On Your Deathbed, You Will Receive a Phantom Asset

There are many famous lines in the movie Caddyshack, the 1980 sports comedy film starring Chevy Chase, Rodney Dangerfield, Ted Knight and Bill Murray.  Among them is the exchange between Angie and Carl (Bill Murray), where Carl is relaying a story about caddying in Tibet for the Dalai Lama.  After the round, the Dalai Lama refuses to pay Carl for his work, saying, “There won’t be any money, but when you die, on your deathbed, you will receive total consciousness,” to which Carl replies, “So I got that goin’ for me, which is nice.”

“And I say, ‘Hey, Lama, hey, how about a little something, you know, for the effort, you know.’ And he says, ‘Oh, uh, there won’t be any money, but when you die, on your deathbed, you will receive total consciousness.’ So I got that goin’ for me, which is nice.”
– Carl Spackler

A similar situation may be unfolding for taxpayers due to the proposed regulations under Section 2704 of the Internal Revenue Code, although it will be anything but nice.  Much of the attention since early August has been on the new 2704-3 language, which contains a new set of disregarded restrictions.  The initial reaction in the wealth planning community was that these new disregarded restrictions would eliminate many valuation discounts in the intra-family transfer context.  More recently, a second interpretation has emerged from both attorneys and representative Catherine Hughes of the IRS.  That is, while the act of disregarding restrictions is material, it does not go so far as to assume rights that do not exist.  For example, there have been suggestions that disregarding a withdrawal restriction does not have the same effect as granting a put right.

If this recent discussion persists and leads to clarifications and modifications to the proposed regulations that are taxpayer-friendly in this regard, the focus of wealth advisors may shift to the amendments to the lapse rules under 2704-1.  The changes to 2704-1 would remove the availability to use the highly important exception contained in 2704-1(c)(1).  Lapses of voting and liquidation rights are considered gifts under the tax code.  However, the exception referenced in this paragraph states that a lapse will not be deemed to have occurred if rights with respect to the transferred interest were not restricted or eliminated.  For example, this allows a 100% owner of a business to transfer two 33% blocks to his children without a lapse being deemed to have occurred, because nothing about the 33% blocks was restricted or eliminated.  Any discounts that apply are entirely driven by the fractionalization of the block, and not by restrictions.

The proposed changes would institute a three-year lookback, such that if the transferor dies within three years of the transfer, a lapse will be deemed to have occurred upon death.  Such a result could entirely unravel the effectiveness of the prior gifts.  If a lapse is deemed to have occurred on death, a phantom asset is includable in the estate that is equal to the value of all interests held by the transferor prior to the transfer, less the value of those same interests after the lapse and on a fractionalized basis.  There are also questions as to whether marital and charitable deductions, and a step-up in basis are available relative to that phantom asset; they may not be.  In short, taxpayers will have to survive three years after making transfers for such transfers to be fully effective.  Folks that have been in the industry long enough will remember either directly or through history lessons, that there used to be a very similar three-year rule.

Might the future of estate tax administration routinely involve the valuation of phantom assets?

Dees and Sorrows Speak in Chicago

Tadd Lindsay and I attended a luncheon at the Standard Club in Chicago put on by the Business Valuation Association (“BVA”).  The BVA’s first meeting of the current season was quite a hit, as the organization brought in Richard Dees and Michael Sorrows of McDermott Will & Emery to speak about the hot topic du jour:  Proposed Section 2704 regulations.

Mr. Dees is one of the nation’s foremost experts on this area of the tax code, and so it was no surprise that the presentation was both highly anticipated and equally enlightening.  The following constitutes my notes on certain important topics within the presentation, coupled with some context and subsequent developments.  You will see many of the same themes emerge as were discussed previously in this piece.

