Proposed Regulations May Limit Discounts on Family Transfers – Guidance on IRS Section 2704

by: Smith and Howard

January 28, 2017

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Time may be running out for restaurant owners to take discounts on transfers to family members. On August 2, 2016, the Department of the Treasury issued proposed regulations under IRC Section 2704 in response to perceived abuses in the use of valuation discounts. Currently, owners transferring non-controlling interests in privately held companies are able to consider discounts for lack of control and discounts for lack of marketability. Discounts for lack of control relate to the inability of non-controlling interest holders to impact the strategic direction of the entity. Discounts for lack of marketability account for the lack of a ready market to sell privately held interests.

The provisions of the IRS 2704 proposed regulations that may have the most impact on restaurant owners seeking to transfer wealth to family members include:

Transfers Within Three Years of Death

Under Section 2704(a) of the proposed regulations, if a transfer resulting in a restriction or elimination of a liquidation right occurs within three years of the transferor’s death, the transfer is treated as if it occurred at death. The effect of this three-year rule is that the transferred interest would be included in the transferor’s gross estate at liquidation value.

Applicable Restrictions

Applicable restrictions will not be considered when valuing interests transferred to family members under Section 2704-2 of the proposed regulations unless certain requirements are met. Section 2704-2 defines an applicable restriction as “a restriction that limits the ability to liquidate the entity if the limitation lapses or the liquidation right may be removed by the transferor or the transferor’s family.”  Applicable restrictions include restrictions on withdrawal rights and other restrictions on liquidation rights imposed under the terms of the entity’s governing documents and under local laws. Exceptions include:

  • Commercially reasonable restrictions on liquidation rights considered compulsory by an unrelated person providing capital to the entity.
  • Restrictions imposed by federal or state law (but only under certain conditions).
  • Each holder of an interest must hold a “put right,” which allows them to receive cash or property (not including notes unless certain conditions are met) at “Minimum Value” (defined as the interest’s share of the net value of the entity on the date of liquidation or redemption) within six months of the notice of the intent to withdraw.

Disregarded Restrictions

Under Section 2704-3 of the proposed regulations, when valuing transferred interests to a family member where the transferor’s family controlled the entity (meaning holding at least 50 percent of either the capital or profits interests) immediately before the transfer, applicable restrictions limiting the ability to liquidate the transferred interest will not be considered in the value of the transferred interest. Section 2704-3 states that, “disregarded restrictions includes one that (a) limits the ability of the holder of the interest to liquidate the interest; (b) limits the liquidation proceeds to an amount that is less than a minimum value; (c) defers the payment of the liquidation proceeds for more than six months; or (d) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.”

While transferring ownership to a nonfamily member may seem like a viable option to avoid the control provision, the proposed regulations stipulate that interests transferred to non-family members are to be disregarded unless certain stringent requirements (including a holding period of at least three years prior to the transfer) are met as outlined in Section 2704-3.

If an applicable restriction is disregarded, the inability to liquidate and, thus, a discount for lack of marketability, is not considered in valuing the transferred interest, resulting in a higher value.

The IRS held a public hearing on December 1, 2016, to discuss the proposed regulations. Over three dozen individuals spoke, most of them in disagreement with the proposed regulations. On January 13, 2017, the AICPA issued a letter urging the  Treasury and the IRS to formally withdraw the proposed regulations, stating they are “overly broad and expand the breadth of section 2704 in a manner not contemplated by Congress.” Stay tuned as we continue to follow developments.


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By Dr. Tami Bolder. This article originally appeared in BDO USA, LLP’s “Selections” newsletter (Winter 2016). Copyright 2016 BDO USA, LL. All rights served.

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