Discounting the value of assets has been an integral part of wealth transfer planning for many years. The IRS has also been fighting this planning technique for many years. There have been indications that regulations will be issued soon to significantly curtail this estate planning technique. While the higher estate tax exemptions put in place several years ago have lessened the need for discounting for most people, if you have a taxable estate over the exemption amount you should consider whether to take action now to take advantage of the current law.
The discounting technique
Generally, discounting involves using planning techniques to facilitate an estate and/or wealth transfer plan by making assets less valuable for gift and/or estate tax purposes. For instance, if an individual has an estate with a value of $10 million, he or she has an estate tax issue. At a rate of 40 percent on the amount in excess of the $5.43 million lifetime exemption, approximately $1,828,000 in estate tax would be due. If the value of the estate could be discounted by 30 percent, the value of the estate is reduced to $7 million and the estate tax due is $628,000 – a savings of $1.2 million.
Discounting in its simplest form is achieved by transferring the assets to an entity (such as a limited partnership or LLC) that imposes restrictions on the owner’s ability to convert the assets into cash. Assume in the above example that the $10 million estate consisted of a $10 million portfolio of marketable securities. The value of a 10 percent interest in this portfolio (assuming such interest was freely transferable) would be $1 million. However, what would someone pay for a 10 percent interest in this portfolio if there was no way to convert the interest to cash and no way to control the investment decisions or the decision to sell the entire portfolio? This interest would of course be worth something, but a buyer would significantly discount the purchase price based on the inability to control or realize the benefit of the 10 percent interest.
Because restrictions cannot be put on the transfer of a percentage interest in a portfolio of stock, the portfolio could be contributed to a limited partnership or LLC, and interests in the partnership or LLC are transferred to someone as a gift. Continuing with the example above, if Dad contributes the portfolio of securities to an LLC and gives a 10 percent interest in the LLC to his daughter, the value of that 10 percent interest depends on the type of restrictions that are put on his daughter’s ability to control the portfolio and sell the interest. Normally, the LLC operating agreement would substantially restrict her ability to sell the interest and would completely prevent her from being able to sell the portfolio or even make investment decisions. The value of the 10 percent interest is therefore clearly not $1 million. The actual value would be determined by an appraiser, but a discount of 30 percent would not be unusual. If Dad gave the entire LLC away to his children (during his life or upon his death), the discount would convert a $10 million portfolio to one with a value closer to $7 million – saving $1.2 million in gift and/or estate taxes.
The IRS position and new developments
The IRS has fought this type of planning, especially where the assets consisted of marketable securities. While a 10 percent interest in the LLC described above is clearly not worth $1 million to a third-party buyer, why would anyone voluntarily enter into a transaction where the value of their assets was decreased by 30 percent? There have been many cases in Tax Court where the IRS has challenged a discounting strategy, although most of the taxpayer losses have been in situations where the partnership or LLC was not set up properly or the gifting was not executed properly.
There has been considerable media attention this summer on the IRS’ plan to curtail this technique in a more serious and permanent way. President Obama’s budget proposal for a number of years included a provision proposing that certain restrictions would be ignored when valuing an interest. The focus of the budget proposal was eliminating the kinds of restrictions that in reality would not impact the value of the interest received by the transferee, such as a transferee’s ability to become a full partner or member. Restrictions applicable to an interest would also be compared to federal law as opposed to state law, eliminating state law restrictions that can justify a valuation discount. These changes have not been included in the budget proposals for the last few years. While this might seem like a positive development, it seems clear that the administration is not giving up on the issue. Rather, the administration likely believes these changes can be accomplished through issuing regulations under current law as opposed to trying to get new legislation passed. Earlier this year, an attorney for the Treasury Department made comments at an American Bar Association meeting hinting that these regulations could come as early as this September.
Treasury’s authority to issue regulations
Can the IRS limit discounting without Congress’ approval? The Treasury Department already has rather broad authority to issue regulations limiting situations where discounts can be taken. Existing regulations provide that an “Applicable Restriction” is ignored when determining the value of an asset. An Applicable Restriction is one that limits the ability of a corporation or partnership (which includes an LLC) to liquidate if the restriction lapses or could be changed in the future by family members. A limit provided under state or federal law is NOT considered an applicable restriction, so these types of restrictions are permitted and can provide the basis for a discount on the value of an interest. For example, under Delaware law, two-thirds of the members of an LLC have to agree to dissolve the LLC. While a valuation expert could take this restriction into account when valuing an interest in the LLC, they could not take into account a provision in the operating agreement of an LLC that required unanimous consent to a liquidation, because this is more restrictive that what is provided by Delaware law.
New regulations could provide additional Applicable Restrictions that would be ignored when valuing an interest, reducing or eliminating the benefit of discounting. The IRS likely has the ability to do this given the following broad authority to issue regulations.
Section 2704(b)(4) of the Internal Revenue Code states:
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 subtitle but does not ultimately reduce the value of such interest to the transferee.
The Treasury Department, therefore, is likely to believe that it has very clear authority to issue regulations that would curtail the use of discounting in certain situations. All indications are that these regulations may be coming out in the next few weeks.
The regulations will likely try to accomplish the goals set forth in past budget proposals. While most practitioners believe that an outright prohibition on marketability discounts would be beyond the power of the Treasury Department, there may be some room for the Treasury Department to scale back the use of this technique. The scope of the changes is unclear; some practitioners say that the regulations may be directed more toward situations such as the example above where marketable securities are put into an LLC or partnership, and arguably a primary purpose of the transfer is to generate a discount. Operating businesses might be left out of the new rules. The timing of the effective date of the regulations is also a question. Although these are likely to be issued as proposed regulations, these types of regulations are often made effective on the date of initial publication – meaning there would be little to no advance notice that the changes are effective.
The type of planning described above tends to be delayed by taxpayers. Regardless of whether regulations are imminent, you should consider reviewing your estate plan and determine whether discounting could be a part of your overall estate plan. If so, the plan should be put in place as soon as possible. These techniques are generally not that expensive, and in most cases the partnership or LLC could (if the partners or members agree) be terminated if the desired goals are not achieved. This is a low-cost, low-risk wealth transfer planning technique that may not be available much longer.
For more information, contact one of the attorneys listed below.