Author: Ryan Kenny, Associate Member, University of Cincinnati Law Review
An important component of estate tax planning concerns the transfer of family business interest from one generation of business owners to the next. For small family-owned businesses in partnerships and close corporations, it can be important to keep control of the enterprise within the family.
However, transfers of business interests from family member to family member via an estate plan provided opportunities for taxpayers to circumvent the purpose of estate planning and tax laws in ways that were never intended. Wealthy families were able to prevent taxation of larger amounts of wealth with careful tax planning.
In 1990, Congress sought to close the estate freezing loopholes by enacting Internal Revenue Code (Code) §§2701 – 2704. The purpose was to prevent the seemingly arbitrary valuations of interests transfers between holders of interests in entities to their family members. However, as tax planners, taxpayers, and state legislatures combined to affect the regulations of Code §2704 and the corresponding state law provisions contained therein, the provision, along with the other anti-freeze provisions, became “effectively toothless.”[
In response, the Internal Revenue Service issued proposed regulations to strengthen the regulations for lapsing liquidation rights to determine the value of transferred interests in partnerships for estate, gifts, and generation-skipping transfer (GST) tax purposes. This analysis addresses the current regulations under Code §2704, and the proposed amendments.
I. Current Treatment of Transfers Under Code §2704.
Beginning in the mid-1970s, many holders of interests in an entity began developing “freezing” techniques, which allowed them to “limit or reduc[e] the value of an interest in a business or other property for estate tax purposes.” By having a member of family from an older generation retain non-appreciating interest while transferring appreciating-interest to a family member of a younger generation, this allowed families to defer taxation on interests in business entities, even though the interests were transferred from the holder in a realization event. Rather than a nonrecognition provision provided for such transfers, taxpayers had found a loophole in the tax system for transfers of interests in business entities to family members as part of the transferor’s estate. In 1990, Congress responded with Code §§2701 – 2704, with the purposes of closing the loophole in estate business interests transfers.
Rules regarding the valuation of transfers of interest in family business interests are found under Code §§ 2701 – 2704. Each section governs different entity interests transferrable to family members. Code §2701 provides rules for valuating a gift of equity interest in a corporation or a partnership. Code §2702 “provides a similar rule for transfers of interests in trust to . . . a member of the individual’s family . . . .” Code §2703 provides that the value of property is determined without regard to any encumbrances or limitations on the rights to the property. This means that any nonrecourse loans (loans attached to the property and not any owner) or remittance rights will affect the valuation of the land in a transfer from owner to a member of the owner’s family. Code §2704 governs the valuation of voting or liquidation rights that lapsed under the control of the transferor, and which are now being transferred to the heirs of the transferor. Code §2704 and the regulations under Code §2704 only apply where the transferor had control over the entity before the transfer, and that control is retained by the family members of the transferor after the transfer.
Voting rights and liquidation rights affect the value of interest in a business. They each give the holder more control over the entity. Voting rights allow the holder to influence the actions of the entity, and liquidation rights allow the holder to terminate the entity or their interest in the entity as it suits them. A “lapsed” voting right “occurs at the time a presently exercisable voting right is restricted or eliminated.” The same principle is applied for liquidation rights, subject to limitations where the right to liquidate does not transfer to the holder’s family, Code §2701 valuations necessary to prevent double-taxation, and lapses in liquidation rights solely due to a change in State law. Thus, a lapsed voting or liquidation right is one which is limited or revoked. These restrictions, from a business perspective, affect the value of the interests in the entity. However, Code §2704 and the regulations diminish the effect of lapses on the valuation of interests.
Generally, the Code treates lapses of voting and liquidation rights as gifts or transfers of gross estate from the transferor to the transferee. The amount of the transfer is the transferor’s total interests in the entity before the lapse, divided by the value of the interests after the lapse. However, when determining the value of liquidation interests with restrictions, certain “applicable restrictions” are not accounted for where there is a transfer of interests in a partnership or corporation and, immediately before the transfer, the transferor and his or her family have control over the entity. An “applicable restriction” is one:
“(A) which effectively limits the ability of the corporation or partnership to liquidate, and
(B) with respect to which either of the following applies:
(i) The restriction lapses, in whole or in part, and the transfer referred to in paragraph (1).
