Family limited partnerships (“FLPs”) and limited liability companies (“LLCs”) are popular estate planning vehicles. This is because substantial discounts for lack of control and lack of marketability may be applicable when valuing gifts of non-controlling interests of these entities. The increasing popularity of these estate planning vehicles has lead to increased scrutiny and challenges from the IRS. The IRS has utilized several strategies to attack valuation discounts applied to family-owned entities. One strategy is Internal Revenue Code Section 2704.
Section 2704 was enacted in 1990 to limit perceived abusive discounts. The IRS was concerned that taxpayers were utilizing operating agreement and partnership agreement restrictions to artificially lower the value of a gifted interest. Some agreements restrict the ability of a member or partner to force a liquidation of the entity. If present, these restrictions may result in high valuation discounts. Section 2704 requires that these restrictions be disregarded when estimating the fair market value of a gift between family members. Section 2704 does not apply to restrictions imposed by federal or state law.
The IRS has tried to expand Section 2704 to cover issues beyond liquidation restrictions. In particular, the IRS has argued that discounts should not be allowed for gifts between family members when the transferee’s family has control of the entity. To date, courts have generally rejected this argument.
Section 2704 appears to give the IRS the authority to issue regulations regarding the implementation of Section 2704. Speaking at the ABA Tax Section Meeting, Cathy Hughes indicated that the IRS may switch tactics by altering Section 2704 to disallow discounts. These new Section 2704 regulations might be released by mid-September 2015. It was indicated that the new regulations would be similar to restrictions in President Obama’s budget proposals from 2010 to 2013.
It is not clear what the final restrictions will say or even if the IRS has authority to make such changes. However, it appears that changes to Section 2704 are imminent. The proposed changes will affect FLPs and LLCs that operate as holding companies. The proposed changes will not be applicable to closely held operating businesses. Some industry experts believe the proposed changes could be made effective as of the date of the release. If changes are made effective as of the date of release, there would be no grandfathering of existing entities. Even if grandfathering was permitted, the entity must have been created prior to the release of the changes. Thus, individuals planning to make gifts or create family-owned holding companies should accelerate those plans.
