On August 4, 2016, the Treasury Department issued much anticipated proposed regulations under §2704 of the Internal Revenue Code, which, if finalized in their current form, will make very significant changes to the valuation of interests in many family-controlled entities for estate, gift and generation-skipping transfer (GST) tax purposes. The proposed regulations treat the lapse of voting or liquidation rights as an additional transfer and disregard certain restrictions on liquidation in determining the fair market value of a transferred interest, thereby eliminating the “lack of control/minority interest” discounts for the vast majority of family-controlled entities.


Under the Treasury Regulations, the fair market value of property for transfer tax purposes is "the [hypothetical] price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." The "willing buyer/willing seller" test may, particularly in the case of closely held entities, be affected by a number of factors, including the ability to control the business or to force its liquidation or sale. Thus, the courts, as well as the Internal Revenue Service (IRS), have recognized that discounts to the net value of an entity may be allowable for "lack of control/minority interest" and/or "lack of marketability."

In 1990, Chapter 14 of the Internal Revenue Code, of which §2704 is a part, was enacted with the intention of preventing the reduction in the valuation of certain closely-held (family-controlled) interests subject to lapsing rights or restrictions by: (a) treating the lapse of a restriction on the right to vote or to liquidate an entity as a transfer for estate and gift tax purposes; and (b) providing that certain “applicable restrictions” on the right to liquidate an entity will be disregarded for estate and gift tax purposes. An "applicable restriction" is any restriction on the ability to liquidate a family-controlled entity where either: (1) the restriction lapses after a transfer to or for the benefit of a member of the transferor’s family; or (2) the transferor or member of his or her family has the right, either alone or collectively, to remove the restriction after the transfer. The amount of the transfer is the excess of the fair market value of all interests held by the transferor in the entity, determined as if voting or liquidation rights were non-lapsing, over the value of those interests after the lapse. An applicable restriction does not include a "commercially reasonable" restriction or a restriction imposed by any Federal or State law.

Section 2704 confers broad regulatory authority on the Treasury Department to interpret that statute. Regulations under §2704 were issued in 1992, but their effectiveness was quickly undercut by court decisions, and by State legislatures that adopted "default" rules (i.e., rules that apply in the absence of a contrary provision in the partnership agreement) that allow an entity to be liquidated only on the unanimous vote of all of the owners.

Summary of Proposed Regulations

The proposed regulations under §2704, when final, would expand the reach of §2704 to virtually eliminate minority interest and lack of marketability discounts now available to transferors of interests in family - controlled closely-held corporations, partnerships and limited liability companies.

The following is a brief summary of the new provisions:

1. Entity Classification: For purposes of determining: (i) control of an entity; and (ii) whether a restriction is imposed under State law, the proposed regulations provide that, for any entity or arrangement that is not a corporation, the form of the entity or arrangement is determined under local law, regardless of its classification for Federal tax purposes. In general, there will be three types of entities: corporations, partnerships (including limited partnerships) and other arrangements (including LLCs) that are business entities as determined under local law. Arrangements that are not "business entities," such as undivided interests in real estate or other investment property, are not covered.

2. "Control" of the Entity: Prop. Reg. § 25.2701-2 clarifies that, in the case of an LLC or any entity or arrangement that is not a corporation or partnership, or limited partnership, "control" means the holding of at least 50 percent of either the capital or profits interests of the entity or arrangement or the holding of any equity interest (such as a general partnership interest) with the ability to cause the full or partial liquidation of the entity or arrangement. Current attribution rules under Treas. Reg. §25.2701-6 will apply in determining control.

3. Lapses of Voting or Liquidation Rights/3-Year Rule: Under an exception in the current Treas. Reg. §25.2704-1(c)(2)(i)(B), the ability to liquidate an interest in an entity is not deemed to have lapsed for purposes of §2704 if a transferor, prior to his or her death, gives away to his or her family members enough of an interest in the entity to eliminate the transferor’s ability to liquidate the entity under the entity’s governing documents or local law, so long as the liquidation rights of the entity are not affected. The proposed regulations would change this by imposing a bright-line three-year rule so that any such transfers would have to be completed more than three years prior to the transferor’s death in order to qualify for the exception.

This change is best illustrated by an existing example in the Prop. Reg. §25.2704-1(f), which is amended (amendments are in underlined italics) to read as follows:

Example 4. D owns 84 percent of the single outstanding class of stock of Corporation Y. The bylaws require at least 70 percent of the vote to liquidate. More than three years before D’s death, D transfers one-half of D’s stock in equal shares to D’s three children (14 percent each). Section 2704(a) does not apply to the loss of D’s ability to liquidate Y because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had the transfers occurred within three years of D’s death, the transfers would have been treated as the lapse of D’s liquidation right occurring at D’s death.

