Recent Estate And Gift Tax Changes Require Immediate Action
AUGUST 22, 2016
The Internal Revenue Service has issued proposed regulations that would effectively end the common practice of discounting the value of interests in “family limited partnerships” and other family controlled entities (this article refers to all such entities as “FLPs”).
If finalized without substantial change, the regulations would apply not only to entities formed to hold passive assets for estate planning purposes, but also to family entities with active business operations.
Fortunately, taxpayers can benefit from the existing rules by engaging in FLP planning before the regulations become effective in 2017.
What is the IRS trying to stop?
The name of the game in estate planning is reducing the value of the taxable estate. FLP transactions that generate valuation discounts are among the most popular estate-reduction techniques. The IRS has long taken the view that these transactions, particularly those involving “deathbed” transfers and FLPs that hold passive assets, are purely tax-motivated transactions undeserving of any tax benefit, although they have generally lost on this point in court (thus necessitating the proposed regulations). These transactions typically arise in one of two typical fact patterns.
In the first, the remaining parent is ill and wants to reduce the value of his or her estate before death. He or she contributes assets to a FLP. He or she then transfers a small amount of interest, say a 10% general partner interest and 26% limited partner interest, which would make it impossible for the parent to liquidate the company by himself, to the children (or trusts for their benefit). On the estate tax return, the decedent parent will claim a reduction in the value of his interest of between 20-50% from the value of his share of the underlying assets. The discount is based on fundamental valuation principles that assets are worth less when they are held in an entity over which the owner does not have control (a “minority” or “lack of control” discount) and for which there is no ready market (“lack of marketability” discount). The size of the discount depends on the nature of the underlying assets, with marketable securities generating the smallest discounts (typically, between 20-25%) and real estate and other illiquid assets generating the larger discounts (between 40-50%).
In the second, one or both parents form an entity and contribute assets that are likely to appreciate in value. They then gift the limited partner interests (or nonvoting stock, or LLC interests without management rights) to their children (or irrevocable trusts for their benefit). On the gift tax return, the parents report the gift tax value of the all of the limited partner interests at a 20-50% discount from the value of the underlying FLP assets based on minority and lack of marketability discounts. The assets are thus removed from the estate with a reduced gift tax hit (or no gift tax if the amount of the gift falls within the lifetime gift exclusion (the first $10.9 million of lifetime gifts are shielded from gift tax for married couples). A popular variation on this theme is to gift a small amount of cash to the children or their trusts and have them purchase the limited partnership interests with that cash as a down payment and issue a promissory note for the balance. This allows taxpayers to “leverage” the gift and remove more value from their estate with a comparatively smaller gift tax effect.
How successful are these transactions in reducing estate taxes? In 2009, the Obama administration’s “Green Book” budget proposal, which contained the seeds of the proposed regulations, estimated that the change in law now codified in the proposed regulations would generate $19 billion in revenue over 10 years.
How do the new rules work?
First Fact Pattern: The rules would address the first fact pattern by disregarding all transfers or lapses of liquidation rights that occur within 3 years of the death of the party who gave up the liquidation right. In our example, if the parent were to die within three years of the transfer, he would be treated as holding the right to liquidate the company. In that case, there should be no valuation discounts on the estate tax return, because a hypothetical buyer could immediately force the company to liquidate and acquire the underlying assets.
Second Fact Pattern: While current law provides that restrictions on liquidation are disregarded in the FLP valuation context, the statute contains an exception for restrictions that are no more restrictive than state law. The second fact pattern generates deductions because of state laws that limit the ability of a limited partner to liquidate the FLP or his interest in the FLP. The proposed regulations would change that result unless the state law rule is mandatory (currently, the state law rules are mere defaults that can be modified by the partnership or other entity governing agreement).
In addition to relying on the state law exception, taxpayers have given charities nominal interests that give the charity the right to veto a liquidation of the company and then argued that the taxpayers are entitled to discounts because the family does not control liquidation. The proposed regulations would put an end to this planning as well, unless the interest held by the charity is substantial (at least 10% of the value of all equity interests) and meets certain other requirements.
It is important to note that the proposed rules would apply with equal force to non-tax motivated business succession planning by which governance of the family business is passed on to the next generation. It can be anticipated that the IRS will receive comments to exclude this situation from the scope of the final regulations but the IRS can ignore these comments.
What can taxpayers do?
Taxpayers have until the end of the year to engage in FLP planning. If, after consulting their tax advisors, they decide to do such planning, it will have to be done with the utmost care, given the IRS’s sensitivity to the issue. Other techniques should be considered as well, including those that could be the next dominoes to fall if Democrats have their way, including short-term grantor retained annuity trusts (GRATs).
Michael Kosnitzky is a partner in charge of Boies, Schiller & Flexner's Tax and Middle Market practice groups.
Matthew Kaden is a Miami-based corporate and tax associate at Boies, Schiller & Flexner LLP.
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