictions 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” (defined as the interest’s share of the net value of the entity on the date of liquidation or redemption); (3) defers the payment of the liquidation proceeds for more than six months; or (4) permits the payment of the liquidationproceeds in any manner other than cash or other property, other than certain notes. With respect to the fourth restriction addressing liquidation proceeds, entities engaged in an active trade or business may in certain situations issue a note in liquidation.

In determining the transferor’s ability to remove a new “disregarded restriction,” a nonfamily member interest will be disregarded unless the interest is “an economically substantial and longstanding one.” Specifically, a nonfamily member interest will be disregarded if the interest (1) is held less than 3 years before the date of transfer; (2) constitutes less than 10% of the equity or capital and profits interest in the entity; (3) constitutes less than 20% of the equity or capital and profits interest in the entity when combined with all interests held by nonfamily members; or (4) lacks an enforceable right for the holder to receive the “minimum value” of the interest in liquidation with no more than six months’ notice.

Effective Dates and Timeline

The amendments defining entities and control found in § 25.2701-2 are effective as of the publication of the final regulations. The amendments to § 25.2704-1 regarding lapses apply to lapses of rights created after October 8, 1990 that occur on or after the publication of the final regulations. The amendments to § 25.2704-2 regarding the applicable restrictions apply to transfers of property subject to restrictions created after October 8, 1990 that occur after the publication of the final regulations. The new § 25.2704-3 regarding the disregarded restrictions applies to transfers of property subject to restrictions created after October 8, 1990 that occur thirty days after the publication of the final regulations. Public comments are due by November 2, 2016. A public hearing will be held on December 1, 2016.

Validity Issues: Initial Thoughts

If the regulations are finalized as proposed, the IRS could face a legal battle as to their validity. Importantly, § 2704's legislative history provides the statute was not intended to affect minority and other discounts available under present law. For a challenged regulation to be upheld, an agency must first show that Congressional intent was not clear on the issue, which is step one of the Chevron deference analysis. Accordingly, Congress’s position on discounts in the family entity context may be problematic to the government’s case. Next, Chevron step two requires a showing the agency’s interpretation was not arbitrary and capricious, which incorporates a reasoned decision-making standard. The proposed regulations were in large part issued as a result of government litigation losses, particularly Kerr v. Comm’r.¹ These so-called “fighting regulations” (i.e., regulations issued to effectively overrule bad precedent) are typically subject to more controversy when their validity is challenged in the courts. In 2015, the Tax Court in Altera Corp. v. Comm’r invalidated an example of fighting regulations for, inter alia, the Treasury’s failure to respond to relevant and significant comments received. With this wound still fresh, expect a thorough public comment period and collaborative hearing conducted by the Treasury and IRS in order to satisfy Chevron step two (assuming Chevron step one can be met).


The family limited partnership (FLP) and its limited liability company variant have been used for years to achieve both tax and nontax estate planning goals. Nontax reasons for forming an FLP include centralized asset management, cost effective administration of family wealth, and creditor protection. The chief tax reason for forming an FLP is to reduce gift and estate taxes through valuation discounts for lack of control and marketability.

Over the years, the IRS and Treasury have long promised to end perceived abusive discount planning and have finally taken a substantial step to make good on that promise. In May of 2015, a Treasury official announced at an ABA Tax Section meeting that proposed valuation regulations under § 2704 were in the works and would likely be released by fall of 2015. After a year of speculation in the tax world as to the scope of those regulations (as well as the scope of the Treasury’s power to issue them), an IRS official at the ABA Tax Section meeting in May of 2016 provided an update on the project, announcing they would be released shortly. On August 2nd, the Treasury released the proposed regulations.

How Does Section 2704 Affect Valuation Discounts?

In 1990, Congress added Chapter 14 to the Code (§§ 2701 through 2704) in an effort to curtail valuation discounts on intrafamily transfers of family controlled stock. Section 2704 disregards liquidation restrictions that are more restrictive than those under applicable state law in valuing the transfer of an interest in a family controlled entity for estate and gift tax purposes. Specifically, where there is a transfer of an interest in a controlled corporation or partnership to a family member, § 2704(b) disregards an “applicable restriction” that (1) limits the ability of the entity to liquidate, (2) lapses (entirely or partially) after the transfer or may be removed (entirely or partially) by the transferor or any family member, and (3) is more restrictive than a restriction imposed under federal or state law.

¹·See Kerr v. Comm’r, 113 T.C. 449 (1999), aff’d on other grounds, 292 F.3d 490 (5th Cir. 2002) (holding the limited partnership liquidation restriction was not a § 2704(b) “applicable restriction” because the partnership agreements did not impose greater restrictions than the limitations on liquidation under state law pursuant to § 2704(b)(3)(B)).. The Fifth Circuit affirmed the Tax Court’s decision on § 2704(b)’s inapplicability not on state law grounds, but instead on the inability of a family member to unilaterally remove a restriction pursuant to § 2704(b)(2)(B)(ii); Estate of Jones v. Comm’r, 116 T.C. 121, 130 (ruling on same grounds as the Kerr Tax Court decision).