Administration Proposals Would Limit Estate Planning Techniques

May 12, 2009

The Obama Administration’s Revenue-Raising Proposals Would Curb Valuation Discounts for Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs) and Would Limit the Use of Grantor Retained Annuity Trusts (GRATs)

Yesterday, the Treasury Department released its “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals.” The “Greenbook,” as it is popularly called, complements the Obama Administration’s budget proposals released at the end of February. Thus, as expected, among many other income tax changes, the Greenbook proposes to reinstate the top 36% and 39.6% individual income tax rates eliminated in 2001, to increase the 15% rate on dividends and capital gains to 20%, and to limit the application of itemized deductions to the 28% rate. (The itemized deduction proposal has already been the target of criticism and was not endorsed in the budget resolution passed by the House of Representatives and the Senate on April 29.)

Estate and Gift Tax Provisions

The Greenbook confirms that the Administration’s budget proposals would make permanent the estate and gift tax law in effect for calendar year 2009 – that is, a rate of 45 percent and an exemption amount of $3.5 million – a goal at least tentatively embraced in the congressional budget resolution. The Greenbook also describes other estate and gift tax proposals, in the context of raising revenues dedicated to health care reform. If the proposals are enacted into law, two of them may significantly limit the use of popular and often effective estate planning techniques, family limited partnerships (FLPs) and grantor retained annuity trusts (GRATs).

Limitation of Valuation Discounts for Family Limited Partnerships and Limited Liability Companies

Among the advantages of family limited partnerships (FLPs) and limited liability companies (LLCs) are the estate and gift tax valuation discounts resulting from the restrictions on management, distributions, liquidation, and transferability associated with interests that are transferred to family members or trusts for family members.

Without many details, the Greenbook signals significant limitations on the use of such valuation discounts.

Background. Effective October 9, 1990, section 2704(b) of the Internal Revenue Code has required transferred interests in corporations and partnerships to be valued without regard to restrictions on liquidation that are harsher than the default restrictions imposed by applicable federal or state law, if the transferor’s family has the power to remove the restrictions. Since 1990, many states have changed their laws governing limited partnerships and limited liability companies to impose harsher default restrictions, thus, in effect, reducing the reach of section 2704(b). Among other things, yesterday’s Greenbook complains that “the enactment of new statutes in most states [has], in effect, made section 2704(b) inapplicable in many situations.”

Also since 1990, the Treasury Department has had the authority to provide by regulations “that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of [the estate and gift taxes] but does not ultimately reduce the value of such interest to the transferee.” Treasury has been working on those regulations for many years, and some have thought for many months that the publication of proposed regulations was imminent. In a possible reference to the work that has been done on those regulations, yesterday’s Greenbook states that “the Internal Revenue Service has identified additional arrangements designed to circumvent the application of section 2704.”

Proposal. The Greenbook generically describes a proposal that would create a more durable category of “disregarded restrictions,” applicable to all family-controlled entities, not just corporations and partnerships. Those restrictions would be measured against standards prescribed in Treasury regulations, not against state law. Transferred interests in family-controlled entities would generally be valued as full equity interests, not merely as “assignee” interests. Treasury would be authorized by regulations to ignore the ownership of certain interests by charities, treating those interests as held by the family.

It is hard to tell exactly what new rules might be included in this legislation if it is enacted, or under the regulations that Treasury is working on whether or not there is new legislation. Nevertheless, it is likely that the limitations on valuation discounts will be stricter that any we have seen before.

As proposed, if Congress agrees, the measure would apply to transfers – gifts and deaths – after the date of enactment.

A Minimum Term for GRATs

Many taxpayers use grantor retained annuity trusts to transfer property expected to increase in value at little or no gift or estate tax cost. The transferor retains an annuity for a fixed term of years, and the value of the gift is determined by subtracting the value of that retained annuity, calculated using the interest rate published by the IRS for that month, from the value of the transferred property. In general, any amount by which the property transferred to the GRAT increases in value above that interest rate passes to the remainder beneficiaries of the trust – typically the transferor’s children – free of gift or estate tax, if the transferor survives the GRAT term. (If the grantor dies before the end of the GRAT term, all or most of the value of the property in the GRAT at that time is subject to estate tax, and the GRAT does not work.)

The Greenbook notes that “[t]axpayers have become more adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor’s death during the term), in many cases to 2 years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.”

The Greenbook proposes to require GRATs created after the date of enactment to have a term of at least ten years. That would still permit GRATs to work, even with little or no gift tax value for the remainder, but a longer term would increase the likelihood that the grantor would die during the GRAT term, causing the GRAT to fail.

Actions That Might Be Taken

Those who are considering creating or transferring interests in FLPs or LLCs might be entirely satisfied by other benefits such entities might offer, but most also expect the transfers of interests in those entities to receive the tax treatment that the law has historically allowed. Therefore, such persons should probably not delay in creating the FLP or LLC or making the contemplated gifts or sales of interests in those entities, before the effective date of any such legislation or regulations.

Similarly, many persons who are contemplating the creation of a GRAT might be comfortable with a ten-year term, especially since that provides a way to lock in the benefits of today’s very low interest rates, which generally increase the opportunity for a GRAT to succeed. But those for whom a shorter GRAT is a better idea should also consider acting before the legislation becomes effective.

The lawyers of Fiduciary Advisory Services and the Private Wealth Services Group of McGuireWoods will continue to monitor and analyze these potentially important developments. An outline entitled Estate Tax Changes in the Obama Administration will be kept up-to-date on the McGuireWoods website.

McGuireWoods’ Private Wealth Services

Our Private Wealth Services is one of the strongest and largest groups of estate planning professionals in the country. The team’s experience and size puts it on the cutting edge of estate planning, tax and probate issue development and analysis.

McGuireWoods’ Fiduciary Advisory Services

Fiduciary Advisory Services, a service of our Private Wealth Services Group, assists financial institutions in a wide array of areas in which questions or concerns may arise. This includes advising corporate trustees on how to avoid litigation before it arises and how to address litigation when it does arise.