September, 2016 Newsletter
Provided by Leimberg Information Services
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Martin Shenkman, Jonathan Blattmachr, Ira S. Herman & Joy Matak: Proposed 2704(b) Regulations Will Zap Discounts, Wealthy Taxpayers Should Plan ASAP
“The new Regs are a game changer. Every wealthy client and every practitioner that advises wealthy clients need to understand the significant implications to planning presented by these Proposed Regulations. Wealthy clients need to react to this quickly. In many cases, it would be worthwhile to complete significant planning steps before the effective date of the Regulations, which could be made final before year-end and could be effective early 2017. Valuation discounts have been the elixir that has driven the estate tax minimization machine for decades. These Proposed Regulations may eliminate valuation discounts and thereby make it far more difficult for wealthy taxpayers to minimize estate taxes. Quite surprisingly, these new rules affect all clients, not just the wealthiest. Specific planning implications for clients who fall below the ultra-high net worth category are discussed below as well.
The new Regs govern the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer (GST) tax purposes. They address the treatment of certain lapsing rights and restrictions on liquidation which have been used in determining the fair market value of transferred interests for estate planning purposes. The stated goal of the Regs is ‘to prevent the undervaluation of such transferred interests.’ However, as demonstrated below, the Proposed Regulations appear to exceed this objective and distort it in a number of complex ways. There is so much more to consider in the Proposed Regulations than merely the potential loss of discounts.”
Martin M. Shenkman, Esq., Jonathan Blattmachr, Esq., Ira S. Herman, CPA and Joy Matak, Esq. provide members with detailed commentary on the proposed regulations under Section 2704(b). Members will find their commentary particularly helpful as it contains a sample client letter as well as their “Annotated Regulations” that can be found at this handy link: Annotated Regulations
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is an attorney in private practice in Fort Lee, New Jersey and New York City who concentrates on estate and closely held business planning, tax planning, and estate administration. He is the author of 42 books and more than 1,000 articles. Marty is the Recipient of the 1994 Probate and Property Excellence in Writing Award, the Alfred C. Clapp Award presented by the 2007 New Jersey Bar Association and the Institute for Continuing Legal Education; Worth Magazine’s Top 100 Attorneys (2008); CPA Magazine Top 50 IRS Tax Practitioners, CPA Magazine, (April/May 2008). His article “Estate Planning for Clients with Parkinson’s,” received “Editors Choice Award.” In 2008 from Practical Estate Planning Magazine his “Integrating Religious Considerations into Estate and Real Estate Planning,” was awarded the 2008 “The Best Articles Published by the ABA,” award; he was named to New Jersey Super Lawyers (2010-15); his book “Estate Planning for People with a Chronic Condition or Disability,” was nominated for the 2009 Foreword Magazine Book of the Year Award; he was the 2012 recipient of the AICPA Sidney Kess Award for Excellence in Continuing Education; he was a 2012 recipient of the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels; and he was named Financial Planning Magazine 2012 Pro-Bono Financial Planner of the Year for his efforts on behalf of those living with chronic illness and disability. In June of 2015 he delivered the Hess Memorial Lecture for the New York City Bar Association. His firm's website is www.shenkmanlaw.com where he posts a regular blog and where you can subscribe to his free quarterly newsletter Practical Planner. He sponsors a free website designed to help advisers better serve those living with chronic disease or disability www.chronicillnessplanning.org which is in the process of being rebuilt.
Jonathan G. Blattmachr is Director of Estate Planning for Peak Trust Company (formerly the Alaska Trust Company), now in both Anchorage and Las Vegas, co-developer with Dallas Attorney Michael L. Graham of Wealth Transfer Planning, a computerized drafting and advice system for lawyers, and a Principal of Pioneer Wealth Partners, LLC, a boutique wealth advisory firm that designs and advises wealth family on wealth preservation matters.
