VALUATION DISCOUNTS THEORY AND PRACTICE

Transcription

1 VALUATION DISCOUNTS THEORY AND PRACTICE April 2003 Dennis I. Belcher McGuireWoods LLP One James Center Richmond, Virginia (804) Copyright 2003 by McGuireWoods LLP

2 I. OVERVIEW A. Pervasiveness of Valuation Discounts 1. One of the hottest techniques in estate planning is using valuation discounts to leverage annual exclusion and unified credit gifts so as to push wealth to lower generations on a tax-advantaged basis. Valuation discounts are not a new area of tax law. Tax advisors have utilized valuation discounts since the enactment of the Internal Revenue Code. Although most of the recent court cases and revenue rulings deal with valuation discounts in the transfer tax area, valuation issues also arise in other areas of tax law. In a 1998 Tax Court decision, Estate of Auker v. Commissioner, T.C. Memo , Judge David Laro observed that 243 sections of the Internal Revenue Code require fair market value estimates to determine tax liability and that 15 million tax returns are filed each year on which taxpayers report an event involving a valuation-related issue. 2. For years estate planners have utilized valuation discounts in transferring common stock in corporations and partnership interests (primarily limited partnership interests) in partnerships holding business assets. During roughly the last two decades, the focus in valuation discounts has shifted from the transfer of businesses to the use of discounts in entities holding non-business assets, such as marketable securities, vacation homes, unimproved real property, artwork, and other assets of value. 3. In many technical advice memoranda released in 1997 and 1998, the Internal Revenue Service aggressively attacked the use of valuation discounts applied to interests in limited partnerships and limited liability companies used primarily to transfer non-business assets to family members. 4. The law governing valuation discounts is constantly changing. It is important that the estate planner stay up to date with recent changes so as to properly evaluate the risks associated with using valuation discounts and to avoid traps that might be sprung by the Internal Revenue Service. 5. Although the use of valuation discounts is not appropriate in every circumstance, discount planning should be considered in many estate plans. If an estate planner fails to consider or properly advise clients on the use of valuation discounts, the planner may be criticized by the client or the client s successors.

3 B. Topics Covered 1. The topics covered in this outline are: a. The impact on discount valuation planning of the changes in the federal estate and gift tax system made by the Economic Growth and Tax Relief Reconciliation Act of 2001 ( the 2001 Act ); b. General valuation principles applicable to gifts and transfers at death; c. Valuation of fractional interests; d. Discounts for minority interest and lack of marketability; e. Discounts for built-in capital gains, blockage, and security law restrictions; f. Valuation of limited partnership interests and limited liability company membership interests; g. Internal Revenue Service attacks on valuation discounts; and h. Maximizing valuation discounts by selecting the appropriate entity and favorable state law. 2. Valuation discounts are applied either to a proportionate interest in an asset (a discount for a fractional interest) or to interests in the entity the holds the asset (a discount for a minority interest in a corporation, partnership, or limited liability company, or a discount for lack of marketability for an interest in a corporation, partnership, or limited liability company). Before applying valuation discounts, the asset or entity must be valued. In general, this outline does not cover the valuation of the underlying asset or entity. II STATUTORY CHANGES AFFECTING DISCOUNT PLANNING A. Key Provisions of the 2001 Act Affecting Gift, Estate, and Generation-Skipping Transfer Taxes 1. Delayed Full Repeal of Estate Tax and GST Tax. There will be no federal estate or GST transfer taxes imposed on the estate of any individual who dies in Meanwhile, the estate and GST taxes are phased out by increasing exemptions and declining maximum rates. But the gift tax will continue in effect even after the repeal of the estate and GST transfer taxes. 2. Increasing Exemptions and Declining Maximum Transfer Tax Rates. As of January 1, 2002, the exemptions increased and the maximum tax rates

4 declined. Beginning in 2004, the GST exemption will be equal to the applicable exclusion amount. This avoids reducing the GST exemption in 2002 and 2003 below the $1,060,000 available for (For 2002, the GST exemption is $1,100,000.) 3. Gift Tax Retained. The gift tax will remain in place, even after 2009, to deter income tax avoidance. 4. Exemption. The gift tax exemption increased to $1 million in 2002 and will remain at that amount, even after the repeal of the estate and GST tax. After 2003, the amount that can be left to beneficiaries tax-free at death will be larger than the amount that could be given away tax-free during life. This is the first time this has happened since the adoption of the unified transfer tax system by the Tax Reform Act of Gift Tax Rate. The maximum gift tax rate will decline, along with the maximum estate tax rate, through In 2010, the maximum gift tax rate will be 35 percent, which is the same as the maximum individual income tax rate scheduled under the 2001 Act to be in effect at that time. 6. New Rules for Transfers to Trusts. Beginning in 2010, any transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor s spouse for income tax purposes under the grantor trust rules (Internal Revenue Code sections ). 7. Reason for Retaining Gift Tax. Presumably, the gift tax was retained to help preserve the income tax base. Several commentators alerted the Senate to the possible techniques that could be used to minimize income taxes in a system with no gift tax, and the resulting damage to federal revenues. See Blattmachr & Gans, Wealth Transfer Tax Repeal: Some Thoughts on Policy and Planning, Tax Notes, Jan. 15, 2001, p. 393; Buckley, Transfer Tax Repeal Proposals: Implications for the Income Tax, Tax Notes, Jan 22, 2001, p. 539; Sullivan, JCT Estimates Widespread Evasion With Gift Tax Repeal, Tax Notes, Apr. 2, 2001, p. 10. But see Aucutt, Gift Tax Repeal Bill Minimized Income Tax Problems, Tax Notes, May 7, 2001, p Replacement of State Death Tax Credit with Deduction for State Death Taxes Paid. The amount of the state death tax credit will be reduced significantly for taxpayers dying after 2001 and before Beginning in 2005, the credit will be eliminated and replaced by a federal estate tax deduction for amounts paid in state death tax. 9. Flattening the Transfer Tax. The combination of increasing exemptions and decreasing maximum rates, with no adjustment to the lower rates, means that the number of effective estate tax brackets will grow smaller. By 2006, the

5 estate tax, like the GST tax, will be a flat tax at the 45 percent rate. TABLE 1 Year-by-Year Changes in Federal Transfer Taxes (assuming no further changes in the law) Estate Tax on Exclusion $675,000 $1 million $1.5 million $2 million $3.5m Re $1 million Lowest rate 37% 41% 45% pea led. Re 41% 46% 45% pla ced Top rate 55% 50% 49% 48% 47% wit 55% h car 5% bubble Yes No ryo ver bas Yes QFOBI Yes No is. Yes State tax credit 100% 75% 50% 25% None. State taxes are deductible. 100% GST Tax Exemption $1 million indexed (from 1998) $1.5 million $2 million $3.5m $1 million indexed Rate 55% 50% 49% 48% 47% 46% 45% 55% Gift Tax Exclusion $675,000 $1 million Lowest rate 37% 41% 41% Top rate 55% 50% 49% 48% 47% 46% 45% 55% 35% 5% bubble Yes No Yes

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