Take-Away: IRC 2703 is one of the special valuation rules that is used for rejecting values in transactions among family members that claim valuation discounts. In applying the rule, the concepts of  agreement and family are broadly construed, but there is some help with a statutory safe harbor and exception.

Background:  As we enter a period where more individuals will seriously consider making a gift in order to use their large applicable exemption amount,  along with a desire to claim valuation discounts for lack of control or lack of marketability,  attention should turn to Chapter 14 of the Tax Code’s special transfer tax valuation rules. Back in 1990 Congress added four provisions to the Tax Code to stop what it perceived to be an abuse of valuation discounts in the transfer of assets among family members- folks who might be prone to collude with one another to reduce the value of assets in order to reduce exposure to gift (or estate) taxes. From those statutory limitations and exceptions, we now have become very familiar with grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs) as part of our estate planning lexicon.

IRC 2703: Yet another of these Tax Code provides that the value of any property is determined without regard to either (i) an option or agreement to acquire or use the property at a price that is less than fair market value of the property without regard to that option or agreement, or (ii) any restriction on the right to sell or use the property. [IRC 2703(a).] Restated, the IRS is given broad authority to disregard an option, agreement or other right to acquire or use the property, as well as any restriction on the right to sell or use such property, when it comes to valuing the interest that is transferred among family members.  [IRC 2703(a)(1)-(2).] This rule applies to transactions that involve family members; family is broadly defined to include any “natural objects of the transferor’s bounty.” [Regulation 25.2703-1(b)(3).] When families do not control the asset or business, the import of IRC 2703 is that the presence of non-family members will assure that fair market value terms are being used. The statute is clear, too, that value must be determined “without regard to such restrictions;” all of which effectively means that any restrictions in the agreement should be given no weight whatsoever

  • Agreement: The concept of agreement is defined quite broadly for purposes of IRC 2703. For example, an agreement can include a right or restriction contained in any contract or business instrument, e.g. certificate of incorporation, or a right to acquire or use property if the price charged is less than that under the fair market value for the acquisition or use of that property. An agreement can also include a restriction on the right to sell or use property.

Example: Dad gives to his son Sam an option to purchase Dad‘s cottage for its current fair market value. On Dad’s death 15 years later his estate cannot claim that the value of the cottage was restricted by the option agreement that he gave to Sam.

  • Other Examples: Mom leases equipment to her brother for a rental value below what the market would otherwise charge. Grandfather licenses the use intangible personal property, like a trade name to his grandson for a below market license royalty fee. Any of these restrictions might be incorporated into any type of business document like corporate bylaws,  buy-sell, redemption agreements, or an LLC’s operating agreement. The overriding purpose of IRC 2703 is to stop the perceived artificial creation of valuation discounts in family transactions simply by adding restrictive transfer or purchase price provisions to governing documents, i.e. a value depressing entity wrapper.

Safe Harbor: Since the target of IRC 2703 is to ignore artificial valuation discounts in intra-family transfers, the Regulations expressly create a safe harbor. Any restriction or option will be deemed to fulfill the safe harbor automatically if “more than 50% of the value of the property that is subject to the right or restriction is owned… by individuals who are not members of the transferor’s family.” [Regulation 25.2703-1(b)(3).] In short, if a business or asset is not family-controlled, then it is deemed to comply with the safe harbor. However, this deemed compliance with the statute is only effective if the third-party owners are also subject to the restriction “to the same extent as the transferor.”

Statutory Exception: The Tax Code also provides an exception to the extremely broad sweep of IRC 2703 even if there are only family members involved in the transfer. The provisions of IRC 2703(a) that cause restrictive business agreements to be ignored by the IRS will not apply if the following requirements are met [IRC 2703(b):]

  • (i) the agreement is a bona fide business arrangement [IRC 2703(b)(1)];
  • (ii) the agreement is not a device to transfer the property to a member of the donor or decedent’s family for less than full and adequate consideration [IRC 2703(b)(2)]; and
  • (iii) the terms of the agreement are comparable to similar arms’ length transactions [IRC 2703(b)(3).]

Importantly, each of these conditions [(i) through (iii)] must be independently met in order for an individual to avoid the application of IRC 2703(a). [Treasury Regulation 25.2503-1(b)(2).]

