Valuation in Treasury’s Greenbook

Capital Letter No. 59

March 21, 2023

Ronald D. Aucutt

The Fiscal Year 2024 Greenbook includes significant proposals to change estate and gift tax valuations.

Dear Readers Who Follow Washington Developments:

The Treasury Department released its “General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals” (popularly called the “Greenbook”) on March 9, 2023. Many of the proposals in the Greenbook are carried over, sometimes with changes, from last year’s Fiscal Year 2023 Greenbook, and many resemble legislative proposals made in 2021 (including in the Fiscal Year 2022 Greenbook) that were not included in the “Build Back Better Act” (H.R. 5376) passed by the House of Representatives on November 19, 2021.

With a sharply divided Congress, it is very possible that none of the Greenbook proposals will be acted on. Even so, whenever we see legislative proposals articulated like this, it is important to pay attention, because they are constantly evolving and could be pulled from the shelf and enacted, if not this year then in the future when the political climate is different. Such proposals never completely go away. And each time they are refined and updated, we can learn more about what to watch for and how to react.

This Capital Letter (adapted from the “Washington Update,” a Bessemer Trust Insight for Professional Partners dated March 13, 2023) will cover the valuation proposals in the Greenbook. Capital Letter Number 60 will cover the income tax, GST tax, and other estate and gift tax proposals. Here are the valuation proposals:

Fractional Interests and Interests in Entities in Intrafamily Transfers
Promissory Notes
Defined Value Formula Clauses

FRACTIONAL INTERESTS AND INTERESTS IN ENTITIES IN INTRAFAMILY TRANSFERS

The Greenbook proposes to replace section 2704(b) of the Code with a rule requiring partial interests transferred to family members of the donor or decedent to be valued at “the interest’s pro-rata share of the collective FMV [fair market value] of all interests in that property held by the transferor and the transferor’s family members, with that collective FMV being determined as if held by a sole individual” (emphasis added). This is often referred to as a “look-through” approach to valuing interests, for example, in an entity that holds assets.

Pro-rata look-through valuation is not a new idea.

The Reagan Administration

“Tax Reform for Fairness, Simplicity, and Economic Growth” (popularly called “Treasury I”), Volume 1 and Volume 2, was published by the Treasury on November 27, 1984, just three weeks after President Reagan’s landslide reelection. Treasury I included the following (at volume 2, pages 386-387) (emphasis added):

“In most instances, the value of property transferred by gift will be the same regardless of whether such value is determined by reference to the separate value of the property, the diminution in value of the transferor’s estate, or the enhancement in value of the transferee’s estate. In other instances, however, these measures of value can vary greatly. This is particularly true in the case of transfers of minority interests in closely held businesses and undivided interests in assets such as real estate. These interests are often valued, for transfer tax purposes, at significant discounts from their pro rata share of the value of the underlying business or asset.

…

“Minority or fractional-share discounts enable taxpayers to structure transfers so as to reduce the aggregate value of property brought within the transfer tax base. This is inconsistent with the underlying purpose of the gift tax, which is to serve as a backstop for the estate tax. Moreover, the overall reduced value of the property as it is reported for transfer tax purposes is inconsistent with economic reality.”

Accordingly, Treasury I proposed (id. at page 387) (emphasis added):

“The value for transfer tax purposes of a fractional interest in any asset owned, in whole or in part, by a donor or decedent would be a pro rata share of the fair market value of that portion of the asset owned by the donor or decedent. Prior gifts of fractional interests in the asset, as well as any fractional interests in the asset held by the transferor’s spouse, would be attributed to the donor or decedent for purposes of determining the value of the fractional interest transferred.”

Notice that the purpose of the proposal was to tax all of the interests held (or previously transferred) by the donor as if they were transferred at one time. The only family attribution that Treasury I proposed was attribution between spouses.

In general, the transfer tax suggestions in Treasury I have not been enacted. Instead, in the consideration of the Omnibus Budget Reconciliation Act of 1987 (Public Law 100-203), the House of Representatives added a repeal of the state death tax credit, a rule valuing interests in family-owned entities at their pro rata share of the total value of all interests in the entity of the same class, and rules regarding “disproportionate” transfers of appreciation in estate freeze transactions. H.R. Rep. No. 100-391, 100th Cong., 1st Sess. 1041-44. The House-Senate conference retained only the estate freeze rules, as section 2036(c).

The George H. W. Bush Administration

Section 2036(c) was never popular or viewed as very workable, and efforts to replace it began almost immediately. The House Ways and Means Committee and Senate Finance Committee received significant input from ACTEC, other estate planning professionals, and the family business community, including input into and comment on a “discussion draft” of a new chapter 14, which was the subject of an extensive Ways and Means Committee hearing on April 24, 1990 (where ACTEC was represented by Estate and Gift Tax Committee Chair Jim Gamble, President Waller Horsley, and Vice President Tom Sweeney). That chapter 14, and the revised chapter 14 that was added to the Omnibus Budget Reconciliation Act of 1990 (Public Law 101-508) by the Senate Finance Committee, included only three sections (2701, 2702, and 2703). The House-Senate Conference added section 2704 “to prevent results similar to that of Estate of Harrison v. Commissioner” (T.C. Memo. 1987-8), in which the IRS had failed to persuade the Tax Court that under sections 2033, 2035, 2036, 2037, 2038, and/or 2041 the value of a decedent’s limited partnership interest that passed to his estate included the right to dissolve the partnership. The conference report added that “these rules do not affect minority discounts or other discounts available under present law.” H.R. Rep. 101-964, 101st Cong., 2d Sess. (Oct. 27, 1990), at 1137.

