Making Use of a Deceased Spouse’s Unused Estate Tax Exemption Simplified

The election for married couples to elect portability of the Federal Estate Tax Exemption was introduced in late 2010 when the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act (“TRUIRJCA”) was signed into law. Portability allows a surviving spouse to possibly make use of their deceased spouse’s unused federal estate tax exemption by adding it to their own exemption. The estate tax is a tax on the amount of a decedent’s taxable estate (pus adjusted taxable gifts). Under federal law, a certain amount of each estate is exempted from taxation. The exemption amount for 2017 is $5.49 million.[1] This means that estates valued above this amount are subject to a 40% estate tax for the amount exceeding the exemption. A little over two years following the signing of the TRUIRJCA, the American Taxpayer Relief Act (“ATRA”) was signed into law, making portability a permanent election for married couples.

However, the unused applicable exemption amount does not automatically transfer to the surviving spouse upon the death of the predeceased spouse. In order to elect portability, the executor must, on or before nine months following the death of the predeceased spouse, file a United States Estate (and Generation-Skipping Transfer) Tax Return (IRS Form 706). On or before that due date, an Application of Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes (IRS Form 4768), can be filed to request an automatic six-month extension.

In the event that the estate missed the nine-month deadline, there were two separate processes in place to elect portability at a later date, depending on the decedent’s date of death. Where the decedent died after December 31, 2010, and on or before December 31, 2013, the IRS, in Rev. Proc. 2014-18, provided for a simplified method of filing so long as the estate met certain qualifications. The decedent must have been a citizen or resident of the United States at the time of death, and the estate must have been one not required to file an estate tax return under Sec. 6018(a) because the value of the gross estate (plus adjusted taxable gifts) did not exceed the basic exemption amount in effect for the year of death. If these qualifications were met, and the estate tax return was filed before the December 31, 2014 deadline, stating that the form was being filed pursuant to Rev. Proc. 2014-18, the estate tax return would be considered timely filed and a valid portability election. No filing fee was required.

However, if the decedent died on January 1, 2014 or later, the process was more difficult and more expensive. Estates that did not qualify for Rev. Proc. 2014-18 relief were required to seek an extension to file the estate tax return to elect portability under Regs. Secs. 301.9100-1 and 301.9100-3 for an estate not required to file an estate tax return under Sec. 6018.[2] Accordingly, the executor looking to elect portability was required to submit a private letter ruling request providing evidence to the IRS’s satisfaction that the executor acted reasonably and in good faith and that granting relief would not prejudice the interests of the government. Regs. Sec. 301.9100-3(c)(1)(i) lists the ways in which an executor can be deemed to have acted reasonably and in good faith. The private letter ruling request had to be submitted in accordance with applicable procedures, contain affidavits and declarations from the parties, and be accompanied by a filing fee ($10,000 for requests received after February 1, 2017).

But recently the IRS, in Rev. Proc. 2017-34, 2017-26 (effective June 9, 2017) eliminated the requirement that an executor seek a private letter ruling to file a late estate tax return electing portability. So long as the decedent was a citizen or resident of the U.S., the estate was not required to file an estate tax return under Sec. 6018, and the estate tax return is filed before the second anniversary of the decedent’s death, or (if later) January 2, 2018, stating that the return is being “FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A),” the executor may elect late portability without seeking a private letter ruling. No fee is required. However, the private letter ruling request procedure is still available to an executor who fails to file under Rev. Proc. 2017-34 within the applicable time constraints.

The IRS has made it easier and less expensive for executors to file late estate tax returns electing portability. For letter rulings pending on the effective date of Rev. Proc. 2017-34, 2017-26, the file will be closed and the user fee refunded. The estate may then obtain relief granted by Rev. Proc. 2017-34, 2017-26, by complying with the above procedure. However, it should be noted that this relief is only available for estates where the gross estate (plus adjusted taxable gifts) do not exceed the exemption amount applicable as of the decedent’s year of death and that the late return must be filed no later than two years after the decedent’s date of death or, if later, January 2, 2018.

