- · Expect the Unexpected: Perhaps one of the most important points to make about the Proposed Regulations is that the implications to planning are not limited to what practitioners anticipated, many aspects are not intuitive or logical, and the consequences can present traps for the unwary that affect determining what planning steps are really appropriate and when, document drafting, appraisals, and much more than just pure discount calculations.
- · Planning Environment in Flux: Consider the broader context that restrictions on discounts might relate to. Hillary Clinton is leading in the polls. Her 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. Likely her 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, might 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 2012’s rush to plan. Suggestions on planning considerations are discussed below.
- · Put Right Might Govern All: While the Proposed Regulations contain a complex array of changes to IRC Sec. 2704, many of the provisions are trumped (can we still use that term without a capital “T”?) 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 that proposed, the right to liquidate any interests in six months’ time will be imputed. This one provision would appear to override any other results and thereby eliminate most or all discounts for lack of marketability. If an interest has to be valued as if it could be put to the entity what marketability discount can really remain? So while all the changes proposed should be evaluated, this one change appears to blanket the planning landscape.
- · 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. But many of these objections had been voiced before the issuance of the Proposed Regulations and they did nothing to stop them. 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, client’s should not take the risk that this may not occur, especially with any additional risk that a second Clinton administration might succeed in making the transfer tax system harsher.
- · 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 planning before the effective date of the Proposed Regulations. It appears that the Proposed Regulations have a potential downside for clients planning that clients need to be informed of, and practitioners need to evaluate. It appears that if a client consummates discounted gifts before the effective date of the Proposed Regulations, dies after the effective date but within three years of consummating the discounted transfer, that the value of a lapse right that gave rise to the discount, will have to be included in the client’s gross estate. Worse, 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 asset transferred increases substantially post death this could prove to be a substantial penalty. For clients in ill health of advanced age it might be worthwhile to evaluate non-discounted alternative planning strategies that might not be subject to that 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 Propose Regulations it is worth considering the relevance to most practitioners. How many client families have a net worth over $10 million that discount planning is relevant at the current high exemption levels? There are about 249,159 households with more than $10 million in assets. With current exemption levels near $11M for a married couple, the reality that all assets cannot be transferred, and 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 hoopla over discount changes suggests. But, that being said consider the next point below. While only a portion of practitioners might have to guide wealth clients as to discount planning before the effective date of the Proposed Regulations, a substantially greater swath of practitioners will be affected by those Regulations.
- · 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 excitement which in contrast is confined largely to a wealthier swath of clients. It is a mistake to presume that there relevance is limited only to the ultra-high net worth client that might engage is discount planning to shift large dollars of wealth. Prior to the Proposed Regulations being issued it appeared that the elimination of discounts ######
- · Appraisals Will Change: Appraisers will have to grapple with new valuation concepts 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 less than a minimum value. This is defined limiting debts to those that would qualify to be deducted under IRC Sec. 2053. Will this analysis differ from what has traditional constituted generally accepted valuation practice? Will appraisers make this determination themselves or consult with tax counsel for guidance that might then be referenced in their valuation report. Also, under the Proposed Regulations different valuation rules will apply to transfers to those who are family and those who are not defined as family. Consideration of the six month payout will have to be interpreted and applied. See Example 5. A determination of which assets are passive and which are not might be required.
- · Forms 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 Proposed Regulations. For transactions consummated 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 should practitioners endeavor to file the gift tax returns reporting those transactions earlier in order to more quickly toll the statute of limitations for audit? There have been different perspectives on which transactions to report on a gift tax return as non-gift transactions. Some practitioners have routinely reported note sale transactions on gift tax returns as non-gift transactions in order to toll the statute of limitations. Other practitioners have not routinely done so. Should that analysis change for those that have not routinely reported these transactions? If discounts rules change might they view the pros/cons of reporting differently? For transactions consummated after the effective date consider the following items. The information that will have to be reported to meet the “adequate disclosure” requirements may expand significantly and be far more complex. Will missing one of the nuances of valuation required under the Proposed Regulations impact the tolling of the statute of limitations? Will separate appraisals have to be reported for valuations of interests transferred to family members and for non-family members? The Regulations require separate calculations. See the comments above concerning what appraisers may have to calculate. 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?
