In an always-anticipated annual tradition, Ronald Aucutt, a McGuireWoods partner and co-chair of the firm’s private wealth services group, has identified the following as the top ten estate planning and estate tax developments of 2016. Ron is a past president of The American College of Trust and Estate Counsel; an observer and frequent participant in the formation of tax policy and regulatory and interpretive guidance in Washington, D.C.; and the editor of the Recent Developments materials that are presented each year at the Heckerling Institute on Estate Planning.
Number Ten: Developments in Split-Dollar Life Insurance — the Morrissette Case
In 2006, when Mrs. Morrissette was 93, her revocable trust advanced about $30 million of premiums to dynasty trusts to buy life insurance on her sons’ lives under a split-dollar arrangement. The insurance proceeds were payable to the dynasty trusts, after payment to the revocable trust of the greater of the premiums advanced or the cash surrender value of the policies. Mrs. Morrissette’s gift tax returns for 2006 through 2009 reported gifts to the dynasty trusts of the cost of the current life insurance protection less premiums paid by the trusts. Upon Mrs. Morrissette’s death in 2006, her executors valued the expected reimbursements to her revocable trust (deferred to her sons’ deaths) at about $7.5 million.
Since the promulgation of final regulations in 2003, split-dollar life insurance arrangements have been governed by one of two different regimes — the “economic benefit” regime of Reg. §1.61-22 or the “loan” regime of Reg. §1.7872-15. Mrs. Morrissette’s gift tax treatment and her executors’ estate tax treatment were consistent with the “economic benefit” regime, and her split-dollar arrangements had even included the following recital:
WHEREAS, the parties intend that this Agreement be taxed under the economic benefit regime of the Split-Dollar Final Regulations, and that the only economic benefit provided to the [Dynasty] Trust[s] under this arrangement is current life insurance protection.
The IRS argued, in effect, that the value of the receivable in Mrs. Morrissette’s gross estate should be determined with reference to the “loan” regime, which presumably would produce a much higher value to be included in Mrs. Morrissette’s gross estate because interest would accrue on the $30 million advance.
In partial summary judgment, the Tax Court (Judge Goeke) agreed with the executors that the economic benefit regime applied because the dynasty trusts had received no economic benefit beyond the current life insurance protection. Estate of Morrissette v. Commissioner, 146 T.C. No. 11 (April 13, 2016). In effect, therefore, Mrs. Morrissette’s revocable trust was treated as the deemed owner of the policies, analogous to the “employer” deemed ownership in the employment context contemplated by the regulations.
The value of Mrs. Morrissette’s revocable trust’s right to repayment still needs to be addressed by the Tax Court or by settlement. That outcome may determine the true significance of the Morrissette holding and the true value of this intergenerational split-dollar technique. If the courts uphold a value of $7.5 million, compared to an outlay of $30 million, that would bode well for some intergenerational split-dollar arrangements.
Morrissette was followed with little additional analysis by Judge Holmes in Estate of Levine v. Commissioner, Tax Court Docket No. 9345-15 (order issued July 13, 2016). The IRS has retained the right to appeal both Levine (to the Eighth Circuit) and, of course, Morrissette, which is not yet final (to the Fourth Circuit).
Number Nine: Unannounced Apparent Changes in IRS Policies and Practices
There have been informal and anecdotal reports of changes in IRS policies and practices that could significantly affect the administration of estates and trusts. The IRS apparently has not made any formal announcements about these changes.
Waiver of Federal Estate Tax Liens. First, the IRS now refuses to issue a waiver of the federal estate tax lien before the estate tax is paid in full or it is determined that there is no tax due. This arguably is what section 6325 has always required, but executors and their advisers have been accustomed to getting waivers of federal estate tax liens fairly routinely about a week or two after applying for them. This new by-the-book approach reportedly took effect June 1, 2016 without any formal announcement, although a September 2016 revision of the Instructions for Completing Form 4422, Application for Certificate Discharging Property Subject to Estate Tax Lien, added a warning to “Submit your application at least 45 days before the transaction date that the certificate of discharge is needed.” This reported change could seriously affect the steps and precautions that executors must take when selling estate property.
GST Tax Letter Rulings. Second, the IRS National Office now declines to issue letter rulings regarding the generation-skipping transfer (GST) tax implications of the modification of a trust that was irrevocable on September 25, 1985, and is therefore “grandfathered” for GST tax purposes or a trust that is totally or partially exempt from GST tax by reason of the allocation of GST exemption. This change reportedly is driven by the need to conserve IRS resources. But if, in the absence of any formal announcement, the way a trustee is to learn of the new no-rule policy is to prepare and submit a full-blown ruling request — complete with exhibits, powers of attorney, declarations and checklists — only to have it returned without action, that would reflect an odd and unbalanced view of the conservation of resources.
The IRS compiles no-rule areas in the third Revenue Procedure published in the first Internal Revenue Bulletin each year, and, if it is necessary to supplement that compilation during the year, the IRS normally does that by a Revenue Procedure or perhaps by a Notice. Currently, Rev. Proc. 2016-3, 2016-1 I.R.B. 126, sec. 3.01(101) lists only “Whether a trust exempt from generation-skipping transfer (GST) tax under § 26.2601-1(b)(1), (2), or (3) of the Generation-Skipping Transfer Tax Regulations will retain its GST exempt status when there is a modification of a trust, change in the administration of a trust, or a distribution from a trust in a factual scenario that is similar to a factual scenario set forth in one or more of the examples contained in § 26.2601-1(b)(4)(i)(E)” under the heading of “Areas In Which Rulings Or Determination Letters Will Not Be Issued.” Now we will watch for Rev. Proc. 2017-3 to see if the new, expanded no-rule policy is included and the omission of any formal IRS announcement is thereby cured.