[1] Some states have their own estate tax, some of which exempt estates at the federal level, and others which have lower exemption levels. In New Jersey, the current exemption is $2 million.

[2] No relief is available for estates large enough to be required to file an estate tax return under Sec. 6018 that failed to timely file.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or Lauren M. Ahern, Associate in the Trusts & Estates Practice Group.

IRS Recognizes Retroactive Validity of GRAT Based Upon Court Reformation

The IRS recently examined whether a Grantor Retained Annuity Trust (hereinafter “GRAT”) could be held valid despite the fact that it omitted certain key language.  In a GRAT, the Grantor transfers property into the irrevocable trust in exchange for the right to receive an annuity for a fixed period of years (“the retained interest”) based upon the IRS monthly interest rate commonly known as the Section 7520 rate. The retained interest must constitute a “qualifying interest” under the Code. When the term of the GRAT ends, the balance of trust assets are distributed to the trust remainder beneficiaries.

The value of the taxable gift, if any, is determined by reducing the fair market value of the assets transferred to the GRAT by the amount of the retained interest (i.e., the annuity). The larger the retained interest, the smaller the taxable gift.  It is noteworthy that GRATs can now be “zeroed-out” which has unlimited upside as there is no gift tax due whatsoever.  In a “zeroed-out” GRAT, the grantor takes back an annuity which soaks up all of value of the property transferred.  The grantor generally must outlive the term of the GRAT for it to be effective.  If the grantor dies before the end of the term, the portion of trust balance needed to generate the annuity payments comes back into the grantor’s estate.

The goal is for the GRAT to outperform the Section 7520 rate.  Providing the GRAT outperforms the Section 7520 rate, any excess growth flows to the remainder beneficiaries’ tax free.  Consequently, this is a great technique to remove portions of the grantor’s taxable estate in a potentially tax free manner. GRATs work best with highly appreciating assets such as securities or closely held business interests.

In this matter, the draftsman failed to include language prohibiting the trustee from issuing a note, other debt instrument, option or other similar financial arrangement in satisfaction of the annuity obligation as required by § 25.2702-3(d)(6) of the Gift Tax Regulations.  In other words, the governing language failed to make the retained interest a “qualified interest” under IRC § 2702(b)(1). After the state court issued an order reforming the trusts to include the language as required by the tax regulations, the grantor sought confirmation that their interest in each trust was a qualified one for federal gift tax purposes.

On balance, the IRS concluded that the trust instruments could be amended so as to qualify them as valid GRATs.  The IRS found that the trust agreements themselves were established with the overarching intent that the retained interest be a qualified one so as to satisfy the tax criterion.  Moreover, and pursuant to the judicial reformation of trusts to correct scrivener’s error, amendment is permitted where it was necessary to achieve the settlor’s tax objectives.  Accordingly, the IRS held that the grantor’s retained interest was a qualified one thereby validating each GRAT under the tax law, effective as of the date each was created.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.

Late Portability Election Denied for Estate That Was Over the Estate Tax Return Filing Threshold

One of the key changes of the 2010 Tax Relief Act is the addition of “portability” of the first deceased spouse’s unused basic exclusion amount, commonly referred to as the deceased spousal unused exclusion amount.  Under portability, the executor of a decedent’s estate can elect irrevocably to allow the decedent’s surviving spouse to take advantage of the unused exemption amount for the spouse’s estate and gift tax purposes.  In other words, the surviving spouse can elect to “port” or transfer the deceased spouse’s unused exemption amount to their own exemption amount so as to use both.  The goal, similar to much of estate tax planning is to fully exploit both spouse’s exemptions from the estate tax.  Indeed, the more exemptions, the less tax.

Prior to portability, the exemption amount was considered personal to the individual and therefore not transferrable to others.  Complex estate planning was often required which involved establishing credit shelter trusts in conjunction with other planning vehicles.  Accordingly, and in an effort to reduce much of the complexity associated with estate planning and to simplify the process, Congress established portability.

