Last week, the IRS issued proposed regulations that will significantly reduce valuation discounts for gifts or sales of interests in family limited partnerships, family limited liability companies, and closely-held corporations.  It will take years and several court cases to determine the overall effect of the regulations.  My best guess is that the regulations will reduce the valuation discount for a typical family limited partnership gift or sale from approximately 35% to approximately 5% or 10%.

These regulations were issued pursuant to a statute that was enacted in 1990.  The reason the IRS waited so long to promulgate these regulations is because they preferred for Congress to change the law.  They have given up on Congress.  The regulations may eventually be ruled to be invalid for exceeding the statutory authority that was given to the IRS to promulgate these regulations.  Nevertheless, my advice is to plan as if the proposed regulations will be valid when issued as final regulations.  Trust me.  You don’t want to pay the legal fees to overturn the validity of IRS regulations.

When will the regulations become final?  We do not know for sure.  The IRS will hold hearings on the regulations on December 1, 2016.  Generally, it takes several weeks or months to finalize the regulations after the public hearings. The IRS will undoubtedly receive vociferous complaints from different groups around the country.

In summary, any planning transactions involving gifts or sales of family limited partnerships, family limited liability companies or closely-held corporations should be completed prior to December 1, 2016.

A previous blog discussed the Mitchell case, in which long-term leases substantially reduced the estate tax value of certain real property. A very significant issue did not have to be decided by the Court because the IRS stipulated that the property gifted by the decedent as well as the property still owned by the decedent at the time of his death would receive fractional interest discounts.

Six days before he died, Mr. Mitchell gave a 5% interest in his beachfront property and his ranch to a trust for his sons. The IRS stipulated before trial that the 5% gift of the beachfront property would receive a 32% fractional interest discount and the 5% gift of the ranch would receive a 40% discount.

The IRS also stipulated that the 95% interests in the beachfront property and the ranch that were owned by the decedent at the time of his death would receive fractional interest discounts of 19% and 35%, respectively.  The combined fractional interest discounts saved more than $1 million of estate taxes.

Numerous court decisions have recognized significant fractional interest discounts. In my experience, discounts of 25% to 35% are typical.  These court decisions influenced the decision by the IRS to concede the discounts in the Mitchell case.

The decedent’s revocable trust devised the 95% interest to the very same trust to which he had gifted a 5% interest just 6 days before his death. Therefore, the trust for the sons received a 100% ownership of the property. However, by dividing the transfer of the property to the sons’ trust into two separate portions, Mr. Mitchell significantly reduced his estate taxes.

Mr. Mitchell’s estate was fortunate to receive the discounts since he made the gift after he became very ill due to cancer. Some prior cases have disallowed otherwise valid discounts for deathbed gifts. Ideally, the gift should be made at least one year before death and certainly before a diagnosis of a terminal illness.

Whenever you plan to make a gift of real estate, you should consider giving part now and part later (or part to one donee and part to another donee). Further, if you are planning to devise real estate through your Will, you should consider giving a small percentage interest in your lifetime and the remainder through your Will.  Now is an excellent time to make a gift due to depressed real estate values and the temporary $5 million federal gift tax exemption.

In a recent case decided by the Tax Court, Estate of James L. Mitchell v. Commissioner, T.C.M. 2011-94, the Tax Court determined that the long-term leases on a ranch and home owned by the decedent significantly reduced the values of the properties. The home was subject to a 20-year lease. The value of the home without a lease was $14 million. The court determined that the value of the property subject to the lease was $6 million. This represents a 57% discount attributable to the lease.

The ranch was subject to a 25-year lease. The value of the ranch without a lease was $13 million. The value of the ranch with the lease was $3.37. This represents a 74% discount due to the lease.

