Valuation Discounts for Transfers in Family Businesses in Jeopardy

The ability to take valuation discounts on the transfer of an interest in a family business for estate, gift and generation skipping transfer tax purposes, would be drastically limited under long-awaited proposed regulations from the Treasury Department.

The element of the proposal with the most impact bars any significant discount for lack of control or lack of marketability associated with the transfer of an interest in a family-controlled entity. 

If the regulations are finalized as written, the tax cost for transferring interests in such businesses will be substantially higher.

The rules would apply to family-controlled corporations, partnerships, limited liability companies, and other similar entities.

Under current rules, transfers of interests in family businesses may be discounted due to lack of marketability and lack of control. The idea is that if you give a percentage of interest in your business to your child, it should be discounted because your child would not be able to immediately sell his or her interest to someone else for the same amount. Discounts of this nature can yield significant tax savings.

For example, assume three siblings inherited an equal third of their parents' business and now one of them wishes to transfer her third to her children. Assume if the business was liquidated or sold, the value of her one-third interest would be worth $5 million.

If a combined 30 percent discount for lack of control and lack of marketability were applied to the business interest, then the value of the gift would be $3.5 million. If the regulations become final and eliminate discounts, then the value of the same gift would be $5 million. At a 40 percent gift and estate tax rate, the impact of the elimination of discounting on this family would be $600,000 in additional tax.

As a result of the proposed changes, if you have been thinking of doing such a transfer involving a family business for estate planning purposes, it is critical to consider doing it now before the regulations become final. 

What is the time frame?

The proposed regulations were issued in early August, and a public hearing was scheduled for December 1, 2016. Generally, the rules go into effect on the day they are published in final form, although certain portions will be effective for transfers occurring 30 or more days after the date of publication.

While it is unclear exactly when that will be, the rules are not expected to be finalized until sometime later this year. Still, you should act soon and contact an estate planning attorney in you want to take advantage of the discounts under the current law. 

Could the rules be retroactive?

Even if you make transfers now, though, there is a new rule in the proposal that might have a retroactive effect. The so-called "three-year rule" in the proposed regulations may prohibit certain discounts taken for transfers made within the three years before the transferor's date of death. 

That rule would apply to transfers that result in the transferor losing a liquidation right. That means that if a transfer is made soon to take advantage of the current rules on discounts - or if the transfer has already been made - the discount might be lost if the final rules go into effect and the person who transfers the interest dies within three years.

The same rule would also apply to measure any gift component of a transfer that has been structured as a sale. Therefore, discounts on gift tax elements of such transfers could also be caught by the three-year rule.

Are there other significant changes?

The proposed regulations are lengthy and some of the applications are still unclear.

But it is important to be aware of one new section of the rules that could have a big impact. That is the creation of a new set of "disregarded restrictions."

These restrictions would be disregarded when valuing the transferred interest for estate or gift tax purposes in any family-controlled entity to compel liquidation or redemption.

For valuation purposes, that means the new rule would assume that someone who holds an interest in a family-controlled entity has the right to liquidate or redeem the interest for its pro rata share of the new asset value in cash or other property payable within six months of exercise.

Under the rules, "disregarded restrictions" will be disregarded if they lapse after the transfer, or if the transferor or the transferor's family may remove or override them.

With respect to restrictions that will be ignored for valuation purposes, the new rules no longer focus on those that are more restrictive that the relevant state law rules, but instead will affect virtually any restriction that limits the ability to liquidate.

Through public comments and a hearing, the rules will continue to be debated and discussed before they become final. To understand the possible application to your family business, contact an estate planning attorney.

Should You Amend or Rewrite Your Revocable Trust?

It is important to review a revocable trust regularly to see if any amendments are needed, such as when something changes in your personal life or in the law. 

There are two ways to go about it. You can either amend the existing trust to change a certain part of it or rewrite the whole trust, which is known as a restatement.

While you might expect that an amendment is easier and more cost-effective, that's not always the case. 

