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Attorney Criticizes Possible Changes to Valuation Discount Rules

AUG. 31, 2015

Attorney Criticizes Possible Changes to Valuation Discount Rules

DATED AUG. 31, 2015
DOCUMENT ATTRIBUTES

 

August 31, 2015

 

 

The Honorable Mark Mazur

 

Assistant Secretary of Tax Policy

 

Department of the Treasury

 

1500 Pennsylvania Ave, N.W.

 

Washington, D.C. 20220

 

 

The Honorable William J. Wilkins

 

Chief Counsel

 

Internal Revenue Service

 

1111 Constitution Ave., N.W.

 

Washington, D.C. 20224

 

Re: Possible New Regulations under Internal Revenue Code Section 2704(b)

 

Dear Messrs. Mazur and Wilkins:

Richard L. Dees,1 the author of this letter, is concerned by a report that Treasury and the Internal Revenue Service will propose in the near future new regulations under Internal Revenue Code2 Section 2704(b) similar to those titled "Rules to Modify Valuation Discounts," which the Administration last proposed in 2013 (the "Greenbook Proposal"). The author believes for the many reasons set forth below that such regulations, if issued in that form, would be invalid.

The legislative title to the Greenbook Proposal suggests that the purpose of the new regulations will be to increase the value for federal transfer tax purposes3 of family-owned equity interests in family companies by limiting valuation discounts. If so, the regulations would result in the estate of an owner of an equity interest in a family business paying a higher estate tax than the estate of an owner of an identical equity interest in a non-family business. However, IRC Section 2704(b) was enacted in 1990 as part of Chapter 14 with the intent of protecting traditional valuation discounts and narrowing the circumstances in which family companies would be subject to discriminatory transfer tax rules. The Greenbook Proposal called for statutory changes by which Congress would confer new regulatory authority under IRC Section 2704(b) on the IRS. The author believes that in the absence of such new authority, regulations under IRC Section 2704(b) mimicking the terms of the Greenbook Proposal would be invalid as contrary to the origin, purpose and scope of the current statute.

Some have speculated that the new regulations would be directed only at family limited partnerships holding investment assets.4 However, neither IRC Section 2704(b) nor any other part of Chapter 14 distinguishes between passive investment companies and active businesses, because of the many unanswerable questions it prompts. Is a holding company active or passive if it owns active businesses through subsidiaries? Is the parent who crop shares the farm with her farming children active or passive? When does rental real estate become active or passive? What if the real estate is passively rented to the taxpayer's active business? What about working capital? Congress understood when it enacted Chapter 14 that drawing those distinctions is impossible; Treasury is not authorized to create such distinctions now. From the Greenbook Proposal, it appears that the regulations might target limited partnerships, but such regulations would necessarily include limited liability companies,5 which may be the entity type most often used for active businesses today.6 It is a myth that the proposed regulations would not impact family businesses.

When Congress added Chapter 14 of the Internal Revenue Code, IRC Section 2704(b)(4) gave Treasury the power to disregard restrictions imposed by an entity's organizational documents (other than existing restrictions delineated in Chapter 14), if those restrictions would have the effect of reducing the value of a transferred interest below what the value would be absent the restriction. However, Congress did not give Treasury or the IRS the power to substitute new provisions for the disregarded provisions, or to rewrite the state statutory law or common law that would apply in place of the disregarded provisions.

An item promising additional guidance regarding restrictions on liquidation under IRC Section 2704 first appeared in the IRS "Priority Guidance Plan" for 2003-2004. The promise of "Guidance" was changed to a promise of "Regulations" in the 2010-2011 plan. Meanwhile, in May, 2009, the Obama Administration first promulgated the Greenbook Proposal. Proposed statutory changes to IRC Section 2704(b) were contained in the General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals (such Explanations are informally known as "Greenbooks"). The proposal was repeated without substantive change in the Greenbooks for Fiscal 2011, 2012, and 2013. The Greenbooks for Fiscal 2014, 2015, and 2016, however, omitted the proposal. The last version of the Greenbook Proposal appeared in the Greenbook for fiscal 2013, released on February 13, 2012.

Congress has not adopted the expansion of IRC Section 2704(b) proposed by President Obama. In fact, a bill to that effect has never been introduced in Congress. Nevertheless, on May 5, 2015, BNA reported that in an ABA Tax Section meeting a representative of the IRS Office of Tax Policy stated that the Treasury will issue regulations in the near future under IRC Section 2704(b)(4). Reportedly, the representative said the form of the regulations will be similar to the Greenbook Proposal, although Congress has not passed that enabling legislation and likely never will.

The Greenbook Proposal would have expanded the scope of IRC Section 2704(b) as follows:

 

This 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. A disregarded restriction also would include any limitation on a transferee's ability to be admitted as a full partner or to hold an equity interest in the entity. For purposes of determining whether a restriction may be removed by member(s) of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family. 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. This proposal would make conforming clarifications with regard to the interaction of this proposal with the transfer tax marital and charitable deductions. (Emphasis added.)

 

I know of no published explanation for Administration's withdrawal of the Greenbook Proposal. It is clear, however, that the proposed legislation would have conferred authority that is not contained in the existing regulatory authority under IRC Section 2704(b)(4), which provides:

 

(4) OTHER RESTRICTIONS -- The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor's family, if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee. (Emphasis added.)

 

This provision authorizes Treasury by regulation to add a restriction to the list of restrictions that are to be disregarded if the restriction (a) is not a restriction addressed elsewhere in the statute; (b) reduces an interest's value for gift or estate tax purposes; and (c) does not "ultimately" reduce its value to the transferee. The sole authority conferred on Treasury is to place a restriction meeting the statutory criteria on the "disregarded" list. Treasury is not authorized to further: (i) create a new category of "disregarded restrictions" based on assumptions and criteria that are not contained in the statute, for example, restrictions already covered by the statute or restrictions that do not reduce the value of a transferred interest below what the value would be absent the restriction; (ii) to prescribe that an interest subject to a disregarded restriction is to be valued in any manner other than by treating the restriction as if it did not exist and otherwise applying the organizational documents and applicable state law; or (iii) to disregard a restriction imposed by applicable state law. The Greenbook Proposal had as its goals enacting directly, or conferring authority to enact by regulations, both items (i) and (ii), and possibly item (iii). The point of the Greenbook Proposal was to confer the additional statutory authority necessary to enact these goals. The Greenbook Proposal never suggested that these goals could be accomplished under existing IRC Section 2704(b)(4) without any statutory change.

 

EXECUTIVE SUMMARY

 

 

  • The origin, legislative history, and purpose of Chapter 14 -- of which IRC Section 2704(b) is a part -- protects traditional valuation discounts and prohibits family attribution, unless specifically provided by Congress. New regulations like those in the Greenbook Proposal, therefore, would be inconsistent with Chapter 14's origin, legislative history, and purpose.

  • The courts will invalidate a regulation manifestly contrary to the intent of a statute, despite the regulation not explicitly contradicting the statute's language.

  • Regulations under IRC Section 2704(b) taking the form of the Greenbook Proposal would contradict the origin and purpose of Chapter 14, which preserved existing case law valuing a transferred equity interest without any consideration of its family ownership or family control of the partnership or corporation. The legislative history of Chapter 14 embraced the existing case law and rejected the uncertainty of IRC Section 2036(c), which Chapter 14 repealed.

  • Initially, the IRS and Treasury recognized in its regulations, rulings and training manual that part of the legislative history and purpose of Chapter 14 was to prevent the use of family attribution for transfer tax valuation purposes. Subsequently, the IRS reinterpreted Chapter 14, arguing that it meant an interest in a family partnership should be valued at its share of the partnership's net asset value, but the courts again rejected the IRS attempts to apply family attribution to ignore traditional minority interest and lack of marketability valuation discounts. The courts will be willing to invalidate any regulations similar to those in the Greenbook Proposal as inconsistent with the origin, legislative history and purpose of IRC Section 2704(b).

  • Regulations similar to those in the Greenbook Proposal would contradict the statutory requirements of IRC Section 2704(b)(4). Contrary to IRC Section 2704(b)(4), such regulations would (a) apply to restrictions covered by other parts of Chapter 14; (b) authorize the IRS to invent provisions to replace those disregarded restrictions; (c) permit the IRS to disregard restrictions that do not reduce the value of the transferred interest because of default state law; and (d) rewrite the definition of family. For all these reasons, those regulations would be inconsistent with the statutory language of IRC Section 2704(b) and, therefore, would be invalid.

  • If regulations similar to those in the Greenbook Proposal are adopted and held to be valid, there likely will be less tax revenue, not more: (i) increased estate tax revenue means less income tax revenue; (ii) increased gift tax revenues are unlikely to appear; and (iii) valuation methods are likely to evolve to circumvent the limits of any new regulations. The threat of costly and lengthy litigation over the validity of new regulations under IRC Section 2704(b) is the most compelling reason for Treasury and the IRS to refuse to propose new regulations.

