More on the Valuation Rules

August 30, 2016 by · Leave a Comment 

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.

Pass Through Loopholes? 

August 15, 2016 by · Leave a Comment 

The pass through mantra, supported by more than 100 national business trade groups, is simple – tax business income once, tax it when its earned, tax it at the same reasonable top rate, and then leave it alone!

Do you want to stop inversions and keep American corporations here at home?  Adopt the mantra.  Do you want to make sure Main Street continues to be a source of job creation and economic stability?  Adopt the mantra.

We’ve been on this message for five years, and sometimes you get the sense it’s starting to sink in.  For example, the Brady blueprint released earlier this year was significantly improved over the Camp draft that preceded it.  Tax rates were lowered for pass throughs and C corporations alike, as was the cost of capital investment in the US.  That’s a good thing.

And then you have the last week.

First, the Center for American Progress issued a paper labeling pass through taxation a “loophole” and calling for double taxing all US businesses with more than $10 million in revenues.  Ouch.  Has CAP noticed that our best corporations are fleeing the US just to avoid the double tax?  So why would extending its reach to Main Street be a good idea?  See our response to the CAP paper below.

And then there’s this:

“We may end many of the loopholes that are currently being used,” Republican presidential nominee Donald Trump said on CNBC in response to question about the use of so-called passthroughs to lower tax rates.

Asked if it’s fair to say he wouldn’t allow passthroughs, Trump said, “We are looking at that very strongly.” More details are coming within two weeks, he said.

Just to be clear, the “loophole” Trump is referring to is different than the “loophole” CAP references.  CAP wants its readers to think the pass through structure itself is somehow a loophole because they pay different taxes than C corporations.  We address that bogus concern below.

Trump is referring to the challenge of taxing different forms of income at different rates and the opportunity for tax arbitrage that it creates.  As Trump advisor Steve Moore told Politico:

Stephen Moore, one of Trump’s economic advisers, made it clear to Bloomberg and to Morning Tax that the campaign is committed to stopping high-earning individuals from gaming that system. But he added: “All I’ve said is that there will be rules, to make sure that the business income that’s declared is actually business income and not wage and salary income in disguise. How you do that is beyond my pay grade. I’m not a tax lawyer.”

Trump suggested to CNBC that his campaign could roll out those rules within two weeks. But Moore told Morning Tax not to hold our breath: “I doubt it. This is a presidential campaign. This isn’t a Ways and Means markup.”

Mr. Moore is exactly right.  This issue has been around for a long time and it’s not going to be resolved in the next two weeks.  It’s also a reminder that the best tax reform would restore rate parity to all forms of income – individual, corporate, and pass through alike.  Anytime you tax different forms of active income at different rates, you run the risk of arbitrage.

That’s why the Pass-Through Principles letter says, “To ensure that tax reform results in a simpler, fairer and more competitive tax code, Congress needs to reduce the top tax rates to similar levels for all taxpayers.”

Of course, CAP and its allies oppose lowering individual rates, which has created the problem in the first place.  How do you make US businesses more competitive without lowering tax rates on individuals?  It’s not easy, but we know one thing for certain – you don’t make them more competitive by forcing them all into the double tax.

Pass Through Response to CAP

As noted above, the Center for American Progress (CAP) released a paper this week calling for imposing a double tax on all US businesses with more than $10 million in revenues.  The paper has innumerable flaws, but it essentially makes three basic points worth reviewing:

  1. Pass through businesses contribute to income inequality;
  2. Pass through businesses are “lightly” taxed and cost the government $100 billion a year in lost revenues; and
  3. All US businesses above $10 million in revenues should pay the double corporate tax.

You’ll notice that points one and two are merely a rehash of last year’s study by a number of Treasury and NBER economists (Treasury) on effective tax rates for businesses.  That study too was deeply flawed.  You can read our initial critiques here and here, and we build on those concerns below.

Point three, on the other hand, is totally new territory.  CAP would extend the harmful double tax currently imposed on C corporations and apply it to all businesses over $10 million in revenues.

