NYSBA Addresses Proposed Regs on Restricted Interest Liquidations

I am pleased to submit the enclosed New York State Bar Association Tax Section Report No. 1358 (the "Report") providing comments on proposed regulations published August 4, 2016 (the "Proposed Regulations"), relating to the special gift, estate, and generation-skipping transfer tax valuation rules of Section 2704 of the Internal Revenue Code of 1986, as amended (the "Code"). The Report was prepared jointly with the New York State Bar Association Trusts and Estates Section.

Section 2704(b) disregards certain restrictions on liquidation, known as "applicable restrictions," when valuing interests in corporations and partnerships. Under Section 2704(b)(4), the Department of the Treasury may provide that certain other restrictions may likewise be disregarded, if they have the effect of reducing the value of the transferred interest for transfer tax purposes but do not ultimately reduce the value of the interest to the transferee. The Proposed Regulations would exercise the Treasury's Section 2704(b)(4) authority for the first time, by defining a new class of restrictions, known as "disregarded restrictions," that would be ignored for gift and estate tax valuation purposes.

Notably, the Proposed Regulations provide that if a restriction is disregarded for valuation purposes, then the property transferred is valued as if the restriction "does not exist," whether in an entity's government documents, local law, or otherwise. The text of the Proposed Regulations, however, leaves unresolved the critical question of how, exactly, an interest in an entity is to be valued on the assumption that a restriction does not exist. Since the Proposed Regulations were issued, Internal Revenue Service ("Service") officials have, in public comments made at meetings of attorneys and accountants, attempted to clarify the effect of the nonexistence assumption. The Report discusses the Service's approach in detail and recommends alternatives that the Service may wish to consider in order to achieve its policy objectives.

The Report's recommendations include the following:

Respectfully submitted,

The Proposed Regulations respond to taxpayers' use of entity-level valuation discounts in order to depress artificially the value of property for gift and estate tax purposes. We commend the Service for exercising its regulatory authority to enact reform in this important area. Nevertheless, as discussed in detail in Part III of this Report, the Proposed Regulations leave unresolved the critical question of how an interest in an entity is valued when, as provided in the Proposed Regulations, a restriction on liquidation or withdrawal is disregarded. This Report also describes alternatives that the Service may wish to consider in order to achieve the Service's policy objectives.

This Report is divided into five parts. Part I summarizes the Report's principal recommendations. Part II provides history and background relevant to the Proposed Regulations. Part III addresses the effect that disregarding a restriction under the Proposed Regulations has on valuation of an entity interest, and concludes by recommending approaches that the Service may wish to consider. Part IV recommends other changes to the Proposed Regulations, including relating to the classification of entities, the definition of family control, the lapse of liquidation or voting rights, and the definitions of "applicable restriction" and "disregarded restriction." Finally, Part V recommends rules on the interaction between the special valuation rules of Section 2704 and the determination of basis of property acquired or passing from a decedent under Section 1014(a).

Our understanding of the Proposed Regulations' intent is informed in part by public comments of Service officials since the Proposed Regulations were issued.⁴ In addition, we have spoken at length with the Proposed Regulations' principal authors. We are grateful for the Service's time and the effort that they have devoted to helping us understand the Proposed Regulations. Our comments are designed to aid the Service as far as possible in achieving its intentions, as we understand them.

Section 2704, which was enacted as part of the Omnibus Budget Reconciliation Act of 1990 ("OBRA"),⁵ contains two distinct rules. The first rule, found in Section 2704(a), treats certain lapses of liquidation or voting rights as if they were transfers of property for gift and estate tax purposes. More specifically, Section 2704(a)(1) provides that if a lapse of a liquidation or voting right in a corporation or partnership occurs, and the individual possessing the right and members of that individual's family hold control of the entity both before and after the lapse, then the lapse shall be treated as a transfer by gift or as a transfer includible in the individual's gross estate at death, whichever is applicable. The amount of the transfer is equal to the difference between the fair market value of the individual's interests immediately before and after the lapse.⁶

The second rule, found in Section 2704(b), disregards certain restrictions when valuing interests in corporations and partnerships. Restrictions may be disregarded in two situations. First, restrictions known as "applicable restrictions" are disregarded under Section 2704(b)(1). That Section provides that if an individual transfers an interest in a partnership or corporation to or for the benefit of a member of the transferor's family, and the individual and members of the individual's family hold control of the entity immediately before the lapse, then any "applicable restriction" is disregarded in valuing the interest. An "applicable restriction" is defined in Section 2704(b)(2) as a restriction which effectively limits the ability of the entity to liquidate, provided that, after the transfer, the restriction will either lapse or can be removed by the transferor or the transferor's family, alone or collectively. Section 2704(b)(3) creates an exception in the case of restrictions that are "imposed, or required to be imposed" by any federal or state law. Regulations currently interpret this exception to mean that a limitation on the ability to liquidate an entity is not an applicable restriction if it is no more restrictive than the limitations that would apply under state law.⁷

Other restrictions, though not defined in the statute, may also be disregarded under the authority granted the Treasury in Section 2704(b)(4). That Section provides that the Treasury may by regulation provide that restrictions, other than applicable restrictions, are disregarded in valuing an interest in a corporation or partnership transferred to a member of the transferor's family, if the restriction has the effect of reducing the value of the transferred interest for transfer tax purposes but does not ultimately reduce the value of the interest to the transferee. The Proposed Regulations, as discussed further in this Report, exercise this authority by defining a new class of restrictions, designated "disregarded restrictions."⁸ Like applicable restrictions, disre-garded restrictions are, under the Proposed Regulations, disregarded for gift, estate, and GST tax valuation purposes.

B. Purposes of the Statute

The legislative history of Section 2704, as the Tax Court observed in Estate of Kerr v. Commissioner,⁹ contains "no meaningful explanation of the detailed language or concepts that were made part of section 2704 as finally enacted." That said, the history¹⁰ does indicate that Section 2704 targets results such as those achieved in Estate of Harrison v. Commissioner.¹¹ In Harrison, the decedent at the time of his death was one of three general partners and the sole limited partner of a limited partnership. As a general partner, the decedent had the right, during his lifetime, to compel the partnership to liquidate. Under the partnership agreement, however, the right lapsed at the decedent's death. Consequently, the Tax Court held that the right to liquidate the partnership would not be taken into account in valuing the interests included in the decedent's gross estate. Section 2704 -- specifically, Section 2704(a) -- overturns this result by causing the difference between the value of a decedent's interests before and after lapse to be included in the amount subject to gift or estate tax.

Legislative history describing the purpose of Section 2704(b) is scant. Without distinguishing between Section 2704(a) and Section 2704(b), the history states that "[t]hese rules do not affect minority discounts or other discounts available under present law."¹² The history also includes the following example, apparently intended to illustrate the application of Section 2704(b):

C. Minority Interest Discounts¹⁵

Prior to issuing the Proposed Regulations, the Service, as discussed in Part II.D below, had attempted to invoke Section 2704(b) to curtail taxpayers' use of minority interest discounts. Those discounts arise under the venerable willing-buyer-willing-seller test, which generally determines the value of property transferred for gift and estate tax purposes.¹⁶ Under the test, the value of property is the price at which it would exchange hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and each being reasonably informed of relevant facts.¹⁷ Where an interest in an entity is illiquid and not freely tradable, the price that a willing buyer would pay, and that a willing seller would demand, is determined based on factors such as the entity's net worth, its earning power, and its dividend-paying capacity.¹⁸

Relevant factors also include the degree of control represented by the interest, as well as the presence or absence of a market in which the interest can be sold and converted to cash.¹⁹ Appraisers generally agree that buyers pay (and sellers demand) less for an interest that does not confer control over management decisions.²⁰ Likewise, buyers pay less for an interest for which there does not exist an active market.²¹ The cases, in consequence, are legion where the value of a minority or non-controlling interest in a privately held entity has been discounted for gift and estate tax purposes.²²

Not surprisingly, taxpayers have exploited these minority interest discounts in order to depress the value of property for gift and estate tax purposes. In a typical fact pattern, a donor, before making any gift, first contributes assets, such as cash or publicly traded stock, to a limited partnership or another entity. In exchange for the contribution, the donor takes back an equity interest.²³ The donor then assigns a non-controlling interest in the entity to or for the benefit of family members.

