Proposed 2704 Regulations to be Withdrawn

On October 2, 2017, Treasury Secretary Steven Mnuchin issued a report recommending, among other changes, the complete withdrawal of proposed regulations under Section 2704 of the Internal Revenue Code.  The proposed regulations had caused significant concern among owners of closely held businesses and their advisors since being released in August of 2016.  Business owners, advisors and members of the business valuation community flooded the IRS with comments and appeared at a public hearing to indicate that the proposed regulations were overreaching, created far too many hypothetical and unrealistic circumstances, and would lead to unintended consequences, including overvaluation in cases where discounts for lack of control and lack of marketability were warranted.

In early 2017, Executive Order 13789 directed the Secretary of the Treasury to identify significant tax regulations issued on or after January 1, 2016, that (i) impose an undue financial burden on U.S. taxpayers, (ii) add undue complexity to the Federal tax laws, or (iii) exceed the statutory authority of the Internal Revenue Service (IRS).  In June 2017, Treasury identified eight proposed, temporary, or final regulations for withdrawal, revocation, or modification.  In early October 2017, Treasury’s announcement included the recommendation to withdraw the proposed regulations under Section 2704.  We found notable the following statements in the Treasury’s report:

• The proposed regulations, through a web of dense rules and definitions, would have narrowed longstanding exceptions and dramatically expanded the class of restrictions that are disregarded under Section 2704…
• Commenters warned… that the valuation requirements of the proposed regulations were unclear…  In particular, commenters argued that it was not feasible to value an entity interest as if no restrictions on withdrawal or liquidation existed in either the entity’s governing documents or state law. A legal vacuum in which there is no law relevant to an interest holder’s right to withdraw or liquidate is impossible, commenters asserted, and, therefore, cannot meaningfully be applied as a valuation assumption.
• After reviewing these comments, Treasury and the IRS now believe that the proposed regulations’ approach to the problem of artificial valuation discounts is unworkable. In particular, Treasury and the IRS currently agree with commenters that taxpayers, their advisors, the IRS, and the courts would not, as a practical matter, be able to determine the value of an entity interest based on the fanciful assumption of a world where no legal authority exists. Given that uncertainty, it is unclear whether the valuation rules of the proposed regulations would have even succeeded in curtailing artificial valuation discounts.
• Moreover, merely to reach the conclusion that an entity interest should be valued as if restrictions did not exist, the proposed regulations would have compelled taxpayers to master lengthy and difficult rules on family control and the rights of interest holders. The burden of compliance with the proposed regulations would have been excessive, given the uncertainty of any policy gains.
• Finally, the proposed regulations could have affected valuation discounts even where discount factors, such as lack of control or lack of a market, were not created artificially as a value-depressing device.

Treasury and IRS are expected to publish the withdrawal of the proposed 2704 regulations in the Federal Register shortly.

Todd G. Povlich, CFA, ASA

Todd is a Partner at MPI and is based in the firm’s New York City office. Since joining MPI, Todd has determined the value of closely held securities of companies and partnerships in many industries for a variety of purposes.