When the Tax Cuts and Jobs Act[1] was introduced on November 2, 2017, perhaps the single most important issue on the minds of many closely held business owners was the future of the estate tax: was it going to be repealed as had been promised? A closely related question – and perhaps of equal significance to these owners’ tax advisers – was whether an owner’s assets would receive a so-called “stepped-up” basis in the hands of those persons to whom the assets passed upon the owner’s death?

When the smoke cleared (only seven weeks later), the estate tax remained in place, but its reach was seriously limited, at least temporarily. Moreover, the stepped-up basis rule continued to benefit the beneficiaries of a decedent’s estate.

To better understand the change wrought by the Act – and to appreciate what it left intact – we begin with an overview of the federal transfer taxes.

The Estate and Gift Tax

The Code imposes a gift tax on certain lifetime transfers, an estate tax on certain transfers at death, and a generation-skipping transfer (“GST”) tax when such transfers are made to a “skip person.”

Estate Tax

The Code imposes a tax on the transfer of the taxable estate of a decedent who is a citizen or resident of the U.S. The taxable estate is determined by deducting from the value of the decedent’s gross estate any deductions provided for in the Code. After applying tax rates to determine a tentative amount of estate tax, certain credits are subtracted to determine estate tax liability.

Estate Tax

A decedent’s gross estate includes, to the extent provided for in other sections of the Code, the date-of-death value of all of a decedent’s property, real or personal, tangible or intangible, wherever situated. In the case of a business owner, the principal asset of his gross estate may be his interest in a closely held business. In general, the value of the property for this purpose is the fair market value of the property as of the date of the decedent’s death.

A decedent’s taxable estate is determined by subtracting from the value of his gross estate any deductions provided for in the Code. Among these deductions is one for certain transfers to a surviving spouse, the effect of which is to remove the assets transferred to the surviving spouse from the decedent’s estate tax base.

After accounting for any allowable deductions, a gross amount of estate tax is computed, using a top marginal tax rate of 40%.

In order to ensure that a decedent only gets one run up through the rate brackets for all lifetime gifts and transfers at death, his taxable estate is combined with the value of the “adjusted taxable gifts” made by the decedent during his life, before applying tax rates to determine a tentative total amount of tax. The portion of the tentative tax attributable to lifetime gifts is then subtracted from the total tentative tax to determine the gross estate tax.

The estate tax liability is then determined by subtracting any allowable credits from the gross estate tax. The most significant credit allowed for estate tax purposes is the unified credit.

The unified credit is available with respect to a taxpayer’s taxable transfers by gift and at death. The credit offsets the tax up to a specified cumulative amount of lifetime and testamentary transfers (the “exemption amount”). For 2017, the inflation-indexed exemption amount was set at $5.49 million; prior to the Act, it was set to increase to $5.6 million in 2018.

Any portion of an individual taxpayer’s exemption amount that is used during his lifetime to offset taxable gifts reduces the exemption amount that remains available at his death to offset the taxable value of his estate. In other words, the unified credit available at death is reduced by the amount of unified credit used to offset gift tax incurred on gifts made during the decedent’s life.

In the case of a married decedent, an election is available under which any exemption amount that was not used by the decedent may be used by the decedent’s surviving spouse (the so-called “portability election”) during her life or at her death.

The estate tax generally is due within nine months of a decedent’s death. However, in recognition of the illiquid nature of most closely held businesses, the Code generally allows the executor of a deceased business owner’s estate to elect to pay the estate tax attributable to an interest in a closely held business in up to ten installments. An estate is eligible for payment of the estate tax in installments if the value of the decedent’s interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate (i.e., the gross estate less certain deductions).

If the election is made, the estate may defer payment of principal and pay only interest for the first five years[2], followed by up to 10 annual installments of principal and interest. This provision effectively extends the time for paying estate tax by 14 years from the original due date of the estate tax.

Gift Tax

The Code imposes a tax for each calendar year on the transfer of property by gift during such year by any individual. The amount of taxable gifts for a calendar year is determined by subtracting from the total amount of gifts made during the year: (1) the gift tax annual exclusion; and (2) allowable deductions.

The gift tax for a taxable year is determined by: (1) computing a tentative tax on the combined amount of all taxable gifts for such year and all prior calendar years using the common gift tax and estate tax rate (up to 40 percent); (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of unified credit not consumed by prior-year gifts.

The amount of a taxpayer’s taxable gifts for the year is determined by subtracting from the total amount of the taxpayer’s gifts for the year the gift tax annual exclusion amount and any available deductions.

Donors of lifetime gifts are provided an annual exclusion of $15,000 per donee in 2018 (indexed for inflation from the 1997 annual exclusion amount of $10,000) for gifts of “present interests” in property. Married couples can gift up to $30,000 per donee per year without consuming any of their unified credit.


The GST tax is a separate tax that can apply in addition to either the gift tax or the estate tax. The tax rate and exemption amount for GST tax purposes are set by reference to the estate tax rules. The GST tax is imposed using the highest estate tax rate (40%). Tax is imposed on cumulative generation-skipping transfers in excess of the generation-skipping transfer tax exemption amount in effect for the year of the transfer. The generation-skipping transfer tax exemption for a given year is equal to the estate tax exemption amount in effect for that year ($5.49 million in 2017).

Basis in property received at death

A bequest, or other transfer at death, of appreciated (or loss) property is not an income tax realization event for the transferor-decedent or his estate, but the Code nevertheless provides special rules for determining a recipient’s income tax basis in assets received from a decedent.

Property acquired from a decedent or his estate generally takes a stepped-up basis in the hands of the recipient. “Stepped-up basis” means that the basis of property acquired from a decedent’s estate generally is the fair market value on the date of the decedent’s death. Providing a fair market value basis eliminates the recognition of income on any appreciation in value of the property that occurred prior to the decedent’s death (by stepping-up its basis).[3]

In the case of a closely held business, depending upon the nature of the business entity (for example, a partnership or a corporation) and of its assets, the income tax savings resulting from the basis step-up may be realized as reduced gain on the sale of the decedent’s interest in the business, or as a reduced income tax liability from the operation of the business (for example, in the form of increased depreciation or amortization deductions).

The Act

To the disappointment of many, the Act did not repeal the federal estate tax.

However, the Act greatly increased the federal estate tax, gift tax, and GST tax exemption amount – for decedents dying, and for gifts made, after December 31, 2017 and before January 1, 2026 – and it preserved portability.

The “basic exemption amount” was increased from $5 million (as of 2010) to $10 million; as indicated above, this amount is indexed for inflation occurring after 2011, and was set at $5.6 million for 2018 prior to the Act.

As a result of the Act, this exemption amount was doubled to $11.2 million per person beginning in 2018 – basically, $22.4 million per married couple – and will be adjusted annually for inflation through 2025.

To put this into perspective, over 109,000 estate tax returns were filed in 2001, of which approximately 50,000 were taxable. Compare this with 2016, when approximately 11,000 returns were filed, of which approximately 5,000 were taxable. The decline appears to be due primarily to the increase in the filing threshold (based on the exemption amount) from $675,000 in 2001 to $5.45 million in 2016.[4] An increase from $5.49 million in 2017 to $11.2 million in 2018 should have a similar effect.

In addition, and notwithstanding the increased exemption amount, the Act retained the stepped-up basis rule for determining the income tax basis of assets acquired from a decedent. As a result, property acquired from a decedent’s estate generally will continue to take a stepped-up basis.


As stated immediately above, the owners of many closely held businesses will not be subject to the federal estate tax – at least not through 2025[5] – thanks to the greatly increased exemption amount and to continued portability.

Thus, a deceased owner’s taxable (not gross) estate in 2018 – even if we only account for conservative valuations of his business interests and for reasonable estate administration expenses – may be as great as $22.4 million (assuming portability) without incurring any federal estate tax.

Moreover, this amount ignores the benefits of fairly conservative gift planning including, for example, the long-term impact of regular annual exclusion gifting (and gift-splitting between spouses), the effect of transfers made for partial consideration (as in a QPRT), or for full and adequate consideration (as in zeroed-out GRATs and installment sales), as well as the benefit of properly-structured life insurance that is not includible in the decedent’s estate.

With these tools, otherwise taxable estates[6], that potentially may be much larger than the new exemption amount, may be brought within its coverage.

The increased exemption amount will also allow many owners to secure a basis step-up for their assets upon their death without incurring additional estate tax, by allowing these owners to retain assets.

