Sibling Rivalry

Many of us encounter family-owned corporations in which the founder’s children are engaged in the business to varying degrees. They may even own shares in the corporation, typically having received them as gifts from their parents.[i] These situations may develop in such a way that they present difficult succession planning considerations for the business.

It may be that two or more siblings actively participate in the business. The more capable among them may aspire to lead the corporation after their parents have retired or passed away. At some point, their competing goals, personalities, or divergent management styles may generate enough friction between the siblings, and within the corporation, so as to jeopardize the continued well-being of the business.[ii]

Alternatively, the siblings may be interested in different parts of the corporation’s business. Each sibling may be responsible for a different line of business; for example, a different product, service, or geographic region. Their differing interests may lead to disagreements as to the allocation of resources and the prioritization of goals.

The dispute between the siblings will sometimes fester – and their relationship will deteriorate – to the point where litigation, along with its attendant costs and disruption of the business, are inevitable.[iii]

Dividing the Business?

In that case, it may still be possible to de-escalate the situation, and avoid further bloodshed[iv] – not to mention expense and loss of revenue – if it can be demonstrated to the feuding siblings that the business may be divided between them on a tax-efficient (i.e., economical) basis, especially where they have already incurred significant legal costs in trying to divorce themselves from one another.

Of course, it would be preferable (and less expensive) if the siblings could separate from one another without first resorting to litigation, although it is often the case that such litigation becomes the impetus for a more constructive approach toward the settlement of the parties’ disputes.

Indeed, if the parents could reasonably foresee the risk of serious disagreement among their successors in the business, they may decide to explore with their tax and corporate advisers whether the business can be divided among the kids while the parents are still alive and before the business suffers the adverse consequences that typically accompany such infighting.[v]

There are two basic forms of corporate division by which two or more shareholders may go their separate ways. In the “split-off” form of division, the parent corporation distributes all of its shares in a subsidiary corporation[vi] to one of more of its shareholders in a complete redemption of their shares in the parent corporation, leaving the parent corporation in the hands of its remaining shareholders. In the “split-up” form of division, the parent corporation distributes all its shares in at least two subsidiary corporations to at least two different sets of shareholders in a complete liquidation of the parent corporation.

There is also a third form of division – a “spin-off” – by which a parent corporation may distribute the stock of its subsidiary corporation to at least some of its shareholders by way of a “dividend,” thereby changing the form of the relationship to that of brother-sister corporations with some degree of common ownership.[vii]

“Tax-Free” Divisions

Whatever form of division is selected, there are numerous requirements that must be satisfied in order for the division to receive favorable tax treatment. In general,

    1. the distributing parent corporation must distribute to some or all of its shareholders all of the stock of a subsidiary corporation[viii] controlled by the parent,
    2. the distributing corporation and the subsidiary corporation must each be engaged in the “active conduct of a trade or business” immediately after the distribution,[ix]
    3. neither active trade or business was acquired in a taxable transaction during the five-year period preceding the distribution,
    4. there is a real and substantial business purpose for the distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, nor unduly expensive,
    5. the transaction must not be used principally as a “device” for the distribution of the earnings and profits of either the distributing corporation or the subsidiary corporation,
    6. the distributee shareholders did not acquire their shares in the distributing parent corporation by “purchase” during the five-year period ending on the date of the distribution; and
    7. the distribution is not made pursuant to a plan by which at least 50% of parent or of the former subsidiary is acquired by third parties.[x]

In general, if these requirements are satisfied, (1) the shareholders will not recognize gain or loss upon the receipt of the subsidiary stock, (2) the distributing corporation will not recognize gain or loss upon the distribution of the subsidiary stock to the shareholders, (3) the aggregate basis of the subsidiary stock received by each shareholder immediately after the distribution will equal the shareholder’s aggregate basis in the distributing corporation stock surrendered in the distribution, and (4) the holding period of the subsidiary stock received by each shareholder will include the holding period of the stock in the distributing corporation with respect to which the distribution of the subsidiary stock is made.[xi]

If these criteria are not met, then the distributing corporation will be treated as having sold the distributed property for an amount equal to the property’s fair market value, it will have to recognize the gain realized on deemed sale of the property, and it will be taxed thereon. The shareholders will be taxed on their receipt of the property distributed by the corporation, either as a dividend of an amount equal to the fair market value of such property, or as a payment of the same amount in exchange for their shares of stock in the distributing corporation.