The entity's governing documents, meanwhile, prohibit or limit the interest holder's ability to participate in management decisions, to compel the entity to liquidate, or to withdraw from the entity and receive back a share of the entity's capital. As a result of these restrictions, the value of the interest transferred is discounted in order to reflect minority interest discounts. In short, by using an entity shell, taxpayers under current law can cause the value of their property to be diminished for gift and estate tax purposes. Several cases have approved this type of planing and have allowed valuation discounts, even when the entity was funded with cash or marketable assets and gifts of entity interests occurred shortly thereafter.²⁴

D. Case Law Limiting the Scope of Section 2704(b)

The Service has sought to curb the use of artificial minority interest discounts in part²⁵ by arguing that restrictions on an interest holder's ability to liquidate or withdraw should be disregarded under Section 2704(b). In Estate of Kerr,²⁶ for example, a case discussed in the preamble of the Proposed Regulations, the taxpayers, acting on the advice of an estate tax planning attorney, formed two Texas limited partnerships, which they funded with life insurance policies, stocks, bonds, and real estate. Shortly after creation of the partnerships, the taxpayers assigned all of the general partnership interests to their children. They then transferred a small number of limited partnership units to a charity. Finally, the taxpayers made gifts of much larger numbers of limited partnership units to their children and trusts for their benefit, which the taxpayers reported on gift tax returns at values that reflected discounts for lack of marketability and control.

The Service, in seeking to assess a gift tax efficiency, argued that provisions of the partnership agreements that prevented the partnerships from dissolving without the consent of all partners should be disregarded under Section 2704(b). The Tax Court, however, declined to disregard the restriction and held that, because the provisions were not more restrictive than the liquidation provisions that would apply under Texas's limited partnership act, they were excepted from the definition of applicable restriction.²⁷ In addition, the Tax Court rejected the Service's fallback argument that the restriction on liquidation was more restrictive than Texas law because Texas' limited partnership act, but not the partnership agreements, permitted limited partners to withdraw upon six months' notice to the general partner. On the contrary, the Tax Court held, a restriction on withdrawal is not a limitation on the ability to liquidate the entity and, therefore, does not come within the scope of Section 2704(b).

The Service appealed to the Fifth Circuit, which also held for the taxpayers, but on different grounds. The Fifth Circuit declined to decide whether the restrictions on liquidation or withdrawal in the partnership agreements could in principle constitute applicable restrictions. Instead, the court held that the restrictions could not qualify as applicable restrictions because the consent of the charity, which held small numbers of limited partnership units, was required before the family could remove the restrictions. Thus, even though the charity would have likely agreed to remove the restriction, the court held that the requirements of an applicable restriction were not satisfied, and that the restrictions of the partnership agreements would not be disregarded in valuing the limited partnership interests.

E. The Proposed Regulations' Response to Kerr

As acknowledged in the preamble, the Proposed Regulations are aimed at both the Tax Court's and the Fifth Circuit's holdings in Kerr.

First, the Proposed Regulations significantly narrow the Section 2704(b)(3) exception for any restriction "imposed, or required to be imposed" by any federal or state law. Under the current regulations, a provision limiting the ability of an entity to liquidate will not be disregarded as an applicable restriction if it is no more restrictive than the default limitations that would apply under state law.²⁸ Consequently, in Kerr, the Tax Court found that the partnership agreements' restrictions on liquidating the limited partnerships were no more restrictive than the default provisions of Texas's limited partnership act, and therefore held that they were not applicable restrictions.

The Proposed Regulations would change this result, first, by providing that an "applicable restriction" includes a restriction imposed under state law.²⁹ The definition of "disregarded restrictions" similarly provides that the source of the restriction is irrelevant.³⁰ Second, the Pro-posed Regulations, taking their cue from a comment in the Tax Court's opinion in Kerr that the current regulations expand the Section 2704(b)(3)(B) statutory exception,³¹ limit the exception to provisions that apply regardless of any contrary provision of the entity's governing documents.³²

A similar rule, once again, is found in the definition of "disregarded restriction."³³ Only mandatory statutory provisions, in short, would qualify for the Section 2704(b)(3)(B) exception under the Proposed Regulations. Mere default rules, by contrast, would not act as a safe harbor under the Proposed Regulations.

Second, the Proposed Regulations define a new category of restrictions, known as "disregarded restrictions," that are disregarded for valuation purposes. In general, disregarded restrictions are restrictions that limit the ability of an interest holder to redeem or liquidate the interest.³⁴ The Tax Court in Kerr held that limitations on an interest holder's ability to withdraw from an entity did not constitute limitations on the ability of the entity itself to liquidate and, therefore, could not be disregarded as applicable restrictions. Exercising the authority granted under Section 2704(b)(4), the Service has provided in the Proposed Regulations that restrictions on withdrawal will be disregarded as "disregarded restrictions" unless they meet certain requirements, including liberal rights to compel the entity to redeem the interest.

Finally, the Proposed Regulations, in defining the term "disregarded restriction" (but not the term "applicable restriction") provide that non-family member interests will be ignored for purposes of determining whether a restriction on withdrawal can be removed by the transferor or members of the transferor's family, unless non-family member interests meet stringent requirements.³⁵ The Fifth Circuit in Kerr had held that restrictions were not applicable restrictions because a charity with a de minimis interest could veto any attempt by family members to remove the restriction. Technically, the Proposed Regulations do not disturb that holding, because non-family member interests are not disregarded under the Proposed Regulations' revised definition of "applicable restriction." In the definition of "disregarded restriction," however, the Service would ignore the rights of non-family members unless the stringent conditions are satisfied.

F. Effect of Failure to Satisfy Put Right Safe Harbor

The Proposed Regulations' targeting of Kerr strongly suggests that, if a restriction is dis-regarded under the Proposed Regulations, then discounts for lack of control and marketability would be eliminated or at least significantly reduced. Support for that inference can be found in the Proposed Regulations' creation of a safe harbor for certain put rights. Specifically, classification of a restriction as an applicable or disregarded restriction can, under the Proposed Regulations, be avoided if the interest holder has the unilateral right to withdraw from the entity, within six months of notice, in exchange for an amount of cash or other property (or, in limited cases, a note) equal to the holder's share of "minimum value" (as defined in the Proposed Regulations).³⁶ A put right of that kind would normally eliminate, or nearly eliminate, discounts for lack of control or marketability.³⁷ Thus, if the interest holder does not possess a put right meeting the requirements of the Proposed Regulations, then, it might seem, the interest must be valued as if such a put right existed. Otherwise, taxpayers would have no reason to take advantage of the put right safe harbor, as more favorable results could be achieved outside of it.

Nevertheless, since the Proposed Regulations were issued, Service officials have publicly disavowed any intent to deem interest holders to have put rights.³⁸ Indeed, Service officials deny that the Proposed Regulations would eliminate (as opposed to merely reduce) discounts for lack of marketability or lack of control.³⁹ The Proposed Regulations, in other words, despite crafting rules apparently designed to overturn the holdings of Kerr, and despite creating a safe harbor for interests having liberal put or withdrawal rights, nevertheless leave taxpayers free, as under Kerr, to exploit minority interest discounts, at least according to the public comments of the Service since the Proposed Regulations were published.

Exactly how the Proposed Regulations do affect the valuation of entity interests is not obvious. The preamble states that if an applicable restriction is disregarded, then "the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction does not exist (that is, as if the governing documents and the local law are silent on the question), and thus, there is deemed to be no such restriction on liquidation of the entity." Similarly, if a disregarded restriction is disregarded, then, according to the preamble, "the fair market value of the interest in the entity is determined assuming that the disregarded restriction did not exist, either in the governing documents or governing law." Part III discusses in detail the valuation assumptions required under the Proposed Regulations where a restriction is disregarded.

G. Other Changes of the Proposed Regulations

In addition to changes aimed at the holdings in Kerr, the Proposed Regulations introduce a number of related reforms. These include:

The Proposed Regulations also provide that the form of the entity determines the applicable control test. An entity has a corporate form if it is a corporation under Treasury Regulations § 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8), an S corporation within the meaning of Section 1361(a)(1), or a qualified subchapter S subsidiary within the meaning of Section 1361(b)(3)(B). For any other entity, the form is determined under local law, regardless of tax classification. Thus, control of a limited liability company (if not an S corporation), regardless of its check-the-box election, is determined under the new control test that applies to business entities other than corporations, partnerships, or limited partnerships.

