2704 Regulations Explained: Proposed Rules Are Set to Further Expand Value Differences between Family-Controlled Entities and Other Companies

The IRS is focused on reducing valuation discounts associated with transfers of interests in family-controlled businesses, but this focus will result in family members being deemed to receive a different value than non-family members.  This also means that an appraiser will be required to establish two different values based on ignoring certain restrictions for family members, while taking those same restrictions into consideration for non-family members.

Consider, for example, a trust that provides that 50 percent of a decedent’s family-controlled business interest will go to charity and the remaining 50 percent will go to family members.  The IRS will be expecting that the interest being conveyed to the family members to result in a higher value when compared to the same percentage interest being conveyed to charity.  This ultimately means that the interest conveyed to family will result in higher estate taxes and the interest conveyed to charity will result in a smaller charitable deduction for estate tax purposes.  The end result is the IRS receives more estate tax from the estate even though the same restrictions apply to all members (both the family members and charity).

This post is part of a series of blog posts addressing the proposed 2704 regulations and the parties that should be reviewing their plans as a result.

View previous posts:

Thomas J. McLaughlin
tmclaughlin@williamsparker.com
941-536-2042

What Do Estate Tax Laws in Other Countries Tell Us About the Presidential Candidates’ Proposals?

Under current law, the federal government imposes a 40% estate tax to the extent an individual’s estate exceeds a $5.45 million exemption. Republican presidential nominee Donald Trump advocates eliminating the tax. Democratic presidential nominee Hillary Clinton previously previously proposed reducing the exemption to $3.5 million and increasing the tax rate to 45%. Last week, she further proposed increasing the tax rate to 50% to the extent an estate exceeds $10 million, 55% to the extent an estate exceeds $50 million, and 65% to the extent an estate exceeds $500 million.

According to a 2015 Tax Foundation study, the current top 40% federal estate tax rate was the fourth highest amongst the 34 countries in the Organization for Economic Cooperation and Development (OECD) at that time. Japan had the highest top rate, 55%. Spain had the next highest rate behind the U.S., 34%. Chile rounded out the top 10, at 25%. 15 countries imposed no estate tax.

Adopting the Clinton proposal would make the U.S. top estate tax rate 10% higher than any other OECD country’s top rate. Even if we ignore the 65% rate applicable only to estates over $500 million, a 55% top rate would tie the U.S. with Japan for the highest rate. Even a 50% top rate would tie the U.S. with South Korea for the second-highest rate.

What does this tell us? The candidates’ proposals are at the opposite extremes of worldwide estate tax policies. While neither proposal seems likely to pass into law, the divergence underscores the tax policy polarization between the candidates.  Rather than “fitting in,” each pushes our nation’s tax policy to an extreme.

There is also a question whether adoption of either policy would serve the proposing candidate well as President.  How would Mr. Trump’s disgruntled blue collar supporters react to estate tax repeal?  One also can wonder whether Ms. Clinton’s proposal would motivate more of the wealthiest Americans to surrender their citizenship and move capital out of the U.S., not a result she relishes.

Here is a link to the Tax Foundation estate tax study: http://taxfoundation.org/article/estate-and-inheritance-taxes-around-world

Here are links to recent media coverage regarding the candidates’ estate tax proposals: http://www.wsj.com/articles/hillary-clinton-proposes-65-tax-on-largest-estates-1474559914

http://www.latimes.com/nation/politics/trailguide/la-na-trailguide-updates-1474577545-htmlstory.html

http://www.forbes.com/sites/robertwood/2016/09/23/hillary-clintons-65-estate-tax-or-donald-trumps-repeal/#450664385bf7

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Applicable Federal Rates for October 2016

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for October 2016:

Short Term AFR (Loans with Terms <= 3 Years)                                          0.66%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.29%

Long Term AFR (Loans with Terms >9 Years)                                              1.95%

7520 Rate (Used in many estate planning vehicles)                                     1.6%

Here is a link to the complete list of rates: https://www.irs.gov/pub/irs-drop/rr-16-25.pdf?_ga=1.112790660.1043379965.1429544687

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

2704 Regulations Explained: Proposed Rules Negating Gift and Estate Tax Valuation Discounts May Ensnare Your Vacation Home Too

As mentioned in several recent posts, the proposed regulations under Code Section 2704 are aimed at reducing valuation discounts associated with transfers of interests in family-controlled businesses.  So that the proposed regulations capture certain entities that may be disregarded for federal income tax purposes, such as single-member limited liability companies, the definition of a family controlled entity under the regulations casts a wide net.  In fact, this net is so expansive that it has the ability to reach certain business arrangements that are significantly different from the typical family business.

