Does Fair Market Value (and its Associated Discounts) Avoid the Intent of 2704 and Thus “Undervalue” Certain Types of Transferred Interests?

[August 2016] The IRS released its long expected proposed regulations in regards to Section 2704 on August 2. The substance of this proposal, according to the IRS, is to regulate treatment of entities for estate and gift tax purposes. According to the summary the proposal is:

“…concerning the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer (GST) tax purposes. Specifically, these proposed regulations concern the treatment of certain lapsing rights and restrictions on liquidation in determining the value of the transferred interests. These proposed regulations affect certain transferors of interests in corporations and partnerships and are necessary to prevent the undervaluation of such transferred interests.”

Before we delve any deeper on this article, let’s clarify a few things up front:

• We are appraisers, not lawyers and we are neither qualified nor particularly interested in dissecting the proposal from a legal perspective. Our friends in the legal community can address that.
• This is a proposal that, as of the writing of this article, is not in effect, could change, or might never go into effect. (Nonetheless we aim to comment from a valuation perspective as if it does).

With that said – what we hope to do in this post is to (i) give readers some context about the impetus of these proposed Section 2704 changes, (ii) share what these proposed changes are, and (iii) share what this might mean from a valuation standpoint.

Background of the Proposal

According to the IRS, treatment by taxpayers in regards to certain rights and transfers, as well as rulings of the Tax Court in regards to these rights and transfers have allowed taxpayers to avoid application of Section 2704. Representative of this sentiment, Page 6 of the proposal puts it this way when referencing Section 2704(b):

“The Treasury Department and the IRS have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments.”

The areas that the IRS cites as no longer ineffective fall into three primary areas:

1. 2704(a). Specifically the area covering so-called “Deathbed Transfers” – whereby liquidation rights lapse upon death. The IRS cites Estate of Harrison v. Commissioner as an example of this. The IRS claims that such transfers generally have minimal economic effects, but result in a transfer tax value that is based on less than the value of the interest.
2. 2704(b). Inter-family transfers and specifically restrictions on liquidation for family interest transfers. Reasons for this include that courts have concluded that Section 2704 applies to restrictions on the ability to liquidate an entire entity, and not on the ability to liquidate a transferred interest in that entity. Also the IRS says state laws and utilization of “assignees” have allowed taxpayers avoid 2704.
3. 2704(b). Granting of insubstantial interests to non-family members (such as a charity or employee) to avoid application of the statute. The IRS says this needs to be changed, because, in reality, such non-family interests generally do not constrain a family’s ability to remove a restriction on an individual interest.

Proposed Changes and Amendments

In light of this perceived avoidance and ineffectiveness of certain provisions in 2704, the IRS has proposed a number of new regulations including:

• Change the definition of a “controlled entity” to be viewed through the lens of an entire family including lineal descendants as opposed to individual(s).
• Amend the regulations to address what constitutes control of an LLC or other entity that is not a corporation, partnership, or limited partnership.
• Amend the regulations to limit the use of eliminating or lapsing rights (voting or liquidation rights) and limit the exception to transfers occurring three (3) years or more before death.
• Ignore transfer restrictions for minority interests and thus assume that they would be marketable, regardless of governing documents and/or state laws.
• Ignore the presence of non-family members with less than 10% of the overall equity value.

Valuation Impact

The IRS is not proposing changing the definition of fair market value. However, when applying fair market value under the constructs as contemplated in the proposed 2704 changes, there would be a smaller (or perhaps no) value delineation for minority interests as compared to enterprise value of an entity. According to the IRS’s position, this would prevent taxpayers from “undervaluing” transferred interests among family members. This, of course, runs in stark contrast to the marketplace, of which fair market value is supposed to be a reflection. The marketplace’s long track record on this is abundantly clear – it differentiates for minority interests as compared to the value of entire enterprises. Thus the proposed regulations essentially circumvent the levels of value for family members as defined in a “controlled entity.”

If the proposal is adopted as contemplated, there will be a powerful incentive for families with businesses and investment holding entities to initiate or complete transfers before these regulations take effect (which is thought to be December 2016). If Mercer Capital can be of any assistance in light of this development, please contact us.

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