944 / What special valuation rules apply to certain lapsing rights and restrictions under Chapter 14?

In general, IRC Section 2704(a) provides that the lapse of certain voting or liquidation rights in a family owned business results in a taxable transfer by the holder of the lapsing right. IRC Section 2704(b) provides generally that certain restrictions on liquidating a family owned business are ignored in valuing a transferred interest. These provisions apply to restrictions or rights (or limitations on rights) created after October 8, 1990.¹ Regulations proposed in 2016 would have modified certain aspects of these special valuation rules, including the definition of applicable restriction discussed below. However, these regulations were withdrawn in 2017.

For more information on valuing a closely held business interest, see Q 927, Q 929.

Lapse of Certain Rights

For estate, gift, and generation-skipping transfer tax purposes, if there is a lapse of a voting or liquidation right in a corporation or partnership and the individual holding such right (the “holder”) immediately before the lapse and members of the holder’s family control the entity (both before and after the lapse), then the holder is treated as if making a transfer. The value of the transfer is equal to the amount (if any) by which the value of all interests in the entity held by the holder immediately prior to the lapse (determined as if all voting and liquidation rights were nonlapsing) exceeds the sum of (1) the value of such interests immediately after the lapse (determined as if held by one individual), and (2) in the case of a lapse during the holder’s life, any consideration in money or money’s worth received by the holder with respect to such lapse.²

A voting right is defined as a right to vote with respect to any matter of the entity. Also, with respect to a partnership, the right of a general partner to participate in partnership management is treated as a voting right. A liquidation right is the right to compel (including by aggregate voting power) the entity to acquire all or a portion of the holder’s equity interest in the entity.³ A lapse of a voting or liquidation right occurs when a presently exercisable right is restricted or eliminated.⁴

The transfer of an interest which results in the lapse of a liquidation right is not subject to IRC Section 2704(a) if the rights with respect to the transferred interest are not restricted or eliminated.⁵ However, a transfer that results in the elimination of the transferor’s right to compel the entity to acquire an interest of the transferor which is subordinate to the transferred interest is treated as a lapse of a liquidation right with respect to the subordinate interest. The lapse rule does not apply to the lapse of a liquidation right with respect to (1) a transfer that was previously valued in the hands of the holder as a transfer of an interest in a corporation or partnership under IRC Section 2701 (see Q 935), or (2) the lapse of a liquidation right to the extent that immediately after the lapse the holder (or the holder’s estate) and members of the
holder’s family cannot liquidate an interest that the holder could have liquidated prior to
the lapse. Whether an interest can be liquidated immediately after the lapse is determined under state law or, if the governing instruments are less restrictive than the state law which would apply in the absence of such instruments, the governing instruments. For this purpose, any applicable restriction under IRC Section 2704(b) (see below) is disregarded.⁶

If a lapsed right may be restored only upon the occurrence of a future event not within the control of the holder or the holder’s family, the lapse is deemed to occur at the time the lapse becomes permanent with respect to the holder (e.g., upon the transfer of the interest).⁷

For attribution rules, see below.

Transfers Subject to Applicable Restrictions

If there is a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor’s family and the transferor and members of transferor’s family control the entity (immediately before the transfer), any applicable restriction is to be disregarded in valuing the transferred interest for estate, gift, or generation-skipping transfer tax purposes.⁸ If an applicable restriction is disregarded under this rule, the rights of the transferor are valued under the state law that would apply but for the limitation (meaning that the interest is valued as though the restriction does not exist).⁹

“Applicable restriction” means any restriction which effectively limits the ability of the corporation or partnership to liquidate if either (1) the restriction lapses (in whole or in part) after the transfer, or (2) the transferor or any member of the transferor’s family, acting alone or collectively, can remove the restriction (in whole or in part) after the transfer.¹⁰ Applicable restriction treatment was avoided where the consent of all parties was required and a charity (a nonfamily member) had become a partner.¹¹

However, any restriction imposed or required by any federal or state law was not previously treated as an applicable restriction.¹² Thus, the definition of an applicable restriction was limited to a restriction that was more restrictive than the limitations which would apply under state law if there were no restriction. Also, whether there is the ability to remove a restriction is determined under the state law that would apply in the absence of the restrictive provision in the governing instruments.¹³

An applicable restriction does not include any commercially reasonable restriction which arises as part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either.¹⁴ Regulations provide that an applicable restriction does not include any commercially reasonable restriction which arises as a result of any unrelated person providing capital in the form of debt or equity to the corporation or partnership for the entity’s trade or business operations. For this purpose, the regulations apply the relationship rules of IRC Section 267(b), except that the term “fiduciary of a trust” under the relationship rules is modified to generally exclude banks, trust companies, and building and loan associations.¹⁵

Furthermore, an applicable restriction does not include an option, right to use property, or other agreement subject to IRC Section 2703 (see Q 943).¹⁶

With respect to a partnership (or LLC) created on a decedent’s deathbed, the IRS has disregarded restrictions where the partnership provided that a partner could not liquidate his interest, while state law provided a less restrictive provision.¹⁷ A few cases have held that partnership liquidation provisions were no more restrictive than state law and should not be ignored under IRC Section 2704(b).¹⁸

Attribution

The following attribution rules or definitions generally apply for purposes of the rules
which apply to certain lapsing rights and applicable restrictions under IRC Section 2704:

In the case of a corporation, “control” means 50 percent ownership (by vote or value) of the stock. In the case of a partnership, “control” means 50 percent ownership of the capital or profits interests, or in the case of a limited partnership, the ownership of any interest as a general partner.¹⁹

A “member of the family” with respect to an individual includes such individual’s spouse, any ancestor or lineal descendant of such individual or such individual’s spouse, any brother or sister of the individual, and any spouse of the above.²⁰

An individual is treated as holding interests held indirectly through a corporation, partnership, trust, or other entity.²¹ Thus, transfers may be either direct or indirect.