Treasury Hits Family Businesses!

The verdict is in, and Treasury’s proposed rules on estate tax valuations of family-owned businesses are broad – very broad indeed. They are, simply put, a direct assault on America’s family-owned businesses.

Here’s the take of WealthManagement.Com:

Although the details are significant, the bottom line is that the proposed regulations would appear to eliminate almost all minority (lack of control) discounts for closely held entity interests, including active businesses owned by a family. To accomplish that, restrictions under the governing documents and even those under state law would be disregarded for valuation purposes.

And Steve Leimberg’s Estate Planning Email Newsletter:

In short, it may appear that, outside of the new three year rule, that not much is being proposed with respect to the valuation of minority discounts.  One might, therefore, conclude… that minority discounts remain largely intact with a narrow exception for transfers made within three years of death.  That reading would not, however, be accurate.  As will be discussed, the proposed regulations under Section 2704(b), in particular based upon a new concept referred to as “Disregarded Restrictions,” are a frontal attack on the concept of discounts in the context of family entities.  Given the failure the IRS has sustained in the courts in terms of its argument favoring a family-attribution principle and given its resulting frustration, it must be conceded that the new Disregarded Restrictions approach seems masterfully drafted.  

So so-called “minority interest” discounts are at risk under the proposed rules. What does that mean?  It means that family owned businesses will be valued, and taxed, at significantly higher rates than businesses owned by non-related parties.  How much more depends on the facts and circumstances of each case, but minority discounts of 20, 30, 40 percent and higher are common and have been approved by the courts.

But aren’t these discounts just a loophole? No, not at all.  Minority interest or “lack of control” discounts reflect the underlying economic reality that ownership without control – control to sell, control to make management decisions, control to distribute profits — is worth significantly less than ownership with control.  If you own 30 percent of a company, but have no say in how the business is run or when it is sold, then your share of the company is worth significantly less than 30 percent of the total value of the company.

For examples of minority discounts, look no further than the stock exchanges. Every stock on the New York Stock Exchange is traded with a minority discount imbedded in the price.  That is why investors seeking to buy a controlling interest in a publicly traded company are willing to offer a premium over the traded price.  Unlike retail investors, they expect to have a controlling interest at the end of the day, so they are willing to pay more.

So when Treasury calls this a “loophole”, what they are really upset about is the underlying economic reality of control. One might as well complain that the sky is blue.

This is not a new fight. The IRS has been waging, and losing, the battle over these discounts for decades.  But the newly proposed rule represents a whole new tact on the part of Treasury that needs to be taken seriously by the business community.  This is the first time in the long battle over discounts that Treasury has hung its efforts on an existing, albeit 26-year old, statute.

So does section 2704 give Treasury the authority to eliminate minority interest discounts for family-owned enterprises? Probably not.  But we won’t have the ultimate answer to that question until these rules are fully litigated in the press, the comments to Treasury, the elections, the Congress, and finally the courts.

For next steps, there’s the 90-day comment period ending in early November, a public hearing in early December, and then the bums rush by Treasury to get these regulations out the door before the end of the Obama Administration.

In the meantime, the business community, including your S Corporation Association, will be up in arms once again. This proposed rule combines the two signature trademarks of this Administration – a jaded view of private enterprise coupled with a willingness to push the envelope on legal authority. We expect to ultimately win this battle, but it will take a long time and waste innumerable resources that could otherwise be used to invest and create jobs.  What’s the point in that?

Tax Policy on the Table for September

Members of Congress are back home and set to return mid-September for a final three week session before the November elections. Add in two or three weeks of possible “lame duck” session, and that’s the extent of time available to tax writers to address the numerous items on their honey-do list:

  • Preventing the 2011 tax hikes (including AMT);
  • Adopting the small business tax bill;
  • Extending the extenders that expired last year;
  • Extending the extenders that will expire this year; and
  • Something on the estate tax.

Given that these issues have been before Congress the entire year, it’s difficult to conceive how Congress would suddenly jump into action on all these items before the clock runs out. And while recent statements by leadership suggest they will make a concerted effort to address most of these items before adjourning for good, the Senate continues to be hamstrung in its ability to move anything. Here’s our take on the where we go from here:

