Tax the Rich?

The President’s plan for a tax regime that would ensure the rich pay their “fair share” of the cost of implementing his programs has come one step closer to being realized . . . maybe . . . well, sort of . . . at least in part. You know, half a loaf (unless it’s whole wheat) is better than none. Voting strictly along party lines,[i] the House of Representatives on Friday[ii] morning passed an approximately $1.75 trillion version of Mr. Biden’s $3.5 trillion Build Back Better plan by a vote of 220 to 213.[iii]

Now, our self-important representatives[iv] can take their Thanksgiving recess secure in the knowledge there are Democrats in the Senate who are wary of the proposed legislation and will insist upon certain revisions – assuming they don’t kill it – before sending the bill back to the House. Who knows, perhaps by mid-December the two Chambers of Congress – specifically, the moderate and the progressive Democrats – will have resolved their differences over a cup of holiday cheer (or a bout of fisticuffs), and the current, diminished version of the President’s Build Back Better plan will be enacted into law just in time for the next Congressional recess.[v]

Not Quite

You know what they say about “good” intentions.[vi]

The President’s – his Party’s – tax plan sought, at various times, to: increase the rate on long-term capital gains; increase the top rate on ordinary income; increase the corporate rate; remove the cap on the 6.2 percent Social Security Tax; eliminate profits interests; enact an annual mark-to-market tax on the rich; revoke the basis step-up for property passing from a decedent[vii]; impose a gains tax on a decedent’s assets as if they had been sold at the time of death; eliminate the enhanced basic exclusion for gift and estate tax purposes[viii]; make the grantor trust rules consistent with the gift and estate taxes (thereby doing away with a host of gift and estate tax planning vehicles); impose a tax on a deemed sale of property by so-called “dynasty trusts” after a prescribed period[ix]; prohibit discounted valuations for investment assets[x]; limit the use of like kind exchanges.

To the relief of many – did you hear their collective sighs? – none of these proposals has survived.

Some Consolation

Still, the President may not come away empty-handed if the bill is finally enacted into law. You know, better some of the pudding than none of the pie.[xi]

The bill passed by the House would: apply the 3.8 percent surtax on net investment income[xii] to an individual taxpayer’s share of partnership and S corporation income, without regard to how active the taxpayer is in the business, provided the individual has more than $500,000 of adjusted gross income (“AGI”)[xiii]; impose a new 5 percent surcharge on individuals with AGI for the year in excess of $10 million[xiv], plus an additional 3 percent (8 percent in total) for those with income for the year beyond $25 million; cut the amount of gain that may be excluded from income on the sale of Section 1202 stock by an individual with $400,000 or more of AGI from 100 percent to 50 percent; make permanent the limitation on the use of excess business losses by individuals[xv]; impose a minimum tax on certain mega-sized, mega-profitable C corporations; increase the IRS’s enforcement budget.

Would the surtax apply to ordinary income and capital gain? Yes, provided the applicable AGI threshold is satisfied. Would the surcharge apply to ordinary income and capital gain, and would it apply regardless of the imposition of the surtax? Yes, provided the applicable AGI threshold is satisfied. Would this capital gain include gain from the sale of one’s business? Yes. And would these “taxes” apply to any Section 1202 gain that is not excluded from income? Yes, provided the applicable AGI threshold is satisfied.

Wait A Minute

That said, I suppose some Democrats probably wish the IRS had not disclosed, so close on the heels of the House’s self-proclaimed “victory” over the rich,[xvi] that the number of federal estate tax returns filed declined by almost 60 percent from 2010 to 2019.[xvii]

Others in the Party – meaning members from states other than California, New York,[xviii] New Jersey, Illinois, and maybe a couple of others – may regret the attention focused on the proposed relaxation of the cap on the SALT deduction,[xix] which the House-approved bill would raise from $10,000 to $80,000 per year – beginning with the current year (2021, that’s right) – but extending the cap to 2031 rather than allowing it to expire in 2025.[xx]

The Congress taketh away and the Congress giveth.[xxi]

Scorecard?

