More on the Valuation Rules
The August recess has given the S-Corp team a little more time to review the pending valuations rules out of Treasury. Recall that 23 years after the IRS surrendered and stopped using their flawed “family attribution” approach to valuing family-owned businesses, Treasury is trying to resurrect the concept using Section 2704. Below are some additional thoughts about why this is a particularly bad and fatally flawed idea.
Scope: Eliminating the application of “lack of control” and possibly “lack of marketability” discounts – the rule is unclear on those — to family business valuations may sound technical and immaterial, but it’s a big deal. Here’s one way to look at it.
Consider a 20 percent interest in a family-owned business transferred from a father to a daughter. The fair market value for the whole company is $500, so the pro-rata value of a 20 percent stake would be $100.
The 20 percent stake is not controlling, however, so its value needs to be adjusted for lack of control – the daughter has no ability to compel the company to buy the shares, nor can she compel the liquidation of the company. Add on the lack of marketability, since the company is closely held and there is no ready, liquid market outside the company to sell the shares.
If those discounts are worth 30 percent, then a 20 percent stake in the business would be valued at $70, and the estate tax would be $28. Under the new Treasury approach, however, there would be no recognition of lack of control and possibly marketability, and the estate tax would be $40 – a 43 percent increase in tax!
Worse, if the daughter seeks to sell her 20 percent stake, any arm’s-length buyer is going to offer her fair market value, which takes into account lack of control and lack of marketability. So the business interest she received from her father is worth $70 to an arm’s-length investor, but under Treasury’s new rules the estate tax would be $40. That’s more than half the value of the inheritance!
Keep in mind that this new rule applies to family-owned enterprises only. If the 20 percent interest were passed on to a non-family member, then the estate would be allowed to take lack of control and lack of marketability into account when valuing the stake, and the estate tax would be $28.
That’s how significant this proposed rule is. It’s a backdoor means of legislating significantly higher estate taxes on family businesses nationwide.
Treasury v. IRS: Perhaps the best case against adjusting the value of business assets in an estate by looking at who is receiving the property is made by our friends at the IRS. Here’s what the IRS Valuation Guide for Income, Estate, and Gift Taxes says:
“[t]he willing buyer and willing seller are hypothetical persons, not actual persons. See United States v. Simmons and Estate of Bright v. United States [citations omitted]. Accordingly, it is irrelevant who the real seller and buyer are. The important thing to remember is that valuation must consider both the willing seller and the willing buyer. …”
Here’s what the IRS says about the appropriate way to value property in Revenue Ruling 93-12:
The value of the property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.
And here’s what it says about discriminating against family members:
After further consideration of the position taken in Rev. Rul. 81- 253, and in light of the cases noted above, the Service has concluded that, in the case of a corporation with a single class of stock, notwithstanding the family relationship of the donor, the donee, and other shareholders, the shares of other family members will not be aggregated with the transferred shares to determine whether the transferred shares should be valued as part of a controlling interest.
The reason valuation science starts with a hypothetical buyer and seller is because that’s the only way to ensure a similar and balanced approach to all valuations. Once you start adjusting valuations based on who is receiving the property, you create an unworkable mess and opportunities for arbitrage. Tax advisors are going to have a field day with this one.
Statutory Authority: President Obama’s Treasury Department has been notable for its willingness to stretch the bounds of legal authority, and these rules are no exception. Treasury cites Section 2704 as the basis for this new rule. That provision, adopted back in 1990 as part of the Omnibus Budget Reconciliation Act, included a change to estate tax rules targeting so-called “lapsing restrictions” that artificially lower the value of family business assets. Here’s what the provision says:
The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee. (emphasis added)
Notice how the provision makes clear that the restriction has to go away at some point? However, “lack of control” and “lack of marketability” are not restrictions, and they don’t go away. They are real and exist in all forms of ownership inside and outside estate tax law. An ownership stake is simply worth less if you don’t enjoy all the rights – including the right to sell – that traditionally come with ownership.
Oh, and here’s the Conference Report that accompanied OBRA90:
The conference agreement modifies the provision in the Senate amendment regarding the effect of certain restrictions and lapsing rights upon the value of an interest in a partnership or corporation. These rules are intended to prevent results similar to that of Estate of Harrison v. Commissioner, 52 T.C.M. (CCH) 1306 (1987). These rules do not affect minority discounts or other discounts available under present law. (emphasis added)
Oops. Keep in mind that if Congress had wanted to go after lack of control and marketability with Section 2704, they could have clearly drafted the provision to do so. But just the opposite is true – Congress clearly did not want to go after those valuation rules. Their desire to preserve them is obvious in both the statute and the accompanying committee report.