Ira S. Herman, MS, CPA, CEA, is a CohnReznick partner and serves as the Firm’s Trusts and Estates Practice Leader. He offers specialized expertise in financial management as it relates to personal, business, retirement, and estate planning. Ira has more than 40 years of accounting, audit, and tax experience and has conducted numerous training programs on technical tax and financial counseling subjects. He has received the Certificate of Educational Achievement (CEA) designation in estate planning and personal financial planning from the AICPA. He is considered exceptionally knowledgeable regarding trust and estate administration and has been called upon as an expert witness regarding fiduciary accounting, tax, and litigation matters. Additionally, Ira has lectured for the Institute of Continuing Legal Education (ICLE) regarding New Jersey Court Rule 4:87-3, which prescribes the form of a statement of account in the State of New Jersey. Ira also has extensive experience with closely held businesses, business succession solutions, and tax planning. He is frequently called upon to lecture before business and trade associations on such topics as business entity selection, succession planning, wealth accumulation, fiduciary accountings, income tax, and estate and gift tax planning. He was also an instructor in accounting and taxation at Fairleigh Dickinson University for a number of years.
Joy Matak, JD, LLM., is a tax director at CohnReznick and a member of the firm’s Trusts and Estates Practice. Joy has more than 18 years of diversified experience as a wealth transfer strategist with an extensive background in providing tax services to multi-generational wealth families, owners of closely-held businesses, and high-net-worth individuals and their trusts and estates. Joy has significant expertise providing her clients with diverse wealth transfer strategy planning to accomplish estate planning and business succession goals. She also performs tax compliance, including gift tax, estate tax, and income tax returns for trusts and estates, as well as consulting services related to generation skipping, including transfer tax planning, asset protection, life insurance structuring, and post-mortem planning. Prior to joining CohnReznick, Joy was a senior tax manager at a Top 20 accounting firm. Early in her career, Joy was a principal in a Virginia-based law firm and also worked as a senior associate in the growing trusts and estates groups of one of the leading commercial law firms in New Jersey. Joy has spoken for the Greater Middlesex/Somerset Estate Planning Council and published articles for the Hudson County Business Journal and Tax Management Estates, Gifts and Trusts Journal on a variety of topics, including wealth transfer strategies, income taxation of trusts and estates, and business succession planning.
Now, here is their commentary:
The new Regs are a game changer. Every wealthy client and every practitioner that advises wealthy clients need to understand the significant implications to planning presented by these Proposed Regulations. Wealthy clients need to react to this quickly. In many cases, it would be worthwhile to complete significant planning steps before the effective date of the Regulations, which could be made final before year-end and could be effective early 2017. Valuation discounts have been the elixir that has driven the estate tax minimization machine for decades. These Proposed Regulations may eliminate valuation discounts and thereby make it far more difficult for wealthy taxpayers to minimize estate taxes. Quite surprisingly, these new rules affect all clients, not just the wealthiest. Specific planning implications for clients who fall below the ultra-high net worth category are discussed below as well.
The new Regs govern the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer (GST) tax purposes. They address the treatment of certain lapsing rights and restrictions on liquidation which have been used in determining the fair market value of transferred interests for estate planning purposes. The stated goal of the Regs is “to prevent the undervaluation of such transferred interests.” However, as demonstrated below, the Proposed Regulations appear to exceed this objective and distort it in a number of complex ways.
There is so much more to consider in the Proposed Regulations than merely the potential loss of discounts.
Points to Consider in Evaluating the Proposed Regulations
Following are some preliminary thoughts on the Proposed Regulations with the caveat that further reflection may result in different conclusions. Hopefully, some of the points raised by this newsletter will be addressed in the upcoming public hearings and potentially result in modifications of the Regulations before they are finalized.
- Expect the Unexpected: Perhaps one of the most important takeaways from the Proposed Regulations is that the implications to planning are not limited to what practitioners had been anticipating, and many aspects of these Proposed Regulations are not intuitive or logical. Hidden within the Proposed Regulations are traps for the unwary beyond pure discount calculations, requiring practitioners to exercise caution when drafting documents and evaluating which planning steps are appropriate. Even the seemingly simple act of obtaining appraisals could have far-reaching consequences.
