As uncertainty took center stage in the estate-planning community, valuation issues added to the perplexity
Waiting for Godot is a classic play in which the protagonists await the arrival of a mysterious problem solver who never arrives. For estate planners and valuation professionals, 2010 was similarly a time for waiting — for tax law resolutions, for the economy to take off and for clarity on valuation controversies. We're still waiting for the last two.
Several significant valuation issues were the subjects of cases in 2010, although the issues remain far from settled. The appropriate treatment of built-in gains (BIG), what disqualifies partnership and limited liability company interests from annual exclusion gifts, the ongoing saga of Internal Revenue Code Section 20361 estate inclusion and modified carryover basis were among the major valuation matters of the year.
Since 1998, many courts have agreed with the concept that, assuming everything else is held constant, a company that owns assets with a high BIG tax is worth less than a company with no BIG tax. These courts ruled that the potential BIG tax liabilities should be taken into account in valuing a company's stock, even though no liquidation or sale of the corporation or its assets was planned.
Estate of Jensen2 decided last year, was the most recent of these cases. At issue was the value of a controlling interest in a closely held C corporation that held appreciated real property, and whether the BIG tax liability should be subtracted dollar-for-dollar as though the BIG tax was currently payable or through the use of an alternative approach.
Citing Davis,3 Litchfield,4 Jelke5 and Borgatello6 for support in applying a present value approach (account for future appreciation on the property and apply a present value discount to the projected gains when realized), the court in Jensen left an opening for continued use of this approach in determining the discount for the BIG tax. In reaching its conclusion, the court performed its own present value approach7 and calculated a BIG tax liability, which was slightly greater than that indicated by a dollar-for-dollar discount. On that basis, the court accepted the amount claimed by the estate based on the dollar-for-dollar approach.
As shown in “Built-in Gains Tax: What's the Trend?” p. 37, case law in this area is trending toward dollar-for-dollar outcomes.8
With the exception of Litchfield and Jensen, cases tend to support a dollar-for-dollar reduction attributable to estimated BIG tax liabilities. Both Litchfield and Jensen have notable factors. In Litchfield, the Tax Court wasn't asked to and thus didn't address the concept of whether a full dollar-for-dollar valuation discount was applicable. In Jensen, the court's present value approach resulted in a larger amount than the dollar-for dollar amount claimed by the taxpayer. In both Litchfield and Jensen, the application of the present value approach resulted in outcomes that closely approximated the amount determined by the dollar-for-dollar approach (Litchfield's outcome was slightly lower and Jensen's was slightly higher). The lingering question after Jensen is whether any remaining controversy exists over approaches if the end results are almost the same.
Annual Exclusion Gifts
Back in 2002, the Tax Court in Hackl9 found that the restrictions in the operating agreement sufficiently limited a member's interest so that there was no unrestricted right to the immediate use, possession or enjoyment of either the property or its income. Accordingly, gifts of such member interests failed to qualify for the annual exclusion under IRC Section 2503(b), which applies only to gifts of a present interest.
In 2010, the Tax Court revisited the issue in Price10 in the context of a limited partnership. The Price partnership agreement prohibited withdrawals of capital, withdrawal from the partnership, required all partners to consent to transfer of a limited partner (LP) interest other than to existing partners and stated that if there was a transfer, each of the partners had a right of first refusal to purchase the interest for fair market value (FMV). Further, the general partner (GP) had discretion over whether to make distributions from the partnership and in some years, the GP made no distributions of income. Of course, that also means that in some years, the GP did make distributions. The court determined that the absence of required distributions to the partners to cover income tax liabilities and the GP's discretion over distributions prevented the LP interest from possessing an unrestricted right to the enjoyment of the partnership's income.
With both Hackl and Price as precedent, operating or partnership agreements drafted to satisfy annual exclusion present interest requirements will need to incorporate some form of mandatory income distributions, put options or withdrawal or redemption rights.
Each year seems to bring forth new IRC Section 2036 cases. In 2010, the taxpayers in Shurtz11 successfully argued that transfers to a second limited partnership to hold interests in a partnership that managed the family's timberlands business met the bona fide sale exception to Section 2036. The legitimate and significant non-tax reasons for establishing the second partnership included: (1) to protect the family business from creditors and lawsuits, and (2) to provide management efficiency for the business that required active management in recognition of the intent to give partner interests to children and grandchildren. The court permitted estate tax savings as a motivating factor in forming the partnership so long as it wasn't the predominant factor. Similarly, facilitation of a gifting program, which generally isn't a legitimate non-tax reason, may be so if the underlying property requires active management, and gifting without the partnership may impair efficient management.
2010 Modified Carryover Basis
The estate tax holiday for 2010 provided one year free from federal estate taxes, but didn't leave decedents who died in 2010 free from valuation issues in their estates. The one-year-only imposition of modified carryover basis provides that property acquired from a decedent, for tax basis purposes, is treated as if the property were acquired by gift. That is, the property's tax basis is the lower of the decedent's adjusted basis or the property's FMV.12 The need to establish the basis in the property received from a 2010 decedent requires estate executors not only to perform the unenviable task of uncovering the decedent's basis, but also to determine the date-of-death FMV of such property.
