For owners of family businesses, the history of estate tax planning has resembled a chess match. No sooner do owners and their professional advisers develop a useful technique to reduce the tax burden than Congress acts to close what it views as a loophole. Taxpayers and their advisers counter with new or modified techniques to restore or replace all or part of the lost benefits. Congress deliberates and, once again, tries to block that move with new legislation.
And so it goes, on and on. This match has lasted far longer than any grandmaster competition, at great cost to family business owners, who must keep guessing what Congress’s next move will be and hiring top advisers to protect their assets. With no endgame in sight—and with the Clinton Administration proposing to restrict some of the most recent strategies—is there any hope for a solution?
Before trying to answer that question, let me review the history of the moves and counter-moves to see how the game has been played so far.
Prior to the late 1980s, one strategy frequently used by family business owners was the preferred stock recapitalization. Members of the older generation exchanged the bulk of their common stock for preferred stock with a fixed value, and gifted their remaining common stock (worth little) to members of the younger generation. By so doing, they transferred all of the subsequent appreciation in the value of the business to their successors, essentially free of gift and estate tax.
In response, Congress in 1987 enacted an amendment to the tax code, section 2036(c), a clumsy and unworkable attempt to re-include such appreciation in the estates of the older generation. Two years later, faced with overwhelming criticism from owners and their advisers, Congress replaced 2036(c). However, the new legislation, known as Chapter 14, also restricted an array of techniques intended to shift growth in asset value to the younger generation.
Besides making the traditional preferred stock recapitalization impractical for most family firms, Chapter 14 limited the use of buy-sell agreements to freeze the value of assets. The amendment also sharply curtailed the use of lapsing rights and restrictions on voting and control, particularly in family partnerships, as techniques for shifting future growth in value to younger-generation members. (By letting their right to vote the stock or partnership interests they are transferring “lapse,” seniors hope to get a discount on the value; likewise, by placing restrictions on voting and control of shares they receive, the younger generation seeks to reduce the value, since they cannot influence payment of dividends or sale of the business.)
In interpreting and enforcing the legislation, the Internal Revenue Service has not overtly thwarted legitimate estate planning techniques. Nevertheless, it has intensely scrutinized techniques used by many family business owners, and often has been skeptical or openly hostile to them.
A good example has been Treasury restrictions on the use of buy-sell agreements to determine, for estate tax purposes, the value of a decedent’s interest in a closely held business. When the surviving shareholders of a private company have not been members of a decedent’s family, the IRS has typically accepted the value established in the buy-sell agreement at which the estate is required to sell stock.
For family businesses, in contrast, the IRS has often tried to develop evidence that the agreement is a device to transfer property to family members at less than fair market value. The IRS has taken this stance, typically, even when the family has demonstrated that the agreement’s terms are comparable to arrangements entered into, at arms’ length, by unrelated parties in similar businesses.
Valuation discounts
In response to Chapter 14, estate planners have begun to focus on ways to employ properly various discounts in valuing family business interests (and other assets) subject to gift tax or estate tax. In the simplest case, the older generation has retained voting stock and made gifts of non-voting stock to the younger generation. The value of the non-voting stock is discounted to reflect lack of control and, typically, lack of marketability, even though both classes of stock share equally in any dividends, and would share the proceeds from a sale of the business.
More recently, family business owners have maximized their use of family limited partnerships (FLPs) and limited liability companies (LLCs). Under both types of setup, the seniors have transfered illiquid minority interests to the younger generation. Such gifts and bequests confer no control and are untradable in any market. They have therefore qualified for substantial valuation discounts for tax purposes.
Although there is no set rule defining the allowable discount for lack of marketability and control, case law indicates that combined discounts ranging from 10 to 60 percent have often been appropriate. Even conservative advisers have concluded that discounts of up to 40 percent would be reasonable.
By making lifetime gifts of discounted FLP or LLC interests, a taxpayer has leveraged his or her annual exclusion of $10,000 and, in effect, transferred assets worth more than that. Similarly, discounted lifetime gifts of FLP or LLC interests have been used to leverage a taxpayer’s unified lifetime credit for gift and estate tax (now $650,000) and the generation-skipping tax exemption for transfers to grandchildren (currently $1,010,000) as well.
A few bills pending in Congress would eliminate the Federal estate tax entirely. In July, the House of Representatives, as part of a broad tax cut bill, included a measure that would gradually lower estate tax rates annually over a 10-year-period then eliminate the tax entirely in 2009. This legislation is unlikely to go anywhere because of opposition in the Senate and the Administration to the tax cuts. President Clinton, however, has included in the proposed fiscal year 2000 budget provisions that directly affect the gift and estate tax system. One such proposal would eliminate valuation discounts for interests in FLPs and LLCs other than those holding interests in an active trade or business (no discounts would be allowed for holding publicly traded securities).
The prospects for enactment of such legislation this year are not great either, but the proposal could easily become law if control of the House and Senate once again changes hands—and Democrats retain the Presidency—after next year’s elections.
No matter what attempts Congress makes to “reform” or “simplify” the applicable rules, new opportunities for tax savings will almost always be generated. So why go on with the game? Why not save everyone time, trouble, and resources by simply reducing the top marginal rates at which the Federal estate tax is assessed. In fact, diminishing top marginal rates is the only way to reduce the tax savings generated by sophisticated planning.
For evidence, one need look no further than the legislation in the 1980s that reduced the top Federal income tax rate to 28 percent. The law sharply curtailed the benefits of sophisticated planning (a $1 deduction would produce no more than a 28-cent tax savings). So instead of trying to avoid taxes, people turned their attention to maximizing real returns from investments. The tax shelter industry was devastated, and the portion of the nation’s taxes paid by the rich went up. Aren’t we overdue to apply the same principle to the estate tax and end the chess match?
The need for rate reductions in the estate tax is particularly acute. By the year 2006, when the estate tax exemption reaches $1 million, the lowest estate tax marginal rate (41 percent) will exceed the highest Federal income tax rate (39.6 percent). A reduction in top estate tax rates would diminish the time, energy, and money business owners spend on planning the next countermove in the chess match. It would allow them to redirect their family’s energies to sound business and succession planning.
Michael L. Fay is chairman of the trusts and estates division at Boston law firm Hale and Dorr, and heads the firm’s Family Business Practice.