What A Week

It was quite a week, wasn’t it?


Senator Manchin continued to attract a lot of attention.

To the dismay of his fellow Democrats, the West Virginian – who also chairs the Senate Energy and Natural Resources Committee – challenged the wisdom of a “carbon tax” (which may harm his state’s coal industry), and unequivocally stated that natural gas (a fossil fuel) must be part of President Biden’s clean energy initiative.[i]

However, in what may be described as a response to the Senator’s stated budget cap of $1.5 trillion, the White House floated the idea of a 2022 budget with approximately $2 trillion in spending.[i] In furtherance of this proposal, the Administration and Congressional Democrats are now considering how to scale back their originally proposed $3.5 trillion budget while preserving many of the key components of the President’s Build Back Better plan.[ii]

Beyond the Federal Debt

In another positive development, the Senate, with the cooperation of several Republicans, overcame that Chamber’s cloture rule[iii] and approved an agreement to temporarily increase the federal debt ceiling (into December).[iv] The House will vote on the increased debt ceiling bill in the coming days.

Following the expected passage of the bill, the Democrats will certainly refocus their efforts on the Administration’s budget proposal; in fact, Senator Schumer stated that he hopes to reach a deal on the spending provisions of the bill by the end of October[v] – no easy task considering the not insignificant divisions between the Party’s moderate and so-called “progressive” members.


Among the issues dividing these two “factions” of Democrats is the $10,000 SALT deduction cap, enacted in 2017.[vi] The cap is slated to disappear after 2025, but many Democrats in Congress (from states with high taxes) would like to accelerate its departure.

Last week, the Second Circuit signaled to Congress and taxpayers not to expect any assistance from the judiciary on this issue when it rejected an argument made by New York, New Jersey, and Connecticut that the SALT cap violated the Tenth and Sixteenth Amendments of the Constitution.[vii]

Around the World

The week ended with a disappointing jobs report for September, as the U.S. economy added fewer jobs than expected, though on the same day the OECD announced that almost all its members had agreed to apply a minimum corporate income tax rate of 15 percent on multinational enterprises beginning in 2023.[viii]

For those who did not find enough excitement in the foregoing developments,[ix] I hope the disclosure of the Pandora Papers was somewhat entertaining.[x]

The Mid-Terms

Running throughout the foregoing? The 2022 mid-term elections (just over one year from now) and the very real possibility the Democrats will lose their very slight Congressional majority.[xi]

A Race Against Time

With so many developments of which to keep abreast,[xii] who has time to do any work? Just kidding.[xiii]

As indicated in the last few posts on this blog,[xiv] many taxpayers, and especially the owners of closely held businesses, are now racing against the clock to complete the sale of their businesses or to make gift transfers of interests in such businesses;[xv] in some cases, they are doing both.

These taxpayers and their advisers recognize that the bill approved by the House Ways and Means Committee[xvi] would increase the income tax rate for long-term capital gains recognized by individuals after September 13, 2021.

They are also aware that the bill’s limitations on the use of grantor trusts[xvii] are proposed to be effective (1) for trusts created on or after the date of enactment, and (2) in the case of a trust that was established before the date of enactment, for the portion thereof which is attributable to a contribution made on or after such date.

However, many of these taxpayers are hoping that the longer it takes Congress to pass a budget, including the related revenue raisers (the tax legislation), the greater the odds that the effective date for the increase in the capital gains tax rate, and for the changes in the grantor trust rules, will be deferred to the beginning of 2022.[xviii] If that were the case, these changes would coincide with the proposed reduction of the unified gift and estate tax exemption amount which, under the Committee’s bill, is to be effective for transfers made on or after January 1, 2022.

Impact on Valuation

Query whether Congress will see the logic of this approach toward the effective dates with respect to the above-referenced changes to the Code, notwithstanding how late in the year the legislation is ultimately enacted.

Even then, however, an individual taxpayer who makes gifts of equity in a closely held business before the end of this calendar year (to use their remaining exemption amount before it disappears) while also trying to sell such business (or an interest therein) during the same two-and-one-half-month period (to take advantage of what they hope will be the continued application of the lower capital gains tax rate) may face some serious challenges.[xix]

Specifically, the proximity of the two transfers – the gift presumably for the benefit of a family member (whether outright or in trust), the sale presumably to an unrelated person – may, depending upon the sales price, cause the IRS to question the valuation of the equity transfer for purposes of the gift tax.