(ii) The transferor or any member of the transferor’s family, either along or collectively, has the right after such transfer to remove, in whole or in part, the restriction.”
The regulations provide more detail on what defines an applicable restriction. To be an “applicable restriction,” thus invoking Code §2704, the restriction in question must be more restrictive than the limitation imposed by State law. This would apply to any restriction beyond restrictions mandated by State law, thus including any additional restrictions in the holder’s contract, and presumably federal law. A restriction is only an applicable restriction “to the extent that either the restriction . . . will lapse at any time after the transfer, or the transferor (or the transferor’s estate) and any members of the transferor’s family can remove the restriction immediately after the transfer.”
One can see how this regulation is effectively toothless. So long as the holder’s interest agreement allows his or her estate or his or her family to remove the restrictions after the transfer as a gift or gross estate, any effect of the restriction is void. This allows the holder generation to pass on liquidation interests as if the restriction does not exist. Thus, the transferor can “freeze” the value of the interests by allowing the liquidation right to lapse.
II. The Proposed Changes to the Regulations Under Code §2704.
The push to change the regulations under Code §2704 came seventeen years
after the Kerr v. Commissioner ruling against the Internal Revenue Service. Interpreting a family partnership agreement under Code §2704(b), the court held that Code §2704(b) only applied to restrictions to liquidate an entire entity, and not to the transferred interest in that entity. Therefore, an individual recipient of transferred liquidating interest from a lapsing right is not governed by Code §2704 and its regulations when that individual wishes to liquidate his or her interest.
The proposed changes include an amendment to Regulation §25.2704-2 redefining the term “applicable restriction,” and the addition of a new section, Regulation §25.2704-3 addressing the liquidation of individual interest in an entity and the effect of non-family interest holders on liquidation.
Currently, an applicable restriction is any restriction that goes beyond any restriction proscribed under State law. The proposed regulation eliminates the language concerning restrictions of state law entirely, thus incorporating any limitation imposed on liquidation rights as triggering the effects of Code §2704. Before, any restriction that was less restrictive than limitations imposed by State law were not subject to the valuation limitations of Code §2704, because such limitations were treated as though they did not exists for valuation of interest purposes. Under the proposed regulation, any limitations on liquidation rights are considered applicable restrictions, with no regard for State law. This will greatly broaden the scope of Code §2704 (and the regulations thereunder) for lapsed liquidation interest transfers.
The changes to individual liquidation of interest in an entity will disregard non-family holders in the entity, unless certain requirements are satisfied. In Kerr, the court held that Code §2704(b) provided no exception permitting the court “to disregard non-family partners who have stipulated their probably consent to the removal of the restriction.” Thus, the proposed regulation will directly overturn Kerr, which means that an individual family member may liquidate his or her interest in an entity, received as a gift or from a gross estate, from a lapse of liquidation right without regard to non-family members, unless the requirements of proposed regulation §2704-3(b)(4) are satisfied. This will make it easier for family members to terminate restrictions on liquidation rights, permitting the application of §2704 for valuation of interest received from a lapse liquidation right by another family member.
There was significant panic regarding the proposed changes to the valuation rules of liquidation rights under Code §2704. However, the proposed changes are aimed at breathing new life into the regulations, giving effect to the original purpose of Code §2704. By broadening the definition of an applicable restriction, and thus disregarding those restrictions for valuation purposes so long as the regulation requirements are met, families may see larger tax bills on the liquidation of interest. Since limitations on rights would logically reduce the value of those rights, the Treasury Department will broaden the tax base, while also increasing the gain recognized on the liquidation of interest.
