2704 Regulations Explained: Why is the IRS Targeting Valuation Discounts on Family Controlled Entities?

The simple answer is that the IRS believes that valuation discounts taken on family controlled entities are falsely high, which results in lower transfer tax revenue to the Treasury.  With the foregoing in mind, it is important to understand how the IRS, courts, and taxpayers value a business interest under current law for estate and gift tax purposes.  The general rule for a valuation is to determine the price at which property would change hands between a willing buyer and a willing seller, both of whom have reasonable knowledge of the facts and neither of whom is compelled to complete the transaction.

The courts and the IRS have recognized that discounts should be allowed where the property transferred is a minority interest in an entity that cannot force or compel the entity to act (“lack of control”) and where there is a limited market for the property (“lack of marketability”).  Taxpayers and their planners began to take advantage of this knowledge by adjusting their entity’s governing documents to increase the discounts available when transferring interests to family members.  In 1990, Congress enacted Code Sections 2701 through 2704, known as Chapter 14, to quell what was seen by some as aggressive, and in some cases abusive, uses of these discounts to reduce transfer tax values especially when many of the restrictions imposed had limited or no significant substantive effect because the family had the ability to fully control the entity and eliminate the restrictions at its will.  Since Chapter 14 became effective, the IRS has slowly seen Chapter 14’s impact dwindle due to court decisions and changes in state law.  As a result, the Treasury began seeking legislative changes to Chapter 14; however, these changes were not getting traction in Congress after several years.  The proposed regulations are Treasury’s response to the inaction of Congress and an attempt to substantially reduce discounts that the Treasury believes to be an estate and gift tax planning fiction.

Over the next several weeks we will be providing a series of blog posts addressing the proposed regulations and a synopsis of the parties that should be reviewing their plans as a result of the regulations.

Thomas J. McLaughlin
tmclaughlin@williamsparker.com
941-536-2042