The U.S. Treasury Department’s long-awaited proposed changes to the tax code addressing valuation discounts were released the first week of August. Months later, reasonable minds still differ on what they mean. Numerous articles have proclaimed the impending elimination of valuation discounts, yet Treasury officials appear dismayed by such interpretation. There likely won’t be a middle ground – the impact will be material…or negligible. If negligible, one might ask why all the fuss?
The Big Picture for UHNW Families
These regulations are designed part to become effective when finalized1 and part 30 days thereafter. Because they are unclear as drafted, and may be revised, we simply can’t predict their ultimate impact. Regardless, the perspective for wealthy families is:
- Investments: No change. The rules are geared to impact valuation of interests in entities being transferred intra-family, so no asset allocation shift is triggered.
- Estate planning: No change. Families often use entities, and embed restrictions on those entities, for non-tax reasons, such as prohibiting business interests from being distributed in a divorce outside the family.
- Estate tax planning: Possible changes. These rules could undermine certain strategies that have become popular for high net worth families and immediate planning may be justified.
Who’s in Charge?
Internal Revenue Code Section 2704(a) treats lapses of voting and liquidation rights as deemed transfers. The proposed regulations seek to bolster these rules. Arguably, the most significant proposal is a three-year clawback.
This proposal aims at prohibiting discounts on “death bed” transfers by including some value in the estate of a transferor if, within three years of death,2 a transfer was made that reduced the decedent’s control over liquidating the entity. In other words, if an individual had voting authority to liquidate the entity before the transfer, but not after (and died within three years of the transfer), the event of death would be a deemed lapse, resulting in a phantom asset in her estate.
The calculation of the clawback is unclear, but at a minimum would include the discounts on the original transfer. Critically, because it is a phantom asset, no marital or charitable deduction would be available to defer or reduce taxation.
Protect Against a Surprise Increase in Value (and Tax)
IRC section 2704(b) provides that “applicable restrictions” are to be ignored in valuing family controlled entities. The proposed regulations seek to plug the gap created by the existing code’s reference to permit restrictions if a default under the law by only respecting mandatory state law restrictions (which are very unlikely).
A significant controversy is whether there is to be a deemed “put right” that would permit each owner to “cash out” and receive cash payment within 6 months equal to “minimum value” (for example, pro-rata net value of the underlying assets).
Summary of Planning Action Steps
Begun in 2003, Treasury took 13 years to draft these regulations, yet several material uncertainties exist. Until clarified, protect clients conservatively by:
- Completing contemplated and partial prior transfers.
- Modifying entity structure to mandate supermajority to force liquidation. Thus, when the client transfers ownership, she already wouldn’t have liquidation authority and ergo be outside the scope of the estate inclusion deemed lapse. Warning: applicable restrictions in pre-October 8, 1990 agreements may be grandfathered.
- Implementing tax apportionment clauses because the risk of unfairness due to increased transfer tax values has increased. Consider whether to apportion estate taxes to the recipients of the assets rather than the residue, or use “net-net” gifts.
- Using “self-adjusting” transactions to avoid a disruption to the estate plan from enhanced value, including GRATs and defined value clauses.
Complete By When?
Technically, the regulations could be finalized on December 31, 2016, but that seems unrealistic. Many instead predict the second quarter 2017.
Under the Federal Administrative Procedures Act, Treasury must respond to all comments when finalizing regulations. This doesn’t mean separate correspondence to everyone who commented; it’s often handled by specific categorical references in the preambles to final regulations. The anticipated volume of comments might further delay the finalization of the regulations.
Further, after January 20, 2017, there will be new appointees to positions that must “sign off” on the regulations. This also could delay finalization.
However, Chapter 14 regs were published merely 15 months after the statute. So, regardless of the probability of time beyond December 31 to act, there is the possibility that there may not be. Act fast, but only when appropriate. For while discounts are an important strategy in a planner’s tool kit, there are other options for clients that will remain available.
1. Three bills have already been introduced in Congress that would negate finalization of the proposed regulations.
2. If included in the final regulations, the measuring period might be shortened, perhaps to one year. After all, Congress has spoken as to what transfers are subject to a 3-year look-back (Internal Revenue Code Section 2035) and a one year period is sufficient to snarl deathbed transfers. There also is a potential that the final regulations will be clarified to capture only transfers initiated after finalization.