IRS Notes that Students May Be Foregoing Tax Benefits by Mistake

Last year the IRS published a Fact Sheet explaining that the complex interaction of scholarships and Pell Grants with the American Opportunity Tax Credit (AOTC) may be causing students to miss out on refundable tax credits.  The AOTC is available for qualified tuition, fees, and course materials (qualified expenses or QE’s) of the first four years of higher education.  The AOTC is equal to 100% of the first $2,000 of QE’s paid plus 25% of the next $2,000 of QE’s, for a total maximum credit of $2,500.  The main point to note is that 40% of the AOTC ($1,000 maximum) is a refundable credit, meaning that the IRS will pay you this portion of the credit even if you have no income tax to offset the credit against.

The Pell grant permits a student to choose whether to allocate the grant to QE’s or to living expenses when filing an income tax return.  Many scholarships also permit this flexibility.  But if the terms of the scholarship restrict it to the payment of QE’s only, then an allocation cannot be made.  Making the proper choice is key to unlocking hundreds of dollars in refunds that might otherwise go unclaimed.

·        If the grant or scholarship is allocated to QE’s, it makes the financial assistance nontaxable, but it also reduces the amount of eligible college expenses available for the AOTC.

·        Allocating the grant or scholarship to living expenses such as room and board causes the financial assistance to become taxable income, but it no longer reduces the amount of QE’s necessary for the AOTC.  The student can make this allocation on his or her tax return even if the educational institution applies the funds against tuition and fees.  Most students are low income taxpayers, and causing some of the grant or scholarship to become taxable often will not increase the student’s income tax.  If tax is increased, the higher AOTC most often will more than cover the increased tax.

Who should consider this strategy?  If the total amount of your QE’s minus your grant and scholarship is less than $4,000; then you will not generate the maximum AOTC without allocating a portion (it is not an all or nothing allocation choice) to taxable living expenses.  On the other hand, if QE’s exceed total grants and scholarships by $4,000 or more, you will generate the maximum AOTC without the need to allocate a portion of the grant and scholarship to taxable living expenses.

Each person’s situation is unique and this strategy should be carefully considered to determine whether it is beneficial.

A Few Reminders Regarding the Tangible Property Regulations

Two years ago, taxpayers and preparers had to deal with the implementation of the Treasury Department’s final regulations regarding deducting repairs, capitalizing improvements, and depreciating and disposing of tangible property.  The regulations were and remain complex and in many instances, go contrary to the natural inclinations of accountants.  Some of the pro-taxpayer provisions of the regulations require an annual election and should be considered each year for tax planning purposes.  Here is a checklist of some of these provisions:

1.      De Minimis Safe Harbor.  This annual election statement must be made in a statement attached to a timely filed (including extensions) income tax return.  The election enables a taxpayer to deduct the purchase of any unit of property costing $2,500 or less pursuant to the taxpayer’s accounting policy.  The accounting policy should be in writing (although not technically required at the $2,500 level) by the start of the tax year.  For the election to be effective, purchases covered by the policy must also be expensed in the financial accounting records and statements (book conformity).

a.      The policy doesn’t need to be set as high as $2,500, it just can’t exceed this amount and remain in the “safe harbor.”  Because of the impact on book income, some businesses choose to set the policy at a lower amount, such as $1,000 for example.

b.     For taxpayers having an “applicable financial statement (AFS),” the threshold is $5,000.  The accounting policy for an AFS must be written.  An AFS is a financial statement that is provided to the SEC, or has been audited by an independent CPA, or is otherwise required to be provided to the government (excluding tax returns).

2.      Partial Asset Disposition.  This annual election must be made in a timely filed (including extensions) income tax return.  The election enables a taxpayer to deduct the adjusted tax basis (net tax book value) on the disposition of a portion of an asset.  The election is not made with a statement, rather it is made by deducting the adjusted basis.  In addition, the replacement asset must be classified in the same depreciable asset class as the disposed portion of the underlying asset.  Examples of partial dispositions for a building include replacing a roof and removing old tenant improvements to accommodate a new tenant.

a.      When it is impractical to determine the cost of the disposed portion of an asset, a reasonable method may be used to estimate the cost.  The regulations give three examples of reasonable methods:

                                                              i.      If the replacement asset is part of an overall “restoration” (and isn’t a “betterment” or an “adaptation”) of the underlying asset, the cost of the partial disposition may be estimated by deflating the cost of the replacement asset by the producer price index back to the year the disposed portion of the asset was originally placed in service.