- Planning Environment in Flux: Consider the restrictions imposed by the Proposed Regulations within the broader context of the current political climate. Pundits have prognosticated that a Democratic victory of the White House could affect down-ballot races and flip the Senate to the Democrats. The Democratic tax platform includes the reduction of the estate tax exemption to $3.5M, elimination of inflation adjustments to the exemption, a $1M gift exemption and a 45% tax rate. Likely the Democratic plan will also include the array of proposals included in President Obama’s Greenbook restricting or eliminating GRATs, note sale transactions to grantor trusts, and more. Clients who don’t seize what might be the last opportunity to capture discount planning could very well lose much more than just the discounts. They might lose many of the most valuable planning options. For the wealthy, this could be a repeat of the “2012 Rush to Plan.” Suggestions on planning considerations are discussed below.
- Put Right Might Govern All: While the Proposed Regulations contain a complex array of potential regulatory changes to IRC Sec. 2704, many of the provisions are superseded by what appears to be a mandatory put right. Regardless of how any restrictions on valuation apply to a particular situation, if the Proposed Regulations are enacted in a form similar to those that have been proposed, the right to liquidate any interests in six months’ time will be imputed even if the right to liquidate does not exist and never will exist. This one provision would appear to override any other results and thereby eliminate most or all discounts for lack of marketability. See, e.g., Estate of Jameson v. Commissioner, TC Memo 199-43, rev’d on other grounds, 267 F.3d 366 (5th Cir. 2001). If an interest has to be valued as if it could be put to the entity, such interest is to be redeemed by the entity at the ownership percentage based on the new concept of “minimum value” which conceptually is based on enterprise value multiplied by the ownership percentage. However, the minimum value might actually differ from this because of the rules on timing of the put (six months), rules on notes, etc. What marketability discount can really remain? So, while all the changes proposed should be evaluated, this one change appears to blanket the planning landscape with respect to family controlled entities.
- Even if Treasury Exceeded Its Authority: There have been a host of cogent arguments made that the Treasury has exceeded its authority with the Proposed Regulations. In fact, Treasury issued the Proposed Regulations over the objections of many experts who had been voicing their concerns when Treasury first intimated a change would be made to the Chapter 14 regulations. As such, even if some portions of the Proposed Regulations are eventually modified before finalized, or even if the Treasury re-evaluates its position and determines that some of the objections are valid, clients should not take the risk that this may not occur, especially with any additional risk that a Democratic administration might succeed in making the transfer tax system tougher for taxpayers to avoid.
- Recapture Lapse Value if Transferor Dies within 3 Years: Although it appears that discounts will be curtailed or eliminated prospectively, it may not be as simple as advising every wealthy client to consummate estate tax discount minimization strategies before the effective date of the Proposed Regulations. The Proposed Regulations appear to have a major potential downside. Specifically, transfers occurring prior to implementation of the Proposed Regulations may be tainted by the death of the transferor after the effective date of the Proposed Regulations but within three years of the original transfer. The Proposed Regulations include a bright-line three year test which appears to require recapture of the discount in the transferor’s estate, to the extent that the discount equaled the value of a lapse right that gave rise to the discount. If correct, this would appear to apply the restrictions of the Proposed Regulations retroactively and to transfers occurring before these new rules were drafted. Worse, at least in some situations, this inclusion amount appears to have to be valued based on the date of death value, not the earlier date of transfer value. If the value of the transferred asset increases substantially post death this could prove to be a substantial penalty. For clients in ill health or advanced age, it might be worthwhile to evaluate non-discounted alternative planning strategies not subject to this date of death valuation/inclusion risk. See Prop. Reg. Sec. 25.2704-1 which addresses deathbed transfers that result in the lapse of a liquidation right.
- How Many Clients Really Need Discounts: For all the hoopla of Proposed Regulations, it is worth considering the relevance to most practitioners. How many client families have a net worth over $10 million such that discount planning is relevant at the current high exemption levels? There are about 249,159 households with more than $10 million in assets.[i] With current exemption levels near $11M for a married couple, the fact that all assets cannot be transferred, and the reality that many wealthy have already planned, what portion of the typical estate planner’s client base is realistically concerned about discounts? The number is no doubt far lower than the hysteria over discount changes suggests. Nonetheless, while only a portion of practitioners might have to guide wealthy clients as to discount planning before the effective date of the Proposed Regulations, a substantially greater swath of practitioners – and their clients - will be affected by these Regulations. However, for those individuals domiciled in jurisdictions with an independent death system that has a far lower exemption, the loss of discount could be troublesome. Nonetheless, for some families, a higher estate tax value will be welcome as it will increase tax basis under Section 1014. That might be the case for the surviving spouse who inherits, under the protection of the estate tax marital deduction under Section 2056, a restricted interest in a family business. The artificially high estate tax value results in an artificially high basis, meaning less gain or greater loss if and when the surviving spouse sells the interest before his or her own death.