• Disregarded Restrictions / Minimum Value
  • Possibly the most important takeaway is that Catherine Hughes, a Fellow of ACTEC and currently an Estate and Gift Tax Attorney-Advisor in the Office of Tax Policy at Treasury, has recently made statements publicly that the rules are not meant to eliminate discounts and are being interpreted too harshly.  Ms. Hughes’ interpretation, which is shared by many attorneys, including Dees and Sorrows, is that the act of disregarding restrictions does not automatically institute a put right into the equation.  Just because the minimum value language exists does not mean that minimum value is “The Value” that must be substituted for fair market value.
  • While it is certainly easy to read the regulations as if a put must be assumed, focus has shifted to the concept of “eraser” versus “pencil.”  Mr. Dees explains this by stating that Treasury knew it did not have authority to write in features, but rather only has the authority to erase features under the disregarded language of 2704(b).  Therefore, the distinctions between having withdrawal rights, put rights, withdrawal restrictions, and total silence on the matter is coming to the forefront.  Treasury appears to be using an eraser to create silence (a vacuum) with respect to the withdrawal concept, leaving it to the appraisal community to determine under a great deal of uncertainty how an interest ought to be valued.
  • For corporations, it is common to see silence with respect to redemption rights.  This is a fundamental aspect of corporations, which issue securities / stock certificates to equity investors.  Stockholders owns securities and have no demand right to underlying assets or to be cashed out.  When asked, Dees and Sorrows suggested that appraisers should not be so quick to dismiss discounts in the corporate context, as the new regulations may not dramatically change the dynamics.
  • At a minimum, the IRS has done a superb job at hijacking the entire conversation, injecting a focus on net asset value and liquidation value, and sending shockwaves through the community of high net worth individuals and planners, even if minimum value is not “The Value” that must be determined.  Is this an attempt to shift the burden of proof to taxpayers to show that discounts are warranted, in comparison to the current regime where the existence of discounts is a given.
• Intersection of 2703 and 2704
  • Some experts are focusing on the fourth of five exceptions to the definition of a disregarded restriction: (iv) “An option, right to use property, or agreement that is subject to section 2703 is not a restriction for purposes of this paragraph (b).”
  • A reasonable interpretation is that the terms of a buy-sell agreement that satisfy the three-pronged criteria in 2703 are not to be disregarded under 2704.  There is a thought that further clarification here could effectively result in the injection of an arms’ length standard into 2704.  This would be consistent with the fact that 2701 and 2703 contain arms’ length standards, but 2704 does not without this exception.
  • The ABA is preparing (or has already submitted) comments on the proposed regulations, and this exception is one that will receive significant attention and requests for clarification.  The New York State Bar and New York State Society of CPAs are also likely to address this issue.
• Commercially Reasonable Exception
  • Exception (ii) to the disregarded restrictions is a “commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity’s trade or business operations whether in the form of debt or equity…”  This language is very clear in that the financing must be from an unrelated third party, such as a bank.  Some practitioners are speculating that there could be an uptick in line of credit and other lending agreements with highly restrictive bank covenants.  Might we have business owners asking for strict covenants for the first time in recorded history?
• Property
  • It is not entirely certain what the term “property” means in the context of determining minimum value.  Does property include both tangible and intangible property?  In other words, all assets including goodwill?  Moreover, when determining minimum value, do you assume a liquidation?  And if so, might that imply a fire sale or forced sale scenario, or at least a breakup of the in-place assets which might jeopardize the value of goodwill?
• Family Control
  • Many concerns have already been voiced by attorneys, appraisers and others that the control threshold is problematic. Among other issues, the proposed language seems to characterize a family that is equal 50-50 partners with an unrelated party as having control of the entity.  This result would be a clear departure from economic reality.
  • State partnership laws are generally more clear with respect to withdrawing from a partnership compared to, for example, an LLC.  It is possible that IRS could take the position that limited partnerships are easier to liquidate, or that taxpayers could take the tax position that LLCs are not as easy to liquidate.
• Securities FLPs