                                                            ii.      The cost of the partial disposition may be estimated by prorating the cost of the underlying asset by dividing the cost of the replacement asset by the total estimated replacement cost of the entire underlying asset.

                                                          iii.      The cost of the partial disposition may be estimated by means of a cost segregation study.

3.      Capitalize and Depreciate Repairs and Maintenance Costs.  This annual election statement must be made in a timely filed (including extensions) income tax return.  This election appears to be applicable only to “trade or business” assets and not to property held for the production of income (e.g. real estate rental).  A taxpayer might consider this election if they have expiring tax loss carryovers or if the taxpayer does not want to deal with potential IRS audits over the subjective nature of whether an expenditure qualifies as a deductible repair or should be capitalized as an improvement.  A “book conformity” rule requires the costs be capitalized in the taxpayer’s financial books and records.  This requirement can be problematic for taxpayers using generally accepted accounting principles which require expensing of repairs.

4.      Routine Maintenance Safe Harbor.  Although not an election statement to be included with the tax return, a taxpayer should create a written maintenance plan for each significant asset acquired during the year.  If the plan indicates that the taxpayer reasonably expects to perform repairs and maintenance more than once during the asset’s depreciable life (as determined under the alternate depreciation system), then the IRS should accept the deduction of routine maintenance and repair expenses.  For real property, the time frame for conducting repairs and maintenance more than once in the written maintenance plan is 10 years.  The election to capitalize and depreciate repairs and maintenance costs will override the routine maintenance safe harbor.

5.      Small Taxpayer Safe Harbor for Real Estate.  This annual election statement must be made in a timely filed (including extensions) income tax return.  The election permits qualifying small taxpayers to deduct repairs, maintenance, and improvements without having to separately analyze the eight different building systems for purposes of deciding whether an expenditure must be capitalized or deducted.

a.      A small taxpayer has average annual gross receipts of $10 million or less for the three preceding tax years and

b.     Total repairs, maintenance, and improvement costs do not exceed the lesser of $10,000 or 2% of the unadjusted cost of the building.

                                                              i.      This limit applies to each building separately.

                                                            ii.      The building’s cost must be $1 million or less.  If the taxpayer leases the building, then the total undiscounted lease payments for the entire term of the lease, including renewals, are summed for this purpose.

                                                          iii.      Counted against the $10,000/2% limit are costs expensed under the de minimis safe harbor and the routine maintenance safe harbor.

                                                          iv.      If costs exceed the $10,000/2% threshold for a building, then the election is unavailable and regular rules apply to all the building’s repairs, maintenance, or improvements.

6.      Capitalize and Depreciate Rotable Spare Parts.  The taxpayer may elect in a timely filed (including extensions) income tax return to treat any rotable, temporary, and standby emergency spare parts acquired during the year as depreciable property rather than treating the parts as materials and supplies (M&S).  If spare parts are treated as M&S, their cost generally cannot be deducted until disposition.  The election is made on an asset-by-asset basis and once made, may not be revoked without IRS permission.  The election is made by depreciating the spare parts, there is no election statement.

R&D Tax Credit Changes to 2016 Tax Returns May Benefit Small Businesses

The tax code provides a research and development (R&D) tax credit to spur invention and innovation in the United States.  However, the structure of the R&D credit rendered it useless to many small businesses that did not have regular income tax liability.  New tax law enacted at the end of 2015 made three significant changes to the R&D credit allowing the credit to benefit many more small businesses.

1.      The R&D tax credit was made a permanent feature of the tax code (no more waiting for Congress to extend the credit every one to two years), being retroactively extended to qualifying research expenses paid or incurred after 2014.

