Commentary: Estate taxes would increase under proposal before Congress
Issue Date: March 25, 2009
The California Farm Bureau Board of Directors spent three days in Washington, D.C., last week, educating members of Congress and their staff about the issues facing California family farmers and ranchers. One of our top priorities continues to be reforming the estate tax, to keep the estate as a family farming operation. The legislation mentioned below is just one example of the battles we will fight as we work to protect farmers and ranchers from this unfair tax.
—Paul Wenger, first vice president, California Farm Bureau Federation
By John Toney
John Toney
The window of opportunity may be closing on the use of family limited partnerships and similar entities in succession planning. House Resolution No. 436 was introduced on Jan. 9 by U.S. Rep. Earl Pomeroy, D-N.D. The legislation, known as The Certain Estate Tax Relief Act of 2009, would amend the Internal Revenue Code of 1986, but its name may be a misnomer. As currently worded, H.R. 436 would hardly provide relief for U.S. taxpayers. Instead, its provisions would likely result in substantially increased estate and gift tax payments.
The legislation does have some good news for taxpayers. H.R. 436 proposes to freeze the unified credit exclusion amount at $3.5 million beginning next Jan. 1, which shelters the first $3.5 million of a decedent's estate ($7 million for couples) from taxation. It would also freeze the maximum estate tax rate at 45 percent. However, it would eliminate valuation discounts on transfers and estates that hold interests in entities that are not actively traded, or are controlled by other family members. These consequences are devastating for owners of closely held family businesses, partnerships and farming entities.
Here is an illustration of how the proposed legislation might affect a family who owns farmland worth $10 million in California's Central Valley. A family limited partnership was established between Mother and Son with the land as the only asset. Son is the general partner, owning a 2 percent general partnership interest and also a 49 percent limited partnership interest. Mother owns the remaining 49 percent limited partnership interest. Under the Internal Revenue Service "Fair Market Value" standard, when Mother passes away, her minority 49 percent limited partnership interest is subject to discounts for lack of control and lack of marketability because she has limited ownership rights. She has no ability to cause a liquidation of the family limited partnership's underlying assets, control the FLP or receive cash for her investment. The estate tax due with and without valuation discounts is shown in the chart.
As seen in the chart, the elimination of valuation discounts will considerably increase the estate tax burden. In the example, the decedent's family would face an additional $630,000 tax payment on this one asset alone. Further, the decedent's $3.5 million exclusion will be gobbled up much faster, causing the estate to pay additional taxes on other assets, such as bank accounts, which are not subject to valuation discounts.
H.R. 436 curbs the effectiveness of past and future succession planning as valuation discounts on transfers of interests in family businesses would also be disallowed. Discounts would no longer apply for a husband and wife's community property interest or for any minority interest where other family members control the entity. This ignores the challenges brought about by fragmented ownership in a family business by treating each minority interest as a controlling interest, an unrealistic assumption.
The IRS has long contended that business interests held by family members should be aggregated for estate and gift tax valuations. The U.S. courts have consistently disagreed, however, ruling against family attribution in Estate of Lee v. Commissioner (1978), Estate of Bright v. United States (1981), Propstra v. United States (1982), Estate of Andrews v. Commissioner (1982) and many other cases. After consistently losing in the courts, the IRS reversed its position and issued Revenue Ruling 93-12, which eliminated family attribution for estate and gift tax valuations. H.R. 436 disregards more than 25 years of case law and 15 years of IRS precedent. Additionally, it completely contradicts the "Fair Market Value" standard used for estate and gift tax valuations.
Due to the "sunset provisions" contained in the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress must address the estate taxes issue in 2009, or else 2010 will become a year with no estate tax. With a new administration and a looming deadline, there is good reason to believe that this legislation may pass quickly. As proposed, H.R. 436 eliminates valuation discounts for passive assets and minority interests in family-owned entities, resulting in a substantially increased estate tax burden.
Given the proposed changes to the estate tax code outlined above, we urge you to contact your tax advisor and/or an estate planning professional to determine how these changes will affect you, and to review any estate planning that might currently be in place. With the proposed estate tax changes, coupled with the current state of the economy and the already reduced property and investment values, now is the time to transfer minority interests in family-owned entities and take full advantage of the current regulations. We also strongly urge you to contact your congressional representative and express your concern about this proposed tax increase before it's too late.
(John Toney, MBA, ASA, is the valuation manager with Wallace & Associates Inc. in Sacramento, specializing in business appraisals for estate and gift tax purposes.)
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