IRS Considers New Tax on Wealthy Families

By Robert Milburn

The IRS wants to sharply curtail a favorite tax benefit affecting family partnerships and LLCs. The U.S. Treasury Department is zeroing in on new regulation that would effectively raise the taxable value of assets transferred into family partnerships and LLCs, currently granted a discount. Private bankers are nudging their wealthy clients to get out ahead of the likely new rules and set up such partnerships now, in order to capture valuable discounts while they still exist. Current speculation is that the new rules will be announced in early September.

Any changes could have sweeping ramifications. Partnerships and LLCs allow families to tax-efficiently pass on to heirs, say, a minority stake in the family business or in a pool of privately-held investments. The reasoning: The minority shares in the private business are illiquid, can’t really be sold to anyone else but the family, and therefore are worth less, from a tax perspective, than their stated market value. That helps families trim the taxable value of their assets, sometimes below the $5.43 million gift-tax exemption, and works well even if, say, the underlying investments getting passed on in this way are liquid. A pool of marketable securities that is packaged and passed on, might, for example, get a discount of 20% to 25%, says Lisa Featherngill, managing director at Abbot Downing. A basket of illiquid assets could get a larger haircut of 25% to 35%.

So let’s say a family business is worth $25 million and is entirely private owned by the family. You decide to pass on a 25% minority holding in the company to your heir via a Partnership or LLC. The IRS, as the rules stand now, allows you to discount the shares up to 35%, because they are illiquid. So, instead of passing on $6.25 million in shares, triggering a tax bill, you’re only passing on shares valued by the IRS at $4.1 million, which makes the transfer tax free, since it remains well below the $5.43 million gift-tax exemption.

The Treasury Department has put the estate planning community on notice that this all may change. In May, Cathy Hughes, of the Treasury Department’s estate and gift tax division, dropped hints at an American Bar Association event, saying that new rules on family partnerships could be released before the ABA’s next taxation meeting, scheduled for September 17 to 19. The proposed regulations have been on the Treasury’s list of things to do before, but were formally dropped during the 2010 to 2013 budgets, when the appetite to hit the wealthy with yet another Obama-era tax was diminished. Now that happy days are here again, the subject is very much back on the Treasury’s wish list.

The rules will tighten definitions and attempt to clarify existing murkiness, perhaps even narrowing discounts for certain assets. “Currently, it’s a battle of the experts, with the IRS’s expert up against the taxpayer’s expert” about how illiquid an asset is and what kind of a discount it should get, says Jim Hogan, of tax advisory Andersen Tax. The courts usually wind up serving as an arbiter, defining which assets are justifiably discounted, he says. The IRS doesn’t like that; it’s inefficient and a costly and time-consuming process to administer. “The new rules should give the IRS a tool to deal with discounts themselves,” Hogan says.

Details on the proposed legislation are sparse, which explains why the estate planning community is abuzz with speculation. Hogan left the IRS in April 2014 and, although not privy to the details of the new rule, supplies a few key insights. He suggests that certain assets are justifiably discounted, such as an operating business with sales; others have a harder time demonstrating that a “legitimate business purpose exists beyond just getting a discount.” An example of the latter might be putting an art collection into a family partnership. That “might be questionable,” Hogan says, unless, of course, the family maintains a gallery and actually sells its artwork. Abbot Downing’s Featherngill says the IRS could even take issue with LLCs that hold liquid securities like bonds and stocks.

However the proposed rule shakes out, wealth managers are advising clients to act now. Earlier this month, Abbot Downing sent out an email alert to all of its relationship managers, suggesting they talk with any client “considering formation of a family entity… Now may be the time to accelerate those discussions.”

Why? If more stringent rules are proposed, the Treasury could choose to make the rules effective immediately, even as details are hammered out at a later date. Which explains why many families are fervently hoping the Treasury department will just kick the whole can further down the road, as it has happened in previous years. We’ll know by the fall.