2.      For tax years beginning after 2015, eligible small businesses (ESBs) having $50 million or less in gross receipts may claim the R&D credit against their alternative minimum tax (AMT) liability (previously the credit could not reduce AMT).

a.      An ESB is defined as a sole proprietorship, partnership (including an LLC), or non-publicly traded corporation having average annual gross receipts for the three prior tax years of $50 million or less.

                                                              i.      Partners (including LLC members) and S corporation shareholders must also separately meet the gross receipts test since the credit is claimed against their individual income tax liability.

b.     It appears that an unused ESB 2016 R&D tax credit may be carried back one taxable year and be claimed against 2015 AMT for a refund.

3.      For tax years beginning after 2015, qualified small (start-up) businesses (QSB) having less than $5 million of gross receipts for the current year may elect (by the due date of the tax return including extensions) to claim up to $250,000 per year of the R&D credit against their employer FICA tax liability.  The election is made by completing new Section D on revised Form 6765 (Credit for Increasing Research Activities).  New Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) will be filed with a revised Form 941 (Employers Federal Quarterly Tax Return) to claim the elected R&D credit against the employer’s FICA tax liability on line 11 of revised Form 941.

a.      A QSB is defined as a sole proprietorship, partnership (including an LLC), or a corporation having gross receipts for the tax year of the election of less than $5 million

b.     A QSB must not have had any gross receipts for any tax year preceding the five-taxable-year period ending with the current tax year.

                                                              i.      For the 2016 tax year, any gross receipts in 2011 or earlier disqualifies the business.

c.      The election may only be claimed for five taxable years.

d.     The credit can only offset the employer’s FICA tax liability for the first calendar quarter beginning after the date on which the QSB files its income tax return claiming the R&D credit and making the election.

                                                              i.      For example, if a C corporation files its 2016 calendar year income tax return on April 15, 2017, the earliest payroll tax savings will be for the third calendar quarter payroll tax return beginning July 1, 2017 and ending September 30, 2017.  If the tax return is filed by March 15, 2017, then the credit be claimed against the second quarter payroll tax return.

e.      If the elected credit exceeds the quarter’s employer FICA liability, the excess credit carries over to the next quarterly payroll tax return.

f.       Special rules apply to determine who makes the election and for determining gross receipts of controlled groups of businesses.

New Legislation Overrides Draconian IRS Penalties on Small Employers that Reimburse or Pay for Employee Health Insurance Premiums

On December 13, 2016, Pres. Obama signed into law the “21^st Century Cares Act.”  Part of that legislation allows small employers to provide qualified health reimbursement arrangements (HRAs) for employees.  When the Affordable Care Act (ACA) was enacted, the long-time practice of allowing employers to pay for a limited amount of employee medical expenses, including health insurance premiums, on a tax-free basis was rendered non-compliant.  The ACA required these HRAs to be integrated with a group health insurance plan meeting the ACA mandate, such as no annual limit on the amount of benefits provided.  Large employers, meaning those with 50 or more full-time equivalent employees, are required by the ACA to offer minimum essential and affordable group health insurance to their full-time employees.  Small employers are not required to offer group health insurance, but many want to provide some financial assistance to their employees who want to select their own individual health insurance plans.  The financial assistance was provided under so-called “stand alone” HRAs which the ACA rendered non-compliant.  Small businesses that continued these stand-alone HRAs were threatened by the IRS with $100 per day per employee penalties ($36,500 a year per employee) under IRS Notice 2015-17.  Under the Notice, such small businesses had to stop the practice by June 30, 2015 (with a special rule for one-employee S corporations).  Thus, even though small employers aren’t subject to the mandate to offer group health insurance, they could be put out of business by the government for offering to help pay for the individual health insurance plans of their employees!  The penalty was a way of strong-arming small employers to enroll employees in the government run Small Business Health Options Program (SHOP) marketplace exchange.

This government nonsense is finally dealt with by the 21^st Century Cares Act which is applicable to HRA plan years beginning after 2016.  To avoid the $100 per day per employee penalty after 2016, small employers must now render any financial assistance through a qualified small employer HRA which meets these requirements:

1.      The employer must have less than 50 full-time equivalent employees.

2.      The employer must not offer group health insurance to any employee.

3.      All eligible employees must receive the same terms under the HRA, although variances based upon age or the number of family members is permitted (much like the pricing of a health insurance policy).  Excluded employees are those who haven’t completed 90 days of service, who haven’t attained age 25, who are part-time or seasonal workers, or who are part of a union.