Of course, some states, like New York, will continue to impose an estate tax on estates that will not be subject to the federal estate tax.[7] In those cases, the higher federal exemption amount, coupled with the absence of a New York gift tax, provides an opportunity for many taxpayers to reduce their New York taxable estate without any federal estate or gift tax consequences, other than the loss of a basis step-up. The latter may be significant enough, however, that the taxpayer may decide to bear the 16% New York estate tax on his taxable estate rather than lose the income tax savings.[8]


In light of the foregoing, taxpayers should, at the very least, review their existing estate plan and the documents that will implement it – “for man also knoweth not his time.”[9]

For example, wills or revocable trusts that provide for a mandatory credit shelter or bypass trust may have to be revised, depending upon the expected size of the estate, lest the increased exemption amount defeat one’s testamentary plan.

A more flexible instrument may be warranted – perhaps one that relies upon a disclaimer by a surviving spouse – especially given the December 31, 2025 expiration date for the increased exemption amount, and the “scheduled” reversion in 2026 to the pre-2018 exemption level (albeit adjusted for inflation).

The buy-out provisions of shareholder, partnership and operating agreements should also be reviewed in light of what may be a reduced need for liquidity following the death of an owner. For example, should such a buy-out be mandatory?[10]

Some taxpayers, with larger estates, may want to take advantage of the increased exemption amount before it expires in 2026 so as to remove assets, and the income and appreciation thereon, from their estates.[11] This applies for both estate and GST tax purposes; a trust for the benefit of skip persons may be funded now using the temporarily increased GST exemption amount.

Of course, gifting comes at a cost: the loss of stepped-up basis upon the death of the taxpayer.

Conversely, some taxpayers may want to consider bringing certain appreciated assets (for example, assets that they may have previously gifted to a family member) back into their estates in order to attain the benefit of a basis step-up.

Those taxpayers who decide to take advantage of the increased exemption amount by making lifetime gifts should consider how they may best leverage it.

Some New York taxpayers – who may otherwise have to reduce their gross estates in order to reduce their NY estate tax burden – may want to consider changing their domicile so as to avoid the New York estate tax entirely while holding on to their assets (that would be sheltered by the increased exemption amount) and thereby securing the step-up in basis upon their passing.

There may also be other planning options to consider, some of which have been considered in earlier posts to this blog. For example, ESBTs may now include nonresident aliens as potential current beneficiaries without causing the S corporation to lose its “S” election.

As always, tax savings, estate planning, and gifting strategies have to be considered in light of what the taxpayer is comfortable giving up. In the case of a closely held business owner, any loss of control may be untenable, as may the reduction of cash flow that is attributable to his ownership interest.

Moreover, there are non-tax reasons for structuring the disposition of one’s estate that may far outweigh any tax savings that may result from a different disposition. Tails, dogs, wagging – you know the idiom.

*  At least until 2026 – keep reading.  With apologies to St. Paul. 1 Corinthians, 15:55.

[1] Pub. L. 115-97 (the “Act”); signed into law on December 22, 2017.

[2] The interest rate applicable to the amount of estate tax attributable to the taxable value of the closely held business in excess of $1 million (adjusted for inflation) is equal to 45 percent of the rate applicable to underpayments of tax (i.e., 45 percent of the Federal short-term rate plus three percentage points). This interest is not deductible for estate or income tax purposes.

[3] It also eliminates the tax benefit from any unrealized loss (by stepping-down its basis to fair market value).

[4] http://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax

[5] This provision expires after 2025. Assuming the provision survives beyond 2020 (the next presidential election), query whether the exemption amount will be scaled back. Has the proverbial cat been let out of the proverbial bag?

[6] Including individuals who had already exhausted their pre-2018 exemption amount.

[7] The NY estate tax exemption amount for 2018 is $5.25 million.

[8] In the case of a NYC decedent, for example, the tax savings to be considered would include the federal capital gains tax of 20%, the federal surtax on net investment income of 3.8%, the NY State income tax of 8.82%, and the NYC income tax of 3.876%. Of course, the likelihood of an asset’s being sold after death also has to be considered.

[9] Ecclesiastes, 9:12. As morbid as it may sound, planning for an elderly or ill taxpayer is different from planning for a younger or healthier individual – it is especially so now given the 2026 expiration of the increased exemption amount.

[10] Of course, there may be overriding business reasons for such a buy-out.

[11] If the exemption amount were to return to its pre-2018 levels in 2026, query how the IRS will account for any pre-2026 gifts that were covered by the increased exemption amount. The Act directs the IRS to issue regulations addressing this point.

Last week, we reviewed the various U.S. federal income tax consequences that may be visited upon a foreign person who owns and operates U.S. real property (“USRP”). Today we will consider the U.S. federal gift and estate tax consequences of which a foreign individual must be aware when investing in USRP.

Gift Tax

As you probably know, the gift tax is imposed upon the transfer of property by an individual, to or for the benefit of another individual, for less than full and adequate consideration. The typical scenario involves an outright transfer to a family member, or a transfer to an irrevocable trust for the benefit of a family member.

For a U.S. person – meaning a citizen or an alien individual who is domiciled in the U.S. – who makes a gift, the Code currently affords an annual exclusion of $14,000 per donee, plus a combined lifetime/testamentary exemption of $5.49 million, plus an unlimited marital deduction provided the donor’s spouse is a U.S. citizen.  (Note that “domicile” for gift and estate tax purposes is not necessarily the same as “residency” for U.S. income tax purposes; domicile is a more subjective concept: what jurisdiction does the foreign individual consider to be his “permanent home”?)

In the case of a non-U.S. person who is also a non-domiciliary, the Code provides the same $14,000 annual exclusion as above, as well as an annual $149,000 exclusion for gifts to a non-U.S. citizen spouse (not an unlimited marital deduction). There is no other exclusion. The marginal gift tax rate is 40% for taxable gifts over $1 million.

U.S.-Situs Property

In order for the U.S. gift tax to apply to a transfer of property by a non-domiciliary, the property transferred must be located in the U.S. Thus, a gift transfer of USRP is taxable.

Importantly, however, a transfer of intangible property, including shares of stock in a USC, including a U.S. real property holding corporation (USRPHC), is not subject to the gift tax.

As a result, a gift transfer by a foreign individual (“FI”) of shares of USRPHC stock (or of cash to fund a corporation’s acquisition of USRP) to an irrevocable foreign trust for the benefit of the FI’s family is not subject to U.S. gift tax. It is imperative that the foreign donor respect the separate identity of the corporation the stock of which stock is being gifted: the corporation should have its own accounts, act in its own name, hold board meetings, etc. – it may even be advisable that the FI not use the corporation’s USRP without paying a fair market rental rate for such use; otherwise, the IRS may be able to ignore the corporate form and treat the transfer of the stock as a transfer of the underlying USRP.

Similarly, though it is not entirely free from doubt, a transfer of an interest in a partnership that owns USRP should not be subject to gift tax, provided the partnership is not engaged in a U.S. trade or business (USTB).

Estate Tax

We all have to go sometime. It’s the morbid truth. Even wealthy foreigners.

The U.S. estate tax is imposed on the FMV of the U.S. assets of a foreign decedent. This includes the foreigner’s direct interest in USRP.

It also includes the FMV of USRP in a foreign trust if the FI gifted the USRP into the trust and retained an interest in the income from, or in the use of, the trust’s property.

Where the USRP is subject to a nonrecourse debt, the amount of such debt may be applied to reduce the FMV of the property for estate tax purposes. In order to claim a reduction for any recourse debt encumbering the property, the estate of the FI must disclose his/her worldwide assets and claim only a proportionate part of the debt as a deduction, the assumption being that the FI’s worldwide assets are available to satisfy the recourse debt.

The FI’s U.S. gross estate also includes his shares of stock in a U.S. corporation (“USC”), including a USRPHC.

The state of the tax law as to the situs of a partnership interest is not entirely clear, though there is authority for the proposition that U.S. property includes an interest in a partnership that is engaged in a USTB.

The gross estate does not include shares of stock in a foreign corporation (“FC”), however, even if its only asset is USRP, and even if the FC has elected to be treated as a USC for purposes of FIRPTA (see above). Again, it is imperative that the FI have respected the corporate form: it should have its own accounts, act in its own name, etc. (see last week’s post); otherwise, the IRS may be able to ignore the corporate form, treat the FC as a sham, and include the value of the underlying USRP in the FI’s estate.

The FI’s estate does not include an interest in USRP that is held in a foreign trust, provided the FI did not retain (expressly or implicitly) any beneficial interest in, or control over, the trust.