The Proposed Regulations define the terms "applicable restriction" and "disregarded restriction" in detail but contain only brief statements of the effect that disregarding a restriction has on valuation. In the case of an applicable restriction, section 25.2704-2(e) of the Proposed Regulations provides:

B. Comparison of Nonexistence Assumption with Restrictions Disregarded under Section 2703

At first, it might seem that the nonexistence assumption simply incorporates valuation concepts that have existed for decades. In many cases, under Section 2703,⁴⁸ property interests have been valued without regard to certain rights or restrictions.⁴⁹ Even before that section was enacted, courts disregarded options to purchase property if they were not created for bona fide business reasons or were substitutes for a testamentary disposition.⁵⁰ The long history of disregarding restrictions in gift and estate tax cases may be relevant to the determination of value where an applicable or disregarded restriction is deemed not to exist. Indeed, we understand that the nonexistence assumption is intended to have effects similar to those of disregarding restrictions under Section 2703.

On closer inspection, however, it seems that the nonexistence assumption departs significantly from past cases where restrictions have been disregarded. An example of the latter is Estate of Elkins v. Commissioner.⁵¹ There, the decedent and his children, who each owned fractional interests in the same collection of artworks, effectively agreed to waive their respective rights to bring an action for partition and sale of the works. The court disregarded the waiver of the owners' partition rights under Section 2703(a), and proceeded to value the decedent's fractional interests as if a right to partition existed after all.⁵² Put another way, the court valued the decedent's fractional interests as if the default rules of state law, which granted each co-owner a right to sue for partition, applied.

Restrictions under the Proposed Regulations, by contrast, may be disregarded regardless of whether they are found in state law or any other source. As section 25.2704-3(f) of the Proposed Regulations states, fair market value is determined "as if the disregarded restriction does not exist in the governing documents, local law, or otherwise." Consequently, state law default rules cannot, as in Elkins and other cases applying Section 2703, be used to determine value, unless the state law default rules themselves meet the stringent requirements of the Proposed Regulations. If those requirements are not met, then, under the nonexistence assumption, state law default rules must be assumed not to exist. Thus, unlike Section 2703, the Proposed Regulations forbid appraisers from assuming that state law default rules apply. Exactly what appraisers are required to assume, in lieu of a default state law rule, is discussed below.

C. Nonexistence Assumption Implies a Uniform Federal Standard

The Proposed Regulations are designed to produce the same results regardless of whether restrictions are found in the governing documents, state law, or otherwise. That goal, which we support, is illustrated by the following two scenarios:

Yet the Proposed Regulations leave it unclear how, exactly, that uniform valuation result is achieved. As discussed, unlike in the case of a restriction that is disregarded under Section 2703, in the case of a restriction that is disregarded under the Proposed Regulations, state law default rules must be ignored. The Proposed Regulations imply, therefore, that taxpayers and appraisers must adopt valuation assumptions independent of state law. Presumably, those assumptions, if not found in state law, are to be found in federal law. In other words, once restrictions are disregarded, an appraiser would be required to apply a federal valuation standard.

The nonexistence assumption is apparently meant to act as that federal valuation standard. Yet neither section 25.2704-2(e) nor section 25.2704-3(f) of the Proposed Regulations, which set forth the nonexistence assumption, explains what it means, for valuation purposes, for a restriction not to exist, even under state law. In particular, neither section states explicitly what facts an appraiser should assume in lieu of restrictions that are deemed not to exist. The Proposed Regulations instead leave the reader to infer what assumptions should be applied. Below, we identify three possible inferences from the nonexistence assumption. At a minimum, the final regulations should explain what facts, exactly, an appraiser should assume in place of a provision that is deemed not to exist, and provide examples illustrating how those facts should be taken into account.

D. Three Possible Federal Valuation Standards under the Nonexistence Assumption

We can see three possible ways of understanding how an interest in an entity should be valued under the nonexistence assumption. The first, as discussed below, is that the interest holder is deemed to have a right to compel the entity to liquidate or to redeem the interest from the holder. The second is that the nonexistence assumption has no effect on valuation. A final possibility is that an appraiser must assume a state of legal uncertainty as to whether interest holders may liquidate or withdraw.

We understand that the third possibility -- an assumption of legal uncertainty -- is closest to the intent of the Proposed Regulations. Nevertheless, for the sake of comparison, we describe each possibility in further detail below.

Deeming a put or liquidation right to exist would normally increase the value of an interest for gift and estate tax purposes. After all, if an interest holder can readily exit from an entity in exchange for cash or other property, a willing buyer of the interest would be less sensitive to the usual downsides of owning an illiquid, noncontrolling interest. For example, the lack of a market for the interest would not be a worry because the holder, even without any other interested buyer, could always sell the interest back to the entity. Similarly, lack of control would not be a worry because the interest holder, if unhappy with management, could exit and have complete control to redeploy cash elsewhere. For these reasons, courts have not allowed significant discounts where interest holders have liquidation rights.⁵³

That said, we understand that the Service emphatically did not intend interest holders to be deemed to have deemed put rights.⁵⁴ Indeed, we understand that the Service does not believe that the Treasury even has the authority to deem the holder of an interest to have a put right. Consequently, where a restriction is disregarded, it appears that the final regulations will not treat holders of entity interests as having deemed liquidation or put rights.

In Scenario A and Scenario B, for example, an appraiser would value the limited partnership interest by taking into account that a limited partner could not readily convert his or her interest into cash. Consequently, especially if there is no market for the limited partnership interest, the appraiser would, as under present law, likely conclude that discounts must be applied to reflect the interest's lack of marketability. In other words, under this reading of the Proposed Regulations, as counter intuitive as it may sound, restrictions, though deemed not to exist, would still effectively be taken into account in the valuation process.

The notion that a provision is deemed not exist, yet still have the same impact on valuation as if it did exist, is hard to fathom. Certainly, it would be strange to impose complex and elaborate regulations that effectively failed to change current law. At a minimum, such regulations would create needless confusion and impose costs on taxpayers and their advisors as they try to understand them, if only to reach the conclusion that they regulation have no effect. We therefore disagree with other reports on the Proposed Regulations to the extent they recommend that the final regulations should have no effect on valuation.⁵⁵

Fortunately, we understand that the Proposed Regulations are indeed intended to have some effect on value, even if the effect is merely to reduce but not eliminate valuation discounts. The only question is how.

We urge the Service not to adopt this approach in the final regulations, whether expressly or by implication. Our objections are described below.

E. The Assumption of a Legal Vacuum

As discussed, the nonexistence assumption is intended to create a federal valuation standard independent of state law. The federal standard, however, is not that the interest holder is deemed to have the right to compel the entity to liquidate or to redeem the interest. Rather, an appraiser must assume a state of legal uncertainty as to the holder's rights to liquidate or withdraw.

For the reasons described below, we believe that the final regulations should either reject this approach or at least provide detailed examples illustrating how it should work. We have six principal objections.

Even where state law rights are uncertain, the courts, in valuing an interest in property, do not assume the existence of a legal vacuum. On the contrary, they attempt to estimate value based on how the uncertainty is likely to be resolved. In Dickerson v. Commissioner,⁵⁷ for example, a waitress who held a winning lottery ticket made a gift of her winnings to family members. In valuing the gift, the court allowed a 65% discount in order to reflect a possible lawsuit by the waitress's coworkers for a share of the winnings. (The discounts were granted even though the taxpayer ultimately defeated her co-workers' claims in Alabama Supreme Court.) To determine the discount, the Dickerson court relied on testimony from experts in Alabama law as to the validity of the co-workers' potential claims. The court did not, in other words, assume a complete legal vacuum, even though legal issues critical to the value of the property were unresolved. Rather, the court valued the property based on the probable outcomes under state law as it existed at the time of the gift.

In short, the law, like nature, abhors a vacuum. Disputes over unresolved issues arise against a background of statutes, case law, secondary literature, fundamental legal principles, and other authorities. A hypothetical world with literally no legal authority, and, therefore, no way of determining the rights of parties, does not and probably cannot exist, at least not in an advanced legal system.

Yet the nonexistence assumption, if read the way that we understand it is to be read, would require taxpayers and the courts to value entity interests assuming just such a hypothetical world. As such a world is all but impossible even to imagine, it is difficult (if not itself impossible) to value property as if such a world existed. The assumption of a legal vacuum would leave courts without any frame of reference to apply.

