In my prior article, I discussed why some of the provisions in the proposed Section 2704 regulations exceeded the Internal Revenue Service’s authority. The proposed Section 2704 regulations contain several more examples of overreaching on the part of the Treasury Department and IRS, including those discussed below.
Disregarded Restrictions Generally
The entire proposed regulation (PR) Section 25.2704-3 on disregarded restrictions misses a vital requirement of the enabling Internal Revenue Code Section 2704(b)(4). That section includes the prerequisite that the disregarded restriction “not ultimately reduce the value of such interest to the transferee.” In each of the four situations described in PR subparagraphs (i) through (iv) of Section 25.2704-3(b)(1) involving various limitations on the ability to redeem or liquidate an interest in any entity, however, the value of the interest in the transferee is ultimately reduced. Therefore, all of the “disregarded restrictions” listed in PR Section 25.2704-3 are invalid.
Removal of Applicable and Disregarded Restrictions
The PRs incorrectly extend the attribution rules (including the trust attribution rules) referenced at Section 2704(c)(3) to the requirement that the restrictions must be removable after the transfer by the transferor and/or members of the transferor’s family.
Section 2704(c)(3) provides that “[t]he [attribution] rule of section 2701(e)(3) shall apply for purposes of determining the interests held by any individual.” (Emphasis supplied.) The “interests held by any individual” language is referenced in the IRC Sections 2704(a)(1)(B) and (b)(1)(B) prerequisites that the transferor and members of the transferor’s family “hold” control of the entity, and in the Section 2704(a)(2) determination of the value of the lapsed voting or liquidation right. This same “held” language isn’t employed as part of the Section 2704(b)(2)(B)(ii) requirement that “[t]he transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.”
Thus, for example, if the limited entity interest is transferred, either during lifetime or at death, to an irrevocable trust that includes an independent trustee or co-trustee, how can it be said that: “[t]he transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.” To remove the restriction, the family members would need the consent of the independent trustee or co-trustee. There’s nothing in the IRC that authorizes a “deemed” or “attributed” consent concept in the right to remove the restriction context.
Disregarding Interests Held by Nonfamily Members
Although the IRS arguably has the authority to disregard de minimis or nominal ownership interests generally, the question is whether the proposed regulations have exceeded this authority. The three-year, 10 percent, 20 percent and put right requirements add up to a very significant interest indeed, far exceeding what’s generally thought to be a de minimis or nominal interest.