Wealth Inequality, COVID-19, Recession, The 2020 Election & The Estate Tax

Farrell Fritz, P.C.
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Politics and Wealth Inequality

As we approach the presidential convention season,[i] and the election campaign that will follow, the thoughts of many business owners have turned to the federal estate tax, and for good reason.[ii]

After the Great Recession of 2007-2009,[iii] the economy enjoyed a period of sustained growth of approximately 11 years, which ended only recently thanks, in large part, to the economic shutdown. During this time, however, many economists observed a significant increase in “wealth inequality,” whether measured in terms of income or net asset value.

Perhaps more importantly, the general public became more aware of, and attuned to, the wealth gap that almost everyone recognizes is a “natural” by-product of economic activity.[iv] Indeed, it was during this period that the catchphrases “the one percent” and “the 99 percent” entered our lexicon; more recently, “the 0.10 percent” was introduced to refer to really big earners.[v]

Ironically, to many, during this same period the federal estate tax rate and the federal exemption amount have been travelling in somewhat different directions, with the rate remaining steady while the exemption amount has been increasing, especially following the doubling of the basic exemption amount beginning in 2018.[vi] (See the table below, which indicates tax year, exemption amount, and tax rate.)

2007 $2 million 45%
2008 $2 million 45%
2009 $3.5 million 45%
2010 No tax – elective
2011 $5 million 35%
2012 $5.12 million 35%
2013 $5.25 million 40%
2014 $5.34 million 40%
2015 $5.43 million 40%
2016 $5.45 million 40%
2017 $5.49 million 40%
2018 $11.18 million 40%
2019 $11.4 million 40%
2020 $11.58 million 40%

The COVID-19 Shutdown

Thus, as we started 2020, a married couple could pass along a taxable estate worth over $23 million without incurring any federal estate tax liability. If the couple’s assets included a closely held business, it is likely that its “actual” value[vii] was somewhere north of the amount shown on the federal estate tax return.[viii] If one or both members of the couple created irrevocable life insurance trusts (“ILITs”) to acquire life insurance on their lives,[ix] then a substantial sum of cash may also be passed upon the death of the insured(s) without triggering any estate tax.[x]

Enter the quarantine[xi] and economic shutdown. The federal government has already dedicated almost $6 trillion in response to the shutdown, the states have spent several billion on their own, and it is a near certainty that still more will have to be expended, both to bolster the economy and to support the millions of individuals in need of financial assistance.

Add to this dire fiscal situation the President’s “disapproval” rating, the realistic possibility that the Democrats may take the Senate while retaining control of the House,[xii] plus the strong influence of a reinvigorated Democratic left, and you have an environment in which the revival of the federal estate tax as a tool for generating meaningful revenue,[xiii] and of “redistributing wealth,” may be an attractive option both politically and economically.[xiv]

Because of these developments, many business owners are starting to believe that their ability to transfer significant amounts of wealth to their family may become severely restricted after 2020.[xv]

For these individuals, the 2020 year-end holiday gift season may start early and run through the final day of the year.[xvi]

Regardless of which gifting vehicle a business owner decides to use in shifting equity in their business[xvii] – and the future appreciation thereon – out of their estate and into the hands of their family (and perhaps future generations), the economic benefit of the transfer will depend in large part upon the valuation of the business interest.

Valuation of Transferred Business Interests

The fair market value of an interest in a closely held business is a question of fact; according to IRS regulations, it is the price at which the interest would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts and circumstances.[xviii] These relevant facts and circumstances include whether discounts for lack of control and lack of marketability are factored into the fair market value of an interest in the closely held entity.[xix]

In resolving valuation issues, a taxpayer, the IRS and a court will usually consider the opinion of an expert. The court, for example, will weigh an expert’s opinion in light of the expert’s qualifications and credible evidence – it has relatively broad discretion to evaluate the expert’s analysis. If the court finds one expert’s opinion persuasive, it may accept that opinion in whole or in part over that of the opposing expert. Alternatively, the court may reach “an intermediate conclusion as to value” by drawing selectively from the testimony of various experts.[xx]

Although the valuation process relies upon the analysis of objective data, the conclusions drawn therefrom are inherently subjective and will necessarily depend upon the experience of the appraiser and the exercise of their professional judgement. In other words, competent appraisers may reasonably disagree and arrive at different conclusions of value.