Consequently, if the nonexistence assumption is adopted, courts will be left with no precedents or rules to apply. That lack of precedent is not surprising, because, as discussed, a world without law is difficult even to imagine. In some sense, the very thing to be valued -- that is, the bundle of property rights represented by the entity interest -- would be left undefined. Without further guidance, courts would be left to fill in the gaps.⁶⁰

This Report takes no position on whether the Service has taken an unduly conservative (or liberal) view of the Treasury's authority. We do, however, wish to suggest that the supposed dichotomy between the authority to disregard and the authority to create -- so neatly brought to life by the metaphor of the eraser and the pencil -- is a false one. Where a provision is disregarded, some assumption must be substituted in its place.⁶¹ As we have seen, for example, where a restriction is disregarded under Section 2703(a), the property is valued as if the default rules of state law applied, as in Elkins. Similarly, under current law, where an applicable restriction is disregarded, the transferred interest is valued not only as if the restriction does not exist but also "as if the rights for the transferor are determined under the State law that would apply but for the restriction."⁶²

If state law itself is disregarded, then, as discussed previously, some federal standard must be substituted in its place. The Proposed Regulations are artfully drafted to avoid the appearance that they create a substitute rule to replace provisions that are disregarded. But the nonexistence assumption, even as intended, does create a substitute rule, namely, complete legal uncertainty as to the rights of interest holders to compel liquidation or to withdraw. The Service may or may not decide to adopt that substitute assumption, but it is a substitute assumption nevertheless. It is as much penciled into being by the Proposed Regulations as the deemed put rights that Service wishes to disavow.

To elaborate further, if literally no law exists on whether an interest holder has the right to withdraw, then it follows that an interest holder must have at least some nonzero chance of ultimately being allowed to withdraw. (The chance may be precisely fifty percent: after all, if there is, hypothetically, no law on point, then perhaps it follows that any outcome is equally likely and there is exactly a fifty percent chance of success and exactly a fifty percent chance of defeat.) A right with less than a one hundred percent probability of being vindicated is not the same thing as an undisputed right, but it is still a right. If, as the Service believes, the Treasury cannot deem interest holders to have put rights that are undisputed, then, by the same token, the Treasury cannot deem interest holders to have put rights of uncertain validity. In both cases, the regulations would be deeming a right to exist, which is the very outcome that we understand that the Proposed Regulations were attempting to avoid.

Again, we doubt that it is even possible, in principle, to disregard a restriction without positing some alternative assumption. The Service should reject the false dichotomy between "eraser" or "pencil." In any event, if the final regulations will disregard state law for valuation purposes, then they should explicitly state what federal valuation standard is substituted in its place. Failure to do so will create confusion and uncertainty.

In Lauder, the decedent was party to an agreement that required shareholders, before transferring their stock to third parties, to offer the stock to the corporation and the other shareholders at a price based on the adjusted book value of corporate assets. The court held that the option price was a device to transfer the decedent's shares to the natural objects of his bounty for less than full and adequate consideration and, consequently, disregarded the option price under Treasury Regulations § 20.2031-2(h). Ultimately, the court allowed a forty percent discount to reflect the lack of a market for the shares.⁶⁵

In Holman, the taxpayers made gifts of interests in a limited partnership holding only publicly traded Dell stock. The Tax Court held that various restrictions under the partnership agreement, including an option by the partnership to purchase interests transferred in violation of the partnership agreement, would be disregarded under section 2703 of the Code. Nevertheless, the court allowed some discount for lack of control and lack of marketability.

We understand that the Service sees Holman and Lauder as relevant because, in both cases, the courts took into account the probable desires of the other entity owners. Thus, in Lauder, the court, in a later decision,⁶⁶ allowed that, though the shareholders' agreement would be disregarded, a willing purchaser of the decedent's stock would still take into account the family's zeal to maintain control and prevent any third party from acquiring a controlling interest.⁶⁷ In Holman, the Commissioner's expert successfully argued that the discount for lack of market ability should be limited because the partners would always prefer to purchase a partner's interests at some discount than allow that partner to sell at a higher discount to a third party. A purchase for any discount, the expert argued, would increase the remaining partners' proportionate share of underlying Dell stock. Thus, the partnership and the other partners would always effectively compete to purchase any interest offered for sale, which in turn lessened the effects of the lack of a market for the transferred interests.

In neither Lauder nor Holman, however, did the intentions of other owners determine how an interest should be valued once a restriction is disregarded. In Lauder, for example, even if there had not been a shareholders' agreement, the court could still have valued the decedent's shares by taking into account the desire of the shareholders to maintain family control. Similarly, in Holman, even if the partnership agreement had not contained restrictions on transfer, the court would still have valued the interests by taking into account the rational desire of the other partners to buy the interests before they were sold to another party. In each case, in other words, the value of the transferred interest reflected the desires of other owners, but that was not because a restriction was disregarded. Rather, the courts considered the desires of other owners as a fact independent of the disregarded restriction. That a restriction was disregarded, in short, and that fair market value reflected the desires of other owners, was a coincidence in both cases.

Neither case, therefore, explains what substitute assumptions are to be applied when a restriction is disregarded under the Proposed Regulations. On the contrary, both the Lauder and Holman courts seem to have simply taken for granted that state law default rules applied. Indeed,in a footnote, the Lauder court corrected a valuation expert on whether shareholders had the right under state law to review corporate books and records.⁶⁸

As best we understand it, the authors of the Proposed Regulations view Lauder and Holman as relevant to understanding the nonexistence assumption because, if there were a complete legal vacuum, the entity holders would attempt to reach an agreement on a rule that achieves their collective goals. Perhaps, under the nonexistence assumption, appraisers and courts would be required to substitute for a disregarded provision whatever hypothetical provision the parties would agree to adopt, if they were to form the entity from scratch. But that approach would require a speculative inquiry into what the parties would freely negotiate. Furthermore, negotiation always takes place against a backdrop of legal rights, which the nonexistence assumption would ignore. A negotiation in a world without law, like a world without law itself, is difficult to imagine. As with the assumption of a legal vacuum, therefore, we do not think the hypothetical outcome of a hypothetical negotiation in a world without law is a workable federal valuation standard.

In drafting regulations designed to avoid running afoul of Chevron step one, the Service may have inadvertently cause the regulations to fail Chevron step two. The nonexistence assumption, that is, may create so much confusion and uncertainty that a court would ultimately invalidate the regulations as arbitrary and capricious.⁷¹ The Service should take this risk into account when drafting final regulations.

F. Alternative Approaches

In light of the flaws in the nonexistence assumption, we believe that the final regulations should take a different approach. We have three suggestions.

Final regulations could anticipate and foreclose possible techniques for avoiding a gift on formation. For example, a senior family member and/or his or her spouse might attempt to form and capitalize an entity initially without the participation of any other family members. No gift would occur (absent other rules) because the mere formation of a single member entity (or two-member entity with the family member's spouse) would not cause a shift of wealth to any other person, other than, perhaps, a transfer to a spouse qualifying for the gift tax marital deduction.⁷⁶ Only after the entity has been formed would the senior family member transfer interests to junior family members.

This opportunity to avoid a gift on formation through clever sequencing could be foreclosed through a rule that a gift on formation will be deemed to occur if an entity is formed in contemplation of making gifts or transfers of entity interests at valuation discounts. To determine whether an entity was formed in contemplation of making gifts, the Service could by regulation adopt presumptions that an entity was formed in contemplation of making gifts if an entity interest is transferred to or for the benefit of family members within a certain period, such as three years from formation.

Neither the Proposed Regulations nor the existing regulations (whether under Section 2701 or Section 2704) address control where the general partner interest of a limited partnership is held through a separate entity, such as a corporation or a limited liability company (a "GP Entity").⁸⁰ Similarly, no authority addresses control where a managing membership interest is held through a separate entity (a "Management Entity"). Accordingly, there is some uncertainty as to whether a taxpayer or his or her family members hold an interest as a general partner (or managing member) -- and therefore should be deemed to control a limited partnership (or limited liability company) -- by reason of holding minority or non-controlling interests in the GP Entity (or Management Entity).

We recommend that the Service modify Treasury Regulations § 25.2701-2(b)(5) to clarify that holding a non-controlling interest in a GP Entity (or Management Entity) is not equivalent to holding an interest "as" a general partner (or managing member), and therefore does not give rise to control over the limited partnership (or limited liability company). Section 2701(b)(2) provides that the holding of any interest "as" a general partner constitutes control over the limited partnership. Similarly, Treasury Regulations § 25.2701(2)(b)(5)(iii) provide that, "in the case of a limited partnership, control means the holding of any equity interest as a general partner." This statutory and regulatory language suggests that control requires the taxpayer or his or her family members to be the general partner, or hold interests authorizing such individuals to act as general partner.

