Treasury Issues Long Awaited Section 2704 Regulations In Effort To Curb Valuation Discounts


by Timothy C. Polacek, J.D.

In August 2016, the Treasury issued long awaited proposed regulations under Section 2704 of the Internal Revenue Code. The proposed regulations are intended to deny the application of valuation discounts that have been routinely applied in the past in valuing interests in family-controlled business entities, including corporations, limited liability companies, and partnerships. It is expected the proposed regulations will be challenged in the future, since they are likely to be used by the Service to deny discounts in valuing interests in these entities for estate and gift tax purposes.

Hearing Scheduled December 1, 2016

A December 1, 2016 hearing has been scheduled for comments and the final regulations won’t be effective until at least 30 days after they become final. This suggests it may be possible for taxpayers to engage in planning before year-end free of the effect of the regulations. At first glance, the proposed regulations appear complex such that their exact effect may not be known for a while.

IRC 2704(a) and (b): Lapsing Voting Rights and Liquidation Rights, Applicable Restrictions

The original regulations under IRC Section 2704 were effective October 9, 1990 and focused on two major areas: lapsing rights and applicable restrictions. First, Section 2704(a) created a taxable event when the right to liquidate lapsed (i.e., disappeared) or when voting rights lapsed. Second, Section 2704(b) disregarded, for purposes of estate and gift tax valuation, certain restrictions that affected the ability to liquidate (i.e. sell) the interest.

Determining “Control” Under The Proposed Treasury Regulations

The proposed regulations apply to business entities that are controlled by family members. In this regard, control is to be measured by disregarding ownership interests held by non-family members: (i) that have been owned for less than three years before the valuation date, (ii) that are less than ten percent (10%) of the value of all interests in the entity, (iii) when combined with ownership interests of other non-family persons are less than 20% of the value of all equity interests in the entity, and (iv) lack a right to put the interest to the entity and receive a “minimum value” equal to a pro rata share of the entity’s value.

Essentially, the above rules will allow discounts for lack of control (or minority interest) only when the family group actually owns less than a majority interest. Furthermore, it is apparent that the somewhat convoluted ownership percentage tests shown above are intended to preclude taxpayers from using charitable entities to represent non-family members for the purpose of denying the family the legal right of control (at least on paper, for valuation discount purposes) so that the transfer can obtain reduced transfer tax values.

Year End Planning Opportunities To Secure Valuation Discounts?

Tax advisors are already suggesting their clients consider taking action before year-end in order to transfer business interests to family members at discounted values. Clients are likely to feel deja vu all over again when remembering being put into a similar position in 2012 - when they had to deal with the prospect of seeing the estate tax exemption be returned to the $1,000,000 limit.

Some practitioners are suggesting business interests be transferred to “intentionally defective grantor trusts” (IDGTs) in exchange for interest-only promissory notes at discounted values. Other practitioners are suggesting that grantor retained annuity trusts (GRATs) be considered as part of this planning technique. Such alternatives continue the long standing practice of arranging family wealth into a fixed return type security (i.e. a “preferred” interest) and an appreciating type security (i.e. a “common” interest), which has been the backbone of estate planning for business entities since transfer taxes were originally imposed.

Discounts For Undivided Interests In Real Estate

The proposed regulations address the valuation of interests in “business” entities and, therefore, do not affect the application of discounts for undivided interests in real property. However, real property that is owned by a LLC or partnership, for example, would appear to preclude the application of a discount in valuing an ownership interest in the entity. Thus, some taxpayers may find it appropriate to dissolve their “FLP” or “FLLC” before year end so that transfers of real property interests can be made. Of course, such planning will invite a necessary review of possible adverse issues such as property tax reassessment, lender “due on transfer” problems, creditor liability concerns, as well as changes in the right to legally manage and control the property.

Alternatively, some practitioners are likely to suggest that the FLP or FLLC not be dissolved, but that a small undivided interest (e.g. 10%) in the property be transferred out of the entity. Whether or not the IRS will honor such an arrangement, if the undivided interest is held by family members, will remain to be seen. Thus, having friendly business partners, for example, become co-owners of the property may be a reasonable alternative.

Elimination of Income Tax (Gain) For Non-Taxable Estates

A silver lining can be seen in the proposed regulations. Namely, those taxpayers who no longer have taxable estates would seem to be able to ignore valuation discounts for estate tax purposes, when the business interest of a decedent receives a new income tax basis. Because valuation discounts have the effect of reducing income tax basis in the hands of the heirs, the proposed regulations should allow the heirs to eliminate (through an IRC Section 754 election) any capital gain that previously would result from the application of discounts to inherited interests.


Over the next few months, scholars and professionals will review the details of the proposed regulations and there will be considerable debate as to their interpretation. It appears the Treasury has done an excellent job in drafting regulations that will cause the value of a family owned business interest to be at least as high as its proportionate share of the value of the entity.

We will keep you informed as new details emerge. Should you have any questions or comment, contact Tim Polacek (

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