 

I. IF THE TAXPAYER DEMONSTRATES THAT A NEW REGULATION IS MANIFESTLY CONTRARY TO THE PURPOSE OF IRC SECTION 2704(B), A COURT WILL INVALIDATE THE REGULATION, DESPITE ITS NOT EXPLICITLY CONTRADICTING THE STATUTORY LANGUAGE

The seminal case under Chapter 14 finding a Treasury Regulation was an unreasonable and invalid extension of the relevant Internal Revenue Code section is Audrey Walton v. Commissioner.7 In Walton, the full Tax Court found Treas. Reg. § 25.2702-3(e), Example 5 was an invalid interpretation of IRC Section 2702 because the regulation did not follow the origin and purpose of the statute.

The Tax Court found that the taxpayer had met its burden to overturn that regulation example, whether the taxpayer burden for overturning an "interpretive" regulation is used, or the taxpayer burden for overturning a "legislative" regulation is used. The Tax Court explained:

 

The regulations at issue here are interpretative regulations promulgated under the general authority vested in the Secretary by section 7805(a). Hence, while entitled to considerable weight, they are accorded less deference than would be legislative regulations issued under a specific grant of authority to address a matter raised by the pertinent statute. See Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843-844 (1984) (Chevron). United States v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982). A legislative regulation is to be upheld unless "arbitrary, capricious, or manifestly contrary to the statute." Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. supra at 843-844.

With respect to interpretative regulations, the appropriate standard is whether the provision "'implement[s] the congressional mandate in some reasonable manner.'" United States v. Vogel Fertilizer Co., supra at 24 (quoting United States v. Correll, 389 U.S. 299, 307 (1967)). In applying this test, I look to the following two-part analysis enunciated by the Supreme Court:

 

When a court reviews an agency's construction of the statute which is administers, it is confronted with two questions. 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 for 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, as would be necessary in the absence of administrative interpretation. 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. [ Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., supra at 842-843; fn. refs. omitted. ]

 

A challenged regulation is not considered such a permissible construction or reasonable interpretation unless it harmonizes both with the statutory language and with the statute's origin and purpose. See United States v. Vogel Fertilizer Co., supra at 25-26; National Muffler Dealers Association v. United States, 440 U.S. 472, 477 (1979) (National Muffler).

I pause to note that before the Chevron standard of review was enunciated by the Supreme Court, the traditional standard was simply "whether the regulation harmonizes with the plain language of the statute, its origin, and its purpose", as prescribed by the Supreme Court in National Muffler Dealers Association v. United States, supra at 477. As I have observed in a previous case, the opinion of the Supreme Court in Chevron failed to cite National Muffler and may have established a different formulation of the standard of review. See Central Pa. Sav. Association v. Commissioner, 104 T.C. 384, 390-391 (1995). In the case before us, I conclude that it is unnecessary to parse the semantics of the two tests to discern any substantive difference between them, because the result here would be the same under either.

Because section 2702 does not speak to the issue of the permissible term for a qualified annuity, Example 5 does not expressly contradict any statutory language. Accordingly, I focus on the statute's origin and purpose for further guidance.

 

As the Tax Court observed in Walton, uncertainty then existed about whether Chevron supplanted National Muffler in testing the validity of tax regulations. In 2011 the Supreme Court resolved this debate and held that the validity of a tax regulation is tested under Chevron. Mayo Foundation v. United States.8 The Mayo court noted that National Muffler considered a variety of factors that would not be considered under Chevron, and concluded that the Chevron approach prevails.

Mayo left open the question whether "legislative" and "interpretive" tax regulations continue to be subject to different tests in determining their validity under Chevron.9 The separate tests mentioned by the Tax Court in Walton appear to have support in the Chevron opinion itself, which states:

 

If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute. Sometimes the legislative delegation to an agency on a particular question is implicit, rather than explicit. In such a case, a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency. 467 U.S. at 843-844.

 

However, the Mayo opinion does not clearly acknowledge this distinction or say how it would be applied to legislative and interpretive tax regulations. Instead the Mayo opinion seems to read Chevron as applying a uniform test to all regulations, with "not arbitrary, capricious or manifestly contrary to the statute" and "reasonable interpretation" being different ways of describing the same test.10

As the Tax Court mentioned in Walton, Chevron did not answer whether the former test for determining the validity of a legislative regulation still applied. Nor did Mayo answer this question. The burden inherent in determining if a legislative regulation is valid may now be the standard for both interpretative and legislative regulations. Chevron and Mayo may be understood as applying the same test for overturning interpretive and legislative regulations. The Tax Court avoided resolving this uncertainty by concluding that the regulatory example in Walton was "manifestly contrary to the statute," which met the taxpayer's highest burden.

Although the Tax Court in Walton found the regulatory example did not expressly contradict the statutory language, the court found it to be "manifestly contrary to the statute", by focusing "on the statute's [IRC Section 2702] origin and purpose." Chevron and Mayo do not preclude consideration of the statute's origin and purpose in determining whether a regulation is contrary to the statute. Furthermore, with respect to a legislative regulation issued pursuant to a special grant of regulatory power such as that conferred by IRC Section 2704(b)(4), whether a regulation is "contrary to the statute" includes not only whether it is contrary to the statute it interprets, but also whether it is in compliance with the statutory provision granting the special power to regulate. As one commentator on Mayo has stated: "A regulation is valid only to the extent that it accords with the statutory delegation on which it is based. Thus, assuming that the argument has been properly raised, a court assessing a challenge to a regulation should identify the precise statutory language of the delegation in question, then determine whether the regulation is within the scope of that language."11

II. IF NEW TREASURY REGULATIONS UNDER IRC SECTION 2704(B)(4) TAKE THE FORM OF THE GREENBOOK PROPOSAL, THE REGULATIONS WILL BE INVALID AS MANIFESTLY CONTRARY TO THE ORIGIN AND PURPOSE OF, AND AS AN UNREASONABLE AND INVALID EXTENSION OF THE AUTHORITY GRANTED IN, IRC SECTION 2704(B)(4)

In the absence of any further Congressional authorization, any regulation that takes the form of the Greenbook Proposal will be invalid as contrary to the legislative history of Chapter 14 and beyond the authority granted Treasury by Congress in IRC Section 2704(b).

 

A. If the Regulations under IRC Section 2704(b)(4) Take the Form of the Greenbook Proposal Those Regulations Will Violate the Origin and Purpose of IRC Section 2704(b)

 

Regulations mimicking the Greenbook Proposal could permit valuing a transfer of an interest in a family business as if family attribution applied, which is clearly contrary to the origin and purpose of IRC Section 2704(b) and all other provisions of Chapter 14. IRC Section 2704(b)(4) authorizes disregarding a restriction not already disregarded under the statute, but it does not authorize changing the result of disregarding a restriction to something entirely new, as contemplated by the Greenbook Proposal. Rewriting the statutory language of IRC Section 2704(b)(4) in this way would be contrary to the origin and purpose of IRC Section 2704(b), which assumes that the organizational documents and state law would control once a restriction is disregarded.
1. Prior to the Passage of Chapter 14 in 1990, Case Law for Valuing Proportionately Held Family Enterprises with One Class of Equity Provided:

 

(i) That the legal rights and interests inherent in that property must first be determined under state law and only after that determination is made is federal tax law then applied to determine how such rights and interests will be valued for transfer tax purposes;

(ii) That transfers of non-controlling interests in family enterprises are to be valued the same way non-controlling interests in non-family enterprises are valued; and

(iii) That no special valuation premiums should result from family attribution in closely held family enterprises.

 

2. The Courts Rejected the Initial IRS Position in 1981 That Closely Held Family Businesses Should Be Valued Differently Than Closely Held Non-Family Businesses Because of Family Attribution
The courts consistently rejected the IRS position in revoked Rev. Rul. 81-25312 that no minority shareholder discount is allowed with respect to transfers of stock between family members if the family, in the aggregate, has control (either majority voting control or de facto control through family relationships) of the corporation. That ruling also states that the IRS would not follow the Bright case discussed below.

In Estate of Bright v. United States13 the decedent's undivided community property interest in shares of stock, together with the corresponding undivided community property interest of the decedent's surviving spouse, constituted a control block of 55% of the shares of a corporation. Because the community-held shares were subject to a right of partition the Fifth Circuit held that the decedent's own interest was equivalent to 27.5% of the outstanding shares and, therefore, should be valued as a minority interest, even though all the shares were to be held by the decedent's surviving spouse as trustee of a testamentary trust.

Propstra v. United States14 agrees with the result in Bright. Estate of Andrews v. Commissioner15 and Estate of Lee v. Commissioner16 both held that corporate shares owned by other family members cannot be attributed to an individual family member for purposes of determining whether the individual family member's shares should be valued as a controlling interest in the corporation.

For purposes of determining the fair market value of the gifts of interests in a family enterprise, the identity and intentions of the recipient of that interest are irrelevant. The standard is an objective test using hypothetical buyers and sellers in the marketplace and is not a personalized one which envisions a particular buyer and seller.17 Thus, the family relationship between the donor and donee and the family ownership in the business are ignored for valuation purposes.

