October 2016 Client Advisory: Potentially the Biggest Changes to Estate Tax Planning in 25 Years

Dear Clients and Friends:

You may have heard about IRS proposed changes that would substantially alter the way in which interests in family controlled businesses, real estate and investment holdings and other transfers are valued for gift and estate tax purposes.  These changes will make it far more difficult for Clients to minimize estate taxes.

Proposed IRS Regulations: 

The IRS has issued proposed Regulations that would dramatically affect estate planning by eliminating or significantly curtailing valuation discounts taken on transfers of family interests.  For Clients looking to reduce their future estate tax, currently allowable discounts are extremely helpful in minimizing the gift tax consequence of family transfers.  As planners, we seek to reduce for transfer tax purposes the value of family assets by structuring entities utilizing all discounts for lack of control and lack of marketability that have historically applied.  The discounts enable a person to leverage the maximum amount of assets that can be protected from estate tax without triggering a gift tax to do so.

The proposed Regulations, if enacted, would be effective prospectively.  Hearings on these Regulations are scheduled for December 1 and planning consummated prior thereto should not be affected.  We expect that the Regulations will not be enacted until sometime next year but the safer course would be to do planning this calendar year.

What’s at Stake:

Here is an example as to how discounts work currently.  Client X has an estate which includes a $10M business or $10M worth of real estate.  He gifts 40% of the business or the real estate entity (that we would create) to a trust for the benefit of Client’s spouse and children so that future appreciation will not be included in Client’s estate. The gross value of the 40% interest in the business or real estate entity transferred is $4M.  Since the new trust will be a minority stockholder and cannot cause a sale of the entity or a redemption of the trust interest, the non-controlling interest is worth less than the proportionate value of the underlying assets.  Also, the value should be reduced to reflect the difficulty of marketing or selling the non-controlling interest.  As a result of these discounts, the value of the 40% interest transferred to the trust for gift tax purposes may be $2.4M not the $4M, resulting in a reduction of the taxable estate by $1.6M.  This is the type of discounting that the IRS seeks to stop.

In this example, not only would $1.6M in value be removed from the taxable estate of the Client but all future appreciation in the value of the ownership interest held by the trust would not be included in the Client’s estate.

Also, in addition to saving estate taxes, the trust that will be the recipient of the transfer could be structured to accomplish these other objectives:

  1. To permit the Client’s spouse to be a lifetime beneficiary thereby giving access via the spouse to all the income of the transferred assets during the life of the spouse;
  2. To create a multigenerational trust to protect trust property from death taxes and spouses and other creditors of children and grandchildren for generations; and
  3. Where appropriate, to permit the Client to be added into the trust as a beneficiary in the future so that funds could thereafter be distributed to the Client.

Note, if the Democrats win the White House and their estate tax proposals are enacted, many more estates will be subject to the federal estate tax and at higher rates.  More estate tax planning will be then necessary and we may not have the opportunity to utilize discount planning.

Many estate planners, including us, believe that these IRS Regulations are overreaching and will be scaled back but there is no certainty that this will happen.  Also, Congress is looking at these Regulations and considering legislation to limit their applicability.

What Should You Do?

Clients with taxable estates should consider whether or not transfers should be made to reduce the estate tax burden. Circumstances should be reviewed now to determine if it is appropriate to take advantage of the significant discounts that are still available.

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