- Many Clients (Not Just Ultra-High Net Worth) Affected: The Proposed Regulations affect a large swath of clients and practitioners alike, not just the ultra-high net worth client as it might seem at first blush. This is a significant difference from the recent Form 8971 (dealing with basis consistency and essentially requiring no claim to be made of an income tax basis greater than an asset’s estate tax value) excitement which, in contrast, was confined largely to wealthier clients. It is a mistake to presume that the relevance of the new Regs is limited only to the ultra-high net worth client since Chapter 14 rules apply regardless of the size of the estate. Even non-taxable estates must run the rigors of these provisions.
- Appraisals Will Change: Appraisers will have to grapple with new valuation concepts that could be created by the Proposed Regulations. While appraisers might well be inundated with discount appraisals for deals to be consummated before the effective date of the Proposed Regulations, they also have to gear up for new concepts to address after the effective date. For example, under the Proposed Regulations, a Disregarded Restriction includes one that limits the liquidation proceeds to an amount that is not less than a “minimum value.” The calculation of minimum value limits debts to those that would qualify to be deducted under IRC Sec. 2053. Will this analysis differ from what has traditionally constituted generally accepted valuation practice? Will appraisers make this determination themselves or consult with tax counsel for guidance? Should such consultation with qualified expert tax counsel be referenced in valuation reports? Should this be the new standard for valuations? Further, different valuation rules appear to apply to transfers based upon whether the transferee is a “family member” or not, as defined in under the Proposed Regulations. A valuation must consider whether the Deemed Liquidation Right must be applied and whether the proceeds are required to be paid to the transferee over a six month period. See Example 5 of Prop. Reg. Sec. 25.2704-3. The valuation may also need to determine which assets are passive and which are nonpassive because special rules apply in determining whether redemption for a note will be respected. Not all valuation issues are eliminated. If the client does not have control it appears that valuation discounts will remain available. Nonetheless, avoiding control will be difficult, as the determination will have to factor into the analysis both the definition of “control” as set forth in the Proposed Regulations and the attribution rules.
- Defining and Identifying a “Transfer”: For the many circumstances when discounts are eliminated, appraisers will have challenges to address new valuation considerations. For example, is personal goodwill a component of the “value” of a particular business which ought to be excluded from the valuation since it is personal to the current owner or parent who is transferring the interest? Would that goodwill actually be part of the interest conveyed? Will planning shift to creating business opportunity in what heretofore has been a donee, analogous to the Bross Trucking case, in order to create value in the name of the intended beneficiary and avoid a transfer for which valuation may be an issue (and for which the Proposed Regulations’ approach is too burdensome)? See Bross Trucking Inc. v. Commr.,TC Memo 2014-17. In this case, the father owned and operated a trucking company. Regulatory issues arose. The father’s sons started their own business and used some equipment that had been used in the father’s business and some of the same suppliers and customers. The father was not involved in the new business started by sons. IRS said the creation of new business by sons was a distribution of goodwill by Bross Trucking to the father, followed by a gift of goodwill by the father to his three sons. The Tax Court said that the IRS was not correct. The goodwill belonged to the father as a shareholder, not the corporation. There was never an employment agreement or non-compete agreement that would have formalized this. The Tax Court also held that there was no gift by Dad to sons (or sons’ business) because the new company had a different name, etc. This planning approach might become more common if the Proposed Regulations are enacted in their current form.