In determining the value for gift and estate tax purposes of any asset that is transferred, the legal rights and interests inherent in that property first must be determined under state law. After that determination is made, federal tax law then takes over to determine how such rights and interests will be valued for federal transfer tax purposes.18 In its legislative history to various revenue acts, Congress has endorsed these principles, which had been developed under case law. For instance, the reports to the 1948 changes in the estate taxation of community property provide that those changes restore the rule by which estate and gift tax liabilities are to depend upon the ownership of property under state law.19

An excellent synopsis of the relevant case law and authorities for the proposition that state law controls in determining the nature of the legal interest that is transferred for estate tax purposes (in particular, a partnership interest) is found in a brief filed by the government in a Fifth Circuit Court case.20 The case concerned the estate taxation of a Louisiana partnership interest. The Justice Department, in one of its briefs in that case, provided that synopsis, which the Court quoted in its opinion:

 

It is now well established that state law is determinative of the rights and interests in property subject to federal estate taxation. In Morgan v. Commissioner, 309 U.S. 78 [626], 60 S. Ct. 424, 84 L. Ed. 585 (1940), the Supreme Court said (p. 80): 'State law creates legal interests and rights. The federal revenue acts designate what interests or rights, so created, shall be taxed.' Estate of Rogers v. Commissioner, 320 U.S. 410, 414, 64 S. Ct. 172, 88 L.Ed. 134 (1943); United States v. Dallas Nat. Bank, 152 F.2d 582 (C.A. 5th 1945); Smith's Estate v. Commissioner, 140 F.2d 759 (C.A. 3d 1944). See Aquilino v. United States, 363 U.S. 509, 513, 80 S. Ct. 1277, 4 L.Ed. 2d 1365 (1960); Commissioner v. Chase Manhattan Bank, supra [259 F.2d 231 (5th Cir. 1958)], p. 249; United States v. Hils (C.A. 5th 1963) [318 F.2d 56]. * * *

The courts must determine the substance of the state property law provisions and apply the estate tax provisions to the property interests so determined.21

 

Thus, among the relevant considerations in connection with determining the gift or estate tax value of a transferred partnership interest, or minority position in a corporation, are the liquidation restrictions and voting restrictions that are inherent under the organizational documents and default state law rules.

The IRS also argued prior to the passage of Chapter 14 that the dissolution and withdrawal rights possessed by a general partner would or could be transferred by that general partner's estate and, thus, would be a key relevant fact considered by a hypothetical willing buyer. That argument was also rejected by the courts. For instance, in Estate of Watts v. Commissioner,22 (a case decided in 1987 before passage of IRC Section 2704(b)(4)) both the Tax Court and the Eleventh Circuit allowed an 85% discount to liquidation value even though the decedent was a general partner who enjoyed, under applicable Oregon law, full dissolution rights during her life. Both courts reasoned that the transfer tax value of the partnership interest was what a hypothetical willing buyer would pay based upon his expectations as to whether or not the family would want the partnership to continue to exist after his purchase. The Eleventh Circuit reasoned that the hypothetical willing buyer would necessarily be an assignee under state law, negatively impacting the value of the interest the hypothetical buyer could acquire.

3. Congress Has Never Supported a Change in the Above Case Law and Made that Clear When It Passed Chapter 14 (Including IRC Section 2704(b)(4)) in 1990 that Chapter 14 Was To Be Interpreted in a Manner Consistent With the Existing Case Law
In the fall of 1987, the House of Representatives, in its Revenue Bill of 1987, passed legislation that would have overturned the above case law and eliminated minority and other discounts then established by case law for purposes of valuing closely held corporations and partnerships.23 On the other hand, the Senate Finance Committee advocated for a narrower fix that would prevent estate "freezes" using preferred stock. The Senate proposed to leave alone the valuation of common stock in family companies without preferred stock. Because the two Committees exchanged published "offers," their respective positions are known. The House cut back its family attribution rule so much that it would apply only when the two spouses were the only owners of the business or real estate. The Senate rejected even this very narrow family attribution rule. Congress eventually agreed to enact only the Senate's "anti-estate freeze" provision for preferred stock as a new IRC Section 2036(c). The legislative history with respect to IRC Section 2036(c) made it clear that Congress was not targeting entity discounts with the passage of IRC Section 2036(c).24 For instance, the House Report made it clear that IRC Section 2036(c) did not change the law with respect to the valuation of pro rata corporations and partnerships: "[t]hus, section 2036(c) does not apply if the transferor retains an undivided interest in property, i.e., a fractional or percentage share of each and every interest in the property."25

However, when IRC Section 2036(c) was added to limit estate freezes it was heavily criticized, including significant criticism by the author of this letter.26 The author is proud of the process in which he played a small role that resulted in the repeal of IRC Section 2036(c) and its replacement by Chapter 14. Understanding the history of Chapter 14 can be a challenge, because the statute went through five published iterations, many followed by public hearings addressing the drafts. The initial "Discussion Draft",27 the "House bill",28 the "Senate bill",29 the "Compromise bill"30 reflecting the tentative agreement between the House and Senate and, finally, the "Conference Agreement".31 Each of these iterations of Chapter 14 reflected a hearing with hundreds of pages of testimony and many negotiations among Congressional staff, Treasury and tax practitioners.

Commentators were not the only persons who had concluded by 1990 that IRC Section 2036(c) exemplified poor tax policy, and that estate tax inclusion under IRC Section 2036 was not the right solution to the estate freeze problem. Several prominent Republican Senators felt this way. What is perhaps more noteworthy is that several powerful Democrat Senators felt the same way. Thus, the repeal of IRC Section 2036(c) enjoyed rare bipartisan consensus.32

In 1990 when Congress repealed the failed IRC Section 2036(c) and replaced it with a new Chapter 14, it made clear that the compromise that originally produced IRC Section 2036(c) required it to reject any family attribution rule and protect traditional minority and lack of marketability discounts in family companies. Because Congress considered Chapter 14 to be a replacement of IRC Section 2036(c), Congress never revisited -- in any of these five statutory iterations -- the original compromise rejecting family attribution and preserving valuation discounts. Moreover, Congress was not shy in expressing its intention to preserve traditional valuation discounts in the legislative history of Chapter 14. Congress was not satisfied with merely expressing its intent to preserve traditional valuation discounts; it restricted the IRS from discriminating against family members in family owned businesses through the use of any variation of the family attribution rule, except when Chapter 14 specifically requires the adverse treatment of family member owners. Among the reasons cited by the Senate in its legislative history were the following:

 

The [Senate Finance] committee believes that an across-the-board inclusion rule [application of Section 2036(a)] is an inappropriate and unnecessary approach to the valuation problems associated with estate freezes. The committee believes that the amount of any tax on a gift should be determined at the time of the transfer and not upon the death of the transferor. . . . In developing a replacement for current section 2036(c) the committee sought to accomplish several goals: (1) to provide a well defined and administrable set of rules; (2) to allow business owners who are not abusing the transfer tax system to freely engage in standard intra-family transactions without being subject to severe transfer tax consequences; and (3) to deter abuse by making unfavorable assumptions regarding certain retained rights.33

 

Congress adopted the suggestion of numerous commentators and approached the reform with respect to inclusion of partnership interests and corporate interests as a valuation problem. It reaffirmed the traditional inclusion and taxation of partnership interests, in which part of the partnership is held in preferred form, under IRC Sections 2511 and 2033. Those sections were modified, however, through the passage of new valuation rules under Chapter 14.

The legislative history in enacting the new valuation rules made clear that Congress, once again, was comfortable with existing case law treating proportionately held (pro rata stock ownership or partnership ownership) closely held businesses owned by family members the same way as closely held businesses not owned by family members with respect to ignoring family attribution for valuation purposes and determining the legal rights of any transferred interest under the relevant state law.

The Senate Report on the bill is clear that Chapter 14 was not to affect the discounts associated with creating an entity, including pro rata partnerships or corporations without a senior equity interest:34

 

The value of property transferred by gift or includable in the decedent's gross estate generally is its fair market value at the time of the gift or death. Fair market value is the price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts (Treas. Reg. § 20.2031-1(b)). This standard looks to the value of the property to a hypothetical seller and buyer, not the actual parties to the transfer. Accordingly, courts generally have refused to consider familiar relationships among co-owners in valuing property. For example, courts allow corporate stock to be discounted to reflect minority ownership even when related persons together own most or all of the underlying stock.

. . . .

The bill does not affect minority discounts or other discounts available under present law.

. . . .

. . . the bill does not affect the valuation of a gift of a partnership interest if all interests in the partnership share equally in all items of income, deduction, loss and gain in the same proportion (i.e., straight-up allocations). (Emphasis added.)

 

Congress was not satisfied with merely expressing its intent to preserve traditional valuation discounts; it restricted the IRS from discriminating against family members in family owned businesses through the use of any variation of the family attribution rule, except when Chapter 14 specifically requires the adverse treatment of family member owners:35

 

In developing a replacement for current IRC Section 2036(c) the Committee sought to accomplish several goals: (1) to provide a well defined and administrable set of rules; (2) to allow business owners who are not abusing the tax system to freely engage in standard intra-family transactions without being subject to severe transfer tax consequences; and (3) to deter abuse by making unfavorable assumptions regarding certain retained rights.

