“The” Proposed Regulations
They were years in the making – proposed regulations that seek to address what the IRS believes are abuses in the valuation of family-owned business and investment entities. Based upon the volume of commentary generated in response to the proposed rules, it is clear that the IRS has struck the proverbial raw nerve. It is difficult to recall the last time there was this much interest in proposed estate tax and gift tax rules. Almost every tax adviser under the sun has issued a client advisory. Many of these have been quite critical of the proposed rules. All have urged clients to act now, before the rules are finalized, or face the prospect of paying millions of dollars in transfer tax later.
By way of comparison, when the original version of these regulations was proposed in 1991, the year after the enactment of the legislation under which the regulations are being issued, the IRS received only one set of comments from the tax bar before finalizing them in 1992.
I think it’s safe to say that the IRS will be inundated with comments, questions and suggestions this time around. I daresay that, by the time the November 2, 2016 deadline for such comments arrives, the IRS may decide that it has to add an additional day of hearings to the single, currently scheduled day of December 1, 2016.
Given the importance of these proposed regulations, the amount of attention that they have garnered, and the calls-to-action from the estate tax planning bar, today’s post – which will be the first of three posts on the proposed regulations – will try to provide some historical and theoretical context for the regulations. In this case, historical perspective is important not only for purposes of understanding the regulations, but also in appreciating the “valuation options” that remain available. Tomorrow’s post will consider Section 2704 of the Code and the valuation of an interest in a closely-held business, generally. The third and final post will appear next week, and will discuss and comment on the technical aspects of the proposals, themselves.
Planning, In General
In order to better appreciate the effect of the proposed regulations, we need to first consider the traditional goal of estate tax and gift tax (“transfer tax”) planning, which has been to remove valuable, preferably appreciating, assets from a taxpayer’s hands.
In the case of interests in a family-owned business, a related goal has been to structure and/or reduce the taxpayer’s holdings in the business in such a way so as to reduce their value for purposes of the estate tax, to thereby reduce any resulting tax liability and, thus, to maximize the amount passing to the taxpayer’s family.
Over the years, many transfer techniques and vehicles have been developed to assist the taxpayer in accomplishing the goal of removing assets from his estate, though some of these vehicles/techniques have, themselves, been under attack by the IRS. In connection with the transfer of business interests, planners have used, among other things, GRATs, sales to grantor trusts, sales in exchange for private annuities, sales in exchange for self-cancelling installment notes, recapitalizations into voting and non-voting interests, and simple gifts.
Each of these techniques, standing alone, enables the taxpayer to save transfer taxes on the transfer of an interest in a family-owned entity to members of his family, even without significant valuation discounting.
However, if the interest being transferred is valued on a favorable – i.e., significantly discounted – basis, the tax-saving impact of the transfer is multiplied. The taxpayer is effectively given a “head start.”
Saving On Taxes – It’s Not Everything
Although tax savings are obviously an important considerations in any gift/estate tax plan, the assets to be transferred must be “disposable” insofar as the transferor is concerned.
No doubt, many of you have fond memories of the final days of 2012, when many believed that the transfer tax exemption amount would revert to its 2001 levels. Many taxpayers rushed to make gifts as we approached the end of that year, lest they lose their ability to make large gifts free of transfer tax. Many acted without sufficient regard for their own personal needs, or their tolerance for loss of control. All that seemed to matter was that if they didn’t act right away, they would “lose” the ability to make transfers free of gift tax.
Following the “permanent” restoration of the $5 million exemption (indexed to $5.45 million for 2016; likely to approach $5.5 million in 2017), many of these same taxpayers sought to recover the gifted properties or to rescind the gifts. Clearly, many acted only for the transfer tax benefit. Not a good move.
A Cautionary Note
As stated above, many advisers are urging taxpayers to act quickly, before the proposed regulations are finalized, or face the prospect of enormous tax bills. To this I respond: remember 2012. In other words, does the gifting being considered make sense from a personal and business perspective? If not, then stop right there.
Next, I say, keep in mind the increased (and indexed) exemption amount, not to mention the portability of the exemption amount between spouses, which may allow a taxpayer to hold onto property until his demise.
Closely connected to this is the basis step-up, to fair market value, for property that a taxpayer owns at his date of death, and the ability afforded by the step-up to avoid or reduce future income taxes, capital gains taxes, and the surtax on net investment income.
Many individuals who have already implemented a gift program should also keep in mind that reduced valuation discounts may actually benefit them. For example, a GRAT that is forced to distribute interests in a closely-held business may have to distribute fewer equity units of the business to satisfy the trust’s annuity obligation if the units are valued at a greater amount than would result with the application of large discounts.
The Top Tier
Of course, in the case of more affluent taxpayers, gift tax planning retains its luster. For these folks, the proposed regulations, if finalized in their present form, may present a significant challenge.
For those very affluent individuals who have deferred their gift tax planning, it may be advisable to act now, before the regulations are finalized. The goal in acting now will be to secure larger valuation discounts, and lower transfer tax values, for the closely-held business interests to be transferred.
Even as to these taxpayers, however, caution should be exercised. They have been forewarned that the IRS does not have a favorable view of the items identified in the proposed regulations. In fact, many taxpayers have already experienced the IRS’s suspicion of these items; for the most part, the proposed regulations do not introduce new concepts – rather, they embody the IRS’s historical audit and litigation positions. Thus, these taxpayers (and their advisers) can expect a serious challenge by the IRS, and should be prepared for it.
Prospects for Change Before Going Final?
Many advisers believe that the IRS has exceeded its authority in issuing these regulations. They believe that the courts will strike down the proposed rules if finalized in their current form. That may be, but I would not bet on it, nor would I plan for it; if the courts speak at all, it will likely be years from now – the IRS and death wait for no one.
Moreover, I disagree with this assessment of the IRS’s authority. The 1990 enabling legislation granted the IRS significant authority to interpret the statute and to issue regulations. That being said, my guess is that the IRS will be responsive to some of the comments from the tax bar, which may include some tweaking of the effective date for one provision of the proposed rules.
As regards all other items covered by the proposed regulations, the clock is in fact running. The good thing is that the proposed regulations will be effective prospectively only. Of course, we don’t know when they will go final – December 1, 2016 (the scheduled hearing date) is a possibility, as is early 2017. Of course, we also have to await the outcome of the presidential election in November.
Before we turn to the proposed regulations, tomorrow’s post will briefly describe some of the factors that are typically considered by the IRS in determining the value of an interest in a closely-held business, including the rules under Section 2704 of the Code.