Defined Value Clause

This uncertainty has been the reason for the volume of gift and estate tax valuation disputes brought before the U.S. Tax Court. It is also the reason many taxpayers – especially one making a gift the value of which may exceed the taxpayer’s remaining exemption amount, thereby triggering a tax liability – have sought to limit the degree of uncertainty by utilizing a so-called “defined value clause” (“DVC”) in connection with a gift of property that is difficult to value, including an equity interest in a closely-held business.

A DVC may be used where the donor seeks to keep the value of the gift at or below their remaining gift tax exemption amount. In order to accomplish this goal, the gift may be phrased in terms of “that number of units which have an aggregate dollar value on the date of transfer that is equal to my remaining federal exemption amount” – in other words, the transfer of a fixed dollar amount. In the event the IRS successfully determines that the value of the shares of stock or partnership units gifted by the taxpayer exceeds the taxpayer’s available exemption amount, the DVC provides that some of these shares or units would be “returned” to the taxpayer, as if they had never been transferred – the taxpayer transferred only an amount equal to the exemption amount.[xxi]

Although this formulation sounds relatively straightforward, the courts continue to address situations in which the IRS has thought it worthwhile to challenge the taxpayer, as was demonstrated by a recent decision of the U.S. Tax Court in which the issue presented was whether the taxpayer had transferred a fixed dollar amount of interests in a partnership or a percentage interest in such partnership.[xxii]

Percentage or Fixed Value?

Taxpayer was a partner in Partnership. Taxpayer formed Trust for the benefit of their spouse and children. Taxpayer then transferred interests in Partnership to Trust. The first transfer (in late 2008) was a gift. The memorandum of gift provided as follows:

[Taxpayer] desires to make a gift and to assign to [the Trust] her right, title, and interest in a [partnership] interest having a fair market value of [$2.096 million] as of December 31, 2008 * * *, as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.

Taxpayer structured the second transfer (in early 2009, just a few days after the first one) as a sale.[xxiii] The memorandum of sale provided:

[Taxpayer] desires to sell and assign to [the Trust] her right, title, and interest in a [partnership interest] having a fair market value of [$20 million, as determined by a qualified appraiser within [180] days of the effective date of this Assignment.

Neither the memorandum of gift nor the memorandum of sale (collectively, the “transfer instruments”) contained clauses defining fair market value or subjecting the partnership interests to reallocation after the valuation date.

Taxpayer retained an appraiser to value Partnership in connection with the transfers. Because the transfers occurred so close together, the appraiser used the same date for valuing both transfers. On the basis of this valuation, it was determined that Taxpayer’s two transfers equated to 6.14 percent and 58.65 percent of the interests in Partnership, respectively.[xxiv]

Partnership’s agreement was amended to reflect transfers of partnership interests of 6.14 percent and 58.65 percent from Taxpayer to Trust.[xxv] Partnership reported the reductions of Taxpayer’s partnership interest and the increases of Trust’s interests on the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., attached to Partnership’s Forms 1065, U.S. Return of Partnership Income. Partnership also made a proportional cash distribution to Trust based upon its 64.79 percent interest, which in turn was based on the appraiser’s valuation.

Tax Returns and Examination

Taxpayer filed IRS Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Returns, for 2008 and 2009. On their 2008 Form 709 they reported the gift to the Trust “having a fair market value of $2,096,000 as determined by independent appraisal to be a 6.1466275% interest” in Partnership. Taxpayer did not report the 2009 transfer of the interest in Partnership on their 2009 Forms 709, consistent with its treatment as a sale.

The IRS examined Taxpayer’s gift tax returns and asserted deficiencies based on a greater value for Partnership.[xxvi] Taxpayer sought to negotiate a settlement agreement with IRS Appeals, but it was never completed. However, on the basis of these discussions with IRS Appeals regarding Partnership’s fair market value, Taxpayer amended Partnership’s agreement to record Trust’s interest in Partnership, based on a transfer of $22.096 million of value, as 38.55 percent (rather than 64.79 percent)[xxvii] and made corresponding adjustments to the partnership’s and the trust’s books. Partnership also adjusted prior distributions[xxviii] and made a subsequent proportional cash distribution to its partners to reflect the newly adjusted interests.

