Capital Letter
By Ronald D. Aucutt
No. 17
Washington, D.C.
May 12, 2009
Administration’s revenue raisers would require consistency in determining basis, limit valuation discounts, and impose a minimum ten-year term on GRATs.
Dear Readers Who Follow Washington Developments:

The Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals” (popularly called the “Greenbook”) was released on May 11, 2009.  The Appendix, on page 125, confirms that “[e]state and gift taxes are assumed to be extended at parameters in effect for calendar year 2009 (a top rate of 45 percent and an exemption amount of $3.5 million).”  At pages 119-23, as revenue raisers dedicated to health care reform, three revenue-raising proposals are described under the heading “Modify Estate and Gift Tax Valuation Discounts and Make Other Reforms.”  (A fourth proposal under that heading addresses the tax treatment of alternative fuels.)

“Require Consistency in Value for Transfer and Income Tax Purposes”

Invoking the relatively noncontroversial principle of consistency, this proposal would require the income tax basis of property received from a decedent or donor to be equal to the estate tax value or the donor’s basis.

In a possibly unintended change from current substantive law, the proposal would apparently require the basis of even property acquired by gift to be no greater than the gift tax value.  Under section 1015(a), the basis for determining the donee’s gain can be greater than the gift tax value if that was the donor’s basis.

The executor or donor would be required to report the necessary information to both the recipient and the Internal Revenue Service.  Regulations could extend this reporting requirement to annual exclusion gifts and estates for which no estate tax return is required.  Regulations could also provide relief for the surviving joint tenant or other recipient who has better information than the executor.

The proposal would be effective as of the date of enactment and is estimated to raise tax revenue by $1.87 billion over ten years.  Interestingly, a similar proposal floated by the staff of the Joint Committee on Taxation in 2005 was estimated to raise less than $50 million over ten years.

“Modify Rules on Valuation Discounts”

The Greenbook recalls that sections 2701-2704 were enacted to curb techniques designed to reduce transfer tax value but not the economic benefit to the recipients.

Specifically, the Greenbook points out that section 2704(b) provides that certain “applicable restrictions” that would otherwise justify valuation discounts are ignored in intra-family transfers of interests in family-controlled entities, but adds that “[j]udicial decisions and the enactment of new statutes in most states have, in effect, made section 2704(b) inapplicable in many situations.”  The Greenbook also states that “the Internal Revenue Service has identified additional arrangements designed to circumvent the application of section 2704.”  This identification may have occurred during work on the pending regulations project under section 2704(b)(4), which authorizes Treasury regulations providing “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 this subtitle but does not ultimately reduce the value of such interest to the transferee.”  Indeed, because the section 2704(b)(4) regulation project has been authorized by statute since 1990 and has been on the Treasury-IRS Priority Guidance Plan since 2003, it is entirely possible that an important purpose for the current legislative proposal is to obtain congressional clarification and direction that will assist in the completion of that project.

Using section 2704(b) as a framework, the proposal would create a more durable category of “disregarded restrictions.”  Disregarded restrictions would “include” restrictions on liquidation of an interest that are measured against standards prescribed in Treasury regulations, not against default state law.  Thus, no change in state law would affect the reach of the statute.  In addition, the Greenbook is careful to cast its references in terms of all “entities,” not just corporations or partnerships.

Although the Greenbook does not say so, it is possible that that the “disregarded restrictions” in view, which “include” certain limitations on liquidation (the current scope of section 2704(b)(2)(A)), may also include other restrictions, such as restrictions on management, distributions, access to information, and transferability.  If so, this proposal might call for reconsideration of the famous disclaimer in the 1990 conference report that “[t]hese rules do not affect minority discounts or other discounts available under [former] law.”  H.R. Rep. No. 101-964, 101st Cong., 2d Sess. 1137 (1990).

Disregarded restrictions would also include limitations on a transferee’s ability to be admitted as a full partner or other holder of an equity interest, thus apparently overriding any disposition to value a transferred interest as an “assignee” interest.  Treasury would be empowered by regulations to ignore the ownership of certain interests by charities, treating those interests as held by the family.

