Capital Letters

Proposed Section 2704 Regulations to be Withdrawn

Capital Letter No. 42
October 6, 2017

Treasury’s second response to White House directives announces the pending withdrawal of the controversial proposed regulations under section 2704.

Dear Readers Who Follow Washington Developments:

In a second Report in response to Executive Order 13789, the Treasury Department and the Internal Revenue Service have announced that they will withdraw the controversial Proposed Regulations about disregarded restrictions and lapsing rights under section 2704.  The Report says nothing about revisions, further study, or any other additional consideration of these Proposed Regulations.  There are lessons to be learned, but some implications of Treasury’s Report are still uncertain.  Reports of the death of the Proposed Regulations may now have been confirmed, or may still be premature.


As discussed in Capital Letter Number 40Executive Order 13789 (April 21, 2017) directed the Treasury Department to identify tax regulations issued on or after January 1, 2016, “that (i) impose an undue financial burden on United States taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the Internal Revenue Service.”  It directed that such regulations be identified in an interim report to the President within 60 days, or by June 20, 2017.

Treasury’s initial response, dated June 22 and released July 7, 2017 as Notice 2017-382017-30 I.R.B. 147, identified eight regulations that it said “meet at least one of the first two criteria specified by … Executive Order 13789” – that is, undue financial burden or undue complexity.  These eight regulations included six sets of regulations that were already in effect (three final, one final and temporary, and two temporary) and two sets of regulations that were only proposed (the section 2704 Proposed Regulations and a set of proposed regulations tightening the requirements a political subdivision must meet to be qualified to issue tax-exempt bonds under section 103).  The Notice said this about the Proposed Regulations:

“Commenters expressed concern that the proposed regulations would eliminate or restrict common discounts, such as minority discounts and discounts for lack of marketability, which would result in increased valuations and transfer tax liability that would increase financial burdens.  Commenters were also concerned that the proposed regulations would make valuations more difficult and that the proposed narrowing of existing regulatory exceptions was arbitrary and capricious.”


Now, in its second response to Executive Order 13789, Treasury has issued an 11-page Report, dated October 2 and released October 4, 2017, announcing the action it will take regarding the eight regulations identified in Notice 2017-38, including withdrawal of the Proposed Regulations.  Here is the full discussion of the Proposed Regulations in the Report:

“Section 2704 addresses the valuation, for wealth transfer tax purposes, of interests in family-controlled entities.  In limited cases, Section 2704 disregards restrictions on the ability to liquidate family-controlled entities when determining the fair market value of an interest for estate, gift, and generation-skipping transfer tax purposes.  Also in limited cases, Section 2704 treats lapses of voting or liquidation rights as if they were transfers for gift and estate tax purposes.  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.  In addition, the proposed regulations would have required an entity interest to be valued as if disregarded restrictions did not exist, either in the entity’s governing documents or under state law.  No exceptions would have been allowed for interests in active or operating businesses.

“The goal of the proposed regulations was to counteract changes in state statutes and developments in case law that have eroded Section 2704’s applicability and facilitated the use of family-controlled entities to generate artificial valuation discounts, such as for lack of control and marketability, and thereby depress the value of property for gift and estate tax purposes.  Commenters warned, however, that the valuation requirements of the proposed regulations were unclear and that their effect on traditional valuation discounts was uncertain.  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.  Commenters also argued that the proposed regulations could have produced unrealistic valuations.  For example, the lack of a market for interests in family-owned operating businesses is a reality that, commenters argued, should continue to be taken into account when determining fair market value.

“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.

“In light of these concerns, Treasury and the IRS currently believe that these proposed regulations should be withdrawn in their entirety.  Treasury and the IRS plan to publish a withdrawal of the proposed regulations shortly in the Federal Register.”


In general, the Report is rather noncommittal.  The second paragraph, for example, mentions that “the goal of the proposed regulations was to counteract changes in state statutes and developments in case law.”  That reflects the statement in the Preamble to the Proposed Regulations that “the Treasury Department and the IRS have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments,” giving as examples case law like Kerr v. Commissioner, 113 T.C. 449 (1999), aff’d, 292 F.3d 490 (5th Cir. 2002), changes in state partnership statutes, the practice of transferring partnership interests to assignees rather than to partners, and the practice of transferring “a nominal partnership interest to a nonfamily member, such as a charity or an employee.”  Then the Report, mirroring the two sentences in Notice 2017-38 quoted above, summarizes the concerns about which “commenters warned,” “commenters argued,” and “commenters asserted.”  Treasury and the IRS do not state whether they agree or disagree with those commenters, although they do appear to distance their own motivating goal from the views of those commenters by use of the word “however.”

