The Winter of our Discontent?

Gridlock continued in Washington throughout most of last year. On inauguration day, the new administration put a freeze on new government regulations, which included the proposed regulations (proposed regs) under Internal Revenue Code Section 2704. Nearly nine months later, the Treasury proposed to withdraw the proposed regs as too burdensome on taxpayers. The formal freeze on regulations seemed to carry over informally to few valuation cases emerging from the courts. Also contributing to the uncertain environment in the trusts and estates community was the slow movement on tax reform and associated estate tax repeal. The administration’s outline for tax reform¹ wasn’t made public until late September; Congress released the initial version of legislation² in early November; and by early December, the House and Senate had passed their respective versions of tax reform legislation. No matter how skillful planners can be in drafting flexible plans for clients, it’s difficult to overcome the natural reaction of waiting until there’s some clarity on what the rules will be. Uncertainty will continue until the Congressional chambers reconcile the House version that provides for future estate tax repeal with the Senate version that doesn’t.

Withdrawn But Forgotten?

On Oct. 2, 2017, the Secretary of the Treasury recommended that proposed regs under IRC Section 2704 be withdrawn in their entirety.³ The proposed regs sought to restrict valuation discounts applicable to family-held businesses. The proposed regs were released in August 2016, followed by a 90-day period for comments and a Dec. 1, 2016 public hearing. The proposed regs attracted thousands of comments and a full slate of testifiers at the public hearing. We may never know how persuasive the comments and testimony were in the Treasury’s recommendation to withdraw because the intervening event of President Trump’s election victory in early November sealed the fate of these regulations.   

The proposed regs were crafted to eliminate or minimize valuation discounts in transfers of family businesses to other family members. The linchpin for the regulations was family attribution when family members had control. Much of the focus was on specific mechanisms to accomplish the objective of the proposed regs, such as a 50 percent ownership threshold among the family group, a 3-year look-back rule on transfers and a put right for a cash payout at pro rata value. A withdrawal of the proposed regs does away with these rules for Section 2704. However, the concept of family attribution may not die so readily.

Family attribution as addressed in the proposed regs is a workaround of the fair market value premise of a hypothetical willing buyer and seller. Before the proposed regs were released, the issue of family attribution was front and center in a federal estate tax deficiency case with approximately $1.2 million at stake. In Estate of Pulling,⁴ the estate had ownership interests in five contiguous parcels of land. The decedent owned three small parcels outright, and a land trust of which the decedent held a 28 percent interest owned two parcels. The sum value of the individual parcels was substantially less than the value of the five parcels when combined. The three parcels the estate owned were small and burdened by limited public right-of-way access. It wasn’t disputed that the value of the five parcels could be enhanced by consolidating them into a single property for residential development.

The attribution issue related to the land trust, which held the critical two parcels. The decedent owned a noncontrolling 28 percent interest in the land trust, but other members of his family held sufficient ownership interests to provide control. The Internal Revenue Service argued that the economic benefits of assembling the parcels and the ties among the owners of the land trust made it reasonably likely that such assemblage would occur and avail the estate of the higher value. The court found that, without specific evidence that family members would agree to combine the properties, “the mere fact that they are related to decedent is not enough.” Thus, the court concluded that the five parcels should be treated and valued as individual parcels, rather than as an assembled whole.

A withdrawal of the proposed regs isn’t a deterrent to the IRS arguing that clear economic benefits flow to a decedent’s interest and all parties if they agree to act as one in a family limited partnership (FLP) or limited liability company setting. This is a variation on automatic family attribution of interests called for in the proposed regs by inserting economic benefit as the focus to attack discounts applicable to standalone noncontrolling interests. The withdrawal of the proposed regs increases the degree of difficulty for the IRS in pursuing family attribution, but the issue lives on.

Cross Your T’s and Those of Others

Charitable contribution deductions continued to attract the attention of the IRS. Two easement cases were decided during 2017 with unfortunate results for the taxpayers. In both cases, the compliance failures under IRC Section 170 were those of the recipient or third parties rather than the taxpayer or the supporting appraisal.  

In RP Golf, LLC⁵ a conservation easement was the subject of the charitable contribution. RP Golf, LLC (RP Golf) was the sole member of National Golf Club of Kansas City LLC (National Golf), which held two golf courses it purchased and developed. In the purchase and development of the golf properties, RP Golf and National Golf entered into various loan agreements.  These agreements contained language that prohibited any oral modifications.

On Dec. 29, 2003, National Golf entered into an agreement to grant a conservation easement to a valid IRC Section 501(c)(3) organization, Platte County Land Trust (PLT). RP Golf took a $16.4 million conservation easement charitable deduction on its 2003 tax return.

On April 14, 2004, bank officers executed consents subordinating the interests of the two banks, approximately 100 days after the PLT agreement, and recorded the consents in the Platte County Recorder’s Office on April 15, 2004. Each consent states that the subordination was made effective as of Dec. 31, 2003, even though National Golf executed the PLT agreement on Dec. 29, 2003 and recorded it on Dec. 30, 2003.

