An Overview of the IRC Section 2704 Proposal

Section 2704 of the Internal Revenue Code (IRC) pertains to family-controlled corporations and partnerships, specifically dealing with gratuitous transfers between family members in connection with the family owned business. According to IRC, the IRS can treat some of these transfers as taxable transfers. Section 2704 creates special valuation rules for federal gift, estate, and generation-skipping transfer taxes. Currently, Section 2704 provides for certain reductions in the transfer tax value of an interest in a family-controlled corporation or partnership. As such, many individuals use family businesses for succession planning purposes because individuals can make gifts of interest in the family business entity to family members at discounted tax rates.

This year, the IRS has proposed changes to Section 2704 that would significantly change the law regarding family owned business and gratuitous gifts to family members. Before delving into the proposed changes, it is important to note that these are not definite changes. There is a 90-day public comment period and a public hearing on these proposed changes scheduled for December 1, 2016. Broadly, the proposed changes to Section 2704 would reduce the valuation discounts currently used to value transfers between family members.

The first proposed change deals with deathbed transfers. Currently, Section 2704 provides a tax exception the lapse of voting or liquidation rights if the lapse results from the transfer itself, if the interest keeps the voting or liquidation right after the transfer. This rule allows the individual transferring the interest to escape taxation on the loss of the right to vote or liquidate. The IRS believes that this exception should not be permissible if the transfer occurs at or soon before the transferring individual’s death. The proposed change would limit this exception to transfers that happened more than three years before the transferring individual’s death. Therefore, if the transfer occurs less than three years before the transferring individual’s death, the value of the lapsed interest would be considered part of the transferring individual’s estate for tax calculation purposes.

Second, the proposed changes expand the types of family-controlled businesses subject to Section 2704. This would include limited liability companies (LLC), along with corporations and partnerships. The definition of “control” as it pertains to family management is clarified to mean 50% of capital or profit interests in the entity or the power to liquidate the entity.

Additionally, the proposed changes would eliminate one “applicable restriction” of Section 2704. State-imposed restrictions are no longer taken into consideration for valuation purposes. These state-imposed restrictions can also be overridden by agreement of the family members. The proposed changes also affect “disregarded restrictions”. Essentially, the changes would look at the value of what the interest holder would receive if they liquidated the interest, rather than looking at the interest holder’s ability to liquidate. This would affect the valuation of the transferred interest.

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