Bad Moon Rising? Proposed Section 2704 Regulations

JurisdictionUnited States,Federal
AuthorBy Joy Paeske & Phillip Jelsma
CitationVol. 25 No. 4
Publication year2016
Bad Moon Rising? Proposed Section 2704 Regulations

By Joy Paeske1 & Phillip Jelsma2

Section 2704 was added to the Internal Revenue Code ("IRC") in 1990 to curb the use of certain estate tax freezing techniques designed to reduce transfer tax values without a corresponding reduction in the economic benefit to the beneficiaries. Specifically, Section 2704 was enacted to prevent the consideration of certain lapsing rights and restrictions designed to reduce the value of a transferred interest in a partnership or corporation. Commencing in 2009, President Obama's budget proposals (sometimes called the "Greenbook") requested more durable rules for disregarding restrictions under Section 2704.3 The Greenbook lamented that "[j]udicial decisions and the enactment of new statutes in most states, in effect, have made section 2704(b) inapplicable in many situations." The Greenbook also noted "the Internal Revenue Service has identified other arrangements designed to circumvent the application of section 2704." In response to the Greenbook proposals, the Treasury Department ("Treasury") issued proposed regulations on August 4, 2016, that would modify and augment the existing treasury regulations applicable to Section 2704.

This article is not intended to serve as a treatise on Section 2704. Rather, the purpose of this article is to discuss a general history of Section 2704, the Treasury's perceived hurdles in applying Section 2704, and the proposed treasury regulations published by the Treasury on August 4, 2016 to address such perceived problems. This article will only discuss the relevant provisions of Section 2704 sufficient to give the reader a frame of reference to understand the proposed modifications to Section 2704 under the proposed regulations as well as discuss its planning implications for practitioners advising closely-held business owners.4

A. Background

Prior to the enactment of Section 2704, lapsing liquidation and voting rights were used to depress the value of business interests transferred both during life and retained interest transferred at death. While alive, members of a senior generation would transfer business interests to a younger generation while retaining voting or management rights to liquidate the business. The retention of these liquidation rights resulted in the depression of value of the transferred interest. Upon the subsequent death of the senior interest holder, the retained rights would lapse, thereby further reducing the value of the senior interest for estate tax purposes.

Section 2704 was enacted, in part, in response to Estate of Harrison v. Commissioner.5 In Harrison, the decedent held all of the limited partnership interests in a limited partnership as well as an interest as a general partner. Any of the general partners had the right to liquidate the partnership during the decedent's lifetime, thus causing all of the partners to obtain the value of such partner's interest. The Harrison court determined that the right of the decedent as general partner to liquidate the partnership lapsed upon the decedent's death. Resultantly, because the decedent no longer had the ability to liquidate the partnership and obtain the full value of the limited partnership interest, the value of the limited partnership interests included in the decedent's estate was deemed to be less than the value of the limited partnership interest in the hands of the decedent immediately before death. The loss upon death of the ability of the senior taxpayer in Harrison to vote to cause the liquidation of the partnership is commonly referred to a lapse of a voting or liquidation right.

Currently, Section 2704(a) provides if a holder of a voting right or liquidation right in a corporation or partnership in conjunction with such holder's family control of an entity immediately before and after the lapse of a voting of right or liquidation right, the lapse of such right is treated as a transfer by the individual who held such right directly or indirectly immediately before its lapse. An inter vivos lapse is deemed to be a gift, and a lapse at death is deemed to be a transfer includible in the holder's gross estate. The amount of the deemed transfer is the fair market value of all interests held by the individual before the lapse (determined as if the voting and liquidation rights were nonlapsing) reduced by the value of such interests immediately after the lapse (determined as if all interests were held by one individual).6

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Treasury Regulation ("Treas. Reg.")Section 25.2704-1(c) (1) provides that a lapse of a liquidation right occurs at the time when a presently exercisable liquidation right is restricted or eliminated. However, an exception to Section 25.2704-1(c) (1) currently exists as to any transfer of an interest that results in the lapse of a liquidation right if the rights with respect to the transferred interest are not restricted or eliminated.7Therefore, if a transferor initially holds sufficient power in the aggregate to compel the liquidation of an entity, but then subsequently transfers an interest that causes the loss of such right, such transfer is not a lapse under Section 2704(a). For example, in Estate of Murphy v. Commissioner,8 the decedent held nearly 51 percent of the stock of a corporation prior to her death. In order to avoid the inclusion of the controlling interest in such corporation in the decedent's estate at her death, she transferred minority interests in the corporation to her children shortly before her death with the intention of reducing her interest to a minority interest in the corporation. The effect of such transfers is that she was able to claim a discount on the valuation of the minority shares transferred to her children. Additionally, her minority interest in the corporation at her death was also eligible for a discount. Although the transfers by the decedent prior to her death resulted in the loss of her voting and liquidation rights as a majority shareholder, the transfers were not deemed to be lapses under Section 2704(a).

B. Proposed Regulation

The Treasury stated in the preamble to the Proposed Regulations that the proposed modification of Treas. Reg. Section 25.2704-1(c)(1) was designed to eliminate the lapse of liquidation right at deathbed such as the one that occurred in Estate of Murphy. Under proposed Treas. Reg. Section 25.2704-1(c)(1), if an interest in an entity is transferred less than three years before death and such transfer results in a lapse of a voting or liquidation right, then such transferred interest will be valued under Section 2704(a). The Treasury noted that the three-year rule would replace the subjective "contemplation of death presumption," which the Treasury opined to be fact specific and "administratively burdensome."9

Under proposed Treas. Reg. Section 25.2704-1, if a transferor owning a 51 percent interest in a corporation were to transfer a two percent interest in such corporation to her children within three years of her death, the inter vivos transfer of the two percent minority interests interest might (or might not per Section II below) still be eligible for a lack-of-control discount. However, the valuation discount on the minority interest retained by the transferor would be invalidated. Notably, the decedent would still only report the value of 49 percent of the shares at death (and not necessarily the full 51 percent, as the other two percent really was transferred), but in determining any potential minority discount, the 49 percent would be valued assuming the 51 percent interest was still present (which means no minority discount).

A. Background

Prior to the enactment of Section 2704, taxpayers frequently used liquidation restrictions to reduce the value of transferred interests for transfer tax purposes. A senior generation would transfer business interests to a younger generation subject to a restriction on the right to liquidate their interests in the entity. The value of the transferred interest was reduced due to this restriction. Subsequently, this restriction would lapse, either upon the death of the senior transferor or upon the discretion of the family. This subsequent lapse was not initially treated as a transfer for gift or estate tax purposes.

In its current form, Section 2704(b) provides that certain restrictions, called "applicable restrictions," will be disregarded for estate, gift, and generation skipping tax purposes in valuing interests in corporations or partnerships transferred to family members. Section 2704(b)(2) defines an "applicable restriction" as any restriction which effectively limits the ability of a corporation or partnership to liquidate, and with respect to which, either of the following applies: (1) the restriction lapses, in whole or in part, after the transfer or (2) the transferor or any member of the transferor's family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.

Section 2704(b) currently describes certain restrictions that are not considered to be applicable restrictions. First, any commercially reasonable restriction which arises as part of any financing by the corporation or partnership for the entity's trade or business operations with a person who is not related to the transferor, the transferee, or a member of the family of either will not be an applicable restriction under Section 2704(b).10 For example, a debtor net worth covenant in a loan document or guarantee that requires the lender's or the lender's representative's consent to liquidate will not be deemed to be an applicable restriction.

Additionally, an option, right to use property, or agreement that is subject to section 2703 is not an applicable restriction.11 Notably...

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