Tax Regulatory Shake-up in the Works

The sweeping tax reforms recently proposed by Donald Trump’s White House have given rise to a high degree of media scrutiny, public debate, and strongly held personal convictions.

If passed, proposals to abolish the estate tax, re-work tax brackets, and do away with a number of familiar exemptions and deductions would have far-reaching effects not only on the nation’s budget, but on the after-tax earnings of Americans across the country and across economic classes. It remains uncertain, however, whether the political capital exists for such sweeping reforms to be implemented, especially in light of growing dissent from Republicans in states with high state and local taxes, whose constituents would be hurt by doing away with the state and local tax deduction.

Far less fanfare has been given to Trump’s April 21st executive order, which called on the Treasury Department to identify tax regulations which create an undue financial or compliance burden on taxpayers, or exceed the IRS’ statutory authority. Tax regulations are the rules, promulgated by the Treasury, intended to both clarify and give teeth to the tax laws enacted by Congress. The executive order further called on the Treasury to recommend which regulations should be repealed, replaced, or reworked. Because the Treasury can essentially act unilaterally to create, modify, and repeal regulations, any proposed changes should be taken very seriously, as they do not rely on the more onerous and politically divisive process of passing tax reform through Congress.

On October 2nd, the Treasury released its “Second Report to the President on Identifying and Reducing Tax Regulatory Burdens.” This ten-page document provides significant insight into the regulatory philosophy of Secretary Steven Mnuchin’s Treasury Department, and makes specific recommendations effecting owners of family businesses with potential estate tax exposure, people entering into partnerships, and corporations with overseas operations.

• Family Companies

One recommendation deals with abandoning proposed regulations effecting ownership interests in family-controlled business entities, which must be assigned a value to determine whether a decedent’s estate exceeds the $5.49 million ($10.98 million if married) estate tax exemption, and if so, how much tax will be owed. In setting a value, taxpayers must determine what a third party would pay for the ownership interest in an arms-length transaction. For ownership interests in large, publicly-traded companies, this is a simple task, and merely requires looking at the company’s stock price on the day decedent passed away. For small companies, however, this is more difficult. Since there are typically no comparable, contemporaneous sales of small businesses with which to compare, valuation is based on some combination of the company’s underlying assets and its income stream.

Taxpayers tasked with appraising ownership interest in such companies, however, have long argued that an unrelated third-party purchaser would not purchase a partial interest in a company for the full value of the underlying assets it represents. Instead, they would demand discounts for factors such as a lack of control (the fact that the other owners could act in concert to over-rule any decision they try to make on behalf of the company) or lack of marketability (both due to there not being an established market within which to sell the interest, as well as due to possible restrictions in the company’s bylaws limiting how the interest may be transferred). While some sort of valuation discount for these items is certainly warranted when valuing a company, Congress and the IRS have been wary of instances in which discounts are over-stated, or non-business wealth is transferred into a family-controlled business entity to create an “artificial” discount. As a response to perceived abuses, Congress passed Internal Revenue Code Section 2704 in 1990, which requires that, among other things, certain restrictions on transferability and liquidation of family-controlled entities be ignored when determining the value of an estate.

Since 1990, practitioners and the IRS have been in an ongoing battle to expand or limit valuation discounts for lack of control and marketability. Taxpayer friendly state legislatures have even joined the fray, passing default rules allowing restrictions on transferability, where before they were typically unfriendly towards agreements limiting owners’ abilities to transfer their interests. As a result, the case law, regulations, and practice surrounding valuation discounts have become increasingly complex over the years, and were set to become even more complex in light of proposed regulations announced by the Obama Treasury Department in 2016, which would have pushed back against recent developments in state law and appraisal practice. Specifically, they would have disregarded many restrictions on transferability, even when such restrictions were enshrined in state law, and they would have treated the lapse of certain voting rights restrictions (which are used to create a larger “control” valuation) as separate taxable transfers.

By announcing its intention to abandon the proposed regulations, Mnuchin’s Treasury has signaled a desire to slow the pace of new regulations which practitioners would have to master, and gives greater weight to regulatory burden than to the abuses the regulations were intended to curtail. Furthermore, under new leadership, the Treasury seems far more concerned that a small number of legitimate valuation discounts could be disallowed, than that taxpayers will get away with illegitimate, “artificial” discounts.