Unlike the estate of a U.S. citizen or domiciliary, the estate of a FI will not have the benefit of the $5.49 million exemption. Rather, there is only a $60,000 exemption amount (though some treaties may provide for a greater amount provided the FI’s estate discloses its worldwide assets). The 40% rate kicks in when the U.S. taxable estate exceeds $1 million in value.

Additionally, there is no unlimited marital deduction unless the FI’s surviving spouse is a U.S. citizen. If the spouse is not a U.S. citizen, a qualified domestic trust (“QDOT”), with a U.S. trustee, will allow an unlimited marital deduction, and the resulting tax deferral benefit, though it is less than ideal for planning purposes. For example, every time principal is distributed to the surviving spouse, the U.S. trustee must report the distribution, and must withhold and transmit the applicable estate tax.

Finally, let’s not forget that any property that is included in the U.S. estate of a FI receives a basis step-up, thereby removing the depreciation in basis during the life of the decedent, and the appreciation in value of the property, from the reach of the U.S. income tax.


Last week’s post explained that the role of the U.S. tax adviser is to educate the foreign client as to basic U.S. tax considerations before the foreigner acquires USRP; to confer with the foreigner’s non-U.S. tax advisers as to the treatment of the investment under foreign tax law; and to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals. The many relevant, and oftentimes competing, factors that we have discussed over the last couple of weeks must be identified and weighed, the various options must be formulated and presented to the foreign client, the client must understand the advantages and disadvantages of the options available, and then the best option under the circumstances must be selected.

“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.

The Goals

The owners of interests in closely-held businesses have long sought out ways by which they can remove the future appreciation of such interests from their gross estates for estate tax purposes, but without incurring gifts taxes and income taxes.

One popular method to achieve these goals has been the sale of the closely-held interest to a grantor trust. A grantor trust is an irrevocable trust of which the seller is treated as the owner for income tax purposes. Thus, for income tax purposes, a grantor trust is taxed as if the deemed owner owned the trust assets directly, and the deemed owner and the trust are treated as the same person. This results in transactions between the trust and the deemed owner being ignored for income tax purposes; specifically, no capital gain is recognized when an appreciated interest in a closely held business is sold by the deemed owner to the trust.

For transfer tax purposes, however, the trust and the deemed owner are treated as separate persons and, under certain circumstances, the trust is not included in the deemed owner’s gross estate for estate tax purposes at the death of the deemed owner. In this way, the post-sale appreciation has been removed from the deemed owner’s estate for estate tax purposes. The greater the post-sale appreciation, the greater the transfer tax benefit achieved.

The IRS Doesn’t Like It

Sales to grantor trusts use the disconnect between the income tax and transfer tax rules – specifically, the ability to sell a property for gift tax purposes, but to still own it for income tax purposes – in order to transfer wealth while minimizing the gift and income tax cost of such transfers. If this wasn’t bad enough for the IRS, future capital gains taxes can also be avoided by the grantor’s “repurchase,” at fair market value, of the appreciated asset from the grantor trust and the subsequent inclusion of that asset in the grantor’s gross estate at death. Under current law, the basis in that asset is then adjusted (“stepped-up”) to its fair market value at the time of the grantor’s death, often at an estate tax cost that has been significantly reduced or entirely eliminated by the grantor’s lifetime exclusion from estate tax.

Consequently, the IRS will often challenge a taxpayer’s sale to a grantor trust. The results have been mixed, depending upon how carefully the subject transaction was structured, as illustrated by one case earlier this month.

A Recent Example

The Decedent was employed by and held the majority of the voting and nonvoting shares of Company, a closely-held manufacturing business.

In 1999, the Trust was executed by Decedent and his Spouse as donors, and their two sons as trustees. The Trust purchased three life insurance policies on the joint lives of Decedent and Spouse.

The Trust and Company entered into a Split-Dollar Insurance Agreement that covered the three life insurance policies owned by the Trust. Pursuant to this agreement, Company was obligated to pay a portion of the annual premiums equal to the total premiums less the annual Value of the Economic Benefit (VEB) amounts. Decedent was required to pay the annual VEB amounts. Upon the death of the survivor of Decedent and Spouse, the Trust was required to reimburse Company for its prior premium payments.

In 2006, Decedent sold all of his nonvoting stock of Company to the Trust in exchange for a promissory note in the amount of $59 million, and bearing interest based upon the applicable federal rate. The purchase price was determined by an appraisal of the stock’s fair market value by an independent appraiser.

The sale of the nonvoting stock was made pursuant to an Installment Sale Agreement, which provided that the Decedent sold stock to the Trust worth $59 million. The agreement further provided that both the number of shares of stock sold and the purchase price of $59 million were determined one month before the sale, but that Decedent and the Trust acknowledge that the exact number of shares of stock purchased by the Trust depended on the fair market value of each share of stock. The sale agreement further provided that, based on a recent appraisal of the stock, this resulted in one million shares of stock being purchased, but that in the event that the value of a share of stock was determined to be higher or lower than that set forth in the appraisal, whether by the IRS or a court, then the purchase price would remain the same but the number of shares of stock purchased would automatically adjust so that the fair market value of the stock purchased equaled $59 million.

At the time of the 2006 stock sale, and subsequently, the Trust had significant financial capability to repay the promissory note without using the acquired nonvoting stock of Company or its proceeds.

At the time of the sale, the Trust owned three life insurance policies on Decedent’s and Spouse’s lives with an aggregate cash surrender value of over $12 million. Decedent’s estate claimed that all of this cash value could be pledged to a financial institution as collateral for a loan that could be used to make payments on the promissory note to Decedent. A portion of the cash value could also be accessed via policy loan or via the surrender of paid-up additions to the insurance policies that could be used to make payments on the note. Moreover, since Company was required to continue making payments during Decedent’s and Spouse’s lifetimes under the Split-Dollar Insurance Agreement, the amount of cash surrender value available for this purpose would continue to grow.

In addition, the beneficiaries of the Trust executed personal guarantees in the amount of ten percent of the purchase price of the stock.

Decedent passed away in 2009, and his estate tax return was filed in 2010. After examining the return, the IRS timely issued a Notice of Deficiency in 2013. Decedent’s estate filed a petition with the Tax Court .

The IRS’s Challenge

The Notice of Deficiency asserted a deficiency in gift taxes for 2006 (the year of the stock sale) in excess of $31 million. Specifically, the IRS determined that the promissory note that Decedent received in the exchange should be disregarded, and the entire fair market value of the nonvoting shares of Company stock that Decedent sold to the Trust in 2006 – which the IRS determined was over $116 million (almost double the value of the taxpayer’s appraisal) – should be treated as a taxable gift. (You should always count on the IRS to challenge the reported fair market value of a closely-held company.)

In the alternative, the IRS determined that the Decedent made a taxable gift equal to the difference between the fair market value of the Company shares sold to the Trust in 2006 and the principal of the promissory note received in exchange.

The IRS also determined that the entire value of the stock acquired by the Trust in 2006 should have been included in Decedent’s gross estate for purposes of the estate tax (again ignoring the promissory note), claiming that Decedent had retained, for his life, the possession or enjoyment of, or the right to the income from, the Company stock Decedent sold to the Trust in 2006. (By the date of Decedent’s death, the value of the stock had increased another $46 million, according to the IRS.)

Finally, the IRS asserted that the 2006 stock sale was not a bona fide sale for adequate and full consideration, and that the promissory was not the personal and enforceable obligation of Decedent.

Oh, Shucks

After being scheduled for trial, the Decedent’s estate and the IRS reached a settlement, and the Tax Court signed a stipulated decision in which both parties agreed that there were no gift tax or estate tax deficiencies.

“Why, Lou, are you disappointed?” you may ask. “Didn’t the taxpayer emerge victorious?”

True, but think about it. The Decedent’s sale to the Trust was not especially remarkable, at least on its face. The Trust was funded with sufficient assets to support the note, and the beneficiaries personally guaranteed the note. A contemporaneous value for the shares was obtained from an independent appraiser. The note bore adequate interest, at the applicable federal rate. The transaction was properly documented. Why would the IRS have challenged such a transaction?

That being said, there were some elements of the transaction, the Court’s resolution of which could have had implications for future planning. For example, the use of insurance on the life of the Decedent to support the Trust’s note. Also, did Decedent and the Trust use separate counsel? What about the beneficiaries who guaranteed the debt? Did they have independent wealth to support their guarantees?

What’s Next?

As we said last week, so much will depend upon the outcome of the November elections.  A Democratic victory could see the introduction of proposals to eliminate the disconnect between the income tax and transfer tax rules.

