Earlier this month the IRS and Treasury Department issued proposed regulations that could significantly limit the valuation discount used by many wealthy families for estate and gift tax valuations.

If the proposed regulations were to become effective they would eliminate a number of commonly used techniques focused on reducing or eliminating estate and gift tax.

The impact of the proposed valuation discount regulations for individuals whose net worth exceeds the current lifetime exemption of $5.45 million ($10.9 million for married couples) could be significant. For estates exceeding the exemption amount the top estate tax rate can be as high as forty percent.

Under current legislation, an individual can establish a holding company or entity that holds privately held stock, real estate, marketable securities, cash, or other illiquid or difficult-to-value assets.

The holding company or entity is oftentimes structured as a Family Limited Partnership or FLP. The ownership of the FLP is commonly comprised of a general partner and limited partner(s).

The general partner is responsible for the management, operations, and decisions of the assets held by the Family Limited Partnership.

While limited partners have an economic interest in the Family Limited Partnership, they do not have any legal authority to control, direct, or make any decisions related to the FLP.

This includes the acquisition, distribution, or sale of any of the assets held.  As a result, limited partners have NO CONTROL over their partnership interests. Because of this a discount can be applied to the value of the assets held by the FLP for estate tax purposes due to lack of control.

In addition to receiving a valuation discount for lack of control, a valuation discount can also be applied to reflect an entities lack of marketability. Marketability being defined as the ability to convert ownership interest to cash quickly with a high degree of certainty, with reasonable transaction and administrative costs.

The result of applying these two discounts will generally range in a discount of 30% to 50% of the assets value, and in some cases may be even higher.

To go one step further it looks like the proposed legislation would effect privately held businesses. This would significantly reduce the likelihood of a family business from continuing through the generations.

business valuation discountFor example, Joe and Mary own a commercial property valued at $20 million. They are in the process of doing some estate planning.  Their attorney brought to their attention that by contributing the property to a family limited partnership they would be able to receive a discount on the value of the commercial property for purposes of estate and gift taxes.

After hiring a qualified appraiser, the value of the partnership owning the commercial property were as follows:

  • $20 million less 20 percent Discount for Lack of Marketability = $16 million
  • $16 million less 25 percent Discount for Lack of Control = $12 million

The aggregated discounted value of the partnership units would be forty percent.

Assuming the top estate tax rate of forty percent, Joe and Mary’s estate would have owed estate taxes on the $20 million property of $8 million. By contributing the property to a partnership its interests received a valuation discount from $20 million to $12 million for estate tax purposes.

Assuming a $12 million value the estate tax owed would be $4.8million at the death of the second spouse – resulting in an estate tax savings of $3.2 million.

Estate planning is nothing more than using tools and techniques to create leverage. Leverage in estate planning is usually created in three different ways:

  1. Discount the value of an asset or assets due to lack of marketability and lack of control (as discussed previously),
  2. Freeze the value of an asset so that any growth or excess cash flow would occur outside of the estate thereby being excluded from estate taxes, and
  3. Purchase life insurance in an irrevocable trust to leverage the death benefit to provide liquidity to pay for estate taxes.

If the proposed valuation discount rules become effective it would eliminate a significant portion of planning options available to wealthy families for purposes of reducing estate taxes.

Many wealthy families who find themselves in a situation where their estate may owe taxes have net worth’s comprised primarily of privately held stock and real estate – both considered to be illiquid assets.

Because of this it can be difficult for an estate to come up with the liquidity needed to cover estate taxes. Even in our example with Joe and Mary, discounts allowed them to reduce their projected estate tax from $8 million to $4.8 million, but what liquidity do they have to pay the tax at their death.

Whether you like it or not, life insurance creates tremendous leverage and provides for needed liquidity to cover estate tax exposure for wealthy families.

Life insurance is often overlooked as an extremely effective way to create leverage to pay for some or all estate taxes.

Estate planning attorneys do an excellent job of using all the tools and techniques available to them to reduce the size of a taxable estate.

But, depending on the size of the estate, there can be assets that will still be subject to estate tax or insufficient levels of liquidity to keep the estate intact – forcing the estate to sell assets to cover the obligations of the estate.

If the proposed valuation discount rules become effective it will:

  1. Create larger taxable estates,
  2. Make it much more difficult for privately held businesses to be transferred to future generations, and
  3. Make the need for estate liquidity more necessary.

At this time there is still some uncertainty as to if the revisions are likely, or what they might be. The IRS and Treasury Department are currently accepting comments on this proposal. A hearing is scheduled for December 1, 2016. It is likely the administration will try to make these changes effective before a new president takes office.

If you have been considering or thinking about using a legal structure that would utilize discounts for lack of control and marketability it would be prudent to move quickly, before any rules take effect.

Click here to view the proposed regulations. From this page you will also be able to publicly comment.

About Jason Mericle

Jason Mericle is the founder of Mericle & Company. He has been directly involved with the evaluation, placement, and management of more than $500,000,000 of life insurance coverage over his career.

His extensive knowledge of life insurance products are complimented by an in-depth understanding of the different tax and legal structures for which life insurance is used.

About Jason Mericle

Jason Mericle is the founder of Mericle & Company. He has been directly involved with the evaluation, placement, and management of more than $500,000,000 of life insurance coverage over his career.

His extensive knowledge of life insurance products are complimented by an in-depth understanding of the different tax and legal structures for which life insurance is used.

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