Valuation, Generally

The value of an equity interest in a closely held business is the price at which such equity would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.[xx]

Among the factors considered is whether the stock transferred represents a majority or minority interest and, if the latter, does it have potential as a swing vote?

The valuation of a minority interest in an operating business would normally include a discount from the interest’s pro rata share of the business’s going concern value in recognition of the interest’s inability to influence decisions, including distributions, sales, and liquidation.

A business owner would normally try to leverage such valuation discounts to reduce the value per share of stock, and thereby to maximize the amount of equity gifted, while not exceeding their remaining gift tax exemption amount.

The valuation is keyed to the date on which the gift transfer is completed.[xxi] In general, events occurring after the valuation date should not be considered in determining fair market value as of such date.

Post-Transfer Date Events

That said, a post-transfer event should be accounted for valuation purposes if it is relevant to the question of value and was reasonably foreseeable as of the valuation date.

However, when is an event “reasonably foreseeable”?

It seems logical that a prospective seller would inform a prospective buyer of all favorable facts to obtain the best possible price, and a prospective buyer would elicit all the negative information from a seller to obtain the lowest possible price. In the arm’s length negotiation between the two parties, all the relevant factors available to either party, or known to both, provide a basis on which the buyer and seller will decide to buy or sell, and come to an agreement on the price. This would include current information concerning transactions that may occur after the valuation date.

In other words, the “reasonable knowledge of relevant facts” to which the valuation regulations refer should include those “future facts” that were knowable on the valuation date.

Fourth Quarter

Under the facts and circumstances of October 2021, many individual business owners are making gifts of interests in their business while also trying to the sell their business, or an interest therein.

If the sale occurs soon after the gift – indeed, it is the taxpayer’s goal (or so we are assuming) to complete the sale on or before December 31, 2021 – it is very likely the sale was reasonably foreseeable.

Thus, the purchase price for the business, and how it is paid to the seller,[xxii] will have to be considered in determining the value of the gift made and may only be discounted if the taxpayer can demonstrate intervening events – very unlikely under the circumstances – to which the increased value at the time of sale were attributable.

Transfer Vehicles

If the business owner determines that the estate tax benefits of gifting interests in the business outweigh the economic benefits of retaining the interests, the taxpayer will have to consider which of the following commonly used transfer vehicles may be utilized to accomplish their goals: selling the business while also making gifts of interests in the business that utilize their remaining gift tax exemption amount but not trigger a gift tax liability.[xxiii]

N.B. Much of what follows is dependent upon the effective date for any amendments of the grantor trust rules that may be enacted as part of the 2022 budget.[xxiv]


There is a statutorily approved means of transferring property to one’s beneficiaries, while retaining an interest in the property and reducing the amount of the gift: the GRAT (or grantor retained annuity trust).[xxv]  GRATs allow the transfer of future appreciation in contributed property, generally without any estate or gift tax charged on the growth of that property.

The GRAT is an irrevocable trust to which a business owner may contribute interests in the business (ideally, which are expected to appreciate) in exchange for the right to receive an annuity (a fixed amount, typically based upon a percentage of the FMV of the business interests as of the date they were contributed to the trust) from the trust for a term of years.  At the end of the term, the business interests, or the proceeds from their sale, may pass to the owner-grantor’s family.[xxvi]

The term of the owner-grantor’s annuity interest should be such that they will survive the term; if the owner-grantor dies during such term, the retained annuity interest will cause at least part of the trust to be included in the owner’s gross estate for estate tax purposes.[xxvii]

For gift tax purposes, the retained annuity interest represents consideration for the contribution to the trust and, so, reduces the amount of the gift. Specifically, the amount of the gift is equal to the FMV of the business interest contributed to the GRAT by the owner over the actuarially determined present value of the owner’s retained annuity interest.[xxviii]

If the IRS were to successfully challenge the FMV of the business interest contributed to the GRAT, the GRAT automatically, and retroactively, “self-corrects” the required annuity amount by requiring the trust to pay the owner-grantor the difference between what they would have received had the correct valuation been used from inception and what they actually received, thereby reducing the amount of any taxable gift that would otherwise result.[xxix]

If properly structured, the amount of the gift can be minimized; in other words, the present value of the annuity may be nearly equal to the value of the business interest contributed to the trust. This allows the grantor’s exemption amount to remain largely intact and available for other gifting (including outright gifts, not in trust). In addition, with a short enough annuity term, the owner-grantor is more likely to survive the term of the annuity and, so, the trust property, and the appreciation thereon, are more likely to avoid being included in the owner’s estate.[xxx]  At the end of the annuity term, any property remaining in the trust (that has, hopefully, appreciated) passes to the family free of gift tax and estate tax.