- Form 709 Will Change: Gift tax reporting might be affected and the impact will be different for transactions consummated before and after the effective date of the Regulations. For transactions finalized before the effective date consider the following points: If there is a flurry of 2016 transfer tax planning prior to the effective date of the Proposed Regulations, practitioners may wish to file the gift tax returns reporting those transactions earlier in order to toll the statute of limitations for audit more quickly. There have been different perspectives on which transactions to report on a gift tax return as non-gift transactions. Some practitioners have routinely reported installment sales to grantor trusts on gift tax returns as non-gift transactions in order to start the running of the statute of limitations. Other practitioners have not routinely done so. Should practitioners rethink reporting these transactions in order to avoid application of the new discount valuation restrictions (if implemented)? If discount rules change, might practitioners view the pros/cons of reporting differently? For transactions consummated after the effective date of the Regulations, consideration may be given to the following items: The information that will have to be reported to meet the “adequate disclosure” requirements under Reg. 301.6501(f), to commence the running of the statute of limitations for assessment of gift tax, may expand significantly and be far more complex. Will the statute of limitations still toll if the taxpayer inadvertently fails to report one of the nuances of the valuation as required under the Proposed Regulations? Will separate appraisals have to be reported and provided to support the different calculations of value of interests transferred to family members and to third parties? Will these calculations and the supporting documentation for each of these new items have to be disclosed? What substantiation should be disclosed to demonstrate that a debt deducted for valuation purposes meets the new requirement that it would qualify for IRC Sec. 2053 purposes? Will the standard for determining the underlying value of assets in an entity change as a result of the Proposed Regulations? In other words, will appraisers give far greater attention to how to value assets held in an entity because entity-level discounts are no longer available? The determining factor will now be the underlying asset and/or business value - not the discounts. In the past, if the plan assumed a 30%+ discount there may have been less pressure to evaluate nuances of underlying asset values with technical precision. The Proposed Regulations change this dynamic. In all likelihood, the battle front will shift from discount valuations to asset valuations.
- Forms 706 and Form 8971 Will Change: Estate tax reporting on Form 706 and Form 8971 might be affected. Different appraisals and different valuations will be required for assets affected by the new valuation discount rules, depending upon whether the asset was being devised to family donees/heirs, third parties (non-family members), and/or charities. If part of an asset was being devised to different types of donees/heirs, it is possible that different valuations might be needed for the same asset. The proposed regulations relating to Form 8971 require the executor to advise every beneficiary who might receive an asset of its estate tax value and basis within 30 days of the filing for the United States Estate (and Generation-Skipping Transfer) Tax Return (Form 706). This will mean different reporting for family members and for non-family members in cases involving family controlled entities. It appears that different amounts will be included in the value of the gross estate for each group of heirs and then those amounts will set the parameters for any applicable marital and charitable deduction. This leads to the incongruous result of having a gross amount reported for a spousal bequest which differs from that reported for interests in the same asset passing to an unrelated charity. The marital and charitable deductions will be different from each other. It would appear that, to the extent transactions have to be reported on Form 8971, different values might have to be used for different beneficiaries. Thus, an interest in a family business passing to children may have a different value than a comparable interest passing to an unrelated person, even an un-adopted step-child. See Example 4 of Prop. Reg. 25.2704-3. If the estate is evaluating an estate tax deferral election under IRC Sec. 6166 (or a Section 303 Redemption), might the different valuations affect the percentages required to qualify? If the estate is considering the possible benefits of an alternate valuation date election, will revised appraisals have to be obtained for family and non-family heirs since the valuation figures are different under the Proposed Regulations? How will clients react to the additional complexity and cost?