Indeed, the purpose of the control rule in Section 2704 (as imported from Section 2701) is to capture entities that a taxpayer and his or her family members in fact control, before and after a lapse or transfer. Because a general partner of a limited partnership generally has the power to bind the limited partnership, it is reasonable to treat a limited partnership as a family-controlled entity if the taxpayer (or his or her family members) acts as general partner. (The same reasoning applies with respect to a taxpayer who has the authority to act as managing member of a limited liability company.) By contrast, merely holding a minority or non-voting interest in a GP Entity (or Management Entity) would not in itself authorize the taxpayer or family members to control the limited partnership as general partner (or the limited liability company as managing member), and therefore should not give rise to control for purposes of Section 2704 (or Section 2701).

The Service has itself reached this conclusion when analyzing control for purposes of a transaction under Section 2701.⁸¹ In PLR 9639054, the taxpayer and the taxpayer's applicable family members (as defined in Section 2701(e)(2)) held less than fifty percent of the capital or profits interest in a limited partnership, and further held less than fifty percent of the total voting power or equity of a corporation serving as general partner. The Service determined that the family did not control the limited partnership for purposes of Section 2701.⁸²

To provide clarity on this issue, we recommend that the final regulations incorporate the conclusion of PLR 9639054. Specifically, if a taxpayer and the members of his or her family do not control a GP Entity, and are not otherwise able to exercise the powers of the general partner, such as special voting or liquidation powers, the limited partnership should not be deemed to be a family-controlled entity, so long as the taxpayer and family members also hold less than fifty percent of the equity or profits interests in the partnership. Similarly, a limited liability company should not be a family-controlled entity provided that the taxpayer and the members of his or her family do not control a Management Entity, and are not otherwise able to exercise the powers of the managing member, and hold less than fifty percent of the equity or profits interests in the partnership.

Control of the GP Entity or Management Entity may be determined by applying the same rules that generally apply for purposes of determining control of corporations, partnerships or other entities under Sections 2701 and Section 2704. Accordingly, in the case of a GP Entity or Management Entity that is a corporation, control would constitute holding at least fifty percent of the corporation's voting power or equity, and in the case of GP Entity or Management Entity that is a partnership, control would constitute holding at least fifty percent of the capital or profits interests. Where the GP Entity or Management Entity is a limited liability company, the new rule set forth in Proposed Regulations § 25.2701-2(b)(5)(iv) should apply, so that control would mean holding at least fifty percent of entity's capital or profits interests. Finally, in the absence of a GP Entity or Management Entity (or if the taxpayer and the taxpayer's family members hold no interests in the GP Entity or Management Entity), the limited partnership or limited liability company nevertheless should be deemed to be controlled if the taxpayer or members of the taxpayer's family otherwise hold powers similar to those of a general partner or managing member, such as special voting or liquidation powers, which would enable them to act "as" general partner or managing member.

B. Lapses of Liquidation and Voting Rights

The Proposed Regulations do not state whether a transfer made before their effective date could cause a deemed lapse at death if the transferor dies within three years of the transfer but after the Proposed Regulations are effective. Taxpayers who made transfers before the Proposed Regulations were issued could not have anticipated that their transfers would cause an additional amount to be included in their gross estates. Consequently, they may not have planned adequately for the possibility of unexpected additional estate tax.⁸⁶

Further, Proposed Regulations § 25.2704-4(b)(1) provide that the new Section 2704(a) rules apply to lapses "occurring on or after the date these regulations are published in the Federal Register." Although the new rules would deem a lapse to have occurred at death as a result of transfers made three years before death, the actual lapse of liquidation or voting rights would occur at the moment of transfer. Thus, the effective date provisions of the Proposed Regulations imply that the deemed-lapse-at-death rule will not apply to transfers made before publication of the final regulations. We suggest the Service clarify that a transfer made before publication of the final regulations will not cause a deemed lapse at death.

The difference between OBRA and the Proposed Regulations may create an inadvertent discrepancy between transfers of interests in entities created before and after October 8, 1990. To illustrate, consider the following two variations of Treasury Regulations § 25.2704-1(f), Example 4, as amended by the Proposed Regulations:

The OBRA effective date provisions do not necessarily compel such a discrepancy. Although, in Variation 2, D's rights as a shareholder existed on or before October 8, 1990, the limitation on D's right to liquidate was not created until after that date. That is, the limitation did not exist on October 8, 1990; it only came into being on the date of D's transfers to his children. Thus, under the statutory effective date, Section 2704(a) should apply in both variations. In any event, there does not appear to be a policy justification, based on taxpayer reliance or otherwise, for foreclosing planning opportunities that arise from the mere act of transfer, but only where the transferred interest was created after October 8, 1990. We recommend, therefore, that the Service clarify that the new Section 2704(a) rules apply to any lapses, regardless of when the entity interest was created, that result from transfers occurring after the final regulations are published.⁸⁹

C. Issues (Other than Determination of Value) Common to Applicable Restrictions and Disregarded Restrictions

The following examples illustrates the possible interaction of Sections 2703 and 2704(b).

Suppose instead that, unlike in the foregoing example, neither the operating agreement nor the buy-sell provisions satisfies the requirements of Section 2703(b). In other words, consider the following example:

In light of these possibilities, the final regulations should clarify the effect of the Section 2703 exception. Presumably, in crafting the exception, the Service was merely trying to confirm its view that Section 2703 and Section 2704(b) do not overlap, but did not intend to cause restrictions to escape the application of Section 2704(b) artificially. The Service could avoid creating an unintended loophole by clarifying that Section 2703(a) does not apply to restrictions on liquidating an entity or redeeming an interest in an entity.

Alternatively, the Service could consider deleting altogether the exception for restrictions subject to Section 2703. If the Service is correct that Section 2703 and Section 2704(b) do not overlap, then the exception is unnecessary, because it merely restates existing law. But if Section 2703 and Section 2704(b) do overlap, then deleting the exception will avoid creating an unjustified exception to the rules of Section 2704(b).

For example, the Treasury could be whipsawed if Section 2704(b) applied to the valuation of entity interests transferred to the grantor in satisfaction of GRAT annuity amounts. Suppose that, before the final regulations become effective, an individual funds a GRAT with an interest in an entity that, after the application a minority interest discounts, is worth $1 million. As a result of the discount, the donor can, without increasing the amount of the donor's taxable gift, reduce the annuity amounts required to be paid to him or her. Nevertheless, if the annuity amounts are later in paid in kind with entity interests that are not discounted, then fewer entity units will be needed to satisfy the annuity amounts, and more property will pass tax-free to the remainder men if the grantor survives the fixed term. In short, the donor is able to exploit discounts in funding the GRAT, yet exploit the lack of discounts when the annuity amounts are paid.⁹³

On the other hand, a rule that Section 2704(b) does not generally apply to transfers of entity interests by trusts could sometimes whipsaw taxpayers. Suppose, for example, that a trust holds an entity interest worth $1 million without discounts but only $600,000 after traditional valuation discounts are applied. Suppose, further, that the grantor of the trust acquires the interest in exchange for cash equal to the value of the interest. If the entity interest is valued with discounts, then the grantor must pay the trust no more than $600,000 in order to avoid a part-gift-part-sale. But if the grantor thereafter transfers the interest by gift or at death, the interest could be deemed to be worth $1 million if valuation discounts are eliminated. In other words, in exchange for $600,000, the grantor would effectively receive $1 million of value. The amount subject to wealth transfer tax would be artificially increased by the $400,000 difference.

Finally, to turn the tables yet again, taxpayers could themselves sometimes exploit a general rule that Section 2704(b) does not apply to transfers of property by trusts. Suppose, for example, that a trust that is not exempt from GST tax holds an entity interest worth $1 million without discounts but only $600,000 after traditional valuation discounts are applied. If the interest is transferred to a skip person in a generation-skipping transfer, and the interest is valued without discounts, then a GST tax will be imposed on the amount of $1 million. But before that happens, suppose that a trust that is exempt from GST tax acquires the interest in exchange for cash equal to the value of the interest. If the interest is valued with discounts, then the non-GST-exempt trust can transfer $1 million of taxable value to the exempt trust, but in exchange for only $600,000 of cash. An amount equal to the $400,000 difference escapes GST tax.

In light of the foregoing complexities, we recommend that the Service study further how entity interests transferred by trusts should be valued in light of Section 2704(b). The Service could first solicit views on this interesting topic from the public and the bar.