On balance, the President will not have fared too badly, at least not from the perspective of most income-tax-generating events realized by wealthier individuals. Assuming the above-described provisions become law, many if not most of those business owners whom New Yorkers would say are “well-off,” though not necessarily wealthy,[xxii] will probably see an increase in their annual federal tax bills. It is also probable that individual owners will pay significantly more tax on the sale of their businesses under the new rules.

But what about the estate, gift, and generation-skipping transfer taxes?[xxiii]

Estate and Gift Taxes

It’s true that, in the absence of intervening legislation, the basic exclusion amount will revert to $5 million per individual in 2026 (half of the current $10 million[xxiv]), just four years from now.[xxv]

In the meantime, wealthy individuals and their progeny will continue to benefit from various gift-estate-GST tax[xxvi] planning techniques, including zeroed-out-short-term GRATs, sales to grantor trusts, and SLATs – that is, provided folks are careful with their implementation and maintenance.

They will also continue to enjoy the benefits of the step-up in basis,[xxvii] which allow a decedent’s beneficiaries to dispose of property received from the decedent without paying income tax on the appreciation in value realized by the decedent prior to their demise.

In the case of property for which the beneficiaries may claim cost-recovery deductions (for example, the depreciation of real property improvements used in a trade or business or held for investment), the basis step-up increases their deemed investment in the property and allows the beneficiaries to offset the tax liability they would otherwise incur with respect to the property.[xxviii]

Next Steps?

Until Congress acts, if ever, what will the IRS do to prevent taxpayers from improperly avoiding their federal transfer tax liability?

What it has been doing for years. In the case of a lifetime transfer of property, for example, the IRS must identify the donor,[xxix] determine whether there was a completed transfer and, if there was, whether the transfer was a gift, a partial gift, a sale for full and adequate consideration, or something else.[xxx] Next, the IRS must determine whether the donor retained any interest in the transferred property and, if so, whether the value of such interest may be accounted for in determining the value of the gift[xxxi] – the form of the transfer will often be significant, especially where the Code prescribes its terms (for example, a GRAT). The bona fide nature of every step in the transfer will also be considered; the IRS may decide to ignore certain steps or to “step them” together, or it may decide to treat as a gift a transfer that was structured as something else. Finally, the IRS must determine the fair market value of the property interest transferred, which may first require the valuation of the larger property in which the interest was gifted, as well as the value of the donor’s retained interest or the amount of consideration, if any, paid to the donor.

In general, IRS estate and gift tax examiners are pretty good at what they do[xxxii] – a taxpayer who thinks otherwise, or who believes they will get one over on an examiner, is in for a surprise. We all have our days, however, as was demonstrated in a recent decision.[xxxiii]

Value the Transfer or the Receipt?

Over several years, Taxpayer gifted interests in various tracts of land to his two Sons, with each receiving a 48 percent interest in each tract, while Taxpayer retained a 4 percent interest.

Taxpayer reported and paid gift tax on these transfers as two separate gifts to Sons, each transfer representing the gifted 48 percent interest in each tract. Taxpayer valued the gifts using discounts meant to account for the possibility that the interests were less valuable to hypothetical buyers than they might be otherwise.[xxxiv]

IRS Challenge

The IRS challenged Taxpayer’s valuations and assessed gift tax deficiencies.[xxxv] Taxpayer paid the deficiencies in full and filed claims for refunds with the District Court.[xxxvi]

The IRS moved for partial summary judgment[xxxvii] and asked the Court to “conclude as a matter of law that no discount should be available for a gift of a fractional interest in property unless the taxpayer making the gift held such interest in fractional form before the gift, rather than viewing several simultaneously gifted portions of the same property as fractional interests in the hands of the donor for purpose of valuing the gift.”[xxxviii]

The IRS maintained that the gift tax law prohibits such a discount in valuing a gift of land to more than one individual and contended “that the value of each donee’s interest is simply the value of the whole times the percent ownership.”

The Court explained that fractional interests reflect ownership over parts of the whole, and fractional interest discounts allow taxpayers to account for the lower value that may attach to certain fractional interests in property on account of the owner’s lack of control over the property and the lack of marketability for their interest in the property given the difficulty of finding a buyer for a fractional interest.

