Last month, I discussed the consequence of the Internal Revenue Services’ (IRS) proposed Section 2704 regulations and how family-owned businesses could be facing significantly increased tax liabilities. On December 1, 2016, the IRS held a hearing where 37 witnesses testified to the IRS to fight the proposed IRS Section 2704 regulations. The witnesses included valuation experts, attorneys, wealth planners, and family business owners.
Over the past few months, I have spoken with dozens of attorneys, estate planners, and business owners regarding these new regulations. As I am writing this months update, three things seem apparent to me; 1) attorneys, estate planners, and family business owners have mixed thoughts if the regulations will be passed; 2) the IRS will want to act quickly on these regulations, in its current or edited form, prior to President-elect Donald Trump taking office; and 3) it makes sense to contemplate a gift, sale, or transfer to family members now in order to capture the more favorable tax treatment currently offered.
Attorneys and estate planners should be proactive by advising their clients about the proposed changes and what it means for them.
According to Catherine Hughes, attorney-advisor at the Treasury, the proposed regulations will not eliminate minority discounts. However, it is expected that discounts related to intra family transfers will be significantly reduced, which will increase tax liabilities for family business owners. The IRS cites that some large family owned businesses take advantage of current loopholes through discounts. However, Forbes cites that approximately 90% of all U.S. businesses are family-owned. In short, the proposed IRS Section 2704 regulations use large family owned businesses, such as Walmart, as a prop to effect these changes. The reality is, if you or someone you know owns a small family owned business, they will inevitably pay more taxes once these regulations are finalized.
According to Charlotte Chyer, IRS Special Counsel, the three-year look-back rule will not be retroactive and would only affect transferred after the date the final regulations are published. This rule affects changes in ownership, after death, designed to create a minority or lack-of-control discount at death. Currently, a valuation is performed as if the deceased owner still owned the interest transferred, which allows for a discount for lack of control. The three-year look-back rule nullifies discounts taken for certain transfers that occurred within three years of the transferor’s death.
2. President-elect Donald Trump and the IRS
Many observers believe the finalized regulations will go into effect by the first quarter of 2017, prior to President-elect Donald Trump taking office.
2.1. Who Oversees The IRS?
During a press conference on May 2013, President Obama stated that the IRS is not exactly an “independent agency.” In fact, it is a bureau of the Treasury Department, an executive agency within the federal government. The Commissioner of Internal Revenue heads the IRS and is nominated by the President and confirmed by the Senate. The Commissioner of Internal Revenue has a five-year term of office, according to the IRS Restructuring and Reform Act of 1998 (amended Code section 7803). Also, federal law indicates that the Commissioner can be removed from the position “at the will of the President” for cause.
2.2. Positive Factors For Family Owned Businesses?
On January 20, 2017, President-elect Donald Trump will take office. After one year of his tenure, the President may elect a new Commissioner, with the consent of the Senate. Currently, the senate is dominated by Republicans who may be more favorable to an election made by a Republican President as opposed to a Democratic President. A new Commissioner of Internal Revenue appears to be on the horizon with ideologies similar to President-elect Donald Trump. If corporate taxes are cut, then owners of corporations will enjoy additional income that would have otherwise been taxed. This will not apply to partnerships as they pay on the individual level. Additionally, the additional tax-free cash flows would increase the value of a family owned corporation utilizing the discounted cash flow method (one of the more popular methods).
2.3. Negative Factors For Family Owned Businesses?
Many observers believe it is likely that the proposed IRS Section 2704 regulations will be updated to reflect some of the comments made at the hearing on December 1, 2016. These observers also believe the finalized regulations will go into effect buy the first quarter of 2017, prior to President-elect Donald Trump taking office. This means that the finalized Section 2704 regulations will be effective for one year prior to Trump electing a new commissioner. Family owned businesses will bear the burden of the new tax laws if and until they are changed.
The foreseeable decreases in taxable income to businesses would increase interim cash flows an owner would receive and therefore the value of the company. This may assist business owners in a third-party sale, but not for a transfer or gift of ownership to a family member. Since the majority of all businesses in the U.S. have sales below $5 million, the majority of family owned businesses will not be significantly impacted. They will be able to utilize their full lifetime exclusion in their estate plan. However, there are still over 1.5 million privately-held family owned businesses in the U.S. with sales above $5 million, that will be negatively impacted by the new regulations even if the tax rate is decreased. Below is a comparison of two different tax rates applied to the same company. (The 15% tax rate is based on statements made by President-elect Donald Trump).
As you can see from the example above, a married couple gifting a 100% interest in a company will pay more in gift taxes even with a reduced corporate tax rate. While I understand that most, if not all, gifts and transfers are less than a 100%interest this example illustrates the long-term tax impact assuming you want your children to eventually own and control the company. Another important note is that just because your company’s value increased by approximately $2.7 million does not necessarily mean that you will receive 100% of the increased value or cash proceeds prior to death or a transfer of that interest. For instance, if the tax rate changed yesterday under the example above, then your company’s value would increase by the $2.7 million (using a discounted cash flow method). However, you have not realized the additional cash flows from the tax savings today.
3. What should you do?
It is uncertain exactly when the proposed regulations will go into effect. However, it does appear likely that the regulations may go into effect buy Q1 2017. Attorneys and estate planners should be proactive by advising their clients about the proposed changes and what it means for them. I can’t predict the future but if I was contemplating a gift, sale, or transfer of an interest in a family owned business, it makes sense to consider capturing the current more favorable tax treatment by completing the transfer sooner rather than later.
It makes sense to consider capturing the current more favorable tax treatment by completing the transfer sooner rather than later.