[Note: This post from the Leimberg Estate Planning Newsletter was reproduced with Permission of Leimberg Information Services, Inc. (LISI) at http://www.leimbergservices.com.]

Executive Summary

Much has been written about the perfect storm of estate planning: the coincidence of low values, low interest rates, valuation discounts and the $5 million ($10 million for a married couple)¹ gift and estate tax exemption. Unfortunately, the $5 million gift and estate tax exemption ends (reverting to $1 million) after December 31, 2012. Values of certain assets are increasing. However, most importantly, valuation discounts may be severely restricted at any time by IRS regulations. Thus, the best opportunities may close well before December 31, 2012. Don’t wait for this “last chance” at once-in-a-generation estate planning.

Facts:

Over the last three years of economic crisis and unfunded legislative spending, extraordinary deficits have been created and will continue for years to come. Congress and the Administration continue to examine all available means for raising new tax revenue, including additional gift and estate tax revenue. The Administration’s revenue raising proposals for the 2010, 2011 and 2012 budgets, set forth in the “Green Book”² (hereinafter the “Green Book”) include: (1) disregarding valuation discounts applicable to certain restrictions on transfer of interests in family-controlled entities; and (2) limiting grantor retained annuity trusts to a minimum 10-year term. In addition, the IRS has for several years maintained that it has the authority to restrict or eliminate valuation discounts by regulation. The Green Book notes that Chapter 14 of the Code (Sections 2701-2704) was intended to limit planning techniques designed to reduce transfer tax values, but that do not reduce the economic benefit to the transferee. Since 2003, the Treasury-IRS Priority Business Plan has included issuing new rulings or regulations to limit valuation discounts pursuant to Section 2704 of the Code.

Unexpected Loss of Family Discounts

Several political and legal factors suggest that such regulations could be issued at any time, effective on the date of publication, without an opportunity for notice and comment. President Obama has promulgated the “We Can’t Wait” doctrine to justify extensive regulatory actions and bypass Congress.³ “Millionaires and billionaires” are often cited as able to bear more of the needed tax increases and they are the exclusive users of intra-family valuation discounts. If there is political concern regarding the potential outcome of the 2012 elections, there is strong incentive to implement more “can’t wait” regulations. Furthermore, since the 2011 U.S. Supreme Court decision in the Mayo case,⁴ many believe that IRS regulations are much more difficult to challenge successfully.

What does this mean to those desiring to take advantage of the current perfect storm of estate planning? We should assume that one important aspect of this opportunity – valuation discounts – could be severely limited at any time by administrative fiat without notice.⁵

Application to Traditional Discount Planning

Many traditional planning techniques employ valuation discounts to enhance the transfer of wealth to heirs with little or no gift or estate tax consequences. For example, a Grantor Retained Annuity Trust (“GRAT”) allows a person to transfer assets to a trust in exchange for payment from the trust of an annuity (a yearly amount) that includes an interest factor set by the IRS, called the Section 7520 rate (which is 1.4% for February, 2012). The annuity payment can be set so that the grantor receives total payments during the term of the GRAT (two years or more, under current law) equal to the value of assets contributed to the trust. If so, there is no gift at inception (called a “zeroed-out GRAT”). If the value of GRAT assets increases more than 1.4% per year, the entire excess passes to or in continuing trust for the grantor’s children.

This has been a favorite wealth transfer technique of the rich and famous, including the Gates, Buffet and Walton families, and numerous Google (and presumably Facebook) millionaires. For example, pre-IPO Google shareholders held stock worth a fraction of its IPO price and a much smaller fraction of its post-IPO run up in value. Many such shareholders contributed shares to zeroed-out GRATs shortly before the IPO, received an annuity measured by the pre-IPO value, and terminated the GRATs after two years with a transfer of 10 times the pre-IPO value in trust for their children.

GRATs work for many different asset types including marketable securities, family businesses, real estate and family investment partnerships. The value of many of these assets is at 5 to 10-year lows today. The IRS implied interest rate of 1.4% is among the lowest rates ever. In addition, if the assets are held in an entity such as a partnership, LLC or corporation, traditionally accepted valuation principles permit an interest in the entity holding the assets to be discounted in determining its fair market value for estate and gift tax purposes.

