The U.S. Treasury department is proposing to close a tax loophole that certain types of taxpayers have used for years to understate the value of their assets in order to reduce the size of their estates for gift and estate tax purposes. Closing this loophole would prevent them from continuing to do this and force them to pay their fair share of gift and estate taxes on their assets.

Loophole for the Wealthy

Gift and estate taxes are levied on assets that are distributed either during the lifetime of the donor or at their death. There is currently a $5.45 million exemption for estate taxes, which is double the amount for married taxpayers. Donors can also transfer several thousand dollars’ worth of cash or assets each year to another person besides their spouse without owing gift tax. Middle class Americans therefore don’t typically need to worry about incurring these taxes, but they can be substantial considerations for wealthy taxpayers. (For more, see: Estate Planning Tips for Financial Advisors.)

Mark Mazur, Treasury's assistant secretary for tax policy stated in a blog post that, “It is common for wealthy taxpayers and their advisors to use certain aggressive tax planning tactics to artificially lower the taxable value of their transferred assets. By taking advantage of these tactics, certain taxpayers or their estates owning closely held businesses or other entities can end up paying less than they should in estate or gift taxes.” Mazur also said that the Treasury’s closure of this loophole would prevent taxpayers from using these tactics in the future solely for the purpose of reducing their taxable estates. Of the exemption amounts for these taxes, he stated, “These generous exemption amounts mean that fewer than 10,000 of the largest estates are subject to any transfer tax at all in a year.”

The loophole closure measure will focus chiefly on the transfer of ownership of closely-held businesses, such as corporations or partnerships between family members. Under the current rules, restrictions that are placed upon the ownership of shares of the business, such as voting rights, the ability to sell shares or a lack of control over the business allow family shareholders to take a minority interest discount on the value of their shares for gift and estate tax purposes. The Treasury Department’s proposal centers on the repeal of this rule so that family shareholders can no longer take this discount. (For more, see: Estate Planning Questions to Ask Clients Annually.)

Rose Watson, director of advanced planning at Commonwealth Financial Network, told ThinkAdvisor that the Treasury Department’s proposal may also impact the lapse of a sale or voting right of shares in the business. “Provisions in agreements that result in the lapse of a liquidation on death. Previously those have been disregarded as an exception to the valuation rules and those would now be valued.”

Taxpayers who own shares of closely-held businesses that are transferred between family members would be wise to review their operating agreements and procedures with their tax and financial advisors. Watson also commented on the need for this. “A secondary action would be to consider whether they want to accelerate intra family transfers to be able to take advantage of the current regulations before [the new regulations] become final.”

The Bottom Line

The estate tax has declined substantially since 2001, when the exemption amount was only $1 million. While the closure of this loophole will increase estate and gift taxes for certain wealthy owners and shareholders in closely held businesses, it will not affect the general public. The will be a hearing on the proposal December 1 and a 90-day period for comments. The new regulations will not go into effect until after the comment period is over and then 30 days after the final set of rules has been crafted. (For more, see: Tips for Family Wealth Transfers.)

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