Consider, for example, three siblings who own a vacation home as tenants-in-common.  Assume that the siblings have executed a co-tenancy agreement that restricts each tenant’s ability to partition and sell their interest (as many of these agreements do).  If this arrangement constitutes a controlled entity under the proposed regulations, then the regulations would apply to this co-tenancy arrangement in generally the same manner that they would apply to an active trade or business.  Should the proposed regulations apply, if a co-tenant transfers his or her interest in the vacation home (either during life or at death), the value of this interest for transfer tax purposes may be computed without regard to the restriction on partition in the co-tenancy agreement and, in turn, any valuation discounts that this restriction may warrant.  In this event, the application of the proposed regulations may result in a higher gift or estate tax value associated with this transfer.

This post is part of a series of blog posts addressing the proposed 2704 regulations and the parties that should be reviewing their plans as a result.

View previous posts:

Douglas J. Elmore
delmore@williamsparker.com
(941) 329-6637

2704 Regulations Explained: Winners and Losers of Proposed §2704 Regulations, Is the IRS a Loser?

The recently issued proposed regulations under Code Section 2704 are specifically targeted at substantially reducing valuation discounts associated with family-controlled businesses.  The clear losers are the families that have taxable estates. These families will likely pay additional estate and gift tax once the §2704 regulations are finalized. In order to reduce the impact that will occur when the regulations are finalized, families that have taxable estates should review their existing plans to determine whether planning now could save them substantially later.

The IRS is likely to win in the long run, but the increased estate and gift tax revenue will be offset to an extent by a reduction in income tax.  In addition, courts have been reluctant to go along with the IRS’s past attempts to substantially change the value of a family-controlled business. Accordingly, if the IRS finalizes the regulations without substantial changes, we can expect multiple challenges to be forthcoming from taxpayers, which could further reduce what the IRS likely perceives as a significant revenue booster.

The clear winners are the family business owners that do not have taxable estates ($5.45MM on an individual basis and $10.9MM for a married couple) because the proposed regulations should allow their family to receive a larger step up in the income tax basis of the business, and in some cases the business’ assets, when they pass away.

This post is part of a series of blog posts addressing the proposed 2704 regulations and the parties that should be reviewing their plans as a result.

View previous posts:

Thomas J. McLaughlin
tmclaughlin@williamsparker.com
941-536-2042

Join Us: Doing Business in China Executive Briefing

R&P China BannerWe invite you to join us for an engaging, informative presentation on doing business in China. Williams Parker is pleased to host Maarten Roos and Robin Tabbers, lead partners of R&P China Lawyers (Shanghai) and authors of articles recently published in Requisite V – The International Edition. Our guests will provide practical guidance on manufacturing and sourcing in China, strategies for managing a Chinese subsidiary, and best practices for selling to the Chinese market. The presentation will take place Monday, September 19, from 5:30 to 7 p.m. at the firm’s office, located at 200 S. Orange Ave. in downtown Sarasota.

Williams Parker and R&P China Lawyers work together as part of the Ally Law network (formerly the International Alliance of Law Firms) to provide solutions to companies doing business internationally. R&P China Lawyers is a boutique PRC law firm that supports international business in China. Its attorneys combine in-depth legal expertise and broad experience of the Chinese business environment with a keen understanding of client needs.

Space is limited. If interested in attending, please email MarketingDesk@williamsparker.com.

2704 Regulations Explained: Why is the IRS Targeting Valuation Discounts on Family Controlled Entities?

The simple answer is that the IRS believes that valuation discounts taken on family controlled entities are falsely high, which results in lower transfer tax revenue to the Treasury.  With the foregoing in mind, it is important to understand how the IRS, courts, and taxpayers value a business interest under current law for estate and gift tax purposes.  The general rule for a valuation is to determine the price at which property would change hands between a willing buyer and a willing seller, both of whom have reasonable knowledge of the facts and neither of whom is compelled to complete the transaction.

The courts and the IRS have recognized that discounts should be allowed where the property transferred is a minority interest in an entity that cannot force or compel the entity to act (“lack of control”) and where there is a limited market for the property (“lack of marketability”).  Taxpayers and their planners began to take advantage of this knowledge by adjusting their entity’s governing documents to increase the discounts available when transferring interests to family members.  In 1990, Congress enacted Code Sections 2701 through 2704, known as Chapter 14, to quell what was seen by some as aggressive, and in some cases abusive, uses of these discounts to reduce transfer tax values especially when many of the restrictions imposed had limited or no significant substantive effect because the family had the ability to fully control the entity and eliminate the restrictions at its will.  Since Chapter 14 became effective, the IRS has slowly seen Chapter 14’s impact dwindle due to court decisions and changes in state law.  As a result, the Treasury began seeking legislative changes to Chapter 14; however, these changes were not getting traction in Congress after several years.  The proposed regulations are Treasury’s response to the inaction of Congress and an attempt to substantially reduce discounts that the Treasury believes to be an estate and gift tax planning fiction.

Over the next several weeks we will be providing a series of blog posts addressing the proposed regulations and a synopsis of the parties that should be reviewing their plans as a result of the regulations.