The Clinton Administration

The Clinton Administration’s budget proposals for fiscal year 1999 included a proposal to “eliminate non-business valuation discounts,” described as follows in the “General Explanations of the Administration’s Revenue Proposals” (Feb. 1998) at page 129 (emphasis added):

“The proposal would eliminate valuation discounts except as they apply to active businesses. Interests in entities would be required to be valued for transfer tax purposes at a proportional share of the net asset value of the entity to the extent that the entity holds readily marketable assets (including cash, cash equivalents, foreign currency, publicly traded securities, real property, annuities, royalty-producing assets, non-income producing property such as art or collectibles, commodities, options and swaps) at the time of the gift or death. To the extent the entity conducts an active business, the reasonable working capital needs of the business would be treated as part of the active business (i.e., not subject to the limits on valuation discounts). No inference is intended as to the propriety of these discounts under present law.”

The Clinton Administration’s budget proposals for fiscal year 2000 and fiscal year 2001 repeated this proposal, except that “readily marketable assets” was changed to “non-business assets” and “the propriety of these discounts under present law” was changed to “whether these discounts are allowable under current law.”

This proposal was reduced to legislative language in section 276 of H.R. 3874, 106th Cong., 2d Sess., introduced on March 9, 2000, by the Ranking Democrat on the House Ways and Means Committee, Representative Charles Rangel of New York. This bill would have added a new section 2031(d) to the Code, the general rule of which read as follows (emphasis added):

“(d) Valuation Rules for Certain Transfers of Nonbusiness Assets—For purposes of this chapter and chapter 12—

“(1) In General—In the case of the transfer of any interest in an entity other than an interest which is actively traded (within the meaning of section 1092 [see Reg. §1.1092(d)-1(a) & (b)]), the value of such interest shall be determined by taking into account

“(A) the value of such interest’s proportionate share of the nonbusiness assets of such entity (and no valuation discount shall be allowed with respect to such nonbusiness assets), plus

“(B) the value of such entity determined without regard to the value taken into account under subparagraph (A).”

A slightly different articulation of this rule appeared in section 303 of H.R. 1264, 107th Cong., 1st Sess., introduced by Representative Rangel on March 26, 2001, partly as an alternative to the Republican proposals that became the 2001 Tax Act. Representative Rangel’s bill would have added a new section 2031(d) to the Code, to read as follows:

“(d) Valuation Rules for Certain Transfers of Nonbusiness Assets—For purposes of this chapter and chapter 12—

“(1) In General—In the case of the transfer of any interest in an entity other than an interest which is actively traded (within the meaning of section 1092)—

“(A) the value of any nonbusiness assets held by the entity shall be determined as if the transferor had transferred such assets directly to the transferee (and no valuation discount shall be allowed with respect to such nonbusiness assets), and

“(B) the nonbusiness assets shall not be taken into account in determining the value of the interest in the entity.”

Representative Rangel’s 2001 bill would also have added a new section 2031(e) to the Code, to read as follows:

“Limitation on Minority Discounts—For purposes of this chapter and chapter 12, in the case of the transfer of any interest in an entity other than an interest which is actively traded (within the meaning of section 1092), no discount shall be allowed by reason of the fact that the transferee does not have control of such entity if the transferee and members of the family (as defined in section 2032A(e)(2)) of the transferee have control of such entity.”

Identical statutory language for new sections 2031(d) and (e) appeared in H.R. 5008, 107th Cong., 2d Sess. §3 (introduced June 24, 2002, by Representative Earl Pomeroy (D-North Dakota)), H.R. 1577, 109th Cong., 1st Sess. §4 (introduced April 12, 2005, by Representative Pomeroy), and H.R. 4242, 110th Cong., 1st Sess. §4 (introduced November 15, 2007, by Representative Pomeroy).

Clinton Administration proposals inevitably experienced a bit of a revival after Democrats took control of the Congress and White House. Democratic staff members publicly referred to them as a possible model for legislative drafting. This is perhaps reflected in H.R. 436, the 2009 version of Representative Pomeroy’s bill, discussed below.

