On August 4, the Internal Revenue Service finally issued much anticipated proposed regulations under Section 2704 of the Internal Revenue Code, which regulations are intended to significantly limit taxpayers' ability to apply valuation discounts to family controlled entities. If finalized, the effect of the regulations will be profound on valuation discount planning. 

In 1990, Congress enacted Section 2704 as part of an agenda to close loopholes in gift and estate laws. Section 2704 addresses three distinct issues: (i) lapses of voting and liquidation rights in family controlled entities; (ii) restrictions on liquidation which are disregarded for valuation purposes; and (iii) the authority of the Treasury to issue additional regulations to address other restrictions which will be disregarded for valuation purposes. However, in practice, section 2704 has not had the IRS's intended effect, as valuation experts continue to apply various discounts – and courts continue to uphold such discounts assuming proper planning - based on the types of restrictions included in the governing documents of an entity.

However, Section 2704(b)(4) authorizes the Treasury to issue additional regulations to address other restrictions which will be disregarded for valuation purposes when an interest in a family controlled entity is transferred if the "restriction has the effect of reducing the value of the transferred interest for purpose of this subtitle but does not ultimately reduce the value of such interest to the transferee." The proposed regulations issued on August 4 are the IRS's most recent action to limit what it perceives to be abusive conduct. In brief, the proposed regulations:

1. Define the types of entities covered by the regulations including, but not limited to, business arrangements, corporations, and partnerships.
2. Establish a bright line rule to provide that any lapse of liquidation or voting rights occurring as a result of a transfer within three years of death be treated as an additional transfer subject to transfer tax. The effect of this would be the elimination of death bed transfers to realize minority interest discounts.
3. Create a new class of "disregarded restrictions" which will be ignored for purpose of valuing an interest in a family controlled entity if the restrictions will lapse after a transfer or if the individual transferor or the transferor's family may remove or override the restriction. These disregarded restrictions include anything that: (i) limits the owner's ability to liquidate the interest, (ii) defers payment of the proceeds from liquidation for more than six months, (iii) allows payment of liquidation proceeds in any manner other than cash, property or certain notes, and (iv) limits the liquidation proceeds to amount less than the fair market value.
4. Disregard liquidation restrictions which are not mandated by state or federal law in determining the fair market value of a transferred interest.
5. Eliminate discounts based on a transferee's status as an assignee and not as a full owner of the entity.
6. Broaden the definition of family control for purpose of determining what non-family members may participate in the removal of a disregarded restriction.

If finalized, the proposed regulations will reduce and potentially eliminate discounts currently available and widely utilized in business succession and estate planning for gift and estate tax valuation purposes. A public hearing is scheduled on December 1, 2016 in Washington, DC, to discuss the proposed regulations. Although it is unknown when the proposed regulations will be finalized, transfers made prior to finalization will not be subject to the vast majority of the regulations. Therefore, time is of the essence if you intend to benefit from currently available discounts for a transfer of a non-controlling interest in a family controlled entity.