Number Eight: QTIP Elections on Portability-Only Estate Tax Returns
Rev. Proc. 2001-38, 2001-24 I.R.B. 1335, announced circumstances in which the IRS “will disregard [an estate tax QTIP] election and treat it as null and void” if “the election was not necessary to reduce the estate tax liability to zero, based on values as finally determined for federal estate tax purposes.” The procedure stated that it “does not apply in situations where a partial QTIP election was required with respect to a trust to reduce the estate tax liability and the executor made the election with respect to more trust property than was necessary to reduce the estate tax liability to zero.” The procedure stated that it “also does not apply to elections that are stated in terms of a formula designed to reduce the estate tax to zero.”
Thus, the paradigm case to which the procedure applied was the case where the taxable estate would have been less than the applicable exclusion amount anyway, so the estate would not be subject to federal estate tax, but the executor listed some or all of the trust property on Schedule M of the estate tax return and thus made a redundant QTIP election.
Rev. Proc. 2001-38 was a relief measure. The transitional sentence between the summary of the background law and the explanation of the problem was: “The Internal Revenue Service has received requests for relief in situations where an estate made an unnecessary QTIP election.”
With portability made permanent by the American Taxpayer Relief Act of 2012, an estate tax return to elect portability might be filed that is not necessary for estate tax purposes because the value of the estate is below the filing requirement. For such a return, the question arises whether a QTIP election, made only to support a reverse-QTIP election for GST tax purposes or to gain a second basis step-up at the death of the surviving spouse, might be treated as an election that “was not necessary to reduce the estate tax liability to zero” and therefore as “null and void.”
Rev. Proc. 2001-38 went on to state:
To establish that an election is within the scope of this revenue procedure, the taxpayer must produce sufficient evidence to that effect. For example, the taxpayer [the surviving spouse or the surviving spouse’s executor] may produce a copy of the estate tax return filed by the predeceased spouse’s estate establishing that the election was not necessary to reduce the estate tax liability to zero.
That requirement of an affirmative claim, coupled with the “relief” origin of Rev. Proc. 2001-38, suggested that a QTIP election would be respected unless the taxpayers themselves ask that it be disregarded. A revenue procedure announcing the IRS’s administrative forbearance cannot negate an election clearly authorized by statute anyway. Furthermore, the unseemliness of denying the benefits of a QTIP election to smaller estates while allowing it to larger estates also suggested that a QTIP election would be respected in the case of a portability-only return.
Not surprisingly then, in Rev. Proc. 2016-49, 2016-42 I.R.B. 462 (Sept. 27, 2016), the IRS retained the basic approach of Rev. Proc. 2001-38, but made it inapplicable to QTIP elections on estate tax returns filed only to elect portability. In addition to the surviving spouse’s estate tax return, Rev. Proc. 2016-49 identifies a supplemental estate tax return for the estate of the predeceased spouse and a gift tax return for the surviving spouse as two additional ways to claim relief from an unnecessary QTIP election. But it omits a letter ruling request as a way to seek that relief, which is consistent with the IRS effort to conserve ruling resources discussed under Number Nine.
Rev. Proc. 2016-49 states that in requesting relief:
Taxpayer must identify the QTIP election that should be treated as void under this revenue procedure and provide an explanation of why the QTIP election falls within the scope of section 3.01 of this revenue procedure. The explanation should include all the relevant facts, including the value of the predeceased spouse’s taxable estate without regard to the allowance of the marital deduction for the QTIP at issue compared to the applicable exclusion amount in effect for the year of the predeceased spouse’s death. The explanation should state that the portability election was not made in the predeceased spouse’s estate and include the relevant facts to support this statement.
The last sentence confirms that the repudiation of a QTIP election is not available in the case of a portability-only return, or even a required return in which portability is elected. That seems to be an overreaction. Because the relief of Rev. Proc. 2001-38 and now Rev. Proc. 2016-49 is aimed at QTIP elections that are unnecessarily and therefore inadvertently made, the implication is that there is less concern about mistakes in preparing an estate tax return on which portability is elected than a return that uses the entire exclusion amount. It is entirely possible that in most cases the opposite is true — that portability-only returns, for example, prepared in the context of the smallest estates, would be prepared with even less care than the returns for the largest estates. But executors and surviving spouses are now warned.
Number Seven: Business (Purpose) as Usual with Family Limited Partnerships — the Purdue, Holliday and Beyer Cases
Decided too late in 2015 to make last year’s Top Ten, Estate of Purdue v. Commissioner, T.C. Memo. 2015-249 (Dec. 28, 2015), was the first decided section 2036 case involving a family limited partnership (FLP) or LLC since 2012. Estate of Holliday v. Commissioner, T.C. Memo. 2016-51 (March 17, 2016), and Estate of Beyer v. Commissioner, T.C. Memo. 2016-183 (Sept. 29, 2016), became the second and third such cases.
In Purdue, Judge Goeke ruled that holding and managing marketable securities and a commercial building as “a family asset” was a “legitimate nontax motive” for transfers to a family-owned LLC, so the value of the LLC assets was not included in the transferor’s gross estate. The court pointed out that the decedent and her husband were not financially dependent on distributions from the LLC because she had retained substantial assets outside of the LLC, that there generally was no commingling of the decedent’s funds with the LLC’s funds, that the formalities of the LLC were respected, and that the decedent and her husband were in good health at the time the transfer was made to the LLC. The court did not attach any weight to the fact that the assets of the LLC included a building, and the building represented less than 4 percent of the value of the LLC assets anyway.
In Holliday, Judge Gerber held that the creation of a limited partnership to hold marketable securities 25 months before the decedent died was not a bona fide sale, and the decedent was held to have retained an interest under section 2036(a) because the partnership appeared to be operated essentially to meet the decedent’s needs. In effect, the partnership was administered not like a partnership, but more like a trust, and it was taxed accordingly.