D. Applicable Restrictions

E. Disregarded Restrictions

We agree that the "actually paid" requirement should not be incorporated into the determination of minimum value.⁹⁵ It is uncertain, however, how the "(if paid)" parenthetical assumption should be applied in cases where the value of an obligation is uncertain. Suppose, for example, that a claim for $100,000 of damages has been alleged against an entity, but the claim has only a fifty percent probability of success. The final regulations should clarify that, in deter-mining minimum value, it is not the face amount of the claim (i.e., $100,000) but only its expected value (i.e., $50,000) that is taken into account.

Alternatively, the final regulations could either (i) provide that the "actually paid" requirement for deducting claims under Section 2053 does not apply to the determination of the net value of an entity or (ii) incorporate Section 2053 concepts more narrowly. Under the latter approach, the final regulations would provide that obligations shall be respected only to the extent that they are enforceable obligations of the entity at the time of transfer and, if founded on a promise or agreement, are bona fide and contracted for full and adequate consideration in money or money's worth. The meaning of those terms could be as defined in Section 2053 and Treasury Regulations § 20.2053-4. In addition, the Proposed Regulations could confirm that post-transfer events may be considered in determining an entity's net value.

Resolution of the issue ultimately turns on whether, with respect to transfers (or deemed transfers) at death, the special valuation rules under Section 2704 and its regulations, when applicable, establish fair market value at the time of death for purposes of Section 1014. On the one hand, both Section 2704(a) and Section 2704(b) include introductory language stating that the provisions apply "for purposes of this subtitle."⁹⁸ Section 2704 appears in subtitle B, governing estate tax, gift tax, generation-skipping transfer tax and inheritance tax (applicable with respect to covered expatriates).

In contrast, Section 1014 is set forth in subtitle A, dealing with income tax. Furthermore, while Section 1014 provides that the basis of property is the property's fair market value at the decedent's death, Section 2704 does not include any specific reference to fair market value. Section 2704(b) states that "any applicable restriction shall be disregarded in determining the value of the transferred interest," but does not mention "fair market value."⁹⁹ Section 2704(a) provides that the amount of a deemed transfer is the value of all interests in the entity held by the individual before the lapse less the value of such interests after the lapse, but similarly does not refer to "fair market value."¹⁰⁰

On the other hand, Treasury Regulations § 1.1014-1(a) expressly states that "the purpose of section 1014 is, in general, to provide a basis for property acquired from a decedent which is equal to the value placed upon such property for purposes of Federal estate tax." (emphasis added).¹⁰¹ Because Section 2704 enhances the value of property for estate tax purposes, it follows that this Section 2704 value should determine the Section 1014 basis of the property in the hands of the transferee. Moreover, while Section 2704 does not expressly refer to the term "fair market value," it is clear that the application of the statute (and its regulations) establishes fair market value for transfer tax purposes.

The Proposed Regulations provide that, if a restriction is disregarded, "the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist."¹⁰² Further, Example 4 of Proposed Regulations § 25.2704-3(g) explains that, for purposes of calculating a decedent's estate tax inclusion and marital deduction, the value of an interest subject to Section 2704(b) is the fair market value of such interest, taking into account all relevant factors affecting value, while assuming any disregarded restriction does not exist. With respect to Section 2704(a), the proposed regulations provide that lapses subject to the statute are treated as taxable transfers for estate, gift and generation-skipping transfer tax purposes.¹⁰³ Therefore, for lapses deemed to occur at death, Section 2704(a) establishes value for estate tax purposes, which generally is the fair market value. Moreover, while not directly on point, Section 1014(f) provides that, for tax and reporting purposes, the basis of property acquired from a decedent generally should be consistent with the estate tax value. This demonstrates a policy interest in ensuring basis consistency.

On balance we believe the better approach is to treat the basis of property transferred at death, which is subject to Section 2704, as equal to the value established for such property under Section 2704 and its regulations. Similarly, if, under Proposed Regulations § 25.2704-1(c)(1), a lapse is deemed to occur at death by reason of a transfer occurring within three years of death, the amount of the lapse, which establishes value for estate tax purposes, should be included in the transferee's basis under Section 1014. The foregoing may be addressed either in the final regulations to Section 2704 or by modifying the regulations to Section 1014. Adopting an approach that ensures consistency between basis for income tax purposes and estate tax value established under Section 2704 promotes fairness. Further, treating fair market value of interests determined under Section 2704 differently than fair market value for purposes of determining basis under Section 1014, or remaining silent on the issue, would create unnecessary complexity and confusion.¹⁰⁴

² 81 Fed. Reg. 51413 (Aug. 4, 2016).

³ All references in this Report to "Sections," except as otherwise indicated, are to sections of the Code.

⁴See, e.g., Matthew R. Madara, Proposed Estate Tax Regs Have Been Misconstrued, Official Says, 2016Tax Notes Today 1918 (Oct. 3, 2016); Colleen Murphy, 'A Lot of Misunderstanding' Surrounds New Estate Tax Rules, 191 Daily Tax Report G1 (Sept. 30, 2016); Matthew R. Madara, Misinformation Cited in Estate Tax Valuation Rules Controversy, 2016 Tax Notes Today 223-5 (Nov. 17, 2016).

⁵ Pub. L. 101-508 § 11602(a), 104 Stat. 1388, 1388-491 to 1388-500 (1990).

⁶ I.R.C. § 2704(a)(2).

⁷ Treas. Reg. § 25.2704-2(b).

⁸ Prop. Reg. § 25.2704-3.

⁹ 113 T.C. 449 (1999), aff'd, 292 F.3d 490 (5th Cir. 2002).

¹⁰ H. Conf. Rep. No. 101-964, at 1137 (1990) , 1991-2 C.B. 560, 606.

¹¹ T.C. Memo 1987-8.

¹² H. Conf. Rep. No. 101-964, at 1137 (1990), 1991-2 C.B. 560, 606.

¹³ H. Conf. Rep. No. 101-964, at 1137 (1990), 1991-2 C.B. 560, 606.

¹⁴Id.

¹⁵ This Report uses the term "minority interest discount" as an umbrella term for the types of discounts, primarily for lack of control and lack of marketability, that are associated with non-controlling interests in privately held entities.

¹⁶ Treas. Reg. §§ 20.2031-1(b), 25.2512-1; Rev. Rul. 59-60; United States v. Cartwright 411 U.S. 546, 551 (1973) (noting that "[t]he willing buyer-willing seller test of fair market value is nearly as old as the federal income, estate, and gifts taxes themselves.").

¹⁷ Treas. Reg. §§ 20.2031-1(b); 25.2512-1; Rev. Rul. 59-60.

¹⁸ Treas. Reg. § 20.2031-2(f).

¹⁹See, e.g., Lappo v. Comm'r, T.C. Memo 2003-258 (allowing a 15% lack-of-control discount and 24%lack-of-marketability discount for limited partnership interests in an limited partnership which held municipal bonds and two pieces of commercial real estate).

²⁰See, e.g., Estate of Heck v. Comm'r, T.C. Memo 2002-34 (applying a 10% discount for lack of control over corporate dividend policy).

²¹See Lappo v. Comm'r, T.C. Memo 2003-258.

²²See, e.g., Lappo v. Comm'r, T.C. Memo 2003-258 (allowing a 15% lack-of-control discount and 24% lack-of-marketability discount); Pierre v. Comm'r, T.C. Memo 2010-106 (allowing for a 30% lack of marketability discount); Est. of Thompson v. Comm'r, T.C. Memo 2004-174 (allowing for a 15% lack-of-control discount and 30% lack-of-marketability discount).

²³ Often, the donor will be the sole initial owner of the entity, so that no gift results from the capital contribution. Even if others contribute capital to the entity, the courts have held that no gift occurs so long as each owner receives an interest that is proportionate to his or her share of capital contributions. Est. of Strangi v. Comm'r, 115 T.C. 478 (2000), aff'd in part and rev'd in part, 293 F.3d 279 (5th Cir. 2002); Est. of Jones v. Comm'r, 116 T.C. 121 (2001); Church v. United States, 268 F.3d 1063 (5th Cir. 2001), aff'g per curiam 2000 WL 206374 (W.D. Tex. 2000); see also Shepherd v. Comm'r, 115 T.C. 376, 389 (2000), aff'd 283 F.3d 1258 (11th Cir. 2002) ("Obviously, not every capital contribution to a partnership results ina gift to the other partners, particularly where the contributing partner's capital account is increased by the amount of his contribution, thus entitling him to recoup the same amount upon liquidation of the partnership."). Thus, it is relatively easy, under current law, to avoid a gift on formation of an entity.