In order to avoid the adverse tax consequences described immediately above, it is imperative that each of the requirements for a “tax-free” division of the distributing corporation be satisfied.

Business Purpose

In the context of a family-owned corporation, the requirement that the distribution be carried out for a real and substantial corporate business purpose may present a unique challenge, at least where the ostensible business purpose for the division of the corporation is to enable competing siblings – who would otherwise succeed to the ownership and management of the corporation – to go their separate ways.

Specifically, it may be difficult in that case, depending upon the facts and circumstances, to distinguish between a corporate business purpose, on the one hand, and a personal non-business purpose of the shareholders, on the other.

That being said, it should be noted that one of the most commonly relied upon corporate business purposes for the distribution of a subsidiary as part of a corporate division is that it will enhance the success of each corporation’s business by enabling a significant shareholder or shareholder group to concentrate on a particular line of business, and to thereby resolve management or other problems that arise, or are exacerbated, by the operation of different businesses within a single corporation.[xii]

However, the IRS has long recognized the potential, in the context of a family-owned corporation, for such a distribution to also facilitate the personal planning (such as estate planning or gifts) of a shareholder.

In order to better understand how to prepare for an IRS challenge on such grounds,[xiii] the parties and their advisers will need to familiarize themselves, in the first instance, with the published guidance provided by the IRS itself, including the two rulings described below.[xiv]

Scenario One

The IRS once considered the case of a corporation (“Corp”) that operated an automobile dealership.[xv] Its franchise for the sale of automobiles was in Dad’s name; the franchise could not be held by the corporation, was renewable periodically, and was not transferable by inheritance or otherwise.

Dad managed Corp and owned a majority of its stock. He was elderly, and the Corp stock constituted the bulk of his estate. The balance of Corp’s stock was held equally by Dad’s five daughters, only three of whom were active in the business.

Corp’s wholly-owned subsidiary (“Sub”) was engaged in the business of renting automobiles.

The automobile manufacturer did not permit the granting or continuing of a franchise where there were inactive shareholders in the corporation unless an active majority shareholder held the franchise. Alternatively, the manufacturer permitted the granting or continuing of a franchise where there was no majority shareholder, provided the shareholders were few in number and all were active in the business.

The IRS noted that, upon Dad’s death or retirement, the present stock ownership of Corp, with proportionate bequests or gifts to Dad’s daughters, would preclude satisfaction of the active-shareholder criteria described above for the purpose of renewing the franchise.

In order to ensure that its remaining shareholders would be able to renew the franchise upon Dad’s death or retirement under the alternate conditions of the franchise policy – without chancing a potential interruption in the continuity of, or even the loss of, the franchise which might occur if nothing was done until after Dad’s departure – Corp distributed 75% of Sub’s stock to the two inactive-daughter shareholders in exchange for all of their stock in Corp. The remaining 25% of Sub’s stock was distributed to Dad in exchange for Corp shares of equal value.

Dad intended that, upon his death, the inactive-daughter shareholders would receive their inheritance in Sub stock (and assets other than Corp stock), while the active-daughter shareholders would receive his shares of Corp stock.

The IRS determined that distribution of the Sub stock to Dad furthered the objective of enabling Corp’s active-daughter shareholders to retain the franchise by increasing their percentage of ownership in Corp, and by providing Dad with Sub stock which he could bequeath or gift to the inactive-daughter shareholders, leaving his remaining Corp stock available for transfer to the active-daughter shareholders.

The IRS also found that Dad’s age presented an immediate problem, [xvi] and that the distribution of Sub’s stock was germane to the continuation of Corp’s business in the reasonably foreseeable future. Execution of the plan, therefore, was directly related to the retention of a franchise vital to Corp’s business and would forestall an impending disruption to such business by reason of the current active family group being unable to renew the corporation’s franchise upon Dad’s death or retirement.