In Beyer, Judge Chiechi upheld the assessment of gift and estate tax, plus even gift tax penalties, with respect to transfers to a family limited partnership.
Common to Holliday and Beyer was that the court believed that every benefit claimed for the FLP was offered or could have been achieved by the pre-existing trusts and other arrangements.
Cases like this typically apply the test of a “legitimate and significant nontax reason” articulated in Estate of Bongard v. Commissioner, 124 T.C. 95, 118 (2005). The Purdue, Holliday and Beyer cases demonstrate that the application of this test is subjective and fact-bound. Sometimes it is even viewed as judge-specific.
Number Six: Uncertainty About Defined Value Clauses — the Woelbing Cases
In Estate of Marion Woelbing v. Commissioner (Tax Court Docket No. 30260-13, petition filed Dec. 26, 2013) and Estate of Donald Woelbing v. Commissioner (Tax Court Docket No. 30261-13, petition filed Dec. 26, 2013), the Tax Court was asked to consider a sale to a grantor trust by Donald Woelbing, who owned the majority of the voting and nonvoting stock of Carmex skin care product maker Carma Laboratories, Inc., of Franklin, Wisconsin.
In 2006, Mr. Woelbing sold all his nonvoting stock for a promissory note with a principal amount of about $59 million (the appraised value of the stock) and interest at the applicable federal rate (AFR). The purchaser was a grantor trust that owned insurance policies under a split-dollar arrangement with the company. Two of Mr. Woelbing’s sons, who were beneficiaries of the trust, gave their personal guarantees, apparently for 10 percent of the purchase price.
The sale agreement provided for the number of shares sold to be adjusted if the IRS or a court revalued the stock (the defined value clause).
In its notice of deficiency, the IRS basically ignored the note, treating it as subject to section 2702, essentially viewing it as equity rather than debt. The IRS also doubled the value of the stock to about $117 million. These changes produced substantial gift tax deficiencies.
The IRS ignored the note for estate tax purposes, too, but included the value of the stock, then asserted to be about $162 million, in Mr. Woelbing’s gross estate under sections 2036 and 2038.
The IRS also asserted gift and estate tax negligence and substantial underpayment penalties.
The case was settled, and stipulated decisions were entered on March 25, 2016, and March 28, 2016, finding no additional gift taxes due with respect to either Mr. or Mrs. Woelbing and no additional estate tax due with respect to Mr. Woelbing’s estate. It has been informally reported that an agreed upward valuation adjustment in the settlement was reflected in an agreed downward adjustment in the number of shares Mr. Woelbing transferred in the 2006 sale, much as the defined value clause contemplated. In that case, the value of those shares would have been included in his gross estate, would have qualified for a marital deduction, and thus presumably would increase the size of Mrs. Woelbing’s gross estate and increase the amount of estate tax owed by her estate. The settlement with the IRS probably included her executors’ side agreement to make or accept those changes to her estate tax return.
The ninth item under the heading of “Gifts and Estates and Trusts” in the current Treasury-IRS Priority Guidance Plan is “Guidance on the gift tax effect of defined value formula clauses under §§2512 and 2511.” This project was new in 2015.
In affirming the Tax Court’s approval of a defined value clause in Estate of Petter v. Commissioner, T.C. Memo 2009-280, aff’d, 653 F.3d 1012 (9th Cir. 2011), albeit in the context of a rather narrow subpoint of a condition precedent within the meaning of Reg. §25.2522(c)-3(b)(1), the Court of Appeals for the Ninth Circuit concluded its opinion by quoting the Supreme Court:
“[W]e expressly invite[ ] the Treasury Department to “amend its regulations” if troubled by the consequences of our resolution of th[is] case.” Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 713 (2011) (quoting United Dominion Indus., Inc. v. United States, 532 U.S. 822, 838 (2001)).
In this guidance project, Treasury appears to be accepting that invitation. And perhaps the reason the IRS was so uncharacteristically willing to respect and implement the defined value clause in the Woelbing cases was that it knew it would have the last word in regulations.
Meanwhile, Tax Court petitions in another pair of “defined value” cases, Karen S. True v. Commissioner (Tax Court Docket No. 21896-16) and H.A. True III v. Commissioner (Tax Court Docket No. 21897-16), were filed October 11, 2016. H.A. True III is the son of the late H.A. True Jr. and, as his father’s executor, he had been the petitioner in Estate of True v. Commissioner, T.C. Memo. 2001-167, which involved buy-sell agreements, promissory notes and interest rates.
Number Five: Proposed Regulations on Consistency of Basis
Number Three in the 2015 Top Ten described the surprising July 31, 2015, enactment of the consistency-of-basis rules in section 1014(f) and the related reporting rules in section 6035 and concluded that, “enchanted by the siren song of ‘consistency’ — not to mention the temptation of a conjectural revenue gain — Congress seems not to have thought this through.” Thus, when proposed regulations were released March 2, 2016, it was almost inevitable that they would offer a mixture of nonsense and common sense. And so they do.
Disappointing Guidance. The nonsense was reflected in at least two provisions that have been roundly criticized for imposing burdens on taxpayers beyond what the statute authorizes. The first is that certain after-discovered and otherwise omitted property that is not reported on an initial or supplemental estate tax return before the estate tax statute of limitations runs (thus including all property and omissions discovered after the estate tax statute of limitations runs) is given a value, and therefore an initial basis, of zero. Proposed Reg. §1.1014-10(c)(3)(i)(B). Moreover, if the after-discovered or omitted property would have increased the gross estate enough to cause an estate tax return to be required, but no estate tax return was filed, the estate tax value of all property subject to the consistency rule is considered to be zero. Proposed Reg. §10.1014-10(c)(3)(ii). The statutory support for this punishment of heirs for possibly innocent omissions by executors is very questionable because such property appears to be neither “property the final value of which has been determined for purposes of the [estate] tax” within the meaning of section 1014(f)(1)(A) nor property “with respect to which a statement has been furnished under section 6035(a)” within the meaning of section 1014(f)(1)(B).