The George W. Bush Administration

On January 27, 2005, the Staff of the Joint Committee on Taxation published a 430-page Report titled “Options to Improve Tax Compliance and Reform Tax Expenditures” (JCS-02-05), as requested in February 2004 by Chairman Grassley and Ranking Member Baucus of the Senate Finance Committee. Under the heading of Estate and Gift Taxation, it presented five proposals estimated to raise revenue by $4.2-4.7 billion over 10 years. The second proposal is labeled “Determine Certain Valuation Discounts More Accurately for Federal Estate and Gift Tax Purposes (secs. 2031, 2512, and 2624).” The purpose of this proposal is described as follows:

“The proposal responds to the frequent use of family limited partnerships (‘FLPs’) and LLCs to create minority and marketability discounts. … The proposal seeks to curb the use of this strategy frequently employed to manufacture discounts that do not reflect the economics of the transfers during life and after death.”

The proposal would determine valuation discounts for transfers of interests in entities by applying aggregation rules and a look-through rule. Somewhat reflecting the 1984 proposal in Treasury I, the aggregation rules are what the Report calls a “basic aggregation rule” and a “transferee aggregation rule.”

The basic aggregation rule would value a transferred interest at its pro rata share of the value of the entire interest owned by the transferor before the transfer. For example, a transferred 20 percent interest would be valued at one-fourth the value of an 80 percent interest if the transferor owned an 80 percent interest and at one-half the value of a 40 percent interest if the transferor owned a 40 percent interest.

The transferee aggregation rule would take into account the interest already owned by the transferee before the transfer if the transferor does not own a controlling interest. For example, if a person who owns an 80 percent interest transfers a 40 percent interest by gift and the other 40 percent interest at death to the same transferee, the gifted 40 percent interest would be valued at one-half the value of the 80 percent interest originally owned by the donor and the bequeathed 40 percent interest would be valued at one-half of the value of the 80 percent interest ultimately owned by the donee/legatee.

Interests of spouses would be aggregated with the interests of transferors and transferees. The proposal explicitly rejected any broader family attribution rule “because it is not correct to assume that individuals always will cooperate with one another merely because they are related” (emphasis added).

The look-through rule would require the portion of an interest in an entity represented by marketable assets to be valued at its pro rata share of the value of the marketable assets if those marketable assets represent at least one-third of the value of the assets of the entity.

The Obama Administration

Congressional Proposals. On January 9, 2009, Representative Earl Pomeroy (D-North Dakota) introduced H.R. 436, called the “Certain Estate Tax Relief Act of 2009.” It would freeze 2009 estate tax law – a $3.5 million exemption equivalent (with no indexing) and a 45 percent rate – and would also revive, effective January 1, 2010, the “phaseout of graduated rates and unified credit” of pre-2002 law, expressed as a 5 percent surtax.

H.R. 436 would also add a new section 2031(d), generally valuing transfers of nontradable interests in entities holding nonbusiness assets as if the transferor had transferred a proportionate share of the assets themselves. If the entity holds both business and nonbusiness assets, the nonbusiness assets would be valued under this special rule and would not be taken into account in valuing the transferred interest in the entity. Meanwhile, new section 2031(e) would deny a minority discount (or discount for lack of control) in the case of any nontradable entity controlled by the transferor and the transferor’s ancestors, spouse, descendants, descendants of a spouse or parent, and spouses of any such descendants. The statutory language is identical to the bills introduced by Representative Rangel in 2001 and Representative Pomeroy in 2002, 2005, and 2007. These rules would have applied for both gift and estate tax purposes and would have been effective on the date of enactment.

Proposed Regulations. Famously, on August 2, 2016, the IRS released proposed regulations under section 2704(b). 81 Fed. Reg. 51413-51425 (Aug. 4, 2016). They were proposed under the statutory authority of section 2704(b)(4), which states, in the context of corporate or partnership restrictions that are disregarded:

“The Secretary may by regulations provide 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.”

Although complicated and not always clear, the thrust of the proposed regulations was to provide that an interest in an entity would be valued for gift and estate tax purposes by disregarding certain restrictions on that interest that would limit the ability of the holder of the interest to be redeemed or bought out for the interest’s pro rata share of the net fair market value of the assets held by the entity (which the proposed regulations awkwardly referred to as “minimum value”). The proposed regulations created an almost immediate firestorm of criticism, particularly from the appraisal profession and from representatives of family-owned businesses.

This hostility was aggravated by political skepticism. From May 2009 until April 2013, the Obama Administration’s Greenbooks had included a legislative proposal to “create an additional category of restrictions (‘disregarded restrictions’) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family … [and] the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.” “General Explanations of the Administration Fiscal Year 2013 Revenue Proposals” (Feb. 2012) (emphasis added). That legislative proposal was dropped from subsequent Greenbooks, and meanwhile, in President Obama’s State of the Union Address to Congress on February 12, 2013, in the context of environmental regulation (to which some family-owned businesses are also very sensitive), he stated that “if Congress won’t act soon to protect future generations, I will.” The impression this left seemed to feed the suspicion of both family businesses and appraisers that the substituted (presumably artificial) valuation assumptions for which the IRS had sought congressional approval were being imposed without congressional authority, even though, echoing the 1990 conference committee report discussed above, the preamble to the proposed regulations stated that, subject to the disregarding of certain restrictions (authorized by section 2704(b)(4)), “fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums.” 81 Fed. Reg. at 51418 (emphasis added). (Ironically, although this skepticism was directed toward the Obama Administration, the section 2704 regulation project had been first announced by the Administration of President George W. Bush, pursuant to the statute that had been signed into law by President George H. W. Bush.)