- Governing Documents: The application of the Proposed Regulations will not assure that discounts will be avoided for closely held entities for clients under the estate tax exemption amount. For example, the anti-discount provisions only apply to family members. A member in a family LLC that does not qualify as “family” will not be subject to those rules and therefore his or her basis step up might be limited. This could occur even if a family member’s interest is not discounted because of the Disregarded Restrictions. Thus, practitioners might still need to revise operating and partnership agreements, for example, to “draft-out” discounts for clients below the estate tax exemption amounts in order to maximize basis step up. For example, a provision that provides a fair market value put right to the executors of a deceased member’s estate had been proposed in the professional literature as a means to eliminate discounts without emasculating asset protection benefits of the entity. This approach, however, may not conform to the “minimum value” rule of the Proposed Regulations so that the fair market value calculation under the Proposed Regulations could differ from the fair market value clause under the governing documents. Example: Jean Smith family created the Smith Family LLC. Children and other non-family heirs each own interests. If a child dies, the Disregarded Restrictions including the minimum value rule will apply, effectively negating discounts. However, for the non-family heirs, those rules do not appear to apply and their step-up in basis on death could be limited. Revising the operating agreement to negate discounts should reduce or eliminate undesired discounts. If this is done, will these provisions have to be revisited if a Democratic victory in November results in enactment of the Democratic tax proposals that reduce the estate tax exemption to $3.5M non-inflation adjusted? What happens when the patriarch of a business dies and the real buyout arrangement for the interest in that business requires a two year deferral to recognize the increased costs to transition the business, followed by quarterly payments over 10 years at the AFR. The Proposed Regs presume a sale in six months for cash at the minimum value. The difference between the tax value to be reported and the actual receipt of cash by the estate could be significant. Should practitioners consider tax distribution clauses to pay estate tax for clients owning entities where the tax valuation under the new minimum value rule, with the six month payout, will result in values that are much greater than what might otherwise be available to the estate of a deceased owner? Might clauses analogous to income tax payout clauses be crafted for estate tax payouts?
Taxpayer Actions Viewed as Valuation-Abusive by the IRS Addressed in the Proposed Regulations
The Proposed Regulations strengthen the rules governing “Applicable Restrictions” and add a new tier of restrictions that apply to valuation matters referred to as “Disregarded Restrictions.” Some of the changes are illustrated below:
- Control: The Proposed Regulations Sec. 25.2701-2 define what constitutes control of an LLC or other entity or arrangement that is not a corporation, partnership, or limited partnership to clarify that a 50% ownership interests or a GP position will constitute control even if the overall equity in the enterprise is quite small.
- State Law Restrictions: According to the Treasury, the current regulations have been rendered substantially ineffective in avoiding what the Treasury considers to be abusive valuation discounts by changes in state laws. Since the promulgation of the initial 2704 regulations, many state statutes governing limited partnerships and LLCs have been amended to provide statutory rules that bolster support for discounts. For example, some of these state law changes now limit liquidation of the entity only on the unanimous vote of all owners (unless provided otherwise in the partnership agreement), and to eliminate the statutory default provision that had allowed a limited partner to liquidate his or her limited partner interest. These rules often provide that a limited partner may not withdraw from the partnership unless the partnership agreement provides otherwise. The current regulations except from the definition of an “applicable restriction” any restriction on liquidation that is no more restrictive than that of the state law that would apply in the absence of the restriction. The Tax Court viewed this as a regulatory expansion of the statutory exception to the application of section 2704(b) contained in section 2704(b)(3)(B) that excepts “any restriction imposed, or required to be imposed, by any Federal or State law.” Each of these statutes is designed to be at least as restrictive as the maximum restriction on liquidation that could be imposed in a partnership (operating) agreement. The result is that the provisions of a partnership agreement restricting liquidation generally fall within the regulatory exception for restrictions that are “no more restrictive than those under state law,” and thus do not constitute Applicable Restrictions under the current regulations. The Proposed Regulations prohibit consideration of these restrictions unless they are mandatory under state law and not merely default provisions. Further, anticipating that practitioners could persuade states to enact special statutes with mandatory restrictions, the Proposed Regulations negate the consideration of these as well. Prop. Reg. Sec. 25.2704-2 redefines the definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations of state law.
- Restrictions on Interest Versus Entity: Courts have concluded that, under the current regulations, section 2704(b) applies only to restrictions on the ability to liquidate an entire entity, and not to restrictions on the ability to liquidate a transferred interest in that entity. Kerr v. Commissioner, 113 T.C. 449, 473 (1999), aff ’d , 292 F.3rd 490 (5th Cir. 2002). Thus, a restriction on the ability to liquidate an individual interest is not an applicable restriction under the current regulations. The Proposed Regulations make it clear that this distinction is no longer relevant.
