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?

Mark to Market for Dead People

The President’s budget is out and, as we have in the past, we will start with a disclaimer.  Congress requires the President to issue a budget every year, and every year the President (regardless of party) complies with a ridiculously long and labored set of phone book-like documents outlining the budget.  And every year Congress yawns and says it’s dead on arrival.  So take our commentary below with a grain of salt, as most of the provisions in this budget are going nowhere, fast.

That said, the budget includes a couple tax proposals that caught the attention of our members, including:

  • A higher, 28 percent tax rate on capital gains and dividends;
  • A mandatory 28 percent tax on appreciated assets when the owner dies;
  • A new 30-percent minimum tax (Buffett tax) on high-income individuals; and
  • Applying self-employment taxes to the business income of professional services businesses.

We addressed the so-called Buffett tax and Gingrich-Edwards loophole when they were first proposed in prior budgets.  The capital gains proposals, on the other hand, are new.  The President first talked about them in his State of the Union Address this year.  You can read the White House explanation here and a more detailed Treasury Department summary here.

The basic premise is that wealthy people don’t pay their fair share and need to pay more in taxes.  This, of course, is nonsense.  The federal tax code has many faults, but the lack of progressivity is not one of them.  According to the Congressional Budget Office, the tax code is remarkably progressive and has been for a long time.

The CBO’s estimates on who pays what are from 2010, so they don’t include the recent hike in capital gains and individual tax rates enacted as part of the 2013 fiscal cliff deal.  Combined with the Affordable Care Act taxes put in place that year, capital gains rates increased from 15 to nearly 24 percent.  The new proposal would raise them again to 28 percent, or nearly double their level from just three years ago.

These higher rates work against the Administration’s 2012 framework to reduce corporate tax rates.  What’s the point of reducing the corporate tax rate from 35 to 28 percent if you’re just going to hike the tax paid by corporate shareholders at the same time?  As the CBO pointed out back in December, the marginal effective tax rate on corporate investments includes both layers of the corporate tax.

In 2012, the combined marginal rate on corporate investment was 45 percent (the 35 percent corporate tax plus the 15 percent shareholder tax times the remaining corporate income).  After health care reform and the fiscal cliff, today’s marginal tax on C corporation investment is 50 percent.  If Congress agreed with the President and cut C corporation rates while also hiking capital gains and dividend rates, the net result would be a 48 percent marginal tax.  You’ll notice that’s higher than when we started, which begs the question of how all this is supposed to make the U.S. a more attractive place to invest?

The capital gains tax hike is bad for pass-through businesses too.  For many business owners, selling the business is their retirement plan.  One of the advantages of S corps and partnerships is that their owners get capital gains treatment when they sell the business.  The President’s proposal would raise the tax on those sales to 28 percent.

For owners who choose to pass their business on to their children or employees, the proposal would force them (their estates, really) to pay the capital gains tax at the time of their death, along with any estate tax that is owed.  The Administration used this example:

The largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code – is a provision known as “stepped-up basis.” Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis.

Let’s take a step back.  There are two reasons for stepped-up basis.  The secondary reason is to ease record keeping.  Ask the American Farm Bureau how hard it is to keep track of basis from one generation to the next.  The Administration “solves” the record keeping challenge by forcing the estate (heir, really) to recognize any capital gain when the owner dies.

So if the stock left to an heir in the Administration’s example is a pass-through business, the estate is going to need to raise around $10 million to pay the capital gains tax.  For most estates, coming up with that sort of cash without selling or liquidating the business is simply out of the question, so the proposal will result in an increase in the number of private businesses sold at the death of the owner or, most likely, when the owner is still alive and able to plan the transaction.  Warren Buffett will love this proposal.

But record keeping is the secondary reason for stepped up basis.  The primary reason is the existence of the estate tax.  That $10 million owed by the estate is in addition to the estate tax already owed on the business.  Since the resolution of the fiscal cliff in 2013, the estate tax owed in the Administration’s example is 40 percent on the value of the estate over $5 million, or $18 million.  The tax code recognizes this liability by giving the heir of the estate a step-up in the basis of the assets they just inherited (and the estate just paid tax on).  The Administration ignores this dynamic in their write up and proposal.

So under the President’s plan, the heir inherits a $50 million business but also (in effect) inherits a $28 million tax bill.  What business could survive that sort of tax hit?

The Administration claims their proposal includes protections to ensure that no “small” business would have to be sold to pay the tax, but we’re skeptical.  Congress tried to protect family businesses from the estate tax back in the 1990s, and it was your basic disaster.  Almost no businesses were able to jump through the necessary hoops to gain the protection, and the qualified family-owned business provision was scrapped.

