...Best Time in Decades to Shift or Transfer Wealth within the Family
...Clouds on the "Valuation Discount" Horizon - H.R. 436
...Estate of Litchfield - Corporate Estate Tax Valuation Tax Court Opinion (1/29/09)
I. 2009 - The Year for Family Wealth Transfers and Updated Estate Planning.
Under current law, but for this year only, the estate tax-free exemption equivalent per estate is $3.5 million in taxable estate value, or $7.0 million per couple if proper marital deduction planning is utilized.Therefore, very few estates will result in Federal estate tax liability; however, this assumes proper Wills and trusts, taking advantage of marital deduction benefits and yet still meeting the clients' goals for ultimate estate distribution. As most planners are aware, the year 2010 is scheduled for a 1-year only repeal of the estate tax, and in 2011 it will come back to 2001 levels (a mere $1 million exemption equivalent and a 55% top rate). Wills and trusts must be flexible enough to take this into account, as well as the hoped for estate tax reform in the new Obama Administration. It appears that continuing, perhaps permanently, the $3.5 million per estate exemption, a 45% rate, and perhaps even "portability" of the exemption to insure $7.0 million in tax-free estate transfers by a married couple may well be legislated this year.
But there is more to planning opportunities this year, relating to intra-vivos or lifetime transfers. For example, the February, 2009 applicable federal rates (AFRs) are extremely low, one thing good about the recessionary economy. The short-term AFR (up to 3 year period in loan or sale) is only .60%, the mid-term (3-9 years) is 1.6+% and the long-term (9 and over years) AFR is but 2.9+%. Thus, an intra-family loan for 10 years can bear interest at only 2.96% per year with a balloon for principal at the end of the 10-year period, thus giving the borrowing younger generation family member (or trust for such person's benefit) 10 years within which to build capital at a much higher rate.
While the gift tax lifetime exemption (beyond annual exclusions of $13,000 per donor, per donee) remains frozen at $1 million ($2 million, married couple), a combination of gifts and loans or sales using the low AFR rates will result in shifting substantial wealth to the younger generations. This is especially valuable in this economy in which, in many cases, a family's wealth base has declined in value by 1/3 - 1/2 when compared to a couple of years ago. So, in addition to the tax-free gifts, loans and sales within the family, there is substantial hoped-for future appreciation that would accrue to the benefit of the younger generations through proper planning now. The low February, 2009 7520 rate likewise allows for effective use of other types of transfers, such as certain charitable trusts and grantor retained annuity trusts (GRATs). Therefore, the current down economy offers opportunities for intra-family transfers - transfer within the family in down economic times, and only sell to unrelated third parties when values are high!
II. Will "Valuation Discounts" be Cut Back by Congress and the Obama Administration?
Washington, D.C. tax lawyer Ron Aucutt's "Capital Letter" (1/20/09) reports on H.R. 436 as a development that has captured surprising attention. (see the ACTEC.org website) Rep. Earl Pomeroy, D. N.D., introduced on January 9th H.R. 436 titled "Certain Estate Tax Relief Act of 2009". This Bill, referred to the House Ways & Means Committee, makes permanent the $3.5 million exemption equivalent, freezes the maximum estate tax rate at 45% (but adds back the old 5% phase-out rate for estates between $10 million and $41.5 million), but does not include anything on marital deduction portability.
In spite of the title of this Bill, it is Section 4 that proposes special valuation rules for "certain transfers of nonbusiness assets", essentially removing them from the entity valuation (both as to minority and marketability discounts) and taxed without discounts as if they had been direct transfers of the nonbusiness assets to the transferee(s). There is no way of knowing what sort of traction H.R. 436 has at this time; however, given its attach on valuation discounts, many planners are rushing to complete gifts of entity interests where the entity owns nonbusiness or passive investment assets, since presently the effective date in the Bill is date of enactment of legislation. Given that prior efforts to cut back valuation discounts were unsuccessful, perhaps it is unlikely H.R. 436 will be enacted. But planners and their clients would do well to review the Bill and watch its progress carefully. This but reinforces the importance of inter-vivos transfers now within the family, as part of an overall update of the estate plan (Family Wealth Plan).
III. Lessons on Appraisals and Available Valuation Discounts - the Litchfield Case
On January 29, 2009, the Tax Court (Judge Stephen Swift) issued its memorandum opinion in the Estate of Marjorie deGreef Litchfield v. Commissioner, T.C. Memo. 2009-21. Note to my readers - a copy of the opinion can be obtained from the Tax Court's website, www.u.s.taxcourt.gov.
Having agreed and stipulated on net asset values of two (2) closely-held investment corporations owned by one family's members, the Estate and IRS litigated the valuation discount issues, including discounts for potential built-in capital gains taxes, lack of control and lack of marketability. Further, IRC Sec. 7491(a) (shifting burden of proof on fact issues to the Commissioner in litigation) was a factor here.