4.      Only employer funds may be used to fund the HRA and no employee salary reduction contributions are permitted.

5.      The HRA either pays or reimburses the employee’s eligible medical expenses, and if health insurance premiums are paid or reimbursed, the employee must first submit proof of insurance coverage.  If the HRA permits, employee family member expenses can also be reimbursed.

6.      The maximum HRA benefit is limited to $4,950 for self-only plans, or to $10,000 for HRAs that also provide reimbursement for family members of the employee.  These amounts are adjusted for inflation after 2016.  If an employee isn’t covered for the full year, then these amounts must be prorated by the number of months covered.

7.      The amount of the benefit must be reported as information on the employee’s W-2.  Under a new provision, if the employee does not have minimum essential health insurance for the month in which the medical care is provided, then the HRA reimbursement is taxable compensation and is not tax-free.

8.      A written notice must be given to employees not later than 90 days before the beginning of the HRA plan year or else there is a $50 per employee per failure penalty (not to exceed a maximum $2,500 for a calendar year).  For the first HRA year beginning in 2017, the notice isn’t treated as late if given no later than 90 days after enactment, which is March 13, 2017.  The notice must state the amount of the employee’s permitted benefit, that the employee must inform any health insurance exchange to which the employee applies for advance payment of the premium assistance tax credit of the amount of HRA benefit, and that the employee may be subject to penalty if he or she does not comply with the mandate to purchase minimum essential health insurance coverage.
UPDATE:  IRS Notice 2017-20 suspends the March 13th notification date for 2017 plans until 90 days after further guidance has been issued by the IRS.

The new law removes the penalty for HRA plan years beginning before 2017 for any small employer that failed to stop providing the old style HRA as of June 30, 2015.  It appears that the penalty will apply after 2016 if small employers don’t follow the new qualified HRA rules.

A change is also made for purposes of the premium assistance tax credit for employees purchasing health insurance on an exchange when they also participate in a qualified HRA.  The premium assistance credit is reduced by the amount of HRA benefit.  This provision prevents double dipping where the employee receives both a government subsidy and an employer subsidy for purchasing health insurance on the government exchange.

Interesting 2016 Tax Return Due Dates

While we wait for our elected national leaders to do something responsible with our tax laws, let's look ahead to some interesting 2016 tax return due dates.

·        The tax filing season will officially begin on January 23, 2017.  That is when the IRS will officially begin accepting electronic and paper tax returns.

·        A new tax law requires the IRS to hold tax refunds arising from the earned income tax credit or from the additional child tax credit until at least February 15, 2017, in an attempt to cut down on tax fraud.  Practically, the tax refunds will not be available until the week of February 27th.

·        The April 15, 2017 due date falls on Saturday this year.  Normally, the due date would be the Monday following, but that Monday is a Federal holiday for the District of Columbia (Emancipation Day) so the actual due date is Tuesday, April 18, 2017 for filing 2016 federal individual, trust, and C corporation income tax returns.  The various states will have their own due dates.  Utah’s due date will follow the federal due date.  The April 18th due date is also effective for filing Form 4868 for an automatic six-month extension.  The extended due date is October 16, 2017, because October 15th falls on Sunday.

·        As noted above, the C corporation 2016 tax return due date has been changed to April 18, 2017 from the normal March 15, 2017 due date.  However, the six-month extension period has been shortened to five months, leaving the normal extended due date at September 15, 2017.  UPDATE:  For 2016 C corporation tax returns, the IRS has used its regulatory authority to grant a 6-month filing extension period despite the statute's 5-month limit.  S corporation tax returns are still due March 15, 2017 and the S corporation extension period remains six months.