The Greenbook includes a couple reassuring references.  For example, under the proposal, regulations could “create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of section 2704 if certain standards are met.”  While no details are given, this authority could be used to protect actual family operating businesses and to protect the holder of a restricted noncontrolling interest received from others (including ancestors) if that holder did not create those restrictions and never had a meaningful opportunity to remove those restrictions.

In addition, the Greenbook promises to “make conforming clarifications with regard to the interaction of this proposal with the transfer tax marital and charitable deductions.”  This could override the harsh “reverse-Chenoweth” result seen in Technical Advice Memoranda 9050004 (Aug. 31, 1990) and 9403005 (Oct. 14, 1993) (all stock owned by the decedent valued as a control block for purposes of the gross estate, but the marital bequest valued separately for purposes of the marital deduction), relying on Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987) (estate of a decedent who owned all the stock of a corporation entitled to prove a control premium for a 51-percent block of stock bequeathed to the surviving spouse for purposes of the marital deduction), and Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981).  Such a result would reinforce the overall fairness of the proposal and would be very welcome.

The proposal would apply to transfers – gifts and deaths – after the date of enactment.  Consistent with section 2704 itself, the proposal would not apply to restrictions created on or before October 8, 1990.

The proposal is estimated to raise revenue by $19.038 billion over the ten fiscal years from 2010 through 2019.  The estimate of $667 million of additional revenue for fiscal 2010, which ends September 30, 2010, necessarily assumes that enactment will occur early enough to catch a substantial number of transfers in calendar 2009.  But the drafters of the Greenbook would probably deny that they can predict with that level of precision when Congress might act.

“Require Minimum Term for Grantor Retained Annuity Trusts (GRATs)”

After reciting the history of section 2702 and the use of GRATs, 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.”

While rumors have occasionally been heard of congressional plans to limit the attractiveness of GRATs by imposing a minimum gift tax value for the remainder (such as 10%), the Greenbook instead proposes to increase the mortality risk of GRATs by requiring a minimum ten-year term.  A footnote quixotically compares the ten-year term to the minimum ten-year term of “Clifford trusts” under section 673 (before its amendment by the Tax Reform Act of 1986).

The proposal would apply to GRATs created after the date of enactment. It is estimated to raise revenue by $3.25 billion over ten years. This includes $29 million for fiscal 2010 and $61 million for fiscal 2011, which ends September 30, 2011, and therefore picks up the estate tax from the estates of decedents who die in calendar 2010. Since even a two-year GRAT created in May 2009 would already be subject to estate tax under current law if the grantor dies by December 31, 2010, it is hard to figure out how that extra tax revenue would be generated if the GRAT were required to last longer than two years. Maybe the estimate contemplates additional gift tax on donors who forgo GRATs and make gifts in less leveraged forms.

What Happens Next

The proposals, of course, have to be reduced to statutory language (if they are not already) and considered by Congress.

On April 29, 2009, the conference report on the congressional budget resolution was passed by votes of 233-193 in the House and 53-43 in the Senate.  In general, the budget resolution affirmed the commitment to making 2009 estate tax law permanent, identified in the Administration budget proposals at the end of February.  But section 325 of the budget resolution apparently places any additional estate tax relief in the Senate under a “pay for” discipline in the generic context of “tax relief that supports working families … [and] businesses.”  And section 317 of the budget resolution contains similar language with respect to the House in the generic context of “savings incentives.”

Naturally, it is not clear whether this “pay for” discipline would apply even to making 2009 law permanent (which, beginning in 2011, would be a tax cut), or if it would apply only to expansions beyond 2009 law, such as the $5 million exemption and 35% rate that received conditional support in the Senate, as described in Capital Letter No. 16. The Administration’s February budget proposals appear to have tried to make 2009 law the new “baseline” for some purposes.  But the congressional rhetoric of late April was sweeping enough to have supported either approach.  The fact of the matter is that the politicians will make a political decision, and at this time, as usual, that is hard to predict.

Ronald D. Aucutt
© 2009 by Ronald D. Aucutt. All rights reserved