To elect portability, the executor of the deceased spouse’s estate must timely file a complete estate tax return (Form 706), regardless of the size of the estate.  In general, the estate tax filing requirement is based upon the size of the gross estate.  Where the decedent’s gross estate plus adjusted taxable gifts exceeds the Code’s basic exclusion amount for the year of the decedent’s death, a return is required.  For 2017, the basic exclusion amount is $5,490,000 per person.  It follows that an executor that would not otherwise be obligated to file Form 706 must still file the form within the time prescribed in order to make the portability election.  If an executor who files the Form 706 does not wish to take advantage of portability, they must affirmatively opt out by stating on the Form 706 (or in an attachment to the Form 706) that the estate is not making the election.

A complete estate tax return that is timely filed will be deemed to contain the “computation” of the unused exemption amount.  The unused exemption amount is the lesser of: (1) the basic exclusion amount in effect in the year of the deceased spouse’s death; or (2) the amount by which the deceased spouse’s applicable exclusion amount exceeds the sum of their taxable estate and adjusted taxable gifts.  Interestingly, a surviving spouse may only use their most recent deceased spouse’s unused exemption amount.  For example, suppose Wife Wilma is married to her first Husband Henry.  Husband Henry passes away.  Several years later, Wilma remarries second husband Harold.  Upon Harold’s death, Wilma may only elect portability consideration with respect to her most recent husband, Harold.  This restriction (among others) may make additional planning (such as credit shelter trusts) warranted in many cases.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.

Part II: Naming an Accumulation Trust as the Beneficiary of an IRA

Last month we discussed the benefits of naming a Conduit Trust as the beneficiary of an IRA.  A Conduit Trust allows the IRA to remain tax deferred thereby stretching the Required Minimum Distributions over the lifetime of the trust’s beneficiary which could be a young child or grandchild.  The ability to continue tax-deferred growth over a long period is a key benefit.  As a Conduit Trust is also the named beneficiary, minor children who become beneficiaries will not require a guardianship proceeding.

However, while a Conduit Trust affords these advantages, there are some notable drawbacks.  First, a Conduit Trust requires that all Required Minimum Distributions be distributed immediately outright to the beneficiary.  In cases where the beneficiary is a spendthrift, is at risk for divorce or is in a litigious profession such as physicians, the forced distributions are left wide open and unprotected from creditor claims. Second, a Conduit Trust cannot withdraw retirement account proceeds and accumulate them inside the trust.

Accordingly, a second option is to name an “Accumulation Trust” as the beneficiary of the IRA.  An Accumulation Trust allows  to receive the Required Minimum Distributions and then use their ultimate discretion in making distributions.  This way, distributions from the IRA can be kept within the trust and accumulated rather than being immediately distributed to the beneficiary.  As such, the trust assets have added protection against creditors. This is especially helpful where the beneficiary is a spendthrift and protects against inexperience.

In drafting the trust, special attention must be paid to the governing provisions. Specifically, in order to be able to use the principal beneficiary’s life expectancy for Required Minimum Distribution calculations, the trust agreement must prohibit trust distributions to anyone who is older than the person whose life expectancy is used to calculate the Required Minimum Distributions.  This can be quite limiting as typically named contingent beneficiaries such as spouses or older siblings cannot be so designated.  The trust assets can never pass to any older sibling or relative which may be contrary to the owner’s wishes.  Perhaps equally limiting, only individuals can be beneficiaries which prevents one from designating a charity.  If any of these requirements is not satisfied, the trust will not qualify for stretching.  As such, an Accumulation Trust is probably useful only for certain, older, beneficiaries.

New Congressional Update:   Congress’ Senate Finance Committee recently proposed legislation eliminating the beneficial tax “stretch” and replacing it with a mandatory 5-year liquidation rule for non-spousal beneficiaries.  Under the proposed legislation, an inherited traditional IRA would have to be liquidated generally within 5 years of the original owner’s death.  It will be interesting to see whether any of this legislation is approved.  Stay tuned.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.