 

Congress intended for Chapter 14 to provide: "a well defined and administrable set of rules" that would "deter abuse by making unfavorable assumptions regarding certain retained rights". Chapter 14 was not intended to prevent business owners from engaging "in standard intra-family transactions".

The legislative history of Chapter 14 clearly preserves traditional transfer tax valuation discounts for minority interest and lack of marketability and prohibits any family attribution rule. IRC Section 2704(b) is part of Chapter 14. Therefore, in the absence of additional Congressional action expressing a different intent, any regulations under IRC Section 2704(b) must preserve minority and lack of marketability discounts and must not impose a family attribution rule beyond those few specific rules Congress included in Chapter 14.

Thus, the origin and purpose of Chapter 14 (including IRC Section 2704(b)(4)) for proportionately held family enterprises is not to enact a general family attribution rule or to change the process of first identifying how an interest is treated under state law and then applying federal tax law. Of course, that is not to say that Chapter 14 did not have a distinctive impact on certain family transactions. The new rules applied specifically to transfers to, and interests retained by, family members, with the latter term given specific (and sometimes differing) definitions. But those rules targeted specific transfers defined in the statute; those rules did not enact a general rule of family attribution, "back door" family attribution treatment by another means, or negate the important role state property law plays in transfer taxation.

When Congress replaced IRC Section 2036(c) with Chapter 14, it was concerned about provisions added to the organizational documents of a family enterprise that would typically not be found in similar non-family enterprise documents or under default state property law for the sole purpose of lowering the value of a transferred interest in a family enterprise. The remedy Congress, therefore, employed was to disregard, for valuation purposes, the provisions in organizational documents that would generally not be found in non-family business organizational documents. For instance, IRC Section 2701 disregards certain put, call and conversion rights of senior equity interests, IRC Section 2703 disregards certain transfer restrictions. If the entity is family-controlled, IRC Section 2704(b) disregards an "applicable restriction" on liquidation (the definition of "applicable restriction" is discussed below). Except for the specific provisions that are disregarded, interests in family businesses are to be valued the same way as in non-family businesses without any special valuation premiums because of family attribution.

Congress did not provide substitute provisions for the disregarded provisions in either the statutes of Chapter 14 (including IRC Section 2704(b)) or in its documented legislative history. Nor did Congress give the IRS the power to provide substitutes for the disregarded provisions. In particular, Congress did not provide "substitute" provisions for the "disregarded" provisions that would make the valuation of minority interests in a family business the same as if family attribution applied.

The origin and intent of IRC Section 2704(b) was only to disregard liquidation provisions and other provisions of the organizational documents that lowered the value of interests in a family business for transfer tax purposes below what would occur under state law if those provisions were not in the documents. All other provisions of the organizational documents for a family business are to remain and are to be considered in valuing interests for transfer tax purposes, as are the provisions of applicable state law.36

4. If New Regulations under IRC Section 2704(b) Promulgate Safe Harbors, That Would Repeat the Failures of IRC Section 2036(c), Whose Repeal Was a Key to the Origin and Purpose of Chapter 14
The reported IRC Section 2704(b) proposed regulations would signal a failure of institutional memory by Treasury and the IRS that the waste of resources caused by the enactment of IRC Section 2036(c) is to be repeated. The Greenbook Proposal discusses providing "safe harbors" from the adverse impact of IRC Section 2704(b) in future regulations. Safe harbors sound harmless, but experience shows they are no substitute for fixing a regulation's conceptual problems.

Congress enacted a series of "safe harbors" that if complied with would exempt a transaction from IRC Section 2036(c).37 The safe harbors covered trusts, debt, annuities, loans, preferred stock, compensation arrangements and leases, which IRC Section 2036(c) had been interpreted as reaching. If the taxpayer followed the many technical rules under the safe harbors, they need not worry about estate inclusion. Although IRC Section 2036(c) applied to a myriad of business and estate planning transactions, under the safe harbors family members were allowed only one way to do each transaction safely. Traditionally it would have been sufficient to have an arrangement with arms-length terms to escape any gift tax consequences. The safe harbors required arms-length, PLUS a whole series of technical requirements. If a taxpayer failed to comply with any one requirement of the safe harbor, it would not matter whether the arrangement had the same terms as every other such arrangement on Earth. As with the family attribution rule, under IRS Section 2036(c) the relationships between family members and non-family members could be exactly the same, but the transfer tax imposed on the family relationship could be many times greater.

Congress abolished the use of safe harbors when it repealed IRC Section 2036(c) and replaced it with Chapter 14, which generally allows family business owners engaging with other family members to avoid its application when the terms are arms-length. Applying Chapter 14 as written would obviate the need for any safe harbors.

5. Shortly After the Passage of Chapter 14 in 1990, When the Government's Institutional Memory of Its Origin and Purpose Was Fresh, Treasury and the IRS Consistently Recognized That Chapter 14 Preserved the Pre-existing Valuation Case Law
The courts will not find it difficult to conclude that any new regulations attacking valuation discounts or imposing family attribution are inconsistent with Chapter 14, because Treasury and the IRS reached a similar conclusion in the wake of its enactment. When the IRS' institutional memory failed less than a decade later, the courts struck down the IRS attempt to reverse course. Nothing indicates that the courts are more willing now to accept another government attempt to reinterpret Chapter 14, which is what new regulations under IRC Section 2704(b) would be in the absence of statutory change.
a. In 1992 Treasury Finalized Regulations under IRC Section 2704(b) Protecting Traditional Valuation Discounts Even for Companies That Are Wholly Family Owned
The most obvious interpretation of IRC Section 2704(b) was that it had no application, because it referred to restrictions on liquidation of the entity. Such restrictions do not exist. This interpretation of IRC Section 2704(b) would have meant that it had no application at all.38 As the Supreme Court recently observed, an interpretation that would render a statute meaningless indeed would be a strange interpretation.39 Therefore, that narrow interpretation -- despite fitting the actual language most closely -- was unlikely to ever be adopted in regulations.

On the other hand, if IRC Section 2704(b) were interpreted broadly, IRC Section 2704(b)(2)(B)(ii) could mean equity in any entirely family owned entity would need to be valued for transfer tax purposes as if the entity was to be liquidated. All of the owners of an entity, acting collectively, always can agree to its liquidation. Such a broad interpretation would contradict Congressional intent to limit family attribution and to preserve traditional discounts for minority interest and lack of marketability.40

Neither of the two most obvious interpretations of IRC Section 2704(b) would make sense. The question for the government, therefore, was how to interpret IRC Section 2704(b) in a meaningful manner that would not contradict the statute. The answer came in regulations:41

 

(b) Applicable restriction defined. An applicable restriction is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction.

 

This regulation threaded the needle between the two most obvious interpretations of IRC Section 2704(b). First, the regulations made the statute meaningful by referring to a "limitation on the ability to liquidate the entity," rather than a restriction "which effectively limits the ability of the corporation or partnership to liquidate." The regulation must refer to "a limitation on the" owners' "ability to liquidate the entity." Second, the regulation made the statute consistent with the legislative history by disregarding only those restrictions that were more restrictive than default state law. The IRS treated provisions in organizational documents that made it more difficult to liquidate an entity than default state law would as mere "bells and whistles", which could be disregarded as in the other provisions of Chapter 14.
b. In 1993 the IRS Eliminated Family Attribution in Rev. Rul. 93-12, Finally Acquiescing to the Case Law
Under the final regulations under IRC Section 2704(b)(1), (2) and (3), as noted above, Treasury and the IRS respected Congressional intent by preserving traditional valuation discounts in family owned companies. Within a year after the issuance of these final regulations under Chapter 14, Treasury and the IRS actually conceded in Rev. Rul. 93-1242 that family attribution should not be applied for transfer tax valuation purposes. That ruling considered whether a minority discount was appropriate when the owner of 100% of a corporation transferred all of his shares equally to his five children on the same day.

Rev. Rul. 93-12 revoked Rev. Rul. 81-25,43 which had disagreed with the federal cases overturning the IRS family attribution rule:

 

For estate and gift tax purposes, the IRS will follow Bright, Propstra, Andrews, and Lee in not assuming that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest.

 

The IRS indirectly recognized again that Congress opposed family attribution when it passed Chapter 14.
c. In 1994 Treasury Takes Extraordinary Steps to Excise Language in an Income Tax Regulation Contradicting Chapter 14 Legislative History
In 1994 Treasury finalized certain anti-abuse income tax regulations authorizing the Secretary to disregard a partnership entity when its purposes were inconsistent with Subchapter K.44 Despite being published under an income tax section, the final regulations originally applied for both income and transfer tax purposes. Examples 5 and 6 in these regulations permitted a partnership entity to be disregarded for gift tax purposes. Treasury took the unusual step of amending the Final Regulations to limit the application of the regulations to income tax issues and delete examples 5 and 6.