Scenario Two

In another ruling[xvii] the IRS considered a corporation (“Corp”) the stock of which was owned equally by Parents, Son, and Daughter. Although Parents participated in some major management decisions, most of the management, and all of the operational activities, were performed by Son and Daughter.

Son and Daughter disagreed over the future direction of Corp’s business. Son wished to expand one line of business, but Daughter was opposed because this would require substantial borrowing by Corp. Daughter preferred to sell that line of business and concentrate on Corp’s other business. Despite the disagreement, the two siblings cooperated on the operation of the business in its historical manner without disruption. Nevertheless, it prevented each sibling from developing, as he or she saw fit, the business in which he or she was most interested.

Parents remained neutral on the disagreement between their children. However, because of the disagreement, Parents preferred to bequeath separate interests in the business to their children.

To enable Son and Daughter each to devote their undivided attention, and apply a consistent business strategy, to the line of business in which he or she was most interested, and to further Parents’ estate planning goals, Corp contributed one of its lines of business to a newly-formed and wholly-owned subsidiary corporation (“Sub”), and distributed 50% of Sub’s stock to Son in exchange for all of his stock in Corp. Corp then distributed the remaining Sub stock to Parents in exchange for half of their Corp stock.

Going forward, Daughter would manage and operate Corp and have no stock interest in Sub, and Son would manage and operate Sub and have no stock interest in Corp. Parents would also amend their wills to provide that Son and Daughter would inherit stock only in Sub and Corp, respectively. After the distribution, Parents would still own 50% of the outstanding stock of Corp and of Sub, and would continue to participate in certain management decisions related to the business of each corporation.

The IRS determined that the distribution would eliminate the disagreement between Son and Daughter over the future direction of Corp’s business, and would allow each sibling to devote their undivided attention to the line of business in which they were most interested, with the expectation that each business would benefit. Therefore, although the distribution was intended, in part, to further the personal estate planning of Parents and to promote family harmony, it was motivated in substantial part by a real and substantial non-tax purpose that was germane to the business of Corp. Thus, the business purpose requirement was satisfied.

Guideposts?

It is clear that the division of a family-owned corporation may be effectuated for the purpose of resolving or eliminating management disputes among siblings. It may also be undertaken for the purpose of staving off reasonably foreseeable or imminent harm to a business that is attributable to the composition of its shareholders.

Moreover, the division may be accomplished on a tax-efficient basis, provided the criteria set forth above are satisfied, including the requirement that the distribution by the family-owned corporation of the stock in its subsidiary be motivated in whole or in substantial part by a business purpose, as distinguished from a nonbusiness purpose. Specifically, can the parties to the transaction demonstrate that there is an immediate business reason for the distribution?

In each of the two scenarios described above, there were “clear and present” reasons for the divisive distribution; the failure to act would have resulted in significant harm to the business of either or both of the corporations. The difficulties anticipated were not remote, and the resulting harm to the business was not conjectural.

However, one can imagine a situation in which the immediacy of the stated business purpose may not be obvious to an outsider, or where the severity of the consequences to be avoided is not easily determinable. In the context of a family-owned corporation, the presence of these factors – a remote risk or an ill-defined harm – may call into question whether the distribution is motivated in substantial part by a bona fide business purpose; the failure to establish such a purpose may cause the corporation’s distribution of its subsidiary to be taxable.

For that reason, if a “divisive” transaction is to withstand IRS scrutiny, the closely held corporations and the shareholders that are parties to the transaction must be prepared to substantiate the corporate business purposes which they claim motivated the transaction in whole or substantial part. They must be ready to present documentation that provides complete factual support for the stated business purpose, that describes in detail the problems associated with the current corporate structure, and that demonstrates why the distribution will lessen or eliminate those problems. As always, this body of “evidence” should be compiled contemporaneously with the events that culminate in the division of the corporation – not after the IRS has selected the parties for audit.