21st Century Cures Act Remedies Longstanding Special Needs Trust Issue

On December 13, 2016, President Obama signed the 21st Century Cures Act.  One of the more relevant aspects of the law to estate and special needs planning is found in Section 5007 of the Act, which is called “Fairness in Medicaid Supplemental Needs Trusts.”  The purpose of this section is to amend 42 U.S.C. Section 1396p d(4)(a) to add the words “the individual” to the list of persons who may establish a first party or self-settled special needs trust (SNT) for a disabled individual.

In 1993 Congress enacted the Omnibus Budget Reconciliation Act of 1993 (commonly referred to as OBRA 93).  As part of this larger Medicaid overhaul, 42 U.S.C. Section 1396p d(4)(a) was enacted which allowed a parent, grandparent, guardian or a Court to establish a first party, or self-settled, SNT for a disabled individual under the age of 65 to be funded with that individual’s own assets.  The self-settled SNT has since become an important estate planning tool by allowing disabled individuals to receive certain government assistance while still enjoying the benefit of their own assets to supplement their living expenses.  The tradeoff being that upon the death of the disabled individual or the termination of the trust, the benefits received during the disabled individual’s lifetime must be repaid from trust assets.  Curiously, though, the OBRA 93 language did not provide a mentally competent disabled person the ability to establish his or her own self-settled SNT.  This became particularly onerous when a disabled person had no parent or grandparent to establish such a trust for them, forcing them to petition a Court for approval of their SNT; a costly and time consuming process.

With the passing of the 21st Century Cures Act, however, this issue is rectified.  Now, disabled persons with the requisite mental capacity may establish their own self-settled SNTs without the need for assistance from other parties or Court approval.  It is important to note that the disabled individual must still be under the age of 65 when creating the trust and the trust must still contain a payback provision for government assistance.  Also, it is important to distinguish the self-settled SNT from the third party SNT, a different type of special needs trust which is established and entirely funded by a third party but exists for the benefit of a disabled individual.  These third party SNTs do not require a payback provision and are not affected by the new law.  Special Needs Trusts are an important and powerful tool when considering estate planning for the disabled or individuals with disabled beneficiaries.  Care should be taken to receive appropriate advice regarding the use of special needs trusts as part of a broad, comprehensive estate plan.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.

The Tax Advantages of Naming a Conduit Trust as the Beneficiary of an IRA

IRA’s can represent a large portion of an individual’s retirement assets. For this reason, care should be taken to ensure these assets receive the best tax treatment and are protected from creditors such as divorcing spouses. Indeed, the divorce rate today is close to 50%. The hallmark of IRAs is “tax-deferral.” This means that the investment earnings such as interest, dividends and capital gains accumulate tax free while in the account. The ability to widen or “stretch-out” the IRA’s distributions over a beneficiary’s life expectancy yields more income than if the account was simply cashed out. It follows that the younger the beneficiary, such as a child or grandchild, the longer the tax-deferred growth exists; the very goal of this tax planning.

Required Minimum Distributions  

In general, when an IRA holder turns 70 ½ years old, they must begin taking their distributions (often referred to as “Required Minimum Distributions”). Required Minimum Distributions are based upon the individual’s age and life expectancy.  After the IRA holder passes away, and providing there is a designated beneficiary, that beneficiary gets to use their own life expectancy for taking Required Minimum Distributions. The failure to take a Required Minimum Distribution triggers a 50% penalty of the amount not properly withdrawn.  Conversely, if there is no designated IRA beneficiary, the assets have to be withdrawn rather quickly; namely, within 5 years after the owner’s death. To illustrate, an IRA which is to be paid to the account holder’s estate or a charity is considered as having no designated beneficiary.