The IRS issued notices of deficiency in which it determined that Taxpayer had undervalued the 2008 gift. The IRS also determined that Taxpayer had undervalued the 2009 transfer, resulting in a part-sale, part-gift.

The Gift Tax

The Court began by explaining that the gift tax is imposed upon a transfer of property by gift.[xxix]

When “property is transferred for less than an adequate and full consideration,” it stated, “then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift”.[xxx] Conversely, property exchanged for “adequate and full consideration” does not constitute a gift for Federal gift tax purposes.

Furthermore, according to IRS regulations, the gift tax does not apply to “ordinary business transactions,”[xxxi] meaning “a transaction which is bona fide, at arm’s length, and free from any donative intent.”[xxxii] A transaction meeting this standard, the Court stated, “will be considered as made for an adequate and full consideration in money or money’s worth.”

It added, however, that a transaction between family members would be “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.”

The Court then turned to the transfers at issue. To determine the amount of any gift tax due on all or part of these transfers, the Court noted that it had to decide the value of the interests transferred. But before doing so, it first had to decide the nature of the interests transferred.

Nature of the Interests Transferred

The parties agreed that the transfers were complete once Taxpayer executed the transfer instruments parting with dominion and control over the interests.[xxxiii] But they disagreed over whether Taxpayer transferred interests in Partnership valued at $2,096,000 and $20 million, as Taxpayer contended, or percentage interests of 6.14 percent and 58.65 percent, as the IRS contended, the values of which were subject to adjustment based upon the IRS’s revaluation of Partnership.

The Court looked to the transfer documents to decide the amount of property given away by Taxpayer in a completed gift. Taxpayer argued that the transfer instruments showed that they transferred specific dollar amounts, not fixed percentages, citing a series of cases that respected formula clauses as transferring fixed dollar amounts of ownership interests. In each of those cases, the Court respected the terms of the formula, even though the percentage amount was not known until the fair market value was subsequently determined, because the dollar amount of the transfer was known.[xxxiv]

The Court then distinguished a DVC from a “saving clause.” The latter, it stated, has been rejected by the courts because it relies on conditions subsequent to adjust the amount of the gift or transfer; thus, the size of the transfer cannot be known on the date of the transfer.

By contrast, the courts have upheld a gift of an interest in a partnership expressed as “a dollar amount of fair market value in interest,” rather than a percentage interest that was determined in agreements subsequent to the gift. The Court explained that “a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.”

Taxpayer argued that the Court should construe the transfer clauses here as transferring dollar amounts rather than percentages. However, as part of their argument, they also cited evidence of their intent, which included their settlement discussions with IRS Appeals and the subsequent adjustments made in Trust’s percentage interest to reflect changes in valuation of Partnership, but not of the amount transferred.[xxxv]

To decide whether the transfers at issue were of fixed dollar amounts or fixed percentages, the Court started with the formula clauses themselves, rather than the parties’ subsequent actions. The Court observed that although the gift was expressed as a partnership interest having a fair market value of $2.096 million, and the sale was expressed as a partnership interest having a fair market value of $20 million, in each case the transferred interests were expressed as an interest having a fair market value of a specified amount as determined by an appraiser within a stated period after the transfer.

The Court stated that the term “fair market value” as used in the Taxpayer’s formula clause was expressly qualified by reference to the post-transfer determination of value by the appraiser – therefore, it was not fixed amount. This could not be ignored, the Court stated; Taxpayer was bound by what they wrote at the time.

The Court concluded that Taxpayer transferred 6.14 percent and 58.65 percent interests in Partnership to the Trust, and not a dollar amount that was fixed on the transfer date; the value reported was not known at the time of the transfers, but was only determined by the appraiser after the transfers. Thus, the amount of the reported gift was not accepted by the Court.

Don’t Let Your Attention Wander-y[xxxvi]

Words to live by, sort of, if one is planning to rely upon a DVC to avoid a gift tax deficiency on the transfer of an interest in a closely held business. That being said, the Court’s decision with respect to Taxpayer’s transfers seems harsh, and should serve as a warning to anyone contemplating a Wandry-like transfer using a DVC; if you’re going to make a gift of a fixed dollar amount on the transfer date, the amount should not be qualified by subsequent events.