The sequentially applied three (3) valuation discounts involved the Estate's appraiser opining discounts about double that presented by the IRS appraiser. This opinion by Judge Swift sets out a thorough summary of how the "valuation game" is played and the primacy of the court's role as trier of fact. In summary, Judge Swift determined combined discounts that were over 85% of those sought by the Estate itself, the combination thereof ending up being over 40% off the net asset value of each of the corporation's as to the Estate's interests in same. Of course, the discount levels and results in any one case are not authority for discounts in any other case - but the court's analysis remains important.
Litchfield Realty Co. (LRC) and Litchfield Securities Co. (LSC) both were incorporated in the 1920s and had a long history over many decades. Mrs. Litchfield died in 2001, her husband having predeceased her in 1984 and then establishing a Qtip marital deduction qualifying trust. The assets of LRC consisted of crop share (active business) leased farmland plus securities, while the LSC assets were marketable securities. Both corporations were C corporations, until LRC elected Subchapter "S" status January 1, 2000 - with then the special 10-year period commencing for corporate level tax on sales of S corporation assets where the C corporation was converted to S status. LSC remained a C corporation.
The Estate elected the 2032 alternate valuation date, which was 10/17/01. While apparently not a major factor in the valuation here, LRC and its shareholders entered into a restrictive buy-sell agreement (partly to protect "S" corporation status) in 2000. The assets of both corporations, as of the alternate valuation date, were substantially appreciated in basis over cost or other adjusted basis - thus there were substantial unrealized capital gains tax liabilities.
Federal Estate Tax Return (Form 706) and IRS Audit - On the 706, the Estate claimed combined discounts totaling 54.9% of its 40+% minority interest in LRC and 52.7% for its 23% interest in LSC. After over two (2) years of IRS examination of the 706, a 90-Day Letter (statutory notice of deficiency) was issued to the Estate, valuing the LRC and LSC equity interests at over 50% higher than the reported values, for an estate tax deficiency of $6.2 million.
The "Bottom Line" Result - In summary, Judge Swift agreed, after a detailed discussion of Sec. 7491(a), that the burden of proof on the valuation fact issues was to be shifted to respondent IRS; the Estate's expert was correct in his opinions on the discounts both for potential capital gains tax liabilities and lack of control; and finally the court determined toward the midpoint lack of marketability discounts in this case.
The "Valuation Game" - The court pointed out, during its discussion in depth of valuation principles in estate tax cases, "...a court's valuation need not be tied to specific testimony or evidence if it is within the range of values supported by the evidence." And remember here the burden of proof had been shifted to IRS. The "net asset value" of each corporation had been stipulated by the parties; therefore, only the discounts were at issue.
Three (3) Discounts, Sequentially Appled - See my Leimberg Information Services, Inc. (LISI) commentary posted as Estate Planning Email Newsletter - Archive Message #1410 (plus the Paul Hood LISI commentary, Archive Message #1409, and a clarifying posting as #1411), www.leimbergservices.com. These newsletters go into depth on the court's analysis and conclusions.
(1) The built-in capital gains potential liability disount ("BIG" discount) - Here the courts have considered and adopted one of two choices - a present value computation of the BIG discount (such as in this case) and the "dollar-for-dollar" discount, such as in Dunn v. Commissioner, 301 F.3d 339 (5th Cir. 2002) and Jelke v. Commissioner, 507 F.3d 1317 (11th Cir. 2007, cert. den. U.S. Supreme Ct., 10/06/08). The present value computation, if credible evidence is available, appears to be a better approach, especially where the projected asset sales also have projected additional appreciation to dates of sale before the p.v. discount is computed. As the result of this approach, in Litchfield, a high percentage of the built-in gain potential liability at the alternate valuation date was allowed here. The court agreed with the Estate's proposed discounts of 17.4% for LRC and 23.6% for LSC.
(2) Lack of control discount - in addition - Again, the court agreed with the Estate's appraiser, who concluded this discount should be 14.8% for LRC and 11.9% for LSC. Judge Swift compared the methodology and valuation analysis of both appraisers, and found that the Estate's appraiser performed a more credible job.
(3) Lack of marketability discount - again, in addition - Here the court reviewed both appraisal reports and testimony at trial, and disagreed in part with each appraiser. Reviewing the opinion is worthwhile to learn how the court deals with opposing appraisals. In the end, the court concluded lack of marketability discounts of 25% for LRC and 20% for LSC as applied to the Estate's interests therein.
And so here we have one more corporate valuation case to consider in the valuation area. Likely, more will come down this year, and no doubt there will be more FLP/LLC valuation cases (note my archived newsletters of 9/14/08, 10/20/08 and 12/18/08 dealing with both gift and estate tax case opinions).
Proper valuation evidence, by competent appraisers providing credible appraisal reports and testimony, is important. Note that if the 3-year gift tax statute of limitations is to be available, the gift tax return (Form 709) must contain "adequate disclosure" of the gift(s) - meaning usually a credible appraisal report, etc.
As always, I hope that this newsletter provides my readers with worthwhile information. The next newsletter will deal with Buy-Sell Agreements and their impact on gift and estate tax valuation.
Regards to all,
Owen Fiore