These benefits are enhanced by the fact that the GRAT may be treated as a grantor trust during the term of the owner-grantor’s “retained” annuity interest for purposes of the income tax; thus, its income is taxable to the owner-grantor, allowing the trust to grow further while simultaneously reducing the owner’s gross estate.[xxxi]

Sale to Grantor Trust

Another option that should be considered is a sale of the business interest to a grantor trust.  To use this technique, an irrevocable trust must be created and funded by the business owner. The trust is structured as a grantor trust so that the owner-grantor/seller is treated as the owner of the trust for income tax purposes.

In general, the trust should receive a “seed” gift equal to at least 10 percent of the FMV of the business interest to be sold to the trust.  The still-enhanced gift tax exemption allows a greater seed gift to be made on a tax-free basis, which allows more property to be purchased by the trust.

The owner then sells business interests to the trust in exchange for a note[xxxii] with a face amount equal to the value of such interests, bearing interest at the applicable federal rate[xxxiii] and secured by the property acquired. The interest should be payable annually,[xxxiv] with a balloon payment at the end of the note term.

The sale to the grantor trust is not subject to capital gains tax (because the owner-grantor is dealing with themselves[xxxv]), and the issuance of the note prevents any gift tax (because there is adequate consideration).

However, if the IRS were to successfully challenge the adequacy of the consideration, the shortfall would be treated as a gift, which may or may not be protected by the grantor’s remaining exemption amount.

If successful, the value of the business interest sold to the trust (or the proceeds from its sale to a third party) is frozen in the grantor’s hands in the face amount of the note, and the remaining, excess value of the interest (hopefully appreciated) passes to the beneficiaries of the trust.

Price Adjustments

In the case of a sale to a trust (grantor trust or otherwise) of an intertest in a closely-held business, the IRS may challenge the transfer as a bargain sale; one in which the sales price is below the FMV of the property sold.

To address this possibility, taxpayers have sometimes included a valuation adjustment clause in the purchase and sale agreement. In general, the IRS has refused to recognize such clauses, claiming they violate public policy.

More recently, taxpayers have employed “formula clauses” that express the amount of the property being sold as a formula; for example, “that number of shares of Co. stock having a FMV of $X as determined for gift tax purposes.”  To the extent that the value of the shares sold, as finally determined, exceeds the stated purchase price, the “excess” shares have usually been directed to a spousal trust or to a charity (but not back to the seller).

However, the Tax Court has approved a defined value clause where the excess business interest was “returned” to the donor-taxpayer; the court held that what the taxpayer had transferred was units in a business having a specific dollar value, and not a specific number of units. Thus, the taxpayer was able to limit the size of the gift to their remaining exemption amount and, thereby, avoid a taxable gift.[xxxvi]

In the case of a grantor who has completely exhausted their gift tax exemption amount, but who still wants to transfer business interests to a child by way of a sale, the parent may want to consider a defined value clause to try to ensure that the amount sold to the child does not exceed the consideration received for the sale.

Alternatively, an owner-grantor who makes a gift of an interest in a business may pair that transfer with a sale to a grantor trust. If the defined value clause is triggered, the excess interest transferred may instead be treated as part of the sale with appropriate adjustments[xxxvii] being made.


So, what does this mean for the owner of a closely held business who may be planning for the sale of their business, but who may also be interested in making some gifts as part of their estate plan, all before the end of 2021?

For one thing, their timing sucks.

In part, this is attributable to the reluctance of many, if not most, business owners to give up any ownership until they are ready to consider a sale of the business. This is borne out by the number of times I have had owners, who have just executed a letter of intent for the sale of their business, ask me about transferring some of their interest in the business to a trust for the benefit of their families.

In part, their hand is being forced by Congress and the Administration – if their budget (including tax/revenue) proposals are enacted, the income tax rate for capital gains will be increased, the reach of the 3.8 percent surtax on net investment income will be extended, a new 3 percent surcharge and, at the same time, the gift tax exemption will be reduced by half while decades of precedent under the grantor trust rules will be overridden.