Bona Fide Business Arrangement: For a restriction contained in an agreement to satisfy the bona fide business arrangement ‘test,’ the arrangement must further a business purpose. Examples of such a purpose might be to preserve a family business, address disharmony within the family unit, facilitate a business succession plan, act as a hedge, e.g. a ‘put’ if the interest is a minority interest in the operating business, etc. In addition, planning for future liquidity needs on the death of a family member will also constitute an appropriate business purpose under IRC 2703(b)(1).]

  • Example: IRC 2703(a) even applied when public traded stock was the subject of the transfer. Parents moved their public traded Dell stock, a small amount compared to Dell’s total market capitalization, into a restrictive partnership. The parents then gifted partnership interests to their children. On their Form 709 Federal Gift tax return, the parents claimed steep valuation discounts on the gifts’ values. There was no family –control rationale; the partnership restrictions did nothing to further the efficient family management of an enterprise, as there was no ‘enterprise’, which the court referred to as ‘a mere asset container.’ Thus, the court denied the claim that the partnership furthered ‘family management/control’ as a viable business purpose and the partnership interests gifts to the children were not subject to any valuation discounts. Holman v. Commissioner, 601 F.3d 763 (8th 2010.) However, the result in this case has continued to cause confusion. The Tax Court judge found that the partnership was outside the scope of the safe harbor of IRC 2703(b). Yet, the judge then found that the Holmans were still entitled to valuation discounts of 22.4%, 25% and 16.5% on their three respective gifts of partnership interests- what happened to the “no weight whatsoever” remedy that IRC 2703(a) was intended to target? {I digress.}

Not a Device: This ‘test’ can be problematic since it poses the subjective question of the transferor’s testamentary intent. Fortunately, the courts have looked to objective evidence to determine that intent. Such intent is judged at the time the agreement is entered into, rather than with hindsight.

  • Example: One court identified several factors to look at in looking to an agreement as a device to transfer: (i) the decedent’s ill health when entering into the agreement; (ii) the lack of negotiations between the parties before executing the agreement; (iii) the lack of (or inconsistent) enforcement of the buy-sell agreement; (iv) the failure to obtain comparable examples or appraisals to determine the buy-sell agreement’s formula price; (v) the failure to seek professional advice in selecting the formula price; (vi) the lack of provisions in the buy-sell agreement that required periodic review of a stated fixed price; (vii) the exclusion of significant assets from the formula price; and (viii) the acceptance of below-market payment terms for the purchase of the decedent’s interest. Estate of True v. Commissioner, 82 Tax Court Memo, 27 (2001), affirmed 390 F.3d 1210 (10th 2004.)

Comparable to Similar Arrangements: This ‘test’ probably presents more difficulty than the other two ‘tests.’ Data on arrangements entered into among private parties is sparse, if any even exist. As such, due to the lack of real-life comparable transactions, courts have slowly gravitated toward accepting expert testimony, specifically for quantitative restrictions like buy-sell options- appraisals and looking solely at appraisal methodologies. Unfortunately, this often means that the judge will have to decide between two equally credentialed appraisal experts and then decide what qualifies as reasonable market practice.

  • Example: The individual held substantial minority interests in a privately held bank. The owner was a passive investor in the bank, i.e. the owner was not active in the bank’s business. The bank then merged with another bank, after which the individual’s conservator decided it would be prudent to secure a fixed-price repurchase guarantee from the surviving bank. This at-death reciprocal put/call option between the individual and the bank provided ‘a hedge against risk…in holding a minority interest in a closely held bank.’ The court probed the relevant appraisal, though not too aggressively. Although the equity under review was priced at over 84% markup to the buy-sell price within two years after the guarantee was negotiated, the court noted that post-transfer factors contributed to the higher price, expressing  a reluctance to use hindsight in its examination of appraisal and the value of the stock. In sum, the court employed IRC 2703(b)(3) as more of a sanity check on the buy-sell agreement with the options in question, rather than an invasive analysis of the appraisal itself. Estate of Amlie v. Commissioner, 91 Tax Court Memo, 1017 (2006).

Conclusion: There exists the natural incentive of tax conscious business owners to self-impose artificial, value-depressing business entity restrictions in order to reduce their transfer tax liability. Standing in the way of that natural tendency to use artificial tax-driven business arrangements is IRC 2703(a). If a family owned business or asset is the subject of the transfer, then the transferor will have to satisfy the three conditions of IRC 2703(b) in order to claim valuation discounts with regard to the transferred interests- resulting in a lot of time and expense expended to document the reasons for those claimed discounts.