ABA Mid-Year Tax Section Roundup

Estate, Gift, and Tax Projects in the Horizon

At the ABA Mid-Years Tax Section Meeting, Cathy Hughes and Melissa Liquerman of the IRS Office of Chief Counsel revealed a number of projects that are underway at the Service. In this article, several of those projects pertinent to valuation analysts are discussed, including the status of sec. 2704 regulations.

At the ABA Tax Section Meeting on May 6, 2016 Cathy Hughes with the Treasury Department Office of Tax Policy) and Melissa Liquerman (Branch 4 chief, IRS Office of Associate Chief Counsel (Pass-through and Special Industries) spoke about upcoming IRS guidance.  In addition, Ms. Liquerman spoke at the ABA Real Property, Trust, and Estate Law Section meeting on May 12, 2016.  They addressed various projects on which guidance would likely be issued in the near future.  Ms. Liquerman said, “We hope in the next couple months to issue five or six projects,” Several Gift, Estate, and Trust Projects Expected Before July, TAX NOTES TODAY, 2016 TNT 90-11 (May 10, 2016) (hereinafter “Projects Expected, TAX NOTES TODAY”).

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The first of these projects that will be issued are §2704 proposed regulations (discussed below).

The following projects were cited as forthcoming this summer:

1. Section 2704 Proposed Regulations. Treasury Officials stated the timing as to when the regulations would be issued as, “very, very shortly,” “this spring, before summer,” “some could come as soon as the next two weeks,” “the next four to eight weeks.”  It is of import to note that they spoke of these as proposed regulations as opposed to other types of guidance.  Liquerman indicated that the first of the estate and gift projects that would be issued by the IRS in the near future would be the Sec. 2704 proposed regulations that could place further restrictions on being able to apply valuation discounts in valuing transfers of interests in entities (such as FLPs and FLLCs).  It should also be noted that the approach and scope of the proposed regulations are highly uncertain at this point, but the regulations could have a very important impact on valuing transfers of interests in such entities.  Finally, neither of the speakers gave any hint as to whether the proposed regulations would take the rare approach of providing that the regulations, once finalized, would be applied retroactively to the date of the proposed regulations.
2. Section 2053 Proposed Regulations. This project will address issues left unresolved in the regulations that were issued in 2009 regarding the valuation of disputed claims against an estate.  The preamble to those regulations includes the following statement: “The Treasury Department and the IRS believe the issue of the appropriate use of present value in determining the amount of the deduction allowable under Section 2053 merits further consideration.  The final regulations reserve Section 20.2053-1(d)(6) to provide future guidance on this issue,” T.D. 9468, Sec. 13, I.R.B. 2009-44.  The Treasury Priority Guidance Plans for 2009-2016 include a project to address when present value concepts should be applied in determining the deductible amount of claims against an estate and administration expenses (including, for example, attorneys’ fees, Tax Court litigation expenses, etc.) as well as the treatment of personal guarantees.  It should be noted that officials have previously indicated, on an informal basis, that “Graegin loans”—on which interest that will be payable for the full term of the loan is deducted from the outset as an administration expense—are within the scope of this project.
3. Section 2032(a) Final Regulations. These regulations will address whether certain transactions will be treated as distributions or dispositions during the six-month alternate valuation period.  As a general rule, a sale or distribution of an asset within the six-month valuation period fixes the alternate valuation of that particular asset as of the date of the sale or distribution.  Proposed regulations were issued in 2008 in response to Estate of Kohler v. Commissioner, T.C. Memo. 2006-159 (tax-free reorganization is not a disposition that accelerates the alternate valuation date).  Those proposed regulations were controversial in various respects, and the proposed regulations were revised and re-issued on November 18, 2011.  For example, the proposed regulations, among other things, provide that making multiple distributions of minority interests within the first six months cannot convert a majority interest into a series of minority interest for valuation purposes and that contributing assets to a limited partnership in the first six months cannot result in discounting the assets under the alternate valuation rules, see Prop. Reg. Sec. 20.2032-1(c)(1).

Cathy Hughes also referenced the following as other projects that are longer-term and will not be issued anytime in the near future.  These include guidance on the valuation of promissory notes and the gift tax effect of defined value clauses.  In addition, two generation-skipping transfer tax projects addressing allocation issued under Section 2642 were also longer-term projects (as well as other projects listed in the “Gifts and Estates and Trusts” section of the 2015-2016 Priority Guidance Plan).

1. Section 469 Proposed Regulations Regarding Material Participation by Trusts. How trusts materially participate in a business under Section 469 has taken on additional significance in light of the “non-passive trade or business exception” from the net investment income tax under Section 1411, and in light of the Tax Court’s position in Frank Aragona Trust v. Commissioner, 142 T.C. 165 (2014).  Hughes indicates that this is a longer-term project, “We have taken an approach to this project by deciding we weren’t going to be bound by any other approach in the code that exists to the question of material participation; we’re starting from scratch and evaluating from the ground up.”
2. Valuation of Promissory Notes. The Business Plan refers to the valuation of promissory notes under Sections 2031, 2033, 2512, and 7872.  Some examining agents have taken the position in gift tax audits that promissory notes bearing interest at the AFR should not be treated as being worth the face amount of the note, but have been reluctant to allow discounts in valuing such notes for gift and estate tax purposes.

