New Tax Regulations Will Impact High-Net-Worth Estate Planning

September 14, 2016Alerts Taxation and Wealth Planning Alert

Proposed regulations issued in August by the IRS's rulemaking department will affect the ability of high-net-worth families to take advantage of current law to reduce their estate tax burden. What makes the law important to clients is that, by its terms, it is not retroactive to most planning done before its enactment in final form, which will, by the terms of the proposal, occur sometime after December 1, 2016.

Clients who own family businesses, or those with closely held business interests who have a “taxable estate” — meaning more than $5.45 million in net worth ($10.9 million for married couples) — should be advised of this imminent change in the law. This is because the effective date of the proposed regulations is “not before” (i.e. “after,” in IRS speak) 30 days after the proposed regulations become final. Further, because the public hearing for comment is set for December 1, 2016, they will most likely not be effective until next year.

Window of Opportunity to Save Millions

This means there is now a window — from now at least until the end of the year — within which clients in this situation can effectively plan to rely on existing (favorable) precedent that permits discounts in the business-transfer context. There is therefore a three-month period to implement strategies that can result in millions of dollars in estate (transfer) tax savings.

The law applies to “valuation discounts” taken by some competently advised families in the transfer of fractional interests in family business entities, such as family corporations, partnerships and LLCs. What it means is that currently legal tax-avoidance strategies, such as use of family limited partnerships, or FLPs, to gift or sell portions of family businesses (or family wealth held inside businesses), will have reduced usefulness in planning such estates. This is because the value of such interests will no longer be based on the familiar “willing-buyer-willing-seller” standard that applies to most such transactions, but will instead be subject to special valuation rules when family members are involved in the transfers. Those special valuation rules will eliminate or greatly curtail the discount (lower valuation) that applies when a small piece of a business, with limited control and liquidation rights, is transferred.

For example, under current rules, a 5 percent or 10 percent interest in a family business would be based on what a willing buyer (in or outside the family) would pay for the interest, after considering its limited voting and liquidation rights (most minority interests have limited ability to control the business or force a liquidation).

Under the current iteration of the new rules, these restrictions would be disregarded, resulting in a much higher valuation of the interests, and therefore a much higher transfer tax problem. Among other aspects, they purport to impose a “deemed put right” (the right of the holder of an interest to sell it back to the entity or transferor) based on the proportional value of the underlying assets.

For example, assume a family has 100 shares of family entity A, the underlying assets of which are worth $100 million. Senior generation gifts 15 shares of A to a trust for junior generation. Because of the new regulations, it is quite likely that this gift would be valued at $15 million — even though the junior generation has no right to liquidate the entity, control its decisions, manage its assets or sit on the board.  This will result in a nearly $2 million transfer tax.  If the gift is made before the regulations become final, discounts would apply to the fractional interest, which in most instances would entirely eliminate the transfer tax.

Note that the value of the gifted share will be determined as if those (obvious) restrictions on the shareholder’s right did not exist!

While many commentators question the validity of the regulations given the scope of the statute that authorizes them, it is unwise to proceed on the assumption they will be declared invalid or changed. Current U.S. Supreme Court decisional law gives executive agencies (such as the IRS) broad authority to issue implementing regulations which have the effect of law.  Clients and their financial (tax, legal) advisers should consider a number of actions presently legal and within the bounds of decisional law, such as:

  • Lifetime gifts of percentage/fractional interests in trust
  • Installment sales to grantor trusts
  • “Walton style” GRATs
  • Charitable Lead Trusts funded with discounted interests
  • Use of family limited partnerships (FLPs) and limited liability companies (FLLCs) to hold family assets and portfolios of assets, including marketable securities

Conclusion

The proposed regulations, if adopted as final, would represent the biggest change in large-estate tax planning in 25 years. The regulations would eliminate the minority (lack of control) discounts for family-controlled entities, whether passive or active, by use of a deemed put right, which artificially inflates the transfer tax value of interests in the entity. Indirectly, they will affect lack of marketability discounts as well.

Action should be considered and, if appropriate, taken as soon as practicable.

If you have questions about the above alert or need guidance in any area of estate planning, please contact Peter S. Myers at 415.651.1465 or [email protected], Michael J. Maransky at 610.397.6502 or [email protected] or Adam M. Grenker at 973.994.7814 [email protected] or any member of Fox’s Taxation and Wealth Planning Department.