The Obama Administration released its proposed budget for fiscal year 2014 on April 10, which included several proposals affecting estate planning. These are described in the Treasury Department’s General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals (commonly referred to as “the Greenbook”). Noticeable by its absence was the perennial proposal to restrict or eliminate valuation discounts for transfers of interests in family-controlled entities. Treasury has long maintained that IRC Section 2704(b)(4) gives it authority to disregard such valuation discounts and many believe regulations have been in preparation for some time. This article discusses the importance of acting promptly to take advantage of valuation discounts before the announcement of proposed regulations.
The American Taxpayer Relief Act of 2012 provided an unexpected windfall to estate planners and their clients – a permanent change to exemptions for estate, gift and generation-skipping tax ($5 million per person), an indexing of those exemptions, a fixed tax rate (40%), and portability of a deceased spouse’s exemption. Finally, some certainty to help normalize the planning process, following the uncertainty and resulting chaos at the end of 2012. Few planners considered that the fiscal year 2014 budget proposals would have any greater impact on the planning process than budget proposals for prior fiscal years. However, the Obama administration 2014 budget proposal1 and the companion Treasury Department Greenbook explanation2 contain two significant surprises. First, the administration proposes returning estate, gift and generation-skipping exemptions and rates to 2009 levels for tax years beginning in 20183. Second, for the first time in many years, there is no proposal to disregard valuation discounts applicable to certain restrictions on transfers of interests in family-controlled entities.
The IRS has for several years maintained that it has the authority to restrict or eliminate valuation discounts by regulation. Prior Greenbooks note that Chapter 14 of the Code (Sections 2701-2704) was intended to limit planning techniques designed to reduce transfer tax values, but that do not reduce the economic benefit to the transferee4. Since 2003, the Treasury-IRS Priority Business Plan has included issuing new rulings or regulations to limit valuation discounts pursuant to Section 2704 of the Code. The absence of this proposal in the 2014 Greenbook portends the issuance of proposed regulations, and is a “death knell” for family discounts.
Unexpected Loss of Family Discounts
Several political and legal factors suggest that such regulations could be issued at any time, effective on the date of publication. President Obama has promulgated the “We Can’t Wait” doctrine to justify extensive regulatory actions and bypass Congress5. “Millionaires and billionaires” are often cited as able to bear more of the needed tax increases and they are the exclusive users of intra-family valuation discounts. Since prevailing in the 2012 elections, the Administration has shown less restraint in issuing and proposing new regulations and asserting more executive power. Furthermore, since the 2011 U.S. Supreme Court decision in the Mayo case,6 many believe that IRS regulations are much more difficult to challenge successfully. The absence of an intra-family valuation discount proposal in the 2014 Greenbook signals the likelihood of the long-expected proposed Section 2704 regulations.
Planners will remember the 2006 IRS announcement and proposed regulations7 that effectively eliminated the use of private annuities as an income tax deferral device. The effective date for those regulations was the day following the announcement. This will be the likely effective date approach used in new Section 2704 family valuation discount regulations given the years of advance notice to taxpayers. Thus, anyone considering transactions involving family valuation discounts should act promptly.
Application to Traditional Discount Planning
Many traditional planning techniques employ valuation discounts to enhance the transfer of wealth to heirs with little or no gift or estate tax consequences. For example, a Grantor Retained Annuity Trust (“GRAT”) allows a person to transfer assets to a trust in exchange for payment from the trust of an annuity (a yearly amount) that includes an interest factor set by the IRS, called the Section 7520 rate (which is 1.4% for April, 2013).8 The annuity payment can be set so that the grantor receives total payments during the term of the GRAT (two years or more, under current law) equal to the value of the assets contributed to the trust. If so, there is no gift at inception (called a “zeroed-out GRAT”). If the value of GRAT assets increases more than 1.4% per year, the entire excess passes to or in continuing trust for the grantor’s children.