CAP makes no attempt to defend this position on economic grounds, and for good reason.  The corporate double tax is widely understood to reduce domestic business investment, lower wages and job creation, and generally encourage the migration of businesses from the US to other countries.  Here’s our 2011 EY study on the topic:

The double tax is economically important and can distort a number of business decisions. One important such distortion arises because the double tax mainly affects business income generated by activities financed through equity capital within the C corporation form. Interest expenses are generally deductible by businesses, leading to a tax bias in favor of financing with debt rather than equity. The double tax thus raises the cost of equity financed investment by C corporations relative to debt financed investment and provides an incentive for leverage and borrowing rather than for equity-financed investment. Accordingly, the double tax contributes to the tax bias for higher leverage. Greater leverage can make corporations more susceptible to financial distress during times of economic weakness.

The double tax also increases the cost of investment in the corporate sector relative to the rest of the economy. This tax bias against investment in the corporate sector leads to a misallocation of capital throughout the economy whereby capital is not allocated to its best and highest use based on economic considerations. This reduces the productive capacity of the capital stock and dampens economic growth. As noted before, the diversity of organizational forms can be seen as a useful choice for businesses to make in organizing themselves, but the impact of differential treatment should be recognized. Finally, the double tax raises the overall cost of capital in the economy, which reduces capital formation and, ultimately, living standards.

Reformers might disagree on what the top business tax rate should be, but very few tax experts openly advocate for expanding the double tax.  So in this instance, CAP is making itself an outlier in the tax discussion and an advocate for fewer jobs and less investment here in the United States.  Not the place to be.

Treasury “Findings” Exaggerated

CAP writes that the Treasury study “implies that the growth of these lightly taxed pass-through businesses cost the federal government $100 billion in 2011.”  Notice the use of the weasel word “implies”?  CAP had to insert that word because the Treasury study explicitly does NOT find that the growth of the pass through sector has cost the government revenue.

This nuance was lost on the tax reporters at BNA, who dutifully reported that “The growth of passthroughs cost the U.S. $100 billion in lost tax revenue in 2011, according to a Center for American Progress report released Aug. 10.”  But Treasury never says that!  Here’s what the Treasury study says:

We find that allocating partnership income to traditional businesses results in an average tax rate on business income of 28.1%, which exceeds the average tax rate on business income of 24.3% in 2011 by 3.8 percentage points. Since the pass-through sector earned $1.1 trillion in business income in 2011, an additional 3.8 percentage points on the tax rate would have generated 97 billion more dollars in business tax revenue, which would amount to an approximately 15.5% increase in tax revenues from business income on an annual basis.

We stress that this exercise is not a projection for the likely effects on tax revenue from business tax reform. It is mechanical and assumes no behavioral responses, but has the advantage of being transparent. (Emphasis added)

Transparent?  Hardly.  BNA wasn’t the only news outlet to get the story wrong.  It is wholly misleading for Treasury to toss out this estimate and then say in effect, “Oh, just kidding.”

Treasury has to say “just kidding” because the whole exercise of taking 2011 pass through income and taxing it according to 1980 rules is ridiculous.  Which tax rates apply to the newly designated corporate income, those in force today or those from 1980?  What about the growth in the business tax base?  As we’ve noted in the past, business income today makes up 11 percent of our national income, while it was only 9 percent back in 1986 – that’s bigger and it’s the result of the shift in the taxation from the harmful double tax to the more efficient and competitive single layer pass through tax.  Did Treasury adjust tax collections back to 1980 levels to account for this growth?  No.