The second questionable burden, imposed by Proposed Reg. §1.6035-1(f), is a seemingly perpetual requirement that all recipients of a Form 8971 Schedule A, which is used to report the estate tax value of an asset to the recipient of the asset, must in turn file a Schedule A when making any gift or other retransfer of the property that results in a carryover basis in whole or in part for the transferee. The preamble to the proposed regulations cites the regulatory authority granted in section 6035(b)(2) and also a concern “that opportunities may exist in some circumstances for the recipient of such reporting to circumvent the purpose of the statute (for example, by making a gift of the property to a complex trust for the benefit of the transferor’s family).” While such property does indeed continue to have a basis determined in part with reference to the value at the time of someone’s death in the past, section 6035 by its terms appears to impose the reporting requirement only on the “executor,” and section 1014(a) itself appears to apply only to property acquired “from a decedent.” This creates great doubt about the statutory authority for Proposed Reg. §1.6035-1(f), especially when one of the explicit changes Congress made to Treasury’s longstanding legislative proposal on this subject was to omit the application to lifetime gifts.
In other exasperating details, Proposed Reg. §1.6035-1(c)(3) confirms the position previously taken in the Instructions to Form 8971, that Form 8971 and its Schedule A, which is used to report the estate tax value of assets to the recipients of those assets, are due 30 days after the estate tax return is filed. That is a harsh rule because an executor will rarely know that soon which beneficiaries will receive which assets. And giving every beneficiary a list of every asset the beneficiary might ultimately receive (as the proposed regulations and the Instructions suggest), aside from the wastefulness of it, seems almost certain to aggravate family discord where it exists or even create family discord where it did not otherwise exist. In any event, a beneficiary who has not yet received (and may never receive) the property has no use for basis information, and providing such information serves no discernable purpose of section 1014(f).
Moreover, like the Instructions, the preamble to the proposed regulations refers to “each beneficiary who has acquired (or will acquire) property from the decedent” and the statutory requirement of section 6035(a)(1) itself attaches only “to each person acquiring any interest in property.” It seems that the regulations could have carried that linguistic comparison to its logical conclusion by requiring Form 8971 and Schedule A only with respect to property that is distributed — that is, “received” or, in other words, “acquired.” In that case, section 6035(a)(3) would be construed to require reporting 30 days after the estate tax return is filed only for property passing upon death or distributed before the estate tax return is filed, whereas property distributed after the estate tax return is filed would be reported on a supplemented Schedule A after that distribution. Not only would that be a much more workable rule, but it arguably would stretch the words of the statute a lot less than do the zero-basis and successive-transfer burdens the proposed regulations would impose.
Encouraging Guidance. On the other hand, wrestling with a difficult statute, the proposed regulations offer some welcome common-sense respite. For example:
Only the “initial” basis of property received from a decedent is subject to these rules. Proposed Reg. §1.1014-10(a)(1). Subsequent authorized adjustments are not precluded. Proposed Reg. §§1.1014-10(a)(2) & 1.6662-8(b).
The consistency rules do not apply to tangible personal property for which an appraisal is not required under Reg. §20.2031-6(b) — generally, household and personal effects other than “articles having marked artistic or intrinsic value of a total value in excess of $3,000.” Proposed Reg. §1.1014-10(b)(2).
In addition to such tangible personal property, cash (other than a coin collection or other coins or bills with numismatic value), income in respect of a decedent, and property that is sold (and therefore not distributed to a beneficiary) in a transaction in which capital gain or loss is recognized are exempt from the reporting requirement and do not have to be included on Form 8971. Proposed Reg. §1.6035-1(b)(1).
Form 8971 is not required if the estate tax return was not required for estate tax purposes and was filed solely to make a portability election or a GST tax election or exemption allocation. Proposed Reg. §1.6035-1(a)(2).
A public hearing was held June 27, 2016, and the final regulations should be published by January 31, 2017. That is exactly 18 months after the enactment of the statute, which is the deadline, under section 7805(b)(2), for publishing regulations that are to be retroactive.
Number Four: Proposed Regulations Under Section 2704
Statutory Authority. Section 2704(b)(1) and (2) provide that defined “applicable restrictions” on the ability of a corporation or partnership to liquidate shall be disregarded in valuing an interest in the corporation or partnership for transfer tax purposes. Section 2704(b)(4) goes on to state:
The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this [the estate, gift, and GST tax] subtitle but does not ultimately reduce the value of such interest to the transferee.
While this grant of regulatory authority is unartful, it seems most likely to this observer that it contemplates a restriction that “has the effect of reducing the value of the transferred interest [solely] for purposes of this subtitle but does not [necessarily] reduce the value of such interest to the transferee.” Every restriction the statute contemplates must “reduce the value of such interest to the transferee”; otherwise, there would be no impact on value from disregarding that restriction. Therefore, the seemingly counterfactual reference to a restriction that “does not ultimately reduce the value of such interest to the transferee” must mean simply a restriction that could easily or just as well be removed when it no longer serves a transfer tax purpose. If so, the likely target is the ephemeral restriction that supports a discount until the estate or gift tax statute of limitations has run, but then can be removed with no harm to the underlying assets or to the family owners. Significantly, that should not apply in the case of a typical operating business because a redemption or partial liquidation of an operating business (in contrast to a portfolio of marketable securities, for example) would not simply make the business smaller, it would make it weaker and less competitive, and therefore, a restriction on such a redemption or partial liquidation could not easily or just as well be removed when the estate or gift tax statute of limitations has run.