  • Some practitioners are wondering aloud as to the future use (or lack thereof) of cash and securities FLPs in estate planning.  Dees and Sorrows stated that it would be a surprise if anyone came forth in comments or at the public hearing addressing these entities since the focus of the community has been primarily on operating businesses, real estate companies and farms.  Numerous advisors were surprised at the lack of an operating company exception.  Might there ultimately be a path for Treasury to make the exceptions for operating companies that so many advisors believe is appropriate, thereby eliminating or reducing the effectiveness of cash and securities FLPs in estate planning.
  • Where will real estate FLPs land at the end of such process?  On the other hand, tenant-in-common arrangements seem to fall outside of the proposed regulations, allowing fractional interest discounts to stay in place for such real estate ownership arrangements.
• Final Thoughts
  • The ABA will likely be taking a strong position through comments that the regulations go too far, and will propose changes for Treasury’s consideration.
  • Treasury appeared to read carefully Mr. Dees’ September 2015 open letter, which criticized various concepts from Treasury’s Greenbook proposals.  Among them, Mr. Dees was critical of the concept of substituting new features in the place of restrictions.  This is the eraser vs. pencil concept.  The proposed regulations are careful to use an eraser and do not technically impose new features.  In addition, Mr. Dees wrote that “drawing a line” between active and passive businesses was not practical.  The proposed regulations make no attempt to do so, thereby casting a wide net that may ensnarl far too many family transfers.  Mr. Dees joked that we can all thank him for the wide net.
  • Treasury released the proposed regulations in early August.  For those skeptics out there, the timing is suspect.  Congress was out of session and many congressmen and senators have been focused on election campaigns between September and November.  Thus, it was nearly 6 weeks hence that we saw bills being introduced in Congress to stop the proposed regulations.  The comment period of 90 days feels shorter and does not give business groups much time to organize to thwart the process.  There is at least one business group that has filed a comment asking for a 90-day extension to the comment period.
  • A recent bill would stop the funding of the IRS with respect to time spent on finalizing the regulations.  Since Congress has full spending authority, this bill is being supported by business groups as “having legs.”  On the other hand, it is a longshot that any such legislation would make it through Congress, much less be signed by President Obama.
  • The US Chamber of Commerce has actively sought comments and may be involved in challenging the regulations.
  • Dees and Sorrows indicated that there are many signs that these regulations are on the “fast track.”  However, Ms. Hughes has more recently suggested that the proposed regulations have virtually no chance of being finalized quickly, due in large part to the wave of comments coming in and the nature of the process generally.  A potential wild card is the Presidential Election.  Many advisors have wondered aloud that if Mr. Trump is victorious, Treasury might speed up efforts to finalize the regulations before a new administration takes hold in Washington, D.C.  Again, Ms. Hughes’ comments seem to suggest this is unlikely.
  • As of November 1, 2016, over 9,400 comments had been received by Treasury, as can be seen on regulations.gov (Docket ID: IRS-2016-0022).
  • A public hearing is scheduled for December 1, 2016. Experts from the legal, business and appraisal communties are expected to present oral comments at that time.

While we are all peering into our crystal balls, we know there is no way to predict the remainder of this process.  The current consensus, much of which is influenced by the recent comments made by Ms. Hughes, seems to be that the regulations will be revised through a lengthy process that will give due consideration to comments from ABA, ACTEC, the New York State Bar, and a host of other organizations and individuals.  This process could take months or years to play out.  In addition, it is entirely possibly that even the revised, final regulations will be challenged in Tax Court many years from now.

Despite all of the above, change is in the air, and it is more likely than not that we will see new regulations under Section 2704 at some point.  Advisors have been wise to alert their clients to the tremendous uncertainty that exists around this issue, and to the real possibility that meaningful change will be brought to the world of intra-family transfers and gift and estate tax valuation as early as next year.

Todd G. Povlich, CFA, ASA

Todd is a Partner at MPI and is based in the firm’s New York City office. Since joining MPI, Todd has determined the value of closely held securities of companies and partnerships in many industries for a variety of purposes.