In Pari Materia

The IRS argued, however, that “allowing the discounts would endorse a circumvention of one of the primary purposes of the gift tax.” It claimed that, when valuing interests in property like the property interests in question, discounts should be prohibited for gift tax purposes because “the gift tax is construed in pari materia with the estate tax” in order to prevent taxpayers from “avoiding the estate tax altogether” by “depleting their estates through inter vivos transfers.”[xxxix]

The Court conceded that the IRS was correct in noting “there would be no discounts based on the separate values of the interests received by each son” if this were a case about the estate tax. A tract of land that was included in a decedent’s estate would be valued for estate tax purposes as a single tract notwithstanding the decedent’s having devised the land (for example, in their will) to many beneficiaries.

No Legal Support

The Court also observed, however, that the IRS had failed to provide any support for its legal conclusion that, if no discount would be allowed in determining the value of a property for purposes of an individual’s estate tax where interests in such property were distributed to several beneficiaries, then the individual’s lifetime gifts of the same interests in the same property to the same beneficiaries should be treated as the transfer of a single property (i.e., the multiple interests gifted should be aggregated) and there should be no discount in determining the value of those interests for purposes of the gift tax.

The Court then reviewed some of the many decisions rendered by other courts which determined that dividing real property into separate interests usually lowers the property’s fair market value. The Court noted that these holdings were clearly contrary to a conclusion that “no discount should be allowed as a matter of law,” as urged by the IRS.[xl]

The Court also acknowledged that the Tax Court has accepted that a fractional interest discount was available as a matter of law and has found persuasive taxpayers’ arguments that “a discount [wa]s appropriate because of problems of control, lack of marketability, and costs of partition relating to a fractional undivided interest.”

Value in the Hands of the Donor

The IRS also emphasized that “the value of a gift for federal gift tax purposes is the value to the donor, not the donee.” It then argued that the value of the properties gifted here should “reflect[] the economic reality that [Taxpayer] transferred what to him equaled the value of a 96% interest in each of the Properties.” The IRS maintained that disallowing fractional discounts where there was no fractional interest beforehand ensures that “the value of the gift made by the donor, not the measure of enrichment to the donee, . . . is determinative.”  In other words, even if the property is now worth less because of the creation of fractional interests, the property was worth more in the donor’s hands before the fractional interests were created, and it is that value, not the new value, that should be the basis for calculating the gift tax.

The Court Disagrees

In response, the Court pointed out that the gift tax statute, the regulations, and relevant case law “require the court to look at the value of each gift at the time it passes from the donor to the donee.” The gift tax statute pertaining to valuation of gifts, the Court stated, provides: “If the gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift.”[xli]

By way of contrast, the Court continued, the estate tax statute expressly looks at “the value of all property to the extent of the interest therein of the decedent at the time of his death.”[xlii]

The regulations also reflect this distinction, the Court stated. The gift tax regulations provide that “if a gift is made in property, its value at the date of the gift shall be considered the amount of the gift.”[xliii] The regulations state that “the tax is . . . measured by the value of the property passing from the donor . . . ,”[xliv] whereas the estate tax regulations provide that “the value of the gross estate of a decedent . . . is the total value of the interests” included in the gross estate.[xlv]

The Court then described various decisions in which the Tax Court determined that gifts must be valued at the time of the gift, not before the gift is made (when the donor still owns the property to be gifted). Moreover, the Tax Court has held that each separate gift of an interest in a property must be valued separately.

With that, the Court concluded that, for gift tax purposes, the value of the fractional interest in the property transferred, and not the value of the property as a whole, must ultimately be decided. The fair market value of a fractional interest in real property, it held, cannot as a general rule be derived by simply applying the percentage of the interest in the whole to the value of the entire property. Rather, under applicable law, the gifts in questions were not of a single 96 percent interest but two 48 percent interests given to two different donees; accordingly, the gifts had to be valued separately at the time of transfer.

“Let’s Be Careful Out There”[xlvi]

Truer words have never been spoken.