Proposed regulations were released August 2, 2016, and published in the Federal Register August 4, 2016. 81 Fed. Reg. 51413-51425 (Aug. 4, 2016). Like the statute, the proposed regulations are not always artful and clear.
“Disregarded Restrictions.” Specified restrictions (called “disregarded restrictions”) are disregarded in valuing an interest for gift or estate tax purposes when that interest is transferred to a family member. Under Proposed Reg. §25.2704-3(b), a “disregarded restriction” is a “provision” (of the governing document or applicable law) that limits the ability of the holder of the interest to compel liquidation or redemption of that interest on no more than six months’ notice for cash or property equal at least to “minimum value.” “Property” may not include a promissory note, except in the case of certain “market interest rate” notes issued by entities engaged in an active trade or business. Proposed Reg. §25.2704-3(b)(1)(iv). “Minimum value” is generally the interest’s pro rata share of the net fair market value of the assets of the entity. Proposed Reg. §25.2704-3(b)(1)(ii).
Proposed Reg. §§25.2704-2(b)(4)(ii) & -3(b)(5)(iii) would limit the exception for “any restriction imposed or required to be imposed, by any Federal or State law” literally to really mandatory, unavoidable restrictions. Basically, this change would revert to the apparent meaning of the statute itself (section 2704(b)(3)(B)) and would walk back a lenient expansion of this exception in the 1992 regulations (Reg. §25.2704-2(b)) to mere default state law in the absence of an overriding provision in the governing document. There are undoubtedly some federal laws (maybe some securities laws) and some state laws (maybe consumer protection laws applicable to financial institutions) that have such a harsh effect, but for the most part, this change would limit “disregarded restrictions” to provisions of governing documents only.
Family Members’ Ability To Remove a Restriction. The appropriateness of interpreting section 2704(b)(4), and thus the regulations, with a view to a restriction that could easily or just as well be removed is reinforced by the acknowledgment in the proposed regulations that the threshold element is still the ability of family members to remove the restriction. Proposed Reg. §25.2704-3(b)(1). But, for this purpose, the proposed regulations would provide that interests held by nonfamily members, which otherwise might give those nonfamily members the power to prevent the removal of a restriction, are themselves disregarded unless those interests have been held for at least three years, represent at least 10 percent of the ownership of the entity (and 20 percent in the aggregate with other nonfamily members), and can be redeemed by the nonfamily holder on no more than six months’ notice. Proposed Reg. §§25.2704-3(b)(4)(i) & -3(b)(6). In other words, the nonfamily member’s interest must be substantial (reflected in the 10-percent and 20-percent requirements) and must be a willing and active investment (reflected in the decision to have stayed in for at least three years despite the ability to get out).
While all these attributes would never or rarely be found in a single nonfamily holder, a typical target of this rule is evidently a nominal interest held by a “captive” charity, which has neither the ability to bail out nor, because it is merely the beneficiary of a gratuitous gift, any incentive to rock the boat. An example would be the interest held by the University of Texas in Kerr v. Commissioner, 113 T.C. 449, 473 (1999), aff’d, 292 F.3d 490 (5th Cir. 2002), about which the preamble to the proposed regulations explicitly states that “taxpayers have avoided the application of section 2704(b) through the transfer of a nominal partnership interest to a nonfamily member, such as a charity or an employee, to ensure that the family alone does not have the power to remove a restriction. Kerr, 292 F.3rd at 494.”
Effect of Disregarding a Restriction. An important, although widely misunderstood, step in analyzing the proposed regulations is the effect of disregarding a “disregarded restriction” and particularly the role of “minimum value” in defining that effect. “Minimum value” is merely a part of the test to identify a “disregarded restriction.” “Minimum value” is not the minimum value for transfer tax purposes. The proposed regulations would not require the holder of any interest in any entity to have the right to redeem for “minimum value.” Nor would the proposed regulations require the interest to be valued as if the holder had such a right (widely referred to as a “deemed put” in discussions since the proposed regulations were published). Indeed, Proposed Reg. §25.2704-3(f) confirms this:
If a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise.
Thus, factors that cannot be disregarded and will still support discounts, if relevant, include:
the risk that the holder of the interest may be unable to negotiate a favorable buyout;
the risk a hypothetical willing buyer would incur in dealing with an unrelated family; and
the lack of ability to control or influence the operations or investments of the entity as a going concern.
And, in the case of a family-owned operating business:
the business plan, business environment, competition, illiquidity and the need for capital, unpredictability, and other obstacles to the business’s redemption of the interest;
the existence or loss of a key person in the business;
the fact, stated previously, that partial liquidation (redemption) makes a business not just smaller, but weaker and less competitive; and
the fact that the managers or majority owners of the business therefore may owe a fiduciary duty to the other owners to view a partial liquidation as not in the best interests of the business or the other owners.
Again, all that an appraiser is required or allowed to “disregard” under the proposed regulations is a provision in the governing document that purports to artificially make the interest less marketable and artificially enhance the discounts justified by the real factors listed above. Some commentators have appeared to view all of those factors and even governance facts of life such as the general partner’s power to control the limited partnership, in effect, as disregarded restrictions too. But the narrower view expressed in this Alert has been repeatedly affirmed as the intention of the drafters by persons in Treasury and the IRS who have participated in that drafting. And the consequence of not disregarding the factors listed above is that the proposed regulations would not affect family-owned operating businesses very much, and perhaps in most cases, not at all.
