The House Ways and Means Committee’s attempt to legislate family limited partnership (FLP) valuation discounts out of existence has failed. On Oct. 28, the tax writers of the $1.75 trillion Build Back Better bill (also known as H.R. 5376) signaled that they didn’t plan to move forward with changes to the estate tax, grantor-retained annuity trusts and valuation discounts. Once again, the FLP valuation discount has shown its resilience.
We would like to think that the valuation discount persists because the arguments for eliminating it are wrong-headed and unsound. For politicians, closing tax “loopholes” certainly resonates when speaking to the masses, but, at the end of the day, any law passed by Congress should be based on sound economics. Any economic analysis must begin with and be framed by certain parameters or definitions. Herein lies the problem. The Internal Revenue Service and those that espouse the tax loophole argument rest on the notion of attribution. That is, the assumption that all fractional interest holders of a family-owned entity (here an asset holding, pass-through entity) will act in concert and at the direction of one individual. The attribution argument can prove true if there are facts to verify such behavior. Attribution can’t be presumed to be the basic nature of a family organization, however.
The valuation discount is an economic consequence of ownership of equity securities issued by various types of entities. These entities and their issued securities are all creatures of state law. The courts generally don’t subscribe to the attribution theory as they follow the provisions of state law dictating the rights, restrictions and privileges of individual equity owners. The economic foundation for the discount is the degree of control an equity holder has over the issuing entity. This power, or lack thereof, defines the probability of expected economic returns and, ultimately, this determines value.
What’s the Explanation?
So, is the soundness of the economic argument for the discount the explanation for why it always seems to escape the political grasp of those who portray it simply as a tax loophole? Probably not. The more likely reasons are more practical in nature.
First, eliminating the discount doesn’t raise much money for the national Treasury. In the case of the current Build Back Better bill, some claimed that eliminating valuation discounts would raise $20 billion over 10 years. If that’s the case, at $2 billion per year, it would seem the FLP valuation discount is hardly the egregious tax loophole it’s made out to be.
Second, the argument that the discount is a tax loophole used by the mega-wealthy to protect dynastic wealth may hit a little close to home to many on Capitol Hill. Wealth, it seems, is a non-partisan phenomenon. According to Forbes, America’s 50 wealthiest families hold about $1.2 trillion in assets. Based on a report from the Spectrem Group, in 2018, there were 173,000 U.S. households with over $25 million in net worth and there were 1,397,000 households with a net worth of between $5 million and $25 million. Where do you draw the line between “mega-wealthy” and just plain “wealthy”?
History of Repeated Attacks
The recent assault on the valuation discount from the Build Back Better bill is nothing new. The valuation discount associated with family businesses has been the subject of repeated attacks since the 1970s. These efforts aimed at bringing about its demise have been both legislative and regulatory.
In 1990, Congress added new tax law under Chapter 14 of the Internal Revenue Code. The Treasury published final regulations in 1992. The rules were designed to ensure that clever lawyering of family estate planning wouldn’t result in transfers at unreasonably low valuations. IRC Sections 2703 and 2704 required that transfer restrictions, which were more restrictive than the default provisions of state law, were to be disregarded. The IRS expected these regulations to result in very low or even no valuation discounts.
But this wasn’t to be. The courts, especially the U.S. Tax Court, found that substantial valuation discounts were appropriate under the fair market value (FMV) definition described in the tax regulations. The IRS complained of “gift on formation,” “disappearing value,” “recycled value” and “lack of business purpose” but, for the most part, these arguments proved ineffective. (To be sure, the IRS must deal with a lot of fraud and abuse. But, for those taxpayers who are trying to avoid taxes while staying tax compliant, the feeling is that they’re being tarred with the same brush as the tax evaders.)
On the magnitude of the FLP discount, the courts (without saying so) tended to more or less split the difference between the taxpayers and the IRS. Eventually, the body of knowledge created by these cases served to inform the discounts selected by the parties. The effect was to bring the magnitude of discounts down and lessen the gap between taxpayers and the IRS. Still, in the eyes of the IRS, the discounts were far too high.
The draconian estate tax provisions of the Build Back Better bill, especially the elimination of valuation discounts for nonbusiness assets and the “look through” rule, harken back to the Pomeroy Bill (also known as H.R. 436) introduced in 2009. (William Frazier, “The Pomeroy Bill Sledgehammer,” Trusts & Estates (May, 2009.)) That bill never made it out of committee but many of its provisions were later to be seen in the Obama Greenbooks of 2009–2012. Citing national income inequality and taxpayer non-compliance as the need for tax reform, the Greenbooks included valuation discounts as a target. The Greenbooks complained about adverse judicial decisions and the enactment of new statutes by state legislatures which had thwarted the intent of Chapter 14. However, with a divided Congress after the 2010 elections, very little was accomplished.
Proposed Section 2704 Regs
A more serious challenge was an expected change to the regulations governing Section 2704. After the regulation was finalized, a glitch was discovered that, contrary to congressional intent, would allow the Treasury to virtually prohibit any valuation discounts. Treasury made assurances that it would revise Section 2704 to address the problematic issues. For years, the tax community wondered when these changes would be issued and what would be in them. Finally, in 2016, Treasury unveiled REG-163112-02, better known as “Proposed Changes to 2704.” Initially, many tax experts reported that the changes to Section 2704 would result in the elimination of valuation discounts. While a more detailed analysis found that interpretation to be an overstatement, the proposed changes did point to significantly reduced discounts.
The logic of the valuation parameters of the revised Section 2704 seemed to follow some of the valuation methodology successfully employed by the IRS in Holman v. Commissioner, 130 T.C. 170 (2008). That is, FMV would be decided by a negotiation between the departing family member and the remaining partners. Furthermore, one of the negotiating parameters was that the price a non-family member might pay for the interest would set the lower boundary for the negotiations. The Holman decision was appealed to the Eight Circuit but was affirmed.
On Dec. 2, 2016, 37 speakers testified on the proposed changes to Section 2704. Of these, all but one were opposed or at least suggested significant changes. The backdrop to this event, however, was the November surprise of Donald Trump winning the presidential elections. On Oct. 2, 2017, Treasury Secretary Steven Mnuchin formally withdrew the proposed changes to the regulations.
With the legislative route having failed, it’s likely we’ll will see the return of the proposed changes to Section 2704. The Treasury has the authority to simply issue these regulations. However, after the loud outcry by taxpayers and their advisors in 2016, Treasury and the IRS unofficially committed to seriously considering making further revisions. When might this occur? Probably not soon. The Treasury/IRS review process is very thorough and must pass through and be approved at a number of levels. If this project has already been reactivated, the IRS is keeping very quiet about it.