One way to reduce estate tax exposure involves the use of special trusts (specifically “grantor trusts”) that take advantage of inconsistencies in the Tax Code where there is an overlap between the rules applicable to income taxes versus the rules applicable to estate taxes.  My new post “What is a Grantor Trust?” describes how these special trusts work and how to take advantage of the tax benefits.

When the Treasury Department issued the long-awaited Proposed Regulations under IRC 2704, the Whitehouse blog referred to the new rules as “closing a loophole that allows some wealthy families to avoid paying their fair share of estate taxes” and added that the “action reduces tax avoidance by making it more difficult for the wealthiest Americans to exploit this loophole and avoid contributing their fair share”.

Is there really a “loophole” being closed?  Or do the Proposed Regulations actually create a situation where certain taxpayers (primarily family business owners) will be treated unfairly?

Assume for a simple example that you own a business equally with two unrelated partners (you and each other partner owning 1/3rd) and that the business as a going concern (i.e., if sold as a whole) is worth $100. Would someone purchase your interest in the business for $33?  Probably not.  Your interest is not worth $33 because you are unable to unilaterally control certain actions that would allow you to monetize your investment.  These include you not having the ability to control distributions from the business or cause a sale of the business.  If you were to sell your 1/3rd interest in the business to a stranger, the stranger would expect to pay less than $33 (use $25 for purposes of this post) since they also would not have control over those actions.

In the past (and in the present until the regulations are finalized), if you wanted to gift your 1/3rd interest in the business to your child, you would get an appraisal of the business interest and the appraisal would take into account the fact that, as a 1/3rd owner, you have little control over the investment.  As such, the appraisal would consider the going concern value of the business ($100) and then “discount” your proportionate (1/3rd) share of the going concern value for your lack of control and your interest’s lack of marketability (both facts that reduce your ability to monetize the investment).  The fair market value determined by the appraisal should be equivalent to what a willing buyer and willing seller would agree on for the purchase price.  Using the above example, the appraised value should be equal to what a stranger would pay for the interest – the $25 mentioned above.

Contrast the above to a new hypothetical.  Instead of owning 1/3rd, you own 100%, but you want to give each of your three children 1/3rd interests in the business.  Given that you can control the entity as the 100% owner, there would be no “discount” applicable to your ownership if you transferred the entire 100% ownership to one child; however, once you divide that ownership up into three equal shares for your children (with each child taking 1/3rd), none of the children, individually, have control over the business.  Traditionally, since no child individually had control over the business, each of the three 1/3rd interests being gifted to the children would be subject to a “discounted” value (the $25 value).

The Treasury Department, consistent with the Whitehouse blog, views the above result as a “loophole” because you have effectively transferred ownership of a business that was worth $100 to your three children using a value of $75 (the $25 value multiplied by each of the 1/3rd interests).  On the other hand, each of your children received something that was actually worth $25 to them, so is it really a loophole?

Under the Proposed Regulations, you would not be able to transfer the business interests to your three children at a discounted value (even though that value is the fair market value). Rather, you would need to use a value of $33 for each transfer (the going concern value multiplied by the 1/3rd interest).  This seems to be an unfair result given the reality that if one of the three children were to subsequently market his/her 1/3rd interest, a purchaser would expect to pay the “discounted” $25.

There is a strong likelihood that the Proposed Regulations will be finalized in some form or another and that the final Regulations will be successful in taking away the availability of valuation discounts.  Or, put another way, the final Regulations will be successful in inflating the value of inter-family transactions.

It will be interesting to see how this issue ends up.  In the interim, anyone considering inter-family transactions should review how these new rules apply to them and should act soon.

Under the tax laws, significant income tax benefits can be lost if someone names their estate or a traditional trust as the beneficiary of his or her retirement accounts.  Leaving a retirement account to a young individual beneficiary can offer the tremendous benefit of continued long-term income tax deferral, but sometimes the original account holder is not comfortable with giving the young beneficiary full control over the account.  My new post “What is a Retirement Benefits Trust?” provides information about how specialized trusts can be used to resolve these problems.

Thank you for taking the time to look at my new site.  This is my first attempt at blogging.  My goal with this blog is to present useful information on developments in taxation and estate planning matters.

From time to time I will be writing posts about developments in estate and tax planning.  In addition, I will be populating this site with information regarding estate planning concepts.  This information can be found under the “Planning Concepts” menu.  These posts will cover a wide range of topics, from basic to sophisticated planning.  I have already written two posts on basic planning concepts.  The first post is “Why do you need a Will?” and the second post is “What is a Living (Revocable) Trust?”.

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