In the third paragraph, Treasury and the IRS concede that, in view of the comments, the approach of the Proposed Regulations is “unworkable.”  “In particular,” the Report continues, “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.”  They stop short of admitting that their draft was based on their own fanciful assumptions, but neither do they accuse the commenters of making fanciful assumptions.  They seem to state, matter-of-factly, that if the Proposed Regulations assume “a world where no legal authority exists,” that indeed would be a “fanciful” assumption.  Is that dismissing as “fanciful” the view that the Proposed Regulations would produce such a result (the “broad view” discussed and rejected in Capital Letter Number 41)?  There is no reason to think that the Report intended to go that far.

It is in the first paragraph that the Report uses the most surprising wording.  Without attribution to “commenters,” the Report states that “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.  It is true that the Proposed Regulations “would have narrowed longstanding exceptions” – for example, the exception from the disregard of “applicable restrictions” under section 2704(b) of restrictions imposed by mere default law and the exception of certain lapses from deemed gift treatment under section 2704(a) if the transferor dies within three years.  It is also true that some observers might characterize these rules as “a web of dense rules and definitions.”  But that is a much more subjective and gratuitous characterization, which is odd for the Report to use.

It is also true that the Proposed Regulations would have “expanded the class of restrictions that are disregarded under Section 2704(b),” namely by the addition of “disregarded restrictions.”  Describing that expansion as “dramatic” is a subjective label some observers might use, but again is odd for the Report to use.

It is almost as if these aspersions on Treasury’s own work come from sources outside Treasury.  Or possibly sources who were outside Treasury when the Proposed Regulations were published in August 2016.  If so, we may have witnessed, to a degree unusual for estate tax regulations, the direct influence of the political tone, and possibly the political appointees, of the Trump Administration.  The Report, after all, is a response to Executive Order 13789.


Withdrawal of the Proposed Regulations

The withdrawal of the Proposed Regulations is not a surprise.  Another option might have been to identify specific fixes to address the concerns that public comments expressed and to promise to make those fixes.  But the 90 days allowed by Executive Order 13789 between the first Report (Notice 2017-38) and this second Report was simply not enough time to fix the Notice of Proposed Rulemaking that itself took 14 years to draft.  So simple withdrawal was the most likely expected response.

Indeed, in its August 1, 2017, Comments in response to Notice 2017-38, after introducing a discussion of the most serious burdens imposed by the Proposed Regulations, ACTEC stated:

“ACTEC concludes that these burdens are so severe, and the fundamental problems with the Proposed Regulations have proven to be so intractable, that the only feasible remedy is to withdraw the Proposed Regulations without further delay, with the possibility of re-proposing them for further public comment when they can be redrafted with the substantial modifications and clarifications they need.”

Thus, the Report reaches the same conclusion that ACTEC recommended.

No Reference to Modifications or Different Approaches

The Report tells us that the Proposed Regulations will be “withdrawn in their entirety.”  It says nothing about modifications or different approaches that might be considered.

Perhaps the drafters of the Proposed Regulations are just weary of the subject for now.  ACTEC’s own recommendation suggests that we really won’t be interested in hearing more about this subject unless and until Treasury and the IRS have figured out how to address our concerns.  As ACTEC said, nothing about withdrawing the Proposed Regulations precludes their re-proposal when the necessary modifications have been made.  Presumably the perceived need for such regulations to curb “artificial valuation discounts” is a great as it was in August 2016 when the Proposed Regulations were published, and it is only the particular approach chosen for the Proposed Regulations that is, as the Report says, “unworkable.”

Or perhaps the Proposed Regulations are truly dead.

In this context, we return again to the fact that six of the eight “regulations” identified in Notice 2017-38 are already in effect, and for them “withdrawal” is not a procedural option.  In the Report, three are identified as “Regulations to Consider Revoking in Part,” and three are identified as “Regulations to Consider Substantially Revising.”  In the discussion of those six items, the Report is more or less specific about elements Treasury and the IRS want to retain, perhaps with modifications.