·        A very important change affects 2016 partnership tax returns.  The due date is now March 15, 2017 instead of April 18, 2017.  In addition, the normal five-month extension period has been lengthened to six months.  But with the shortened original due date, the extended partnership due date remains September 15, 2017.  The Utah 2016 partnership tax return due date stays on April 18, 2017 under HB39.

·        Another change affects the federal trust tax return extension period.  The extension period for 2016 trust income tax returns is lengthened to five and a half months from five months, making the extended due date October 2, 2017 (since September 30^th falls on a Saturday) instead of September 15, 2017.

·        Still another very important change affects the Foreign Bank Account Report (FBAR, FinCen 114) 2016 due date.  The FBAR is now due at the same time the individual income tax return is due.  In a news release dated December 16, 2016, FINCEN announced that the 2016 FBAR is due April 18, 2017 instead of June 30th.  In addition, unlike past years, the FBAR may now be extended to the individual income tax return extended due date.  In the announcement, FINCEN stated that automatic extensions to October 15th would be granted for those failing to meet the April deadline without the filing of any forms or extension requests.  The announcement indicated that the extended due date is October 15, 2017.  Since the FBAR due date is tracking the individual income tax return due date, it is possible that the automatic extended due date will actually be October 16, 2017, and indeed the IRS confirms the October 16th extension date on its website.

·        Forms 1099 and W-2 have typically been due to payees by January 31^st and remain so for the 2016 forms.  However, the due date for submitting the forms to the government has changed to January 31, 2017 from the normal due date of February 28^th (for paper-filed forms) or March 31^st (for electronically-filed forms).

Planning for Possible Tax Law Changes After 2016

Pres.-Elect Trump has stated that a major tax bill lowering taxes is one of his top three priorities.  In addition, House Republicans have readied major tax reform proposals.  It seems clear that changes will happen as soon as 2017.  Although we don’t know the specific details of what will be enacted, we do know many of the proposals, and taxpayers should act in the remaining days of 2016 to garner tax savings.  Some of the more significant possible changes, and relevant ways to reduce your taxes, are listed below.  The planning ideas below are general in nature.  Your specific tax situation might call for different action.  Actual tax changes may differ from proposals.  You should work with your tax preparer to project your 2016 and 2017 income taxes so that the proper actions for your circumstances can be taken.

1.      Reduction of the top ordinary individual income rate to 33.0% from 39.6% (long-term capital gain and qualified dividend rates are proposed to remain the same).

a.      Defer income to 2017 when it will be taxed less at the lower rate.

                                                              i.      Defer a December bonus to January.

                                                            ii.      Exercise non-qualified stock options after 2016.

                                                          iii.      Cash basis businesses whose profits are taxed in your personal tax return can delay billings until late December so that collections are received in January.

                                                          iv.      Those attaining age 70 ½ in 2016 can defer their first required minimum distribution from IRAs or other retirement accounts until as late as April 1, 2017, although that means two RMDs will be received in 2017.

                                                            v.      Defer taxable Roth IRA conversions to 2017.

b.     Accelerate deductions to 2016 when more taxes will be saved at the higher rate.

                                                              i.      See discussion below for ideas on prepaying itemized deductions.

                                                            ii.      See discussion below for business deduction strategies.

c.      Note that because of the differences in rate bracket amounts between current law and proposed law, those in certain lower brackets of taxable income may experience a tax rate increase from 2016 to 2017.

2.      Repeal of the Affordable Care Act (Obamacare) net investment income tax (NIIT) of 3.8%.

a.      Defer the recognition of 2016 investment gains until 2017.

b.     Harvest capital losses to offset any recognized 2016 capital gains.

                                                              i.      Be careful to avoid the wash-sale rule when reinvesting proceeds.

c.      Defer cashing in U.S. savings bonds.

3.      Increase in the standard deduction to $30,000 for joint filers and $15,000 for singles, up from $12,600 and $6,300 respectively.

a.      If your total itemized deductions are not much more than the new limits, prepay some of your 2017 itemized deductions in 2016 to avoid losing tax benefits.

                                                              i.      Prepay several years of charitable contributions.  Establish a donor-advised fund to receive your donation if you are not prepared to give the funds to specific charities now.  Donating long-term appreciated capital assets doubles the tax benefits by eliminating the tax on the unrealized gain.