A contentious public hearing was held on the proposed regulations on December 1, 2016, and the proposed regulations were withdrawn on October 20, 2017, after a life of 14½ months. 82 Fed. Reg. 48779-80 (Oct. 20, 2017). Capital Letters Number 40, 41, and 42 offer more detailed analysis of the proposed section 2704 regulations and their reaction.

The Biden Administration

Section 6 of Senator Bernie Sanders’ (I-Vermont) “For the 99.5 Percent Act” (S. 994, introduced on March 25, 2021, in the last Congress, would add a new section 2031(d) to the Code, valuing “nonbusiness assets” held by a non-actively-traded entity as if they were transferred directly to the transferee, without any valuation discount. This is similar to what Senator Sanders has been introducing in every Congress since 2010. The same statutory language was included in the version of the “Build Back Better Act” approved by the Ways and Means Committee on September 15, 2021, but not included in the version passed by the House or the “Inflation Reduction Act” that ultimately became law on August 16, 2022. In addition, for purposes of the deemed realization of gain proposal (which will be discussed in Capital Letter Number 60), the Greenbook provides that “a transferred partial interest generally would be valued at its proportional share of the fair market value of the entire property.”

The Greenbook Proposal

Reasons for Change. Under the heading of “Reasons for Change,” the Greenbook (at page 131) offers the following (emphasis added):

“The valuation of partial interests in closely held entities, real estate and other personal property offers opportunities for tax avoidance when those interests are transferred intrafamily. Taxpayers regularly transfer portfolios of marketable securities and other liquid assets into partnerships or other entities, make intrafamily transfers of interests in those entities (instead of transferring the liquid assets themselves), and then claim entity-level discounts in valuing the gift. Similarly, taxpayers often make intrafamily transfers of partial interests in other hard-to-value assets such as real estate, art, or intangibles, allowing all family co-owners to claim fractional interest discounts.

“While valuation discounts for lack of marketability and lack of control are factors properly considered in determining the FMV of such interests in general, they are not appropriate when families are acting in concert to maximize their economic benefits. In these cases, because the family often ignores the restrictions that justified the discounts, the claimed FMV of the transferred interest is below its real economic value, artificially reducing the amount of transfer tax due.”

Unlike the proposals during the Reagan and George W. Bush Administrations, the current Greenbook is focused on the potential tax-reduction motivation of the entire family, not just spouses. The guiding principle of the staff of the Joint Committee on Taxation in 2005 that “it is not correct to assume that individuals always will cooperate with one another merely because they are related” has been superseded by the assumption that “the family often ignores the restrictions that justified the discounts.”

On the other hand, unlike the concern of the Reagan Administration’s “Treasury I” with variations in value that were “particularly true in the case of transfers of minority interests in closely held businesses,” the current Greenbook is apparently intended to follow the example of the Clinton Administration’s focus, Representative Pomeroy’s subsequent focus, and the Ways and Means Committee’s focus in September 2021 on “non-business assets.” That could be crucial.

Proposal. The current Greenbook proposal (at page 132) is expressed this way (emphasis added):

“The proposal would replace section 2704(b) of the Code, which disregards the effect of liquidation restrictions on FMV, and instead provide that the value of a partial interest in nonpublicly traded property (real or personal, tangible or intangible) transferred to or for the benefit of a family member of the transferor would be the interest’s pro-rata share of the collective FMV of all interests in that property held by the transferor and the transferor’s family members, with that collective FMV being determined as if held by a sole individual. Family members for this purpose would include the transferor, the transferor’s ancestors and descendants, and the spouse of each described individual.”

It is interesting that the proposal leads with the replacement of section 2704(b), in light of both section 2704(b)’s unique provenance as an addition by the 1990 conference committee and its role as the center of the controversy over the 2016 proposed regulations. In what apparently is an effort to protect operating family businesses from the effects of the proposal, the Greenbook adds (emphasis added):

“In applying this rule to an interest in a trade or business, passive assets would be segregated and valued as separate from the trade or business. Thus, the FMV of the family’s collective interest would be the sum of the FMV of the interest allocable to a trade or business (not including its passive assets), and the FMV of the passive assets allocable to the family’s collective interest determined as if the passive assets were held directly by a sole individual. Passive assets are assets not actively used in the conduct of the trade or business, and thus would not be discounted as part of the interest in the trade or business.”

It is not at all clear what the second sentence is intended to say. This is often true of narrative proposals like this, for which it takes actual legislative language to provide clarity. The problem may actually be just a matter of grammar that centers on something as simple as the meaning of the word “the.” Here again are the two sentences involved, with emphasis added to highlight the ambiguity:

“In applying this rule to an interest in a trade or business, passive assets would be segregated and valued as separate from the trade or business. Thus, the FMV of the family’s collective interest would be the sum of the FMV of the interest allocable to a trade or business (not including its passive assets), and the FMV of the passive assets allocable to the family’s collective interest determined as if the passive assets were held directly by a sole individual.”