a. Gift Tax Value of Notes in Sale Transactions

For gift tax purposes, the IRS sometimes challenges the value of promissory notes, either arguing that the AFR is not a sufficient interest rate, or that the collateral is not sufficient such that collectability problems exist.  While Section 7872 clearly applies in valuing a cash loan for gift tax purposes, its concepts do not clearly apply for sale transactions.  Section 7872(F)(8) specifically says that Section 7872 does to apply to any loan to which Section 483 or 1274 applies (which generally apply to sales or exchanges of property).  The taxpayer response is that Section 7872, Frazee v. Commissioner, 98. T.C. 554 (1992), and True v. Commissioner, T.C. Memo. 2001-167, affirmed on other grounds, 390 F.3d 1210 (10^th Circuit 2004) support using the AFR with notes given in sales transactions.  The Tax Court in Frazee specifically pointed to the language in Section 7872(f)(8) in support of this position:

Nowhere does the text of section 7872 specify that section 7872 is limited to loans of money.  If it was implicit that it was so limited, it would be unnecessary to specify that section 7872 does not apply to any loan to which section 483 or 1274 apply.  The presence of section 7872(f)(8) signaled Congress’ belief that section 7872 could properly be applicable to some seller financing.  We are not here to judge the wisdom of section 7872, but rather, to apply the provision as drafted, 98 T.C. 554 (1992).

Private Letter Rulings 9535026 and 9408018 similarly take the position that Section 7872 will apply to the fit tax valuation of notes issued in intra-family sales transactions.  (Private Letter Ruling 200147028, on the other hand, concluded that a trust would retain its GST exempt status following loans to second generation beneficiaries as long as the loan was adequately secured and was subject to a market rate of interest).

Another argument made in some audits is that the note transaction is not a bona fide loan, but is a gift.  Cases list a variety of factors considered in determining whether debt is legitimate or not (in a variety of different contexts beyond just gift issues), but the fundamental issue is whether a reasonable expectation of payment exists.

b. Estate Tax Value of Notes.

While Section 7872 addresses gift tax issues, and subsequent authority recognizes that notes with interest at the AFR will not be discounted merely for gift tax purposes because of the interest rate, no such similar certainty exists for estate tax purposes.  Does that mean the note can be discounted for estate tax purposes because no regulations are on point for estate tax purposes?  Because no coordinating regulation exists, some attorneys take the position that general valuation principles should be applicable, and it may be possible to discount the note for estate tax purposes if the note uses the AFT as the interest rate.  It is of import to note, the IRS estate tax agent may feel that taking a discount for this reason alone is abusive (because the note was not similarly discounted for gift tax valuation purposes at the time of the sale) and may closely scrutinize every aspect of the sale or loan.

Section 7872 specifically authorizes the issuance of regulations addressing the valuation of notes in light of Section 7872.  The IRS indeed has issued a proposed regulation that purports to say the value of the note could not be discounted for estate tax purposes except to make adjustments where the stated interest rate under the note is lower than the AFT in effect at the date of death, or where the facts impacting the collectability of the note have changed “significantly since the time the loan was made,” Prop. Reg. Section 20.7872-1.  This regulation has never been finalized.

c. Income Tax Effects of Discounting Notes.

If a note is discounted for estate tax purposes, but the full amount of the note is later paid, the excess payments over the basis of a note (i.e., the estate tax value) will be ordinary income to the recipient.  If an individual inherits a note (other than an installment sale note) valued below face, and if the individual receives payments on the note exceeding the discounted value of the note, the excess is treated as ordinary income.  For example, sections 1271-1275 deal with OID by requiring the debt holder to take any discount into income as ordinary income, not as capital gain, e.g., Treas, Reg. Sections 1.1275-1(b)(3) (treatment of market discount for calculating OID accruals).

The income tax effect should be different if an individual receives the note by gift.  Under the dual basis rules of Section 1015, the donee’s basis in the note would be the donor’s basis for purposes of determining the amount of any gain.  Therefore, the reduction in value of the note up to the time of the gift would not result in a decreased basis for purposes of determining the later gain on the note.

If the note is an installment sales note, special rules apply if the note is satisfied at less than face value, if a disposition or cancellation of the note occurs, or if related parties dispose of property purchased with the installment note within two years of the final sale, I.R.C. Section 453B(a), 453(e)(1).

In summary, discounting a note may provide immediate estate tax benefits, but it may come at a cost for income tax purposes.  The income tax cost may be greater than the estate tax savings; the federal top rate is 39.6% +3.8 net investment income tax, or 43.4%.  In addition, some states have income tax rates of up to 10%.

Defined Value Clauses.  The new item regarding defined value formula clauses suggests that the IRS will eventually issue regulations regarding the effect of defined value formula clauses, despite its losses in the McCord, Christianson, Petter, Hendrix, and Wandry cases.  Sales to grantor trust transactions may use a Wandry clause, providing for a sale of that number of shares equal to a given value (that was the approach taken in the Woelbing sale transaction, which was settled with the IRS apparently respecting the Wandry provision.  Estate of Donald Woelbing v. Commissioner, Docket No. 30261-13; Estate of Marion Woelbing v. Commissioner, Docket No. 30260-13).  Alternatively, a sale transaction may use a price adjustment clause.  Either of these may be within the scope of the regulation project.

Peter H. Agrapides, MBA, CVA, is with the Salt Lake City, Utah, and Las Vegas, Nevada, offices of Western Valuation Advisors. Mr. Agrapides’ practice focuses primarily on valuations for gift and estate tax reporting. Mr. Agrapides has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1 billion.

Mr. Agrapides can be reached at (801) 273-1000 ext. 2, or by e-mail to panayotiagra@yahoo.com.