These discounts (for lack of marketability and minority interest), determined by appraisers and confirmed in numerous decisions of the Tax Court and Federal appellate courts, often range from 30% to 40% or more. Such discounts greatly increase the wealth transfer opportunity from the GRAT. “Can’t Wait” regulations could eliminate this aspect of GRAT planning. In addition, current revenue raising proposals would also severely limit the use of GRATs by requiring a minimum 10-year term (Grantor must survive to the end of the term), rather than the current 2-year requirement. In theory, the IRS could also change this rule by interpretive regulations.

Elimination of family valuation discounts would impact many other conventional planning techniques. One is a sale to an intentionally defective grantor trust (“sale to a DGT”). The benefits of a sale to a DGT are effective immediately – the grantor does not have to survive any certain time (as in a GRAT). The beneficiaries of the DGT also can include grandchildren, as well as children, unlike a GRAT.

Another technique that would be impacted is a transfer to a charitable lead annuity trust (“CLAT”). The CLAT is a Trust to which the grantor transfers assets and the Trust pays an annuity (a yearly amount) to a charity for a period of years, after which the remaining trust assets pass to the grantor’s children or other beneficiaries. The annuity payment is a fixed percentage of the initial value of the assets transferred to the CLAT, including valuation discounts.

The value of the gift to remainder beneficiaries is measured by the initial discounted value of assets, value of the annuity payments, and term, so like a GRAT, the gift can approach zero. There are many nuances applicable in considering these and other planning techniques that should be reviewed with a qualified estate planning professional.

Rates and Exemptions Will Change

Finally, the grand revenue raiser – rates and exemptions. No one would have predicted that 2010 would be the year with no estate tax or that the gift and estate tax exemptions would increase to $5 million with a maximum estate and gift tax rate of 35% in 2011 and 2012. Now, the specter of a 2013 estate tax resurrection looms – with a $1 million exemption and a 55% marginal tax rate. The additional revenue from these changes would be substantial.

Do Your Planning Now

This window of opportunity, combined with the possible loss of valuation discounts, should create some urgency for those desiring to transfer wealth to children and grandchildren. The “perfect storm” of estate planning is a once-in-a-generation opportunity and will end soon. Advisors and clients should act now.

Gordon Schaller
Scott Harshman

Gordon A. Schaller is a partner in the Orange County office of Jeffer Mangels Butler & Mitchell LLP. Gordon focuses his practice on tax, estate planning, charitable planning, wealth management services, business succession planning, life insurance planning and trust and estate litigation. He represents high net worth individuals and business owners as well as numerous public and private charitable organizations. Gordon is a fellow of the American College of Trust and Estate Counsel and a frequent writer and speaker on captive insurance, life insurance, estate and tax planning, and charitable planning.

Scott A. Harshman is a partner in the Orange County office of Jeffer Mangels Butler & Mitchell LLP. Scott has an LL.M. in taxation from the University of San Diego School of law and is a certified specialist in estate planning, trust and probate law by the State Bar of California. He has extensive experience in tax, trust and estate matters and business planning, for high net-worth individuals, including wealth transfer planning, income tax planning, corporate and partnership taxation, business succession planning, and international estate and tax planning. Scott also has vast experience in probate and trust administration, trust and probate litigation, and the structure and formation of nonprofit entities, including private foundations and public charitable organizations.

¹ Due to automatic inflation adjustments, the gift and estate tax exemption has increased to $5,120,000 for 2012.
² See http://www.treas.gov/offices/tax-policy/library/grnbk12.pdf
³ See www.whitehouse.gov for numerous “We Can’t Wait” for Congress executive orders and regulations.
⁴ Mayo Foundation for Medical Education & Research v. U.S., 562 U.S. ___, 131 S. Ct. 704 (2011), where the Supreme Court held that administrative convenience can justify the terms of a regulation and regulations are entitled to strong deference.
⁵ Compare the unexpected issuance of proposed regulations effectively eliminating private annuities which contained an immediate effective date. IR-2006-161 (October 17, 2006).

LISI Estate Planning Newsletter #1933 (March 1, 2012) at http://www.leimbergservices.com/ © Gordon A. Schaller and Scott A. Harshman, 2012. Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

I just returned from two weeks in Turkey and Syria, vacationing with my family. There is nothing like a trip overseas, to strange countries and cultures, to gain new perspectives.