It remains to be seen in which parts of its jurisdiction the IRS will concentrate or increase its enforcement efforts, assuming the budgetary support under the Build Back Better bill (they couldn’t come up with another name?) materializes, and there is no reason at this point to doubt it won’t be forthcoming.

The examination of wealthy taxpayers’ transfer tax returns does not often yield noteworthy economic results – for one thing, so few of them are filed – but it can be used to send a message to such taxpayers and to those who advise them.

Moreover, as in the case described above, the government may feel emboldened to direct an agency like the IRS to pursue arguments that may be legally questionable, at least under most existing precedent, in the hope of finding a receptive court or negotiating a favorable settlement.[xlvii]

For that reason, advisers will have to be even more diligent during the planning and implementation stages of a gift/estate plan in the current environment.


[i] Well, almost. One Democrat from Maine voted against it based upon their opposition to the SALT tax relief included in the bill.

[ii] And what better gift for the nation’s chief executive, who turned 79 years of age on Saturday, one day after undergoing a colonoscopy and recklessly leaving the Vice President in charge, albeit for only a couple of hours.

[iii] The approximately $1 trillion infrastructure law was enacted last Monday.

[iv] After all, the Constitution begins with “We The People of the United States.” I have been carrying the same copy – now very well-worn – in my book bags and briefcases since 1976, when I started high school.

[v] Recess, or play time, can be quite an incentive for getting things done, at least in the case of Congress and children. Speaking for myself, and for countless others of my ilk (at least if they’re honest about it), I’m sure the worst days of the year are those immediately preceding days away from the office – there’s much to be done, too much. The days away are far too few to recover from this ordeal and to forget about the onslaught that awaits your return. Speaking of which, the worst days of the year are those immediately following an absence from the office. All you retain from your “time off” is the regret of having gone away at all.

[vi] Misguided, maybe?

[vii] IRC Sec. 1014.

[viii] IRC Sec. 2010.

[ix] I would actually support a measure limiting the “benefits” of dynasty trusts.

[x] If the 2016 proposed regulations had focused on these alone, their chance of success would have improved greatly.

[xi] A Romanian proverb. In truth, it would very much depend upon the pudding.

[xii] IRC Sec. 1411.

[xiii] In the case of a joint return.

[xiv] Filing a joint return.

[xv] Further limiting one’s ability to use business losses to offset non-business income. IRC Sec. 461(l), which is otherwise scheduled to disappear for taxable years beginning on or after January 1, 2026.

[xvi] https://www.irs.gov/pub/irs-pdf/p5332.pdf

[xvii] Probably no surprise there. The exemption amount increased steadily through 2017, then was doubled beginning in 2018. It is set to revert to a lower threshold for deaths after 2025.

[xviii] I should mention that California and New York are the number 1 and number 3 states, respectively, for the highest number of estate tax returns filed. Florida (which doesn’t have an income tax) is number 2, but Ricky Bobby would say, “if you’re not first, you’re last.” Talladega Nights is a classic of the cinema.

[xix] IRC Sec. 164.

[xx] There are elections in 2022 and 2024 – one needs to consider such things.

[xxi] “The Lord giveth and the Lord taketh away.” The Book of Job, 1:21 (KJV).

[xxii] Have you looked at any cost-of-living indices lately?

[xxiii] https://www.taxslaw.com/2021/11/gift-transfers-not-on-the-congressional-agenda-but-still-in-the-crosshairs-of-the-irs/.

[xxiv] Pursuant to the Tax Cuts and Jobs Act (P.L. 115-97). Adjusted for inflation, this amount is set at $11.7 million for 2021, and will increase to $12.06 million in 2022.

[xxv] There will be mid-term elections in 2022 and a presidential election in 2024, which may impact this outcome.

[xxvi] “Transfer taxes.”

[xxvii] Attention members of tax partnerships: IRC Sec. 754 can be your friend. And don’t forget to consider the decedent’s share of partnership debt, as well as their share of partnership items that represent IRD (for which no basis adjustment is allowed). Reg. Sec. 1.742-1.