But are pass through businesses really taxed “lightly” as CAP so amusingly claims.  No.  There too, the Treasury estimates used by CAP have significant challenges.  Here’s a list of their problems:

  • Treasury uses 2011 filings and tax rules, so it misses the sharp rate hike on pass through businesses that took effect in 2013. The fiscal cliff resolution hiked top tax rates on pass throughs from 36 to 39.6 percent, imposed the new 3.8 percent surtax on top of that, and then restored the old Pease limitation on deductions.  The net effect of all this was to increase the tax top tax rate on pass through businesses from 35 to 44.6 percent!   Treasury issued their paper just last year, so they could have adjusted their estimates to reflect these higher rates, but they chose not to.
  • Treasury assumes shareholder-level taxes add another 9 percentage points to the C corporation average rate, but that assumption is based on economic literature from 2004 rather than tax collections from 2011. It also employs some heroic assumptions about the composition of corporate distributions (Footnote 16 in the Treasury report). A subsequent CRS study earlier this year found that shareholder level taxes added just 2.3 percentage points to the effective tax rate of C corporations, while a recent report by the Tax Policy Center found that only 24 percent of C corporation shares are held in taxable accounts, or less than half the level as assumed by Treasury.  More work needs to be done on this!
  • For partnerships, Treasury fails to differentiate between active business income and investment income previously taxed at the corporate level, which is obviously taxed at lower rates. The study notes that 70 percent of partnerships are “finance and holding companies” and that “capital gains and dividend income, which are taxed at preferred rates, amount to 45% of partnership income.” To the extent these partnerships are investing in C corporations whose income is already taxed at the entity level, it makes sense that their effective tax rate would be lower than the top statutory rate.  Perhaps this partnership income should be included in the C corporation bucket, since they are C corporation shareholders?  Something needs to be done to fix this, otherwise you have C corporations credited with both layers of tax, but their partnership shareholders credited with the second layer of tax only.
  • Treasury attributes about twenty percent of partnership income to “Unidentified TIN type” and “Unidentified EIN.” It then appears to assume this unidentified income was taxed at a blend of the two lowest applicable rates, resulting in an even lower average rate for partnerships.
  • Treasury appears to use “taxable income” in the denominator when calculating their effective tax rates, at least for C corporations. You can read our full concern with this here, but the net effect of using taxable income as the base is to overstate the effective tax rate for C corporations versus other business types.
  • Treasury fails to account for the size of business. This is material because while C corporation income comes almost entirely from large, multinational companies, a large portion of pass through income is earned by smaller, less profitable companies who pay the lower income tax rates.  To get a true comparison of tax burdens, Treasury should have broken down their estimates by size.

So Treasury overstates the tax paid by C corporations and understates the tax paid by pass through businesses, and then concludes that C corporations pay more.  Somebody in the economic world needs to take another run at this topic.

Here’s is the effective rate table from the Treasury report that is reprinted in the CAP report.

Treasury Rate Chart

You’ll notice that even with Treasury’s flawed approach, S corporations pay a higher effective tax rate than C corporations on their income when it is initially earned, even with the lower rates on pass through businesses in place back in 2011.  This is a reality that many policymakers do not understand.  S corporations and other pass through businesses pay tax on their income when it is earned, just like C corporations.  And today, their top tax rate is much higher than the C corporation rate.  Our effective rate study from 2013 included the higher, post-fiscal cliff rates and it found S corporations pay the highest effective rates of all.

So it’s simply inaccurate for CAP to argue that the government would collect more in taxes if it forced businesses paying a top marginal tax rates of 44.6 percent to instead pay the lower C corporation rate of only 35 percent.

What about income inequality?  Here’s what CAP says:

Until recently most analyses of income inequality, such as that by Thomas Piketty in Capital in the 21st Century, have ignored the role of pass-through income in the U.S. tax system by allocating it according to a standard economic formula. But, as this report will highlight, it is impossible to understand the growth of income inequality without a deeper look at pass-through income: about 40 percent of the increased share of income going to the top 1 percent of households is explained by pass-through income—twice the contribution of other forms of capital, such as corporate stocks and bonds.

And here’s what we wrote about the Treasury report last year.  It all applies here:

Pass through taxation doesn’t add to “income inequality.” C corporation tax treatment masks it. This is something we have written about in the past.