[i] Or as partial gifts (as in the case of a bargain sale); rarely in exchange for capital contributions, or as compensation.

[ii] Regardless of the size of the social unit, be it a family, a business, or even a nation, the results can be severe. History gives us many examples. The Old Testament alone is full of references to the consequences of sibling rivalry: Cain and Abel, Isaac and Ismael, Esau and Jacob, then down to the sons of Solomon (ironic that the kingdom of the man who rendered the Judgment of Solomon – “suggesting” that a baby be split in half in order to ascertain its true mother – should be split in two after his death).

[iii] Forget about holidays and family gatherings – Thanksgiving is never the same.

[iv] Tax lawyers enjoy the figurative use of language because we are so rarely afforded the opportunity. Our exchanges (pun intended) with others are so often limited to words such as “gain, loss, deferral, recognition . . .” and, of course, “tax.”

[v] Too often, the parents don’t want to deal with the obviously gestating issues within their family. They tell themselves that the kids will learn to work together, or they will deny the problem altogether, leaving it for the kids to resolve it after the parents are gone. We know how that usually works out. Not the sort of legacy for which most folks yearn.

[vi] The subsidiary may be formed just prior to the distribution; for example, the parent corporation may contribute one line of business to a newly-formed subsidiary as a prelude to the distribution of the stock of the subsidiary, as described above; or it may be an existing entity that is engaged in a trade or business that is related to, or completely different from, the business conducted by the distributing corporation (or by its remaining subsidiary).

[vii] This is likely the form of division that parents would undertake in preparation for transferring different parts of their business to different children.

[viii] Often referred to as the “controlled corporation.”

[ix] I.e., a “trade or business” that has been “actively conducted” throughout the 5-year period ending on the date of the distribution. This requirement has spawned some litigation between taxpayers and the IRS.

[x] Underlying the divisive reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

[xi] IRC Sec. 355, IRC Sec. 368(a)(1)(D).

[xii] For example, in Example (2) of Reg. Sec. 1.355-2(b)(5), Corporation X is engaged in two businesses: the manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B expect that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The example concludes that the distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

[xiii] An exercise that should be completed before the transaction is even undertaken.

[xiv] Although the IRS’s public pronouncements are generally limited to the application of the law to a specific set of facts, they nevertheless provide a useful glimpse into the IRS’s thinking on the issues examined therein.

[xv] Rev. Rul. 75-337.

[xvi] In contrast, the IRS described a decision where the court held, under a plan to avoid any remote possibility of interference in a business by future sons-in-law, that the spin-off had no immediate business reason, involved a personal motive, and had as its primary purpose a desire to make bequests in accordance with an estate plan. The difficulties anticipated were so remote that they might never come to pass. The daughters might never marry – thus eliminating completely any cause to worry about business interference by future sons-in-law. There was, at best, “only an envisaged possibility of future debilitating nepotism,” and the effect on the business was conjectural. Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971).

[xvii] Rev. Rul. 2003-52.

“Add-Backs”

In the course of valuing a target business, a potential buyer will want to develop an accurate picture of the target’s earnings and cash flow. In doing so, the buyer will try to normalize those earnings by “adding back” various target expenses that the buyer is unlikely to incur in the ordinary course of operating the business after its acquisition. These may include certain one-time costs (for example, an “ordinary and necessary” litigation expense), but the most common add-backs involve payments made to or for the benefit of persons who are somehow related to the owners of the business. Among these related party payments, the compensation paid to family members is by far the most frequently recurring add-back.

“Why is that?” you may ask. Because family-owned and operated businesses are notorious for often paying unreasonable amounts of compensation to family members. These payments may exceed the fair market value of the services actually rendered by the family member – “reasonable compensation,” or the amount that would be paid for like services by like enterprises under like circumstances – or even may be made to a family member who does not actually work in the business. In the case of a family member who is employed by, and provides a valuable service to, the business – a service for which the buyer will have to pay after the acquisition – the add-back will be limited to the amount, if any, by which the payment exceeds reasonable compensation.