Those amended regulations went further to indirectly address whether investment partnerships are somehow different than active business partnerships. The final regulations as amended provide that: "Subchapter K [partnership provisions] is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax [emphasis added]." The parenthetical language had not appeared in the proposed regulations, but was added in the Final Regulations in response to comments.45

Again, Treasury and the IRS felt it necessary to comply with the origin, purpose and legislative history of Chapter 14 even when the regulation was promulgated as part of the income tax rules. Moreover, their actions demonstrate how difficult it would be to draw lines distinguishing between active businesses and passive investment companies.

d. In 1994 the IRS in Its Own Training Manual and in Its Own Technical Advice Memorandum Emphasized that Valuation Discounts Are to be Allowed for Pro Rata Interests in Family Entities and That Those Discounts Are Not Affected by Passage of Chapter 14
In the Valuation Training for Appeals Officers, issued by the IRS National Office in 1994, the IRS stressed that valuation discounts may be allowed and there is no family attribution in determining those discounts.46 Based on that publication, the IRS National Office in 1994 agreed that even after passage of Chapter 14 and IRC Section 2704(b) family attribution was generally irrelevant for determining value under transfer tax law, and that valuation discounts for lack of control and lack of marketability are to be applied in valuing an interest in a closely held family enterprise.

Also, in a technical advice memorandum issued in 1994,47 the IRS held that the value of a donor's gift of 100% of corporate stock in equal shares to each of his 11 children was determined by considering each gift separately and not by aggregating all of the donor's holdings in the corporation immediately prior to the gift. Whether the donor owned a controlling interest prior to the transfer and whether the donees were family members or various third parties were not determining factors in valuing each block of stock transferred to a donee or in deciding whether a separate gift was subject to a minority interest discount.

6. In 1997 the Courts Stopped the IRS from Reinterpreting Chapter 14 to Eliminate Valuation Discounts and Impose Family Attribution
As noted above, fresh from the enactment of Chapter 14, the IRS initially took the view that Chapter 14 did not affect the value of closely held family limited partnerships and family limited liability companies that were held in pro rata form of ownership. However, beginning in early 1997, the IRS embarked on a frontal assault on the use of family limited partnerships and other closely held entities for estate planning purposes through the issuance of technical advice memoranda and private letter rulings.48 In these pronouncements, the National Office of the IRS took the position that an interest in a closely held entity can be valued for transfer tax purposes based on the pro rata net asset value of the interest in the entity transferred, essentially disregarding the existence of the entity. One of the arguments raised by the IRS in each of these pronouncements was that under IRC Section 2704(b) transferred partnership interests can be valued without regard to any restrictions on liquidation or withdrawal contained in the partnership agreement or provided under state law.

The IRS reversal on its view of the application of IRC Section 2704(b) was repudiated by the full Tax Court in Kerr v. Commissioner49, which is the first opinion addressing whether the IRS's broad reinterpretation of Chapter 14 was consistent with the courts' understanding of Congress' intent.

The Kerrs, in filing their federal gift tax returns for 1994 and 1995, computed the fair market value of the interests that were transferred to grantor annuity trusts (GRATs), which complied with IRC Section 2702, by applying valuation adjustments for minority interest and lack of marketability. The IRS, however, determined that IRC Section 2704(b) barred any adjustment for minority interest and lack of marketability in computing the fair market value of the partnership interests. The IRS claimed that the provisions of the partnership agreements that restricted the right of a limited partner to liquidate his limited partnership interest were "applicable restrictions" which should be disregarded in determining the fair market value of the interests transferred.

The IRS's argument had two components. First, the IRS claimed that the provisions of the partnership agreements which stated that the partnership shall liquidate upon the earlier of December 31, 2043, or the consent of all the partners, were restrictions on the liquidation of the partnerships that constitute "applicable restrictions" within the meaning of IRC Section 2704(b) that must be disregarded in valuing the interests transferred. Second, the IRS claimed that the provisions of the partnership that restricted a limited partner's right to withdraw from the entity were "applicable restrictions" that must be disregarded in valuing the interests transferred. Because a limited partner in a partnership that did not have a fixed liquidation date (i.e., December 31, 2043) had the right to withdraw his interest under state law on six months notice, the IRS claimed that the fair market value of the interest is equal to the proportionate pro rata net asset value of the partnership interest transferred.

The Tax Court held that IRC Section 2704(b) did not apply to the valuation of the transferred interests. The Tax Court's analysis focused on whether the partnership agreements imposed greater restrictions on the liquidation of the partnerships than the limitations that generally would apply under Texas law.

The Tax Court's holding repudiated the thrust of the IRS's IRC Section 2704(b) position in its pronouncements issued from 1997 through 2000. Regulations under IRC Section 2704(b) modeled on the Greenbook Proposal would resurrect the arguments buried by the Kerr court. Nothing suggests that the courts are any more willing today to accept a reinterpretation of IRC Section 2704(b) inconsistent with the Chapter 14 legislative history simply because that reinterpretation might be contained in new regulations, particularly when Congress has refused to enact the statutory authority for regulations requested by the Greenbook Proposal.

 

B. Not Only Would Regulations Under IRC Section 2704(b)(4) That Take the Form of the Greenbook Proposal Violate the Origin and Purpose of IRC Section 2704(b), Those Regulations Also Would Be Manifestly Contrary to the Its Statutory Language

 

As noted above, when the Tax Court found in Walton that the example in the Treasury Regulations was "manifestly contrary to the statute [IRC Section 2702]" the court found the regulation did not expressly contradict the statutory language, but found it violated the statute's origin and purpose. In addition to violating the origin and purpose of IRC Section 2704(b) (see the discussion in Section II A above), if the regulations under IRC Section 2704(b)(4) take the form of the Greenbook Proposal, those regulations will expressly contradict the statutory language of IRC Section 2704(b)(4). Under the Greenbook Proposal, state statutory and common law would not necessarily provide the substitute for any disregarded provision in an organizational document. Rather, the IRS would be authorized to create new default provisions, which are probably not found in state statutory and common law, to substitute for the disregarded provisions. The IRS then would value transferred interests in family companies as if the organizational documents as rewritten by the IRS governed the interests, rather than the terms written by the owners or default provisions enacted by state legislatures. In other words, for valuation purposes the IRS could disregard not only restrictions in the entity's organizational documents, but also restrictions imposed by state law. As discussed below, this would directly violate IRC Section 2704(b)(3)(B).
1. If They Take the Form of the Greenbook Proposal, Certain Regulations Will Apply to a Liquidation Restriction Already Described in Other Parts of IRC Section 2704(b)
The Greenbook Proposal states that the IRS may disregard restrictions on "a holder's right to liquidate". However, certain liquidation restrictions are already clearly described in IRS Section 2704(b)(1), (2) and (3) and are, thus, not to be covered by IRC Section 2704(b)(4), because that statute only applies to "other restrictions".

For example, any new regulation under IRC Section 2704(b)(4) may not cover any restriction "which effectively limits the ability of the corporation or partnership to liquidate, and . . . the transferor or any member of the transferor's family, either alone or collectively, has the right to remove, in whole or in part the restriction."50 Thus, if a family partnership agreement provides that the partnership shall last 50 years and it requires a unanimous vote of the partners to remove that restriction, that restriction is not within the scope of IRC Section 2704(b)(4), because the efficacy of that restriction, and when and in what manner it is disregarded, is already covered in other parts of IRC Section 2704.51 If the regulations under IRC Section 2704(b)(4) purport to cover liquidation restrictions that are covered by other sections of IRC Section 2704(b), then those regulations are contrary to the express statutory provisions of IRC Section 2704(b)(4).

IRC Section 2704(b)(2)(A) is unclear whether it applies to a restriction on an individual partner's right to withdraw from the partnership (as opposed to a restriction on liquidation of the entire partnership), and is therefore already disregarded as an "applicable restriction" if it is more restrictive than state law. If so, it is not an "other restriction" that can be addressed under IRC Section 2704(b)(4).52 Because most state statutes strictly curtail a limited partner's right to withdraw from the partnership, the issue is not of great significance currently but would be if the proposed regulations address such a restriction and disregard state law.53

Because IRC Section 2703, which is part of Chapter 14, addresses the transfer tax effect of transfer restrictions, "other restrictions" cannot refer to transfer restrictions any more than it can refer to liquidation restrictions. The reference in the Greenbook Proposal to ignoring restrictions on the transfer of rights in a partnership should be tested under IRC Section 2703, not IRC Section 2704(b). Unlike IRC Section 2704(b), IRC Section 2703 recognizes for valuation purposes terms that are comparable to those in arms-length agreements among non-family owners. Because IRC Section 2704 can be used to disregard any specified restriction in agreements for a wholly owned family business, the IRS would prefer to apply IRC Section 2704(b) which makes no exception for arms-length agreements. For that reason, IRC Section 2704(b)(4) does not authorize regulations that apply to restrictions covered elsewhere in Chapter 14.