Lapses of Voting or Liquidation Rights Under Section 2704(a). In a surprising twist, the proposed regulations, which had been anticipated under the disregarded restriction provisions of section 2704(b), also make changes to the regulations under the lapsing voting or liquidation rights provisions of section 2704(a). The statute (section 2704(a)(1)) provides: “A lapse of any voting or liquidation right in a corporation or partnership … shall be treated as a transfer.” The 1992 regulations (Reg. §25.2704-1(c)(1)), again leniently, provide: “A transfer of an interest that results in the lapse of a liquidation right is not subject to this section if the rights with respect to the transferred interest are not restricted or eliminated.” And, again, a proposed amendment would walk back that leniency if the transferor dies within three years, which the preamble describes as a “bright-line” test for identifying when “the loss of the power to liquidate occurs on the decedent’s deathbed.” The proposed amendment to Reg. §25.2704-1(c)(1) provides:
The lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor’s death is treated as a lapse occurring on the transferor’s date of death, includible in the gross estate pursuant to section 2704(a).
This raises a number of questions about when and how the lapse is valued, whether a marital deduction is available if the transferee was the decedent’s spouse, whether any property involved gets a new basis under section 1014, and whether and how the lapse might affect the eligibility of the estate for special tax treatment such as the treatment provided by sections 2032A and 6166.
Effective Dates. Under Proposed Reg. §25.2704-4(b)(1), the provisions applicable to the lapse of voting and liquidation rights will “apply to lapses of rights created after October 8, 1990, occurring on or after the date these regulations are published as final regulations in the Federal Register.”
Because the proposed amendment to Reg. §25.2704-1(c)(1) treats certain transfers during life as lapses “occurring” on the transferor’s date of death, and the regulations are proposed to apply to transfers “occurring” after the date the regulations are finalized, it looks like the three-year rule would apply to inter vivos transfers before the effective date of the regulations if the transferor’s death within three years occurs after the effective date. Again, persons in Treasury and the IRS who participated in drafting the proposed regulations have stated that that was not their intention.
The new rules for “Disregarding Certain Restrictions on Redemption or Liquidation” (Proposed Reg. §25.2704-3) will not take effect until 30 days after the date the regulations are published as final regulations. This follows 5 U.S.C. §553(d), the provision of the Administrative Procedure Act rule applicable to “substantive” regulations.
Number Three: Reaction to the Proposed Section 2704 Regulations
Intensity of the Controversy. Who can deny that in 2016 the public reaction to the proposed section 2704 regulations has been even more fascinating than the proposed regulations themselves? I have never seen a dialogue about proposed regulations overcome with such unfounded concerns. The idea that every interest in a family-owned entity must be valued as if it had a put right — the “deemed put.” The ideas, flowing from the deemed-put notion, that every interest has to be valued at “minimum value” and that all valuation discounts are wiped out. Even the idea that the proposed regulations are aimed at the family-owned operating trade or business.
In my opinion, these ideas overlook some simple facts about the proposed regulations. The fact that the only thing that can be a “disregarded restriction” is a written provision of a governing document (or, rarely, applicable law) specifically restricting redemption of an individual’s interest. The fact that “minimum value” is only part of the test to identify a “disregarded restriction” and has no direct bearing on the estate or gift tax value. The fact that disregarding a written provision restricting liquidation would still leave many other substantial barriers to liquidation that would justify significant discounts. And, perhaps most surprising of all, the unwillingness to be persuaded even by assurances from participants in the drafting of the proposed regulations about what they intended and how they would make sure that any final regulations are clarified.
Climate of Cynicism. One explanation might be found in the history of the proposed regulations. Section 2704 was enacted in November 1990, the first regulations were finalized in January 1992, and this formal regulation project was launched in 2002. In 2009, 2010, 2011 and 2012, Treasury’s legislative proposals in connection with the Administration’s budget proposals, contained in the annual “General Explanations of the Administration’s Fiscal Year … Revenue Proposals” (popularly called the “Greenbook”), included a proposal to “Modify Rules on Valuation Discounts” by strengthening Treasury’s regulation authority.
Then, on February 12, 2013, in his first State of the Union Address since his re-election, President Obama, referring to issues involving the environment and climate change, said:
Now, the good news is we can make meaningful progress on this issue while driving strong economic growth. I urge this Congress to get together, pursue a bipartisan, market-based solution to climate change, like the one John McCain and Joe Lieberman worked on together a few years ago. But if Congress won’t act soon to protect future generations, I will.
People heard with disproportionate clarity this perceived promise by the President to use his “executive pen” — perhaps, it was thought, to do unilaterally what Congress had not authorized. Owners of small businesses, sometimes feeling especially burdened by federal regulation, including environmental regulation, heard the challenge. Persons already wary of — or downright hostile toward — the Obama Administration saw this as more confirmation of their suspicions. And a call for a certain type of response to climate change ended up creating or aggravating a climate of cynicism.
Then, less than two months later, on April 10, 2013, the 2013 Greenbook was published with the proposal for congressional cover for valuation regulations omitted.
And on August 9, 2013, the 2013-2014 Priority Guidance Plan was published, with the section 2704 regulation project still included, proving to some that the Administration fully intended to go ahead with promulgating regulations without the congressional cover that Treasury had admitted it needed in the 2009, 2010, 2011 and 2012 Greenbooks.
Of course, such cynicism did not indulge the possibility that, without congressional cover, the proposed regulations would be dialed back to omit the most ambitious elements for which additional authority had been sought while limiting the proposed regulations to actions that section 2704(b)(4) already authorized. Instead, long before the proposed regulations were even released on August 2, 2016, the narrative was building in some circles that the regulations would exceed the statutory authority. In those circles, when the proposed regulations were published, readers simply saw what they had been expecting.
Oops! What Were They Thinking? But not all criticism of the proposed regulations has been unwarranted. The design and wording of the proposed regulations themselves have fueled the concerns about their breadth.