Married Couples

Married couples typically name the surviving spouse as the direct beneficiary of their IRA. The key benefit here is that following the first spouse’s death, the surviving spouse can rollover the IRA into his or her own IRA (commonly known as a “Spousal Rollover”). The rollover allows the assets and perhaps most importantly, any growth or appreciation therein to remain tax-deferred.  At the age 70 ½, the surviving spouse can then begin taking their Required Minimum Distributions based upon their own life expectancy.

Planning for Widows, Widowers and Single Individuals

Estate planning for the single client presents unique challenges. It is noteworthy that IRAs are exempt from the reach of creditors; as such, they afford asset protection. To illustrate, if an individual pursues bankruptcy or is named in a lawsuit, the funds held in their IRA are protected from creditors.

However, when an IRA is left to a child, grandchild or other beneficiary, it is treated as an “Inherited IRA.” Unfortunately, Inherited IRAs do not receive the same favorable asset protection afforded Spousal Rollovers. Courts have opined that Inherited IRAs are not precisely “retirement funds” and as a result, they are not exempt from an individual’s creditors such as divorcing spouses. Most individuals do not want a child’s ex-spouse to get their IRA. The question thus becomes what can be done to protect this wealth.

The “Conduit Trust

One effective strategy is to name a “Conduit Trust” as the beneficiary of the IRA. With a Conduit Trust, all distributions from the IRA are required to be immediately distributed to the trust’s beneficiaries.  In general, where a trust is named as the beneficiary of an IRA, the beneficiary with the shortest life expectancy is deemed by the IRS to be the beneficiary; as such, this beneficiary’s life expectancy is then used to determine the Required Minimum Distributions. However, qualifying a Conduit Trust as a designated beneficiary under the tax rules is quite taxpayer friendly as the beneficiary to receive distributions is considered the only beneficiary which the IRS will construe in assessing which beneficiary of the trust has the shortest life expectancy. This makes compliance much easier and helps maximize tax deferral.

Most importantly, Conduit Trusts afford asset protection as the IRA will now be exempt from the reach of creditors such as divorcing spouses. Furthermore, it will allow the IRA to remain tax deferred thereby stretching the Required Minimum Distributions over the lifetime of the trust’s beneficiary which could be a young child or grandchild. As the Conduit Trust is the named beneficiary, minor children will not require a guardianship proceeding. The establishment of a trust also affords the grantor control over how the asset will be inherited and prevents a beneficiary from simply cashing it out thus defeating the tax-deferred benefits. As with any estate planning, such benefits should be weighed against the potential drawbacks which include for example, the additional cost of setting up a trust, the added complexity and trust accounting.

By not designating a Conduit Trust as the beneficiary of an Inherited IRA or by simply having the IRA pass outright, one may face serious setbacks.  First, if the intended beneficiary passes away and the new beneficiary is a minor, the parties will have to go to court for the appointment of a legal guardian. Thereafter, and following this potentially burdensome process, any distributions must be paid to a court appointed guardian. Second, even providing the beneficiary is an adult, they may seek to liquidate the entire account, which will trigger a substantial tax and end any tax-deferred growth. All of these outcomes may very well contradict the original owner’s final wishes.  Moreover, and equally problematic, the funds themselves are readily available to the beneficiary’s creditors, which include a divorcing spouse. In light of the high divorce rate, this is a very real concern today.

In summary, naming a Conduit Trust as the beneficiary of an IRA affords creditor protection, spendthrift protection, control over estate planning and maximizes tax-deferral. In addition to maximizing the tax objectives, using a trust in this context helps prevent the chance of unintentional beneficiaries inheriting the asset thereby keeping it in the family.

For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq., member of the Trusts & Estates Practice Group, at 973-230-2088 or jgrey@genovaburns.com.

Transfers with Retained Interest and Continued Enjoyment Included in Taxable Estate

In a recent Tax Court case, the court held that the gross estate included the value of assets which a deceased health care company CFO transferred inter vivos through trust to, and were held by, a family limited partnership on the date of death.  See Estate of Beyer, T.C. Memo 2016-183. There, the decedent had transferred extensive stockholdings asserting that this constituted a qualified bona fide sale for adequate consideration under Section 2036.

