Counting the Days?
We are 302 days away from the national mid-term elections, to be held November 8, 2022, yet the first full week of the new year has already highlighted some of the economic issues with which the Administration will have to grapple over the next few months if it hopes to have any chance of enacting at least a portion of its social spending measures and the tax increases by which it plans to finance them.
Among the issues facing the Administration – and on which tax professionals are keeping a close watch – are the following:
Gift Planning: “What’s Past is Prologue”[viii]
What does this all mean for those owners of family and other closely held businesses who either resisted the siren’s call to sell last year or who were not ready for a sale, but who are interested in passing along a portion of their business to family members this year while also considering a sale?
Well, we began last year with a new Administration that was hell bent on increasing the income tax burden of every individual making more than $400,000 annually, while also reversing the “recent” increase in the unified estate/gift tax exemption amount. With the President’s Party holding a majority of both Chambers of Congress, it seemed likely that such increases would be enacted.
As the year unfolded, some Party leaders, perhaps emboldened by their “control” of Congress and the White House, sought to go further, proposing fundamental changes to the Code, including the elimination of the basis step-up at death, the introduction of a mark-to-market tax that would be applied on the deemed sale of a taxpayer’s property either on an annual basis or upon the death of the taxpayer, the elimination of valuation discounts with respect to certain investment assets held by a business entity, and the wholesale revision of the grantor trust rules which would eliminate or greatly restrict such planning techniques as the sale of property to a grantor trust and the transfer of property to a GRAT.
Eventually, these folks realized there was dissension within their own ranks. Although some Dems were cowed by their Party’s leadership, a very small number of them refused to be. Consequently, all the proposals directed at gift and estate tax planning were dropped from consideration, as were most of the income tax-related proposals.
In fact, at least insofar as the gain realized from the sale of a domestic business was concerned, the only tax-generating provisions in the bill passed by the House, but which stalled in the Senate, were the expansion of the 3.8 percent Medicare surtax on net investment income, the addition of a new 5-to-8-percent surcharge to existing income tax rates for higher-income individuals, and the reduction in the amount of gain excluded from income by individuals who dispose of qualified small business stock.
Thus, the year ended with a whimper insofar as the Administration’s tax plans were concerned.
That said, the President and his Party remain committed to passing some version of their spending plan in the new year, and that will require funding which he has promised will be in the form of increased tax revenue. However, in light of recent history, it is unlikely such revenue will be derived from any of the previously proposed, and rejected, fundamental changes to the estate-and-gift tax rules described above.
What to Do?
We begin 2022 with the economic uncertainty attributable to Congress’s failure to pass a federal budget, the increased level of deficit spending by the federal government, the threat of inflation, the Fed’s announcement of plans to increase borrowing rates, and the resurgence of COVID-19 – basically, the issues confronting the Administration.
What’s missing is the threat of significant across-the-board tax increases – including those relating to estate and gift tax planning – though the surtax and surcharge described above should remain in play and will probably continue to motivate certain owners to complete the sale of their business prior to the enactment – and, hopefully, the effective dates[ix] – of these taxes.
Based on the foregoing, an individual business owner who is interested in reducing their exposure to the federal estate tax may consider utilizing, and perhaps leveraging, their remaining federal exemption amount by making gifts and/or sales of interests in their business to family members or to trusts (including grantor trusts[x]) for the benefit of such family members, provided the transfer makes sense from a “business” perspective, and provided the owner is comfortable with giving up the economic benefits associated with such interests.[xi]
Thus, the transfer of business interests to GRATs[xii] or the sale of such interests to grantor trusts[xiii] in exchange for a promissory note remain viable and effective options, at least in the current interest rate environment.[xiv]
In any case – whether an outright gift, an outright sale, a part-sale/part-gift, a transfer to a GRAT, or a sale to a trust – it is imperative that the owner-grantor obtain a well-reasoned and thorough valuation of the business interest to be transferred, one that is prepared by a qualified and experienced appraiser.
