Two opinions were issued last year that changed the landscape of valuing pass-through entities (PTE) for transfer tax purposes. These two cases, Estate of Jones v. Commissioner and Kress v. United States, broke with the 20-year-old convention that tax-affecting the earnings of a PTE, such as an S corporation (S corp), partnership and limited liability company, for an assumed corporate tax rate is disallowed when determining such entity’s fair market value (FMV).1 In contravention of this practice, both Jones and Kress hold that it’s appropriate to tax-affect the earnings of a PTE for federal gift tax purposes if the facts of the case and the accompanying valuation can support its application. A third opinion, Cecil v. Comm’r, is currently in the Tax Court’s pipeline and is expected to fully address and further clarify the permissibility of tax-affecting the initial valuation of PTEs.2
Prior to these cases, in the 1999 seminal case Gross v. Comm’r, the Tax Court agreed with the Internal Revenue Service’s valuation experts and held that an S corp’s earnings shouldn’t be tax-affected for a corporate rate in the context of valuing non-controlling interests.3 Disallowing this practice effectively increased a PTE’s estimated FMV for transfer tax purposes with a corresponding increase in transfer tax liability. This prevailing view continued for two decades until the Jones and Kress rulings were released in 2019.
Though Jones and Kress are groundbreaking opinions on the issue of tax-affecting, there’s some irony in that the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted years after the gifts in question were made, but prior to the judges’ rulings. The transfers in both Jones and Kress were made during the sub-prime mortgage crisis circa 2008. By permanently lowering the top corporate income tax rate from 35% to a flat 21%, the TCJA limited the benefits of tax-affecting that had for so long eluded planners.4 That said, tax-affecting can still be a valuable tool for minimizing transfer tax liability and delivering the best possible result for clients.
In fact, the current trend toward the acceptance of tax-affecting makes now a good strategic time to transfer business interests to the next generation in a tax-efficient manner. Given the current COVID-19 global pandemic, estate-planning professionals should discuss with their clients whether it makes sense to plan more aggressively to take advantage of depressed market conditions, high transfer tax exemptions, low interest rates and the ability to value a PTE on a C corporation (C corp) equivalent basis.
Effect of Tax-Affecting
The concept of FMV is well known and whether income or asset based, the valuation methodology implemented in an appraisal has a significant effect on the value of the interests for transfer tax purposes.5 To highlight the benefits of tax-affecting, let’s focus on the income-based method. The income-based (or discounted cash flow) method discounts to present value the anticipated future income of the company whose stock is being valued. More often than not, comparables for valuations in these cases are C corps that measure returns on an after-tax basis. C corps’ earnings are taxed at the entity level and are taxable as dividends to the shareholder when distributed. PTEs aren’t subject to this double layer of taxation as there’s not an entity-level tax, and the individual owners are responsible for paying tax on their proportionate share of the entity’s earnings at ordinary tax rates, whether that income is distributed or not.
Once the initial value for a PTE is established based on C corp data, valuation professionals will determine whether any adjustments need to be made to account for the differential in taxation between the PTE and the C corp form. Prior to Gross, it seemed customary to adjust the earnings from the PTE to reflect estimated corporate income taxes that would have been payable had the pass-through form, specifically S status, not been elected.6 These adjustments were meant to avoid distortions when applying industry ratios such as price to earnings. In finding that tax-affecting of an S corp’s earnings wasn’t supported by the facts, and going so far as to call the assumed corporate tax rate of 40% “fictitious,” Judge James S. Halpern’s opinion in Gross marked a defining moment. The ruling obstructed the taxpayers’ ability to reap the potential benefits of tax-affecting a PTE.
In Gross and subsequent cases, a 0% corporate tax rate was applied, and tax-affecting was categorically rejected on the grounds that PTEs aren’t subject to an entity-level tax. Twenty years later, there was a reversal of fortune with Jones and Kress. In finding resoundingly for the taxpayer, the Tax Court in Jones held that tax-affecting the earnings of an S corp and a limited partnership at a 38% combined federal and state tax rate was appropriate under the circumstances. As mentioned earlier, the gifts in Jones were made between 2007 and 2009 when the top federal corporate tax rate was 35%, and the top dividend tax rate was 15%. Tax-affecting the earnings of the family businesses resulted in significant tax savings for the Jones’ estate. Similarly, in Kress, the district court sided with the taxpayers’ expert that tax-affecting the earnings of the family company was appropriate and concluded that S corp status was a neutral factor and not a valuation premium as the IRS expert contended.