Under one such proposal (that has appeared in the current Administration’s budgets for several years and that would likely be reintroduced under the right circumstances), if a person who is the deemed owner of a trust under the grantor trust rule engages in a transaction with that trust that constitutes a sale or exchange that is disregarded for income tax purposes by reason of the person’s treatment as the deemed owner of the trust, then the portion of the trust attributable to the property received by the trust in that transaction (i) would be subject to estate tax as part of the gross estate of the deemed owner, (ii) would be subject to gift tax at any time during the deemed owner’s life when his or her treatment as a deemed owner of the trust is terminated, and (iii) would be treated as a gift by the deemed owner to the extent any distribution is made to another person during the life of the deemed owner.

Until then, however, taxpayers and their advisers should monitor the IRS’s efforts in the courts to restrict sales to grantor trusts, and they should be careful in how they structure such transactions.

Don’t miss Part I, here!


Taxable Gift Transfers

In general, where property is transferred for less than an adequate and full consideration in money or money’s worth, the amount by which the value of the property exceeded the value of the consideration is deemed a gift. A necessary corollary of this provision is that a transfer of property in exchange for an adequate and full consideration does not constitute a gift for gift tax purposes. gifttax

The Treasury Regulations confirm that:

“[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions.”  The application of the gift tax depends “on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.”  Thus, donative intent on the part of the transferor is generally not an essential element in such application.

The regulations define a “transfer of property made in the ordinary course of business” as (i) a transaction which is bona fide, (ii) at arm’s length, and (iii) free from any donative intent. A transaction meeting this standard “will be considered as made for an adequate and full consideration in money or money’s worth.” That is so even if one party to the transaction later concludes that the consideration he received was inadequate. In other words, even in the case of a bad bargain, no one would think for a moment that any gift is involved.

Of course, a transfer of property within a family group will almost always receive close scrutiny. However, a transfer of property between family members may nonetheless be treated as one “in the ordinary course of business” if it meets the criteria set forth above.

On numerous occasions, the courts have held that an arm’s-length transfer of property, in settlement of a genuine dispute between family members, was made for “a full and adequate consideration” because it was a transaction in the “ordinary course of business.” For example, a taxpayer’s settlement of litigation with a family member may be regarded as economically advantageous where the taxpayer was not certain of the outcome of the litigation and, by accepting the settlement, the taxpayer also avoided additional legal expense. In that case, the taxpayer may be said to have acted as one would act in the settlement of differences with a stranger, and a payment of settlement of the litigation may be described as “an adequate and full consideration in money or money’s worth.”

A transfer of property will be regarded as occurring “in the ordinary course of business” and thus will be considered to have been made “for an adequate and full consideration in money or money’s worth” if it satisfies the three elements in the regulations described above. To meet this standard, the transfer must have been (1) bona fide, (2) transacted at arm’s length, and (3) free of donative intent.

In applying this regulation to settlements of family disputes, the courts have identified certain subsidiary factors that may also be relevant. They have considered, for example:

  • whether a genuine controversy existed between the parties;
  • whether the parties were represented by and acted upon the advice of counsel;
  • whether the parties engaged in adversarial negotiations;
  • whether the value of the property involved was substantial;
  • whether the settlement was motivated by the parties’ desire to avoid the uncertainty and expense of litigation; and
  • whether the settlement was finalized under judicial supervision and incorporated in a judicial decree.

1.  Bona Fide

The requirement that the transfer be “bona fide” considers whether the parties were settling a genuine dispute as opposed to engaging in a collusive attempt to make the transaction appear to be something it was not. Here, there was no indication that the dispute between Father and Number Two was a sham designed to disguise a gratuitous transfer to Number Two’s children.  (A word of warning to advisors who would fabricate a dispute: don’t.)

Number Two was not working in concert with Father or Number One in any sense of the word. To the contrary, he was genuinely estranged from them, and this estrangement worsened as time went on. On both the business and family fronts, they each had (or believed they had) legitimate grievances against one other.

According to the Court, Number Two’s agreement to release his claim to 33 1/3 shares of Holding Co stock represented a bona fide settlement of this dispute. Although he had a reasonable claim to all 100 shares registered in his name, Father had possession of these shares and refused to disgorge them, forcing Number Two to commence litigation. The Court went on to note that the “oral trust” theory on which Father relied was evidently a theory in which he passionately believed. Additionally, it had some link to historical fact: at Holding Co’s inception, Number Two was listed as a registered owner of 33.33% of Holding Co’s shares even though he had contributed a disproportionately smaller portion of its assets.

2. Arm’s Length

The requirement that the transfer be “arm’s length,” the Court said, is satisfied if the taxpayer acts “as one would act in the settlement of differences with a stranger.” Number Two was genuinely estranged from Father and Number One. The evidence established that they settled their differences as such.

Number Two hired a lawyer and commenced lawsuits against Father, Number One and Holding Co. The lawyers for all parties negotiated for many months as true adversaries in search of a compromise. They eventually reached a settlement that Number Two accepted on his lawyer’s advice; both evidently regarded this compromise “as ‘advantageous economically.’” “The presence of counsel at the conference table for the purpose of advising and representing the respective parties as to their rights and obligations, together with other relevant facts and circumstances, dispelled any theory that a payment made in connection with such settlement was intended for or could have been a gift,” the Court stated.

All the elements of arm’s-length bargaining existed here. There was a real controversy among the parties; each was represented by and acted upon the advice of counsel; they engaged in adversarial negotiations for a protracted period; the compromise they reached was motivated by their desire to avoid the uncertainty and embarrassment of public litigation; and their settlement was incorporated in a judicial decree that terminated the lawsuits. Because Number Two acted “as one would act in the settlement of differences with a stranger,” his transfer of shares in trust for his children was an arm’s-length transaction.

3.  Absence of Donative Intent

Although donative intent is not prerequisite to a “gift,” the absence of donative intent is essential for a transfer to be treated as made “in the ordinary course of business.” Generally, donative intent will be found lacking when a transfer is “not actuated by love and affection or other motives which normally prompt the making of a gift.”

Number Two transferred 33 1/3 Holding Co shares in trust for his children. A transfer of stock to one’s children, however, is not necessarily imbued with donative intent.

Number Two’s objective throughout the dispute was to obtain for himself ownership of (or full payment for) the 100 Holding Co shares originally registered in his name. He filed lawsuits because he refused to embrace the “oral trust” theory and wished to obtain possession, in his own name, of all 100 shares.

Both economic and family reasons may have motivated Number Two to insist on securing outright ownership of (or payment for) all 100 shares. Having abruptly quit the family business, he was likely concerned about his own financial security, and he may have been reluctant to transfer wealth to his children, one of whom he had recently placed in a mental hospital.

The evidence clearly established that Number Two transferred stock to his children, not because he wished to do it, but because Father demanded that he do it. The transfer of stock in trust for his children was prompted by Father’s desire to keep the family business within the family. Number Two was forced to accept this transfer in order to placate Father, settle the family dispute, and obtain a $5 million payment for the remaining 66 2/3 shares.

Thus, the Court concluded that Number Two acquiesced in the notion of an “oral trust” because he had no other alternative. There was no evidence that he was motivated by love and affection or other feelings that normally prompt the making of a gift. Because his transfer of stock to his children represented the settlement of a bona fide dispute, was made at arm’s length, and was “free from any donative intent,” it met the three criteria for a transaction “in the ordinary course of business.”

The Tax Court Disagrees with the IRS

The Court next turned to the IRS’s argument that, because Number Two’s children were not parties to the litigation or settlement of the dispute, they did not provide (and could not have provided) any consideration to Number Two for the transfer of the shares. Because no consideration flowed from the transferees, the IRS contended that Number Two ‘s transfer was necessarily a gift.

According to the Court, the IRS’s argument derived no support from the text of the governing regulations, which provide that “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth.” They further provide that a “transfer of property made in the ordinary course of business * * * will be considered as made for an adequate and full consideration in money or money’s worth.”

The IRS’s argument, the Court noted, focused on whether the transferees provided consideration. However, the regulation asks whether the transferor received consideration, that is, whether he made the transfer “for a full and adequate consideration” in money or money’s worth. The regulation makes no reference to the source of that consideration.

The Court determined that Number Two received “a full and adequate consideration” for his transfer—namely, the recognition by Father and Number One that he was the outright owner of 66 2/3 Holding Co shares and Holding Co’s agreement to pay him $5 million in exchange for those shares.