Remember that your trust should provide instructions to your heirs about your wishes, so it has to be clear and comprehensive.

If you are making one or two simple changes, then amending is often sufficient. That's especially trust if the changes do not interrelate.

However, if you have made a lot of changes over time, it might be time for a restatement to ensure that the trust clearly states your wishes and is set up to be administered properly. 

In addition, a restatement can reduce how much paperwork you need to give to third parties, like banks, and avoid beneficiaries learning about prior terms of the trust.

Survivorship Life Insurance Can Be A Good Vehicle for Estate Planning

Survivorship life insurance (also known as "second-to-die" life insurance) can be an important vehicle to consider for estate planning, in the right cases.

This type of insurance policy covers two lives, and pays out the proceeds when the second insured dies. 

One benefit is that the premium tends to be lower than it would be for two separate policies because the life expectancy is based on the two insureds' combined ages, and the insurer has lower administrative costs.

As a result, these policies typically provide a much higher face value than you would obtain for an individual at the same premium cost. This sort of policy can be used for a married couple, though it can be used for any pair of people, such as a parent and child or even two business partners.

For planning purposes, when the life insurance pays out on the second death it can be used to cover any estate tax payments. It can also be a good option for a couple with a modest income that wants to ensure some amount of an inheritance for their children.

Often, an irrevocable life insurance trust is set up to buy the policy. Using the trust as the owner keeps the death benefits paid from the policy out of the survivor's estate when he or she dies, and retained in the trust for the benefit of the heirs. You provide the funding as the grantor of the trust, and can make gifts to the trust to be used to pay the premiums, but the trustee actually pays the premiums and manages the trust. 

Keep in mind that when the first spouse dies, the surviving spouse has to be able to afford to continue paying the premiums.

Also, if a couple has a survivorship policy and gets divorced, it may be best to divide it in two (if the carrier allows such a division) with each spouse owning half of the initial face value.

Deciding whether survivorship life insurance is a beneficial estate planning vehicle for you is complicated and should be evaluated on a case-by-case basis, with the advice of an attorney. 

Be Very Careful with Inherited IRA's

Leaving someone an IRA as an inheritance can have a lot of tax advantages, and it's often a very good estate planning strategy. However, the rules for inherited IRA's are complicated, and it's easy to make mistakes. If you have recently inherited an IRA, or if you expect to inherit an IRA, it's important to speak to an estate planner or other advisor right away before you make any decisions about the account. And if you're planning to leave someone an IRA, you'll want to make sure that person knows what to do, so the tax benefits aren't lost through an innocent mistake.

The big advantage of an inherited IRA is that the assets may be able to remain in a tax-sheltered account and grow tax-free for years before they're taken out. So generally, you want to make sure the assets are left in the account for as long as possible.

The exact rules depend on the kind of IRA and whether the beneficiary is the surviving spouse of the owner. For example:

If a surviving spouse inherits a traditional IRA. There are a number of options, but the three primary ones are: 

1. The spouse can roll the IRA into his or her own IRA. This is simple - there's only one account to deal with - and the spouse can postpone required minimum distributions (RMD's) until age 70 1/2 and calculate them based on his or her own life expectancy. The downside is that there's a 10% penalty on withdrawals before age 59 1/2, and there might be accelerated RMD's if the surviving spouse was older than the deceased spouse. 
2. The spouse can transfer the assets into a separate account that's titled as an "inherited IRA." This is more complicated, but it might avoid the 10% penalty on early withdrawals and the accelerated RMD's. Because of the RMD rules, this option might be better in cases where the spouse who passed away hadn't yet reached aged 70 1/2.
3. The spouse can take the additional step of converting the account to a Roth IRA. This can be smart in certain situations, such as if the spouse expects to be in a higher tax bracket later in life.

If someone other than a spouse inherits a traditional IRA. The beneficiary can transfer the assets into a separate "inherited IRA." The beneficiary will have to take RMD's starting the next year, but they'll be based on the beneficiary's life expectancy, not the owner's, which can save taxes. 

