Bad Moon Rising? Proposed Section 2704 Regulations

By Joy Paeske¹ & Phillip Jelsma²

Section 2704 was added to the Internal Revenue Code ("IRC") in 1990 to curb the use of certain estate tax freezing techniques designed to reduce transfer tax values without a corresponding reduction in the economic benefit to the beneficiaries. Specifically, Section 2704 was enacted to prevent the consideration of certain lapsing rights and restrictions designed to reduce the value of a transferred interest in a partnership or corporation. Commencing in 2009, President Obama’s budget proposals (sometimes called the "Greenbook") requested more durable rules for disregarding restrictions under Section 2704.³ The Greenbook lamented that "[j]udicial decisions and the enactment of new statutes in most states, in effect, have made section 2704(b) inapplicable in many situations." The Greenbook also noted "the Internal Revenue Service has identified other arrangements designed to circumvent the application of section 2704." In response to the Greenbook proposals, the Treasury Department ("Treasury") issued proposed regulations on August 4, 2016, that would modify and augment the existing treasury regulations applicable to Section 2704.

This article is not intended to serve as a treatise on Section 2704. Rather, the purpose of this article is to discuss a general history of Section 2704, the Treasury’s perceived hurdles in applying Section 2704, and the proposed treasury regulations published by the Treasury on August 4, 2016 to address such perceived problems. This article will only discuss the relevant provisions of Section 2704 sufficient to give the reader a frame of reference to understand the proposed modifications to Section 2704 under the proposed regulations as well as discuss its planning implications for practitioners advising closely-held business owners.⁴

I. SECTION 2704(A): CERTAIN LAPSING VOTING AND LIQUIDATION RIGHTS DISREGARDED FOR VALUATION PURPOSES