- Assignee Interest: Taxpayers have attempted to avoid the application of section 2704(b) through the transfer of a partnership (LLC) interest to an assignee rather than to a new or substituted partner (member). Again, relying on the regulatory exception for restrictions that are no more restrictive than those under state law, and the fact that an assignee is allocated partnership income, gain, loss, etc., but does not have (and thus may not exercise) the rights or powers of a partner, taxpayers have successfully argued that an assignee's inability to cause the partnership to liquidate his or her partnership interest is no greater a restriction than that imposed upon assignees under state law. Kerr, 113 T.C. at 463-64; Estate of Jones v. Commissioner, 116 T.C. 121, 129-30 (2001). Courts have agreed that assignee status of the transferred interest is not an Applicable Restriction. The Proposed Regulations would confirm that there will be no valuation differential for this and would amend Treas. Reg. §25.2704-1 to clarify the treatment of a transfer that results in the creation of an assignee interest.
- Non-Family Member Owner: Finally, taxpayers have avoided the application of section 2704(b) through the transfer of a nominal partnership interest to a nonfamily member, such as a charity or an employee, to ensure that the family alone does not have the power to remove a restriction. Kerr, 292 F.3rd at 494. The Proposed Regulations provide bright line, stringent requirements before ownership interests held by third parties become relevant to the analyses. A third party (unrelated) equity holder must have at least 10% interest, the aggregate interests of all third parties must be at least 20%, and those interests have to have been held for three years in order to be considered. See Example 4. Prop. Treas. Reg. Sec. 25.2704-3 that addresses the effect of insubstantial interests held by persons who are not members of the family.
Planning steps should consider capturing discounts when feasible (and before the effective date of the Proposed Regulations) for clients who might benefit from discount planning. Any planning technique that can secure discounts should be evaluated in the process of identifying options that might be appropriate for any given client:
- BDITs – Heirs holding assets that they wish to shift out of their estate for asset protection or divorce protection but utilize a beneficiary defective trust (BDT) under Section 678.
- IDITs – note sales to grantor trusts (installment sales to defective or grantor trusts) to freeze the value of discounted interests in closely held businesses may be warranted.
- GRATs – Grantor retained annuity trust described in Section 2702(b) can be funded with discounted business interests.
- Gifts – simple gifts of assets valued at a discount (perhaps to grantor dynastic trusts).
Practitioners should bear in mind that many transactions will not be viable without discounts. For example, the sale to a grantor trust of a non-controlling interest in a family business valued with a 40% discount might facilitate distributions from the business to the trust sufficient to pay debt service on the note used in the transaction. Without any discount, the distribution from the cash flow might not suffice to make the note payments.
Practitioners should also bear in mind that application of these traditional planning techniques may have to be addressed in modified ways in light of the current environment. The traditional GRAT approach was to use short term rolling or cascading GRATs. But with short term GRATs funded with family business interests there would in many cases be payments of the annuity in kind, i.e. in the same equity interests gifted to the GRAT. However, once those interests come back into the estate via annuity payments, after the effective date of the Regulations taxpayers will no longer be able to discount them if they try to roll them into new GRATs (or other planning techniques). It might be more advantageous to use longer term GRATs so that the distributions from the equity interests gifted to the GRAT can be used to fund the annuity payments, and leakage of the equity back into the estate can be minimized. Obviously with a longer term GRAT mortality risk increases. If a longer term GRAT is contemplated, practitioners should consider having a life expectancy analysis completed to help set the longest reasonable period for the GRAT. Another GRAT point. It will be interesting to see if the IRS permits payments in kind made by GRATs funded prior to the new Regulations being effective to be valued without discounts for the annuity. This appears to be what the Proposed Regulations would require. However, if the asset gifted to the GRAT was discounted when the plan was implemented prior to the effective date of the Regulations that could result in a valuation whipsaw against the IRS, i.e. discounted asset into GRAT prior to the effective date, and non-discounted distribution of same equity interest out of the GRAT if the annuity payment is made after the effective date of the Proposed Regulations.
Practitioners should be mindful of issues that a crush of near year-end planning could create:
- Step transaction doctrine. If transfers are made close in time this could be, as in 2012, a more significant issue than if planning were not compressed in time.
- Trust accounts will take time to establish and those clients waiting to close to year end might have difficulties.
- Valuation firms might, like 2012 be inundated with work and transfers might have to be structured based on estimates and employ defined value mechanisms.