Note that, if the three-year test is not met, the lapse is deemed to occur at the transferor’s death. It is unclear, however, whether a lapse that occurs pursuant to a transfer made prior to the date that the regulations are finalized will be grandfathered if the transfer occurred less than three years prior to the transferor’s death.

A transfer that results in the conversion of an interest in an entity into an "assignee" interest (an interest unable to exercise voting or liquidation rights) upon transfer also is viewed as a lapse under the proposed regulations.

4. Effect of State Law: Under §2704(b)(3)(b), an “applicable restriction” does not include a restriction imposed or required to be imposed under State or Federal law. As noted above, states rushed to enact default rules that imposed indefinite lock up periods on a partner’s or shareholder’s ability to liquidate an entity. These restrictions could be overridden by the entity’s governing documents, however. The proposed regulations would disregard restrictions imposed under local law unless such restrictions are mandatory.

5. New "Disregarded" Restrictions: Using its grant of regulatory authority under §2704(b)(4), the Treasury Department and IRS describe a new class of "disregarded" restrictions that will severely limit the availability of both minority interest and lack of marketability discounts for family – controlled entities. These include restrictions that:

  • Limit the ability of the holder of the interest, as opposed to the entire entity, to liquidate the interest;
  • Limit the liquidation proceeds to an amount that is less than a “minimum value,” which is defined as the interest’s share of the net value of the entity on the date of liquidation or redemption, after taking into account only those liabilities that would qualify for the federal estate tax deduction;
  • Defer the payment of the liquidation proceeds for more than six months. This requirement –of a six month "put" right - appears to be aimed at reversing the 2002 decision of the Fifth Circuit in Kerr v. Commissioner, in which the court ruled that inability of the taxpayer to force a redemption of his limited partnership interest within a reasonable period of time was not an applicable restriction on liquidation; or
  • Permit the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes. Acceptable notes include those issued by an entity that is an active trade or business, are adequately secured, bear a market rate of interest, are not attributable to passive assets of the business, and have a fair market value (when discounted to present value) equal to the liquidation proceeds.

6. Ability to Remove Restrictions: Rights of Unrelated Parties. In determining whether the transferor and/or the transferor’s family has the ability to remove a restriction included in the new class of disregarded restrictions, any interest in the entity held by a person who is not a family member is disregarded if it is not substantial. A "substantial" interest is one that: (a) has been held for less than three years; (b) constitutes less than 10 percent of the value of all of the equity interests in a corporation (or capital and profits interests in a partnership); when combined with the interests of all other non-family members constitutes less than 20 percent of the value of all of the equity interests in a corporation (or capital and profits interests in a partnership); or (c) is redeemable upon six months’ notice for minimum value. This rule should prevent the common practice of the avoidance of §2704(b) by giving a charity a minimal interest in the entity in order to claim that the transferor and transferor’s family cannot, acting alone, remove an applicable restriction.

The new regulations will be applicable to the marital deduction, so that, the value of a bequest of an interest in an entity to a spouse must be determined under §2704(b). However, the value of a bequest of an interest in the same entity to a third party, such as a charity, would be determined under normal principles of valuation, thus setting up the potential for a tax on phantom value.

Timing and Planning Opportunities

The provisions of the proposed regulations applicable to voting and liquidation rights are proposed to apply to any rights and restrictions created after October 8, 1990 to the extent that a transfer of an interest occurs after the date the regulations are published as final regulations. The provisions of the proposed regulations applicable to disregarding restrictions will not take effect until 30 days after the date the regulations are published as final regulations.

The public hearings on the proposed regulations are set for December 1, 2016. Additionally, it is likely that there will be significant comments to the proposed regulations. Accordingly, we anticipate that the earliest the regulations will become final will be sometime in 2017. However, since the timing is not certain, any gift or intra-family sale transaction occurring after December 1, 2016 runs the risk of being under the new valuation regime.

Because of the broad nature of the proposed regulations, we anticipate challenges to the Treasury Department’s authority to finalize them in their current form. However, any individual with interests in family-controlled entities that are subject to lapsing rights should consider making transfers, whether by gift or intra-family sale, as soon as possible. Note, however, that it is possible that if the transferor dies within three years of the date of transfer and after the date that the proposed regulations have been published as final, the transferor may still be under the new valuation regime, resulting in the amount previously taken as a discount being treated as an additional “phantom asset” of the estate and generating additional estate and GST tax.

Additionally, any individual with interests in family-controlled entities should meet with an attorney to review his/her estate plan and discuss the source for payment of the transfer tax on any such family-controlled entities in light of the likely unavailability of "lack of control/minority interest" discounts at death, as well as on any potential "phantom asset."