Assume that one family member owns and transfers a 30 percent interest in a business entity that is entirely owned by that family. What is “the interest” that the second sentence contemplates as the first item to be added? Put in grammatical terms, what is the antecedent of “the interest”? Or what is the meaning of “the”?

First Possibility: In what the second sentence is apparently intended to say, the antecedent is the “interest in a trade or business” in the first sentence – in other words, the 30 percent interest being valued. In that case, in valuing that 30 percent interest for transfer tax purposes,

that 30 percent interest is first valued by ignoring the passive assets (or non-business assets) owned by the business or by the entity in determining the underlying value of the entity’s assets, but still by applying all lack of marketability and lack of control discounts appropriate to a 30 interest;
the passive assets excluded in the first step are valued as a whole as if owned by one person, and that value is multiplied by 30 percent; and
those two values are added together to determine the gift or estate tax value of the 30 percent interest.

Second Possibility: But the antecedent could be viewed as “the family’s collective interest” (which is the previous use of the word “transfer” that is closest to “the interest” and therefore perhaps the first choice of antecedent as a matter of pure grammatical construction). In that case, in valuing that 30 percent interest for transfer tax purposes,

the entire family business (that is, “the family’s collective interest”) is valued by ignoring the passive assets owned by the business or by the entity but as if the business were owned by one person (because the entire business is owned by one family in this example), and that value is multiplied by 30 percent;
the passive assets excluded in the first step are valued as a whole as if owned by one person, and that value is multiplied by 30 percent; and
those two values are added together to determine the gift or estate tax value of the 30 percent interest.

That possibility could be quite different. There are often restrictions associated with even majority interests, designed, for example, to “keep the business in the family,” or to “keep the family in the business,” or simply to permit the vetting and filtering of prospective equity-investors, that would not necessarily apply to a business owned by just one person. The first possibility would respect such restrictions, which seems to be the very point of exempting businesses from the proposal. In the second possibility, it is hard to see how the objective of providing for passive assets to be “segregated and valued as separate from the trade or business” would be achieved, or would make any difference. Again, it is likely that actual statutory language would remove this ambiguity. But in the meantime, this multiple use of the word “interest” to describe the replacement of section 2704(b) might have the same unsettling effect that, for example, the use of the term “minimum value” had in the 2016 proposed regulations under section 2704(b).

In either interpretation, however, it is possible that the proposal may still leave a significant marketability discount, as it should, because even the entire (“collective”) trade or business would present a lack of marketability if it were to be sold (in contrast to marketable assets like stock of a publicly traded business corporation that could be sold at any time). The marketability discount interest may be higher for a small interest in a business (like the 30 percent interest in the example), but a marketability discount is usually appropriate for even a majority (or “collective”) interest in a business. Although the Greenbook offers as a reason for the proposal the point that “discounts for lack of marketability and lack of control … are not appropriate when families are acting in concert to maximize their economic benefits,” there is no reason to interpret that to include the decision of the current or predecessor family members to own and operate a business. And the operation of the business is hardly something the authors of the Greenbook proposal could have assumed “the family often ignores.” Indeed, returning to technicalities of grammar, the Greenbook’s reference to “valuation discounts …” is itself limited to “such interests,” which in that case clearly refers to entities holding “marketable securities and other liquid assets” and “other hard-to-value assets such as real estate, art, or intangibles” (with no mention of businesses).

Finally, any interpretation and implementation of the Greenbook proposal that provides a different valuation method for “passive assets” must deal with the appropriate definition and identification of such “passive assets.” For example, “working capital” is explicitly treated as a business asset in the Clinton Administration proposal discussed above. But what about capital reserves held for possible expansion, modernization, or other extraordinary expenses incurred by the business?

These are important questions, and the answers could have a big impact on determining whether such legislation, if it gained any traction in Congress, would meet opposition of the kind and degree met by the proposed section 2704 regulations in 2016.

Application. The Greenbook proposes that this change apply “only to intrafamily transfers of partial interests in property in which the family collectively has an interest of at least 25 percent.”

Effective Date. The Greenbook proposes that this change apply to valuations for which the valuation date is on or after the date of enactment.

Revenue Estimate. This proposal and the following proposal regarding the valuation of promissory notes are together estimated to raise approximately $12.3 billion over 10 years.

PROMISSORY NOTES

Background

Loans with an interest rate equal to the applicable federal rate (AFR) incorporated into section 7872 are not treated as gifts, but the lender may take the position that the note should be discounted for gift tax purposes on a later re-transfer or for estate tax purposes at death because the interest rate is lower than a commercial rate at the time. Section 7872, added to the Code by the Deficit Reduction Act of 1984 (Public Law 98-369, July 18, 1984), authorized the issuance of regulations to address the estate tax valuation of notes, and proposed regulations were promptly promulgated but have never been finalized. Meanwhile, although the note is included in the decedent’s gross estate, it is possible that it could be valued for estate tax purposes at less than its face amount, under general valuation principles, because section 7872 is not an estate tax valuation rule. That would be especially true if interest rates rise between the date of the sale and the date of death.