The Proposed Regulations are a game changer. The complex nuances of a number of new provisions and concepts still need to be evaluated. Practitioners should inform clients of sufficient wealth to plan quickly before the effective date of the Proposed Regulations in order to secure discounts to leverage wealth out of their estates. That recommendation should be tempered by the risks posed in these Proposed Regulations.
Sample Client Letter
Proposed Regulations Just Issued: The Treasury (IRS) just issued Proposed Regulations that could have a dramatic impact on your estate planning by eliminating valuation discounts. For wealthy people looking to minimize their future estate tax, this is critical. It can also be essential for others as well. If you are concerned about protecting a family business from the risks of future divorce, or protecting your assets from lawsuits or malpractice claims, discounts can enable you to leverage the maximum amount of assets out of harm’s way, without triggering a gift tax to do so.
Act Now: Time is of the essence. Once the Proposed Regulations are effective, which could be as early as year-end, the ability to claim discounts might be substantially reduced or eliminated, thus curtailing your tax and asset protection planning flexibility.
What are Discounts Anyway? Here’s a simple illustration of discounts. Bernie has a $20M estate which includes a $10M family business. He gifts 40% of the business to a trust to grow the asset out of his estate. The gross value of the 40% business interest is $4M. Since a minority 40% trust/shareholder cannot force a sale or redemption of its interest, the non-controlling interest in the business transferred to the trust is worth less than the pro-rata value of the underlying business. Thus, the value should be reduced to reflect the difficulty of marketing the non-controlling interest. As a result, the value of the 40% business interest transferred to the trust might be appraised, net of discounts, at $2.4M. The discount has reduced the estate by $1.6M from this one simple transaction.
Election Impact: If the Democrats win the White House and the Democratic estate tax proposals are enacted, the results will be devastating to wealth transfer planning. Pundits have prognosticated that a Democratic White House could affect down-ballot races and flip the Senate to the Democrats. The Democratic tax plan includes the reduction of the estate tax exemption to $3.5M, elimination of inflation adjustments to the exemption, a $1M gift exemption and a 45% rate. The Democratic plan will most likely include the array of proposals included in President Obama’s Greenbook which seek to restrict or eliminate GRATs, note sale transactions to grantor trusts, and more. Wealthy taxpayers who don’t seize what might be the last opportunity to capture discount planning, might lose much more than just the discounts. They might lose many of the most valuable planning options.
Not a 2012 Boy Who Cried Wolf: Many of you might remember the mad rush to plan in late 2012 on the fear that the gift, estate and generation skipping transfer (GST) tax exemption might be reduced from $5M to $1M in 2013. After many incurred significant costs and hassles in implementing planning quickly, that change never occurred. For those who might be affected by discounts, the situation in 2016 seems vastly different. The Proposed Regulations could be changed and theoretically even derailed before they become effective. The more likely scenario is that they will be finalized after public hearings and the ability to claim valuation discounts will be severely curtailed. If you do undertake planning, be cognizant of an important lesson from much of the poor planning that was done in 2012. Consider using planning techniques that assure you (or if you are married, your spouse) access to funds transferred in the discount planning. The main regrets in 2012 planning were for those who transferred assets out of their own reach. That is really not necessary.
What You Should Do: Contact your planning team. A collaborative effort is essential to have your planning done well. Your estate planning attorney can review strategic wealth transfer options that will maximize your benefit from discounts while still meeting other planning objectives. Projections completed by your wealth manager could be essential to confirming how much planning should be done and how. Your CPA will have vital input on wealth transfer options, federal and state income tax implications, and more. Your insurance consultant can show you how to use life insurance to backstop some of the planning strategies, in coordination with the financial forecasting done by your wealth manager, to maximize both the tax benefits and your financial security.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
Martin M. Shenkman
Ira S. Herman
LISI Estate Planning Newsletter #2448 (August 22, 2016) at http://www.leimbergservices.com Copyright © 2016 Martin M. Shenkman, Jonathan Blattmachr, Ira S. Herman and Joy Matak. Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.
[i] 2015 U.S. TRUST INSIGHTS ON WEALTH AND WORTH citing Cerulli Associates, Cerulli Lodestar — Retail Investor Subscription, 2013.
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