2. IRC Section 2704(b) Only Empowers the IRS to Disregard Certain Restrictions in Family Entity Organizational Documents Not to Replace Those Disregarded Provisions with IRS-Invented Alternatives
IRC Sections 2704(b)(1) and 2704(b)(4) have identical operative language: each provides that a restriction "shall be disregarded". Neither section gives the IRS the power to "substitute" alternative language to take the place of the disregarded restriction. Instead, the organizational documents should be read as if they omitted the restriction. As noted above, unless there is a contrary provision in the federal statute, the Supreme Court has taken the position that for transfer tax purposes a state's statutes and common law determine how the agreement is to apply absent the "restriction" in the agreement. Indeed, the contemporaneous regulation written under Treas. Reg. § 25.2704-2(c) on January 28, 1992, uses that remedy:

 

(c) Effect of disregarding an applicable restriction. -- If an applicable restriction is disregarded under this section, the transferred interest is valued as if the restriction does not exist and as if the rights of the transferor are determined under the State law that would apply but for the restriction.

 

If the new regulations take the form described in the Greenbook Proposal, the IRS could claim the power under those regulations to substitute alternative provisions for the disregarded provisions of the organizational documents that may not be found in the default state property law. The Greenbook Proposal states:

 

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.

 

The substituted assumptions or standards must be different than state statutory or common law; otherwise, no change in the regulations would be necessary. In effect, this would treat restrictions imposed by state law in the same manner as "applicable" restrictions, in direct violation of IRC Section 2704(b)(3)(B), which provides that "[t]he term 'applicable restriction' shall not include . . . any restriction imposed, or required to be imposed, by any Federal or State law."

Without enactment of the statute contemplated by the Greenbook Proposal, IRC Section 2704(b)(4) is clearly inadequate to authorize substitutions for disregarded provisions. Congress did not provide for substitute provisions for the disregarded provisions in either the statutes of Chapter 14 (including IRC Section 2704(b)) or in its extensive legislative history. In particular, Congress would not, and did not, authorize the IRS to invent "substitute" provisions for the "disregarded" provisions that would make the valuation of minority interests in a family business the same as if family attribution applied.

3. Under IRC Section 2704(b)(4), the Only Restrictions That May Be Disregarded Are Those Restrictions That Have the "Effect of Reducing the Value of the Transferred Interest" Below What the Transferred Interest Value Would Be Even if the Restriction Was Not in the Organizational Documents
If regulations under IRC Section 2704(b)(4) take the form of the Greenbook Proposal, certain of those regulations will disregard restrictions, even if the value is not reduced because of those restrictions, which contradicts the express statutory provision of IRC Section 2704(b)(4). Certain restrictions may exist under state statutory and common law that are consistent with the written liquidation restrictions in an organizational document. Their removal from the organizational document would not reduce the value of the transferred interest, because of the operation of state property law.

For instance, the limited partnership agreement may mandate if the partnership is not sooner liquidated it must be liquidated in 40 years. That provision is not a liquidation restriction, it is the opposite. That provision mandates liquidation under a time certain (40 years). The partnership agreement may also provide that a limited partner may not withdraw until the partnership liquidates. While that provision is a liquidation restriction, it may be a restriction that would apply anyway, if the agreement were silent on that issue, because of operation of state law for a term of years limited partnership agreement. As a consequence, that liquidation restriction in the organizational documents, may not be disregarded under IRC Section 2704(b)(4), because its removal would not have any effect on the transfer value of a limited partnership interest under state law.

Another example would be a provision in a partnership agreement consistent with state property law that allows the partners to admit a transferee as one of their partners, but does not mandate that the transferee to be so admitted. The Greenbook Proposal apparently would give the IRS the power to disregard that provision:

 

A disregarded restriction also would include any limitation on a transferee's ability to be admitted as a full partner.

 

If the regulations are consistent with that proposal, then those regulations would be contrary to the express statutory provision that requires that the absence of the disregarded provision in the organizational documents reduce the value of the transferred interest. Even if that provision was absent from the partnership agreement the value of the transferred interest would not be affected because of the operation of state property law, which allows partners to choose their own partners.

This one Greenbook example shows how far the Greenbook Proposal has deviated from existing law and from the reasons the Administration gives for needing the Greenbook Proposal. The target is a provision that makes any transferee of a partnership interest an assignee. Yet every state's law has forever provided for assignee treatment of transferees of partnership interests.

This provision is not, as the Greenbook suggests, needed as a result of taxpayer friendly state law changes.

Some have suggested that IRC Section 2704(b)(4)'s reference to a restriction "has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee"54 is intended to mean any restriction that can be removed by the family.55 However, that would require adding similar statutory language in IRC Section 2704(b)(4) to that already in (b)(2). Without that language, 100% ownership by the family of a partnership would not justify an assumption that a restriction would not ultimately reduce the value of the transferred interest. In fact, family owners are probably more likely than non-family owners to enforce restrictions on liquidation or transfer, because such restrictions align with the family's desire for the continuation of the family business.

4. Regulations under IRC Section 2704(b) That Track the Greenbook Proposal Would Improperly Redefine Family for Purposes of IRC Section 2704(b), Which It Cannot Do.
IRC Section 2704(b) applies only to restrictions that would "lapse" or that may be removed by the "family". Family is specifically defined:56

 

(2) Member of the family. The term "member of the family" means, with respect to any individual --

(A) such individual's spouse,

(B) any ancestor or lineal descendant of such individual or such individual's spouse,

(C) any brother or sister of the individual, and

(D) any spouse of any individual described in subparagraph (B) or (C).

 

The Greenbook Proposal would have authorized regulations to redefine the meaning of family by allowing certain owners to be ignored. The disregarded owners might be charities that would be presumed never to oppose liquidation or other owners with minor ownership interests. The Greenbook Proposal provided no standards for that redefinition.

I am unaware of any other regulations that rewrite the meaning of family when the statute specifically defines the term in the statute. Such regulations would necessarily contradict the statute and, therefore, be invalid without the statutory authorization assumed by the Greenbook Proposal.

III. IF NEW REGULATIONS ARE ISSUED UNDER IRC SECTION 2704(B)(4), THE RESULT WILL BE THE COLLECTION OF LESS TAX REVENUE NOT MORE AT THE COST OF YEARS OF EXPENSIVE LITIGATION

 

A. In the Unlikely Event That Regulations Such As Those in the Greenbook Proposal Are Upheld by the Courts, the Regulations Are More Likely to Reduce Future Income Tax Revenue More Than They Increase Estate Tax Revenue

 

It is ironic -- more accurately strange -- that the administration would target valuation discounts now. This IRS project appears to have been on the drawing table for a dozen years, despite the transfer tax landscape being transformed during that period. The increase in the estate tax exemption to around $11 million for a couple has substantially reduced the number of individuals subject to estate tax. However, nearly every taxpayer remains subject to the federal income tax. As a result, an estate planning program is more likely to feature a presentation on planning to reduce income tax than one on planning to reduce estate tax. Moreover, the two types of planning often conflict with each other.

For example, the estate tax value of a partnership interest in a family business also becomes its tax basis for determining capital gains tax if the interest is sold. Moreover, if the post-death tax basis in estate's partnership interest is higher than its pre-death tax basis, the estate can obtain the benefit of that higher basis in its partnership interest ("outside basis") by increasing the tax basis in the partnership assets ("inside basis") attributable to the estate. The estate, therefore, would be able to use the higher estate tax value to reduce income tax without selling the partnership interest in the family business.

New regulations that would eliminate valuation discounts in family partnerships will increase estate tax in those few estates of unmarried individuals that will remain subject to the estate tax. Eliminating valuation discounts, however, also will increase the tax basis of interests in those same family partnerships and reduce income tax. No one can know whether the estate tax increases will exceed the income tax losses, particularly as the estate tax exemption will increase by more than a hundred thousand dollars every year.

 

B. The Uncertain Validity of Any Proposed Regulations Modeled on the Greenbook Proposal Will Certainly Reduce Any Increase in Future Gift Tax Revenue

 

The Greenbook Proposal would have applied "to transfers after the date of enactment". Any proposed regulations under IRC Section 2504(b)(4), which are sure to be controversial and are "legislative" in nature, should be made effective only upon issuance of final regulations. Even after the regulations become final, as the above discussion demonstrates, their scope and validity will be in doubt. Taxpayers will seek to find ways to cope with the uncertainty.

Government estimates always substantially overestimate the increased gift tax revenue from any law change. This failure relates to the government's misunderstanding of human nature of taxpayers with estates large enough to potentially be subject to the estate tax. The government presumes that those taxpayers intend to give away certain specific assets, and the taxpayer will proceed with those gifts, despite a substantially increased gift tax cost.

Longtime estate planners can aver that rarely will an individual whose death would generate an estate tax, even the most wealthy, be willing to incur any gift tax to make a transfer of assets during life. First, the individual will seldom predict his or her death -- some even doubt its occurrence. Second, the controversy over the estate tax during the last decade, its repeal and reenactment with substantially higher exemptions and lower rate causes individuals to justifiably fear that he or she will be the last gift tax payor. Finally, a wealthy individual is likely convinced that he or she can reinvest the gift tax savings at such a high rate of return that the increased estate will more than offset the higher estate taxes.

