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Haile Shaw & Pfaffenberger Attorneys at Law

Future of Valuation Discounts under Internal Revenue Code Section 2704

Matthew N. Turko - estate planning attorney

Matthew N. Turko, a Wills, Trusts & Estates attorney with Haile Shaw & Pfaffenberger wrote an article for the Palm Beach Daily News’ annual Estate Planning Guide published on January 8. If you missed it, here is the story below. If you have any questions, call us at 561.627.8100.



Future of Valuation Discounts under Internal Revenue Code Section 2704

By Matthew N. Turko

The Internal Revenue Service published its much anticipated Proposed Regulations on IRC Section 2704 on August 4, 2016. These Proposed Regulations may be final before the end of 2016 and effective in early 2017 before or shortly after this article is published. The Proposed Regulations are broad and substantially change the landscape for valuation discount planning.

Estate planners utilize valuation discounts in conjunction with estate planning techniques in an effort to depress the value of interests in entities for transfer tax purposes. For example, a client wishes to make a gift of an interest in an LLC that owns underlying assets valued at $10 million to an irrevocable trust for the benefit of the client’s family. Based on various restrictions included in the LLC operating agreement, the client obtained an appraisal of the LLC interest that allows a 20% discount for lack of marketability of the LLC interest. Coupled with a 20% discount and a $5 million gift tax exemption available, the client is able to gift up to a 60% interest in the LLC appraised at $5 million without incurring any gift tax. The gift receives an immediate $1 million boost in the irrevocable trust’s pro rata share of the LLC’s underlying asset value -i.e., 60% of $10 million.

The Proposed Regulations eliminate valuation discounts in the context of family-controlled entities. The Proposed Regulations clarify that Section 2704 covers not only corporations and partnerships but also limited liability companies and any other entity or arrangement that is a business entity. Furthermore, the Proposed Regulations clarify the definition of control of an LLC or any other entity -not a corporation or partnership – constitutes owning 50% of the equity in such entity or owning any equity interest with the ability to cause the liquidation of the entity.

Importantly, the Proposed Regulations close a loophole in Section 2704(b). Under Section 2704(b), “applicable restrictions” are disregarded for valuation purposes.  Applicable restrictions are any restriction limiting the ability of an entity to liquidate and either the restriction lapses after the transfer or the transferor or any member of the transferor’s family -i.e., spouse, ancestor, lineal descendant, sibling or spouse of any of aforementioned – has the right after a transfer to remove such restriction. However, Section 2704(b) carved out an exception to applicable restrictions for restrictions that are no more restrictive than state law. As a result, many states modified their entity legislation after Section 2704(b) was enacted to provide for default rules that mirrored various restrictions commonly included in partnership and operating agreements. This allowed such restrictions to be no more restrictive than state law and allowed discount planning to continue despite Section 2704(b). The Proposed Regulations address this exception to provide that only mandatory restrictions imposed by state law will be considered no more restrictive than state law.  Therefore, the default rules provided in state entity statutes will no longer insulate various restrictions – e.g., unanimous consent to liquidate a limited partnership – from being considered applicable restrictions and these restrictions will no longer be considered for valuation purposes.

Additionally, the Proposed Regulations create a new class of disregarded restrictions if such restrictions either lapse after a transfer or can be removed by the transferor or his or her family.  Disregarded restrictions include the following:

  • limits on the ability of the holder of the interest to liquidate it,
  • limits on the liquidation proceeds to an amount that is less than minimum value – that is, the pro rata share of the assets of the entity -,
  • deferring the payment of liquidation proceeds for more than 6 months and
  • payment of liquidation proceeds in any manner other than in cash or other property, other than certain notes. These restrictions are disregarded for valuation purposes.

Even if a non-family member has the power to remove a disregarded restriction, such restriction will still be disregarded for valuation purposes unless the non-family member’s interest has been held for more than 3 years, constitutes at least 10% of the value of all equity, and at least 20% of the equity is owned by non-family members.

If the Proposed Regulations are finalized, valuation discount planning will be over for family-controlled entities.

It would be in a client’s best interests to complete transactions relying on valuation discounts before the Proposed Regulations are finalized to potentially “lock in” discounts.

However, estate planning techniques that are the fundamental basis of the valuation discount planning – such as installment sales, gifting and GRATs – will still remain viable and continue to offer clients an opportunity to remove assets from their estate and allow the future appreciation from such assets to accrue free of federal estate, gift and GST taxes despite the absence of the boost of valuation discounts.


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