The Tax Court ruled that written subordinations by lenders, issued within 100 days of a conservation easement charitable donation and legally enforceable as of the day after the donation, failed to comply with the strict requirements of Section 170 which, as interpreted by the courts, have held that such written documents of subordination must be dated and issued prior to any charitable conservation easement donation. The taxpayer wasn’t entitled to a deduction on its 2003 tax return for a qualified conservation easement. 

In Ten Twenty Six Investors,⁶ the taxpayers donated a façade easement of a warehouse to the National Architectural Trust, Inc. (NAT), a qualified Section 501(c)(3) organization under Section 170. Late in 2004, investors in the warehouse donated a façade easement and claimed an $11.355 million charitable deduction, which amount was determined by appraisal. All appeared well, until the IRS denied the deduction because NAT hadn’t recorded the deed in 2004. A representative of NAT accepted and signed the deed on Dec. 30, 2004. However, NAT didn’t record the deed until 2006. Because the deed wasn’t recorded until 2006, the IRS argued that the taxpayer couldn’t have taken a valid deduction for a charitable gift in 2004, determined a 40 percent gross valuation misstatement penalty under IRC Section 6662(a) and filed for summary judgment. 

In its decision, the court turned to New York law (NYECL Section 49-0305(4)), which stated, “An instrument for the purpose of creating, conveying, modifying or terminating a conservation easement shall not be effective unless recorded.” As a result, in 2004, the perpetuity requirements of Sections 170(h)(2)(C) and (5)(A) couldn’t have been satisfied because the façade conservation easement transfer wasn’t “effective” until it was recorded. The result was that no charitable deduction was permitted.

In easement cases, the appraisal is typically the primary focus of the IRS, and the issue is the amount of the deduction. Both of these 2017 cases were technical process matters in which compliance with the letter of the law was the linchpin. The result for the taxpayer in each case was the denial of any deduction rather than a reduced deduction. These cases provide a taxpayer with justification to micromanage when an easement charitable deduction is at stake.

Expanded Reach of Section 2036 

Typically, a bad facts IRC Section 2036 case isn’t particularly significant beyond the specific matter, but Estate of Powell⁷ is an exception. It was a full Tax Court case, and it expanded the reach of Section 2036 to a decedent that only held a limited partnership interest. 

In this case, a son, using a power of attorney for his mother, contributed approximately $10 million of cash and marketable securities on her behalf to an FLP in return for a 99 percent limited partner (LP) interest. Her two sons contributed promissory notes to the FLP for the 1 percent general partner (GP) interest. On the same day that the FLP was formed, the son transferred all of his mother’s LP interest to a charitable lead annuity trust with the remainder to the two sons. The mother died seven days after formation of the FLP.

The outcome of Powell resulting in the estate inclusion of the amount transferred on the mother’s behalf to the FLP wasn’t surprising in light of the deathbed aspects of the transfers and the apparent absence of non-tax purposes. The application of Section 2036(a)(2)⁸ is the noteworthy issue from the case. Finding that a decedent, in conjunction with other partners, could dissolve the partnership and control distributions, which led to gross estate inclusion, had previously only applied in the Strangi⁹ and Turner¹⁰ cases, in which a decedent’s interest also included some GP interest. In Powell, the decedent only had an LP interest and never owned a GP interest. The court’s decision regarding the application of Section 2036(a)(2) didn’t appear to be premised on the large LP percentage owned by the decedent or that there were only two other partners to act “in conjunction with.” Any LP interest, regardless of how small, can conceivably act “in conjunction with” the other partners to dissolve the partnership if Section 2036(a)(2) is broadly extended in the most unfavorable way for taxpayers.

From a valuation perspective, the court provided the mechanics as to how Section 2036 inclusion works with IRC Section 2043¹¹ inclusion to avoid double inclusion of the same asset. This has been a non-issue in previous Section 2036 inclusion decisions because by disregarding the FLP and bringing the undiscounted underlying assets into the estate, the full value of transferred assets are recognized under IRC Section 2033. Coming to the same result as taxing the underlying assets, the majority of the court chose to outline the mechanism for partial inclusion under Section 2033 and partial inclusion under Section 2043. Under Section 2036, the LP interest is recognized and is included in the estate with applicable valuation discounts. Then, under Section 2043, the difference in the value of the underlying assets transferred to the FLP less the discounted value of the LP interests is included in the estate.¹² 

In this situation, there were only seven days between formation of the FLP and the decedent’s death, and the parties agreed to disregard any change in the value of assets between the dates. The court observes in Footnote 7 of the opinion that the difference between the value in the estate by Section 2036 inclusion as compared with the two-pronged Section 2033 and Section 2043 approach proffered by the majority won’t avoid double inclusion if there’s appreciation in the assets between transfer and date of death.

Changes in the value of the transferred assets would affect the required inclusion because Section 2036(a) includes in the value of decedent’s gross estate the date-of-death value of those assets, while Section 2043(a) reduces the required inclusion by the value of the partnership interest on the date of the transfer. To the extent that any post-transfer increase in the value of the transferred assets is reflected in the value of the partnership interest the decedent received in return, the appreciation in the assets would generally be subject to a duplicative transfer tax. (Conversely, a post-transfer decrease in value would generally result in a duplicative reduction in transfer tax.)

