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Estate planning advantage under siege?

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This is a bit complicated, but hold on to your hat, because for some clients, it could be incredibly important.

The IRS recently proposed regulations that could adversely affect estate planning for many wealthy clients. Advisers need to understand the broad strokes of what this change is, which clients it might affect and why those clients need to act fast to get planning in place before the end of the year.

Once the proposed regulations become effective, which could be around year end, clients’ right to claim discounts might be substantially reduced or eliminated, thus curtailing your tax and asset protection planning flexibility.

Valuation discounts have been at the heart of many estate plans, so let’s look at an example.

Your clients have an $18 million estate and face a large estate tax. Their estate includes a family business valued at $12 million.

The husband, John, gifts 40% of the business to a trust, and his wife, Jane, gifts 35% of the business to another trust, to grow the value out of their estates. The gross value of the two gifts is $9 million [(35% + 40%) x $12 million].

Those gifts would use up $9 million of their gift and estate tax exemptions ($5,450,000 each this year). But under the law before the new regulations become effective, these non-controlling 40% and 35% interests in the family business are worth less than the pro-rata value of the underlying business.

The real economic logic behind discounts is this: A minority 35% shareholder can’t force a sale or redemption of its interest. If your client owned 35% of a manufacturing corporation, the 65% shareholder could control when dividends would be paid, whether the corporation could be sold, and other critical factors. (Caveat: unless the shareholders agreement included express provisions to the contrary).

Thus, the true economic value to the 35% client is reduced to reflect these real-world difficulties of selling a non-controlling interest, and the inability to force a distribution. So if the corporation was worth $10 million, the 35% interest would be worth something less than the $3.5 million pro-rata interest. How much less is a question of facts and analysis for an appraiser.

If the various valuation discounts total 40%, then the value of the business given to the trusts would be appraised, net of discounts, at $5.4 million. The discount has reduced their estates by $3.6 million from these gifts.


Discounts can also be critical to an estate plan working as planned. A simplified example glossing over some of the tax planning nuances can highlight the vital nature of discounts.

A single client, Mary, owns a business worth $60 million. She wants to reduce future estate tax costs and plans to sell two $25 million interests to two separate trusts.

The trusts will give a note to Mary to consummate the purchase. The IRS specifies minimum interest rates that must be charged on transactions.

Assume the current rate is 2%. Cash flow from the business is $950,000.

“Once the proposed regulations become effective, which could be around year end, clients’ right to claim discounts might be substantially reduced or eliminated, thus curtailing your tax and asset protection planning flexibility.”

If each trust issues a $25 million note to Mary to buy stock, the interest would be $1 million ($25 million x 2 x 2%). But the trusts combined would only receive $791,667 of cash flow [$950,000 total cash flow x ($25+25/$60)].

If, however, valuation discounts were available, the two $25 million interests might be valued, net of a 40% discount, at $30 million [($25 + $25) x (1-40%)]. At the discounted value, the trusts would have to pay interest on notes used to buy the stock of $600,000 [$30 million x 2%].

The $791,667 of cash flow the trusts would receive would exceed the cash flow necessary to service the debt. This illustrates how without discounts it may be feasible for a wealthy client to transfer business interests in a sale transaction.

However, once the new regulations become effective, and if they restrict discounts as severely as the proposal suggests, many estate planning transactions would simply not be feasible.

Some wealthy clients looking to minimize gift and estate taxes can benefit from discounts, and as illustrated above, in some instances, the discounts will be essential for planning to succeed. The size of the estate, the nature of the assets and other factors will all be relevant to determining whether discounts are irrelevant, important or essential to the plan.

Other categories of clients may also benefit from discounts. A client concerned about protecting a family business from the risks of future divorce or protecting assets from lawsuits or malpractice suits may need discounts to help leverage more assets into trusts without triggering a gift tax.


While the buzz about the discount restrictions is growing, there is another very important piece to the story. If Democratic presidential candidate Hillary Clinton is elected, the party’s platform includes the reduction of the gift and estate tax exemption to $3.5 million, eliminating the inflation adjustment of the exemption, a $1 million gift exemption and a 45% maximum gift and estate tax rate (the current rate is 40%). The Democratic estate tax proposals may also include may of the planning restrictions that President Barack Obama has proposed for years.

These include restricting or eliminating grantor retained annuity trusts, note sale transactions and other techniques used to shift significant wealth. Although it is impossible to ascertain their probability, these should be considered in determining what planning to undertake.

It really appears that a significant restriction on valuation discounts is imminent. But it also might be that other even more damaging clouds are on the planning horizon.

If advisers or their clients see any merit to these concerns, perhaps the year end planning to capture discounts should be broader to address these future planning risks as well.

“Advisers should contact wealthy clients who might be affected and encourage those clients to consult with their planning team on an urgent basis.”

But there is a flip side to the above scenario that also should be considered. If Republican presidential candidate Donald Trump captures the White House, that GOP’s platform calls for the elimination of the estate tax.

How might wealthy clients address the above planning risks while reflecting the possibility that any planning done might prove irrelevant? The one-word answer is flexibility.

There are many planning techniques that can maximize clients’ access to funds given away. This approach to planning can allow clients to take action to protect themselves against the loss of discounts and potentially harsher tax laws, and not unduly restrict them should opposite legislative results occur.

Many advisers and clients might remember the mad rush to plan in late 2012 on the fear that the gift, estate and generation skipping transfer tax exemption might have been reduced in 2013 to $1 million from $5 million. After many incurred significant costs those tax restrictions never happened.

The potential restrictions on valuation discounts seems more likely to happen, but there is no certainty. The real issue, is can clients afford to wait?

If a client waits to see what happens, it might be too late to plan. Perhaps this year, like 2012, will be a case of better safe than sorry.

Advisers should contact wealthy clients who might be affected and encourage those clients to consult with their planning team on an urgent basis.

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