IRS Proposed Changes – §2704
For many years, the IRS has discussed proposing changes to sections of the federal tax code in order to curb perceived abuses arising from strategic related-party (family business) transactions. In August 2016, the Service released their proposal, which, if implemented, would treat the transfer of fractional equity interests between related parties differently than other transactions. The results of these proposed changes to the tax code are anticipated to have detrimental consequences for family-owned businesses.
It is easy to prove, from publicly available data, that a buyer of a business typically pays a premium over the value of non-controlling equity interests in order to gain control of the business. “Control” refers to, primarily: the ability to sell a business or a portion (fractional interest) of the business, to make acquisitions or divestitures, the discretion to pay dividends to shareholders, to change the capital structure, to take a company public, to hire and fire employees, etc. The inverse is also true in that a party who owns a non-controlling interest in a company is typically “along for the ride”. A non-controlling shareholder can make none of the decisions listed above and oftentimes their holdings are subject to restrictions on the sale of their respective interest in the business. As such, the non-controlling interest in an enterprise or an asset (typically, revenue generating real estate or intellectual property) is less appealing (less “marketable”) to a potential investor as the investor has little, if any, control in the decision making of the business or the asset. Substantial market data reflects this lack of control when minority interests are exchanged versus that of a controlling interest. Therefore, buyers of non-controlling shares pay less for their respective shares/units as reflected in the valuation discounts applied to quantify the lack of control.
When a valuation professional provides an opinion as to the fair market value of a non-controlling interest in a business, recognized theory and methodology are applied to arrive at an opinion of the fair market value of the non-controlling interest, including the consideration of adjustments (“discounts”) to the pro rata value. These adjustments recognize the lack of control and lack of ready marketability of the non-controlling position.
Section 2704 of Chapter 14 of the Internal Revenue Code (“IRC”) was enacted in 1990 as a response to estate freeze strategies by estate tax planning professionals and their clients. Section 2704 (a) addresses non-voting and minority ownership interests. Section 2704 (b) was written, in part, to address restrictions in shareholder agreements, for example, written to purposely depress the value of an interest being passed among familial parties while not affecting the economic interest of the transferee. The IRS is proposing changes to 2704 that will not only limit or eliminate certain commonly accepted valuation discounts, such as lack of control and lack of marketability, but also include clawback provisions for related-party transactions where the seller or transferor dies within a three-year period after the transaction.
Currently, the IRS requires valuations utilize the commonly known definition of Fair Market Value as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
The proposed revisions to 2704, in essence, cannot utilize this definition of Fair Market Value for interfamily transactions. If these revisions are enacted, a valuation expert will be expected to apply a standard that implies a transaction between a “willing seller” and a “related, known buyer”, irrespective if the buyer is willing or unwilling to purchase non-controlling shares at the seller’s price.
It is the IRS’s position in the proposed regulations that ALL those who sell, gift, or transfer non-controlling interests in operating entities to family members do so at a value other than Fair Market Value as the IRS is assuming ALL related shareholders:
Will always act in unison;
Will always agree on all matters of economic interest;
Will always be paid a fair dividend; and
Therefore, valuation discounts, such as lack of control and lack of marketability, should not be applied.
As proposed, these regulations imply an inequity. The ramifications and consequences will be detrimental to closely-held businesses, especially to family-owned businesses who struggle to survive from one generation to the next. The IRS’s proposed regulations promote a broad interpretation of their authority and the increase in transfer tax will have a devastating effect on business continuity.
Marshall & Stevens has performed thousands of fractional interest valuations of businesses and assets for a variety of purposes, such as: buy-sell consideration, recapitalization, estate and gift taxation, and litigation support for divorce and shareholder dissention. It is our experience that related party shareholders do not always agree on matters of business as they have their own respective economic interests to consider.
Furthermore, many of our valuation experts are certified through the American Society of Appraisers (“ASA”) and must adhere to appraisal standards as governed by the Uniform Standards of Professional Appraisal Practice (“USPAP”).¹ Since the standard of value proposed by the IRS will no longer be Fair Market Value as defined in Section 2031 of the Estate Tax Regulations and 2512 of the Gift Tax Regulations, the valuation analysts will need to opine on a “hypothetical” value to be in compliance with USPAP. This conflict in definition creates different values for the same non-controlling shareholder equity interest depending on the potential transaction being contemplated.
The Treasury Department is accepting comments regarding the proposed revisions to 2704 during a 90-day comment period expiring November 2, 2016. A public hearing is scheduled for December 1, 2016. We urge everyone with a vested interest in the outcome of these proposed regulations to provide their comments and concerns. While we expect many important questions will be answered subsequent to December 1st, waiting until after Congress makes its ultimate decision may be detrimental to those owners hoping to take advantage of the current tax code provisions for their succession planning.
At this time, we cannot say with certainty whether the changes to Section 2704 will be implemented as proposed, whether the changes will be prospective or retroactive, or whether they will survive legal challenge. They will most likely, however, be implemented immediately after becoming final, with the exception of the disregarded restriction rules which will be implemented within 30 days of being made final. As such, many tax planning professionals recommend a contemplated sale, gift, or transfer be executed before November 30, 2016.
¹USPAP is the generally recognized ethical and performance standards for the appraisal profession in the United States. USPAP was adopted by Congress in 1989, and contains standards for all types of appraisal services, including real estate, personal property, business and mass appraisal.