As a consequence, taxpayers and their advisors will nearly always hedge against the uncertainty that will arise from any new regulations under IRC Section 2704(b)(4). These hedges will limit any immediate increase in gift tax revenues while on-going litigation increases the frustration of both taxpayers and the government.

 

C. In the Unlikely Event That Regulations Such As Those in the Greenbook Proposal Are Upheld by the Courts, Valuation Methods Will Continue to Evolve and Could Result in Discounts from Net Asset Value Similar to Those Allowed by Present Law

 

Although new IRC Section 2704(b) regulations might erode the hypothetical buyer/seller test in family businesses, even if ultimately upheld, the regulations will be unable to banish it completely. Moreover, the IRS is unlikely to be able to revive family attribution as contained in Rev. Rul 81-253. A mixed valuation landscape, therefore, is likely to result. Minority interest and lack of marketability valuation discounts have come to dominate valuations because the courts and the IRS have accepted them. However, valuation is not a static science. Other valuation methods that do not rely on discounts are likely to replace those that do, mitigating the increased tax cost.

For example, one method of valuation, the Non-Marketable Investment Company Evaluation Method,57 determines the fair market value of transferred interests in closely held holding companies by estimating the cost of capital that reflects the greater risk associated with the transferred interest in the closely held enterprise in comparison to the investor holding a proportionate share of the assets of the enterprise. This valuation method does not use marketability and minority discounts derived from so-called benchmark studies. This method treats the closely held nature of the transferred interest as a liquidity investment risk that is embodied in the cost of capital for the transferred interest. This valuation method determines what a willing buyer would pay for the transferred interest taking into account liquidity investment risks associated with the expected returns.

 

D. Bottom Line: Avoiding Lengthy and Costly Litigation over the Scope and Validity of New Regulations That Would Be Modeled on the Greenbook Proposal Is the Strongest Reason for Treasury and the IRS to Withhold Such Regulations

 

The author has written this lengthy and detailed letter to make the case that Proposed Regulations under IRC Section 2704(b) are more likely to be invalid than valid if they reflect the Greenbook Proposal. The letter, however, does not stop with presenting the technical arguments against their validity. Rather, the letter also reminds its readers of the failed history and the enormous costs resulting from the IRS' history of repeated failed efforts to accomplish similar objectives in other ways.

Before Congress repealed Section 2036(c) retroactively, taxpayers, professionals, Congress, Treasury and the IRS expended substantial resources needlessly at an immeasurable cost. The government's decision to keep the terms of Section 2704(b) out of the public debate prior to its enactment represents a costly missed opportunity to rationalize the valuation of partnership interests.58 The IRS litigated the validity of one example in the Chapter 14 regulations in Walton for eight years before the courts invalidated it. After implementing the legislative history of Chapter 14 for years after its enactment in 1990, the IRS reversed course in litigation only to lose in Kerr Estate. If Treasury and the IRS promulgate new regulations modeled on the Greenbook Proposal, this sad and costly history will likely repeat itself again.

 

* * *

 

 

Richard is happy to answer any questions that you may have concerning this letter and may be reached as follows:
Richard L. Dees

 

McDermott Will & Emery

 

227 West Monroe Street

 

Chicago, IL 60606

 

(312) 984-7613

 

Email: rdees@mwe.com

 

FOOTNOTES

 

 

1 "Richard". Richard authored one of the first articles critical of Internal Revenue Code Section 2036(c) after Congress attempted to fix it through technical corrections in 1988: Dees, "Section 2036(c): The Monster That Ate Estate Planning and Installment Sales, Buy-Sells, Options, Employment Contracts and Leases," TAXES 876 (Dec. 1988) ("Monster"). He has authored eight more articles on Chapter 14. His "Monster" article led to Richard being an invited witness at the first Congressional hearing on whether to repeal Section 2036(c): Senate Finance Committee on May 10, 1989 [Testimony appears in S. Hrg. 101-380 at pp. 34, 88]. Thereafter, the National Grocers Association and the Small Business Legislative Council retained Richard as a technical expert. In that role, he appeared as a witness in two more Congressional hearings and negotiated with Congressional staff, including Joint Committee of Taxation staff, and representatives of the Treasury and the Internal Revenue Service ("IRS") concerning the terms of Chapter 14.

Richard acknowledges the helpful suggestions and comments of Agnieszka Kawecki, of Chicago, Illinois; Turney P. Berry, of Louisville, Kentucky; Dan Hastings, New York City, of New York; and S. Stacy Eastland, of Houston, Texas ("Stacy"). Stacy graciously shared a copy of his paper, "The History and Future of Valuation Discounts," to be presented at the Southern Federal Tax Institute, with John Porter, on October 22, 2015.

2 "IRC" or "Code".

3 The term "transfer taxes" collectively refers to the estate tax in Chapter 11, the gift tax in Chapter 12 and the generation-skipping transfer tax ("GST Tax") in Chapter 13. Chapter 14 provides special valuation rules for transfer tax purposes.

4 "Navigating Tougher I.R.S. Rules for Family Partnerships," NEW YORK TIMES (August 7, 2015); Moyer, "IRS Takes Aim at an Estate-Planning Strategy," THE WALL STREET JOURNAL (June 26, 2015). However, that distinction does not appear in the legislative history or in the statute. Both non-family and family partnerships frequently own passive securities. Furthermore, Congress and the Treasury have long recognized that groups (including families) commonly use partnerships as appropriate entities to invest in and hold passive securities and, accordingly, such partnerships should be recognized for all tax purposes:

 

(i) Because of IRC Section 7701(a)(2), the IRS has always recognized that "passive investment clubs," through which investors engage in passive investment activities, may be conducted in the partnership form of ownership for all federal tax purposes (including transfer tax purposes). See Rev. Rul. 75-523, 1975-1 C.B. 257 (because of IRC Section 7701(a)(2), a partnership was recognized for tax purposes even though the only purpose of the partnership was to invest in certificates of deposit) and Rev. Rul. 75-525, 1975-1 C.B. 350 (because of IRC Section 7701(a)(2), a partnership form of ownership was recognized for tax purposes even though the only purpose of the partnership was to invest in marketable stocks and bonds).

(ii) The Internal Revenue Code liberally defines the term "partnership" in IRC Sections 761(a), 6231(a), and 7701(a). Under the Internal Revenue Code, Congress clearly provides that for income, gift, estate, and generation-skipping tax purposes unless it is "manifestly incompatible" with Congress' intent, a group or syndicate that carries on business or financial operations and is neither a corporation, nor a trust, nor an estate is a partnership for purposes of Chapters 1, 11, 12, 13, and 14. Congress clearly intended that an individual would always be treated as a partner of a partnership for purposes of Chapters 1, 11, 12, 13, and 14 of the Code if that individual is a member of a group that conducts any financial operation, including investing in stocks and bonds, unless that group is a trust, an estate, or a corporation.

(iii) Specific rules that apply only to partnerships holding passive investment assets appear in the Internal Revenue Code and the Treasury Regulations:

 

(1) Under IRC Section 721, taxpayers contributing assets to a partnership that is deemed an "investment company" (generally, one made up of over 80% marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts) will recognize gain or loss on contribution unless each partner's contributed stock portfolio is substantially diversified.

(2) IRC Section 731(c)(3)A(iii) addresses the favorable tax treatment of distributions of marketable securities made to partners of "investment" partnerships (which is defined under IRC Section 731(c)(3)(C)(i) as a partnership which has never engaged in a trade or business and substantially all of its assets are passive securities).

(3) Treas. Reg. § 1.704-3(e)(3) contains a special aggregation rule for "securities" partnerships (at least 90% of the partnership's non-cash assets consist of stocks, securities and similar instruments tradable on an established securities market).

(4) Treas. Reg. § 1.761-2(a) expressly confirms that investment partnerships are to be treated as partnerships under subchapter K (unless a contrary election is made).

(5) The final partnership anti-abuse regulation acknowledges that the "business" activity of a partnership may be investing assets: "Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax." Treas. Reg. § 1.701-2(a) (emphasis added). The parenthetical language referring to investment as a business activity was added after the release of the proposed regulation. Compare Prop. Reg. § 1.701-2(a).

5 IRC Section 7701 has generally treated a limited liability company ("LLC") as a partnership for federal income tax purposes, including for purposes of Chapter 14. However, under the Check the Box regulations in Treas. Reg. § 301.7701-1 et al. most state law entities can elect to be a partnership, an S Corporation (because it is taxed under Subchapter S) or an association taxed as a corporation under Subchapter C.

6 The promulgation of the Check the Box regulations allowed states to revise their laws governing LLC's to remove some of the awkward provisions intended to provide partnership income tax treatment. The result is that the LLC form provides limited liability for all of its owners with fewer formalities than a corporation requires. State law benefits, rather than estate tax savings, have caused business owners to switch to using LLC's.

7 115 T.C. 589 (2000) ("Walton").

8 107 AFTR2d 2011-341, 131 Sup. Ct. 704 (2011).