  • Small Business Tax Bill: The bill itself is non-controversial and has bipartisan support. What’s holding it up is a fight over the process — will amendments be allowed and, if so, how many — and on-going debates over extraneous tax items like the future of the estate tax. Majority Leader Reid was very close to a deal with  Minority Leader McConnell just prior to the break. We expect further progress and ultimate adoption of this package in September.
  • Tax Hikes: Last week, Finance Committee Republicans issued a statement calling on the Committee to hold a markup on extending current rates “as soon as possible to bring certainty of continued tax relief.” Meanwhile, House Majority Leader Steny Hoyer is calling for extending only those provisions for taxpayers making less than $200,000. And several Senate Democrats — notably Senators Kent Conrad (D-ND) and Evan Bayh (D-IN) — have expressed support for a one-year extension of everything. No clear path out of this challenge, but we continue to believe a one-year extension of everything is most likely, followed by failure of Congress to pass anything. A one year extension of the middle-class relief is a close third.
  • Extenders: Extenders will likely move as part of the small business tax bill in September, which is good news for manufacturers and families living in states with no state income tax. The bad news is the extension would last just until the end of this year, so another bill would have to follow soon.
  • Estate Tax: We’re now four months away from seeing the estate tax rise from the dead (55 percent top rate and $1 million exemption) with no apparent solution in view. Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) are pressing for lower rates and a higher exemption (35 percent and $5 million) while others support adopting the rules in place in 2009 (45 percent and $3.5 million). Still a third camp is happy to see the estate tax return in full force. Time is short, and no side appears to have the 60 votes necessary to prevail, which means current law has the upper hand.

Regarding the floor situation, Senate Majority Leader Reid set up the small business bill to be pending business as soon as they get back on September 13th. He introduced yet another substitute before they left and filled the amendment tree to block other amendments. He then filed cloture on several democratic amendments to the bill as well as the underlying legislation, setting up a series of 60-vote threshold cloture votes in the first couple days when they return.

While it’s possible these votes take place and fail along party lines, it’s more likely the two leaders come to an agreement on allowing a limited number of amendments — including adding the extender package to the mix - for the bill to move forward. At least that’s what we hope, since there are some very good provisions in the small business bill that should help investment and job creation.

Regarding the other items, including Extenders v. 2011, we’re expecting the rest of the to-do list to get pushed into a lame duck, with some sort of omnibus bill that includes federal funding and tax provisions presented to members in November or December. No idea how that battle royale turns out, but we’ll be sitting in the front row to watch.

More on S Corporations and Employment

The ongoing battle over the pending tax hikes has a tendency to devolve into a debate over the definition of “small” business and other random characteristics a firm needs before it be considered “real” by some policymakers. For example, proponents of the tax hike appear to believe a manufacturer is more “real” than a law firm, even though both are taxed as flow-through entities and both might be defined by the SBA as small.

But this debate over which types of business activity are “real” is silly and misses the point. The point is that a large percentage of the pending tax hike will be imposed on employers and investment. One half of all business income is taxed at the individual tax rates. One quarter to one-third of all business income is subject to the top two rates. That’s a lot of economic activity subject to the pending tax hikes.

Consider this debate from the perspective of the employee: whether your job comes from a large S corporation or a small S corporation makes no difference to you; both are employers, and your job is your job. So why should policymakers care whether you work at a 500 employee manufacturing plant or a 12 person law firm? Why do some policymakers believe one job worth saving but the other not?

One challenge we face in this debate is that while the folks at the Statistics of Income break down firms by structure, they don’t include employment numbers, so it’s difficult to tell how many employees work for S corporations. One way to back out an estimate is to look at their payroll and executive compensation numbers. If we assume the average compensation of an American worker is $40,000 (admittedly a rough estimate) then it appears S corporations employed about 21 million workers back in 2007.

Moreover, S corporation employment gets bigger the more revenue and income a firm makes (as you’d expect). Firms with more than $50 million in revenues employed about 4.5 million workers, while firms with $10 to $50 million in revenues employed 4.4 million workers.

Firms that size have average business income per shareholder exceeding $335,000, which means more often than not, their business income is taxed at the top two rates. Are the nine million employees who work at these firms less deserving than the employees who work at the local coffee shop? Obviously not, but for some reason the other side of this debate spends an enormous amount of time trying to minimize the value of those employees and the firms they work for.

Again, these numbers are just rough estimates, but the point they make is valid nonetheless: flow-through businesses — including S corporations — represent the majority of employers in this country and raising their taxes is not going to help the economy or the job picture.

Joint Committee Estimates Tax Hikes

In response to a request from the Ways and Means Committee, the Joint Committee on Taxation released some estimates last week on who would benefit from foregoing the rate hikes and other tax increases next year. You may have seen related stories focusing on how much “millionaires” would benefit. A couple thoughts:

First, while the JCT estimates that taxpayers earning over $1 million would see an average tax break of $103,834, they also estimated this break would reduce their tax burden by only 11 percent, suggesting that these taxpayers will pay nearly $1 million in income taxes next year on average.

Second, the revenue “cost” of avoiding all the tax hikes next year is not substantially more than the cost of avoiding those for taxpayers making less than $200,000 — $227 billion versus $202 billion.

That’s not as much as we would have expected, and in our view raises the odds that Congress extends for one year all the 2001 and 2003 tax cuts. It’s not a done deal, of course, and total inaction by Congress is also possible, but with the weak job market and pending elections, the legislative equivalent of a punt — a one year extension of everything — is looking increasingly likely.

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