Of course, as indicated earlier, there are many other means by which a business owner may seek to make a tax efficient gift of an interest in the business before 2021. Some owners may even decide that these other transfer vehicles will serve them well even under a reduced exemption transfer tax regime.

These folks should be reminded of the estate and gift tax proposals set out in President Obama’s 2017 Budget.[xxxvii] The Green Book called for an increase in the transfer tax rate to 45 percent, and a reduction in the exemption amount to $3.5 million for estate and GST taxes and $1 million for gift taxes, with no indexing for inflation.

Among other changes proposed were the following:

  • Require that a grantor retained annuity trust (“GRAT”) have a minimum term of ten years and a maximum term of the actuarial life expectancy of the annuitant plus ten years. The minimum term proposal would increase the risk that the grantor would not outlive the GRAT term, thereby bringing it back into their estate and losing any anticipated transfer tax benefit.
  • The proposal also included a requirement that the remainder interest have a value greater than zero at the time the interest was created – no more “zeroed out” GRATs.
  • On the 90th anniversary of a trust’s creation, the GST exemption allocated to the trust would terminate. This would be achieved by increasing the trust’s inclusion ratio to one, thereby rendering the entire trust subject to GST tax. Farewell dynasty trust.
  • Upon the death of a grantor who sold property to a grantor trust[xxxviii] (a disregarded transfer for income tax purposes), the portion of the trust attributable to the property received in that transaction (including all of its retained income and appreciation) would be subject to estate tax as part of the grantor’s gross estate. So much for sales to so-called “IDGTs.”
  • In addition, such portion of the trust would be subject to gift tax during the grantor’s life when their treatment as the deemed owner of the trust is terminated. Any distribution from the trust to another person would also be treated as a gift by the grantor.

Query whether any of these earlier legislative proposals will find their way into Congress after 2020. I wouldn’t be surprised – low-hanging fruit. The same may be said for the previously withdrawn proposed regulations aimed at curtailing valuation discounts for interests in closely held businesses.

It will pay to do some homework and to be prepared for whatever may come our way.

[i] The Republican Party’s convention is scheduled for August 24-27; the Democratic Party’s for August 17-20. The suspense is killing me. Not.

The following quotation is attributed to the late 18th, early 19th century French political philosopher, Joseph de Maistre: “Every nation gets the government it deserves.” If there is any truth to this statement – and I believe there is – then no matter which way you look at our circumstances, it doesn’t say very much about us. However, it also leaves open the possibility that we can do better.

[ii] No, that is not a comment on the ages of either candidate (74 and 77), or an observation on the ages of the Senate majority leader or the speaker of the House (78 and 80, respectively). I carry my AARP card proudly, sort of.

Did you know that Roman Senators held office for life? You see the difference, don’t you?

[iii] Which saw the great bank bailout, and came only a few years after the dot.com bubble burst. And don’t forget the 1989 savings and loan bailout, or the 1987 stock market crash.

[iv] Witness the “occupy” movement of 2011.

[v] According to Forbes, the U.S. added almost 700,000 millionaires from 2018 into 2019. Jack Kelly, October 22, 2019.

[vi] Tax Cuts and Jobs Act. P.L. 115-97. The basic exemption amount is scheduled to be reduced to its pre-2018 level beginning in 2026. IRC Sec. 2010.

Also in 2018, the IRS withdrew proposed regulations that would have limited, somewhat, a donor-taxpayer’s ability to discount the value of a gifted interest in a closely held business.

[vii] If its assets were sold at FMV and the net proceeds distributed to the owners.

[viii] See the discussion below regarding the valuation of interests in closely held businesses.

[ix] Perhaps a second-to-die policy, which would be more cost efficient.

[x] And let’s not forget the effect of the GST Tax exemption and the creation of so-called “dynasty trusts,” which effectively removed these assets from the transfer tax system for generations. President Obama’s last Green Book sought to reduce the impact of such trusts. https://www.taxlawforchb.com/2016/03/1833/

[xi] The flight of many of the well-to-do to far-away locations did not go unnoticed by the American public. Selfie anyone?

[xii] Assuming they take the White House, the Democrats need to pick up only three seats to win a majority. The Republicans would need to pick up 18 or 19 seats to min a majority in the House.

