[IMGCAP(1)]Many accountants and valuation experts are anxiously attempting to predict the contents of the revised Section 2704 regulations from the IRS on the valuation of family limited partnerships and other family-controlled entities.
At a recent trusts and estates luncheon, an IRS official indicated that the IRS is not expected to issue the valuation discount regulations until the end of this year. While we await the release of these regulations, it would be very instructive for accountants and financial advisors to consult prior case law and Greenbooks for clues.
Examining previous case law can be helpful in attempting to chart the anticipated changes. For example, in Kerr v. Commissioner, the taxpayers and their children created two family limited partnerships (FLPs) with identical liquidation restrictions and shortly after formation, the taxpayers gifted their interests to their children. On their federal gift tax return, the taxpayers claimed substantial gifts and after audit, the Tax Court held that the partnership agreements of the taxpayers’ FLPs were not more restrictive than the limitations that generally would apply to the partnerships under state law.
The U.S. Court of Appeals for the Fifth Circuit did not analyze that issue but instead held that because the restrictions were not removable by the family, there were no “applicable restrictions” under Section 2704, and as such, the special valuation rule did not apply.
Regulation §25.2704-2(b) states that “[a]n applicable restriction is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction.” Therefore, Kerr basically provided "default state law"—that is, the measuring stick for a restriction imposed or required to be imposed will be determined by the applicable state law. This default can, of course, be overridden by the partnership agreement.
As a result of this decision, modifications of Section 2704 made an appearance in the Treasury-IRS Guidance Plan in 2003-2004. The goal articulated in the Greenbooks was to create a more durable category of disregarded restrictions that include “limitations on a holder’s right to liquidate that holder’s interest that are more restrictive” than the default state law or judicial decisions. However, in the general explanation of the Administration’s Fiscal Year 2014 Rev. Proposal issued April 2013, the proposal for the Section 2704 additional legislation was not included and has not reappeared since. It is now generally understood that the IRS and the Treasury intend to proceed without the additional statutory cover originally sought in the Greenbooks.
In the years following Kerr until the issuance of the Administration’s Fiscal Year 2014 Revenue Proposal in April of 2013, the IRS and Treasury proposal to modify the valuation discounts focused on creating an additional category of restrictions, i.e. disregarded restrictions, that would not be considered when valuing an interest in a family controlled entity transferred to a member of the family if after the transfer the restriction will lapse or be removed by the transferor and/or the transferor's family. These disregarded restrictions would also include any limitation on a transferee's ability to be admitted as a full partner or to hold an equity interest in the entity.
Overall, the goal of the new regulations would appear to require that the transferred interest be "valued by substituting for the disregarded restrictions certain assumptions," which will be outlined in the new regulations. When considering the application of these new "disregarded restrictions," any interests held by a charity or non-family members will more than likely be deemed to be held by the family.
Notwithstanding this, it appears that any new regulation will permit, in the formation of family controlled entities, one to create a safe harbor by drafting "the governing documents of a family-controlled entity so as to avoid the application of Section 2704 if certain standards are met."
In addition, it is highly likely that the asset for which one is attributing the discount will matter. Therefore, discounting, aggressive or otherwise, of entities holding only cash or securities may no longer be an option. In addition, there is a good chance that nontax reason exceptions will not be available and any nontax benefit may actually be considered an enhancement of the value of the family-controlled entity.
Also, while genuine operating businesses should not be impacted negatively by the revised restrictions, it appears that family limited partnerships created without a genuine business purpose will most certainly be held to greater scrutiny. And it is likely that the creator of the restriction and/or transferor of the interest will feel the impact of the modifications to Section 2704 and not necessarily the transferee of the interest if the transferee does not have an ability to change or terminate the restriction.
Finally, as for the effective date, it appears likely that the new Section 2704 regulations will be effective as to the date of the gift of the business interest, as opposed to the date of the formation of the family controlled entity based on the information available in the Greenbooks.
Overall, it remains essential for accountants and financial advisors to work with their clients to better understand how the ultimate changes in the Section 2704 regulations will impact them.
Moira Jabir is an attorney with Moritt Hock & Hamroff, where she is involved in many aspects of various trust and estate matters, including: preparation of wills and trust agreements, estate and gift taxes, estate administration, post-mortem estate planning, formation and representation of private foundations and the representation of fiduciaries and beneficiaries in numerous litigated matters, including contested probate and accounting proceedings, numerous gift and estate tax audits.