                                                            ii.      Prepay any 2016 state income taxes that would be due with your tax return in April 2017 (assuming you are not subject to the AMT).

4.      Cap the total amount of itemized deductions to $200,000 (joint)/$100,000 (single).

a.      If your total itemized deductions exceed these limits, prepay your 2017 itemized deductions in 2016 as discussed above.

b.     Furthermore, if you have considered making a substantial charitable contribution sometime in the near future, 2016 may be the year to do so to avoid losing the tax deduction if the cap is indeed imposed on charitable donations.

5.      Repeal of the alternative minimum tax (AMT).

a.      Defer to 2017 items that typically cause AMT.

                                                              i.      Payment of state and local tax.

                                                            ii.      Exercise of incentive stock options (ISO).

b.     If you are subject to the AMT and the AMT exemption has been fully phased-out, your marginal tax rate on ordinary income would increase from 28% in 2016 to 33% in 2017.

                                                              i.      Accelerating 2017 non-investment income (because of the NIIT) into 2016 will save tax.  Examples are exercising a non-qualified stock option or making a Roth IRA conversion.

c.      If you are subject to the AMT and the AMT exemption is in the process of being phased-out, your marginal tax rate on ordinary income would decrease from 35% to 33%.

                                                              i.      Prepaying charitable deductions or other deductions permitted under the AMT would save taxes at a slightly higher rate within the AMT exemption phase-out range of income.

6.      Repeal of the 40% tax on estates over $5.45 million (per individual).  Imposition of a capital gain tax at death for estates valued over $10 million (it is unclear whether this limit is per individual or per married couple, and whether it is an actual tax at death or if it is simply the loss of tax basis step-up to the value at death).

a.      This proposal is a difficult area to plan for because a person’s life expectancy will most likely extend beyond the president-elect’s term in office, and a future administration/Congress could reenact the estate tax.

b.     It is also difficult to plan for because we don’t know whether the current rules allowing a step-up in tax basis to fair market value at death will be continued.

c.      Taxpayers currently planning to make gifts to beat the effective date of proposed regulations that substantially eliminate valuation discounts are in a tough position, as the regulations may not be finalized.

d.     It seems that a “wait and see” approach may be best before undertaking irrevocable planning strategies before we know what the rules will be.  You should discuss your individual circumstances with your estate planner to decide upon the most prudent course of action (or non-action).

7.      Reduction of the C corporation top tax rate from 35% to 15% (Trump) or 20% (House)

a.      Deferring taxable income to 2017 will result in permanent tax savings.

b.     Accelerating deductions to 2016 will likewise result in tax savings.

                                                              i.      Electing to expense certain asset acquisitions placed in service in 2016 under Section 179 may be advisable.

                                                            ii.      Review the purchase of low-cost assets to be sure they are expensed under your capitalization policy rather than recorded as depreciable assets.

                                                          iii.      Consider whether the “partial disposition” rules might apply to a significant improvement made during the year, such as the replacement of a roof.

Proposed Tax Regulations to End or Restrict Valuation Discounts for Family Gifts

UPDATE:  On October 2, 2017, the Treasury Department informed Pres. Trump that, as part of its review to eliminate burdensome tax regulations, the proposed regulations discussed below will be withdrawn in their entirety.  It is expected that the withdrawal will occur in 60 days by publication in the Federal Register.
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On August 4, 2016, the Treasury Department issued long anticipated “proposed” tax regulations restricting the use of valuation discounts for gifts to family members.  The effective date is expected to be sometime in 2017 when final regulations are issued.  A public hearing on the proposed regulations is scheduled for December 1, 2016.  Already legislation has been proposed in Congress to nullify these controversial regulations.  However, it was Congress that gave Treasury the power to write these regulations in the first place.  When Code Section 2704 was enacted back in 1990, it was intended to eliminate the ability of taxpayers to use artificial means to depress the value of ownership interests in corporations or partnerships gifted to family members when the family retained control of the entity (and therefore the full economic value of the entity).  Congress left the details of how to implement the statute to the Treasury Department.

