Valuation of family-owned entities for estate and gift tax purposes under sec. 2704.

• Author: Williamson, Donald T.

Family-controlled corporations and partnerships are frequently part of an estate plan to transfer wealth from one generation to another, particularly for closely held businesses gifted or bequeathed from owners to their children or grandchildren. Such entities are especially attractive because of the ability to employ discounts for lack of marketability or control in valuing the transfer for gift, estate, or generation-skipping transfer tax purposes. (1) However, with the recent release of proposed regulations under Sec. 2704, the IRS is substantially curtailing the use of such valuation discounts. If and when these regulations become final, they will in many instances disregard certain restrictions on a shareholder's or partner's rights to participate in management, receive distributions or force liquidation, and/or sell or transfer interests in family limited partnerships or closely held corporations, thereby negating valuation discounts that for decades have been a basic component of many estate plans.

This article describes the general rules of Sec. 2704 that disregard lapses or other restrictions of certain voting or liquidation rights in the context of measuring the value of gratuitous transfers of family-controlled entities where such lapses or restrictions are intended to impact the tax value of a transferred interest but not its ultimate economic value to a recipient family member. The proposed regulations limit certain exceptions in the regulations to this general rule and offer additional limitations for valuing "deathbed" transfers. The regulations also clarify the meaning of "control" in entities, as well as modify what constitutes an "applicable restriction" by adding a new concept of "disregarded restrictions." These proposed rules addressing the valuation of closely held enterprises transferred among family members may significantly restrict discounts for lack of control and marketability that have been the driving force for the creation of many family limited partnerships.

Sec. 2704: Lapses

For wealth transfer tax purposes, Sec. 2704 has for more than two decades prescribed rules for disregarding certain lapsing rights and liquidation restrictions in valuing transferred interests among family members in family-controlled corporations and partnerships. (2) With respect to lapses, the legislative history to Sec. 2704 (3) states that it is intended to overturn the holding of Estate of Harrison, (4) which considered the valuation of partnership interests held by a decedent where the decedent's general partnership interest had the right to liquidate the partnership, but his limited partnership interest had no liquidation right. Upon his death, the partnership agreement required the decedent's partnership interest to be sold to his children, providing at the same time that his right to have his interest liquidated lapsed upon his death. The court held that the lapse of the liquidation power at death resulted in a sizable reduction in the value of both the general and limited partnership interests for estate tax purposes.

To reverse this result, Sec. 2704(a)(1) provides that a lapse of any voting or liquidation right (5) where the individual (6) with such right and members of his or her family (7) hold, both before and after the lapse, control (8) of the entity shall be ignored in valuing the interest for wealth transfer tax purposes.

Example 1: A father and daughter have controlling interests in a corporation. If the father's stock has voting rights that lapse on his death and his stock is bequeathed to his daughter, Sec. 2704(a)(1) would include the value of the lapsed rights in the father's estate. If the father's stock has voting rights that lapse upon the gift of the shares to the daughter, the father is treated as making a taxable gift to the daughter on the date of the lapse.

For this purpose, Sec. 2704(a)(3) grants broad regulatory authority to the IRS to define rights that are similar to voting or liquidation rights.

Example 2: X and members of his family own all the stock of Corporation Z. Under the terms of the share certificates, X has the power to cause Z to liquidate, but that power lapses upon X's death, and his shares are bequeathed to his family. Under Sec. 2704(a)(1), the shares are valued for estate tax purposes as if the lapse had never existed.

Thus, if the lapse occurs during the life of the owner of an entity, it is treated as a gift, and if it occurs at the owner's death, it is treated as a transfer includible in the gross estate.