Forward to 2011
Back in 2001, legislation was enacted that gave Congress 10 years to address estate tax provisions that would sunset at the end of 2010. After nine years and 350-plus days, Congress labored forth with what amounts to a two-year patch and another sunset at the close of 2012. Thus, still looming for Jan. 1, 2013 is a top gift, estate and generation-skipping transfer (GST) tax of 55 percent (plus an additional 5 percent surtax on certain gifts and estates). Also, the exemption for gift and estate tax returns to $1 million in 2013. The GST tax exemption also drops to $1 million indexed for inflation since 1998.
For 2011 and 2012, gift and estate taxes once again are unified with the same 35 percent rate and $5 million indexed exemption. For executors of decedents who died in 2010, the year isn't entirely in their rear view mirror. The new legislation has an option for 2010 estates. The choice is which estate tax law applies — no estate tax with modified carryover basis or the federal estate tax at 35 percent with a $5 million exemption and a basis step-up. In either case, determining the date-of-death FMV of assets will play an important role in the decision-making process.
Although company valuations have risen from their troughs in the past two years, they still remain low relative to the boom-period valuations of the pre-financial crisis days. Moreover, this time, Congress didn't legislate away the opportunity for estate planning using grantor retained annuity trusts (GRATs) and the Section 7520 rate remains as low as it has ever been. Valuations discounts for interests in family-owned entities were also untouched by the new legislation. While regularly on the legislative chopping block, these discounts remain a viable alternative for efficiently passing wealth to secondary generations.
The estate-planning community isn't alone in dealing with sunset provisions and uncertain tax rates after 2012. There's also a similar two-year patch that leaves existing income tax rates unchanged until 2013. Increases in the top personal marginal rates, capital gains rates and treatment of dividend income, which affect valuations of S corporation stock, are now possible in two years. The benefit to shareholders of S corporation status and therefore the valuation attributes of their stock is heavily based on the interplay among personal, corporate and dividend tax rates. Depending on how various tax rates end up in 2013, there will be an impact on the value of S corporation stock, with the potential for a sharp spike in premiums associated with S corporation interests.
The silver lining for estate planning with the prospect for sluggish economic growth and low interest rates well into 2011 is that such conditions are favorable for beneficial estate planning as such factors keep asset valuations at relatively low levels. The potential for future adverse legislative changes to GRATs and discounts for family entities, which are driven by the government's need for revenue after the past two years of unprecedented budget deficits, makes now the time to deal with such assets.
- Internal Revenue Code Section 2036 recaptures in the estate the value of certain assets transferred by the decedent during lifetime where the decedent has retained economic benefits from the transferred assets.
- Estate of Marie J. Jensen v. Commissioner, T.C.M. 2010-182 (Aug. 10, 2010).
- Estate of Artemus D. Davis v. Comm'r, 110 T.C. No. 35 ( June 30, 1998).
- Estate of Marjorie deGreeff Litchfield v. Comm'r, T.C.M. 2009-21 (Jan. 29, 2009).
- Estate of Frazier Jelke III v. Comm'r, T.C.M. 2005-131 (May 31, 2005); Estate of Jelke v. Comm'r, 05-15549 (11th Cir. 2007).
- Estate of Charles A. Borgatello v. Comm'r, T.C.M. 2000-264 (Aug. 18, 2000).
- In Jensen, supra, note 2, the court determined a future value of the land and improvements owned by the corporation over a period of 17 years. It used a compound annual rate of appreciation of 5 percent for the land and 7.725 percent for the improvements. The court applied a 40 percent combined federal and state corporate tax rate on the capital gains and discounted those gains to present value by using the same 5 percent and 7.725 percent rates.
- Estate of Pauline Welch v. Comm'r, T.C.M. 1998-167 (May 6, 1998); Eisenberg v. Comm'r, 155 F.3d 50 (2d Cir. 1998); Estate of Richard R. Simplot v. Comm'r, 112 T.C. No. 13 (March 22, 1999); Estate of Jameson v. Comm'r, T.C.M. 1999-43 (Feb. 9, 1999), vacated 267 F. 3d 366 (5th Cir. 2001); Estate of Dunn v. Comm'r, T.C.M. 2000-12 (Jan. 12, 2000); Estate of Dunn v. Comm'r, No. 00-60614 (5th Cir. 2002); Jensen, supra, note 2; Davis, supra, note 3; Litchfield, supra note 4; Jelke, supra note 5; and Borgatello, supra, note 6.
- Christine M. Hackl v. Comm'r, 118 T.C. No. 14 (March 27, 2002).
- Walter M. Price v. Comm'r, T.C.M. 2010-2, (Jan. 4, 2010).
- Estate of Charlene B. Shurtz v. Comm'r, T.C.M. 2010-21, (Feb. 3, 2010).
- IRC Section 1022.
Radd L. Riebe is a managing director in the Cleveland office of Valuation and Financial Opinions Group, Stout Risius Ross, Inc.