Estate and Gift Tax Risks and Opportunities for Family Owned Entities: Impact of Recent Court Decisions and Legislation

Description

Many clients have or wish to create family-owned entities to own and manage assets in a way intended to facilitate participation in shared investments, the transmission of wealth and allocation of control among family members. The assets held in the entity can be operating businesses, real estate, liquid investments or almost anything else. Often senior generation family members control the entity while trusts (established by the senior family members) for younger generation beneficiaries hold non-controlling interests in the entity. On the other hand if each family member simply contributes a prorata share of the entity’s capital many of the tax issues disappear.

Use of closely held entities can be a tax-efficient way to facilitate family participation in business or investments and to transmit wealth to the next generation and accomplish other goals, but there are possible traps. At inception there are gift tax concerns, including the appropriate valuation of the entity. During the life of the entity, its income and gains must be reported appropriately. And upon death of the senior family member, there may be estate tax and valuation questions.

The IRS has a long history of challenging valuation discounts for both gift and estate tax purposes and asserting estate tax inclusion for closely held entities. Recently, in Estate of Powell v. Commissioner, the Tax Court ruled for the first time that the decedent’s taxable estate included a completely non-controlling limited partnership interest (which was supposedly given away a week before she died) by way of Section 2036(a)(2), which requires the inclusion of property when a decedent retains certain rights in the property transferred.

Even though the decedent never had any control rights over the partnership, the court ruled that the partners (including the decedent as a limited partner) could join together and terminate the partnership, and this was enough to result in the estate tax inclusion of the partnership interest in the Powell estate. The same reasoning was used in Estate of Cahill v. Commissioner a year later. These rulings have a significant impact on existing closely held entities (including possible re-organization), and advisors recommending new closely held entities must consider these developments as well.

In addition, tax reform provided a record high estate tax exemption indexed to $11.58 million in 2020. Assets removed from the taxable estate (for example, in trusts holding interests in a successful closely held entity), however, won't benefit from the date of death step-up in basis. Many such entities were created when the exemption was much lower. Knowing when and which assets should be moved to a closely held entity (or when it should be unwound or reorganized) after tax reform is critical. Then again, the higher unified credit is scheduled to pass with the 2026 sunset, adding another wrinkle to long-term planning. And major changes in the tax system have been proposed recently that would change all of the analysis.

Listen as Keri D. Brown, Partner at Baker Botts, explains evaluating, organizing or re-organizing a closely held entity for tax efficient administration and transmission of assets, avoiding tax traps, and the impact of recent court cases and tax reform on these entities.