One thing this trip reminded me: don’t believe something just because the media says it.

Syria is about as ‘out’ with the U.S. as a country can get. It sponsors Hamas, is destabilizing the Middle East, etc. etc. True — yet what we discovered is that the person on the street (as opposed to the government functionaries working for the dictatorship in power) was as friendly, helpful and genuinely curious about us Americans as I’ve ever met. Compared with (for example) the French, there is no comparison. Our perceptions going in were totally inverted by the time we left.

As a valuator, the lesson is ‘don’t ever accept something at face value’. Our job is to dig into the details of a company and craft an objective interpretation of the future value of the business. It takes effort, but it’s the only way to get the real story. Just because something is ‘common knowledge’ does not mean it is true. Face value is not real value.

Have you gained new perspective from a recent trip abroad or a new experience? Let us know in a comment below!

News flash: most of the companies we’ve been asked to value so far in 2010 are reporting lower-than-normal growth rates since the 2008 recession began, or even outright sales drops.

To paraphrase James Carville, ‘it’s the economy, stupid’! No doubt about it: the economy stinks, and it’s awfully tough to predict when things will get better.

But every cloud has a silver lining. If there ever was a great time to gift interests in your business, that time is now. Take a look at this Wall Street Journal article from late 2008. Sound familiar? We’re in virtually the same boat as two years ago, and the opportunities still exist.

Company values are generally lower thanks to economic and industry woes, so you can gift away many more shares now than in years past. Tax rates are likely to go up in the years ahead as Federal, state and local governments seek every means at their disposal to grow tax revenues, so gifting likely will become more expensive as time passes.

Talk with your advisor. The stars have aligned for business owners who want to transfer interests in their companies to others.

Know someone who would like this post? Please share using the buttons below! How have you taken advantage of the economy? Leave a comment to share your story.

This blog is meant to bring fresh ideas about business value to business owners and their advisors. While our first posts have been written articles, we hope to use other media to communicate our message as well – and we plan on using video a lot more in the future.

Here’s our first video, a 90-second talk by SPARDATA president Brad Davidson on why a valuation should serve as the foundation for planning for your future.

If you would like to set up a consultation, please click here.

Did you like this video? Do you have suggestions for topics you’d like to hear more about? Let us know by leaving a comment! You can also share this and other posts using the icons below.

A recent U.S. Tax Court case reminds us of a valuation ‘fact of life’: credentials are important and, in a dispute, often are the difference between winning and losing.

In Ringgold Telephone Company v. IRS Commissioner, a taxpayer and the IRS disagreed about the value of a limited partnership interest in a cellular license.  The taxpayer claimed the interest was worth $2,980,000 on the valuation date; the IRS argued the interest was worth almost twice as much: $5,220,423.  Judge Wells of the Tax Court decided the correct answer was $3,727,142 – signifying a win for the taxpayer; a defeat for the IRS.

Ringgold shows first-hand the importance of using a credible appraiser. 

“As is customary in valuation cases”, said the Court, “the parties offered expert opinion evidence to support their opposing valuation positions.  In such cases, we evaluate the opinions of experts in the light of the demonstrated qualifications of each expert…”  The taxpayer’s appraiser was a CPA with an ABV designation conferred by the AICPA and who had extensive experience valuing telecommunication entities.  The IRS’ appraiser, on the other hand, was a CPA who had no valuation credentials and had never valued a telecommunications entity.   

When you choose a valuator, always assume the appraisal may end up in court.  So choose someone who is competent, knowledgeable, experienced and can explain complex ideas in layman’s terms.  Those are the ingredients that Judge Wells of the Tax Court (or any judge hearing your case) is looking for.

Another aspect of this case is also interesting.  A short six months after the valuation date, this taxpayer sold his interest for $5,220,423 to BellSouth.  (That is where the IRS’ number came from.)  Nevertheless the Tax Court ruled the sale price was not the interest’s fair market value. 

How can this be?  Doesn’t the price at which an asset changes hands determine ‘fair market value’?  Not necessarily!  BellSouth was a ‘strategic buyer’, not a ‘financial buyer’.  In the valuation world, strategic buyers pay more for assets than ‘financial buyers’.  In a future blog post I’ll explain the difference between the two.  To get that post and other Valuation Matters updates delivered right to your email, enter your address in the Subscribe box on the right.