For example, the simple use of the term “disregarded restrictions” has fed the overreach narrative. That was the same term used in the Greenbooks, which stated:
This proposal would create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family. Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.
The current authority in section 2704(b)(4), of course, is only to “provide that other restrictions shall be disregarded.” There is no authority to “substitut[e] for the disregarded restrictions certain assumptions to be specified in regulations.” But that was the Greenbook model. Some government people working on the regulations even said publicly before the proposed regulations were published that the Greenbooks could be consulted as an indication of their thinking. And it is only reasonable to assume that their view of the necessary changes would not fundamentally change to something else merely because they dropped the Greenbook proposal. All these things combined to create an expectation of “substituting … certain assumptions.” Of course, the convenient substituted assumption perceived in the proposed regulations was the “deemed put.”
Another convenient substituted assumption is “minimum value.” Although a careful reading shows that what the proposed regulations call “minimum value” is not a minimum value for transfer tax purposes, the confusion is understandable, if not inevitable.
Earlier, in Number Seven, this Alert quoted Proposed Reg. §25.2704-3(f) as confirmation that the proposed regulations do not contemplate a “deemed put”:
If a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise.
But if, as it seems the drafters intended, “disregarded restrictions” include only “provisions” in the governing documents, or in rare cases governing law, why would they add the word “otherwise”? Similarly, the preamble includes the following paragraph:
Finally, if a restriction is disregarded under proposed §25.2704-3, the fair market value of the interest in the entity is determined assuming that the disregarded restriction did not exist, either in the governing documents or applicable law. Fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums, subject to the assumptions described in this paragraph.
The word “assumptions” in the second sentence has to be merely a reference to the concept of “assuming that the disregarded restriction did not exist” in the first sentence. But why use the plural word “assumptions” for that? And, again, “assumptions” is the same word Treasury used in the Greenbooks to seek the congressional authorization it never received to mandate that “the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.” Again making confusion practically inevitable.
And while the proposed regulations do not intend that valuations assume a “deemed put,” it certainly doesn’t help that the definition that some have confused with a “deemed put” (Proposed Reg. §25.2704-3(b)(1)) is essentially the same as the definition of the actual put right (Proposed Reg. §25.2704-3(b)(6)) that a nonfamily holder of an interest must have for that interest to be respected (Proposed Reg. §25.2704-3(b)(4)(i)).
Thus, when commentators who have tried to read the proposed regulations as they were intended nevertheless call on Treasury and the IRS to clarify the wording, we could very understandably be accused of substantial understatement. (But, of course, not to be confused with a “substantial understatement” that gives rise to an accuracy-related penalty under section 6662!)
Contemporaneous Political Statements. Pouring fuel on the flames of suspected overreaching, when the proposed regulations were released, Assistant Secretary of the Treasury for Tax Policy Mark Mazur stated:
Today, the U.S. Department of the Treasury announced a new regulatory proposal to close a tax loophole that certain taxpayers have long used to understate the fair market value of their assets for estate and gift tax purposes.
Even the White House chimed in:
The Obama administration has made considerable progress over the past eight years to make our tax code fairer. This week, the Treasury Department is building on that progress through proposed new rules closing a loophole that allows some wealthy families to avoid paying their fair share in estate taxes.
It is easy to imagine the cynics saying, “See, there they go.”
Inevitable Political Fallout. Of course the uproar over what it was believed the proposed regulations were meant to do reached the halls of Congress, and bills were introduced to block the regulations. H.R. 6042, introduced on September 15, 2016, by Rep. Jim Sensenbrenner (R-WI), states:
Regulations proposed for purposes of section 2704 of the Internal Revenue Code of 1986 relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes, published on August 4, 2016 (81 Fed. Reg. 51413), and any substantially similar regulations hereafter promulgated, shall have no force or effect.
And the “Protect Family Farms and Businesses Act,” H.R. 6100, introduced in the House of Representatives on September 21, 2016, by Rep. Warren Davidson (R-OH), and S. 3436, introduced in the Senate on September 28, 2016, by Senator Marco Rubio (R-FL), states:
The proposed regulations under section 2704 of the Internal Revenue Code of 1986 relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes, published on August 4, 2016, in the Federal Register (81 Fed. Reg. 51413) shall have no force or effect. No Federal funds may be used to finalize, implement, administer, or enforce such proposed regulations or any substantially similar regulations.
This, plus the likelihood that this is one of the “Obama Administration overreaches” on the list of President-elect Trump’s transition team to undo or stop on his first day in office, leave the future of the regulation project greatly in doubt.
The December 1, 2016, IRS Hearing. More than three dozen members of the public spoke to four Treasury and IRS panelists at the public hearing on December 1, 2016. The government panelists were patient and seemed committed to being responsive in the final regulations. In response to the very first speaker, they emphasized on the record that there is no intended put right and no intention to make the three-year rule retroactive, and that those points would be made absolutely clear in the final regulations. Even so, apparently motivated by deemed-put and other eliminate-all-discounts alarms that were heard so soon and so persistently after the proposed regulations were released, many appraisers argued that the proposed regulations would rewrite the rules, redefine fair market value, and leave appraisers with no comparables or relevant market data.
Many small business owners — and lawyers, CPAs and trade association representatives speaking on their behalf — stressed the importance of family-owned businesses and the challenges of business succession, and asserted that their businesses might not survive these regulations and that the proposed regulations far exceed the statutory authority. They were clearly sincere, and their compelling stories, even if inapplicable to the true, limited intended scope of the regulations, were definitely worth hearing by both the government panelists and the public audience. If the regulation project falls victim to the loud rhetoric it has generated, an opportunity to provide now the real clarity and reassurance these citizens need and deserve through revision or reproposal of the proposed regulations will have been lost.