Section 7872(i)(2) states:

“Under regulations prescribed by the Secretary, any loan which is made with donative intent and which is a term loan shall be taken into account for purposes of chapter 11 [the estate tax chapter] in a manner consistent with the provisions of subsection (b) [providing for the income and gift tax treatment of below-market loans].”

Proposed Reg. §20.7872-1 (published on August 20, 1985, barely a year after the enactment of section 7872) states:

“For purposes of chapter 11 of the Internal Revenue Code, relating to estate tax, a gift term loan … that is made after June 6, 1984, shall be valued at the lesser of:

“(a) the unpaid stated principal, plus accrued interest; or

“(b) the sum of the present value of all payments due under the note (including accrual interest), using the applicable Federal rate for loans of a term equal to the remaining term of the loan in effect at the date of death.

“No discount is allowed based on evidence that the loan is uncollectible unless the facts concerning collectibility of the loan have changed significantly since the time the loan was made. This section applies with respect to any term loan made with donative intent after June 6, 1984 [the effective date of section 7872], regardless of the interest rate under the loan agreement, and regardless of whether that interest rate exceeds the applicable Federal rate in effect on the day on which the loan was made.”

The estate planner’s answers to the proposed regulation would include the arguments that

the proposed regulation is not effective unless and until it is finalized,
the loan represented by the installment note is not a “gift term loan” because it uses an interest rate calculated to avoid below-market treatment under section 7872(e), and
with respect to both this proposed regulation and section 7872(i)(2) itself, the loan is not made “with donative intent” because the transaction is a sale, not a gift.

With respect to the first point, it is arguable that section 7872(i)(2) itself requires consistency even in the absence of regulations (although it still might be unclear what “consistency” means in that context). Tax Court Judge Tannenwald distinguished between “how” regulations and “whether” regulations in Estate of Neumann v. Commissioner, 106 T.C. 216 (1996). Section 2663(2) provides that “the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this chapter, including … regulations (consistent with the principles of chapters 11 and 12) providing for the application of this chapter [the GST tax] in the case of transferors who are nonresidents not citizens of the United States.” This, Judge Tannenwald held, refers to a “how” regulation that is not a necessary condition to the imposition of the GST tax on transfers by nonresident noncitizens. Similar results with reference to the phrase “under regulations” (which is the phrase also used in section 7872(i)(2)) were reached in Francisco v. Commissioner, 119 T.C. 317 (2002), and Flahertys Arden Bowl, Inc. v. Commissioner, 115 T.C. 269 (2000). Compare section 465(c)(3)(D), which provides that a special rule “shall apply only to the extent provided in regulations prescribed by the Secretary.” Alexander v. Commissioner, 95 T.C. 467 (1990). Also compare Frazee v. Commissioner, 98 T.C. 554 (1992), and Estate of True v. Commissioner, T.C. Memo. 2001-167, aff’d, 390 F.3d 1210 (10th Cir. 2004), discussing other proposed regulations under section 7872.

Under section 7805, the proposed regulations could probably be expanded even beyond the strict mandate of section 7872(i)(2), and, under section 7805(b)(1)(B) such expanded final regulations might even be made effective retroactively to the publication date of the proposed regulations in 1985. But, unless and until that happens, most estate planners have seen no reason why the estate tax value should not be fair market value, which, after all, is the general rule, as elaborated in Reg. §20.2031-4:

“The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless. However, items of interest shall be separately stated on the estate tax return. If not returned at face value, plus accrued interest, satisfactory evidence must be submitted that the note is worth less than the unpaid amount (because of the interest rate, date of maturity, or other cause), or that the note is uncollectible, either in whole or in part (by reason of the insolvency of the party or parties liable, or for other cause), and that any property pledged or mortgaged as security is insufficient to satisfy the obligation.”

The 2015-2016 Treasury-IRS Priority Guidance Plan for the 12 months beginning July 1, 2015, released on July 31, 2015, included a project, new that year, titled “Guidance on the valuation of promissory notes for transfer tax purposes under §§2031, 2033, 2512, and 7872.” It was retained in the 2016-2017 Priority Guidance Plan but dropped from the slimmed-down 2017-2018 Plan published October 20, 2017, by the Trump Administration. It is not clear that this guidance project was related to Proposed Reg. §20.7872-1, which it does not cite. This project was joined in the 2016-2017 Plan by an item under the subject of “Financial Institutions and Products” described as “Regulations under §7872. Proposed regulations were published on August 20, 1985.” When the promissory notes project was dropped from the subject of “Gifts and Estates and Trusts” in the 2017-2018 Plan, that item under “Financial Institutions and Products” remained. It was carried over to the 2018-2019 Plan, but dropped from the 2019-2020 Plan.

