by Howard M. Zaritsky
In response to the President’s Executive Order of April 21, 2017, the Internal Revenue Service has issued Notice 2017-38, 2017, designating the Proposed Regulations under Section 2704 of the Internal Revenue Code as imposing an undue financial burden or adding undue complexity (or both).
The proposed regulations, issued on August 4, 2016, could dramatically expand the scope of Section 2704, particularly as it applies to transfers of limited partnership interests, non-managing membership interests, and non-voting stock. REG-163113-02, 81 Fed. Reg. 51413-02 (Aug. 4, 2016).
Key Provisions of Proposed Regulations
The key provisions of the extensive proposed regulations would, in part:
- extend Section 2704(a), dealing with lapses of rights to liquidate or vote, to transfers of partnership interests to an assignee, unless the transfer occurs three years or more before the transferor’s death;
- limit the use of limited partnership interests, non-managing membership interests, and nonvoting stock to generate valuation discounts, expanding the scope of Section 2704(b) and the rules on applicable restrictions by ignoring as a restriction imposed by state law only those made mandatory by state law, rather than those set as default rules under state law; and
- limit the use of limited partnership interests, non-managing membership interests, and nonvoting stock to generate valuation discounts, by adding a new category of disregarded restrictions that have the same tax effect as applicable restrictions, but that exceed certain restrictions delineated by the regulations.
On December 1, 2016, the Treasury and the IRS held hearings and received public comments regarding the proposed regulations under Section 2704, and comments by Treasury representatives suggest at least one of the major changes likely to be made in the final regulations. Most of the day-long meeting was occupied with taxpayer and association representatives pointing out problems with the proposed regulations and suggesting possible solutions, but the representative of the Treasury did make several statements that may give some comfort to practitioners who have been finding the proposed regulations difficult to understand. These statements included that “there is no intended put right and we will absolutely make that clear in the final regulations" and that Treasury “will make it very clear that these regulations are not intended to eliminate minority discounts. We will make that very clear, if it wasn't already.”
2017 Presidential Action
On April 21, 2017, President Donald J. Trump issued Executive Order 13789, 82 Fed. Reg. 19317 (April 26, 2017), requiring the Treasury Secretary to review all significant tax regulations issued after January 1, 2016, to identify those that impose an undue financial burden on United States taxpayers, add undue complexity to the Federal tax laws, or exceed the statutory authority of the Internal Revenue Service.
On July 8, 2017, the Internal Revenue Service issued Notice 2017-38, 2017 WL 2899737, explaining that, of the 105 temporary, proposed, and final regulations promulgated after January 1, 2016, eight met the criteria described in Executive Order 13789. These include the proposed regulations under Section 2704, about which the Notice states that:
Commenters expressed concern that the proposed regulations would eliminate or restrict common discounts, such as minority discounts and discounts for lack of marketability, which would result in increased valuations and transfer tax liability that would increase financial burdens.
Commenters were also concerned that the proposed regulations would make valuations more difficult and that the proposed narrowing of existing regulatory exceptions was arbitrary and capricious.
Therefore, the IRS includes these regulations in the class of promulgations that must be reviewed and, presumably, revised to reduce their adverse impact. The Treasury requests comments on whether these regulations “should be rescinded or modified, and in the latter case, how the regulations should be modified in order to reduce burdens and complexity.”
The effect of this categorization of the proposed Section 2704 regulations is unclear. Notice 2017-38 is the first of two reports that Treasury must make to the President. The second report, due September 18, 2017, will contain specific recommendations to mitigate the burden of the identified regulations.
Thus, it appears that the final 2704 regulations must be rewritten substantially or withdrawn entirely. Based on the statements by the Treasury representatives at the hearings on the proposed regulations, the Treasury position appears to be that, under the regulations, an interest in a family-controlled entity should be valued as if any member can freely transfer his or her interest to whomever he or she wishes, free of any impediments.
This interpretation, which will require significant changes in the proposed regulations, should have only a small effect on valuation discounts. A prospective hypothetical buyer would still be unable to reach the underlying assets. If the underlying assets are an active business or tangible property that is not readily marketable, substantial valuation discounts should still be available. If the underlying assets are entirely cash, marketable securities, and similar liquid assets, there should still be some discounts, because the other owners of interests and independent third-parties will still be skeptical about buying a minority interest that does not enable them to compel either the liquidation of the entity or the distribution of current income. This does not appear to be a substantial change from the present law.
Obviously, the real effect of Notice 2017-38 and its characterization of the proposed Section 2704 regulations depends on what the Treasury does with the proposed regulations to make them less burdensome. It seems reasonable to expect that the regulations will be finalized, but in a form that will be far less problematic for estate planners.
This discussion is based on material published in the August 2017 issue of Probate Practice Reporter. Subscriptions to Probate Practice Reporter may be obtained at probatepracticereporter.com.
For more information, download these documents.
- PROPOSED REGULATIONS UNDER SECTION 2704
by Mitchell M. Gans and Jonathan G. Blattmachr
- ESTATE TAX REPEAL IS NOT A TEMPORARY OR PERMANENT CERTAINTY: HOW TO PLAN NOW
by Jonathan G. Blattmachr and Martin M. Shenkman
Howard M. Zaritsky is a consulting estate planning attorney in Rapidan, Virginia, and the author or co-author of TAX PLANNING FOR FAMILY WEALTH TRANSFERS DURING LIFE (5th ed. Thomson-Reuters/WG&L) and STRUCTURING ESTATE FREEZES AFTER CHAPTER 14 (Thomson-Reuters/WG&L) (with Ron Aucutt).