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.

Courts Overvalue S Corps

For over 15 years, the IRS has discriminated against S Corporations when it comes to estate taxes and other matters where business valuation plays a role and, for 15 years, S Corp has been fighting them on it.

Our S-Corp advisor Nancy Fannon has written extensively on the subject. In 2007, we told you about her book, The Comprehensive Guide to S Corporation Valuation, which did a great job of laying out the entire issue.

Now, Nancy has followed up with Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle. You can purchase the book here and you can register here for a special May 20th webinar workshop Nancy is hosting.

For those new to the issue, the challenge is whether the courts take taxes into account when they value S corporations as part of an estate or other legal proceeding.  In many cases, the courts ignore the taxes S corporations pay, resulting in them being subject to 60 percent or higher premium over similar C corporations. As you can imagine, premiums that large have been noticed by the S corporation community.

The discrimination stems from the Gross v. Commissioner case decided in 1999 where the court ruled against “tax affecting” the projected income of the S corporation – that is, adjusting the income down to reflect taxes paid – because S corporations are not subject to the corporate tax.

The tax community will recognize that the court was effectively asserting a distinction without a difference.  The lack of an entity level tax on S corporations is one of form, not substance.  S corporation shareholders are required to pay tax on their business income when it is earned (just like C corporations), regardless of whether the income is distributed (just like C corporations), and often at higher rates than C corporations are subject to.  This reality is lost in the Gross decision.

The effect of that decision is that, in many cases, the IRS fails to adjust the fair market value of an S corporation to reflect the business’s overall tax liability, as they do when assessing the fair market value of a C corporation. Congress should be aware of this on-going discrimination on the part of the IRS against S corporations.

S corporations pay taxes – lots of them — through their shareholders.  As our 2012 Quantria made clear, the average tax burden on S corporations is actually higher than the corresponding burden on C corporations, and this tax burden should be reflected in their fair market value when they are part of an estate.

If S corporation valuation is important to you, read Nancy’s book and watch her seminar.  And know that with the ongoing debate over the estate tax, S-CORP will continue to fight the good fight and ensure family-owned businesses are valued fairly.

S Corp Payroll Tax Hike Resurfaces

Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:

Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.

Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:

Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.

We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current reasonable compensation rules are clear and the IRS has a history of going after offenders and winning.

Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.

For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:

This new approach, particularly the ”principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).

The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current ”reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.

For those who want more, here are links to the business community letter as well as a longer history of the issue:

SBA Weighs in on Corporate Tax Reform

A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:

Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.

New data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.

These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business tax expenditures.

The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.

By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.

The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:

Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.

So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.

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