In general, Section 2036 requires the inclusion of property in the gross estate where the decedent has transferred property but retained: (1) the right to income from the property transferred; (2) the possession or enjoyment of the property; or (3) the right, either alone or in conjunction with any person, to designate the individuals who shall possess or enjoy the property or income therefrom. In other words, where an individual transfers property but retains certain “strings,” the property is included in their estate.  In rendering its decision, the court found that the taxpayer could not establish that the decedent received adequate and full consideration in money or money’s worth regarding the transfer.  Likewise, the taxpayer failed to show that there was no implied agreement to retain possession or enjoyment of, or right to income from, those assets under Section 2036.  Rather, the record reflected that the decedent continued to use the subject assets after the transfer and did not retain sufficient assets outside of the family limited trust to pay their anticipated financial obligations. In light of this, the court concluded that the assets should be included in the decedent’s estate.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Esq., Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq. and Lauren M. Ahern, Esq., Associates in the Trusts & Estates Practice Group.

Tax Controversy Matters: IRS Softens Criteria for Streamlined Installment Agreements

The IRS has announced on its website that it is testing expanded criteria for the streamlined processing of Installment Agreements. The new criterion is available through September 30, 2017 and will afford more taxpayers the ability to enter into streamlined agreements which as discussed below offer significant advantages.

IRS collection cases come in different flavors and as such, may be settled through different approaches such as making an Offer in Compromise, requesting favorable “Currently Not Collectible” status or negotiating an Installment Agreement.  For example, an Offer in Compromise is an agreement between the IRS and taxpayer to settle the debt for less than the full amount owed.  Each approach is designed to get the taxpayer back on the road to compliance while reducing the deficiencies owed to the government (commonly referred to as the “tax gap”).

Installment Agreements are beneficial to taxpayers as they permit the debt to be paid over time with a reduction in penalties.  The IRS cannot file a tax lien during this period.  Moreover, and unlike other forms of settlement, the IRS must enter into such an agreement where the taxpayer’s aggregate tax liability (without interest, penalties, additions to tax and additional amounts) is not more than $10,000.  There are very few settlements where the government is required to participate and this is one of them; as such, a significant portion of tax debts are settled in this fashion.

In addition, there are “streamlined” Installment Agreements which benefit taxpayers as they are processed quickly, without financial analysis or managerial approval.  The maximum term for a Streamlined Installment Agreement is 72 months. It is noteworthy that where the taxpayer owes no more than $50,000 in back taxes, the IRS may accept a Streamlined Installment Agreement without requiring the taxpayer to produce extensive financial statements (the invasive IRS Form 433).  Indeed, the ability to settle the tax controversy at such an early level without providing sensitive and private financial information is a major advantage.  To illustrate, the IRS Form 433 requires the taxpayer to disclose in writing where they work, the banks they use, whether they earn income from trusts, whether they are a beneficiary of any trust or estate, whether they serve as a trustee of any trust, whether they have ever lived abroad or filed for bankruptcy.  This can be particularly burdensome on clients who are involved with family trusts.  For this very reason, a Streamlined Installment Agreement is often the favored approach to settling tax debts.

Newly Expanded Criteria

Most importantly, the IRS is now testing expanded criteria for processing Streamlined Installment Agreements.  Specifically, and under this new approach, taxpayers who owe up to $100,000 in tax, penalties and interest will qualify for streamlined processing providing their proposed monthly payment meets certain requirements. Once again, the ability to satisfy the debt over time with a reduction in penalties and without disclosing financial information is an advantage as it allows taxpayer’s time to resume their normal activities without much interruption or reduction in their finances. Such new criteria will afford even more taxpayers who owe substantial back taxes the ability to come forward and settle their debt in a fast and non-invasive manner.  In conclusion, the new program is highly taxpayer-friendly and should increase overall resolution thereby closing the tax gap.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.