Thomas J. McLaughlin
tmclaughlin@williamsparker.com
941-536-2042

Applicable Federal Rates for September 2016

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for September 2016:

Short Term AFR (Loans with Terms <= 3 Years)                                          0.61%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.22%

Long Term AFR (Loans with Terms >9 Years)                                              1.90%

7520 Rate (Used in many estate planning vehicles)                                     1.4%

Here is a link to the complete list of rates: https://tax.thomsonreuters.com/wp-content/pdf/checkpoint/ria-wgl/2016/September2016-AFR.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Want to Diversify an Appreciated Asset Position Without Paying Capital Gains Tax? Take a Federal Government Job With a Conflict of Interest.

If you want to convert a substantially appreciated asset into a diversified asset portfolio without paying capital gains tax, choose your favorite Presidential candidate with extra care.   He or she could save you a lot of tax by giving you a job.

If that candidate becomes President, appoints you to an Executive Branch position, and determines owning the appreciated asset creates a conflict of interest in your new Executive Branch job, Internal Revenue Code Section 1043 allows you to sell the appreciated asset and buy a diversified investment portfolio or Treasury Securities without paying the capital gains tax. Judicial appointees enjoy a similar opportunity.

Sound crazy? In 2006, media speculated that former Goldman Sachs CEO Hank Paulson would use Section 1043 to avoid millions of dollars of capital gains tax from selling appreciated Goldman Sachs stock when President George W. Bush appointed him Treasury Secretary. One might expect the tax benefit far exceeded the value of Mr. Paulson’s salary and other compensation.

But Section 1043  isn’t a complete “win” for the appointee. The gain is only deferred, not permanently eliminated, so the appointee must recognize the gain and pay the capital gains tax if and when he or she sells the newly purchased investments.  Also, diversification isn’t always voluntary.  As a condition to confirming his or her appointment, a Congressional committee can require an appointee to sell an asset the appointee wants to keep.  Another noteworthy consideration: these jobs aren’t necessarily easy.  One can wonder if, given a crystal ball, Mr. Paulson would rather have paid the capital gains tax, than serve as Treasury Secretary in the early days of the the Great Recession and, as a Republican, drop to a knee before the Democratic Congressional leadership to beg support for rescue legislation in the midst of financial crisis.

Nevertheless, don’t hesitate to raise an eyebrow if our future President appoints someone with a lot of gain (to defer) to an Executive Branch position. And if you find a job attractive in part for its tax perks, take heart that you aren’t necessarily the first person to submit your resume under such circumstances.

Here is a link to Internal Revenue Code Section 1043: https://www.law.cornell.edu/uscode/text/26/1043

Here is a link to a 2006 Forbes article discussing Mr. Paulson’s tax situation and some quirks to Section 1043 in more detail:  http://www.forbes.com/2006/06/01/paulson-tax-loophole-cx_jh_0602paultax.html

Here is a link to 2008 coverage of Mr. Paulson’s kneel: http://www.nytimes.com/2008/09/26/business/26bailout.html

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Tax Court Approves Non-Safe-Harbor “Reverse” 1031 Exchange Even Though Titleholder Had No Ownership Benefits or Burdens

A 1031 Exchange is a popular capital gains deferral strategy for business and investment property. Taxpayers use the strategy to defer capital gains tax on property “sold” by acquiring “like kind” replacement property, usually in coordination with an intermediary or accommodation party.

After deliberating for a decade, the U.S. Tax Court has held that an accommodation party with no benefits or burdens of ownership can hold title to real property outside the established IRS “reverse” 1031 Exchange safe harbor without disqualifying the taxpayer’s 1031 Exchange.  The case arose from transactions spanning from 1999 to early 2001, before the IRS issued its safe harbor ruling for such transactions.  The accommodation party held the potential 1031 Exchange replacement property for over one year (longer than the 180-day period allowed by the IRS safe harbor) before transferring it to the taxpayer, following the taxpayer’s sale of its intended relinquished property.  During this period, the taxpayer funded all costs (including acquisition and construction costs) associated with the property, and entered into arrangements that constructively prevented the titleholder from realizing the benefits of owning the property.

The “owner” of property for federal income tax purposes usually is the party with the “benefits and burdens” of ownership, not legal title.  Application of that standard would have disqualified the 1031 Exchange by treating the taxpayer as owning the replacement property before acquiring the relinquished property. But the Tax Court found that different rules apply in the 1031 Exchange context, such that the arrangement was acceptable to treat the temporary accommodation titleholder as the income tax owner until the taxpayer completed its 1031 Exchange.

The Tax Court’s reasoning relied heavily on a decision of the U.S. Court of Appeals for the Ninth Circuit, the appellate court with jurisdiction over California and other western states.  While the Tax Court also relied on other precedent, there remains a risk cases in other geographic areas could have different outcomes.  The case is nevertheless significant, bolstering the substantial flexibility taxpayers enjoy in structuring 1031 Exchanges.

Here is a link to the Tax Court opinion in Estate of Bartell v. Commissioner: http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=10868.