Thus, the Court concluded that Number Two’s transfer of 33 1/3 shares of Holding Co stock to the trusts for his children constituted a bona fide, arm’s-length transaction that was free from donative intent and was thus “made in the ordinary course of business.” Because “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions,” the Court found no deficiency in Federal gift tax.

What Does This Mean for Planning Purposes?

The application of the “ordinary course of business” exception in the context of a family dispute, as described above, is almost, by definition, something for which a taxpayer cannot plan. After all, a dispute among family members, especially in a business setting, can arise under any number of circumstances, few of which are reasonably foreseeable.

That being said, there are some important lessons to be derived from the Court’s discussion of the regulation’s three factors that may be applicable in many other family business settings.

As always, the members of a family that owns a business must never forget that any transactions involving the business, or transfers of interests in the business, within a family group will receive close scrutiny by the IRS that may result in the characterization of such transactions or transfers, at least in part, as taxable gifts. These transactions may include the sale or leasing of property, the sale of stock, the issuance of stock to an employee, the payment of compensation, including incentive and deferred compensation.

Although a gift may not even be intended, it will behoove the family to recognize the factors on which the IRS will focus and to prepare accordingly. Thus, the parties to a transaction should be represented by separate counsel, and they should act in an arm’s length manner, as one would act when dealing with a stranger. In this way, they will avoid the surprise that the IRS tried to spring on the taxpayer in the decision discussed herein.

“One Day, Lad, All This Will Be Yours.”

Many a closely-held business was created before its founder became a parent or when the founder’s children were still very young. As the business grew, and as the founder’s children matured, the founder may have entertained the notion of eventually having her children take over the business. In some cases, after finishing school, one or more of the children may have decided to join the business, to the delight of the founder.

From that point on, however, the children and the founder become engaged in a very delicate dance, of which they may not be fully cognizant. One child may be more capable than another; the founder may favor one child over the other. Depending upon the personalities involved, this situation can get ugly, and will sometimes raise unexpected tax issues, as was illustrated in a recent decision of the Tax Court.

 The Business

Father started the Business and, years later, his younger son (Number Two) joined him, followed later by Father’s elder son (Number One). The Business grew to cover many locations, each operated out of a separate corporation. Father, Number One and Number Two eventually came to own various percentages of these various corporations, with Father’s aggregate share being the largest.

In order to consolidate their interests in a single entity, Holding Co was incorporated with Father and his two sons as the original directors and officers.

Upon the incorporation of Holding Co, Father, Number One and Number Two each contributed to it their stock in the pre-existing corporations, in exchange for which each of them received100 shares of voting common stock. This was in keeping with Father’s decision to divide the shares evenly. The stock certificates indicated that they were each registered owners of 100 unrestricted shares of Holding Co common stock.

As it turned out, “[t]he decisions taken at [Holding Co’s] organizational meeting contained the seeds of the problem that would blossom into the tax dispute now before us.” Although Father, Number One and Number Two were each registered owners of 33.33% of Holding Co stock, the values of their capital contributions to Holding Co were disproportionate to their shareholdings, with Father making a disproportionately larger contribution.

The Dispute

As Holding Co continued to prosper, Father gave Number One more public and “glamorous” jobs, while Number Two had principal responsibility for operational and back-office functions. At the same time, Father and Number Two had a falling out as a result of certain non-Business related matters.

Number Two began to feel marginalized within the family business. He became dissatisfied with his role at Holding Co, with certain business decisions that Father and Number One had made, and with what he regarded as a lack of respect for his views. He began to discuss, in general terms, the possibility that he might leave the Business. This possibility became more concrete when Number One, without first discussing the matter with Number Two, hired Outsider to take over part of Number Two’s responsibilities in Holding Co. When Number Two learned of this, he quit the Business.

Upon leaving, Number Two demanded, but did not receive, possession of the 100 shares of stock registered in his name. He took the position that he was legally entitled to, and had an unrestricted right to sell, the shares registered in his name. He threatened to sell the shares to an outsider if Holding Co did not redeem them at an appropriate price.

Vintage Stock Certificate

Number Two’s threat to sell his shares to an outsider irked Father and Number One because they wished to keep control of the Business within the family. Father refused to give Number Two his stock certificates, contending that Holding Co had a right of first refusal to repurchase the shares. Father and his attorneys also developed an argument that a portion of Number Two’s stock, though registered in his name, had actually been held since Holding Co’s inception in an “oral trust” for the benefit of Number Two’s children.

This argument was built on the fact that Father had contributed a disproportionately larger portion of Holding Co’s capital yet had received only 33.33% of its stock. In effect, he contended that he had gratuitously accorded Number Two more stock than he was entitled to, and that, to effectuate Father’s intent, the “extra” shares should be regarded as being held in trust for Number Two’s children.

The parties negotiated for six months in search of a resolution. They explored, without success, various options whereby Number Two would remain in the business as an employee or consultant. Number Two offered to sell his 100 shares back to Holding Co, and the parties explored various pricing scenarios under which this might occur. As the family patriarch, however, Father had most of the leverage, and he insisted that Number Two acknowledge the existence of an oral trust for the benefit of Number Two ‘s children. Father’s insistence on an oral trust was a “line in the sand.”

Upon reaching an impasse, Number Two filed lawsuits against Father, Number One and Holding Co. The actions alleged that Number Two owned 100 shares of voting common stock, that these shares were “unencumbered and unrestricted as to their transferability,” and that the 100 shares should be delivered immediately to Number Two. Father answered that he had possession of all the stock registered in Number Two’s name and that a portion of the shares so registered were “held in trust for the benefit of * * * [Number Two’s] children.”

The Settlement

This litigation became nasty, and its public nature was extremely distressing to the family. In the course of negotiations, it became apparent to Number Two’s attorney that Number Two had to separate completely from Holding Co and that Father would not be placated unless Number Two acknowledged the supposed “oral trust” and placed some of the disputed shares in trust for his children.

Number Two firmly believed he was entitled to all 100 shares of Holding Co stock that were originally registered in his name, and that he had never held any shares under an oral trust for his children. He believed that he was being forced to renounce his ownership interest in the 33 1/3 shares and to acknowledge the existence of an oral trust in order to placate Father and obtain payment for the remaining 66 2/3 shares. However, he accepted his attorney’s advice that it was in his best interest to compromise and settle the litigation.

The parties ultimately reached a settlement along these lines. The parties agreed that Holding Co would purchase from Number Two the 66 2/3 shares of stock that he was deemed to own. They further agreed that his “2/3 stock interest was to be valued at Five Million Dollars for purposes of a settlement agreement” (Settlement Agreement). Number Two transferred these shares to Holding Co in exchange for $5 million.

The Settlement Agreement required Number Two to execute irrevocable declarations of trust for the benefit of his children, with Number One named as the sole trustee of each trust. Number Two assigned 33 1/3 shares of Holding Co stock to these trusts.

Finally, the Settlement Agreement required the parties to execute mutual releases respecting claims concerning Number Two’s ownership interests in Holding Co, and Number Two resigned from all positions he had held in the Business.

The IRS Gets Involved . . .

Number Two did not file a Federal gift tax return for the year of the Settlement Agreement. He did not believe that the Holding Co shares he transferred to the trusts constituted a taxable gift.

Almost thirty – yes, thirty – years later, as a result of some unrelated litigation, Number Two’s transfer of the Holding Co stock came to the attention of the IRS and, after an examination (and shortly after Number Two’s death), the IRS issued a timely notice of deficiency to Number Two’s estate asserting a deficiency of almost $740,000 in Federal gift tax.  The estate filed a petition with the Tax Court.  Tomorrow’s post will review the Court’s decision.

Make sure you check out Part I before reading below…

The Bigger Picture

In addition to the SCIN-specific issues, the complaint touches on a number of themes of which every estate-planning adviser – and every client – should be aware.

The Facts Matter

An adviser should assume that the IRS will scrutinize the estate plan closely, especially in the case of a large estate or a prominent client.

The adviser should prepare for such an exam contemporaneously with the implementation of the plan, not later. This may be especially important in the case of a client’s premature or unexpected death.

The Technique and Execution Matter

An adviser should recognize that certain techniques, including the use of SCINs, are likely to attract the attention of the IRS.

Whenever a “risky” technique is employed as part of an estate plan, it must be prudently and properly executed if it is to withstand IRS scrutiny.

As a general rule, transfers between family members will be subject to greater scrutiny, and could be challenged as not being bona fide and not being conducted at arm’s-length. Failing to have separate counsel for the parties to the transaction will only exacerbate the matter. The estate plan as a whole could be deemed to be a testamentary device deployed purely to avoid tax liability.

