Treasury Seeks to Eliminate Valuation Discounts through Newly Issued Proposed Regulations under IRC Section 2704August 4, 2016
Proposed Treasury Regulations: Section 25.2701-2, Section 25.2704-1, Section 25.2704-2, and Section 25.2704-3.
One fundamental aspect in estate and gift tax (“transfer taxes”) planning is how to value transferred assets. Transfer taxes are generally assessed on the value of the asset transferred based on what a willing buyer would pay and a willing seller would accept if each were under no compulsion to buy or sell. The valuation becomes difficult, and nuanced, when a taxpayer owns an equity interest (either in a partnership, limited liability company, or a corporation) because the ownership rights and responsibilities that come with an equity interest can vary significantly.
Taxpayers often use business entities to hold assets for a variety of business purposes, such as centralized management, simplifying transfer of ownership, avoiding probate, aggregating capital, educating children about business operations, etc.
There are often restrictions placed on the taxpayer’s interest with respect to transfer, distribution, and liquidation. These restrictions reduce the value of the equity interests for transfer tax purposes, resulting in a lower transfer tax liability because an unrelated third-party would demand a discount due to the restrictions. This reduced value is commonly referred to as a valuation discount (or a minority interest discount).
The IRS often argues against these valuation discounts because it believes that the purpose for using a closely-held business in this planning is to discount assets for transfer tax purposes, thus reducing transfer taxes. After years of rumors that such regulations were coming, the Treasury Department released proposed regulations seeking to eliminate valuation discounts. In issuing the proposed regulations, Mark J. Mazur, Assistant Secretary for Tax Policy, stated “[i]t is common for wealthy taxpayers and their advisors to use certain aggressive tax planning tactics to artificially lower the taxable value of their transferred assets. By taking advantage of these tactics, certain taxpayers or their estates owning closely held businesses or other entities can end up paying less than they should in estate or gift taxes. Treasury’s action will significantly reduce the ability of these taxpayers and their estates to use such techniques solely for the purpose of lowering their estate and gift taxes.”
While still in proposed form and subject to a 90-day notice and comment period, the proposed regulations are broad and far-reaching. The proposed regulations seek to disregard valuation discounts relating to restrictions placed on equity interests transferred to family members if the restrictions can be removed by a group consisting of the transferor, the transferor’s family, and the transferor’s estate. The proposed regulations also remove the ability of a taxpayer to transfer a de minimis equity interest to a non-family member or charity to avoid disregarding these new restrictions. For a non-family member’s equity interest to be considered exempt from these regulations, non-family members must own at least 20% of the value of all equity interests and only non-family members who own at least a 10% equity interest will count. In addition, such non-family member must own the interest for at least three years before the intra-family transfer seeking to be valued and the non-family member must own a put right on the equity interest.
There are a couple of narrow exceptions. First, a restriction can result in a valuation discount if the equity interest is a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity’s trade or business, whether in the form of debt or equity. There are also exceptions for those restrictions imposed by federal or state law, certain rights to use property described in IRC Section 2703, and certain put rights.
The proposed regulations will have a significant impact on transfer tax planning if finalized. We will be monitoring these proposed regulations during the notice and comment period, commencing with the public hearing scheduled for December 1, 2016.
Please contact one of our estate planning attorneys if these proposed changes impact your estate plan or if you have questions about future transfer tax planning.
By Jonathan J. Cavanagh