Discounting IRAs for Income Tax Liability?

Overview

On a daily basis, I field many questions from practitioners, farmers, ranchers, agribusiness professional and others.  Some areas of tax and ag law seem to generate more questions than others and, of course, the facts behind each question often dictate the correct answer.  But, sometimes a question comes in that I have never had before.  I recently got a new one – when valuing an individual retirement account (IRA), is the potential federal income tax liability to the beneficiaries to be considered? 

Valuation discounting and IRAs, that’s today’s topic.

Discounting Basics

Valuation discounts have been in the news recently.  Last fall the IRS issued new I.R.C. §2704 proposed regulations that could seriously impact the ability to generate valuation discounts for the transfer of family-owned entities.  While it doesn’t look likely now that the proposed regulations will be finalized, if they do become finalized in their present form, they would largely eliminate the ability to derive valuation discounts through various estate planning techniques.

Over the past few decades, valuation discounting through the use of family-owned business entities has become a popular estate and gift tax planning technique.  If structured properly, the courts have routinely validated discounts ranging from 10 to 45 percent.  Valuation discounting has proven to be a very effective strategy for transferring wealth to subsequent generations.  It is a particularly useful technique with respect to the transfer of small family businesses and farming/ranching operations.  Similar, but lower, valuation discounts can also be achieved with respect to the transfer of fractional interests in real estate. 

The basic concept behind discounting is grounded in the IRS standard for determining value of a transferred interest – the willing-buyer, willing-seller test.  In other words, the fair market value of property is the price it would changes hands at between a hypothetical willing-buyer and a willing-seller, with neither party being under any compulsion to buy or sell.  Under this standard, it is immaterial whether the buyer and seller are related – it’s based on a hypothetical buyer and seller.  Thus, there is no attribution of ownership between family members that would change a minority interest into a majority interest.

Discounting Possibilities

Family limited partnership (FLP).  The principal objective of an FLP is to carry on a closely-held business where management and control are important.  FLPs have non-tax advantages, but a significant tax advantage is the transfer of present value as well as future appreciation with reduced transfer tax.  See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235.  Commonly in the ag setting, the parents contribute most of the partnership assets in exchange for general and limited partnership interests.  However, as the use of FLPs expanded, so did the focus of the IRS on methods to avoid or reduce the discounts.  In general, FLPs have withstood IRS attack and produce significant transfer tax savings.  But, there are numerous traps for the unwary.  Formation shortly before death can result in the FLP being disregarded for valuation purposes.  See, e.g., Priv. Ltr. Rul. 9719006 (Jan. 14, 1997); Priv. Ltr Rul. 9725002 (Mar. 3, 1997).  Indeed, if the only purpose behind the formation of a family limited partnership is to depress asset values, with nothing of substance changed as a result of the formation, the restrictions imposed by the partnership agreement are likely to be disregarded.  See, e.g., F.S.A. 200049003 (Sept. 1, 2000).  There also should be a business purpose for the FLP’s formation.  See, e.g., Estate of Bongard v. Comr., 124 T.C. 95 (2005).

Corporate liquidation and built-in gain.  Until 1998, the IRS disallowed discounts when valuing interests in C corporations to reflect built-in capital gains tax.  But, the courts then began focusing on the level of the discount until, in 2007, a federal appellate court ruled that in determining the estate tax value of holding company stock, the company’s value is to be reduced by the entire built-in capital gain as of the date of death.  Estate of Jelke III v. Comr., 507 F.3d 1317 (11th Cir. 2007).  Later, the Tax Court allowed a dollar-for-dollar discount for built-in gain.  Estate of Litchfield v. Comr., T.C. Memo. 2009-21; Estate of Jensen v. Comr., T.C. Memo. 2010-82.  That makes sense.  When a buyer purchases C corporate stock, the value of the stock to the buyer is what it takes to get cash in a liquidation.  One of the “things” it takes is the payment of deferred income tax.  The discount reflects that.

Restricted Management Account.  An alternative to the FLP is the restricted management account (RMA).  An RMA is an investment account where the investor gives up control of certain assets to an investment manager for a certain period of time and the manager exclusively manages the account assets.  During the term of the account (as set forth in a written agreement), the investor cannot make withdrawals, and transfer to family members are limited.  Based on these restrictions, the argument has been that the value of the assets in the RMA should be discounted for transfer tax purposes.  But, in 2008, IRS said that the restrictions in an RMA agreement do not result in anything other than valuation of the account assets at fair market value.  Rev. Rul. 2008-35, 2008-2 C.B. 116.

Discounts for IRAs?

Back to the question at hand – can a discount from fair market value be taken for the potential income tax liability to the beneficiaries of an IRA when the assets in the account are distributed to them?  The issue was presented to the Tax Court in Estate of Khan v. Comr., 125 T.C. 227 (2005).  The decedent died owning two IRAs.  One IRA was valued at $1.4 million at the time of death and the other one slightly over $1.2 million.  The executor reduced the estate tax value of the accounts by 21 percent and 22.5 percent respectively to reflect the anticipated income tax liability on distribution to the beneficiaries.  But, the court rejected the discounts because the inherent tax liability cannot be passed on to a hypothetical buyer.  On this point, the Tax Court followed the lead of the Fifth Circuit in Smith v. United States, 391 F.3d 621 (5th Cir 2004), aff’g., 300 F. Supp. 2d 474 (S.D. Tex. 2004) in noting that I.R.C. §691(c) provides for a deduction for estate tax that is attributable to income in respect of a decedent (IRD), which IRAs are.  That eliminates the potential income tax inherent in assets that are also subject to estate tax, and serves as a statutory substitute for the valuation discount. In other words, a hypothetical buyer would not take into consideration the income tax liability of a beneficiary on the IRD because the hypothetical buyer is not the beneficiary and would not be paying the income tax on the gain inherent in the IRA.  Thus, any additional reduction in estate tax for potential income tax would not be appropriate.  A marketability discount is also not appropriate because there aren’t any restrictions barring the IRA assets from being distributed to beneficiaries upon the account owner’s death.  See, e.g., Priv. Ltr. Rul. 200247001 (Nov. 22, 2002). 

Conclusion

While valuation discounts are still viable for minority interests and lack of marketability in closely-held entities, valuation discounts are not available for assets that are IRD.  That means that IRAs and similar items of IRD will be valued at fair market value for transfer tax purposes.  With an IRA, the IRA doesn’t have a tax liability.  The beneficiary does.