Educate the Client

The client must be presented with alternatives, each of which may accomplish his or her testamentary goals. It is not the adviser’s role to make the necessary “business” decisions.

Assess the Risks

For each alternative, the client must also be informed of the attendant risks, the likelihood of their being realized, and the economic consequences thereof. Without this information, how can the client be expected to make any decision?

According to the complaint, nowhere in DT’s presentation was there a comprehensive list of the relevant and material risks. Rather, it is alleged that DT assured the decedent that its estate plan hedged all risk, maximized the transfer of wealth, and minimized taxes.

One Tool May Not Suffice

In light of the strict scrutiny that a particular decedent’s estate is likely to receive (for example, because of the size of the estate), it may behoove the estate planner to use more conservative and more reliable estate planning techniques.

If more “aggressive” techniques are to be used, the planner should consider not making them the centerpiece of the estate plan. The planner should also consult with subject matter experts, including other legal counsel, doctors, actuaries and others, in connection with the formulation and implementation of such an estate plan.

Too Good to be True

A proposal that purports to eliminate all economic risk to the taxpayer’s estate is the sort of estate plan that the IRS routinely rejects as having no economic substance.

DT’s SCIN-GRAT “circular” transaction eliminated the risk incumbent in the SCIN transactions. Only if the transaction involves an appropriate degree of economic risk will it be found to be a bona fide transfer. Without such risk, the IRS is bound to scrutinize a transaction, like the SCIN, and challenge it as strictly a tax avoidance device.

Substance Over Form

In the case of the decedent’s estate, the IRS concluded that the transfers of stock

in exchange for the SCINs should be viewed as gifts because the SCINs lacked the indicia of genuine debt in that there was no requirement of repayment of principal, there was no reasonable expectation that the debt would be repaid, and DT’s use of the §7520 mortality tables to set the terms of the SCINs was unfounded.

The arrangement was nothing more than a device to transfer the stock to family members at a substantially lower value than the fair market value of the stock.

Although an estate may vigorously maintain that a decedent intended to enforce and collect on a note, it is difficult to support such an assertion without the kind of proof that is demonstrated by the actual receipt of payments.

Know the Law and Apply It

The client will reasonably assume that the adviser is – and the adviser must actually be – intimately familiar with the applicable statutes, regulations, administrative and judicial pronouncements.

In recommending any estate planning technique, the adviser must be able to anticipate the IRS’s reaction and arguments, and he or she must plan for them accordingly.

According to the complaint, the existing authority made clear that the absence of periodic payments of principal in connection with all of the SCINs and, in particular, no requirement of the payment of any risk premium until the end of their term, made them susceptible to being challenged as not being bona fide transactions. DT should have known, it continues, that the IRS generally challenges estate plans that provide purported “win/win” scenarios.


It is not unusual for an estate planner, acting on behalf of a client’s estate, to defend its planning and the implementation thereof to the IRS. In doing so, however, the planner must walk a very fine line and must be completely transparent with respect to its client.

For example, the complaint alleges that DT’s provision of services to the decedent’s estate subsequent to his death was not only intended to defend its plan to the IRS, but also to conceal the defects in that plan from the executors of the client’s estate.

“How Do We Kosher This Pig?”

A former colleague would sometimes put this question to me when confronted with an IRS examination of a transaction or plan that we had not structured, but that we were retained to defend. Too often, there was little we could do to reverse what had already been done, and it was too late to do what should have been done earlier.

This question also highlighted the importance of planning thoroughly and in advance of engaging in any transaction. The best time to prepare for an audit is before the subject of the audit has even occurred.

What would you do?

The decedent was an extremely wealthy man, with a net worth in excess of $3 billion. You are the executor of his estate.

Prior to his death in 2009, he retained one of the top tax firms in the country to review his existing estate plan.

Under his existing plan, which included some taxable bequests, over $700 million would pass to his spouse and about $2.2 billion would pass to various charities, leaving an estate tax bill of about $88 million. The assets passing at his death would receive a step-up in basis for purposes of determining the gain realized on their subsequent sale, thereby reducing the future income tax liability of his beneficiaries. death-tax-photo

The decedent was very ill when he engaged the tax firm, but he wanted to explore the possibility of leaving more of his wealth to his children and grandchildren.

The decedent told the tax firm that he wanted to structure his estate in a tax efficient manner, but did not want to take any unnecessary risks in his estate planning. In particular, he did not want his estate to attract unnecessary IRS attention.

After presenting an overview of several wealth planning options that were potentially available to the decedent – including the use of GRATs, sales to intentionally defective grantor trusts, educational trusts, and testamentary charitable lead annuity trusts – the tax firm focused on the use of SCINs in combination with GRATs.

Within less than one month’s time, a SCIN-based estate plan was implemented: trusts were established and funded with “seed” money, for the benefit of the decedent’s children and grandchildren; and the decedent sold shares of stock in his corporation to the trusts in exchange for 5-year self-cancelling installment notes (“SCINs”), which included risk premiums for the cancellation feature, annually payable interest, and balloon principal payments. He then contributed the SCINs to 5-year GRATs. According to the tax firm, this structure ensured a “win if you live, win if you die” outcome.

Specifically, if the decedent died within 5 years, the SCINs would be cancelled, no further payments under the SCINs would be due, and the stock (which had been transferred to the trusts in exchange for the SCINs), would remain with the trusts.

If the decedent lived, upon the expiration of the 5-year term, virtually all of the principal and risk premium interest payments associated with the SCINs issued by the trusts (which had been transferred to the GRATs) would be transferred to the remainder beneficiaries of the GRATs – the trusts. Thus, the obligors and the obligees on these SCINs were to be one and the same: the trusts.

Seven weeks after the implementation of this plan, the decedent passed away, never having received any interest or principal payments in respect of the SCINs or the GRAT.

You filed estate tax and gift tax returns with the IRS and paid almost $168.5 million of federal estate tax and almost $83 million of federal gift tax.

The IRS examined these returns and challenged the estate plan. It determined that the estate owed almost $846 million of gift tax, and almost $1.887 billion of estate tax (including penalties), for a total deficiency of over $2.7 billion, plus interest.

You consulted with the estate’s professional advisers, and then filed a petition with the U.S. Tax Court in June of 2013.

In July of 2015, you and the government reached a stipulated decision in which you agreed to:

  • Deficiencies of gift tax of approximately $178 million;
  • Estate tax of approximately $153 million; and GST tax of approximately $46 million. This totaled $377 million, as opposed to the more than $2.7 billion originally sought by the IRS.

Are you relieved? Somewhat.

Are you satisfied? Not really, especially when you consider that the hundreds of millions of dollars paid to the IRS would not pass to the charities that were the intended residual beneficiaries of the decedent’s estate.

“Call My Lawyer!”

On September 24, 2015, the executors for the Estate of Davidson filed a complaint against Deloitte Tax LLP (“DT”) in NY Supreme Court, in Manhattan for recovery of approximately $500 million in additional estate and gift taxes, and related fees, penalties, and interest that the executors claim were assessed by and paid to the IRS as a result of DT’s alleged failure to: (i) disclose all material risks and information; (ii) provide reasonable and appropriate advice given the then-existing state of estate and tax planning knowledge; and (iii) design and implement a bona fide and defensible plan that could withstand the inevitable IRS scrutiny that would occur.

Over the course of 90-plus pages, the complaint provides what purports to be a detailed description of the decedent’s discussions with DT, the implementation of his estate plan, its shortcomings, the dispute with the IRS, and the resolution thereof at the Tax Court.


The complaint touches on many of the factors that must be considered in structuring an estate-planning transaction that involves the use of a SCIN. For example, the complaint alleges that DT failed to:

  • Design and implement bona fide economic transactions, conducted at arms’ length, as opposed to purely tax driven transactions;
  • Properly structure the SCIN transactions with appropriate capitalization, interest rates, and repayment terms;
  • Use decedent’s actual anticipated life expectancy in creating the term for the SCINs, as opposed to the 5-year term from mortality tables under IRC §7520, which could not be relied on in light of decedent’s poor health;
  • Calculate the appropriate “risk premium” for the SCINs, instead of improperly relying upon the §7520 mortality tables;
  • Provide for the actual payment of at least a portion of the risk premium to the decedent during the term of the SCINs;
  • Provide appropriate amortization for the repayment of the SCINs, as opposed to, among other things, the use of a “balloon payment” due at the end of the SCINs’ 5-year term, which created the impression that there was no realistic expectation of repayment to the decedent;
  • Fund the trusts that were obligors under the SCINs with sufficient assets in order to be able to repay the holders of the SCINs upon maturity of the SCINs;
  • Create defensible and acceptable transactions, instead of creating circular, illusory arrangements by which certain obligors under the SCINs would in effect owe themselves in the event that the decedent survived their 5-year term; and
  • Separate out the various transactions in a manner that gave independent significance to each transaction, as opposed to effectuating all the various transactions within less than a month, and in some instances on the same day, making the plan subject to challenge under the “step-transaction doctrine.”