Number Two: House Republicans’ Tax Reform “Blueprint” of June 2016
On June 23, 2016, House Republicans, led by Ways and Means Committee Chairman Kevin Brady (R-TX) and Speaker Paul Ryan (R-WI), released “A Better Way: Our Vision for a Confident America,” which they called their “Blueprint” for tax reform. With new life gained from the 2016 election, this Blueprint is likely to be the principal vehicle for consideration of fundamental tax reform in 2017.
The Blueprint announces:
This Blueprint will achieve three important goals:
It will fuel job creation and deliver opportunity for all Americans.
It will simplify the broken tax code and make it fairer and less burdensome.
It will transform the broken IRS into an agency focused on customer service.
It is significant that “the broken IRS” is essentially given equal billing with the U.S. economy and the Internal Revenue Code. Tensions between Republican congressional leaders and the IRS have been very severe, have resulted in significant and (to many observers) unwise cuts in the IRS budget, and are likely to be a distraction as leaders rush to put together the kind of tax legislation the Blueprint envisions.
The Blueprint would collapse the seven individual income tax brackets into three (with rates of 12, 25 and 33 percent); increase the standard deduction; eliminate all itemized deductions except home mortgage interest and charitable contributions; repeal the alternative minimum tax; and “continue the current incentives for [retirement] savings” (presumably retaining the current treatment of “stretch IRAs”). On the business tax side, it would place a lot of emphasis on expensing capital investments, deny deductions for net interest expense, repeal the corporate alternative minimum tax, and limit the offset of carried-forward net operating losses to 90 percent of net taxable income determined without regard to the carryforward. (This would leave 10 percent of that current income still taxable despite the NOL carryforward, possibly a reaction to criticism of President-elect Trump’s use of large NOLs reported during the campaign.)
Regarding the estate tax, the Blueprint states simply:
This Blueprint will repeal the estate and generation-skipping transfer taxes. This will eliminate the Death Tax, which can result in double, and potentially even triple, taxation on small businesses and family farms.
The omission of the gift tax is certainly deliberate.
In contrast, the Trump Campaign website stated, somewhat cryptically:
The Trump Plan will repeal the death tax, but capital gains held until death and valued over $10 million will be subject to tax.
Number One: The 2016 Election — Implications for Tax Reform
The most conspicuous development of 2016, affecting many areas of public policy including tax policy, is clearly the 2016 election, most notably the election of President-elect Donald Trump and the retention of Republican control of the Senate.
While tax reform is discussed almost every four years, and it is harder to do than it sometimes sounds, the talk this year is serious. With control of both Houses of Congress barely changed and the surprising capture of the White House, Republican leadership will be under enormous pressure to produce very significant tax legislation in 2017 by the August recess because now they can, and because, with no excuses left, they must. The June 2016 Blueprint summarized in Number Two of this Alert, which Ways and Means Chairman Kevin Brady has described as 80 percent in sync with President-elect Trump’s campaign’s plan and to which the President-elect’s transition team seems largely willing to defer, will be the likely vehicle.
It might be assumed that the Republican leadership would want some Democratic votes. After all, they made such a big deal of the enactment of the Affordable Care Act without a single Republican vote. But memories are short. In any event, it is not clear that the Republican leadership would want Democratic votes so much that they would try to get 60 total votes in the Senate to “call the question” on regular legislation. A few bipartisan votes are fine, but not so desirable that the leadership would really want to “negotiate” or to concede much to get them. That leaves the process of “budget reconciliation” as the likely process, especially for a clearly fiscal agenda like tax legislation. But while “reconciliation” famously does not need 60 votes in the Senate, the 60-vote requirement cannot be avoided just by using the label “reconciliation.” There must first be a “budget resolution,” setting out broad guidelines for the inputs of multiple committees that will be brought together and “reconciled.” If that budget resolution is not passed by March, or perhaps April, tax reform will be behind schedule.
Budget reconciliation can be used only once a year. It is limited to fiscal matters. And it is limited further by constraints like the impropriety of affecting budget outcomes beyond an arbitrary budget window — most recently ten years. We all remember (or have heard about) the peculiar one-year “repeal” of the estate tax that was enacted in budget reconciliation in 2001. Sunsets are not inevitable. There are workarounds. The Taxpayer Relief Act of 1997 was also enacted through budget reconciliation, with substantial permanent estate tax cuts. But both 1997 and 2001 presented much different fiscal environments. In June 2001, when the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was enacted — before 9/11, Afghanistan, and Iraq — budget surpluses of trillions of dollars were forecast for the coming decade. EGTRRA included only a modest one and one-third trillion dollars of tax cuts! Today, the forecasts are only more deficits.
Predictions are hard. The Trump Administration, and the political tone it sets, will not be conventional. There are no useful behavioral baselines. The fiscal climate is grim. And Republican leaders have many priorities and many diverse and sometimes combative constituencies to which they have made many promises.
All anyone can do is guess. With that in mind:
The technical paths to permanent repeal of the estate tax are complicated and maybe risky to Republicans (especially to the extent they need Democratic support).
The unexpected surge of disillusioned middle-class voters that propelled President-elect Trump to victory may not be very excited about the estate tax.
The attractiveness of repeal even to traditional supporters may be blunted by the prospect of having to keep the gift tax, or having to deal with a scary new capital gain or basis regime, and attempts to “have it all” will cost still more and look still more greedy.
Conclusion: Repeal of the estate tax in 2017, permanently or temporarily, would require political capital that the Republican leadership will probably decide to spend elsewhere. A compromise reduction of rates by 5 or 10 percent is possible, and even with high exemptions, there might actually be some justification in tax policy for bringing transfer tax and income tax rates closer together. But that, too, would look expensive and possibly too greedy.
All anyone can do is guess.