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Limited Time Remains for Valuation Discounts with Family Entities

Expert Witness: Fulcrum Inquiry
Several important changes are expected in estate & gift taxes. A common planning tool involves creating family-owned entities and then valuing the transferred interests at a discount. In all likelihood, this tool will end. As long as the current proposal is not changed to become retroactive, estate planners should accelerate these plans. We describe expected changes in the estate & gift tax, and the likelihood of passage.

HR 436 was introduced in the United States House of Representatives by Way & Means member Congressman Earl Pomeroy (D-ND). It proposes the following significant changes in the U.S. estate and gift tax:

1. Most important for purposes of this article, HR 436 would eliminate minority and marketability discounts for family-controlled “non-business assets”. Under the concept of family attribution, all fractional interests in family-controlled entities will be deemed to be controlling interests. Due to IRS-unfavorable court rulings, the IRS formally abandoned family attribution with Revenue Ruling 93-12. HR 436 would
statutorily supersede Revenue Ruling 93-12 and the related tax court precedents.

The change would be enacted through a new code section that would define non-business assets, also referred to as passive assets, as “any asset which is not used in the active conduct of 1 or more trades or businesses”. Passive assets include marketable securities, cash and cash equivalents, debt instruments, commodities, collectibles, certain royalty-producing assets, and real estate activities where there is not material participation by the transferor. Non-passive entities would be allowed to hold passive assets if required for their working capital needs. The accumulated earnings tax under Code Section 533 contains a substantial body of law for how to determine whether earnings held in a business are for the "reasonable needs" of the business. Similar concepts could be applied when determining what represents necessary working capital in the context of determining allowable valuation discounts.

2. HR 436 would make permanent the current $3.5 million federal estate tax exclusion (which increased from $2.0 million, effective January 1, 2009). The exclusion is the amount you can bequest or give (other than to charities) without any federal estate tax. With the use of ordinary estate planning, such as a bypass trust, one can preserve the exclusion amount for both spouses, so that a total of $7 million can be transferred before estate taxes are paid.

3. The maximum federal estate tax rate will stay fixed at 45% for estates under $10 million. The marginal tax rate for estates over $10 million will be 50% due to an additional 5% surcharge that phases out when the estate reaches $23.5 million. Estates over $23.5 million are taxed at a maximum of 45%.

4. The lower graduated tax rates and the $3.5 million exclusion will be phased out by increasing the tax on estates above $10 million. Whether at 45%, 50%, or some larger rate (due to state estate taxes), the tax is quite large. Estate planning will remain important.

5. Repeal the new “carryover basis” rules scheduled to be effective next year.

Limited Opportunities to Use Family Pass-Through Entities

For immediate tax planning purposes, the repeal of valuation discounts for many family transfers is the most important part of the subject bill. Currently, HR 436 is effective for transfers occurring after the date of enactment. So long as the bill is not altered to become effective retroactively, business owners, farm owners, and others with substantial estates have a short and rare opportunity to apply a now-legal tax benefit that this author believes will soon to be eliminated. (See below for comments regarding passage)

Practitioners often attribute minority interest and marketability discounts when reporting a transfer of interests held by a family limited partnership, family LLC, or other family owned pass-through entities to reflect the fact that (i) a willing buyer would not pay as much for a minority interest as he or she would for a controlling interest, and (ii) the owner cannot easily sell his interest in this family entity. Currently, substantial discounts (generally from 10%-50% of the otherwise taxable estate values, depending on the circumstances) greatly reduce both gift and estate taxes for estates that otherwise likely would be over the federal estate and gift tax exclusion.

Chances for Passage

The January 27, 2005 report, “Options to Improve Tax Compliance and Reform Tax Expenditures,” by the Joint Committee on Taxation concluded that eliminating valuation discounts involving family-controlled entities would raise $500-600 million per year in additional estate taxes for the years 2011 and beyond. In the current deficit environment, with Democrat control of both houses of Congress and the presidency, this potential tax revenue will not likely be ignored.

Since President Obama believes any family earning over $250,000 is “rich” for income tax purposes, taxpayers with larger estate taxes will not get any real sympathy. We would not be surprised if HR436 is amended to increase its tax bite.

Obama’s appointment of Lawrence Summers as head of the White House's National Economic Council provides another strike against the status quo. When Mr. Summers served as Secretary of the Treasury during the last 18 months of the Clinton administration, Treasury proposed changes to the Internal Revenue Code that are quite similar to the discount elimination provision contained in HR 436. The change was not successful because Congress at that time was controlled by Republicans, who were not in favor of increasing the estate tax.

Even if HR436 is not enacted, some change in the estate tax is a near certainty. Absent Congressional action this year, the federal estate tax would be repealed for one year in 2010 and then revert back to a $1.0 million applicable exclusion amount in 2011 and subsequent years. The move to keep the applicable exclusion amount at $3.5 million beyond 2009 is supported by President Obama. There is virtually no chance of repeal of the federal estate tax in the foreseeable future.

HR436 is currently at the House Ways and Means committee.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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