So what’s the punchline?  Check in for Part II tomorrow to find out!

A law suit was recently filed against the U.S. in which the Taxpayers seek a refund of gifts taxes and interest that they claim were erroneously assessed against them by the IRS for their 2007, 2008 and 2009 tax years (the “Tax Years”).

Although it may be some time before the Taxpayers’ claims are resolved, the factual setting upon which the disputed taxes are based is a commonly recurring one.

It is also one that highlights the importance of recognizing the various contexts in which the equity interests in a closely-held business are valued, how they may impact one another, and the importance of being able to distinguish among them.

Family Transfers

Taxpayers are shareholders of Company, an S corporation, the shares of which (the “Shares”) are owned by members of the Taxpayer Family and certain key employees and directors of Company.

Transfers of Company Shares by members of the Taxpayer Family are restricted pursuant to the terms of the Company’s bylaws. Under the bylaws (the “Bylaws”), the “Taxpayer Family” was defined as the issue and descendants of X & Y or trusts whose beneficiaries are members of the Taxpayer Family.

The Bylaws were intended to ensure continuity of ownership in that they provide that members of the Taxpayer Family can only transfer their Shares to other members of the Taxpayer Family. However, no price is established in the Bylaws for Shares that are transferred between members of the family.

A qualified, independent valuation firm (“Appraiser”) annually values the Company to determine the value of minority blocks of Company Shares.

Purchases and sales of Company Shares between Taxpayer Family members are transacted at the Appraiser’s valuation of those Shares.

Key Employee Transfers

According to the complaint filed by the Taxpayers (the “Complaint”), the Share ownership structure of Company has long had as one of its underlying principles the desire to create continuity of ownership for the Company and to give key employees and directors a stake in Company’s success. (This is a common theme in the closely-held business, especially where family members are no longer actively engaged in the business and, so, need to retain qualified employees.)

Historically, Company has offered certain of its key employees and its directors the opportunity, from time to time, to purchase Company Shares. The purchase price for Shares sold to such key employees and directors was set by the Company at the benchmark purchase price of 120% of the book value of such Shares. (Presumably, the service providers did not report any compensation income in connection with the purchase of the shares.)

Transfers of Shares by key employees and directors who are not Taxpayer Family members are restricted and subject to a right of first refusal in favor of the Company pursuant to the terms of the Company’s Bylaws and by restrictions contained in separate stockholder agreements entered into by such key employees and directors. Pursuant to the terms of the Bylaws and the separate stockholders agreements, key employees and directors desiring to sell their Shares back to Company may only do so at a price equal to 120% of the then-current book value of the Shares.

Taxpayers represented that the “120% of book value” purchase price for Company Shares was established by the Company for the purpose of ensuring that key non-Taxpayer Family employees and directors who wished to buy and sell their Shares would have an easily calculated purchase and sale price for those Shares. According to the Complaint, it is only a benchmark for purchases and sales by key employees and directors and bears no relationship to what a willing buyer and willing seller would establish for the price of Company shares.

The Gifts

During the Tax Years, Taxpayers gifted minority Shares to their children and grandchildren. The Taxpayers filed gift tax returns to report the gifts and stated a per share fair market value as determined by the Appraiser. The Appraiser’s valuation was based on a variety of factors including, but not limited to, Company’s historical earnings and financial data, current economic and market conditions, pricing for shares in comparable publicly-traded companies, dividend history, and the book value of all Company assets.

The Appraiser’s valuations included a significant discount for lack of marketability because the Company was a privately-held business lacking an active market for its shares.

Another reason for the lack of marketability discount, the Complaint stated, was the restriction on transfers of Company Shares between the Taxpayer Family members: the Bylaws prohibit Taxpayer Family members from transferring Shares except to other members of the Taxpayer Family. According to the Complaint, the restrictions on the Taxpayer Family transfers were a “bona fide business arrangement” and not a device to transfer shares to a family member for less than adequate consideration.

The Dispute

On the gift tax returns for the Tax Years, Taxpayers reported and paid almost $2.4 million of gift taxes with respect to the gifted Shares.

The IRS challenged the amounts reported on the returns, and eventually sent Taxpayers “30-day letters” proposing an alternative valuation of the Company Shares based upon 120% of the book value of the Shares (the same methodology established by the Bylaws to benchmark the purchase and sale price of Shares sold to and repurchased from key Company employees and directors).

Taxpayers subsequently received Notices of Deficiency (dated August, 2014) from the IRS alleging they owed additional gift tax as a result of the IRS’ fair market value determinations of the minority shares of Company for the Tax Years.

In November, 2014, Taxpayers paid to the IRS the additional amount of gift tax (plus interest) set forth in the Notices of Deficiency. (It is unclear why Taxpayers did not choose to contest the asserted deficiencies in the Tax Court; as a jurisdictional matter, a taxpayer may access the Tax Court without first paying the taxes asserted by the IRS.)

In February, 2015, the Taxpayers filed amended gift tax returns with the IRS for the Tax Years, claiming a refund of the federal gift taxes and interest paid in response to the Notices of Deficiency.

After more than six months had elapsed from the filing of such refund claims (a jurisdictional requirement), the Taxpayers filed a suit for refund in the U.S. District Court.

Which Valuation Standards?

We have heard it a million times: for purposes of the gift tax, the fair market value of an interest in a closely-held business is the amount that a willing buyer would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of the relevant facts.

Among these relevant facts, one would consider any transfer restrictions relating to the interest, provided that any such restriction is a bona fide business arrangement, is not a device to transfer such property to members of the donor’s family for less than full and adequate consideration, and its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.

We are also familiar with the following refrain: where property (including an equity interest in the service recipient) is transferred to an employee or independent contractor in connection with the performance of services by such individual, the fair market value of such property (less any amount paid therefor by the employee or independent contractor) shall be included in the gross income of such employee or independent contractor for the taxable year in which the property becomes substantially vested.

For purposes of this compensation rule, the fair market value of the equity interest for gift tax purposes is generally irrelevant. Rather, for compensation purposes, the fair market value of the transferred equity interest is determined without regard to any transfer restriction other than one which by its terms will never lapse.

Such a “non-lapse restriction” is a permanent limitation on the transferability of property that will require the transferee of the property (e.g., the employee) to sell, or offer to sell, the property at a price determined under a formula, and that will continue to apply and be enforced against the transferee or any subsequent holder (e.g., the employee’s estate).

As a result, in the case of property subject to a non-lapse restriction, the price determined under the formula for compensation purposes will be considered to be the fair market value of the property, unless the IRS establishes otherwise.

Thus, for example, if stock in a corporation is subject to a non-lapse restriction that requires an employee to sell such stock only at a formula price based on book value, the price so determined will ordinarily be regarded as determinative of the fair market value of such property for compensation purposes.

The Outcome?

Interestingly, it appears that the fair market value for the Company Shares as determined by the Taxpayers for gift tax purposes was less than the fair market value of such Shares as determined for compensation purposes – the “120% of book value” purchase price for the Company Shares is likely a non-lapse restriction.

Although, as was noted above, the valuation standards are different for each purpose, a taxpayer who is contemplating a gift of equity in his or her close business should be mindful of any equity-based compensation arrangements and the valuations thereunder, especially where the employee-participants are not related to the taxpayer.

The taxpayer must be prepared to defend the difference in values, especially insofar as such difference may call into question the bona fide business nature of the family-related restrictions, or may support the IRS’s characterization of such restrictions as a device for transferring property to members of the taxpayer’s family for less than full and adequate consideration.

Stay tuned.




At the beginning of every year, the IRS informs the public of those tax matters on which the IRS will not issue letter rulings. Typically, these are areas of the tax law that are under study at the IRS, and that the IRS hopes to address through the publication of a revenue ruling, a revenue procedure, regulations, or otherwise.

A couple of months ago, the IRS added the following item to the list:

Section 1014. Basis of Property Acquired from a Decedent. Whether the assets in a grantor trust receive a section 1014 basis adjustment at the death of the deemed owner of the trust for income tax purposes when those assets are not includible in the gross estate of that owner under chapter 11 of subtitle B of the Internal Revenue Code.