Meaning of 'lapse'

A lapse for this purpose occurs only when the voting or liquidation rights associated with the transferred interest are themselves restricted or eliminated as a result of the transfer. (9)

Example 3: X owns 100% of Y Corporation, the bylaws of which provide that Y can be liquidated only upon the consent of shareholders holding 80% of the stock. X transfers a 30% interest to a family member. There is no lapse under Sec. 2704(a)(1) because the liquidation right of the transferred interest was not restricted or eliminated. (10)

Example 4: Assume the same facts as in the previous example, except X holds two classes of Y stock, transferring one class to a family member and retaining the other, which has a liquidation right subordinate to the right of the transferred interest to approve or deny the liquidation of the retained stock. Because the family member holding the transferred interest can deny X the ability to liquidate the retained subordinate interest, a lapse of that right has occurred. (11)

A lapse of a voting or liquidation right may arise in the same manner as the creation of such a right, i.e., by reason of a state statute, a corporate charter, a partnership agreement, or other private arrangement agreed to among the owners. (12)

Example 5: The bylaws of Corporation Y provide that the voting rights of any transferred shares of Y's single class of outstanding stock are reduced by half following a transfer but are fully restored after five years. X dies with 60% of the stock, which is bequeathed to his children. The temporary reduction of voting power to the transferred shares does not reduce their value for estate tax purposes. (13)

Finally, if a lapse is not permanent but may be restored only by an action or event beyond the control of the interest's holder and the holder's family, no lapse occurs. (14)

Example 6: X and his two children are equal general and limited partners in Partnership Y. Each general partner has the right to liquidate the partnership. The partnership agreement provides that incompetency of a partner does not terminate the partnership, but an incompetent partner cannot exercise the rights of a general partner. A partner's full rights are restored if the partner regains competency. If X is incompetent, the lapse of voting rights is not subject to Sec. 2704(a) because X may later regain rights upon his regaining competency. However, if X dies while incompetent, a lapse subject to Sec. 2704(a) occurs because the lapsed right can no longer be reclaimed. (15)

Exceptions

The general rule of Sec. 2704(a) that disregards restrictions of voting and liquidation rights that lapse in valuing an interest transferred among family members has exceptions. Thus, where the holder's family cannot liquidate the interest after the lapse of a liquidation right, the lapse is not ignored in valuing the interest.

Example 7: D owns 100% of Y Corporation, holding the right to liquidate Y. D dies, leaving the stock to D's children. Y's charter provides that at D's death the right to liquidate lapses, such that the children may not liquidate Y. Thus, the lapsed right may be considered in valuing D's stock for estate tax purposes.

Sec. 2704(a) also does not apply if neither the holder of the interest (or the holder's estate) nor members of the holder's family can, immediately after the lapse, liquidate an interest that the holder could have liquidated prior to the lapse. (16)

Example 8: D and his children hold both limited and general partnership interests. Only the general partnership interests have liquidation rights. D dies leaving his limited, but not his general, interest to his spouse. Because of a general partner's right to liquidate the partnership, a limited interest has a greater fair market value (FMV) when held in conjunction with a general interest. Because D's children could liquidate D's limited interest left to his spouse, its value is not reduced merely because the spouse cannot liquidate the partnership; i.e., the lapse of D's right to liquidate the partnership does not affect the value of the interest passing to the spouse. (17)

Example 9: The facts are the same as in the previous example, except D is the only general partner, and, under state law, the children may liquidate the partnership. Again, the lapse of D's liquidation right is disregarded in valuing the interest passing to the spouse. (18)

Finally, Sec. 2704(a) does not apply to a lapse of a liquidation right if it occurs solely due to a change in state law. (19) Thus, if X owns an interest in a corporation that confers upon him voting or liquidation rights, but pursuant to state law, such rights do not carry over to those receiving gifts of shares from X or to those who inherit the shares upon X's death, such lapses are not disregarded for valuation purposes.

Value of transfer

If Sec. 2704(a) applies to the transfer of an interest among family members, the amount of the gift or the inclusion in the gross estate is the excess (if any) of the value of all interests in the entity held by the transferor before the lapse (determined as if the voting and/or liquidation rights were nonlapsing) over the value of such interests after the lapse.

Example 10: D owns all the preferred stock of Corporation Y (60% of the voting power), and D's children own all of its common stock (40% of the voting power). Under Y's bylaws, the voting rights of the...