The Greenbook Proposal

Rather than following through on the existing statutory authority to adopt regulations addressing the issue, however, Treasury has now proposed, both in the Fiscal Year 2023 Greenbook and the current Greenbook (at pages 130-132), a legislative solution that would limit the discount rate used to value the note for estate tax purposes to “the greater of the actual rate of interest of the note, or the applicable minimum interest rate for the remaining term of the note on the date of death.” The Greenbook adds:

“The Secretary and her delegates (Secretary) would be granted regulatory authority to establish exceptions to account for any difference between the applicable minimum interest rate at the issuance of the note and actual interest rate of the note. In addition, the term of any note (regardless of its rate of interest) would be shortened for purposes of valuing that note if there is a reasonable likelihood that the note will be satisfied sooner than the specified payment date and in other situations as determined by the Secretary.”

Exceptions “to account for any difference between the applicable minimum interest rate at the issuance of the note and actual interest rate of the note” would certainly be appropriate. Otherwise, for example, a note with a commercially reasonable interest rate, such as a note a seller of a home might take back from an unrelated buyer, might be artificially overvalued for estate tax purposes if its true value was depressed because market interest rates had risen.

Subject to what such regulations might provide, it appears that valuing a note by discounting future payments of principal and interest at a discount rate equal to that interest rate would be tantamount to simply valuing the note at its face amount of unpaid stated principal plus accrued interest, the same as in Proposed Reg. §20.7872-1(a) or, for that matter, the general rule in Reg. §20.2031-4 (both quoted above).

The Fiscal Year 2023 Greenbook stated that “the proposal would apply to valuations as of a valuation date on or after the date of introduction.” Presumably that meant the introduction of legislation specifically drafted to implement proposals in this Greenbook, but it is left to the legislation itself to clarify that. In any event, the date of introduction is a rather bold effective date approach, usually reserved for cases where Congress perceives a particular abuse or other need for urgency. An argument for urgency, of course, could be somewhat awkward in a context that includes proposed regulations that have been pending since 1985. On the other hand, the argument described above that section 7872(i)(2) itself already requires consistency could make it awkward to object to that effective date as a surprise or as unfair. In any event, the Fiscal Year 2024 Greenbook changes the description of the effective date to “valuations as of a valuation date on or after the date of enactment,” which is more normal.

This proposal was estimated in the Fiscal Year 2023 Greenbook to raise approximately $6.4 billion over the next 10 fiscal years. As stated above, in the Fiscal Year 2024 Greenbook, this proposal and the preceding proposal regarding fractional interests are together estimated to raise approximately $12.3 billion over 10 years.

DEFINED VALUE FORMULA CLAUSES

Background

Defined value clauses have an interesting history. See, for example, Technical Advice Memorandum 8611004 (Nov. 15, 1985) (approving a transfer of “such interest in X Partnership … as has a fair market value of $13,000”); Knight v. Commissioner, 115 T.C. 506 (2000) (disregarding the use of such a technique to transfer “that number of limited partnership units in [the partnership] which is equal in value, on the effective date of this transfer, to $600,000”); Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003) (reviewed by the Court) (approving a defined value clause, with the excess going to charity); Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008) (reviewed by the Court), aff’d, 586 F.3d 1061 (8th Cir. 2009) (approving a formula disclaimer in favor of charity); Estate of Petter v. Commissioner, T.C. Memo. 2009-280, aff’d, 653 F.3d 1012 (9th Cir. 2011) (approving a defined value clause, with the excess going to charity); Hendrix v. Commissioner, T.C. Memo. 2011-133 (approving a defined value clause, with the excess going to charity); Wandry v. Commissioner, T.C. Memo. 2012-88, nonacq., AOD 2012-004, 2012-46 I.R.B. (approving a type of defined value clause, with the excess remaining with the transferor).

The taxpayers’ actual implementation of defined value clauses (that is, returning property to the donors where it might be taxed as part of their estates) was likely an element of the settlements in Estate of Donald Woelbing v. Commissioner (Tax Court Docket No. 30261-13, stipulated decision entered March 25, 2016) and Estate of Marion Woelbing v. Commissioner (Tax Court Docket No. 30260-13, stipulated decision entered March 28, 2016); and possibly in Karen S. True v. Commissioner (Tax Court Docket No. 21896-16, stipulated decision entered July 9, 2018) and H.A. True III v. Commissioner (Tax Court Docket No. 21897-16, stipulated decision entered July 6, 2018).

Another example of the IRS and the taxpayer agreeing to give effect to a formula – in this case a formula for determining the annuity payments from a GRAT – is the stipulation in Grieve v. Commissioner, T.C. Memo. 2020-28 (Judge Kerrigan). In that case, in addition to other transfers, there was a two-year GRAT with annuity payments determined as stated percentages of what the opinion describes only as “the fair market value of assets transferred to the trust for Federal gift tax purposes.” As the court noted in a footnote:

“The parties stipulated that petitioner will not owe additional gift tax if we determine that he understated the initial fair market value of assets transferred to the GRAT if, within a reasonable time, the GRAT pays to petitioner, or to his personal representative in the event of his passing, an amount equal to the difference of the properly payable annuity and the annuity actually paid.”

