Representative Pomeroy introduced estate tax legislation with the snappy title "Certain Estate Tax Relief Act of 2009" (H. R. 436). This bill has good and bad news depending on your view of the estate tax. For many high net worth folks, the news isn't bad. It's really awful. The Bill proposes a host of changes to the estate tax, including those discussed below. Whether this Bill is enacted, or some variation of this or another one of the proposals floating around Congress, the bottom line is most folks need to take action. If your estate is smaller, you need to reassess your planning. A big exclusion doesn't mean you can continue imitating a deer in the headlights. If your estate is larger, get it while you can (and it may be too late!).
The estate tax is here to stay it appears. This proposed bill would make the tax permanent and fix various rates and exemptions and put an end to the long dragged out repeal discussion.
The exclusion (the amount you can give junior without any federal estate tax) will stay at this year's $3.5 million level. FYI some studies have estimated that a net worth of about $2.5 - $3.5 million puts you in the wealthiest 1% of families. Basic planning, such as a bypass trust, to preserve the exclusion of two spouses, means $7 million can escape the estate tax. This is far higher than the levels at which President Obama has indicated taxpayers should bear a larger tax burden. So, the risk of a lower exclusion, now or at some future date, remains. For those under the estate tax threshold, planning needs to be reevaluated.
The maximum federal estate tax rate will stay fixed at 45%. While this rate is lower than the rates charged historically, for those affected by the estate tax, the rate remains, if this bill is enacted, so high that planning to reduce the tax will remain a priority.
Exclusion Phase Out
The lower graduated tax rates and the $3.5 million exclusion will be phased out by increasing the tax on estates above $10 million. Consider the tremendous marginal tax rate this phase out range will create, especially if the decedent was domiciled in a state with a state estate tax (the state estate tax credit is to be repealed). Marginal rates in the phase out range could exceed 60%.
No Carryover Basis
The proposed carryover basis rules won't be enacted. Hey, if you don't know what they are don't worry about it. These rules would have made recordkeeping a real hassle. This is a great change (well, for everyone except your CPA!).
■ Discounts on Passive Assets to be Repealed. ■ The juice of many estate planning techniques, discounts for lack of control and marketability, will no longer apply to transfers of nonbusiness assets. This change will have a huge impact on planning. The value of any nonbusiness assets held by the entity will be determined as if the transferor had transferred such assets directly to the transferee with no discounts (i.e., rather than having transferred an interest in say an FLP that would be discounted, it will be viewed as if you transferred the building and stocks held by the FLP). ■ If you transfer an interest in an entity, no discount will be allowed as a result of your not having control over the entity if you and your family (as defined in IRC Sec. 2032A(e)(2)) control of the entity. This might mean that if people unrelated to you control the entity, discounts will still be allowed. Does that mean you and two sorority sisters can set up a securities FLP and still get discounts? This also might mean that discounts for other purposes, such as for absorption of a large parcel of land, will still be permitted? Jane Z. Astleford, 95 TCM 1497.
■ Example: Assume you have a family real estate development LLC worth $5 million, and the LLC holds $500,000 of investment assets. If you gift 20% of the LLC to a trust for your children, you may qualify to discount the value of the LLC attributable to the active business, but the portion attributable to the passive assets cannot be discounted.
■ What assets are Not Discountable: ■ "Nonbusiness asset" means any asset which is not used in the active conduct of a trade or business. ■ "Passive assets" will not be treated as used in the active conduct of a trade or business unless one of a limited number of exceptions applies. Exceptions are made for active real estate and working capital.
■ Real Estate Isn't Treated as Passive: ■ Real property used in the active conduct of a real property trade or business is not treated as passive. IRC Sec. 469(c)(7)(C)). This means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business in which the transferor materially participates. This means that the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. IRC Sec. 469(h). A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.