[xiii] During the 1970’s the top rate was between 70% and 77%, and between 5% and 8% of estates were subject to the tax. Over the last 20 years, just over 1% of the estates, on average, have been subject to the tax. Since 2010, that figure has dropped to 0.30%. https://itep.org/the-federal-estate-tax-an-important-progressive-revenue-source/

[xiv] Alternatively, the presumptive Democratic nominee, Joe Biden, has raised the possibility of imposing a tax on the unrealized appreciation of assets that pass upon the death of a taxpayer. Such a tax would effectively eliminate the basis step-up enjoyed by a decedent’s heirs under current law. What’s more, Biden has mentioned increasing the long term capital gains tax rate to the ordinary income rate in the case of wealthier taxpayers.

[xv] Indeed, many of the very wealthy seem to be concerned enough to have formed their own organizations – for example, Millionaires for Humanity – that are calling for higher taxes on the wealthy. Remember FDR and the New Deal? It’s called co-opting the left. https://www.hoover.org/research/how-fdr-saved-capitalism . Those who are ignorant of history . . .

[xvi] Anyone remember the end of 2012? It looked like the tax cuts enacted in 2001 would expire; this included the increased exemption amount. In order to take advantage of the then $5.12 million exemption amount before it disappeared, many owners gifted interests in their business to trusts for the benefit of their children.

[xvii] For example, a straight gift, a straight sale, a bargain sale, a GRAT, a sale to a grantor trust.

[xviii] Reg. Sec. 25.2512-1. The willing buyer and willing seller are purely hypothetical figures and, generally speaking, the valuation does not take into account the personal characteristics of the actual recipients of the property being valued.

[xix] See generally Rev. Rul. 59-60.

[xx] As the Tax Court stated in the case described below, for a value (or discount), it is “not necessary that the value arrived at by the trial court be a figure as to which there is specific testimony, if it is within the range of figures that may properly be deduced from the evidence.” Stated differently, the Court may channel Solomon. See the Book of Kings in the Old Testament.

[xxi] See, for example, Wandry, T.C. Memo. 2012-88. The Tax Court ruled that what the taxpayer had gifted was LLC units having a specific dollar value – the exemption amount – and not a specific number of LLC units. https://www.taxlawforchb.com/2014/02/wandrying-about-defined-value-clauses/

[xxii] Nelson v. Comm’r, T.C. Memo. 2020-81.

[xxiii] In connection with the second transfer, Trust executed a promissory note for $20 million.The note provided for interest on the unpaid principal; it was payable and compounded annually; the note was secured by the partnership interest that was sold. Good stuff.

[xxiv] Partnership was valued at approximately $34.1 million. Taxpayer’s transfers of $2.096 million + $20 million = $22.096 million, or 64.79% of Partnership.

[xxv] Effective as of the time of the transfers.

[xxvi] The IRS valued Partnership at $57.3 million.

[xxvii] $100 will get you 64.79% of a business worth $154, but only 38.55% of one that is worth $259.

[xxviii] Partnership had previously made a distribution to Trust based on its holding a 64.79% interest. Query whether Trust was required to return the excess, or whether it was treated as a loan from Partnership.

[xxix] IRC Sec. 2501.

[xxx] IRC Sec. 2512(b).

[xxxi] Reg. Sec. 25.2511-1(g)(1).

[xxxii] Reg. Sec. 25.2512-8.

[xxxiii] Reg. Sec. 25.2511-2(b).

[xxxiv] See the Wandry decision, for example.

Taxpayer transfers $1 million of equity. The FMV of the business is not known, and the percentage interest of the transferred equity valued at $1 million is not known – the value of the business will be known after the transfer, at which point the percentage interest transferred will also be known.

[xxxv] The Court stated that it would look to the terms of the transfer instruments, and not to the parties’ later actions, except to the extent that it concluded the terms were ambiguous and their actions revealed their understanding of those terms.

[xxxvi] Pretty bad, I know. For some reason, tax folks feel compelled to come up with a catchy title or caption. One day, it’ll be my turn to come up with a good one.

[xxxvii] https://www.taxlawforchb.com/2013/09/obamas-2014-budget-estate-and-gift-tax-proposals-how-might-they-impact-your-estate-plan/. https://www.taxlawforchb.com/2016/03/1833/ . You remember Mr. Obama? Mr. Biden’s boss.

[xxxviii] One that is deemed to be owned by the grantor under the grantor trust rules. IRC Sec. 671 et seq.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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