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IRS Closes Valuation Loopholes

The IRS has issued new proposed regulations for valuations of business interests under Section 2704 of the tax code. These long-awaited regulations are designed to close several loopholes for federal estate and gift purposes.

Section 2704 and its accompanying regulations govern the tax treatment of transfers of business interests. Currently, lapses of voting or liquidation rights are treated as transfers in excess of the fair market value (FMV) of all interests held by the transferring taxpayer after the lapse. A "liquidation right" is the right to compel the business entity to acquire all or part of the taxpayer's equity interest. The lapse of such a right generally occurs when the right is restricted or eliminated. This is referred to as an "applicable restriction."

However, under an exception in the existing regulations, a lapse generally isn't subject to this rule if the right isn't restricted or eliminated. In effect, this means that a lifetime transfer of a minority interest by the majority owner taxpayer is not treated as a lapse, even though the transfer results in the loss of the liquidation right.

Accordingly, a deathbed transfer may reduce the valuation of a business interest, because the "applicable restriction" is disregarded.

The IRS is cracking down on this technique. It maintains that such transfers have "minimal economic effects," but result in valuations lower than the value of the interest in the hands of the taxpayer prior to death or the heirs immediately after death. Also, it believes the Section 2704 regs have been rendered ineffective by state law changes, court cases and estate planning techniques avoiding Section 2704.

The proposed regulations include the following provisions:

These new rules will become effective when final regulations are issued. If the valuation of your business interest may be affected, contact your professional advisor immediately.