■ Working Capital Isn't Treated as Passive: ■ Any asset (including a passive asset) which is held as a part of the reasonably required working capital needs of a trade or business will be treated as used in the active conduct of a trade or business (i.e., it will qualify for discounts). But how will the IRS distinguish between passive assets held in the business to try to circumvent this rule, and cash and securities held as working capital to meet the needs of the business? How will "reasonably required" working capital be defined? ■ While it is not clear how this will be defined if enacted, prior law (e.g. such as that governing the accumulated earnings tax), may be used for guidance (or perhaps they'll develop a new set of standards to keep more tax attorneys employed). ■ The accumulated earnings tax under Code Section 533 contains a substantial body of law for how to determine whether earnings held in a business are for the "reasonable needs" of the business. Similar concepts could be applied in the discount context. ■For example, the Bardahl Court evaluated the need for working capital and may provide a test applicable to determining the amount of passive assets that may qualify for discounts as working capital in the active business. Bardahl Manufacturing Corp., TC Memo 1965-200. Accumulated earnings tax analysis revealed that the corporation only needed approximately 35% of its expected annual operating costs and costs of goods sold as working capital to finance its reasonably anticipated costs of normal operations. While the corporation had certain expansion plans, it had actually completed most of its contemplated expansion projects during prior tax years. The corporation did require a cash reserve fund, however, to enable it to obtain certain raw materials during emergency periods. The corporation also had formed specific and definite plans for expenditures to rehabilitate its European market, for capital investments in an Italian subsidiary, and for construction of European plant. But the corporation's investment in certain real estate projects and its loans to several individuals for purposes unrelated to business were unjustifiable withdrawals. This case lead to the development of the so called "Bardahl Test." Under this test a comparison of corporate needs and assets should be made using the following approach. Determine current and accumulated earnings. Calculate non-liquid investments that have no relationship to the business. Calculate the excess of current assets over current liabilities, including federal income taxes due. Compare the available resources to the total of the working capital and other definite needs of the business. ■The Regulations state that investments in, or loans to suppliers or customers, are reasonable business needs if they are necessary to maintain the business of the corporation. Regs. Sec. 1.537-2(b)(5). ■ It is not clear how any of these concepts will be applied, if at all. But if the determination will be based on facts and circumstances, you may benefit by taking steps to corroborate that the passive assets are necessary for the working capital needs of the business in minutes, financial projections, etc. ■ The complexity that these types of analysis create might just push Congress to consider harsher, but administratively simpler, measures.
■ Defining "Passive Assets": ■ The term 'passive asset' means: (1) Cash or cash equivalents; (2) Stock in a corporation or any other equity, profits, or capital interest in any entity, except as provided in future regulations (that means you have to wait for the sequel); (3) Debt, option, forward or futures contract, notional principal contract, or derivatives; (4) Foreign currency, interests in a real estate investment trust, a common trust fund, a regulated investment company (RIC), a publicly-traded partnership (IRC Sec. 7704(b) ) or any other equity interest (other than in a corporation) which pursuant to its terms or any other arrangement is readily convertible into, or exchangeable for, any other asset defined as passive; and (5) Precious metal, unless used or held in the active conduct of a trade or business (351(e)(1)(B)(iii), (iv) and (v)); (6) Annuities; (7) Real property used in a real property trade or business (as defined in IRC Sec. 469(c)(7)(C)), (this appears inconsistent with the provision above). Perhaps it is meant that real estate that is other than an active trade or business in which the taxpayer materially participates); (8) Assets that produce royalties (other than a patent, trademark, or copyright); (9) Commodities; (10) Collectibles (IRC Sec. 401(m)); or (11) Any other asset specified in regulations to be issued (heard that before?).
■ Entities Owning Entities: These are also called "look through rules". If a nonbusiness asset of an entity, say your family LLC, consists of a 10% interest in any other entity, treat your LLC as directly owning its ratable share of the assets of that other entity. Example: LLC-1 owns 20% of LLC-2 which has as $1 million business and a $500,000 stock portfolio. LLC-1 is treated as owning $100,000 passive assets through LLC-2. This subparagraph shall be applied successively to any 10-percent interest of such other entity in any other entity. What if as only a 20% minority owner LLC-2 will not provide LLC-1 sufficient data to characterize assets?
These new rules will apply to estates of decedents dying, and gifts made, after December 31, 2009. There is no assurance that the changes will not be retroactive to the date of proposal, perhaps January 1, 2009 or even another date. There has been a lot of talk about retroactivity.
Whether this particular legislation, or some variation is enacted, it appears that the estate tax will remain, the exclusion at least for now will remain at a substantial level, and cut backs of planning techniques will occur. Other techniques that have been considered for limitations include Crummey powers and GRATs.