Impact of the TCJA
The ability to fully tax-affect the earnings of a PTE for a C corp equivalent using the higher pre-TCJA corporate level tax rate remarkably improves tax savings on transfers of the company interests. The TCJA’s modifications to the Tax Code, however, dulls the blade of tax-affecting post-Jones and Kress for transfers made after its enactment. To summarize the relevant provisions, the TCJA lowers the top corporate income tax rate from 35% to a flat 21%, and the qualified dividend tax rate remains at its 2017 level of 20%. The top individual ordinary income tax rate, which applies to a PTE owner’s earnings, marginally dropped from 39.6% to 37%, and new Internal Revenue Code Section 199A provides a deduction of up to 20% of qualified domestic business income for PTEs.7 The 21% corporate tax rate is permanent, while the latter two provisions sunset after Dec. 31, 2025.
Consider the following hypothetical example for a single individual using pre- and post-TCJA federal tax rates for a company with $1 million in pre-tax income, using the highest individual rate, and assuming the owner isn’t subject to additional state tax and doesn’t qualify for a deduction under IRC Section 199A. Using 2017 tax rates, a C corp shareholder’s total tax liability is 50.47% of the total earnings, while an S corp shareholder’s total tax liability is 43.40%. When applying 2018 rates, as illustrated in “Comparison of Tax Liability,” p. 32, the spread between a C corp shareholder’s total tax liability and an S corp shareholder’s tax liability is so narrow that it can be characterized as a rounding error.
Under the TCJA, it appears that tax-affecting the earnings of a large PTE for an assumed corporate tax rate no longer has the profound effect on the FMV of an entity for transfer tax purposes that it once had. Additionally, the ability of a PTE to offer a greater return on earnings compared to a C corp is further weakened once the TCJA’s individual tax benefits, including Section 199A, expire.
Keep Persisting
One could argue that valuing PTEs may now be less complicated, as previous methods using C corp comparables are outmoded. Ultimately, appraisers must determine whether it’s still prudent to award a premium or to consider a PTE more favorable than a C corp when determining the FMV of an entity for transfer tax purposes.
Tax and valuation professionals should persist with tax-affecting for several reasons. First, smaller businesses that qualify for the 20% deduction in qualified business income under Section 199A benefit from a more significant spread in the total tax liability between a PTE and a C corp equivalent. Second, the impact of tax-affecting will be greater in states that assess a state-level corporate tax, especially in situations in which the corporate tax and individual income tax gap is substantial. Third, because it’s been allowed in cases such as Jones and Kress, and its benefits have been diminished by the TCJA, the IRS may be less motivated to challenge its use going forward. Though the IRS hasn’t released guidance as to whether it’s acquiesced to the practice of tax-affecting, IRS valuation experts might not want to waste time and energy in argument.
Moreover, valuation professionals should create a habit of tax-affecting when appropriate to anticipate a potential change in the corporate tax rate so that they have solid methods and data readily available to support its application. In tracking the key factors in Jones and Kress, the appraisal should explain any PTE benefits and detriments to clearly demonstrate why tax-affecting is appropriate.
Given the reduction in tax revenue from the TCJA, coupled with the massive $2 trillion Coronavirus Aid, Relief, and Economic Security Act stimulus bill, a future corporate tax rate hike isn’t out of the question.8 It could be triggered by a change in administration or if Congress determines it’s the best way to raise revenue and to recoup the cost of the stimulus package. Implementing the logic applied by the respective valuation experts in Jones and Kress as a matter of practice, including tax-affecting, valuation professionals can ensure a better result for their clients now and be prepared for future changes in the law.
The current pandemic environment, though fraught with uncertainty and market decline, is prime for those who have the means and liquidity to transfer assets without jeopardizing their own financial security. The Jones and Kress decisions substantiate the benefits of tax-affecting the earnings of a PTE on a corporate tax basis. Combining tax-affecting with other valuation adjustments for lack of control and lack of marketability, the FMV of a PTE such as a family-owned business can be further depressed. Volatility tends to lend itself to larger lack of marketability discounts for closely held businesses. This is supported by the opinions in both Jones and Kress, in which the gifts were made during and around the 2008 recession. Beginning the wealth transfer process with a reasonable and substantiated FMV is the first step in any effective estate plan.
