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Family Businesses Dodge a Bullet

Section 2704 of the Internal Revenue Code was enacted in 1990 to limit the applicability of valuation discounts for intra-family transfers of interests in certain family partnerships and LLCs. Such discounts have long been an important component of high-end estate planning strategies, significantly reducing the federal estate and gift taxes payable on the transfer of assets from one generation to the next. With proper planning, discounts for lack of marketability and minority ownership have enabled families to transfer assets to lower generations for significantly less than fair market value, with combined discounts sometimes reaching 30 to 40 percent or more.

On August 2, 2016, the IRS issued proposed regulations under Section 2704 that sought to make sweeping and very significant changes to the valuation of interests in many family-controlled entities for estate, gift, and generation-skipping transfer tax purposes. The primary focuses of the proposed regulations were treating the lapse of voting or liquidation rights as an additional transfer and disregarding certain restrictions on liquidation in determining the fair market value of a transferred interest.  The effect of the proposed regulations was to eliminate or greatly restrict the minority interest and lack of marketability discounts as set forth above.

The proposed regulations released last year were met immediately with significant criticism for, among other things, being overly broad and unclear. A public hearing on the proposal occurred in December of 2016 and lasted six hours with over 28,000 comments received. A majority of such comments called for the proposals to be withdrawn.

In response, President Trump issued an executive order in April of 2017 instructing the Treasury Department to review all regulations issued in 2016 to identify any that would impose an undue financial burden on U.S. taxpayers, add undue complexity to the federal tax law, or exceed the IRS’ statutory authority. On October 2, 2017, the IRS announced that they “now believe that the proposed regulations’ approach to the problem of artificial valuation discounts is unworkable.” As a result, the Treasury Department announced that it would withdraw the proposed regulations under Section 2704. The IRS formally withdrew the proposed regulations on October 17, 2017.

This is welcome news to closely-held business owners and their families. With the withdrawal of the proposed Section 2704 regulations, the use of liquidation restrictions to reduce the valuation of a closely-held family business continues to be an effective wealth transfer planning tool. If you own a closely-held family business and have not yet undertaken an analysis to determine the best method for transferring ownership of your business to the next generation, contact us to discuss what the next step is to ensure that you maximize the options available to avoid paying any unnecessary gift or estate taxes.