They never had the opportunity to make such a payment, however, because the taxpayer won the case on the underlying valuation issue.

Nelson v. Commissioner, T.C. Memo. 2020-81 (June 10, 2020, Judge Pugh), involved a gift to a trust of a limited partner interest “having a fair market value” of a specified dollar amount, “as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment,” followed two days later by a sale to the same trust described in the same way, except that the time for obtaining the appraisal was 180 days instead of 90 days. The taxpayer argued unsuccessfully that this permitted an adjustment to the transfer based on the values finally determined for gift tax purposes, as in Wandry. Significantly, the IRS not only accepted the formulas based on appraisals within a specified time but actually advocated for them, obviously not offended by such formula transfers as it is by Wandry clauses. This is understandable, because by the time the IRS looks at the return the transferred quantity will already have been determined, and the IRS can contest the valuation of that quantity.

In affirming the Tax Court in Petter, albeit in the context of a rather narrow subpoint of a condition precedent within the meaning of Reg. §25.2522(c)-3(b)(1), the Court of Appeals for the Ninth Circuit concluded its opinion by quoting:

“‘We expressly invite the Treasury Department to “amend its regulations” if troubled by the consequences of our resolution of th[is] case.’ Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 713 (2011) (quoting United Dominion Indus., Inc. v. United States, 532 U.S. 822, 838 (2001)).”

The 2015-2016 Treasury-IRS Plan included a project described as “Guidance on the gift tax effect of defined value formula clauses under §§2512 and 2511,” but that project was dropped in the 2017-2018 Plan. Maybe, in that guidance project, Treasury was proposing to accept that invitation of the Ninth Circuit.

Meanwhile, the settlements in Woelbing and True, the parties’ stipulation in Grieve, and the Tax Court’s apparent respect for that stipulation in Grieve all might have suggested that actually giving effect to defined value clauses in audit, settlement, or litigation to cut down the tax benefits of an estate planning technique might have become a “new normal.”

The Greenbook Proposal

Now Treasury has signaled, although not very clearly, that it intends just the opposite. In a modest-looking 122-word “reasons for change” and 153-word explanation, the Greenbook proposes to dramatically crack down on the use of value formula clauses to define gifts and bequests. If a clause is based on “the result of involvement of the IRS,” (such as a clause based on values “as finally determined” for gift or estate tax purposes), the Greenbook complains (at page 117) that it

“poses a significant challenge to the administration of the gift and income taxes by potentially (a) allowing a donor to escape the gift tax consequences of undervaluing transferred property, (b) making examination of the gift tax return and litigation by the IRS cost-ineffective, and (c) requiring the reallocation of transferred property among donees long after the date of the gift.”

The Greenbook also notes that such determinations could “create a situation where the respective property rights of the various donees are being determined in a tax valuation process in which those donees have no ability to participate or intervene.”

But, in a most puzzling statement, the Greenbook offers this purported explanation (emphasis added):

“The proposal would provide that if a gift or bequest uses a defined value formula clause that determines value based on the result of involvement of the IRS, then the value of such gift or bequest will be deemed to be the value as reported on the corresponding gift or estate tax return.”

As much as taxpayers would welcome the assurance that the value reported on a return will be automatically accepted as the final value, it is obvious that Treasury does not intend that result. It probably is intended to say that the quantity of the transfer (number of shares, percentage interest, or the like) will be deemed to be the quantity estimated on the return. In other words, Treasury intends to overturn Estate of Petter v. Commissioner, T.C. Memo. 2009-280, aff’d, 653 F.3d 1012 (9th Cir. 2011), and Hendrix v. Commissioner, T.C. Memo. 2011-133 (in which gifts were divided by formula between noncharitable donees and charities), and Wandry v. Commissioner, T.C. Memo. 2012-88, nonacq. (AOD 2012-004, 2012-46 I.R.B.) (in which the entire gift itself was effectively defined by formula).

In any event, this proposed change would not apply if a defined value formula clause depends on action that does not include the involvement of the IRS. The Greenbook offers the example of “an appraisal that occurs within a reasonably short period of time after the date of the transfer (even if after the due date of the return).” That would include the outcome the IRS not only accepted, but argued for, in Nelson v. Commissioner, T.C. Memo. 2020-81, aff’d, 17 F.4th 556, (5th Cir. 2021) (“as determined by a qualified appraiser within ninety (90) [or 180] days of the effective date of this Assignment”).

The rejection of defined value formula clauses also would not apply “for the purpose of defining a marital or exemption equivalent bequest at death based on the decedent’s remaining transfer tax exclusion amount.” This leaves open the possibility that, for example, a charitable lead annuity trust (CLAT) that defines the amount of the annuity to “zero-out” the bequest would be a target of this proposal.

The proposal, once it is clarified, would apply to transfers by gift or on death occurring after December 31, 2023.

Ronald D. Aucutt