The estate planning world is still abuzz over proposed regulations under §2704 released last month. A number of practitioners, commentators, and others have, in the course of their discussion of the proposals (primarily regarding their validity and fidelity to the legislative purpose or the parade of horribles that will surely follow their adoption), revived the now year-old open letter to Treasury and the IRS written by Richard Dees of McDermott, Will & Emery regarding the then-rumored contents of the proposal. At the time that was believed to mean Treasury would track substantially with Greenbook proposals to amend the §2704 regulations to more aggressively address transfer tax valuation discounts in family-held business entities. I won’t rehash the specifics about those validity and fidelity arguments that Dees sets out (they are however interesting, though dense, reading for you tax geeks out there) or the technical details he raises in his critique. Instead, I want to focus on a relative passage that serves more as policy critique than technical attack – that new regulations further restricting discounts may result in a net loss of revenue to the Treasury as higher transfer (and specifically estate) tax values lead to higher bases to transferees (who receive a step-up in basis), leading to lower income tax revenues from decreased capital gain realizations on any future disposition.
It’s a subject that has not seemingly come up in the flurry of commentary that has followed the publication of the proposed regulations, but one that is worth considering in an era of high exemptions and portability that have made income tax considerations an increasingly significant element of estate and business succession planning. At first blush, it would appear that the increases in the estate tax resulting from generally higher valuations would more than offset the income tax losses on any later disposition of the inherited interest (as the estate tax rate generally exceeds the capital gains tax rate). But the knife cuts both ways – the valuation rules do not apply solely to estates that are large enough to incur an estate tax in the first place, and a taxpayer holding interests in a family-owned entity, but with an estate well under the current exemption amount is equally bound to the reductions in discounts mandated by the new rules.
Importantly here, so is the IRS. Granted, Chapter 14 applies only for transfer taxes and is not an income tax rule, but there is no apparent mechanism that would allow revenue agents to even attempt to have it both ways – disallow the discounts when computing the value of the family-held interests held by the estate but require discounting when determining the basis to which the beneficiaries taking those interests would be entitled. Particularly in the new age of basis consistency and the reporting designed to support it, the IRS could see noticeable diminishment in income tax revenues as heirs sell those interests for a smaller gain than they would have realized under existing rules without that loss having ever translated into an estate tax bill at all.
In fact, the Treasury could see notable losses in cases where an heir or beneficiary seeks to sell an inherited interest to an outside party and the value required by Chapter 14 exceeds the amount that such party is willing to offer for the interest, meaning the Treasury comes up short not only the capital gains taxes that could have been realized on the sale itself, but the capital gains taxes on the taxpayer’s sale of other assets that will be offset by the loss suffered on the inherited interests.
At the end of the day, while this will certainly be a negative for those taxpayers with estates that exceed the exemption amount, it could be an advantage to family-held business owners who have been successful but perhaps not lavishly so – enabling them to actually insert restrictions or other limitations into their entities’ operating documents to create the possibility of passing on interests in the entity to other family members with higher bases, allowing for the diminishment of future income tax liabilities through adjustments to the basis of assets to a partnership (allowable when the post-death basis in the partnership interest exceeds its pre-death basis) or simple reductions in gain (or increases in loss) upon later disposition. All without incurring an actual estate tax burden.
The IRS and Treasury should probably take a serious look at this possibility during the finalization process and determine whether the fiscal advantages outweigh the disadvantages, providing a more explicit statement about what sort of forecasts or expectations they’ve taken into consideration. And if the forecasts show a net negative revenue result – or even a notable possibility of one – they would be well served (particularly in light of the legal challenges seemingly already being planned) to explain what other policy considerations are at stake that might justify the rules drag on the national coffers.
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