Looking Forward 

At the time of this writing, it was likely that tax reform would be effective in 2018. However, the specific provisions for estate tax, corporate and personal tax rates and the implications for various valuation issues will remain uncertain until a reconciled version of tax reform is enacted. Much as 2017 experienced relative inactivity in Tax Court decisions involving valuation issues, the uncertainty surrounding tax reform has frozen developments in valuation.

The repeal of the federal estate tax is the foremost item of interest for the estate-planning community. The House-passed version of the Tax Cuts and Jobs Act provides for repeal of the estate tax and generation-skipping transfer tax as of Jan. 1, 2024 and immediately doubles the unified credit amount. The Senate-passed version also doubles the unified credit amount, but leaves the estate tax in place. Additionally, proposed changes in corporate income tax rates for both C corporations and S corporations (S corps) have the potential to alter the 18-year struggle over the appropriate gift and estate tax value of S corps. The enhanced value of S corps is premised on the difference in income tax rates experienced by S shareholders in comparison with C shareholders. Tax reform has the potential to increase, reduce or eliminate the rate gap benefits that S shareholders currently enjoy over C shareholders. At this time, it’s unknown where the comparative rates will settle, but for clients owning S corps or pass-through entities, changes in corporate and personal tax rates that emerge from the reconciliation process have the potential to significantly affect the valuation of their holdings independent of what happens to the federal estate tax.

The IRS has published the inflation-adjusted estate and gift tax exemptions for 2018.¹³ The basic exclusion amount for the unified credit against estate tax increases to $5.6 million (or $11.2 million for a married couple). Since both the House and Senate versions of tax reform provide for a doubling of the unified credit amount, it’s expected that the exemption will increase in 2018 to $11.2 million per person. For those individuals who have exhausted their existing credit amount, the doubling of the credit provides a new opportunity to make tax-free transfers of property. The annual exclusion for gifts will increase to $15,000 per person. In the recently released IRS priority guidance plan,¹⁴ there were only three items listed under “Gifts and Estates and Trust.” The priority guidance plan issued the prior year listed 12 items. Of interest in the current plan is a focus on Graegin loan issues with a priority of “Guidance under §2053 regarding personal guarantees and the application of present value concepts in determining the deductible amount of expenses and claims against the estate.”

Major tax reform legislation is an infrequent event in the United States and when it occurs, new planning opportunities surface. Tax reform is a catalyst for planning, which suggests robust opportunities in 2018.          

Endnotes

1. Unified Framework for Fixing Our Broken Tax Code, Sept. 27, 2017.

2. Tax Cuts and Jobs Act, H.R. 1, introduced on Nov. 2, 2017.

3. Identifying and Reducing Tax Regulatory Burdens, Executive Order 13789, Oct. 2, 2017.

4. Estate of John A. Pulling, Sr. v. Commissioner, T.C. Memo. 2015-134 (July 23, 2015).

5. RP Golf, LLC et al. v. Comm’r, No. 16-3277, 11th Circuit (June 26, 2017).

6. Ten Twenty Six Investors et al. v. Comm’r, T.C. Memo. 2017-115 (June 15, 2017).

7. Estate of Nancy H. Powell v. Comm’r, 148 T.C. No. 18 (May 18, 2017). 

8. Internal Revenue Code Section 2036(a)(2)—the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

9. Estate of Albert Strangi v. Comm’r, T.C. Memo. 2003-145, aff’d 417 F.3d 468 (5th Cir. 2005). 

10. Estate of Clyde W. Turner, Sr. v. Comm’r, T.C. Memo. 2011-209 (Aug. 30, 2011).

11. IRC Section 2043(a): “If any one of the transfers, trusts, interests, rights, or powers enumerated and described in sections 2035 to 2038, inclusive, and section 2041 is made, created, exercised, or relinquished for a consideration in money or money’s worth, but is not a bona fide sale for an adequate and full consideration in money or money’s worth, there shall be included in the gross estate only the excess of the fair market value at the time of death of the property otherwise to be included on account of such transaction, over the value of the consideration received therefor by the decedent.”

12. An example of the mechanism presented by the court: The decedent transfers $9.9 million of assets into the family limited partnership (FLP) in exchange for a 99 percent limited partner (LP) interest valued at $7.425 million (incorporating a 25 percent discount). The value of the LP interest in the estate is
$7.425 million under IRC Section 2033. Section 2043 picks up $2.475 million that represents the excess in value of the $9.9 million transferred to the FLP and the $7.425 million LP interest received in exchange. The combined
$7.425 million under Section 2033 and the $2.475 million under Section 2043 equals $9.9 million or the same result as if the FLP were disregarded, and the underlying assets transferred were returned to the estate. 

13. Revenue Procedure 2017-58.

14. Department of the Treasury 2017-2018 Priority Guidance Plan (Oct. 20, 2017).