The New Landscape? Treasury Issues Long-Awaited Proposed Regulations Designed to Eliminate Valuation Discounting of Family-Controlled Entities

If finalized, the proposed regulations will eliminate minority and marketability valuation discounts for transfers of interests in closely held family businesses. The proposed regulations are not effective immediately. Rather, they only apply to transfers made after the final regulations are promulgated, subject to a possible three-year lookback for estate tax purposes.

The new rules target high net worth families which conduct closely held businesses or have significant wealth concentrated in a family business; namely, those who have enough wealth to have federal estate tax exposure. Currently, the exemption amount from the federal estate and gift tax is $5,450,000 per individual. This means that an individual can leave $5,450,000 to their heirs and pay no federal estate or gift tax. A married couple can exempt a combined $10,900,000 from federal estate and gift taxes.  For those high net worth families who are over these thresholds, the next few months remain critical to revisit succession planning to use the current rules allowing for valuation discounts.

The cornerstone of estate and succession planning for closely held businesses has been the use of favorable valuation discounts. For example, an LLC is structured to include both managing membership interests (controlling) and limited membership interests (non-controlling, non-voting). The limited membership interests, when gifted or transferred at death, can be discounted for lack of marketability and lack of control.

In 1990, Congress enacted Section 2704 to curtail the perceived abuses with respect to this planning; however, several tax rulings and court cases narrowed the scope of these rules thereby undermining the ability of the IRS to enforce them. As detailed below, the newly proposed regulations essentially reflect the Revenge of the IRS and are designed close the loopholes.

Below please find a summary of the major changes.

 “Covered Entities” Subject to Section 2704

As originally enacted, Internal Revenue Code (“IRC”) § 2704 only referred to “corporations” and “partnerships.”  The proposed regulations expand this definition to include any entity or arrangement that is a “business entity” within the meaning of Reg. § 301.7701-2(a) that is controlled by the family immediately before the transfer.

Accordingly, LLC’s are now included in the definition.  LLC’s are included regardless of whether they are disregarded for federal tax purposes.

New Definition of “Control”

Section 2704 applies to entities subject to family control.  Under the existing regulations, “control” for corporations is defined as encompassing at least 50% of the stock by vote or value.  The proposed regulations expand the definition of control for LLCs and other entities.  “Control” in this setting means ownership of 50% of either the capital or profit interests or the ability to cause liquidation of the entity.

Lapse of Voting or Liquidation Rights

In general, Section 2704(a) addresses the “lapse” of voting or liquidation (control) rights.  A “lapse” of a voting or liquidation right occurs where the presently exercisable right is restricted or eliminated. If the lapse occurs during the holder’s lifetime, it is a transfer by gift. Conversely, if the lapse occurs at the holder’s death, it is includible in the holder’s gross estate.

Newly Proposed Regulation:  The lapse of a voting or liquidation right in a family owned entity (meaning the entity is controlled by the family immediately before and after the lapse) is a transfer by the individual holding the right immediately before its lapse.

New 3 Year Look-Back Rule:  In addition, any lapse of a voting or liquidation right within 3 years of death is treated as a lapse at death (and thereby included in the decedent’s estate under Section 2704(a)).

Example:   Father owns 51% of the stock in a closely held business. Within 3 years of death, Father gifts 2% of the stock to his son. Under the current existing rules, Father can claim a minority discount for the 2% gift and at death; furthermore, the remaining minority 49% interest can be discounted for estate tax purposes when Father dies.

However, and under the proposed regulations, if the 2% gift was made within 3 years of death, a lapse is deemed to occur at Father’s death. This results in a “phantom asset” included in the transferor’s gross estate equal to the value of the lapsed voting or liquidation right.  This asset presumably would not qualify for the marital or charitable deduction.

