In 1976 Harvard Law Professor A. James Casner, an acknowledged expert in estates, told the members of the House Ways and Means Committee: “In fact, we haven’t got an estate tax, what we have, you pay an estate tax if you want to; if you don’t want to, you don’t have to.”
About three years later an enterprising law professor named George Cooper wrote what was probably the seminal article on estate planning in the Columbia Law Review summarizing (in 87 pages) the findings of an exhaustive study that he had conducted. He went into great detail on Casner’s view, interviewing literally hundreds of lawyers and other practitioners in the estate planning area to see what they were actually doing, and he concluded that Casner was largely correct.
He observed that there were so many estate avoidance techniques available, that for the well-to-do who were willing to engage in some sophisticated (in some cases not-so-sophisticated) planning, the Federal estate tax was almost a “voluntary” tax. Among the techniques that he summarized were various estate “freezing” techniques, including preferred stock recapitalizations, installment sales, family partnerships, and intra-family diversions of service and capital. He also observed that life insurance and similar annuities and survivorship benefit plans created opportunities for the creation of tax-exempt wealth.
Closing off an option
Fifty years later, just a few weeks ago, the Internal Revenue Service announced that it was moving to close off one of those tax avoidance maneuvers which, to this day, remains wide open and available despite the spotlight shone on it so many years ago. The ability to create substantial valuation discounts by means of gifts to family members has remained a significant estate planning activity. That window of opportunity remains open for those who are seriously interested in favoring their families over the Federal fisc, provided that they are willing to move efficiently and aggressively over the next three to four months.
Back in 1990, Congress enacted several Internal Revenue Code provisions that started to chip away at the available discounts. One of these provisions was contained in §2704, the substance of which was to eliminate in the appraisal process the discounting or diminishing effect of the “lapse” of certain rights and restrictions held by a stakeholder in a family controlled entity. The Treasury was authorized to enact regulations implementing these provisions, but has just gotten around to it, and will be holding public hearings from interested parties on December 1, 2016. Technically, the Treasury then has the authority to issue final regulations, and those become effective 30 days after the date of the announcement. As a practical matter, it’s highly unlikely that all of this can occur any earlier than sometime in the first quarter of 2017, thus creating the “window of opportunity” referred to above.
Highlights of rules
What are the new regulations all about? Although the proposed regulations run 13 pages of fine print in the Federal Register, attempting to address many different situations, they can be fairly summarized as follows:
- They attempt to reduce the “lack of control” discounts that are taken on gifts by minority interest holders of closely-held businesses. That is, a minority interest, which essentially cannot control the direction of the business or force the liquidation of the entity and distribution of its assets, is always worth less than a majority or controlling interest.
- They create a bright line test for “deathbed transfers” that result in a lapse of a dying shareholder’s rights and restrictions. Under the new regulations, any transfer resulting in a lapse of rights and restrictions that takes place within the three years prior to the transferor’s death will be treated as if it took place at his death. This means, in effect, that the discounted amount would be pulled back in the transferor’s gross estate. The “three-year rule” replaces the subjective test currently used by courts to determine whether this kind of transfer is done during the normal course of business or solely to reduce estate tax liability.
- The regulations also go after state legislation by disallowing discounts that stem from non-mandatory restrictions imposed by state law. Many states enacted laws that placed restrictions on transfer and control for the sole purpose of attracting family-owned businesses to the state. These restrictions make it easier for families to take advantage of this federal estate tax loophole. Under the new regulations, a state law that imposes a restriction by default, but allows family-member shareholders to contract around the restriction, may not create applicable as a discount.
Things to keep in mind
There are many legal traps for the unwary in this area of estate planning. If the regulations are finalized according to the quickest possible schedule, they will take effect in January 2017. Since these regulations are very broad and far-reaching, many experts believe they may need to be reviewed and that they will be challenged by the courts after they are finalized. We will also have a new president by that time, which may affect whether and how quickly the regulations are finalized.
Since Donald Trump has expressed his distaste for estate and gift taxes, closing the discount loophole probably will not be popular with him. Hillary Clinton, on the other hand, will likely want the regulations to become enforceable.
If you would like to take advantage of the current discounts as you transfer property and business interests to your family, during life or through your estate, you may want to take action before the end of this year. However, there are many factors that weigh into these kinds of decisions, so consult a knowledgeable professional to ensure that a transfer will make sense for you and your family.
Make sure to stay healthy if you decide to make a transfer soon. The three-year rule will apply to all estates that file an estate tax return after the regulations are finalized. To maintain the discount, the transferor must survive for three years following the transfer to ensure the value of the “lapse” is not included in the gross estate. The Treasury Department has given new meaning to the phrase “live long and prosper.”
Kate McCurdy is an associate in Boylan Code’s trusts and estates group. Sherman F. Levey is of counsel in Boylan Code’s trusts and estates group.