By: Randall A. Denha, J.D., LL.M.
In 1990 the Internal Revenue enacted a small, but quite significant, section of the tax code known as the Chapter 14 (Special Valuation Rules.) It was added to the Internal Revenue Code to prevent the manipulation of the transfer tax value of a proprietary interest in certain entities in the context of transfers between related parties. In effect, these provisions were intended to disregard techniques and provisions designed to suppress the value of a transferred interest by enhancing the marketability discount without reducing the economic benefit to the recipient. In other words, what discounts ought to be taken into account in valuing the transferred interest if control of the entity remains within the family.
More specifically, IRC Section 2704(b) provides that certain “applicable restrictions” are to be ignored in valuing interests. Regulations issued after Chapter 14 was enacted defined applicable restrictions as those more restrictive than applicable state law. Many states responded by amending their respective state business entity laws to allow liquidation rights and withdrawal rights to be defined in business organization documents. State legislation has effectively defeated the applicable restrictions limitations.
Essentially, in the context of a family held entity, if the interest in the entity is transferred to or for the benefit of a member of the transferor’s “family” the value of any “applicable restriction” is disregarded. “Family” for this purpose means an individual’s ancestors, lineal descendants, siblings, and spouses of all of them. An “applicable restriction” is a limitation (i) on the ability to liquidate the entity that is more restrictive than the default rule under state law, and (ii) which lapses at any time after the transfer or where members of the transferor’s family can remove it after the transfer. The bottom line in disregarding the restriction is that the transferred interest is valued as if the restriction does not exist.
Section 2704(b)(4) provides that the Secretary may by regulations provide that other restrictions shall be disregarded in determining the value 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 but does not ultimately reduce the value of such interest to the transferee.
Since 2003, the Treasury Department (Treasury) has indicated that proposed regulations are forthcoming that are intended to place new limits on valuation discounts associated with interests in family entities, including family limited partnerships (FLP) and limited liability companies (LLC). There’s wide speculation as to whether the new regulations will be narrowly focused on specific issues or broader in scope, effectively eliminating valuation discounts.
So what will the regulations cover? At this point there are no clear answers. Potentially, the regulations could:
• Limit the application of discounts applied for lack of control (minority interest) and lack of marketability.
• Apply only to passive entities, e.g., those holding cash and marketable securities, and leave operating businesses for another day.
• Add restrictions in addition to restrictions on liquidation.
• Provide safe harbors for drafting the entity’s governing documents to avoid the application of Section 2704.
• Provide a de minimus rule with respect to non-family ownership in determining who can remove a restriction.
Also uncertain is the effective date of the regulations – although regulations are generally effective when finalized, it would not be surprising if they are immediately effective. Transfers already effectuated should be protected from the new regulations; however, the fact that the entity already exists would likely not insulate post-effective date transfers. It is not known if this Regulation will be effective as of the date of the Proposed Regulation, or as of the date of issuance of the Final Regulation. If gifts, as described above, are contemplated, the safest approach is to make them prior to issuance of the Proposed Regulation and not later than the early fall of 2015.