September 01, 2015

It has been widely reported that the long-awaited Treasury regulations for Section 2704 of Chapter 14 of the Internal Revenue Code will be published in Fall 2015. The regulations are generally seen as a reinstitution of the family attribution theory, which the IRS supposedly abandoned with the publication of Revenue Ruling 93-12.

Since the inception of the family limited partnership (“FLP”), the IRS, with very limited success, has attempted to persuade the courts and Congress that these entities are nothing but a tax device. Most of its arguments (gift on formation, disappearing value, recycling value, lack of business purpose, etc.) ultimately rely upon the assumption of family attribution. It now seeks to do through regulation what it could not convince Congress to enact and the courts decide.

Of course, the question everyone is asking is, “How restrictive will the 2704 regulations be?” The best guess as to the nature of the possible restrictions is to review “Modify Rules on Valuation Discounts” appearing in the Obama Greenbook of 2012. The IRS believes that judicial decisions and changes in state law have circumvented the definition of “applicable restrictions” and that a new, more narrow definition of restrictions is required.

[The Greenbook’s] proposal would create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family. Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.

Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations. This begs the question: “If state law is deemed to be too restrictive, what standard could this possibly be?”

The Greenbook offers a possible olive branch: “Regulatory authority would be granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of section 2704 if certain standards are met.” One wonders what these “certain standards” might be. Also, will this safe harbor be in the forthcoming regulations?

Some members of Congress have attempted to introduce legislation that would eliminate valuation discounts for FLPs but this has been unsuccessful. In January 2009, Congressman Earl Pomeroy (D-ND) introduced a bill that would have set future estate tax rates (prior to expiration of the estate tax on December 31, 2009) and also tacked on a provision to severely restrict the use of valuation discounts in family-controlled entities.1 The bill died in committee. Rep. Pomeroy did introduce another estate tax bill later in the year but this one contained no mention of valuation discounts.

The Greenbook seems to blame the courts and state legislatures for not seeing things their way:

Judicial decisions and the enactment of new statutes in most states, in effect, have made section 2704(b) inapplicable in many situations by recharacterizing restrictions such that they no longer fall within the definition of an “applicable restriction”.

Will the Department of the Treasury by its new regulation be able to so easily ignore state law? Certainly this will be challenged.

With respect to the courts, legal challenges to the new 2704 regulations will likely turn on what the courts see as the intent of Congress when it enacted Chapter 14 as a part of the Omnibus Budget Reconciliation Act (“OBRA”) of 1990. For challenges of this type, legal authorities point to the Supreme Court case of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute… Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute.

Was Congress’ intent with respect to valuation discounts clear? The Senate Finance Committee Conference Report for OBRA 1990 seems a bit contradictory. In one section, it states that the conference agreement is not intended to reduce the ability of taxpayers to avail themselves of valuation discounts permitted under “present law.” However, the report also grants the Treasury Secretary the authority to disregard restrictions which reduce value for transfer tax purposes but which do not ultimately reduce value of the interest to the transferee. This circles back to the long-held presumption that state law governs what is an acceptable restriction.

If Treasury cites the preceding sentence as evidence of Congressional intent, then it seems it must prove that the discounted value is less than “the value of the interest.” What measure other than Fair Market Value would be applicable here? If Treasury is in the position of having to prove that a fractional interest in a partnership is equal to its pro-rata share of the value of the assets (or enterprise value) then it will have an uphill battle.2 Treasury may have its theories as to why valuation discounts are inappropriate but it cannot rely upon value as an argument.

Obviously, Treasury is contending that, because of family attribution, discounts are illusory. Because family members are deemed to act in concert, all interests (whether large or small or general partner or limited partner) are valued the same proportionately. It would seem if Treasury is to prevail on this point, it may have to convince the court that winds up hearing this matter that the family attribution doctrine was built into the statute from the get-go and that Congress understood this. That may be difficult to prove.

Speaking to the evolution of the enactment of Chapter 14 and, more specifically, the first impression of Section 2704, Richard Dees comments: “…the literal language of section 2704(b) would have eliminated minority and lack of marketability discounts in wholly-owned family companies and maybe others. Almost immediately after this glitch was discovered, Treasury and congressional staff agreed to interpret section 2704 narrowly so as to leave those discounts unaffected. For purposes of interpreting section 2704(b), at the very least, Congress’ unwritten rule that traditional discounts were to be unaffected by chapter 14 — contained only in its legislative history — took priority over the actual statutory language.”3

It seems now Treasury wants to erase the unwritten rule.

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1 See: William H. Frazier. “The Pomeroy Bill Sledgehammer.” Trusts & Estates, May 2009.
2 Perhaps the most famous case establishing the validity of valuation discounts is the Supreme Court decision in the Estate of Mary Frances Smith Bright v. U.S.
3 Dees, Richard L., Time Traveling to Strangle Strangi (and Kill the Monster Again), Part 1. Tax Notes, Vol. 116, No. 7, August 13, 2007. Available at SSRN: http://ssrn.com/abstract=1019395.