Talk about a perfect storm engineered by an evenly divided Senate and a barely cohesive (and certainly dysfunctional) majority in the House.[xxxviii]

Based on the foregoing, we start from the premise that the sale of the business was foreseeable at the time of the gift. Does that mean all hope of effective gift planning is lost? Not necessarily. But the business owner will have to act quickly – certainly before their interest in the business is converted from ownership in a business to the right to share in the proceeds from the sale of the business.[xxxix]

Sales take many forms. A buyer may only be interested in acquiring the assets of the business, but not the equity interests of the owners, a portion of which is the subject of the gift.

Even then, certain assets (for example, certain accounts receivable, a less significant line of business, or real estate) may not be acquired by the buyer and will be left behind in the business.

The proceeds from the sale, which may include the right to deferred payments (whether represented as earnouts, installment obligations, or something else), will also be held by the selling business. These proceeds may be reinvested in a new business, or they may be used – after the expiration of any non-compete period – to re-enter the industry in which the business previously operated.

If the buyer is a private equity group, the business may be required to contribute (rather than sell) a portion of its assets in exchange for a minority interest in the acquiring entity or in the acquiring entity’s parent[xl] on a tax-deferred basis, in which case the business will continue after the sale. In fact, the business may be expected to render certain services to the buyer after the sale.

The appraiser retained by the owner-grantor to value the interests gifted will be aware of these facts – including the subsequent sale – and will account for them in their valuation (which may include some discounting), thereby negating, to some extent, the IRS’s “Monday morning quarterbacking” advantage.

If the gift transfers are paired with a formula clause like the one described above, the business owner should be in a decent position to withstand an IRS exam of their gift tax return and to reduce any adverse economic consequences.

[i] Bernie Sanders and The Squad were not happy.

[ii] https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/.

[iii] Which requires 60 votes to end debate on a matter and move it to a vote.

The actual vote on the debt ceiling was strictly along party lines: 50 to 48.

[iv] Following which Senate Majority Leader Schumer excoriated the Republicans from the floor of the Chamber – let’s just say both Republicans and Democrats were embarrassed by his performance, and Senate Minority Leader Mitchell responded by informing Schumer not to expect similar cooperation when the temporary increase of the debt ceiling expires later in the year.

[v] November is more likely.

[vi] P.L. 115-97.

[vii] New York v. Yellen, 2d Cir., No. 19-3962, 10/5/21.

[viii] https://www.oecd.org/tax/beps/statement-on-a-two-pillar-solution-to-address-the-tax-challenges-arising-from-the-digitalisation-of-the-economy-october-2021.pdf . The organization’s members also agreed to revise their nexus rules, moving away from physical presence in a jurisdiction and looking to revenue from such jurisdiction as a basis for taxation.

Sounds familiar? It should. Think Wayfair.

I should note that Senator Minority Leader McConnell warned the Administration against trying to implement the OECD agreement without first obtaining the Senate’s approval in accordance with that Chamber’s Constitutional power to approve treaties.

[ix] What’s wrong with you? Honestly.

[x] I, for one, was disturbed by the number of world leaders, business leaders (including several Americans), and entertainers who use offshore companies and trusts established in jurisdictions with strong privacy laws to hide assets from creditors and to avoid taxes in their home jurisdictions.

Query how so many world “leaders” amass so much wealth. Why are entertainers (including athletes) compensated so handsomely?

Following the IRS’s well publicized efforts to uncover tax cheats through the enforcement of the FBAR, the enactment of FATCA in 2010, the disclosure of the Panama Papers just five years ago, and the worldwide push to raise taxes on the heels of the COVID pandemic, which challenged the ability of governments to care for their people, it smacks of hubris that these economically and politically powerful individuals would still undertake such measures.

Whether in literature or in life, it doesn’t end well for such folks.

[xi] Did you hear that 88-year-old Senator Grassley (Iowa) accepted former President Trump’s endorsement? The Senator is running for an 8th term. He has already served 42 years in the Senate. Assuming he wins – a likely outcome – and assuming he survives his 6-year term – the odds can’t be good (though the life expectancy of an 88-year-old is approximately 6 years) – he will be 94 years old when he comes up for re-election.

Is the Hawkeye State suffering from an extreme case of myopia?

[xii] Someone from our building’s maintenance staff asked me the other evening why I was still in the office. “Where else would I be?” I asked. “Watching the baseball game,” he replied. I gave him an inquiring look. You know the rest of it. Yankees and Red Sox wild card game.