Valuation discounts are an important part of gift and estate tax reduction strategies.  Valuation discounts are allowed both for minority interests (lack of control) and for lack of marketability.  Over the years, creative advisors and friendly state legislatures have devised strategies and enacted local laws that have allowed taxpayers to get around the intent and reach of Section 2704.  Many court cases have sustained these strategies.  Taxpayers have for many years enjoyed making gifts at values discounted to true fair market value.  After years of trying to get Congress to amend the law to prevent avoidance of Section 2704, the IRS has taken matters into its own hands.  The pendulum now swings back in favor of the government because these regulations make the valuation for gift tax purposes greater than the true fair market value of the gifted interest.  Experts have said that gifts made within a family unit will be valued at a higher gift tax value than what the value of the interest would be if it were sold to an unrelated third party!  The regulations also have application to the estate tax value of retained interests held at death.

The regulations are quite complex and will have unintended consequences.  They are also not fully understood.  Some assumptions and commentary made by leading experts and practitioners may, in the end, not be totally consistent with the intent of the regulations.  Without getting into the technical weeds, some of the highlights include:

·         A transfer (gift) of a minority interest to a family member, where family members remain in control of the business on an aggregate ownership basis, will not qualify for valuation discounts.

o   Control is defined as ownership of at least 50% of capital or profits interests, or any equity interest that can cause the entity to liquidate in whole or in part, or any general partnership interest.

o   Family members, for this purpose, are broadly defined to include the individual's spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister of the individual, and any spouse of the foregoing.  This definition does not include nieces and nephews.

·         A new 3-year lookback period is proposed to prevent minority discounts created by transfers made before death.  For example, if father owned 55% of his business entity and made a gift of 6% to his children, his remaining 49% ownership would qualify for a lack of control minority valuation discount at his death.  But if the gift of the 6% occurred within the 3-year period ending on his date of death, his 49% ownership would be valued as if he still owned 55% (meaning no minority interest discount for the 49% he retained).

·         The introduction of “disregarded restrictions” where control remains within the family after the transfer that expand beyond the existing so-called “applicable restrictions” that have been ignored by taxpayers.  Restrictions targeted by these rules include those that:  1) limit the owner’s ability to liquidate his/her ownership interest for cash or property, 2) delay the timing of the liquidation payment for more than six months, 3) allow the liquidation payment to be anything other than cash or property, and 4) limit the liquidation price to an amount below minimum value.  These restrictions will be ignored for purposes of valuing the property that was transferred because they can “lapse” or be removed after the transfer by family members still in control of the entity.

o   Minimum value is defined as the fair market value of assets reduced by liabilities of the entity.

·         An exception to the elimination of the minority interest discount applies if, immediately before the transfer, a nonfamily member owns at least 10% of the entity and the sum of all nonfamily interests total at least 20%, the nonfamily member can redeem its interest for cash or assets with notice of no longer than 6 months, and the nonfamily members have owned their interests for at least 3 years.

·         An exception to the elimination of the minority interest discount also applies if each owner has an enforceable right to liquidate his/her ownership interest within 6 months either in cash or property at minimum value.

What should taxpayers do now?  If you are contemplating making gifts and engaging in estate tax planning strategies, you should do so soon, before publication of the final regulations which is expected sometime in 2017.  But, a gift made to a family member before the effective date to create a minority interest for the decedent will not be effective to create an estate valuation discount if the gift was made within 3 years of death and death occurs after the effective date.  The gift would have received the traditional discounts because it was made before the effective date, but the estate value of the retained interest would not be discounted because death occurred after the effective date and within three years of the gift.

Gifting and estate freezing strategies will still be very effective in reducing estate tax even after publication of the final regulations.  The final regulations will reduce part of the financial benefit of such strategies, but it is the post-gift appreciation outside of the taxpayer’s estate that brings the most financial benefit, and this benefit remains.  For smaller estates that will not incur estate tax, these valuation regulations may represent good news in that the value of retained business interests at death will have a higher value permitting a higher income tax basis under the so-called “step-up in basis” rules.  However, some commentators believe that a higher tax basis step-up because of these regulations is not assured.