GRATs work for many different asset types including marketable securities, family businesses, real estate and family investment partnerships. The value of many of these assets has been rising over the last year. The IRS implied interest rate of 1.4% remains among the lowest rates ever. Most experts expect such rates to begin rising as the Federal Government begins allowing benchmark rates to rise. In addition, if assets are held in an entity such as a partnership, LLC or corporation, traditionally accepted valuation principles permit an interest in the entity holding the assets to be discounted in determining its fair market value for estate and gift tax purposes. These discounts (for lack of marketability and minority interest), determined by appraisers and confirmed in numerous decisions of the Tax Court and Federal appellate courts, often range from 30% to 40% or more. Such discounts greatly increase the wealth transfer opportunity from the GRAT. “Can’t Wait” regulations could eliminate this aspect of GRAT planning. In addition, current revenue raising proposals would also severely limit the use of GRATs by requiring a minimum 10-year term (Grantor must survive to the end of the term), rather than the current 2-year requirement. The “Perfect Storm” of estate planning, about which we have written for years,9 is coming to an end.
Elimination of family valuation discounts would impact many other conventional planning techniques. One is a sale to an intentionally defective grantor trust (“sale to a DGT”). The benefits of a sale to a DGT are effective immediately – the grantor does not have to survive any certain time (as in a GRAT). The beneficiaries of the DGT also can include grandchildren, as well as children, unlike a GRAT. Many planners used the “power of substitution” to create grantor trust status10 for the avalanche of gifts near the end of 2012 designed to maximize use of the about-to-expire $5 million gift tax and generation-skipping tax exemptions. Near the end of 2012 it was virtually impossible to obtain discount appraisals for minority interests in family businesses and real estate and investment entities because qualified appraisers were overwhelmed with 2012 year-end planning. Many planners viewed a gift of cash or marketable securities, coupled with a power of substitution as a means to defer valuation of “discountable” gifts to the following year.11 Now with the likely loss of such family valuation discounts, time is running short on this strategy for advisors and their clients.
Do Your Planning Now
There are many other estate and related income tax planning strategies that could be affected by features of the Obama administration 2014 budget. While most may be slowed or blocked by Congressional gridlock, those in which Congress can be bypassed are in jeopardy now and others are at risk if control of the House of Representatives passes to Democrats in 2014.
About the Authors
Gordon A. Schaller is a partner in the Orange County office of Jeffer Mangels Butler & Mitchell LLP. Gordon focuses his practice on tax, estate planning, charitable planning, wealth management services, business succession planning, life insurance planning and trust and estate litigation. He represents high net worth individuals and business owners as well as numerous public and private charitable organizations. Gordon is a fellow of the American College of Trust and Estate Counsel and a frequent writer and speaker on captive insurance, life insurance, estate and tax planning, and charitable planning. Contact him at GSchaller@JMBM.com or 949.623.7222.
Scott A. Harshman is a partner in the Orange County office of Jeffer Mangels Butler & Mitchell LLP. Scott has an LL.M. in taxation from the University of San Diego School of law and is a certified specialist in estate planning, trust and probate law by the State Bar of California. He has extensive experience in tax, trust and estate matters and business planning, for high net-worth individuals, including wealth transfer planning, income tax planning, corporate and partnership taxation, business succession planning, and international estate and tax planning. Scott also has vast experience in probate and trust administration, trust and probate litigation, and the structure and formation of nonprofit entities, including private foundations and public charitable organizations. Contact him at SHarshman@JMBM.com or 949.623.7224.
3 Id. at 138.
4 See, e.g., 2013 Greenbook at 79.
5 See www.whitehouse.gov for numerous “We Can’t Wait” for Congress executive orders and regulations.
6 Mayo Foundation for Medical Education & Research v. U.S., 131 S. Ct. 704 (2011), where the Supreme Court held that administrative convenience can justify the terms of a regulation and regulations are entitled to strong deference.
7 IR-2006-161 (October 17, 2006).
8 Rev. Rul. 2013-9, IRB 2013-15 (April 8, 2013).
9 Schaller and Harshman, LISI Estate Planning Newsletter No. 1933 (March 1, 2012) at http://www.leimbergservices.com.
10 Internal Revenue Code Section 675(4)(c).
11 Procrastinator-Proof Plan to Maximize 2012 Gift Exemption, Estate Planning 39:12, p. 10 (December 2012).
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