There are many reasons why family-owned businesses pay unreasonable compensation: to support a child or grandchild, to enable a family member to participate in retirement and health plans, to make “gifts” to them as part of the owner’s estate planning, and, of course, to zero-out the employer-payor’s taxable income.

Whatever the motivation, the payment violates one of the precepts often advanced by this blog: in a business setting, treat related parties on an arm’s-length basis as much as possible.

“Father Knows Best” (?)

A recent decision of the U.S. Tax Court described one taxpayer who ignored this precept at great cost.

Taxpayer was a C corporation engaged in a wholesale business. Its president and founder (“Dad”), along with his four sons (not My Three Sons; the “Boys”), were its only full-time employees and officers. Each of them performed various and overlapping tasks for the Taxpayer, including tasks that might have been performed by lower level employees. The Boys performed no supervisory functions.

Just before the tax years at issue (the “Period”), Dad owned 98% of Taxpayer’s stock; the other 2% was owned by an unrelated person. Dad then transferred all of his shares of nonvoting common stock to the Boys, after which Dad owned only shares of voting common stock.

Dad was familiar with the marginal income tax rates applicable to him and to his sons. Dad alone determined the compensation payable to the Boys; he did not consult his accountant or anyone else in determining compensation. The only apparent factors considered in determining annual compensation were reduction of Taxpayer’s reported taxable income, equal treatment of each son, and share ownership.

On its corporate income tax returns for the Period, Taxpayer deducted the compensation paid to the Boys.

During those same years, the Taxpayer paid only one insignificant dividend.

Interestingly, during one of the years at issue, Dad considered selling Taxpayer to an unrelated person. They entered into a nondisclosure agreement, and Dad provided the potential buyer with salary figures for the shareholders (his own and the Boys’), adjusted to a market rate that was significantly below what was actually being paid.

Disallowed Deductions

The IRS audited Taxpayer’s returns for the Period, and issued a notice of deficiency in which it disallowed Taxpayer’s deduction for much of the compensation paid to the Boys, claiming that it was unreasonable.

In general, a taxpayer must show that the determinations contained in a notice of deficiency are erroneous, and it specifically bears the burden of proof regarding deductions.

The Tax Court found that Taxpayer’s evidence with respect to the reasonableness of the compensation, as presented by its expert, was not credible.

In fact, the Court was quite critical of the Taxpayer’s “expert.” In most cases, it stated, there is no dispute about the qualifications of the experts. “The problem,” the Court continued, “is created by their willingness to use their résumés and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, which is contrary to their professional obligations.”

The Court concluded that Taxpayer’s expert disregarded objective and relevant facts and did not reach an independent judgment.

“Reasonable” Compensation

The Code allows as a deduction all the ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. A taxpayer is entitled to a deduction for compensation if the payments were reasonable in amount “under all the circumstances,” and were in fact payments purely for services.

Whether the compensation paid by a corporation to a shareholder-employee is reasonable depends on the particular facts and circumstances.

In making this factual determination, courts have considered various factors in assessing the reasonableness of compensation, including:

  • employee qualifications;
  • the nature, extent, and scope of the employee’s work;
  • the size and complexity of the business;
  • prevailing general economic conditions;
  • the employee’s compensation as a percentage of gross and net income;
  • the shareholder-employees’ compensation compared with distributions to shareholders;
  • the shareholder-employees’ compensation compared with that paid to non-shareholder-employees;
  • prevailing rates of compensation for comparable positions in comparable businesses; and
  • comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

No single factor is dispositive. However, special scrutiny is given in situations where a corporation is controlled by the employees to whom the compensation is paid, because there is usually a lack of arm’s-length bargaining.

The Court’s Analysis

The Court noted that while “the actual payment would ordinarily be a good expression of market value in a competitive economy, it does not decisively answer the question” of reasonableness “where the employee controls the company and can benefit by re-labeling as compensation what would otherwise accrue to him as dividends.”

According to the Court, Taxpayer acknowledged as much in the materials prepared in connection with the possible sale, in which the shareholder salaries were recast to a much lower “market rate.”