I hate wild card games. I still remember the 1975 match between the Vikings (12-2) and Cowboys (10-4); the “Hail Mary” pass from Staubach to Pearson near the end of the game. I’m pretty sure I wept.

[xiii] Though I have to say, when you consider the confluence of the activity arising from the uncertainty surrounding the tax changes proposed by the Ways and Means Committee, including their effective dates, the October 15 due date for federal individual income tax and federal gift tax returns for the 2020 tax year that are being filed on extension and, in New York, the October 15 2021 due date for submitting an election for the state’s SALT cap workaround pass-through entity tax – it should come as no surprise that many tax advisers and preparers are either questioning their career choice or starting to think about early retirement.

[xiv] See, e.g., https://www.rivkinradler.com/publications/disposing-of-assets-under-the-ways-and-means-committees-proposals/.

[xv] Many taxpayers completed such gifts at the end of 2020, or early in 2021 (after learning the results of the Georgia Senate races – remember that?).

[xvi] And which is now at the House Rules Committee, where it may be amended.

[xvii] https://www.taxslaw.com/2021/09/grantor-trusts-on-the-precipice/ . Just a reminder that the Obama Administration’s bill to revise these rules would have applied to trusts that engaged in one of the described transactions on or after the date of enactment – in other words, without regard to when the trust was formed or funded. The IRS would have been granted regulatory authority to create exceptions to this provision.

We may yet see a similar rule added to the bill.

[xviii] https://www.taxslaw.com/2021/10/tax-hikes-senator-manchin-and-politics-whats-next/.

[xix] Reg. Sec. 20.2031-2(f) and Sec. 20.2031-3. Reg. Sec. 25.2512-3. See also Rev. Rul. 59-60. Closely-held entities are difficult to value, and the IRS will often challenge the reported value for such an entity as well as the size of the discount for the transferred interest, depending upon several factors.

[xx] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1.

[xxi] Reg. Sec. 25.2512-1.

[xxii] For example, is it deferred, is it contingent (as in the case of an earnout), is it capped, is it payable in kind, is it payable in equity of the buyer (and, if so, valued as what date), etc.?

[xxiii] Where the business is organized as an S corporation, the owner has to be careful of preserving the election.

[xxiv] https://www.taxslaw.com/2021/09/grantor-trusts-on-the-precipice/ .

[xxv] IRC Sec. 2702; Reg. Sec. 25.2702-3.

[xxvi] Alternatively, the trust may continue for the benefit of family members.

[xxvii] IRC Sec. 2036.

[xxviii] The receipt of the annuity interest, however, does not cause the transfer of property to the trust to be taxable to the grantor, as a sale of the business interest for income tax purposes, because a GRAT is structured as a grantor trust– that is to say, its assets are deemed to be owned by the parent-grantor. IRC Sec. 671 et seq.

Again, the 2022 budget proposal would change this result; if enacted, however, when will it be effective? Only for trusts formed after the enactment date, or for all “taxable” events occurring after such date regardless of when the trust was created and funded?

[xxix] Reg. Sec. 25.2702-3(b)(2).

[xxx] Interestingly, the House bill does not address zeroed out or short-term GRATs, in contrast to the Obama Administration’s last budget proposal which would have required a minimum amount of taxable gift at creation of the trust and a minimum term for the trust (thus, increasing the mortality risk).

[xxxi] The trust can even continue after the annuity term expires, further leveraging the grantor trust status (by causing the grantor to continue to be taxed on the trust income), reducing the grantor’s estate, and maybe providing other benefits (like asset protection) for the family.

[xxxii] A less valuable seed gift may be possible if the beneficiaries of the trust were to guarantee the note and had the wherewithal to satisfy such guarantee.

[xxxiii] IRC Sec. 1274.

[xxxiv] To avoid a deemed contribution to the trust under IRC Sec. 7872, which may cause the application of the anti-grantor-trust rules proposed by the House (for contributions made after the date of enactment).

[xxxv] Rev. Rul. 85-13.

[xxxvi] Wandry, T.C. Memo 2012-88.

[xxxvii] For example, in the amount of interest that should have accrued and been paid.

[xxxviii] I cringe whenever I hear the word “mandate” used in this context.

[xxxix] This would trigger the assignment of income doctrine and would probably defeat the application of any discounts in the valuation of the interest being gifted.

[xl] This is often the most difficult part of the sale for an owner. They go from being the boss, not answerable to anyone, to being a minority owner and employee of a much larger organization.