Due to the depressed market, the applicable federal rates (AFRs) are historically low. AFRs are used for setting the minimum interest rate for intra-family loans, among other things, and are a crucial component of several sophisticated estate-planning techniques. Sales to intentionally defective grantor trusts typically use the mid-term AFR as the interest rate for the promissory note between the seller and buyer, and grantor retained annuity trusts (GRATs) use the IRC Section 7520 rate as the interest rate for the annuity payments made from the GRAT to the grantor. Both techniques are highly effective in “freezing” the value of the transferred asset for transfer tax purposes, while transferring the appreciation to the beneficiaries through the trust vehicle. The July 2020 mid-term AFR is a mere 0.45% (compared with the July 2019 mid-term AFR of 2.08%), and the July 2020 Section 7520 rate is 0.6% (compared with the July 2019 Section 7520 rate of 2.6%).9 Both of these strategies can be leveraged when the FMV of the transferred asset has been tax-affected and discounted.
The TCJA also provides an increased estate and gift tax exemption of $10 million, indexed for inflation, per individual ($11.58 million in 2020) and a corresponding increase in the generation-skipping transfer tax exemption. These increases, like the individual income tax benefits under the TCJA, sunset after Dec. 31, 2025. There are many advantages to using the exemption to transfer assets such as closely held business interests to the next generation now. These opportunities should be thoroughly discussed with tax and financial planning counsel. Consider maximizing the benefit of the current high exemptions by transferring assets that may be less valuable in the current climate, so that appreciation will occur in the hands of the next generation and won’t be included in the donor’s estate for transfer tax purposes. Similar to the reduced corporate tax rate, these benefits could also be on the chopping block prior to the sunset date if there’s a change in administration or if Congress needs to increase revenue.
A Formidable Tool
Though tax-affecting may not move the needle as it once did, it’s still a formidable tool available to planners when assisting clients with the transfer of closely held business interests. The long-awaited Tax Court opinion in Cecil could provide additional support for the validity of tax-affecting as a trusted and established economic theory. Under the TCJA, the benefits of tax-affecting have been tempered, but given the unpredictable nature of changes to our tax laws, tax-affecting could become more of a force should the corporate tax increase. If tax-affecting becomes a widely accepted practice now, it may be less likely that the courts will revert to the dark and draconian days of Gross and the cases that followed in its footsteps.
Endnotes
1. Estate of Aaron Jones v. Commissioner, T.C. Memo. 2019-101 (Aug. 19, 2019); Kress v. United States, 123 A.F.T.R.2d 2019-1224 (E.D. Wis. March 26, 2019).
2. Estate of Mary R. Cecil v. Comm’r, No. 14640-14 (U.S. Tax Ct. filed June 23, 2014). For additional discussion, see Daniel R. Van Vleet, “Kress, Jones and Cecil,” Trusts & Estates (May 2020).
3. Walter L. Gross, Jr. v. Comm’r, T.C. Memo. 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001), cert. denied, 537 US 827 (2002). See also Estate of Gallagher v. Comm’r, T.C. Memo. 2011-148, modified by T.C. Memo. 2011-244 (Oct. 11, 2011); Estate of Natale B. Giustina v. Comm’r, T.C. Memo. 2016-114, supplementing Estate of Giustina v. Comm’r, T.C. Memo. 2011-141, rev’d and remanded (on other grounds), 586 F. App’x 417 (9th Cir. 2014).
4. Tax Cuts and Jobs Act, Pub. L. No. 115-97 (Dec. 22, 2017).
5. Treasury Regulations Sections 20.2031-1(b); 25.2512-1. All section references herein are to the Internal Revenue Code of 1986, and to the regulations promulgated thereunder, unless otherwise stated.
6. Namely, the “IRS Valuation Guide for Income, Estate and Gift Taxes: Valuation Training for Appeals Officers and the IRS Examination Technique Handbook.”
7. For additional discussion on IRC Section 199A, see Alvina Lo, “Getting the Facts Straight on the 199A Deduction,” www.wealthmanagement.com/high-net-worth/getting-facts-straight-199a-deduction (Jan. 17, 2019).
8. Coronavirus Aid, Relief, and Economic Security Act, Pub.L. 116–136 (Mar. 27, 2020).
9. Revenue Ruling 2020-14; Rev. Rul. 2019-16.