The increased unified gift/estate tax exemption amount of $12.06 million per U.S. individual grantor[xv] for the 2022 calendar year may afford the grantor some cushion, but it is not a substitute for a proper appraisal; nor is the use of a formula adjustment clause where the donor cannot demonstrate a good faith effort to determine the fair market value of the property to be transferred.
Gift Prior to Sale
A grantor who may also be planning to sell all or part of their business this year will have to be especially careful to consider the impact of the potential sale upon the value of any gifts made by the grantor, as illustrated in a recent advisory memorandum released by the IRS Office of Chief Counsel.[xvi]
Donor owned a business organized as a corporation (“Target”). He retained the services of an investment banker (“IB”) to explore the possibility of finding an outside buyer for the corporation. The IB marketed the business by reaching out to potential strategic buyers. Potential buyers were expected to purchase a minority interest in Target with an option after several years to acquire the remaining stock based upon a formula valuation.
Approximately six months later, and within a two-week period, the IB presented Donor with offers from five suitors.
Just three days later, Donor created Trust, a two-year GRAT under the terms of which Donor was to receive an annuity payment the amount of which was based upon a fixed percentage of the initial fair market value of the Trust property.
Donor funded Trust with a number of shares of Target stock. The value of the shares transferred was derived from an appraisal obtained by Target approximately seven months earlier for a different purpose[xvii] (the “Appraisal”).
During the three-month period following the initial offers – and just under three months after Donor’s transfer to Trust – four of the corporate suitors increased their offers for Target, while the fifth withdrew from the bidding.
Three months after the new offers were received, Donor accepted Corporation A’s offer, which represented a 10 percent increase over its initial offer for Target, and proceeded to negotiate a purchase and sale agreement. Pursuant to the final offer, an initial cash tender offer was made that was nearly three times greater than the value reached by the Appraisal. During the tender period, Donor tendered a number of Target shares for a price that was almost three times the value reached by the Appraisal.
Shortly thereafter, Target updated the Appraisal.[xviii]
Approximately six months after the end of Trust’s two-year GRAT term, Corporation A purchased the balance of Target’s shares for a price almost double the value of the updated Appraisal.
Hypothetical Willing Buyer
On the basis of the facts presented, the Office of Chief Counsel observed that a hypothetical willing buyer of the Target stock could have reasonably foreseen the acquisition and anticipated that the price of Target stock would sell at a substantial premium over the claimed gift tax value per share that was based upon the earlier Appraisal. [xix]
Chief Counsel’s advisory began by stating that the value of property for federal transfer tax purposes is a factual inquiry that requires the trier of fact to weigh all relevant evidence and then to draw appropriate inferences to arrive at the property’s fair market value. For this purpose, it continued, “fair market value” is the price that a hypothetical willing buyer would pay a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.[xx] Chief Counsel added that the hypothetical willing buyer and willing seller are presumed to be dedicated to achieving maximum economic advantage.
According to Chief Counsel, the principle that the hypothetical willing buyer and willing seller are presumed to have “reasonable knowledge of relevant facts” affecting the value of property at issue applies even if the relevant facts at issue were unknown to the actual owner of the property.
Both parties are presumed to have made a reasonable investigation of the relevant facts. Thus, in addition to facts that are publicly available, reasonable knowledge includes those facts that a reasonable buyer would uncover during negotiations over the purchase price of the property by asking the hypothetical willing seller for information that is not publicly available. In other words, the hypothetical buyer is deemed to have conducted an appropriate level of due diligence.[xxi]
Generally, a valuation of transferred property for federal gift tax purposes is made as of the transfer date (valuation date) without regard to events happening after that date. That said, subsequent events may be considered if they are reasonably relevant to the question of value. Thus, a post-valuation date event may be considered if the event was reasonably foreseeable as of the valuation date.
Furthermore, a post-valuation date event, even if unforeseeable as of the valuation date, may be probative of the earlier valuation to the extent it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date, provided there have not been intervening events that may have significantly affected such value.[xxii]
Interest in Property or in Sale Proceeds?
