IRC 2704: Rules for Family Business Valuations

Valuing an interest in a family-controlled business for federal gift and estate tax purposes presents unique challenges. The standard for these taxes is the asset’s fair market value, or the price it would command on the open market. While this is simple for public companies, valuing a closely held family business with no active market is far more complex. This complexity allows families to structure their businesses and transfers to affect the valuation of those interests for tax purposes. As a result, specific tax rules were created to address situations where a reported value might not reflect the family’s overall economic reality.

The Problem of Artificial Valuation Discounts

A concept in valuing a closely held business interest is the application of valuation discounts. One common discount is for “lack of marketability,” reflecting that an interest in a private family business is illiquid and cannot be sold as easily as public stock. An investor would pay less for this type of asset.

Another discount is for “lack of control,” also known as a minority interest discount. This applies when the transferred interest does not give the new owner power to control business decisions, such as compelling liquidation or dictating dividend payments.

Before specific rules were enacted, families could structure entities to maximize these discounts. For example, parents could place a business in a family limited partnership and gift minority interests to their children over time. Even though the family retained complete control, each gift was of a minority, non-marketable interest. Appraisers could then apply substantial discounts, sometimes over 50%, allowing wealth to be transferred at a much lower tax cost.

Disregarding Lapsing Voting and Liquidation Rights

To address these valuation strategies, Congress enacted Internal Revenue Code (IRC) Section 2704. Section 2704(a) targets the treatment of “lapsing rights” in family-controlled corporations and partnerships. A lapsing right is a voting or liquidation right that is restricted or disappears upon its transfer. For example, a senior family member may hold stock with enhanced voting rights that evaporate when gifted to a child, converting it to an ordinary share.

The rule under IRC Section 2704(a) triggers when two conditions are met. First, the individual holding the right and their family members must control the entity immediately before the transfer. “Control” means holding at least 50% of the stock or partnership interests. A “family member” includes the individual’s spouse, ancestors, lineal descendants, siblings, and their spouses.

If these conditions are met, the lapse of the right is treated as a taxable transfer. The value of this transfer is the difference between the interest’s value with the rights intact and its value after the lapse. This amount is subject to gift or estate tax, negating the valuation benefit of the disappearing right.

Ignoring Certain Restrictions on Liquidation

IRC Section 2704(b) deals with “applicable restrictions.” This provision prevents families from depressing value by imposing liquidation limitations that are more stringent than what state law requires. An applicable restriction is any limitation on liquidating the entity that the family has the power to remove after the transfer.

This rule applies if the family controls the entity, using the same definitions as the lapsing rights rule. For example, a partnership agreement may require unanimous consent to liquidate, while state law only requires a majority vote. If the family holds a majority interest, the unanimity requirement is an applicable restriction because they can amend the agreement.

When an applicable restriction is identified, it is ignored for valuation purposes. The interest is valued as if the less-restrictive state law standard applies, often resulting in a higher valuation based on the entity’s liquidation value.

Impact of the Withdrawn Proposed Regulations

In 2016, the U.S. Treasury Department and the IRS issued proposed regulations to expand the reach of IRC Section 2704 and further limit valuation discounts for family businesses. The proposals included a new class of “disregarded restrictions” and a “deemed put right,” which would have forced an interest to be valued as if the owner could sell it back to the company for a minimum value. These changes would have effectively eliminated most lack of control and marketability discounts.

The business and estate planning communities reacted with widespread opposition. Critics argued the regulations were an overreach of authority that would make succession planning prohibitively expensive. The concern was that the rules would value family-held interests as if they were readily marketable, which did not reflect the economic reality for a minority interest holder.

In response to the backlash, the Treasury Department announced in October 2017 that it was officially withdrawing the proposed regulations. This action returned the legal landscape to the established framework of IRC Section 2704(a) and (b), preserving the ability for family businesses to use traditional valuation discounts.