Currently, there is not much about which to be alarmed. Proposed regulations are generally examined where a simultaneous temporary regulation has been put in place, or where the proposed regulations contain a provision making them reliable authority. Nonetheless, the proposed regulations to Code §2704 may indicate a first step by the Treasury Department to close a loophole that has been in the Tax Code for decades.
 John A. Miller and Jeffrey A. Maine, Fundamentals of Estate Tax Planning, 32 Idaho L. Rev. 197, 232 (1996).
 Ed Zollars, IRS Proposes Changes to Regulations Under §2704 Meant to Reverse Kerr Decision, Current Federal Tax Developments (Aug. 4, 2016) (https://www.currentfederaltaxdevelopments.com/blog/2016/8/4/irs-proposes-changes-to-regulations-under-2704-meant-to-reverse-kerr-decision).
 Howell Bramson, Taxes and Valuation Issues; Special Valuation Rules under Chapter 14, McCarthy Fingar LLP (May 19, 2011) (http://www.mccarthyfingar.com/publications/howell-bramson-white-plains-lawyer-taxes.aspx).
 Id., a realization event is a fundamental principle of US income taxation, and no tax is levied until such an event occurs, Jeffrey L. Kwall, When Should Asset Appreciation be Taxed?: The Case for a Disposition Standard of Realization, 86 Indiana L. J. 77, 78 (2011); However, even where there is a realization event, tax can be deferred until a later time where Congress has specifically provided a nonrecognition provision in the Code, which effectively disregards the transaction for tax purposes, I.R.C. §1001(c).
 Supra Note 1.
 Id. at *230.
 I.R.C. §2701(a)(1).
 Fundamentals of Estate Tax Planning, at *231.
 Id. at *232.
 I.R.C. §2704(a).
 26 C.F.R. §25.2704-1(a)(1).
 26 C.F.R. §25.2704-1(a)(2)(iv).
 26 C.F.R. §25.2704-1(a)(2)(v).
 26 C.F.R. §25.2704-1(b).
 26 C.F.R. §25.2704-1(c).
 I.R.C. §2704(a)(1).
 I.R.C. §2704(a)(2).
 I.R.C. §2704(b).
 I.R.C. §2704(b)(2).
 26 C.F.R. §25.2704-2(b).
 26 C.F.R. §25.2704-2(c).
 Kerr v. Comm’r, 113 TC 449 (1999).
 Id. at *473.
 81 F.R. 51413, 51420-51423.
 Supra Note 21.
 81 F.R. 51413, 51420 (“The term applicable restriction means a limitation on the ability to liquidate the entity, in whole or in part (as opposed to a particular holder’s interest in the entity), if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor’s estate, and/or any member of the transferor’s family, either along or collectively. See § 25.2704-3 for restrictions on the ability to liquidate a particular holder’s interest in the entity.”).
 Supra Note 23.
 81 F.R. 51413, 51422-51423; non-family members may limit family members’ liquidation rights where (A) the non-family member has held the interest for at least three years, (B) for corporations, the non-family member’s interest is at least ten percent of the value of all equity interest, and for other entities recognized for federal tax purposes, the value is ten percent of capital and profits (like in partnerships), (C) non-family members hold at least twenty percent of the value of all equity interest in corporations, and the same percentage for other federal taxed entities’ capital and profits, and (D) each non-family member, as an owner, has a put right as defined in 25 C.F.R. §2704-3(b)(6) of the proposed regulation.
 Kerr v. Comm’r (5th Cir., 2002).
 Ashlea Ebeling, Treasury to Close Estate Tax Valuation Discounts Loophole, Family Businesses Cry Foul, Forbes Magazine (Aug. 3, 2016 at 3:34 pm) (https://www.forbes.com/sites/ashleaebeling/2016/08/03/treasury-to-close-estate-tax-loophole-family-businesses-cry-foul/#6f7026062ed5).
 Zollars, IRS Proposes Changes, Current Federal Tax Developments (Aug. 4, 2016). (https://www.currentfederaltaxdevelopments.com/blog/2016/8/4/irs-proposes-changes-to-regulations-under-2704-meant-to-reverse-kerr-decision).