As in many family enterprises, the Boys were involved early on in the business and did whatever was needed to keep the business going. Compensation in closely-held businesses is subject to close scrutiny because of the family relationships, and it is determined by objective criteria and by comparisons with compensation in other businesses where compensation is determined by negotiation and arm’s-length dealing.

In their testimony, the Boys denied knowledge of principles basic to the performance of their respective functions on behalf of Taxpayer. Moreover, none of them had any special experience or educational background. Each of them testified that they had overlapping duties, but those duties included menial tasks as well as managerial ones because there were no other employees.

Dad testified that he intended to treat the Boys equally, that he alone determined their compensation, and that he was aware of their marginal tax rates, obviously intending to minimize Taxpayer’s, and the family’s overall, tax liability.

The amounts and equivalency of the Boys’ compensation – allegedly to avoid competition among them – the proportionality to their stock interests, the manner in which Dad alone dictated the amounts, the reduction of reported taxable income to minimal amounts, and the admissions in the sale materials relating to their compensation “all justified skepticism,” the Court stated, toward Taxpayer’s “assertions that the amounts claimed on the returns were reasonable.”

The Court was especially critical of Taxpayer’s compensation expert. The expert did not consider any of the foregoing factors. He disregarded sources and criteria that he used in other cases, and that would have resulted in lower indicated reasonable compensation amounts. He used only one source of data although, in his writings and lectures, he had urged others to use various sources. Although he testified that he was an expert in “normalizing owner compensation,” which is “adjusting the numbers to what they think a buyer might experience,” he did not attempt to do so in this case. In attempting to justify the compensation paid to the Boys in the absence of material reported earnings, he assumed that Taxpayer increased in value from year to year.

The expert placed Taxpayer’s officers in the 90th percentile of persons in allegedly comparable positions, which their own testimony showed that they were not. He determined aggregate compensation of the top five senior executives in companies included in his single database while acknowledging that the titles assigned and duties performed by Taxpayer’s officers were not typical of persons holding senior executive offices. He understood that the compensation was set solely by Dad and was not the result of negotiation or arm’s-length dealing, but he ignored that factor. He relied completely on the representations of Dad and the Boys and did not consult any third parties.

Although his report discussed officer retention as a reason for high compensation, he did not consider the likelihood – as confirmed by the Boys’ testimony – that any of them would ever leave Taxpayer’s employ, even if he were paid less.

The approach throughout the appraiser’s report indicated that it was result-oriented – to validate and confirm that the amounts reported on Taxpayer’s returns were reasonable – rather than an independent and objective analysis. The Court found that, overall, neither the expert’s analysis nor his opinion was reliable.

Because Taxpayer’s expert’s opinion disregarded the objective evidence and made unreasonable assumptions, the Court held that Taxpayer failed to satisfy its burden of proving the reasonableness of the amounts paid to the Boys in excess of those allowed in the notice of deficiency.

Apologies to Dad? Nope

Yesterday was Father’s Day, yet here I am, one day later, writing about a Dad who tried to do right by his Boys, but was punished with an increased tax bill. Unfortunately, he deserved it. The compensation paid to the Boys appeared solely related to their shareholdings, to Dad’s desire to transfer his wealth to them equally, and to his desire to reduce the Taxpayer’s corporate income tax liability.

This is what happens when you violate the precept recited above: in a business setting, treat related parties on as close to an arm’s-length basis as possible; stated differently, “you mess with the bull, you get the horns.”

This simple rule accomplishes a number of goals. It supports the separateness of the corporate entity and the protection it affords from personal liability. It rewards those who actually render services, and may incentivize others to follow suit. It may cause those who are not productive to leave the business. It may reduce the potential for intra-family squabbling based on accusations of favoritism. And let’s not forget that it helps to avoid surprises from the IRS.

Where estate and gift planning is a consideration, there are other means of shifting value to one’s beneficiaries. Combined with the appropriate shareholders’ agreement, these transfers may be effectuated without adversely affecting the business.

“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.

Tomorrow’s Post

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.