Although this addition to the no-ruling list may be disturbing to some, it is actually a welcome development insofar as it may lead to the resolution of a tax issue that accompanies a commonly-used estate planning technique for the transfer of interests in a closely held business: the sale to an “intentionally defective” grantor trust.

While many estate practitioners employ sales to grantor trusts to effect the transfer of interests in closely held business entities, many fail to explain to the client (and the client’s beneficiaries) the tax risks associated with this technique upon the premature death of a client.

To better appreciate the import of the IRS’s decision, the following outlines the basic tax consequences of the sale technique, and then discusses the addition to the “no-ruling” list.


The most common means for transferring  a business interest to someone is through a sale of the interest.  Thus, it not unusual for a parent to sell a business interest to a child. In fact, if the parent needs a flow of funds in respect of the business interest, a sale presents an attractive option.

A sale is also an effective tool where the parent wants to shift the future appreciation in the value of the business interest out of his or her estate, but the parent’s remaining gift tax exemption amount is insufficient to cover the transfer.   If a parent sells a business interest to his or her child for consideration in an amount equal to the value of such interest at the time of the sale, no gift occurs. Moreover, the sale allows the parent to effectively “freeze” the value represented by the interest at its sale price – by exchanging the interest for non-appreciating cash or other property – and to shift any future appreciation in the interest (above the sale price) to the child.

The Cost of a Sale

Such a sale of a business interest to one’s children will usually come with a cost: income tax. Where the interest sold was a capital asset (as is typically the case), the sale of which generates long-term capital gain, the 20% federal capital gains rate would apply to the amount recognized, and the 3.8% federal surtax on net investment income may also apply.

 Installment Sales

A sale may be structured as an installment sale in order to defer this income tax liability; i.e., in exchange for the child’s promissory note.

In order to avoid gift characterization of any portion of the sale transfer, the child’s installment obligation should:

  • Bear a statutorily prescribed minimum rate of interest;
  • Be memorialized in writing (with a note and sale agreement);
  • Be secured (at least by the transferred property);
  • Have a term not exceeding the seller’s life expectancy;
  • Require regular payments by the terms of the sale and note agreements; and
  • State the value of the business interest as established by an appraisal.

Using this approach, the gain realized on the sale would be recognized, and taxed as capital gain, as principal payments are made; interest would be taxable as ordinary income.

 Sale to Grantor Trust

While an installment sale may “freeze” the value of the parent-seller’s business interest for estate tax purposes, there are some disadvantages to consider:

  • The interest and principal that must be paid are taxable to the seller;
  • If the seller disposes of the note (or if the child disposes of the purchased property within two years after its purchase), the gain on the sale is accelerated;
  • If the principal of the note exceeds $5 million, a special interest charge will apply that defeats the deferral benefit of installment reporting; and
  • The sale of an LLC or partnership interest may result in immediate gain recognition (if the entity has any indebtedness).

However, there is another option that should be considered: a sale of the business interest to a grantor trust.  In order to use this technique, an irrevocable trust must be created and funded. The trust is structured as a grantor trust so that the parent is treated as the owner of the trust’s income and assets for income tax purposes. In general, the funding requires a seed gift equal to at least 10% of the FMV of the business interest to be sold to the trust.

The parent then sells the business interest to the trust in exchange for a note with a face amount equal to the value of the interest, bearing a minimum rate of interest and secured by the property acquired. The interest may be payable annually, and the note is typically satisfied with a balloon payment at the end of the note term.

The sale to the grantor trust is not subject to capital gains tax (because the parent-taxpayer is treated as dealing with him- or herself), and the issuance of the note prevents any gift tax (because there is adequate consideration). The value of the business interest sold to the trust is frozen in the parent’s hands in the form of the note; the cash flow from the interest and/or the appreciation in the value of the interest should cover the loan; and the remaining, excess value of the interest passes to the beneficiaries of the trust.

Death of the Seller

If the parent dies before the note is satisfied, the value of the note as of the date of death will be included in his or her estate for estate tax purposes. Thus, the FMV of the note at that time, plus the accrued but unpaid interest thereon, may be subject to estate tax. rip

Moreover, because it represents an item of “income in respect of a decedent,” the note will not receive a basis step-up (unlike most items of property that are included in a decedent’s gross estate), thus preserving the tax gain inherent in the note.

Gain on the Sale?

This brings us back to the IRS’s “no-ruling” list.

So long as the grantor retains those rights or powers with respect to the trust property that caused the trust to be treated as a grantor trust for purposes of the income tax (for example, the right to substitute property of equal value), the grantor will be treated as owning the trust’s assets, and any transfer of property by the grantor to the trust, whether or not in exchange for any consideration, will be disregarded for purposes of the income tax.

It is well established that, if a grantor were to release these rights or powers, and the trust thereby ceased to be treated as a grantor trust, any “transfers” of property previously made by the grantor to the trust will become effective – will be “completed” – for purposes of the income tax. Where such a transfer was made in exchange for a promissory note that remained outstanding at the time of the release, a sale will occur at that time.

What if the “release” of the grantor trust powers occurs as a result of the death of the grantor? It is clear, from an income tax perspective, that the trust ceases to be a grantor trust and that the transfer to the trust is completed at the death of the grantor. The question of gain recognition, however, has not been resolved.

Basis Step-Up? Jonathan v. the IRS

The basis of property acquired from a decedent is the fair market value of the property on the date of the decedent’s death. Property that is acquired by bequest, devise or inheritance, or by the decedent’s estate from the decedent, is considered to have been acquired from the decedent.

Many commentators argue that, for income tax purposes, the grantor owned the “trust assets” until the date of the grantor’s death and, so, these assets did not pass to the trust until the grantor’s death. At that moment, these commentators go on, these assets should receive a step-up in basis to the then-FMV of the assets (which will be greater than the original face amount of the note if the asset has appreciated). Upon the immediately subsequent sale of the assets to the trust, this step-up would offset the consideration received (i.e., the note) and eliminate any gain.

The IRS, on the other hand, has stated that because the property was transferred to a trust prior to the death of the grantor, the basis step-up rule should not apply unless the property was included in the grantor’s gross estate for purposes of the estate tax.

This is consistent with legislative measures that have been proposed over the last few years to “remedy” the lack of coordination between the income and transfer tax rules applicable to a grantor trust that, according to the IRS, creates opportunities to structure transactions between the deemed owner and the trust that can result in the transfer of significant wealth by the deemed owner without transfer tax consequences.

Under these proposals, if the grantor of a grantor trust engages in a transaction with that trust that constitutes a sale, exchange, or comparable transaction that is disregarded for income tax purposes by reason of the person’s treatment as a deemed owner of the trust, then the portion of the trust attributable to the property received in that transaction (including the appreciation thereon, net of the amount of the consideration received by the grantor) would be subject to estate tax as part of the gross estate of the deemed owner, which tax would be payable from the trust.

My Opinion

Gross income does not include the value of property acquired by bequest, devise or inheritance. The transfer is a gratuitous transfer – there is no consideration. But what if the property so acquired was encumbered by a mortgage or other indebtedness?

In the case of an intervivos gift, the transferor would be deemed to have received consideration equal to the amount of the indebtedness to which the property was subject: a part-sale, part-gift.

However, the IRS has never tried to argue that the transfer of encumbered property that occurs upon the death of the property owner should be treated as a sale of the property, one that would result in gain to the extent the indebtedness exceeded the owner’s basis in the property.

Similarly, it may be said that, upon the death of the grantor, the property transferred to the trust is “encumbered” by the promissory note, which becomes an obligation of the trust. The trust’s “assumption” of that note (that was the grantor “obligation” until his death) should not be treated as consideration for the testamentary transfer – there is no sale. Moreover, the basis of the property “passing” at the death of the grantor should be adjusted pursuant to the usual step-up rules.

What’s Next?

Hopefully, the IRS will resolve this issue sooner rather than later.

Until the issue is resolved, notwithstanding the IRS’s no-ruling position, estate practitioners should be able to proceed on the assumption that the property sold to the trust will receive a basis step-up on the premature death of the grantor and, so, no gain should be realized on the transfer that is deemed to occur upon such death while the note is still outstanding.

However, practitioners will have to educate their clients who are considering sales to grantor trusts. The clients have to be made aware of the IRS’s position and the uncertainty this creates as to the income tax consequences that may follow upon the death of the grantor. “An educated consumer is our best customer” – it is also the best protection for the practitioner.