There has been a deluge of articles analyzing the proposed Treasury Regulations under Internal Revenue Code (IRC) section 2704, which, if finalized in anything like their proposed form, will greatly reduce or eliminate valuation discounts. Valuation discounts, which have been the key to many estate plans, can reduce values sufficiently to permit moderately wealthy clients to use outright gifts to irrevocable trusts to accomplish their estate planning goals, thereby greatly simplifying planning. Wealthier clients who require grantor retained annuity trusts (GRATs), note sales, and a range of other techniques to leverage their exemption amount have depended on valuation discounts to make the cash flow from an entity or real estate property meet annuity or note payment requirements.
Why Act Now?
The critical question for CPAs is: What actions should be taken now, preferably before the end of the year, in light of these proposed regulations? While the theoretical issues raised are fascinating, theory doesn’t help clients today. Arguing that the Treasury Department does not have the authority to issue the regulations will not help clients if they are finalized before planning is complete. Many commentators have speculated that the regulations might not become effective until mid-2017 or later. That view could be dangerous as well, lulling taxpayers and preparers alike into inaction. In reality, the regulations could be effective as early as the first week of January 2017. In addition, many common planning structures could benefit from components being completed in different tax years. Acting quickly to complete certain steps in 2016 and getting 2017 planning ready (documents completed, valuations done, and only signatures required) can enable planning to be completed before the regulations become effective and improve the profile of that planning.
The following sequence of planning scenarios will highlight why individuals should act immediately and how planning can be designed.
Ben owns 100% of the interests in an apartment building LLC that has been in his family for many decades. This single asset has appreciated to $14 million. Neither he nor his wife Leslie has used any exemptions. The estate is large enough to worry about estate taxes, but not so large that the couple is willing to incur the cost or complexity of GRATs or note sale transactions. Also, they may well need access to the cash flow from the building in future retirement years. The plan is for the LLC interests to be divided between Ben and Leslie and for each to contribute 40% of their interests to a spousal lifetime access trust (SLAT). This plan would permit Ben, with reasonable limitations and formalities, to benefit from the LLC interests held in the trust created by Leslie, and vice versa. But even this planning is a bit much, so they opt to wait to see what happens with the final regulations. Depending upon the regulations’ effective date, the clients might miss the planning boat.
Imagine the same couple waits until the regulations are finalized. Assuming that the regulations are published in mid-December 2016, they would become effective in mid-January 2017. In mid-December, Ben gifts one-half of the LLC interests to Leslie. Their attorney quickly creates two New York irrevocable trusts naming their son Steven as trustee of both. The next day Ben and Leslie both gift 40% of their respective LLC interests to their respective irrevocable SLATs. There is inadequate time to obtain a formal appraisal, so a rough estimate is used. While the couple has implemented planning to secure discounts, that planning leaves much to be desired. In many cases, there can be considerable legal, tax, asset protection, and other advantages to using an institutional trustee and having the trusts formed in tax-friendly jurisdictions (e.g., Alaska, Delaware, Nevada, South Dakota). Given the timing, however, these options would be precluded. Because of the rush, the valuation issues are worrisome and the defined value mechanism (e.g., a Wandry-type clause) is all that can be relied upon.
The transaction also has significant exposure to the step-transaction doctrine. The IRS could argue that because Leslie held her LLC interests for almost no time, there was no economic substance to her ownership. Recasting the transaction as if Ben really made both transfers, ignoring discounts, could result in a transfer of $11.2 million, incurring a significant current gift tax. Even if the discounts are sustained, the value of Ben’s transfers could be $7 million, still resulting in a taxable gift. Given that the two SLATs were funded with identical assets at the same time and have limited differences between trust terms, the IRS could also unravel the entirety of the transaction under the reciprocal trust doctrine.
Finally, imagine the same couple acts immediately. Ben transfers 50% of the LLC interests to Leslie right now. He then forms a trust in Alaska, naming an Alaska trust company as sole trustee and structured as a directed trust naming Ben as investment trustee or advisor, so that he retains management control over the LLC and can limit the institutional trustee to a modest flat fee per year for administration. The building and LLC interests are appraised. Ben then transfers 40% of his LLC interests to his Alaska SLAT based on a draft appraisal report and also utilizing a Wandry-type defined value mechanism. The appraisals value the 40% interests at $3.36 million. The transfer documents use the same Wandry-type formula and therefore the same value for the
LLC interests. Meanwhile, Leslie forms her SLAT in Nevada, naming a Nevada trust company as trustee. Ben, who has managed the property for 40 years, is also named as the investment trustee under the Nevada-directed trust. Leslie contributes $1 million in marketable securities to her SLAT in 2016. All documentation is completed for Leslie to transfer 35% of her LLC interests to the Nevada SLAT, but the transfer is not consummated yet. Instead, she waits until the final regulations are to become effective and transfers her LLC interests in 2017 prior to that date. (Note that if the regulations are delayed too long, Leslie might transfer her interests sooner, before the appraisal becomes stale.)
The risk of a challenge based on the reciprocal trust doctrine has been minimized by crafting more differences into the trust documents, as well as using different institutional trustees, different states for situs and governing law, and different assets. The risk of the step-transaction doctrine has also been reduced by having many months pass between the transfers and having the transfers occur in separate tax years. Furthermore, the issuance of an intervening distribution arguably demonstrates economic substance to Leslie’s holding of LLC interests before the gift to her trust. Because the trusts have been established in trust-friendly jurisdictions, when Ben and Leslie die and grantor trust status ceases, their descendant beneficiaries can avoid New York income tax by letting income that is not needed accumulate inside the trust.
Start Planning Now
The planning implications of the possible reduction or elimination of valuation discounts can be profound. CPAs should take a holistic approach to planning and encourage clients to begin appropriate planning steps immediately—not only to ensure the availability of discounts, but also to potentially enhance the planning and reduce the tax risks of the plan.