Home / Insights / Bad News for Family Limited Partnerships – Code Section 2704 Proposed Regulations and Intra-Family Discounts

Insight Bad News for Family Limited Partnerships – Code Section 2704 Proposed Regulations and Intra-Family Discounts

By Jason Melville,

On August 2, 2016, the Department of Treasury issued proposed regulations under Internal Revenue Code Section 2704 (“Code §2704”)[1], which, if finalized, will dramatically impact estate and business succession planning. The proposed regulations will greatly reduce the effectiveness of family controlled entities, most notably family limited partnerships (“FLPs”), for purposes of estate and gift tax planning and could lead to significantly higher taxes for those individuals who fail to act before the proposed regulations are finalized.


FLPs or other family controlled entities have played a critical role in estate planning for high-net-worth individuals for decades. Specifically, such entities have typically been used by older generation family members to run and manage a business or investment portfolio consisting of valuable or appreciating-in-value assets. Once the FLP or other family entity has been established and funded, the organizing member can gift or sell minority interests in the entity to younger members of the family until the organizing member no longer possesses a controlling interest in the entity and can no longer force a liquidation of the entity’s assets.

Because a non-managing, non-controlling interest in a FLP or other family entity is not highly marketable to the general public, the value of the interests being sold or gifted, or which may remain as a part of the organizing member’s taxable estate at death, will be subject to a discount in value based upon the lack of marketability and lack of control. These discounts serve to reduce the value of the organizing member’s taxable estate or transfers subject to gift tax. In the past, these discounts have resulted in significant estate or gift tax saving for high-net-worth individuals.

Changes Under the Proposed Regulations.

The proposed regulations, however, reduce or eliminate consideration of such valuation discounts under most circumstances and could significantly increase the estate or gift tax paid by high-net-worth individuals. Below is a brief overview of some of the major changes included in the proposed regulations.

Restrictions Under State Law Must be Mandatory.

Code §2704 and related current regulations ignore certain “applicable restrictions” for valuation purposes that limit the ability of a family entity to liquidate and which restrictions either (i) lapse after the ownership interest is transferred (by gift or at death) or (ii) can be removed by the transferor or a family member after the ownership interest is transferred (by gift or at death). (As discussed below, the proposed regulations also create a new class of ignored restrictions designated as “disregarded restrictions.”)

The current regulations, however, do allow, for valuation discount purposes, the consideration of liquidation or control restrictions that are no more restrictive than the default rules provided under applicable state law. Most state laws provide that partnerships and limited liability companies cannot be liquidated and an individual owner cannot be allowed to withdraw unless all owners agree or unless the governing document of the entity provides otherwise. Because, under such state laws, any liquidation or withdrawal restriction in an entity’s governing document would be no more restrictive than such laws, discounts for liquidation and withdrawal restrictions have been allowed. Such restrictions in FLPs have been used for years to discount the value of partnership interests for gift and estate tax planning purposes.

In the preamble to the proposed regulations, the Internal Revenue Service (“IRS”) notes that this “no more restrictive than state law” exception for liquidation restrictions essentially guts Code §2704 and its original goal to limit valuation discounts. Because default state laws are almost always on par with or are more restrictive than any liquidation or withdrawal restrictions in FLP agreements, corresponding valuation discounts have gone unfettered.

To address this perceived loophole, the proposed regulations limit the “no more restrictive than state law” exception to apply only if the state law is mandatory – meaning that the owners of the entity could not otherwise agree to limit the ability to liquidate or withdraw on terms different than the statute. Because taxpayers and states are unlikely to want or to enact laws that mandatorily restrict an owner’s ability to dispose of his or her ownership interest, the proposed regulations will kill valuation discounts in intra-family entities based on liquidation and withdrawal restrictions. 

Three Year Deathbed Transfer Rule.

Current Code §2704 regulations provide that so long as the interests that are transferred retain the right to participate in a liquidation vote, an organizing member may sell or gift multiple minority interests in a FLP or other family entity to members of his or her family; thereby surrendering his or her liquidation rights as to those units and subjecting his or her remaining interest to a significant lack of control and marketability discount. However, the surrendered liquidation rights are to be added back to the organizing member’s estate if such transfers are made on the organizing member’s deathbed.

The proposed regulations create a bright line rule regarding deathbed transfers providing that where a transferor transfers his or her control or liquidation rights in a family entity within three (3) years of his or her death, the value of such lost control or liquidation rights must be added to the value of the transferor’s gross estate.

This could have significant consequences for an organizing member’s estate. Moreover, given that death is not always predicable, this three (3) year rule may not be easy to plan around.

Disregarded Restrictions (New Class of Restrictions).

The proposed regulations create a new, more expansive class of restrictions designated as “disregarded restrictions,” which, like applicable restrictions, are to be ignored for valuation purposes.

These disregarded restrictions include any restriction that:

  1. limits the ability of the holder of an ownership interest to liquidate the interest;
  2. limits the liquidation proceeds to an amount that is less than a minimum value;
  3. defers the payment of the liquidation proceeds for more than six months; or
  4. permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.

The proposed regulations define “minimum value” as the ownership interest’s non-discounted pro rata share of the net value of the entity on the date of liquidation or redemption, reduced by the outstanding obligations of the entity. As presently drafted, the proposed regulations leave some uncertainty as to whether the determination of an entity’s minimum value may include some discounting at the entity level based on the entity’s asset portfolio.

Exception for Commercially Reasonable Restrictions.

In the context of both applicable and disregarded restrictions, the proposed regulations include an exception for commercially reasonable restrictions, which are defined as restrictions on liquidation rights imposed by an unrelated person providing capital for a family entity’s trade or business operations. This exception would apply only to a FLP or family entity actually engaged in business activities (i.e., it would not apply to an entity merely managing an investment portfolio).

Other exceptions to applicable and disregarded restrictions are provided under the proposed regulations (e.g., the exception for restrictions that are no more restrictive than mandatory state law as discussed above), but such exceptions are either largely unworkable or will apply only under unusual circumstances.

Effective Date.

Significantly, the proposed regulations do not apply to transfers occurring before such regulations are made final and rules regarding disregarded restrictions do not apply until thirty (30) days thereafter.

Exactly when the proposed regulations will be finalized is impossible to predict, but a public hearing is scheduled for December 1, 2016. Accordingly, the proposed regulations will likely not be finalized until sometime in 2017 at the soonest.

Note that an organizing member who transfers an interest in a FLP or other family entity resulting in the loss of liquidation or control rights who then dies after the proposed regulations are finalized but within three (3) years of such transfer, may be subject to the three (3) year deathbed rule discussed above.


The proposed §2704 regulations can impact ownership interests in a FLP or other type of family entity. Given the significant changes on the horizon, anyone who has an existing FLP or other type of family entity, or who is considering using one for business and tax planning purposes, should consult an estate planning professional soon and no later than the end of 2016.

If you would like more information about this topic, or other legal issues, please contact a member of our Tax, Estate Planning and Employee Benefits Group 208.344.6000.

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