Chief Counsel then reviewed several decisions in which the Courts had considered whether a donor-taxpayer who had transferred shares of appreciated stock in a target corporation was liable for tax on the gain from the transferee’s subsequent sale of the stock under the anticipatory assignment of income doctrine.
In those cases, based on the surrounding circumstances, the Courts had concluded that the transfers in question occurred after the target shares had “ripened” from an interest in an ongoing business – which, in the case of a minority interest that cannot influence the business, may warrant a valuation discount – into a fixed right to receive cash from the sale of such business because the purchase-and-sale transaction was “practically certain” to close.
Consequently, under the assignment of income doctrine, the donor was taxed on the gain from the transferee’s sale of the target stock.
The IRS’s Conclusion
According to Chief Counsel, the case before it was similar to the assignment-of-income decisions mentioned above; for example, Target’s search to find an acquirer, the exclusive negotiations with Corporation A immediately before the final agreement, the generous terms of the transaction, and the fact the agreement was “practically certain” to go through.
While these cases dealt with the assignment of income doctrine, they also relied upon the proposition that the facts and circumstances surrounding a transaction are relevant to the determination that the transaction is likely to occur, which is relevant from a valuation perspective.
Donor’s case presented an analogous issue: whether the fair market value of the Target shares should consider the likelihood of the sale transaction as of the date of the transfer of such shares to Trust.
Chief Counsel determined that the facts and circumstances of Donor’s gift transfer supported the conclusion that the value of the Target stock should have considered the pending sale. Accordingly, the value determined in the Appraisal did not represent the fair market value of the Target shares as of the valuation date.
Hypothetical Donor’s Advice to Actual Donor
For whatever reason, many business owners (and sometimes even their advisers) believe that the price at which their business was sold – or was almost sold – to an unrelated third party should have no bearing upon the value of the owner’s pre-sale gift of an interest in the business.
Where a sale has been consummated, the owner may claim the buyer – at least in the case of a strategic buyer – paid a premium for the business; or they may take the position that the price reflects a significant non-compete notwithstanding the parties may have assigned little value to such a covenant.
In some cases, these owners rely upon the fact that, at the time of the gift, they have not yet executed a letter of intent (“LOI”) with the buyer, let alone a purchase and sale agreement, as if the absence of such a document somehow influences the inherent value of the business or affords the owner the opportunity to low-ball such value.
What these owners forget is that the LOI includes the object of the purchase (the assets of, or the owner’s equity interest in, the business), the purchase price, and the terms of payment, among other things. These basic terms are typically arrived at only after the prospective buyer has conducted a fair amount of financial due diligence of the target business (usually under the terms of a non-disclosure agreement).[xxiii]
The bottom line: the owner should not unilaterally determine what is or is not relevant to the valuation of their business. Rather, the owner should retain the services of a qualified and experienced appraiser with whom they should share information pertaining to recent or ongoing discussions concerning the possible sale of the business, and especially the details of a pending sale. With this data, the appraiser should be in a position to render an opinion on which the owner may rely in transferring interests in the business to members of their family.
[i] I should point out that the bipartisan-supported infrastructure legislation was enacted November 15, 2021.
[ii] You will recall that Sen. Manchin withheld his support from the current version of the Build Back Better plan. At the same time, however, both the Senator and the President held out the possibility of a deal, which was interpreted as including a scaled back version of the Administration’s plan.
[iii] Query what that says about the effective dates of any tax increases that may be enacted at that time.
You may ask, what has distracted the Dems from what they have described as the centerpiece of their legislative agenda? “Voting rights” or, stated differently, taking steps now to avoid losing control of Congress in November.
Both Parties are shameless.
[iv] This would continue to operate the government at current spending levels. Senate Republicans have threatened to push for a continuing resolution that would cover the rest of the fiscal year, through September 30, 2022.
[v] To more than $31 trillion.
[vi] What a coincidence. Will it make a difference?