For example, Warren Buffett owns a large share of Berkshire Hathaway. That corporation pays no dividends and Buffett never sells any stock, so if one was just looking at the tax rolls, Buffett’s reported income is relatively low despite the fact that he’s one of the richest men on the planet. All his income is effectively hidden within Berkshire’s corporate structure. Treasury touches on this dynamic in a footnote at the bottom of page 2:

‘Note that this evidence may seem to suggest at first glance that at least a portion (e.g., perhaps 56% x 35% = 20%) of the rise in the top-1% income share could reflect merely a change in how business income is reported on Form 1040 returns: before annual business income taxes (as pass-through income subject to ordinary individual income taxes) rather than after annual business income taxes (as post-corporate-income-tax dividends or capital gains distributions).’

Figure 2 at the back of the paper helps Illustrate this dynamic.

NBER PT 1 percent chart

The blue line shows the rise of income inequality, thanks to data from Piketty and Saez. The red line shows how much less inequality would have risen if businesses back in 1980 were taxed as businesses in 2013 – i.e. all that income showed up on the individual tax forms rather than the corporate ones. Lesson: C corporation taxation masks income inequality.

So the economists at Treasury and the NBER issue a flawed study on effective tax rates, CAP repeats the core message and uses it to drive a policy of double taxing US businesses, and the tax press repeats it all without comment or analysis.  The assault on private enterprise continues.

BNA Tax Plan Comparison

BNA has a nice chart showing the tax proposals of Clinton and Trump.  It is copied below.  There is one correction we’d make, however.  For Clinton, all those tax hikes she has planned for individuals, capital gains, and estates would also apply to pass through businesses.

So for an S corporation that right now pays 39.6 percent, plus the 3.8 percent ACA surtax, plus the reinstated Pease limitation on deductions, Clinton would add:

  • The Buffett minimum tax of 30 percent;
  • A 4-percent surtax on income above $5 million;
  • A higher, 42.4 percent tax on capital gains held less than two years; and
  • Higher estate tax rates and a lower exemption levels.

Clinton would raise taxes on pass through businesses when they earn income, when they are sold, and when their owners die.  That strikes us as a pretty comprehensive assault on Main Street and far from “No Changes.”

COMPARISON OF PRESIDENTIAL CANDIDATE TAX PLANS

  Trump Clinton House GOP
Corporate Tax Top rate of 15 percent, immediate expensing. No changes to rate structures. Includes tax credits for businesses investing in community development, infrastructure and those that have employee profit-sharing. 20 percent tax rate, immediate expensing.
Passthrough Taxes Top rate of 15 percent, though Trump has hinted at possible changes to come. Immediate expensing. No changes. 25 percent tax rate, immediate expensing.
International Taxes One-time tax of 10 percent on corporate cash held abroad when corporations repatriate the money. Exit tax on unrepatriated earnings. One-time tax on corporate assets held abroad, split at 8.75 percent on liquid holdings and 3.5 percent on illiquid holdings. Shift to territorial taxation of overseas income. Tax imported goods but not exports.
Individual Taxes Three tax brackets of 12 percent, 25 percent and 33 percent, after initially proposing top individual rate of 25 percent. Eliminate carried interest deduction. Buffett rule of 30 percent minimum tax on individuals with $1 million annual income. Also, 4 percent extra tax on individuals with annual income over $5 million. Carried interest taxed as ordinary income. Three tax brackets of 12 percent, 25 percent and 33 percent.
AMT Eliminate. No changes. Eliminate.
Estate Tax Eliminate. Lower threshold to $3.5 million for individuals, $7 million for married couples, with no inflation adjustor. Raise tax rate to 45 percent. Set lifetime gift tax exemption at $1 million. Eliminate.
Capital Gains Capital gains and dividends taxed at maximum rate of 20 percent. Assets held less than two years taxed at ordinary rates. Reduce rate about 4 percentage points for each additional year asset is held until reaching a rate of 23.8 percent on assets held more than six years. Deduction of 50 percent on net capital gains, dividends and interest income, producing rates of 6 percent, 12.5 percent and 16.5 percent on that investment income, depending on individual’s tax bracket.

 

Treasury Hits Family Businesses!

August 9, 2016 by · Leave a Comment 

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?

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