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The IRS Section 2704 Dilemma – What is Value?

In an earlier article, we discussed the Internal Revenue Service’s proposed regulation changes to IRS Sections 2704 and 2701 of the Internal Revenue Code. If implemented, these changes would treat the transfer of fractional equity interests between related parties differently than other transactions. The results of these proposed changes to the tax code are anticipated to have detrimental consequences for family-owned businesses.

The proposed changes are widely considered by estate planning professionals to be confusing and ambiguous at best. As many of our clients are either closely-held business owners or advisors to individuals with ownership in closely-held entities, we wanted to translate some of the proposed changes into a monetary calculation. Specifically, this is an analysis of the proposed changes to Chapter 14 of IRS Section 2704 regarding the liquidity and marketability of a fractional equity interest in a related party transaction.

Scenario One:  A married couple founded a business (the “Company”). Together, they own 100% of the equity in the Company (referred to as a control position). An opinion of fair market value from an independent valuation firm has concluded that, as November 1, 2016 (date of value), the fair market value of the total equity in the Company is $40,000,000 based upon the IRS’s standard definition of Fair Market Value as follows.

The price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”[1]

If the couple (or either one of them) decided to sell a 10% interest in the Company to any party, related (family member) or unrelated (corporate officer, outside investor, etc.) the sale price of such interest would typically reflect discounts for lack of control recognizing that a 10% interest would have no ability to control decisions made for the Company and lack of ready marketability since, unlike a holding of shares in a publicly-traded company, there is no readily available market for the 10% interest being sold in this example. Under the current fair market value definition, which is reflective of economic reality, the fair market value of the 10% interest would be as follows:

Fair Market Value of a 100% interest in the Equity of the Company:                                              $40,000,000

Pro-Rata Value of 10% interest in the Equity of the Company at Control                                         $4,000,000

Discount for Lack of Control = 20%                                                                                                           –  800,000

Marketable Minority Value of 10% Interest                                                                                            $3,200,000

Discount for Lack of Marketability = 25%                                                                                                 –  800,000

Fair Market Value of minority, non-marketable 10% interest                                                             $2,400,000

 

Scenario Two:  Let’s now assume that the couple wanted to sell a 10% interest to each of their four children. Under the current definition of fair market value, which again reflects economic reality, the total sales price would be:

Sale of 10% interest to each of four children:                                                                                =    $9.6 Million

Under the Proposed Changes to IRS Section 2704, a sale of the same 10% minority interests to their children would not permit discounts for lack of control or lack of ready marketability. The standard of Fair Market Value would not apply in this situation.  Instead, a newly defined “Minimum Value” would be the standard of value for all related party (familial) transactions and the valuation would look like the following:

Fair Market Value of a 100% interest in the Equity of the Company:                                             $40,000,000

Pro-Rata Value of 10% interest in the Equity of the Company at Control                                        $4,000,000

Discount for Lack of Control = 0%                                                                                                            –  000,000

Marketable Minority Value of 10% Interest                                                                                          $4,000,000

Discount for Lack of Marketability = 0%                                                                                                 –  000,000

Fair Market Value of minority, non-marketable 10% interest                                                           $4,000,000

Scenario Three: Considering the same assumption that the couple wanted to sell a 10% interest to each of their four children, under the new definition of Minimal Value under the proposed IRS Section 2704 rules, which does not reflect economic reality, the total sales price would be:

Sale of 10% interest to each of four children:                                                                                =    $16.0 Million

 

Scenario Four: Taking this example a step further, if one of the four children owning the newly acquired 10% interest, valued at $4 Million under the proposed IRS Section 2704 rules, wants to use his/her shares as collateral for a loan, the value the bank would accept for the shares is Fair Market Value, or $2.4 Million, since no outside party would be willing to pay $4 Million for the 10% interest should the bank need to liquidate the interest to collect on the loan.

Scenario Five: What if the same son/daughter wanted to sell his/her 10% interest under the proposed 2704 rules?

  • If the Company wanted to buy back the shares and retire them to Treasury, would the Company pay $2.4 Million (Fair Market Value) or $4.0 Million (Minimum Value)?
  • If he/she were to sell to an outside shareholder, he/she could expect a price of $2.4 Million.
  • If he/she were to sell to a family member, the transaction would have to be done at the Minimum Value of $4.0 Million. If the transaction were to be done at Fair Market Value, or $2.4 Million, it may be considered to have included a gift of $1.6 Million in benefit for the (related party) buyer and trigger a phantom tax (40% of $1.6 Million) or $640,000 in tax)

Essentially, the $1.6 Million difference between Fair Market Value and Minimum Value is disregarded for estate taxation purposes.

Scenario Six:  Assuming one year later one of the children were to get a divorce and the departing spouse wanted to receive cash for his/her 5% interest in the shares (50% of 10% = 5%). Would the departing spouse, now an unrelated party, accept 50% of the Fair Market Value of the shares (50% of $2.4 Million or $1.2 Million) or would the spouse insist upon 50% of the Minimum Value (50% of $4.0 Million or $2.0 Million) since that would be the basis of the shares under the proposed 2704 rules? How is the $800,000 treated? How will the Family Court rule?

By deviating from the time-tested standard of fair market value, which reflects economic reality, the IRS is creating a plethora of unforeseen problems with its proposed Minimum Value standard under the proposed 2704 regulations.

This article is a follow up to an earlier article on the potential problems facing family businesses should the IRS’s proposed changes to IRS Section 2704 be instituted as drafted. As of November 11, 2016, the IRS had received almost 10,000 comments on the proposed changes to 2704. As we said in our prior email on this topic, we cannot predict if, or when, any of the proposed changes will occur. It is our intention to shed some light on the situation and to educate our clients about the devastating monetary consequences of these proposals. It is highly recommended that familial parties, who desire a transfer of wealth between members, do so with the assistance of an experienced advisor who can guide you through the benefits of strategic planning with valuation discounts before the proposed regulations take effect; if indeed that does occur.

 

[1] IRS Revenue Ruling 59-60, Section 2.03.

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