More than 20 House Democrats have announced they will not seek re-election.
What’s more, “Major U.S. corporations are looking to quietly restore ties with Republicans who objected to certifying the 2020 election results following the Jan. 6 insurrection, believing that they cannot afford to burn bridges with the party that is favored to win back the House in the 2022 midterms.”
[vii] Is it a foregone conclusion there will be another variant in the near-term?
[viii] Shakespeare’s The Tempest. To quote the late author and historian, Shelby Foote, “Shakespeare hung the moon.”
[ix] According to conventional thinking, the later into the year these are passed, the less likely it becomes they will be applied retroactively.
[x] The income or gain recognized by a grantor trust is taxed to the grantor rather than to the trust or to its beneficiaries. The grantor’s payment of the tax is not treated as a taxable gift. Rev. Rul. 2004-64.
[xi] A grantor who is driven to continue enjoying the benefits of property they have transferred to or for the benefit of family members (or who continues to determine how the beneficiaries of such transfer will enjoy the property) risks the inclusion of such property in their gross estate notwithstanding the transfer. See IRC Sec. 2036.
[xii] The transfer of property to a GRAT in exchange for an annuity payable by the GRAT is basically a sale to a grantor trust in exchange for a series of fixed annual payments made over a term of years.
[xiii] The grantor’s non-fiduciary right to acquire trust property in exchange for (in substitution of) other property of equivalent value is commonly used to trigger grantor trust status. IRC Sec. 675(4).
[xiv] The IRS prescribes monthly a specified interest rate, under IRC Sec. 7520, that is to be used to calculate the current value of a future interest in property held in trust (the gifted interest). This rate is often referred to as the “hurdle rate.” When this rate is low, the property transferred has a lower rate (or hurdle) to overcome in order to maximize the gift tax benefit of the transfer; stated differently, if the property transferred in trust performs well and generates a greater return than the hurdle rate over the term of the trust, then the value transferred to the trust beneficiaries could exceed the amount of the original gift.
[xv] Meaning a U.S. citizen or a U.S. domiciliary. In the absence of a treaty, a non-U.S. individual may transfer up to only $60,000 worth of U.S.-situs property at their death before incurring U.S. estate tax; no similar exemption amount is provided for inter vivos taxable gifts by such an individual.
[xvi] CCA 202152018.
The Chief Counsel is appointed by the President with the advice and consent of the Senate and serves as the chief legal advisor to the IRS Commissioner on all matters pertaining to the interpretation, administration and enforcement of the Code. For example, the Chief Counsel provides legal guidance and interpretive advice to the IRS, Treasury and to taxpayers.
[xvii] Appraisal was obtained for purposes of IRC Sec. 409A.
[xviii] Again, for purposes of IRC Sec. 409A.
[xix] When asked to explain the use of the outdated appraisal to value the transfer to the GRAT, taxpayer’s appraiser stated only that “[t]he appraisal used for the GRAT transfer was only six months old, and business operations had not materially changed during the 6-month period.” In the absence of the other facts and circumstances described above, this position may have been tenable.
[xx] Treas. Reg. § 25.2512-1; Rev. Rul. 59-60.
[xxi] In the case of an actual M&A transaction, this may include, for example, an audit or quality of earnings analysis.
[xxii] For example, a sale of the gifted shares of stock to an unrelated third party within a relatively short period after the gift would be probative of value even if the sale was not planned at the time of the gift.
This situation changes, however, when shortly after the stock is gifted several large, high-quality veins of various precious metals are discovered under the corporation’s executive golf course. The executives complain over the loss of their favorite pastime. The corporation fires them, whereupon the value of the business skyrockets.
[xxiii] Of course, these terms remain subject to change during the more in-depth examination conducted by the buyer and its advisers during the due diligence period that follows the execution of the LOI. In fact, as a result of this due diligence, the prospective buyer may have decided to walk away from the deal, which may a helpful fact insofar as the gift tax valuation is concerned.
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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