If you own minerals in a corporation, partnership, limited liability company or similar business
arrangement, the Internal Revenue Service (IRS) has recently issued some new proposed
regulations dealing with Internal Revenue Code Section 2704 (Section 2704) that could be of
interest to you.
The IRS believes that families are undervaluing intra-family transfers of ownership interests to
gain an advantage for estate, gift and generation-skipping tax purposes.
These new proposed regulations serve as an alert to taxpayers. They tell taxpayers how the IRS
intends to interpret Section 2704, which will include a controversial concept of valuing an intra-
family transfer as only involving a single taxpayer. The proposed IRS valuing concept basically
eliminates, at the worst, or severely restricts, at the best, any previously allowed use of lack of
control and marketability valuation discounting for an intra-family ownership transaction.
Thus, the IRS will not allow discounting methodology that would be used if the same ownership
transaction involved a non-family member. These new proposed regulations also appear to
attempt an override of twenty-some years of court decisions (Section 2704 was enacted in 1990
and these are the first regulations on Section 2704 that have been proposed), many of which
allowed the type of discounting that the proposed regulations, as drafted, propose to stop.
Here’s an example of what the Section 2704 proposed regulations would do to an intra-family
ownership transaction: Consider, some years back when doing some asset planning, Dad and
Mom set up a limited liability company (LLC) to hold various mineral assets the couple held.
Now, while doing some estate and family tax planning, they decide to gift a twenty percent
interest in the LLC to each of their two children. The LLC is currently valued, in total, at
$500,000. According to the LLC, the interest to be gifted to each child cannot be freely
marketed, nor does the interest have the ability to control anything related to the operation of
the LLC. Based on valuation methodology and prior court cases, a valuation discount of twenty
to forty percent, maybe even more, would be allowed for each interest being gifted, making the
gift to each child valued in a range of $60,000 to $80,000. Under the IRS proposed regulations,
each child’s gift would be valued at $100,000. It is also worth noting for this example, that
Section 2704 only references corporations and partnerships; however, the proposed
regulations include limited liability companies and other similar entities and business
arrangements.
The IRS has scheduled a hearing on the proposed regulations for December 1, 2016. The
hearing is being held to allow taxpayers and interested parties an opportunity to make
comment on and question the content of the proposed regulations. The hearing comments
and questions may not convenience the IRS to change anything in the proposed regulations.
However, there should be plenty of comments and questions for the IRS to consider, which
should also give the IRS some concern for, immediately after the hearing, moving the proposed
regulations to a higher level, as temporary or final regulations, which would require taxpayers
to follow the higher regulations.
The IRS will finalize some form of valuation restriction regulations covering Section 2704 relate
to intra-family ownership transactions; perhaps, not as severe as the current proposed
regulations, that depends on the hearing. But, a best guess of when the changes would take
place appears to be in 2017. However, that delay is not something that can be counted on if
you are considering an intra-family ownership change, whether such ownership change
involves minerals or not, the same new rules will apply. But, don’t rush into a family business
ownership change just to get it done before the valuation rules change. With the estate and
gift tax exclusions currently being over $5 million for each person, the change in discounting
rules may not result in any change to your transaction for tax purposes. Therefore, now would
be the time to consider if your family business ownership planning would be affected by the
Section 2704 proposed regulation changes, and if it is, or, is not, act accordingly.