Just as she was about to finish an extensive (and expensive) round of year-end tax planning, a client of mine became frustrated last week - and I don’t blame her one bit.
This client is doing her best to responsibly manage her family’s wealth, a lot of which is held in real estate. She has two children and wants them to enjoy the property someday. So it made excellent sense for my client to take advantage of the $5.12 million exemption from gift tax that was scheduled to expire at the end of this year.
Our plan was to let her give real estate worth close to $5 million to trusts for the benefit of her children. The properties in question are appraised at about twice that much, so the trusts will buy the remainder of the real estate from my client.
But there is one problem: I cannot tell my client exactly how much of her property she can give to her children tax-free, and neither can anyone else.
My client obtained an independent appraisal, but the Internal Revenue Service is not required to accept the appraisal’s conclusions. Suppose my client gives away 50 percent of the property, thinking this amount is worth $5 million and is therefore exempt from tax, but the IRS later argued that the 50 percent property interest was really worth $7 million. At a 35 percent gift tax rate, that would be create an unanticipated tax bill for $700,000, plus interest.
And if the IRS succeeded in arguing that the property is really worth $7 million, it could add a 20 percent penalty for a “substantial valuation understatement.”
My client wants to do the right thing. She is not trying to be overly aggressive in planning her taxes. But, apart from hiring a qualified appraiser and relying on professional advisers, how is she supposed to know what the right thing is? Granted, she can avoid penalties in some circumstances because she sought professional advice, but only appeals and litigation offer relief from the IRS’ view that an asset is worth whatever the IRS thinks it is worth.
This is the fundamental problem with estate and gift taxes. They do not tax transactions in which values are known; they tax events - a transfer by gift or bequest - at which the key values are often no better than an educated guess.
My client told me she wanted an ironclad tax position. I had to reply that, in a transaction involving anything other than cash or publicly traded securities, there is no such thing. No matter what value we assign to a transaction in untraded property, the IRS may come up with a different one. I have seen IRS valuation professionals offer highly suspect numbers for property ranging from oil wells to jade garden sculptures.
In the end, most of these cases are settled in a negotiation between the taxpayer’s representatives and the IRS. A large number, however, go on to litigation, in which a Tax Court judge usually just substitutes his or her opinion of the value for the positions advanced by the taxpayer and the Service.
Two taxpayers who engaged in identical transactions with identical property could end up with wildly different results, depending upon which appraisers and tax advisers they hired, which IRS examiners – if any – happened to look at the transactions, and which appeals officer or Tax Court judge ultimately decided the value. This is not a fair or sensible way to run a tax system. But then estate and gift taxes are not fair or sensible taxes.
Of course, these taxes do not touch most of the population. Even at an exemption of just $1 million, which is what we would face next week under the “fiscal cliff” scenario, most Americans would never be subject to these headaches, which is the only reason why these taxes can exist politically.
I think a large swath of Americans know this. Estate and gift taxes are not very popular, even though they reach only a small and often-envied slice of the population. My client certainly is not suffering financially, whatever the emotional stress her tax planning may cost her. Yet the unpopularity of these taxes tells me that people understand, explicitly or intuitively, that it is unfair to make people pay taxes merely to keep property in the family, and to base those taxes on somebody’s whim about what property ought to be worth.
There is a time and a place to impose taxes, and that is when someone gets paid for something. Money changing hands is the best indicator of value.
Of course, most Americans pay property taxes, which are also based on a guess as to the value of an asset. Those taxes, too, are often unfairly applied; this is why most jurisdictions have elaborate appeals processes. At least those taxes are applied to most of the property-owning population, so we are all in the same boat. And property taxes are not applied at anything like the rates that apply to gifts and estates, which in recent years have ranged from 35 percent to 55 percent of value.
In the end, my client proceeded with her year-end planning. We’ll do the best job we can on the valuation of her property, and if the IRS wants to pick a fight over it, we’ll defend her position. It’s a lousy, unfair system for taxing wealth, but it happens to be the system we’ve got.
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