• State and Local Bond Interest

Under current tax rules, interest on bonds issued by state and local governments is generally not taxed by the federal government. While this may seem like a rather straightforward concept, it gets hazy when you consider that local government is often subdivided much further than the city or town level, with special political districts created to manage things like shopping districts, sewer districts, or even individual roads. Indeed, at a certain level, these districts can resemble more of a cost-sharing arrangement between businesses than an actual government unit. Proposed regulations by the Obama Treasury Department would have required that such districts be under the “control” of either the state government, or an electorate (a group of people able to vote), and would have created a hardline rule that any district where three people could form a majority (that is, a district with 5 or less people) would not be considered as controlled by an electorate, and would thus not be able to issue tax free interest.

While the report issued by the Treasury states that it “continue[s] to believe that some enhanced standards for qualifying as a political subdivision may be appropriate,” it also states that the proposed regulations would have too great an effect on “existing legal structures.” Because many taxpayers’ investment portfolios are tailored to take advantage of interest-free debt from a variety of tax-free “political subdivisions,” rescinding the proposed regulations can be seen as a generally taxpayer friendly move.

• IRS Use of Private Counsel

The Mnuchin Treasury’s report also proposes scaling back final regulations which allowed the IRS to hire private, non-governmental attorneys to assist in audits. The Treasury Report expresses concern that outside attorneys will “take control” of investigations, and a belief that IRS attorneys are competent enough to perform these functions without assistance. The exact effect that the Treasury’s new position will have on the IRS’ ability to perform complex audits and effectively present their cases to the court remains to be seen, though this certainly does keep them from making use of a large pool of potential talent which may be willing to work with the IRS on a contract basis, but won’t settle for full-time employment at government pay grade. Whether the proposed scaling-back of the IRS’ ability to use outside counsel comes from a legitimate belief in the competency and singular authority of IRS staff attorneys, or a more cynical view that anything which weakens the IRS is taxpayer friendly, it may prove a boon for wealthy taxpayers engaged in ongoing disputes with the IRS.

• Partnership and Corporate Debt Regulations

The report stresses that under previous leadership, regulations were often too rushed, without adequate time for public comment and study, or impose too heavy a burden on taxpayers. It does not, however, seek to roll back all Obama-era regulations. For instance, it considers delaying or revoking proposed and temporary regulations dealing with the treatment of certain recourse liabilities tied to the creation of a partnership, as well as new documentation rules regarding debt issued to corporate shareholders. On the other hand, it endorses regulations dealing with “bottom-dollar-guarantees,” which the Treasury views as an improper method of dodging the partnership “disguised sale” rules.

• America First

The Trump administration has repeatedly stated that they believe in policies which protect American interests and promote domestic investment. To that end, the report endorses Obama-era rules relating to interest deductions for interest paid to overseas shareholders, which attempt to prevent “earnings stripping,” a method by which U.S. companies avoid taxes by funneling money overseas using tax-deductible interest payments. It does not bless all Obama-era rules relating to American companies overseas, however, and indicates that it will relax rules related to transferring assets overseas when those assets include the value of overseas good will.

• Other Regulations

The Treasury report also states that it is considering changes to proposed regulations involving corporate transfers of assets into Regulated Investment Companies and Real Estate Investment Trusts which they believe might lead to over-recognition of gain upon the transfers. Specifically, it believes that the regulations may create a trap for businesses which are not engaged in the behavior the regulations intent to prevent, and identifies them as being overbroad, creating an improper regulatory burden on taxpayers. To that end, the Treasury report also states that it is considering new regulations, to be released later, simplifying the rules related to recognition of gain and loss that arises from conducting business in a foreign currency. Among other things, it would allow a yearly average exchange rate to be used, which could provide significant compliance relief to U.S. companies participating in overseas markets.

If you wonder how the new tax laws will affect your business, send us a message through the form below or call our firm at 816-561-5000 to schedule a consultation.

*This post was originally published on November 3, 2017