- · Forms 706 and 8971 Will Change: Estate tax reporting on Form 706 and Form 8971 might be affected. Different appraisals and different valuations will be required for family donees/heirs receiving assets affected by the new valuation rules and for non-family members (third parties) and charities receiving the same assets. It appears that different amounts will be included in the value of the gross estate for each group and then those amounts will set the parameters for a marital and charitable deduction. So the gross amount reported for a bequest to a spouse might differ 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. If the estate is evaluating an estate tax deferral election under IRC Sec. 6166 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 chapter 14 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 to maximize basis step up. For example, a provision that provides a fair market value put right to the executors of deceased member’s estates 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 step children own interests. If a child dies the Disregarded Restrictions including the minimum value rule will apply negating discounts. However, for the step-children 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 Hillary Clinton as President reduces the exemption to $3.5M non-inflated adjusted? 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?
- · 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.
- · State Law Restrictions: The current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute 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 support 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” a 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, not merely default provisions. Further, anticipating that practitioners would have states 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 argue 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). Taxpayers thus argue that the assignee status of the transferred interest is not an applicable restriction. The Proposed Regulations confirm that there will be no valuation differential for this. The Proposed Regulations amend §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 pars become relevant to the analyses. A third party (unrelated) equity holder must have a 10% interest, the aggregate interests of all third parties must be at least 20% and those interests have to be held for three years. See Example 4. Prop. Treas. Reg. Sec. 25.2704-3 addresses the effect of insubstantial interests held by persons who are not members of the family.
- · BDITs – Heirs holding assets that they wish to shift out of their estate for asset protection or divorce protection.
- · IDITs – note sales to grantor trusts to freeze the value of discounted interests in closely held businesses may be warranted.
- · GRATs – funded with discounted business interests.
Proposed Regulations Will Zap Discounts – Wealthy Taxpayers Should Plan ASAP
OK stop holding your breath! The long awaited discount Regs were just issued. 26 CFR Part 25 [REG-163113-02] RIN 1545-BB71. They will be published in the Federal Register on 08/04/2016 and available online at http://federalregister.gov/a/2016-18370.
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.” But as demonstrated below, the Proposed Regulations appear to exceed this objective and distort it in a number of complex ways.
Wealthy clients need to jump on this quick. Discounts have been the elixir that has driven the estate tax minimization machine for decades. Recently proposed tax regulations may eliminate valuation discounts and make it far more difficult for wealthy taxpayers to minimize estate taxes. But there is so much more to the story then just the potential loss of discounts.
Points to Consider in Evaluating the Proposed Regulations
Here are some thoughts on the proposed regulations. Many of these are quite preliminary and the analysis might, on further reflection result in different conclusions. Certainly some of these points might be changed after the public hearings and possible modifications of the Regulations before they are finalized.
Taxpayer Actions Viewed as Valuation-Abusive by the IRS Addressed in the Proposed Regs
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:
Planning steps should consider capturing discounts when feasible 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:
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 to secure discounts. 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 asses from lawsuits or malpractice claims, discounts can be essential to your being able 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 around 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. But this non-controlling interest in the business is worth less than the pro-rata value of the underlying business because the minority 40% trust/shareholder cannot force a sale or redemption of its interest. Thus, the value is reduced, for example, because of the difficulty of marketing the non-controlling interest. So the value of the 40% of the business given 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: Hillary Clinton is leading in the polls. Her 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. Likely her 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. 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. For the wealthy this could be a repeat of 2012’s rush to plan.
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 that might be affected by discounts the situation in 2016 seems different. The Proposed Regulations could be changed and theoretically even derailed before they become effective. But 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 planning 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 planning 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 steps, in coordination with the financial forecasting done by your wealth manager, to maximize both the tax benefits and your financial security.
 2015 U.S. TRUST INSIGHTS ON WEALTH AND WORTH citing Cerulli Associates, Cerulli Lodestar — Retail Investor Subscription, 2013.
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