That leaves the two regulation projects that have never been finalized, the section 2704 Proposed Regulations and the proposed regulations about political subdivisions under section 103.  They are the two regulations identified in the Report as “Proposed Regulations to be Withdrawn Entirely.”  The political subdivision project appears by far to be the simpler of the two.  It was launched in 2015 and the Notice of Proposed Rulemaking of about 4,500 words, published in February 2016, states that commenters had requested additional published guidance.  In contrast, the section 2704 Notice of Proposed Rulemaking of over 15,000 words had been in the works since 2002, and it is unlikely anyone asked for it.

Despite the relative simplicity of the political subdivision project, the Report forecasts only that “Treasury and the IRS may propose more targeted guidance in the future after further study of the relevant legal issues.”  Not at all specific.

Thus, the Report reflects the following pattern:  For the six regulation projects that have already been through a complete cycle of proposal, comment, and finalization, Treasury and the IRS have gained enough familiarity with the issues that they are able to be specific about what they will try to do to modify the regulations in the future.  For the simpler of the two projects that have not made it to the finalization stage, Treasury and the IRS are able to offer only a generic reference to “more targeted guidance … after further study.”  For the final and more complex project – the section 2704 Proposed Regulations – Treasury and the IRS have said nothing.  Saying nothing could mean that they expect to do nothing, or only that they don’t know yet where to start.  The latter possibility is certainly consistent with the scope of difficulties with the Proposed Regulations that observers have noted.

As to whether the Proposed Regulations will be, or even can be, revived, it is just impossible to be sure.  Both ACTEC’s recommendation and the Report’s conclusion leave all possibilities open.


There are likely many lessons to be learned from the experience with the Proposed Regulations.  But there are two lessons that seem to be very sharply presented by the Report.

The Importance of Congressional Authority

From 2009 through 2012, the section 2704 regulation project was accompanied by a proposal for expanded legislative authority.  Congress did not act, but Treasury and the IRS pursued the regulation project anyway, probably scaled down to reflect the failure to obtain the requested expanded authority.  In fact, as discussed in Capital Letter Number 41, the existence of that legislative proposal during that four-year interval may have played a significant role in shaping the expectations for, and reactions to, the Proposed Regulations.

It is possible that the idea the drafters had for the Proposed Regulations would have worked better with that congressional cover.  It is possible that it simply cannot work, even with revisions, without that congressional cover, and an entirely different conceptual approach must be found.  The view of Capital Letters (e.g., Number 41) has been that any apparent conflict between the Proposed Regulations and the statutory authority should be resolved by narrowly interpreting the Proposed Regulations to fit the statutory authority, not by presuming that the Proposed Regulations exceed the statutory authority.  But in any event – whether for the suitability of the original approach, or for the public acceptance of the original approach, or for shaping an alternative approach, or for discarding an overreaching approach – Congress, in effect, has had the last word.  That says something positive about the rule of law.

The Importance of Commenters

Finally, throughout Notice 2017-38 and Treasury’s current Report, the constant references to commenters could sound like an effort to shift responsibility to the people who submitted comments, the people who roundly criticized the Proposed Regulations at the public hearing, the people who wrote scathing articles, and even the people who lobbied Congress for legislation to block the Proposed Regulations.  “The problem is not the way we drafted the regulations, it’s the excessive public reaction.”

Capital Letters rejects such a cynical view.  Treasury and the IRS are not ducking their responsibility in relying so heavily on the tone and content of the public comments, because in our system the opportunity for notice and comment is a crucial component of rulemaking itself.  The notice and comment process is designed to rely on affected taxpayers to help the drafters identify burdens and complexity.  Real burdens, potential burdens, perceived burdens, even mistakenly perceived burdens – they are a part of the record the practice of proposing regulations is intended to build.  In this case, that record was heard.  That says something positive about the rule of law too.


The Report also states:

“Treasury continues to analyze all recently issued significant regulations and is considering possible reforms of several recent regulations not identified in the June 22 Report. … In addition … Treasury and the IRS have initiated a comprehensive review, coordinated by the Treasury Regulatory Reform Task Force, of all tax regulations, regardless of when they were issued. … This review will identify tax regulations that are unnecessary, create undue complexity, impose excessive burdens, or fail to provide clarity and useful guidance, and Treasury and the IRS will pursue reform or revocation of those regulations.”

These ongoing developments, as well as current developments on the legislative front, will be discussed in what (before the release of the Report) was to be this Capital Letter Number 42 and now will be Capital Letter Number 43, tentatively titled “Where Tax Legislation and Regulations Stand Now.”

Ronald D. Aucutt

© Copyright 2017 by Ronald D. Aucutt.  All rights reserved.