²⁴See, e.g., Holman v. Comm'r, 130 T.C. 170 (2008), aff'd 601 F.3d 763 (8^th Cir. 2010); Linton v. United States, 630 F.3d 1211 (9th Cir. 2011), aff'g in part and rev'g in part 638 F. Supp. 2d 1277 (W.D. Wash. 2009).

²⁵ The Service has advanced other arguments to deny discounts, with limited success. The Service's strategy for attacking abuse of valuation discounts is set forth in FSA 200049003 (Sept. 1, 2000). See also TAM 9842003 (Oct. 16, 1998); FSA 199950014 (Sept. 15, 1999). Of the arguments developed therein, the Service has perhaps had the most, albeit still limited success advancing the theory that assets of an entity may be included in a decedent's gross estate at death under Section 2036.

²⁶ 113 T.C. 449 (1999), aff'd, 292 F.3d 490 (5th Cir. 2002).

²⁷ Interestingly, the Tax Court commented that Treas. Reg. § 25.2704-2(b) represents a regulatory "expansion" of the Section 2704(b)(3)(B) exception for a restriction that is "imposed, or required to be imposed" by any federal or state law.

²⁸ Treas. Reg. § 25.2704-2(b).

²⁹ Prop. Reg. § 25.2704-2(b)(2).

³⁰ Prop. Reg. § 25.2704-3(b)(2).

³¹ 113 T.C. at 472.

³² Prop. Reg. § 25.2704-2(b)(4)(ii).

³³ Prop. Reg. § 25.2704-3(b)(5)(iii).

³⁴ Prop. Reg. § 25.2704-3.

³⁵ Prop. Reg. § 25.2704-3(b)(4).

³⁶ Prop. Reg. §§ 25.2704-2(b)(4)(iv), 25.2704-3(b)(5)(v). For the definition of put right, see Prop. Reg. § 25.2704-3(b)(6).

³⁷Cf. Est. of Jones v. Commissioner, 116 T.C. 121 (2001) ("We do not believe that a seller of [an interest that could force liquidation] would part with that interest for substantially less than the proportionate share of the NAV.")

³⁸ Matthew R. Madara, Misinformation Cited in Estate Tax Valuation Rules Controversy, 2016 Tax Notes Today 223-5 (Nov. 17, 2016) (quoting an official as stating that a deemed put right "isn't there"). LISI Estate Planning Newsletter #2467 (Oct. 31, 2016) reports that, on October 28, 2016, at the recent Notre Dame Tax and Estate Planning Institute, a Service official "stated that the six month put right provision in the Proposed Regulations does not mean that interests would be valued as if they were subject to a six month put right," and "expressed surprise that commentators were concluding that normal state law restrictions on liquidation of an entity would not yield the same discounts as now apply.").

³⁹ Matthew R. Madara, Proposed Estate Tax Regs Have Been Misconstrued, Official Says, 2016 Tax Notes Today 1918 (Oct. 3, 2016); Colleen Murphy, 'A Lot of Misunderstanding' Surrounds New Estate Tax Rules, 191 Daily Tax Report G1 (Sept. 30, 2016).

⁴⁰ Prop. Reg. §§ 25.2704-1(a), 2(a) and -3(a). More specifically, any business entity within the meaning of Treas. Reg. § 301.7701-1(a) will be treated as a partnership regardless of the entity's classification for other federal tax purposes, unless it is described in Treas. Reg. § 301.7701-2(b)(1) , (3), (4), (5), (6), (7), or (8), an S corporation within the meaning of Section 1361(a)(1), or a qualified subchapter S subsidiary within the meaning of Section 1361(b)(3)(B).

⁴¹ Section 2704 will normally only apply where an entity has two or more owners. A disregarded entity, by contrast, may only have a single owner. Treas. Reg. § 301.7701-3(b)(ii). The paradox of a "disregarded entity" having two or more owners arises where one owner is an individual and the other owner or owners are grantor trusts with respect to that individual. See PLR 200102037 (Oct. 12, 2000) (treating a limited liability company owned by a grantor and a grantor trust as a disregarded entity); FSA 200035006 (Sept. 1, 2000) (concluding that a partnership did not exist for tax purposes where the only partners were taxpayer and a grantor trust treated as owned by taxpayer). The Service may wish to consider amending the check-the-box regulations under Section 7701 in order to clarify that a "disregarded entity" is not disregarded for gift, estate and GST tax purposes. Cf. Pierre v. Comm'r, 133 T.C. 2 (2009).

⁴² Treas. Reg. § 25.2704-1(c)(1). However, if the transferor retains an interest that is subordinate to the transferred interest, the transfer is a lapse of a liquidation right if it results in the elimination of the transferor's right or ability to compel the entity to acquire that subordinate interest.

⁴³See Treas. Reg. § 25.2704-1(f), Ex. 4.

⁴⁴ Prop. Reg. § 25.2704-1(c)(1).

⁴⁵Id. at (f), Example 4.

⁴⁶ 113 T.C. 449 (1999), aff'd 292 F.3d 490 (5th Cir. 2002). The Tax Court in Kerr found that the transferees had been admitted as partners and, therefore, did not acquire assignee interests.

⁴⁷ Prop. Reg. § 25.2704-1(a)(4).

⁴⁸ Section 2703 generally disregards, for gift, estate and GST tax valuation purposes, options and other rights to purchase property for less than fair market value, as well as restrictions on the right to sell or use property.

⁴⁹See, e.g.,Est. of Elkins v. Comm'r, 140 T.C. 86 (2013), rev'd on other grounds, 767 F.3d 443 (5th Cir.2014); Holman v. Comm'r, 130 T.C. 170 (2008), aff'd 601 F.3d 763 (8^th Cir. 2010); Fisher v. United States, 106 A.F.T.R.2d 2010-6144 (S.D. Ind. 2010); Est. of Blount v. Comm'r, T.C. Memo. 2004-116, rev'd on other grounds, 428 F.3d 1338 (11^th Cir. 2005).

⁵⁰See, e.g., Dorn v. United States, 828 F.2d 177 (3^rd Cir. 1987); Est. of Lauder v. Comm'r, TC Memo. 1990-530; St. Louis County Bank v. United States, 674 F.2d 1207 (8^th Cir. 1982); Bommer Revocable Trust v. Comm'r, T.C. Memo. 1997-380; Est. of True v. Comm'r, T.C. Memo 2001-167, aff'd 390 F.3d 1210 (10^th Cir. 2004); Est. of Godley v. Comm'r, T.C. Memo 2000-242, aff'd on other grounds, 286 F.3d 210 (4^th Cir. 2002); see also Treas. Reg. § 20.2031-2(h).

⁵¹ 140 T.C. 86 (2013), rev'd on other grounds, 767 F.3d 443 (5th Cir. 2014).

⁵² As it turned out, however, under the court's valuation analysis, which was rejected on appeal by the Fifth Circuit, 767 F.3d 443 (5th Cir. 2014), the decedent's partition right had little effect on value.

⁵³Cf. Est. of Jones v. Commissioner, 116 T.C. 121 (2001) ("We do not believe that a seller of [an interest that could force liquidation] would part with that interest for substantially less than the proportionate share of the NAV.")

⁵⁴ Matthew R. Madara, Proposed Estate Tax Regs Have Been Misconstrued, Official Says, 2016 Tax Notes Today 1918 (Oct. 3, 2016); Colleen Murphy, 'A Lot of Misunderstanding' Surrounds New Estate Tax Rules, 191 Daily Tax Report G1 (Sept. 30, 2016); LISI Estate Planning Newsletter #2467 (Oct. 31, 2016); Matthew R. Madara, Misinformation Cited in Estate Tax Valuation Rules Controversy, 2016 Tax Notes Today 223-5 (Nov. 17, 2016).

⁵⁵See, e.g., The American College of Trusts and Estates Counsel (ACTEC) Comments on Proposed Regulations Under Section 2704 at 1 ("ACTEC seeks clarification that the price that a third party, unrelated purchaser would be willing to pay for an interest continues to be the appropriate measure of fair market value for federal transfer tax purposes and that specific features such as illiquidity, fiduciary duty to other owners, and other causes of inability or reluctance to liquidate an interest will continue to be treated as legitimate factors that a third party purchaser would take into account in determining the price he or she is willing to pay.").

⁵⁶See, e.g., section 601 of the Uniform Limited Partnership Act.

