Proposed New Estate Tax Law HR 436

Summary:

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!).

No
Repeal.

The estate tax is here
to stay! (on the count of 3, all the insurance agents can say “yippee!”).

Exclusion.

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.

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.

Tax Rates.

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.

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.

■
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be Repealed.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?

Effective Date.
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.