But those are just minor details and quibbles compared to the scale of the tax envisioned by the President – over 50 percent in the example above!  Thomas Piketty would be proud.  The new Republican Congress will never go along with these ideas, of course, so they only serve to remind us of just how far apart Congress and the Administration are on tax policy.  It’s just one more reason to be skeptical of tax reform or any other broad tax policy being enacted this year.

Rate Debate is All But Over

Another interesting week in our nation’s capital. The big news is the tax deal struck between Congressional Republicans and the White House. We expect this deal to pass, with few changes, either next week or when Congress returns the first couple weeks in January.  Here are some useful summaries and the legislative text if you’re interested:

The Senate is going to take the package up on Monday and should pass it Tuesday night or Wednesday morning. It then goes to the House, where it faces an angry liberal caucus and its leadership. According to the Hill:

House Majority Leader Steny Hoyer (D-Md.) said earlier Thursday night that the House will probably take a vote but on what remains to be seen.

“Well, we’re going to see what comes from the Senate,” he said on MSNBC. “But we’re going to vote on something, I’m sure. Whether it’s exactly what the president made a deal with on the Republicans or not, that remains to be seen.”

For S corporations and the markets, though, the key was to get an agreement. It is less important that the deal is being temporarily blocked and more critical that we have a little clarity on tax policy for the next two years. Either this year or very early next year, Congress will pass a two year extension of most existing tax policies. The delay of a few weeks might matter to the IRS and short-term withholding tables, but not to real investment and hiring decisions.

In the meantime, the question for policymakers is whether to make concessions to the current House Democratic leadership in order to get them to bring up the bill next week. Knowing that they can pass the deal intact on January 3rd, Republicans are going to be reluctant to make substantive changes to the deal, especially on key items like the estate tax, so the leverage of House leadership should be limited. We’ll see.

Estate Tax Compromise

We know lots of folks care about the estate tax provisions in the deal so here is summary of those provisions. Considering the alternative — higher rates and lower exemptions from now on — the negotiators did a remarkable job getting this agreement:

Temporary estate, gift and generation skipping transfer tax relief. The EGTRRA phased-out the estate and generation-skipping transfer taxes so that they were fully repealed in 2010, and lowered the gift tax rate to 35 percent and increased the gift tax exemption to $1 million for 2010. The proposal sets the exemption at $5 million per person and $10 million per couple and a top tax rate of 35 percent for the estate, gift, and generation skipping transfer taxes for two years, through 2012. The exemption amount is indexed beginning in 2012. The proposal is effective January 1, 2010, but allows an election to choose no estate tax and modified carryover basis for estates arising on or after January 1, 2010 and before January 1, 2011. The proposal sets a $5 million generation-skipping transfer tax exemption and zero percent rate for the 2010 year.

Portability of unused exemption. Under current law, couples have to do complicated estate planning to claim their entire exemption (currently $7 million for a couple). The proposal allows the executor of a deceased spouse’s estate to transfer any unused exemption to the surviving spouse without such planning. The proposal is effective for estates of decedents dying after December 31, 2010.

Reunification. Prior to the EGTRRA, the estate and gift taxes were unified, creating a single graduated rate schedule for both. That single lifetime exemption could be used for gifts and/or bequests. The EGTRRA decoupled these systems. The proposal reunifies the estate and gift taxes. The proposal is effective for gifts made after December 31, 2010.

President Mentions Tax Reform

With the tax outlook for the next two years almost in place, we’re wondering what’s next? The current extension takes us right up to the President’s reelect in 2012 (and the reelect of 23 Democratic Senators) and we can’t imagine they’d welcome a reprise of this year’s battle over rates, etc.

So what’s the plan? The Hill’s On the Money Blog suggests it could be broad based tax reform. According to the Blog:

An administration official said the tax reform ideas are now being examined under the direction of Assistant Treasury Secretary Michael Mundaca and Treasury adviser Gene Sperling.

Treasury and the President’s Economic Recovery Advisory Board previously had examined reforming corporate tax rates, but had not considered eliminating individual tax breaks and lowering individual rates as part of a deficit reduction package until the commission raised the idea, the official said.

And

The administration official said a likely next step will be for placeholder language for tax reform to appear in the Obama 2012 budget, with the details of the tax reform to be worked out in the following months. The deficit commission report recommends putting the new tax code in place by 2012.

Lots of folks are skeptical that this President will be able to work with the incoming Republican House, especially on something like tax reform, but the tax deal just agreed to is evidence that the two sides can work together when circumstances force their hands. With massive deficits projected from now on, the circumstances should be there.

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