Tax practitioners who advise family-owned businesses are breathing a sigh of relief that proposed regulations under Code Section 2704 are part of an eight-regulation bundle that the Treasury has marked to be revoked or revised.
Executive Order 13789, which was issued in April, directed the Treasury to identify significant tax regulations issued on or after Jan. 1, 2016, that impose an undue financial burden on taxpayers, add undue complexity to the code, or exceed the statutory authority of the Internal Revenue Service. However, the review, coordinated by the Treasury Regulatory Reform Task Force, “includes all tax regulations, regardless of when they were issued.”
The most prominent of the regulations slated for modification or repeal are the proposed regs under Section 2704, “Treatment of Certain Lapsing Rights and Restrictions.”
Section 2704 addresses the valuation of interests in family-controlled entities. In certain cases, it disregards restrictions on the ability to liquidate family-controlled entities when determining the fair market value of an interest. The Treasury report recommends that the proposed regulations be withdrawn entirely.
The origin of the regs
For several decades, estate planners have been using entities such as family limited partnerships as an estate planning tool. The FLP is used as a “wrapper” to hold marketable assets that are transferred in trust for children in the family, while taking discounts for lack of marketability, effectively discounting the value of the gift. Depending on the liquidity of the assets, the discount may typically range from 25 to 40 percent.
Although the IRS viewed these strategies as abusive, it conceded that there is some discount applicable to the transfer of the family entity. Recent cases revolved around the size of the discount, with experts weighing in on both sides over the effect of lack of control and lack of marketability on the value. Since there hasn’t been enough legislative support to clamp down on the use of FLPs, the proposed regulations were intended to counteract changes in state statutes and developments in case law that eroded the applicability of Section 2704 and facilitated the use of FLPs to generate valuation discounts.
“Over the last decade, a series of cases have done a fairly good job of defining the rules governing the value of closely held businesses, and the proposed regulations were a complete upheaval of those definitions, in many places ignoring the practical realities of the marketplace,” said Lauren Wolven, a trust and estates partner at Levenfeld Pearlstein. “The community of practitioners who regularly deal with those rules spent much of the end of 2016 and early 2017 providing comments and feedback to the IRS, and it is heartening to see that our input was clearly considered.”
The idea behind the proposed regulations has been around since before Barack Obama was president, according to Richard Dees, a partner at McDermott Will & Emery.
“State statutes have changed, and it was felt that there was a need for some change in the interpretations of Section 2704 since its enactment in 1990,” he explained. “The idea surfaced in the last years of the Obama presidency. Hearings on the regs were controversial, with 28,000 comments. Treasury said at the hearing that practitioners misunderstood the intent.”
“In my view, Section 2704 ought to be repealed. Most of the chapter [in the code] was subject to congressional scrutiny, but Section 2704 was dropped in at the last minute without any opportunity for debate. It was flawed from the beginning,” he concluded.
“Withdrawal of the overly broad Section 2704 proposed regulations will significantly benefit taxpayers owning closely held businesses, particularly family-owned businesses,” said Curtis Hunter, a shareholder in the Coral Gables, Fla., office of Becker & Poliakoff PA. “Shortly after the regulations were proposed, Republican senators sent a letter to the Treasury secretary suggesting the regulations did not directly target any perceived abuses in the valuation of interests. Owners of closely held businesses have long been correctly afforded valuation discounting for transfers of minority and restricted interests, and such minority interest and lack of marketability discounts could have been eliminated entirely by the proposed regs, with no correlation to any perceived abuse.”
“The proposed regulations did nothing more than complicate existing law with additional definitions and restrictions, and would have had a chilling effect on the use of valuation discounts by closely held businesses, resulting in additional tax burdens on owners of family businesses,” he added. “The withdrawal, however, could become moot if the Trump administration is successful in repealing the estate tax.”
The next targets?
In fact, the action by the Treasury may be a precursor to the administration’s efforts at estate tax repeal, according to Cliff Gelber, a partner at the South Florida accounting firm Gerson Preston. “More than anything else, it sends a signal to where the Trump administration is looking to posture itself with estate tax repeal,” he said. “This initiative was started to mitigate the very complicated proposed rules. The Treasury and the IRS believed that the proposed regs were unclear and the effect uncertain. They acknowledged that ignoring restrictions on withdrawal rights upon liquidation isn’t a sound approach. When there is no certainty as to what will come about, it makes for a bad body of regulations.”
“Since the release of the proposed regulations, planners have had to modify their disclosure by stating that valuation discounts may be eliminated if the proposed regulations become effective,” he said.
In its report, the Treasury doubled down on many of the comments to the proposal a year ago.
“The proposed regulations, through a web of dense rules and definitions, would have narrowed long-standing exceptions and dramatically expanded the class of restrictions that are disregarded under Section 2704,” the report stated. “After reviewing these comments, Treasury and the IRS now believe that the proposed regulations’ approach to the problem of artificial valuation discounts is unworkable. In particular, Treasury and the IRS currently agree with commenters that taxpayers, their advisors, the IRS and the courts would not, as a practical matter, be able to determine the value of an entity interest based on the fanciful assumption of a world where no legal authority exists. Given that uncertainty, it is unclear whether the valuation rules of the proposed regulations would have even succeeded in curtailing artificial valuation discounts.”
The eight regulations identified by the Treasury in its report may be merely the tip of the iceberg, according to Scott Harty, a partner in Alston & Bird’s federal and international tax group.
“These eight areas of change may be just the beginning, since Treasury’s report indicates that the IRS has already identified more than 200 regulations for potential revocation,” he said. “It’s encouraging that the review is going beyond the executive order. There is a lot of activity far beyond what they put in this report. It signals that Treasury is listening to taxpayers.”