9 The terms "legislative" and "interpretive" are used by tax practitioners in a way that differs from standard terminology under the Administrative Procedure Act ("APA"). Under the APA, both types of tax regulation would be labeled "legislative" because both have the force of law.

10 On the one hand, referring to the statutory ambiguity and interpretive regulation at issue in the case, the Supreme Court said: "In the typical case, such an ambiguity would lead us inexorably to Chevron step two, under which we may not disturb an agency rule unless it is arbitrary or capricious in substance, or manifestly contrary to the statute." (Internal quotation marks and citations omitted). 107 AFTR2d p. 2011-345. On the other hand, the Supreme Court said: "The full-time employee rule easily satisfies the second step of Chevron, which asks whether the Department's rule is a "reasonable interpretation" of the enacted text." 107 AFTR2d p. 2011-347.

11 Johnson, Preserving Fairness in Tax Administration in the Mayo Era, 32 VA. TAX REV. 45 (Summer 2012).

12 1981-1 C.B. 187, revoked, Rev. Rul. 93-12, 1993-1 C.B. 202.

13 658 F.2d 999 (5th Cir. 1981).

14 680 F.2d 1248 (9th Cir. 1982).

15 79 T.C. 938(1982).

16 69 T.C. 860 (1978), nonacq., 1980-2 C.B. 2.

17 Treas. Reg. § 20.2031-3 provides: "Valuation of interests in businesses. The fair market value of any interest of a decedent in a business, whether a partnership or a proprietorship, is the net amount which a willing purchaser, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion." Accord Treas. Reg. § 25.2512-3. See also Minahan v. Commissioner, 88 T.C. 492 (1987) ordering litigation costs assessed against the IRS for continuing to litigate this issue.

18See United States v. Bess, 357 U.S. 51 (1958); Morgan v. Commissioner, 309 U.S. 78 (1940).

19See H. REP. No. 2543, 83rd Cong. 2nd Sess., 58-67 (1954); H.R. REP. No. 1274, 80th Cong. 2nd Sess., 4 (1948-1 C.B. 241, 243); S. REP. No. 1013, 80th Cong., 2nd Sess., 5 (1948-1 C.B. 285, 288) where the Committee Reports on the 1948 changes in the estate taxation of community property states: "Generally, this restores the rule by which estate and gift tax liabilities are dependent upon the ownership of property under state law." See also the reports of the Revenue Act of 1932 that define "property" to include "every species of right or interest protected by law and having an exchangeable value." H.R. REP. No. 708, 72nd Cong., 1st Sess., 27-28 (1932); S. REP. No. 665, 72nd Cong., 1st Sess., 39 (1932).

20Aldrich v. United States, 346 F.2d. 37 (5th Cir. 1965).

21Id. at 38, 39.

22 823 F.2d 483 (11th Cir. 1987), aff'g 51 T.C.M. 60.

23 H.R. REP.NO. 100-3545, at 1041-1044(1987).

24 H. R. REP. NO. 100-495, at 995 (1987).

25 H.R. REP. NO. 100-795, at 423 (1988).

26 Eastland, "The Legacy of IRC Section 2036(c): Saving the Closely Held Business After Congress Made 'Enterprise' A Dirty Word," REAL PROPERTY PROBATE AND TRUST JOURNAL, Vol. 24, No. 3 (Fall 1989); Dees, "Section 2036(c): The Monster That Ate Estate Planning And Installment Sales, Buy-Sells, Options, Employment Contracts and Leases, 66 TAXES 876 (Dec. 1988).

27 House Ways & Means Committee Press Release No. 28 (March 22, 1990).

28 H.R. 5425 introduced by Rep. Rostenkowski, August 1, 1990.

29 S. 3113 introduced by Sens. Bentsen, Boren and Daschle, September 26, 1990.

30 IRC Sections 7209 and 7210 of Omnibus Reconciliation Bill passed by the Senate, so called because the Senate Finance Committee version reflected a tentative agreement with the House staff.

31 Chapter 14 enacted as part of the Revenue Reconciliation Act of 1990 (hereinafter RRA '90) [IRC Section 11602 of the RRA'90].

32 Congressional Record 101st Congress S. 3113: pg. 1-4 (October 17, 1990).

33 Informal Senate report accompanying the Revenue Reconciliation Bill of 1990 (S. 3209) as printed in the Oct. 18, 1990, Congressional Record, vol. 136, s. 15679 (Daily Edition).

34 136 CONG. REC. § 15679, 15681 (October 18, 1990).

35Id.

36See Treas. Reg. § 25.2704-2(c).

37 Richard's testimony reported in S. Hrg. 101-380 at p. 89 described the IRC Section 2036(c) safe harbors:

 

The safe harbors were intended to allow certainty in business transactions without the need to rationalize the statute and its legislative history. The committee reports state that no presumption is to be drawn that the existence of safe harbors imply the application of Section 2036(c) to other business transactions outside a safe harbor. Thus the question of the scope of Section 2036(c) was ducked in favor of 'cookie cutter' estate and business plans. More of the same is promised as a 45-page notice excepting even more transactions from the section has been promised by the Treasury for more than a year. This process will continue indefinitely unless Congress repeals Section 2036(c) and its over-broad, general language.

This approach to narrowing the application of Section 2036(c) is the equivalent of me telling, someone how to get to my house by describing everywhere in America that I don't live. No matter how well-traveled I am I will leave something out. And the people who draft these safe harbors are not well-traveled in the Business World. A 'safe harbor' sounds like a friendly, inviting, well-lit port of call. A 'safe harbor' under Section 2036(c) is more like a rocky fjord or a slippery sandbar.

 

38See Ken v. Comm., 113 T.C. No. 30. (Dec. 23, 1999). The Fifth Circuit used different reasoning to hold for the taxpayer. 292 F.2d 490 (5th Cir. 2002).

39King v. Bunnell, 576 U.S. ____ (2015), Slip. Op. '14-114 (June 25, 2015) at p.15.

40 Congressional staff indicated informally in 1990 that they failed to understand the linkage between these discounts and the owner's inability to liquidate her equity interest or to force the entity to liquidate.

41 Treas. Reg. § 2704-2(b).

42 1993-1 C.B. 201.

43 1981-1 C.B. 187.

44 Treas. Reg. § 1.701-2 in T.D. 8588 (December 29, 1994).

45 Treas. Reg. § 1.702-2(a).

46See Valuation Training for Appeals Officers (1994) (issued by the IRS National Office), which stresses the hypothetical willing buyer and seller, and states unequivocally that "it is irrelevant who are the real seller and buyer".

47 TAM 9449001 (Mar. 11, 1994).

48See, e.g., PLR 9736004 (June 6, 1997); PLR 9735043 (June 3, 1997); PLR 9735003 (May 8, 1997); PLR 9730004 (April 3, 1997); PLR 9725018 (March 20, 1997); PLR 9725002 (March 3, 1997); PLR 9723009 (February 24, 1997); PLR 9830803 (October 16, 1998).

49 113 T.C. No. 30 (Dec. 23, 1999). See also Kerr v. Commissioner, 292 F.3d 490 (5th Cir. 2002), which held IRC Section 2704(b) did not apply to the transferred interests on different grounds.

50See IRC Section 2704(b)(2).

51See Treas. Reg. § 25.2704-2(d) Example 1.

52 While the Tax Court has held that a restriction on a partner's right to withdraw is not an applicable restriction, no appellate court has yet done so, and the Tax Court position may be questioned. Kerr v. Comm'r, 113 T.C. 449 (1999), aff'd. on other grounds, 292 F.3d 490 (5th Cir. 2002); Estate of Harper v. Comm'r, 79 TCM 2232 , T.C. Memo 2000-202; Estate of Jones v. Comm v. Comm'r., 116 T.C. 121 (2001). See also Knight v. Commissioner, 115 T.C. 506 (2000). The Kerr case is discussed above in Section II A 6 of this letter.

53 This example illustrates how regulations modeled on the Greenbook Proposal would change IRC Section 2704(b) from a statute disregarding certain provisions added by taxpayers to organizational documents governing family businesses to a statute disregarding provisions written into the governing laws of entities written by state legislatures only to be replaced by provisions written by the government. Nothing could be further from Congress' intent to value equity interests fairly without regard to whether the interests are owned by family members or in a company subject to family control.

54 IRC Section 2704(b)(4).

55 IRC Section 2704(b)(2)(B)(ii).

56 IRC Section 2704(c)(2).

57 Frazier, William H. "Cost of Capital of Family Holding Company Interests." Cost of Capital, Fifth Edition. Ed. Shannon P. Pratt, Ed. Roger J. Grabowski. Hoboken, New Jersey: John Wiley & Sons, Inc. 2014. 630-649.

58See Dees, "Time Traveling to Strangle Strangi (and Kill the Monster Again), Part I," TAX NOTES 563, 569-70 (Aug. 13, 2007) ("Time Traveling I"). In Time Traveling I, Richard posits that this secrecy led to the courts incorrectly applying IRC Section 2036(a) to address valuation or operational problems in family limited partnerships, recreating many of the problems that prompted Congress to repeal IRC Section 2036(c) in 1990.

 

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