KPMG report: Pending proposed regulations may limit valuation discounts on interests in family entities

Regulations limit valuation discounts on interests

Proposed regulations under section 2704—expected to be released later this year—may affect the availability of discounts in valuing interests in family entities that are transferred to family members.

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At the American Bar Association (ABA) Section of Taxation meeting last month, Cathy Hughes (Estate and Gift Tax Attorney-Advisor in the Office of Tax Policy of the U.S. Treasury Department) indicated that proposed regulations under section 2704(b)(4)—a regulation project that has long been on the IRS priority guidance plan—could be released before the fall ABA Section of Taxation meeting (which is scheduled for September 17-19, 2015).

In addition, Hughes indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Background

Section 2704 was enacted to limit the use of valuation discounts in connection with gifts of interests in family entities. The concern was that taxpayers were imposing restrictions on the transferred interests that had the effect of artificially reducing the value for gift tax purposes even though the economic value of the transferred property to the recipients was not similarly affected.

Section 2704(b) ignores certain “applicable restrictions” on liquidation (that would normally justify a value discounted for lack of control and/or marketability) in valuing interests in family-controlled entities if those interests are transferred to other family members. Court decisions and state statutes have limited the applicability of section 2704(b) in many cases by re-characterizing restrictions so that they no longer fall within the definition of an “applicable restriction.” 

Budget proposal to modify valuation discount rules

The Obama Administration’s 2010 through 2013 fiscal year (FY) budgets each contained a proposal to restrict or eliminate valuation discounts on transfers of interests in family-controlled entities.

The proposal was dropped from the FY 2014 through FY 2016 budgets. It was not clear at the time why the proposal for new legislation in this area was dropped, although there was some thought that it might be connected to a renewed focus on issuing regulations under the already existing section 2704(b)(4) rather than attempting to have new legislation passed.

The FY 2013 budget proposed creating an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing interests in family-controlled entities transferred to a family member if, after the transfer, the restriction would lapse or might be removed by the transferor and/or the transferor’s family (including certain charities and non-family members). The transferred interest would instead be valued by substituting certain assumptions (to be specified by regulations) for the disregarded restrictions.

The budget proposal provided that disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest—thus, more restrictive than a standard to be specified by regulations. Any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity would also be considered a disregarded restriction.

The FY 2013 budget proposed to grant regulatory authority for various purposes, including the creation of safe harbors under which the governing documents of a family-controlled entity could be drafted to avoid the application of section 2704. The proposal further included conforming changes relating to the interaction of the proposal with the marital and charitable deductions.

Regulatory authority

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Although some tax professionals believe that the IRS does not have the authority to ignore minority and marketability discounts without additional legislative action, the language of this section does seem fairly broad.

Taxpayer considerations

Although Hughes intimated that the regulations may be reminiscent of the Obama Administration’s budget proposal, it is not clear what the regulations will ultimately say. It does seem likely that the proposed regulations would limit the use of lack of control (i.e., minority) and lack of marketability discounts for interests in family-owned entities, especially when the entity does not itself operate an active business—for example, a typical family limited partnership.

Although regulations are generally effective when finalized, there has been some indication that, instead, these regulations could be made effective as of the date the proposed regulations are released. It is believed that there would be no “grandfathering” of pre-existing entities, but only grandfathering of previous transfers of interests in such entities.

Thus, taxpayers who are considering transferring closely held interests to family members (or trusts for the benefit of family members) and who may want to take advantage of potential valuation discounts may find it prudent to act sooner, rather than later. 

KPMG observation

Given the information that is currently available and based on an expectation that the proposed regulations could be released sometime around Labor Day, there is still time for taxpayers to act. But time is of the essence because it could take weeks for taxpayers to make appropriate arrangements and effectuate any necessary transfers.

 

For more information, contact a member of the Estates, Gifts and Trusts group within KPMG’s Washington National Tax practice:

  • Tracy Thomas Stone | 202.533.4186 | ttstone@kpmg.com
  • Scott Hamm | 202.533.3095 | scotthamm@kpmg.com
  • Irene Estrada | 202.533.3150 | iestrada@kpmg.com

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