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.
The Treasury has followed through on its promise to issue proposed regulations that are intended to significantly reduce the lack of control and lack of marketability discounts applied by appraisers when valuing family-controlled entities. The proposed regulations follow closely with guidance provided in the Treasury Department’s “Greenbook” as discussed in our prior post (click here to view prior post). The good news is that the proposed regulations have provided everyone with a window of opportunity to complete their planning before the regulations become final. We will provide a more detailed analysis of the proposed regulations soon.
We are pleased to announce the publication of the sixth issue of our firm magazine, Requisite. This issue focusses on succession planning for family businesses of all sizes. We feature an interview with Ken Feld, the CEO of Feld Entertainment (which owns Ringling Bros. and Barnum & Bailey Circus and Disney on Ice). He is the second generation of his family to run the business and is transitioning its control to the third generation. You will also find articles covering some of the emotional and technical challenges to creating a great succession plan. And we consider an underappreciated connection between Henry David Thoreau and his family’s business.
As the baby-boomer generation ages, an increasing number of family businesses will be experiencing transitions in ownership and/or management. Not all of these transitions will be successful; popular studies indicate that only 30% of family businesses survive beyond the first generation. In some cases, a transition may be undermined by a disconnect between the owner’s estate plan and the business’ succession plan. A transition can be both successful and profitable, however, with patience, persistence, and proper planning.
John Wagner and Doug Elmore recently discussed techniques that can help align a business succession plan with an estate plan at a joint meeting of the Gulf Coast Chapter of the of Florida Institute of CPAs and the Suncoast Chapter of the Financial Planners Association. Here is a link to their presentation materials: Striking a Balance: Aligning the Business Succession Plan With the Estate Plan
If you are, or someone that you know is, considering transferring an ownership interest in a family controlled entity the best time may be now. Speculation abounds over the impact that potential new regulations may have on the valuation of a closely held business interest. For several years, the Treasury Department’s “Greenbook” contained a Revenue Proposal entitled, “Modify Rules on Valuation Discounts.” Based on recent comments made by IRS and Treasury officials, it is possible that new proposed regulations will be issued by the middle of next month. In some cases the Treasury has made proposed regulations effective as soon as they are issued, which could occur in this case as long as the regulations are not otherwise modified when they are finalized. When issued, many practitioners believe that the proposed regulations will reduce the amount of the lack of control and lack of marketability discounts that appraisers apply when valuing family-controlled entities.
With the lack of clear guidance available, it is impossible to know how significant an impact the potential new regulations may have. The best guidance likely comes from last time the proposal was contained in the Greenbook, which read as follows:
This proposal would create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family. Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations. Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations. A disregarded restriction also would include any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity. For purposes of determining whether a restriction may be removed by member(s) of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family. Regulatory authority would be granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of section 2704 if certain standards are met. This proposal would make conforming clarifications with regard to the interaction of this proposal with the transfer tax marital and charitable deductions.
When additional guidance is provided, or the proposed regulations are released, we will provide an update discussing the potential impacts of the regulations.
The Supreme Court’s decision authorizing nationwide same-sex marriage further extends marital rights. But some extraordinarily-tax-motivated same-sex couples may make the same choice that some opposite-sex couples have made for years, to avoid marriage to take advantage of tax planning opportunities married couples cannot.
Marriage brings with it many tax benefits, especially under the federal income tax for families of all income levels with a single wage earner, and under the federal estate and gift tax, where even wealthy spouses are allowed unlimited tax-free transfers between themselves. But married couples are also treated as “related parties” under the Internal Revenue Code. Related party treatment prevents spouses from engaging in many tax motivated transactions that unmarried persons—even those who for all practical purposes function like a married couple—cannot.
For example, unmarried persons who co-own a corporation can more freely engage in redemption transactions in which their corporate share income tax basis offsets distribution income. Married couples are more restricted in this regard. Unmarried persons can buy and sell property between themselves free of related-party rules that re-characterize lower-tax long-term capital gain as higher-tax-rate ordinary income or prevent the purchaser from re-depreciating purchased assets. Members of unmarried couples can serve as counterparties in tax-deferred 1031 exchanges, whereas married couples are restricted in this regard.
The number of persons who would avoid marriage for tax reasons is limited. In our experience, however, some individuals—particularly those with substantial real estate holdings–take these tax planning opportunities into account when deciding whether to marry under the law, even if they are committed in their hearts. Those taxpayers turn Congressional policy on its head, causing tax laws intended to prevent abusive tax avoidance by closely connected individuals into an unintended deterrent to marriage.
Estate Planning is hard for many reasons—from discomfort with death to difficult family dynamics. It is made harder by complicated tax laws and documents. Too often, in estate planning, the focus is solely on tax planning without considering the impact of the planning upon the family or incentivizing the type of behavior that is desired to act as an extension of the client’s system of values.
To conclude the Williams Parker Business & Tax Blog’s inaugural year, a few year-end tax tips:
If you receive a holiday gift check intended to qualify for the donor’s 2014 Federal Gift Tax annual exclusion of up to $14,000 per year, per recipient, improve your chances of repeat future gifts by depositing the check on or before December 31, 2014. If you deposit the check during 2015, the check will not qualify for the donor’s 2014 annual exclusion. That will make your generous donor unhappy because only annual exclusion gifts are “free” for transfer tax purposes. If the gift does not qualify for the annual exclusion, the donor may owe gift tax or have to reduce his or her lifetime exemption, increasing Federal Gift Tax or Federal Estate Tax in the future. More likely, the donor will give you less next year so your total gifts in 2015 fit within the donor’s 2015 annual exclusion.
Charitable gifts are more flexible. Recipient charitable organizations are not required to deposit donation checks on or before December 31, 2014, to qualify for a 2014 income tax deduction. The donor only has to document that the check was mailed or otherwise sent outside the donor’s control on or before December 31, 2014.
We hope you enjoy the holidays and have a happy new year.
Non-controlling family partnership interests with limited marketability have long been discounted for federal gift and estate tax valuation purposes, reducing their deemed fair market value and the gift and estate tax attributable to such interests. The income tax tradeoff for a partnership interest held until death is that the income tax basis in the partnership interest is lower to the inheritor, because that tax basis is automatically adjusted to fair market value. A lower tax basis potentially creates more taxable gain when the asset is later sold.
The tradeoff was traditionally tolerated because the federal gift and estate tax rate was higher than both ordinary income and capital gain tax rates. Since the federal estate and gift tax exemption increased to over $5 million per individual and over $10 million per married couple a few years ago, however, many families’ estate tax exposure has disappeared. For families with no ongoing estate tax exposure, valuation discounts that once made their family partnerships “tax assets” may now make the partnerships “tax liabilities.” Even though they may no longer have estate tax to avoid, the families are still left with a lower mark-to-market tax basis and potentially more future taxable gain after a family member dies.
Also, with recent changes in the law, the highest marginal federal income tax rate and the federal estate tax rate are now very close. For assets that produce ordinary income when sold for a gain, this reduces or reverses the estate-income-tax-rate arbitrage even for families with continuing estate tax exposure.
Should families unwind their family partnerships?
For families affected by these factors, it is worth asking the question anew. The question should be evaluated in the context of the many advantages and disadvantages–including non-tax factors–that characterize family partnerships.
In contrast, families with ongoing estate tax exposure whose family partnerships hold assets that will likely produce capital gain when sold are less likely to be affected by these factors. Their family partnerships likely remain effective estate planning tools.