⁵⁷ T.C. Memo 2012-60.

⁵⁸ 133 T.C. 2 (2009).

⁵⁹See also Morgan v. Comm'r, 309 U.S. 78, 80-81 (1940) ("State law creates legal interests and rights. The federal revenue acts designate what interests or rights, so created, shall be taxed."); Knight v. Comm'r, 115 T.C. 506, 513 (2000) ("State law determines the nature of property rights, and Federal law determines the appropriate tax treatment of those rights.").

⁶⁰ Does the assumption of a legal vacuum, for example, mean that the parties would have literally no recourse to a court in order to resolve a dispute over liquidation or withdrawal rights? In that case, perhaps, the parties may need to settle their dispute through extra-legal means (as in a Hollywood Western, perhaps). Or perhaps it means that there is a precisely equal 50% probability of either side prevailing in court.

⁶¹ The metaphor even fails on its own terms: where a mark is erased, it leaves not a metaphysical void but at least a space, if not a smudge.

⁶² Treas. Reg. § 25.2704-2(c).

⁶³ 130 T.C. 170 (2008), aff'd 601 F.3d 763 (8^th Cir. 2010).

⁶⁴ T.C. Memo 1992-736.

⁶⁵ T.C. Memo 1994-527.

⁶⁶ T.C. Memo 1994-527.

⁶⁷ T.C. Memo 1994-527.

⁶⁸ T.C. Memo 1994-527 at footnote 16.

⁶⁹ 467 U.S. 837 (1984).

⁷⁰ 562 U.S. 44 (2011).

⁷¹Cf. Balestra v. United States, 803 F.3d 1363 (Fed. Cir. 2015) (upholding a regulation under step two of Chevron while also requiring that an agency's path to achieving its goals be "reasonably discernible").

⁷² As stated in the text, this Report takes no position on whether the Treasury has the authority under Section 2704(b)(4) to deem interest holders to possess certain rights.

⁷³See TAM 9842003 (Oct. 16, 1998); FSA 199950014 (Sept. 15, 1999).

⁷⁴Est. of Strangi v. Comm'r, 115 TC 478 (2000), aff'd in part and rev'd in part, 293 F.3d 279 (5th Cir.2002); Estate of Jones v. Comm'r, 116 TC 121 (2001); Church v. United States, 268 F.3d 1063 (5th Cir. 2001).

⁷⁵ The Service could also consider permitting taxpayers to elect, in lieu of a gift on formation, to have interests in the entity valued without discounts when transferred at death or by gift.

⁷⁶See Rev. Rul. 71-443.

⁷⁷See I.R.C. §§ 2704(a)(1), 2704(b)(1) and 2701(b)(1).

⁷⁸See I.R.C. § 2704(c)(1).

⁷⁹ I.R.C. § 2701(b)(2)(B) (emphasis added). See also Treas. Reg. § 25.2701-2(b)(5)(iii).

⁸⁰ In the case of a corporation, Section 2701(b)(2) provides that control means "the holding of at least 50 percent (by vote or equity) of the stock of the corporation." Prop. Reg. § 25.2701-2(b)(5) provides that, in the case of a limited liability company, control means holding at least 50 percent of either the capital interests or profits interests.

⁸¹See PLR 9639054 (Sept. 27, 1996).

⁸²Id.

⁸³ The only exception under current law applies where the transferor retains a subordinate interest and loses the effective power to compel liquidation as a result of the transfer of a senior interest. Treas. Reg. § 25.2704-1(c).

⁸⁴ The Proposed Regulations appear to subtly expand the scope of the general rule that Section 2704(a) does not apply to transfers of entity interests. Whereas the current regulations provide that a transfer that results in the lapse of a liquidation right is not generally subject to Section 2704(a) (if the rights associated with the interest are not restricted or eliminated), the Proposed Regulations provide that a transfer that results in the lapse of a liquidation or voting right is not generally subject to Section 2704(a) (if the rights associated with the interest are not restricted or eliminated and the transfer occurs more than three years before death). Likewise, under the Proposed Regulations, a lapse of either liquidation or voting rights may be deemed to occur at death as a result of transfers within three years of death. It is unclear what the expansion of these rules to encompass lapses of voting rights is intended to accomplish. We suggest that Service clarify the intent in the preamble of the final regulations.

⁸⁵ Section 2704(a) does not apply unless the holder of the interest and members of the holder's family control the entity both before and after the lapse. We recommend that the final regulations clarify that, although the lapse is deemed to occur at death, family control is determined before and after the moment of transfer.

⁸⁶ In some cases, such as where a taxpayer dies with no other assets that can be liquidated in order to pay the tax, the three-year deemed lapse rule may cause the estate taxes due at death to exceed the value of the property out of which the tax can be paid.

⁸⁷ Pub. L. 101-508 § 11602(e)(1)(A)(iii), 104 Stat. 1388, 1388-500 (1990).

⁸⁸ Prop. Reg. § 25.2704-4(b)(1) (emphasis added).

⁸⁹ If the Service chooses to preserve an exception for transfers of interests in entities created on or before October 8, 1990, then we recommend that the final regulations define the circumstances, if any, where a post-October 8, 1990, modification to an entity or other agreement, or to applicable state law, causes the new rules to apply to an otherwise grandfathered lapse.

⁹⁰ Prop. Reg. § 25.2704-3(b)(5)(iv). Section 2703(a) generally provides that the value of property shall be determined without regard to (i) any option, agreement or other right to acquire or use the property at a price that is less than the property's fair market value (without regard to such option, restriction or right), and (ii) any restriction on the right to sell or use such property. Section 2703(b) creates an exception for an option, restriction, or agreement that meets certain requirements, i.e., that it is a bona fide business arrangement, not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth, and is comparable to similar arrangements entered into by persons in an arm's length transaction.

⁹¹ The preamble to the Proposed Regulations claims that Section 2703 and Section 2704(b) do not overlap. We are not certain that this claim is correct. In Est. of Elkins v. Comm'r, 140 T.C. 86 (2013), rev'd on other grounds, 767 F.3d 443 (5th Cir. 2014), for example, the Tax Court held that an agreement waiving the owners' ability to compel a liquidation of property was disregarded under Section 2703. Conceivably, the Service could provide by regulation that restrictions on compelling liquidation of an entity are likewise disregarded under Section 2703. But cf. Est. of Strangi v. Comm'r, 115 T.C. 478 (2000), aff'd in part and rev'd in part, 293 F.3d 279 (5th Cir. 2002) (declining to disregard the existence of a limited partnership under Section 2703); Church v. United States, 268 F3d 1063 (5th Cir. 2001), aff'g per curiam 2000 WL 206374 (W.D. Tex. 2000) (same).

⁹² The gift tax applies to transfers of property by individuals, but not to transfers of property by trusts. I.R.C. § 2501(a).

⁹³ The opposite whipsaw effect is also possible: if entity discounts are reduced or eliminated on funding a GRAT, but are respected when valuing interests paid in kind to the grantor, then the annuity amounts must be increased in order to reduce the grantor's taxable gift, even as more entity units would be required to pay the annuity.

⁹⁴ If a claim is not actually paid, then, to deduct it for estate tax purposes, an estate must generally file a protective claim for refund. Not until the claim is actually paid may the estate claim the deduction, together with an estate tax refund.

⁹⁵ Applying the actually paid requirement to the determination of minimum value would create administrative complexity and would delay final determination of gift tax values, even as those values (as a result of the progressive rate structure of Section 2001(c) and the unified gift and estate tax credit) determine the amount of taxes due in later years and at death. It would also require resolution of ancillary issues, such the scope and application of exceptions to the actually paid requirement.

⁹⁶ Prop. Reg. § 25.2704-3(b)(1)(ii).

⁹⁷See I.R.C. § 1014(a).

⁹⁸See I.R.C. §§ 2704(a)(1) and 2704(b)(1).

⁹⁹See I.R.C. § 2704(b)(1).

¹⁰⁰See I.R.C. § 2704(a)(2).

¹⁰¹ Treas. Reg. § 1.1014-1(a); see also Rev. Rul. 54-97.

¹⁰² Prop. Reg. § 25.2704-3(f); See also Prop. Reg. § 25.2704-2(e).

¹⁰³See Prop. Reg. § 25.2704-1(a).

¹⁰⁴ For similar reasons, we believe that the basis of property transferred by gift, for purposes of determining loss under Section 1015(a), should be equal to the value of such property established under Section 2704.