If a surviving spouse inherits a Roth IRA. There are two main options:

1. The spouse can roll the IRA into his or her own existing or new Roth IRA. There are no RMD's, and  distributions are tax-free as long as the beneficiary is at least 59 1/2, and five years have passed since the original owner set up the account. 
2. The spouse can transfer the Roth IRA assets into a separate "inherited IRA." With this method, the spouse will have to take RMD's, but there can be some tax advantages for early withdrawals. 

If someone other than a spouse inherits a Roth IRA. The beneficiary can transfer the assets into a separate "inherited IRA." The  beneficiary will have to take RMD's starting the next year. 

In addition, in all of the above scenarios, there are two other options:

1. A beneficiary can always take an immediate lump-sum distribution. But unless this is absolutely necessary to pay bills, it's by far the worst choice tax-wise.
2. A beneficiary can also disclaim the IRA assets. The advantage here is that the assets might pass to younger family members who can stretch the distributions out over many more years, thus compounding the tax benefits. Also, when the beneficiary dies, the assets won't be subject to estate tax.

Of course, a disclaimer makes sense only if the beneficiary doesn't need the assets to live on. Moreover, the beneficiary can't simply choose who will get the account; it will go to the person who would legally be entitled to it if the primary beneficiary hadn't been named as  beneficiary. 

This is an important point if you're leaving someone an IRA. You'll want to carefully consider who should be named as the alternate beneficiary - so that if the primary beneficiary chooses to disclaim, the assets will go to the right person tax-wise.

It's also possible to leave an IRA to a trust. This can have a number of benefits, such as protecting the assets from creditors and preventing a beneficiary from withdrawing the money prematurely and losing the tax benefits. However, it's very complicated and should only be done with expert advice. 

One thing to keep in mind is that a beneficiary may need to act quickly. For instance, there are strict time limits for rolling over inherited IRA assets into a new account.

Also, if an IRA owner passed away before taking out an RMD for the year in which he or she died, the beneficiary must take out the RMD before the end of the year or face a 50% penalty. (In fact, if someone dies late in the year without taking out an RMD, it's possible that the beneficiary won't even found out about the bequest until it's too late to avoid the penalty.)

Finally, if your estate plan involves leaving someone an IRA, it's critical to make sure your beneficiary designation form is filled out correctly and on file with the IRA custodian. If there's a glitch and the account ends up going through your estate rather than directly to the  beneficiary, the beneficiary might have to completely empty the account within five years, thus destroying most of the tax benefits.

Moving an Elderly Relative Could Trigger a Tax Problem

It's a common scenario: An elderly relative is no longer able to live alone, so family members sell the relative's house and have the relative start living with them or in a nursing home or assisted living facility that's closer to the family. 

One thing you might not consider during this stressful process is that if the relative moves to a different state, you might have just changed the person's official state of residence for tax purposes. And that could have a significant effect on his or her estate plan.

For instance, if someone moves from a state with no state estate tax to a state with such a tax, and he or she passes away, an estate tax might be owed on the value of the person's assets - even if he or she lived in the new state for only a very short time.

This is a significant danger because, while the federal estate tax generally doesn't apply to estates unless they're worth over $5 million, many state estate taxes start at a much lower figure. In Massachusetts, for example, the state estate tax threshold is only $1 million. 

Such an outcome could even lead to friction between heirs. For instance, suppose the relative's will leaves one child certain specific assets and the other child "everything else." The relative may have set things up so the children would receive more or less equal bequests. But under the law, if a state estate tax is suddenly due, all of it will come from the share of the child who gets "everything else." This could upset a careful estate plan and create family disharmony.

If you're thinking of moving an elderly relative to an out-of-state home or facility, it's a good idea to speak with an estate planner about the change. There might be ways to avoid having the relative be treated as a resident of the new state.

Of course, you might also discover that there are tax advantages to having the relative be treated as a resident of the new state, and you'll want to plan for that as well.