Tax Code Section 2704
Section 2704 was enacted in 1990 as part of Chapter 14 with the aim of limiting discounts for certain family partnerships or limited liability company interests that are transferred to family members and to prevent strategies that were being used to artificially lower estate and gift tax liability.
Under the new proposed guidance tax code, Section 2704 was intended to curb abuses in which valuation discounts were being used solely to avoid paying estate tax on transfers of interests in closely held businesses. The rules imposed by the IRS have generated strong protests from family business owners, practitioners and lawmakers, who say they are too broad. The IRS has currently received over 10,000 comment letters on the proposed regulations—all of which need to be reviewed and digested before any decision can be made. Therefore, the futures of the regulations are tied to two critical areas: (i) what happens to the rules themselves? and (ii) what happens to the estate tax as a whole?
One of President Trump's core campaign promises was to repeal the estate tax, which would essentially make Section 2704 unnecessary. Many believe that if there is no estate tax, then a business valuation is not needed, however, what people may not be aware of is if estate tax is eliminated President Trump is proposing a tax on capital appreciation in its place. If this is put into effect then the proposed Section 2704 regulations are pertinent in determining fair market value of a business in order to calculate estate tax.
During his campaign, Trump proposed eliminating the death tax and in its place taxing the capital gains held until death above an exemption amount of $10 million. What does this mean from a valuation stand point when preparing an estate tax return? Valuing Capital Gains will need to be a priority.
This would not clear up the current valuation issues proposed under IRC Section 2704 instead, valuation issues would persist under a capital gains tax at death. If the Trump administration and Republican lawmakers try to replace the current transfer tax system, they will have to figure out how assets will be valued for purposes of the new capital gains tax.
The Harrison Case is a specific example of Section 2704(a), which provides that if an individual and his or her family hold voting or liquidation control over a corporation or partnership, the lapse of a voting or liquidation right shall be taxed as a transfer subject to gift or estate tax. That provision, often referred to as the “Anti-Harrison Rule,” was created to prevent outcomes like the 1987 decision in the U.S. Tax Court case Estate of Harrison v. Commissioner, T.C. Memo 1987-8. As a result of the Harrison decision, the estate tax appraisal of the decedent's limited partnership interest was valued at less than what it was worth in the hands of the decedent right before his death and to family members immediately afterward.
As of now, President Trump has not mentioned plans for the gift tax. If the proposed changes are not repealed, than the gift tax would still be governed by Section 2704. In essence, there would be two valuation regimes, one at the time of death using the capital gains taxes, and a second gift tax that would still fall under Chapter 14. This could potentially make for a very confusing landscape.
With the abundance of comment letters and the proposed changes from President Trump it seems unlikely that the 2704 will become final in its current state. There will certainly be some sort of change, but, obviously the details are still unknown and it's too early to determine what the revised Section 2704 proposal will look like, or if President Trump's estate tax proposal would fall outside of Section 2704(a).
For more information on these proposed changes and how they may affect you, contact Pat Rafanelli, Valuation Manager at Grassi & Co., at email@example.com.