Disregarding Certain Restrictions on Redemption or Liquidation

Equally limiting, the proposed regulations provide that the transfer of an interest to a family member in a family business (entity where the transferor and family members control the entity immediately before the transfer) that is subject to a “disregarded restriction” will not be respected and therefore valued pursuant to the generally accepted valuation principles (as if the disregarded restriction simply does not exist).

The key requirement for treating a restriction as an “applicable restriction” and thus “disregarded” stems from the fact that following the transfer, the restriction will lapse or can be removed by the transferor or any members of their family.

Therefore, a “Disregarded Restriction” may be described as one that has the following effects:

  1. Limits the ability of the holder to compel liquidation or redemption of the interest; or
  2. Limits liquidation proceeds to less than the “minimum value” of the entity; or
  3. Defers payment of the liquidation proceeds for more than six months; or
  4. Permits payment of the liquidation proceeds in any manner other than in cash or other property.

State Law Exception – Virtually Eliminated

Furthermore, the Treasury seeks to curtail estate and succession planning by eliminating a pertinent State law exception which has been around for years. Congress added Chapter 14 to the Code (§§ 2701-2704) to curtail valuation discounts on intra-family transfers of family controlled stock.  Section 2704 exempts restrictions on the owner’s ability to liquidate the entity “imposed or required to be imposed” by Federal or State Law.  The current regulations state that “an applicable restriction is a limitation on the ability to liquidate the entity that is more restrictive than the limitations that would apply under the State law (often referred to as the “State Default Rule”).

Thereafter, and following the enactment of IRC § 2704, State legislatures substantially tightened their default laws to provide for many restrictions.  As the restrictions in the governing agreements were now consistent with the State default law, the restrictions were not considered “applicable restrictions.”

Newly Proposed Regulation: As the State law restriction is not a mandatory requirement (it’s a default rule), restrictions in an entity’s governing documents that are no more restrictive than those under State law will no longer be given effect in valuing the interest. In other words, the State law must be mandatory to be considered a “real restriction,” or the IRS will simply ignore the restriction.

For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq., Associate in the Trusts & Estates Practice Group, at 973-230-2088 or jgrey@genovaburns.com.

Importance of Estate Planning for Business Owners and Executives

In our practice, we often come across two types of high net worth clients: Business Owners and Executives. The 40% estate tax can adversely impact each group without proper estate and succession planning.

Business Owners:  Many of our clients own local businesses. As noted, the estate tax is a 40% tax on inheritance. Where there is significant estate tax exposure, the Decedent’s family will need the appropriate liquid funds to satisfy the tax liability.  However, and unfortunately, many successful business owners leave estates which, while high in value, are mainly comprised of businesses ownership interests such as stock, S Corp. or LLC interests. These assets are considered “illiquid” and therefore not much help where the family needs immediate funds to pay the estate tax. Through proper planning, the estate can be structured in such a way as to avoid these pitfalls thereby ultimately saving taxes.  For example, a portion of the business can be transferred by sale or gift to an irrevocable trust for the benefit of family members with the use of valuation discounting.

Executives: Similarly, we consult with high level executives which have accumulated significant wealth during their lifetime. The majority of this wealth is typically in the form of “non-probate” assets.  “Non-probate” assets do not pass by one’s Last Will and Testament; rather, they pass by beneficiary designation or by right of survivorship.

To illustrate, the death benefit under any life insurance policies or qualified plan accounts (such as 401Ks and IRAs) will not pass by one’s Will, but by the beneficiary designations pertaining to each such policy or account.  Moreover, one’s bank and investment accounts that are jointly owned (other than as tenants in common) will pass to the surviving co-owner when the first co-owner dies by right of survivorship. Accordingly, care must be taken to ensure that all of these designations are properly in place and equally paramount, that they are consistent with the client’s final wishes. Only when all of these matters are addressed can the estate be disposed of in a timely and tax efficient manner.

For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Director of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq., member of the Trusts & Estates Practice Group, at 973-230-2088 or jgrey@genovaburns.com.