U.S. Treasury Department photo by Roman Boed
The Trump administration has had it shares of ups and downs – lots of people would point to lots of downs – but it has already scored a major tax policy success, and one on which Congress can build when and if it gets around to overhauling the Internal Revenue Code.
The rapid Trump achievement was accomplished by blocking a damaging change in estate tax rules that the Obama administration tried to push into the Treasury regulations in its waning days. If you don’t think blocking the other side from doing harm counts as a success, you probably ought not consider applying for a job as a defensive coach in the National Football League.
The proposed rule change would alter the way shares of family businesses are valued for estate and gift tax purposes. The rules themselves are complex, but the net effect is simple: In many cases, instead of valuing a minority share of a family business at whatever an unrelated party might be willing to pay, the value would be determined as if the entire business were being liquidated and the proceeds distributed pro-rata to the owners.
Officials from the Internal Revenue Service and its Treasury parent agency got quite an earful when they held a hearing on the proposal in December. In over five hours of testimony and nearly 10,000 written comments, tax and valuation professionals joined family business owners in denouncing the proposal as being unrealistic and overreaching.
In January, Trump issued an executive order that the Treasury review all “significant tax regulations” issued since Jan. 1, 2016. The order directed the Treasury to identify rules that “impose an undue financial burden on U.S. taxpayers,” or that add unnecessary complexity to the tax law or exceed the IRS’ statutory authority. As the Treasury sifted through the 105 regulations included in the executive order’s umbrella, it seemed inevitable that the proposed valuation regulations would be flagged.
Sure enough, in April 2017, Notice 2017-38 announced that eight regulations met at least one of the first two criteria specified in the executive order – and one of the eight was the proposed set of regulations on minority share valuations. Referring to comments from the December hearing, the notice affirmed that the regulations would indeed present an undue financial burden on taxpayers. The Treasury solicited comments on whether the regulations it identified should be rescinded or modified; these comments were due by Aug. 7, and the Treasury must recommend a course of action to the White House by Sept. 18. My guess, like that of many other estate planning professionals, is that the department will withdraw the proposed regulations and that we will never hear about them again – at least while Trump remains in office.
The proposed rule was born out of tax officials’ frustration with legal strategies that carve up businesses into small bundles of equity that are subject to many restrictions on transferability and marketability, all of which depress the fair market value of those minority interests. Since estate and gift taxes are based on fair market value, this reduces or, in some cases, eliminates such taxes.
But such restrictions often serve nontax purposes as well. As businesses pass from one generation to the next, it is common for some family members to remain active while others merely receive passive income from dividends. The members who run the business typically want, and often deserve, to retain control of the decision-making. The other minority shareholders have less of a voice, and therefore a less valuable stake, in the entity.
The real problem is with the estate and gift tax itself. It is based on fair market value, but in the absence of a genuine arm’s-length transaction there is no way to be sure exactly how much that is. If fair market value were a fixed number, the prices of stocks would not fluctuate every business day on the world’s stock exchanges. If minority interests were worth as much as controlling stakes, merger offers would not be made at a substantial premium to the prior market price (as is usually the case). And even if value could be accurately and objectively measured, a gift or bequest of a business interest does not free up a nickel of cash with which to pay any tax.
The real solution to abusive estate planning techniques is to get rid of the estate tax. If we taxed business interests only when they were sold, the value would be apparent via the sales price, and the cash for paying tax would be available from sales proceeds. There is a decent chance that a Republican-sponsored tax plan will seek to do something much like this, with a limited exception from capital gains taxes for inherited assets.
Don’t expect many of my fellow estate planners to applaud this development, however. Most will be quiet about it to avoid upsetting wealthy clients, but lawyers and insurance agents who make a good living planning to deal with wealth transfer taxes are in no hurry to see them go away. Neither are universities and other charities that often seek large bequests, partly on the basis that money kept in the family will largely go to the government instead.
Tax officials took a conciliatory tone when faced with the wave of criticism they received in December. By that time, however, the election was over and the writing was on the wall. Trump’s executive order all but assured that they would not be able to get these regulations finalized with only the minor changes that would have been likely had Hillary Clinton been elected.
Trump can’t get rid of the estate and gift tax without congressional action, but at least he can keep the tax bureaucracy from making it less realistic and manageable than it already is. Doing so is one of the high points of his administration so far.