The courts are going to have a field day with this one too.
Money Loser? So here is a question – will the proposed rule put forward by Treasury raise revenue, or lose it?
On its face, increasing the value of business interests passed on from one family member to another would increase estate tax collections. Certainly Treasury thinks so. They scored previous proposals along these lines as raising $18 billion over ten years.
But what about stepped up basis? Most estates are too small to pay the estate tax, but they do get stepped up basis. As Treasury noted in its blog post announcing the proposed rule:
Estate and gift taxes, or transfer taxes, are taxes on the transfer of assets from one person to another either by gift during his or her lifetime or by inheritance at death. Only transfers by an individual or their estate in excess of $5.45 million are subject to tax. For married couples, no tax is collected on the first $10.9 million transferred. These generous exemption amounts mean that fewer than 10,000 of the largest estates are subject to any transfer tax at all in a year.
Setting aside just how “generous” it is to let people keep their own property, the bottom line is that even with the new valuation rules in place, the vast majority of family enterprise assets transferred at death will likely fall under the estate tax thresholds. However, they may receive an increased step up in basis which should reduce future capital gains tax collections when the business is sold. As noted by one estate tax firm:
Another potentially positive, and likely also unintended, effect if the new Proposed Regulations are made final may exist for taxpayers who have a family business entity, but who do not have a large enough estate to cause a federal estate tax or state estate or inheritance taxes. For these taxpayers, disallowing valuation discounts that would normally apply when the family business entity interests are valued at an owner’s death can mean that the family receives a larger income tax basis step-up at that time, even though the increased value does not produce any increased estate or inheritance taxes.
So does this mean the new Treasury rules would reduce overall tax collections? Not sure. There seems to be uncertainty whether Treasury’s new valuation approach would apply to family business interests that are not part of a taxable estate. Consistency would argue that they should, but we stopped expecting consistency from this Treasury Department a long time ago.
Moreover, the same advocates who support punishing family businesses with higher valuations also support raising the overall estate tax rate and reducing the exemption amount. They want those higher valuations to lead to higher estate taxes for everybody, so any tax benefit for smaller estates is likely to be short-lived.
S Corp Gap Revisited
The Trump tax plan has renewed concerns that taxing income at different top rates leads to tax evasion.
Under the Trump plan, salary and wage income is taxed at 33 percent while business income is subject to a top rate of only 15 percent. So what’s to stop taxpayers from shifting income from wages to business to take advantage of the lower pass-through rate? Here’s Politico on the question from a couple of weeks back:
The Agenda’s Danny Vinik examines a big issue that wonks from both sides of the aisle have with both the Trump and House GOP plans – a higher top rate for individuals than pass-through businesses, which gives workers all the incentive to make themselves independent contractors rather than run-of-the-mill wage earners.
Moore – who’s been answering all sorts of questions about Trump’s tax ideas this week – told Danny that there’d have to be some fairly stout rules to block the sort of gaming that has plagued Kansas, which implemented a similar framework in 2012. But how exactly would that work? The wonk set has its doubts that tough-enough rules could be crafted, noting that there’s already an incentive for workers to classify themselves as freelancers to avoid payroll taxes. A Trump-like plan would only accelerate that rush, experts say.
We agree. Anytime you have different top rates, you’ll create an incentive for taxpayers to shift income into the lower tax bucket.
That is why we support establishing the same top rate for all forms of income – wage and salary, pass through, and C corp. Rate parity is not only a matter of tax fairness, it is also a matter of good tax administration. So much of the IRS Code is focused on distinguishing one form of income from another. Tax reform should seek to establish the same, reasonable top rates on all forms of income to increase fairness, reduce complexity, and make the Tax Code easier to enforce.
Doesn’t that mean that capital gains and dividends should be taxed at regular income rates? Absolutely not. Keep in mind that most dividends and capital gains have already been subject to the corporate tax, so the lower rate reflects the fact that tax has already been paid on that income. That’s why we support integrating the corporate code as suggested by Finance Chairman Orrin Hatch. The Hatch plan would establish a single layer of tax for all business income, pass through and corporate alike.
Couple integration with rate parity, and you’ve got the makings of real tax reform.