[xxviii] Compare the policy underlying IRC Sec. 1239, which treats the gain from the sale of property between related persons as ordinary income if the property is depreciable/amortizable in the hands of the transferee. The idea is to prevent a taxpayer from claiming depreciation deductions (thereby offsetting ordinary income) with respect to a property, paying tax on the sale of the property to a related person at the long-term capital gain rate, then allowing that transferee to depreciate the property all over again.

Query how the transfer of such property from a decedent is different.

[xxix] Not always obvious when the transfer is made by a business entity with more than one owner, or by an irrevocable trust.

[xxx] For example, a loan or a lease; perhaps compensation. Think about all the income tax decisions dedicated to distinguishing between a sale and a financing.

[xxxi] Think Chapter 14.

[xxxii] And most are attorneys.

[xxxiii] Buck v. U.S., Civil No. 3:18-cv-1253 (DC CT), September 24, 2021.

[xxxiv] Taxpayer reported that the discounted value of each 48 percent fractional interest was approximately 45 percent of the total value; a 55 percent discount.

[xxxv] Query why Taxpayer did not choose, instead, to go to U.S. Tax Court and forego payment of the tax until that Court’s decision became final. It’s possible that Taxpayer missed the 90-day filing deadline (set by the notice of deficiency), following which the tax was assessed. IRC Sec. 6213.

[xxxvi] Before a taxpayer may bring a refund suit in federal District Court, they must have filed a claim for refund with the IRS and the claim must have been denied or the IRS must have failed to issue a disallowance within 6 months of the filing. IRC Sec. 6532.

[xxxvii] A court may only grant summary judgment if “there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.” Summary judgment is inappropriate only if the issue to be resolved is both genuine and related to a material fact.

[xxxviii] Echoes of Pope & Talbot, which considered the valuation of an in-kind distribution of property by a corporation to its shareholders. For purposes of determining the corporation’s gain from the deemed sale of the property under IRC Sec. 311(b), the corporation argued, in effect, that it distributed multiple fractional interests which should be valued accordingly. The Court disagreed, finding that the gain realized by the corporation should be determined by reference to the property as a whole, while the income realized by the shareholders would be based upon the value of the fractional interest each received.

[xxxix] In other words, the statutes must be read together because one (the gift tax, in this case) supplements the other (the estate tax) – as the IRS pointed out, the gift seeks to prevent avoidance of the estate tax; it does this by imposing a gift tax when property that is transferred by a taxpayer for less than adequate consideration is removed from the taxpayer’s estate and the reach of the estate tax.

[xl] The Court gave the following illustration:

Suppose the owner of a tract of land ripe for commercial development and worth $1 million under single ownership makes a will dividing the tract into three parcels and bequeathing one to each of his adult children. The tract is less valuable as three units than as one, and let us say that the value of each one-third is only $300,000. But then the legatees get together and sell their parcels as a single unit for $1 million. (It might seem that if such a transaction is feasible each parcel must really be worth $333,333.33. But this reasoning ignores transaction costs, which may be substantial if the parcels are in the hands of strangers, negligible if they are in the hands of family members.) If the estate is allowed to value the land on a divided basis (i.e., at $900,000), it will escape tax on 10 percent of the actual value of the legacies.

But in our hypothetical case the siblings own parcels in a tract of land, and the parcels can be combined, and the land sold as a unit, without great difficulty. How solid is this distinction, though? For the aggregate market value of the separate parcels of land to be worth much less than the market value of the land as a single tract, the transaction costs of assemblage into a single tract must be considerable; and even if the cost would be greater for strangers than for family members, the possibility of bickering and dissension within a family can never be excluded. So what we described earlier as a facile mode of tax avoidance might actually be a risky, and therefore self-limiting, tactic.

[xli] IRC Sec. 2512(a).

[xlii] IRC Sec. 2033.

[xliii] Reg. Sec. 25.2512-1.

[xliv] Reg. Sec. 25.2511-2.

[xlv] Reg. Sec. 20.2031-1(a).

[xlvi] Anyone remember Hill Street Blues? Sergeant Phil’s farewell after he finished roll call for the day? No? Your loss.

[xlvii] Most reasonable folks are reluctant to assume the so-called “hazards,” and to incur the costs, of litigation.