New rules are coming that will likely limit techniques used by the wealthy to lower their estate and gift taxes.
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The proposed regulations, issued by the Treasury Department and Internal Revenue Service in early August, apply to moves known as "valuation discounts." They allow people with assets greater than the current exemption of $5.45 million per person ($11.9 million for a couple) to lower the value of their assets that are subject to gift and estate taxes. The top tax rate on amounts above the exemption is currently 40%, so the savings can be substantial.
To get the lower valuations, the owner of assets typically puts them into a holding company or other entity that isn't traded and gives pieces of the company to family members and perhaps a charity. As a result, the assets' value drops because control of the entity is dispersed and the assets would be harder to sell. The combined discounts generally range from 30% to 50% of the assets' value, and can be even higher.
These moves are controversial because the courts have allowed taxpayers to use them to get sizable tax breaks on traded securities and even cash. Thus a wealthy taxpayer could reduce the taxable value of $10 million of blue-chip stocks to $6 million and cut his estate tax by $1.6 million.
Ronald Aucutt, an estate-tax lawyer with McGuireWoods LLP in Washington, says that in some cases families simply wait until three years after the original owner's estate-tax return is filed and the statute of limitations for an audit expires. Then they dissolve the holding company and divide up the assets, having bypassed tax on a large chunk of market value. "This drives the IRS crazy," he says.
The proposed changes in the rules would allow the IRS to ignore many discounts in entities where they currently apply and collect far more estate or gift tax. In addition, the IRS could disallow even more discounts if a taxpayer dies within three years after making certain gifts. Mr. Aucutt thinks the Treasury Department and IRS have the authority to make such changes.
Critics of the changes call them far too broad. "This is an example of Treasury overstepping its bounds," says John Porter, an attorney with Baker Botts in Houston, who has won landmark court cases involving discounts.
Mr. Porter points out that the proposed changes apply to nearly all family-controlled entities, even those holding operating businesses. "If these rules go through in current form, business owners are going to be taxed on value they may not have, or have access to," he says. He expects a court challenge unless there are substantial revisions to the rules.
Experts say it is unclear whether revisions are likely, or what they might be. The Treasury and the IRS are accepting comments on the proposals, and a hearing is scheduled for Dec. 1. Some think the administration will push to finish them before a new president takes office.
There is a window of opportunity for people who have or want to have entities with valuation discounts, because the most important changes won't take effect until 30 days after the rules are made final.
Mark Williamson, an estate-tax attorney with Alston & Bird in Atlanta, advises people who want to set up such entities to move quickly, before the rules take effect. People who have already set up these entities should also revisit them soon to see how the changes would affect their planning. "They may need to finish making gifts now to avoid new restrictions," he says.
Mr. Williamson expects the new rules will mainly affect entities holding marketable securities, but there could be unintended consequences for large family-owned operating businesses as well.
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