One might think that the lease payments were below market. However, evidence presented at trial indicated that the rent charged with respect to both properties reflected market value. The significant decrease in value is attributable to the way properties subject to a long-term lease are valued. Appraisers value the stream of rental income payments plus the value that you could sell the property for after the lease term is over. This stream of payments is discounted by the rate of return that an investor would require to take over the stream of payments. Often, the discounted value of the stream of payments is lower than the value that you could sell the property for if the property did not have a lease.

The properties owned by Mr. Mitchell were somewhat unusual. A more typical circumstance is real estate leased to a family business. You should consider leasing the property for a long-term. 

After a long-term lease is entered into with respect to a property, you should consider some type of gifting transaction. Rental real estate works well for a direct gift, a GRAT, or an installment sale to a grantor trust.

In summary, if you have rental real estate that you intend for you and your family to own for several years, you should consider leasing the property for a long term. The lease can significantly reduce estate taxes upon your death.

When you own a business with one or more other persons, it is advisable to enter into a written agreement with the other owners. These agreements have different names depending upon the type of entity: shareholder agreements for corporations, partnership agreements for limited partnerships and general partnerships; and operating agreements for limited liability companies. These agreements are sometimes generically referred to as “Buy-Sell Agreements”.

Buy-Sell Agreements typically restrict transfers to third parties and specify rights of the parties under certain circumstances such as death, divorce and disability. It is not uncommon for these agreements to give the company and/or the other owners an option to buy your interest in the company for a predetermined price in the event that you die, or become disabled, or transfer your stock to any other person, including your spouse upon divorce. The price is generally less than a proportionate share of the value of the entire business.

If a divorce court awards a portion of your interest in the company to your spouse, your spouse may contend that he or she is not bound by the Buy-Sell Agreement. Alternatively, your spouse may argue that your interest in the company should be valued based upon the different method than that contained in the Buy-Sell Agreement.

Customarily, spouses do not sign Buy-Sell Agreements unless they own an interest in the company. However, a recent case decided by the Tennessee Court of Appeals provides a good reason for asking your spouse to sign the Buy-Sell Agreement.

In the Inzer (pdf) case, the wife argued that her husband’s stock in his company should not be valued in accordance with a formula contained in the Buy-Sell Agreement. The Court indicated that the wife’s argument would have been meritorious if she had not signed the Buy-Sell Agreement. Because she signed the Agreement, the Court ruled that she was bound by the valuation formula.

For purposes of valuing the couples’ marital estate, the stock was valued significantly below its pro rata share of the total value of the company. Because the husband was awarded the stock, this meant that the wife received a smaller share of the other assets. As a result of this case, I plan to recommend that my clients ask their spouses to sign their Buy-Sell Agreements.

Family limited partnerships (or LLCs) are often used to obtain valuation discounts for estate and gift tax purposes. Appraisers typically conclude that the fair market value of an interest in a family limited partnership (“FLP”) is at least 35% less than the value of the assets owned by the FLP.

The IRS dislikes these discounts and has successfully challenged the discounts in several court decisions. As a general rule, the taxpayers were "sloppy" in the cases that the IRS has won. Errors were made either in funding, distributions, or record keeping.

When the FLP is properly funded and administered, taxpayers are able to substantiate the discounts. For every case in which the IRS has successfully disallowed discounts, there are many others where the court approved a discount or the IRS agreed to a discount without going to trial.

A case in point is the recent Rayford L. Keller et al v. United States decision. Mrs. Williams was in the hospital, dying from cancer. Six days before her death, she signed documents to establish an FLP to be funded with $240 million of bonds and $10 million cash.

The assets were not transferred to the FLP until one year after she died. Nevertheless, the Court ruled that her family was entitled to a 47.5% discount on the value of the bonds and cash that were transferred to the FLP.

I do not recommend waiting until death is imminent to establish an FLP. It is far better to establish the FLP when you have several years to live, and then to make gifts or sales of FLP interests when that is appropriate.

Detailed summary of Keller case by Steve Akers of Bessemer Trust Company, N.A.