Income tax changes in 2017 have significantly affected valuation matters in 2018 and will continue to for years to come.

April 10, 2019

Although the noise emanating from Washington, DC, during the past year was deafening, the valuation environment provided an enclave from the turmoil. No major case law roiled the valuation world, and the Treasury set aside regulatory ways to constrain valuation discounts. However, the income tax changes brought about by the Tax Cuts and Jobs Act [1] (the "Act") signed into law in late 2017 had a significant effect on valuation matters. Valuation analyses had to react, adjust, and account for the new tax landscape. The temporary aspects of individual tax reform provisions require consideration of rates through 2025 and higher rates returning in 2026.

Tax Reform Valuation Ripples

As a result of the Act’s changes, C corporations (C corps) and other entities valued as if they were C corps were worth more in 2018 than in the prior year. The Act is structured so that corporate tax reform provisions are permanent and individual tax reform provisions are temporary for taxable years from 2018 through 2025. The sunsetting of individual provisions was necessary to satisfy the “Byrd Rule” [2] so that the Senate could pass the legislation with a majority vote. Among the individual provisions subject to sunset is the gift and estate exclusion amount, which was $11.18 million for 2018. A scheduled eight-year period for current individual provisions ripples through valuation considerations in a number of areas.

A significant individual income tax provision was the introduction of Internal Revenue Code Section 199A, which provides for a 20% deduction applicable to qualifying pass-through business income. The key sunsetting changes that affect current valuations for pass-through entities are:

  • Top marginal individual income tax rate: The Act enacts a new individual tax rate structure with reduction of the top marginal rate from 39.6% to 37%.
  • State and local tax (SALT) deductions: SALT deductions for federal tax purposes are limited to$10,000 on individual tax returns. Accordingly, this prior benefit to S corporation (S corp) shareholders is effectively eliminated. However, SALT deductions are still allowed for C corps.
  • Qualified business income (QBI) deduction: The Act allows for individuals to deduct up to 20% of their pro rata share of the QBI of S corps and other pass-through entities if the business qualifies. In general, an individual qualifies for the QBI deduction if he’s a shareholder of a company classified as being a “non-service” company. The Act limits the 20 percent QBI deduction, with the specific percentage being based on the company’s overall level of W-2 wages and tangible assets. If the subject company is deemed to be a “service” company, the individual shareholders don’t qualify for this specific deduction.

For pass-through income attributable to QBI, the maximum tax rate is reduced from 37% to 29.6%. The Act narrows the difference in tax rates between C corps and S corps, assuming the full IRC Section 199A rate reduction is available. The pre-Act enhanced value of S shares was due to the wide gap between double taxation at the maximum corporate tax rate plus dividend income rate for C corp shareholders and the maximum personal tax rate applicable to S corp shareholders. The Act narrows the tax gap and therefore reduces the S corp premium compared to prior tax law. A smaller S corp premium continues to exist, but much of the existing S corp premium is associated with the sunsetting of current tax rates after 2025, at which time the S corp-premium will return to past levels. It’s now expected that S corp premiums will begin a slow and steady upward creep as the expected longevity of Section 199A becomes shorter and shorter as we approach 2026.

Valuations for both C corps and S corps increased as after-tax cash flows benefitted from new tax breaks. The lower tax rates on corporate income increased earnings, and the Act expanded existing bonus depreciation and allowed for immediate expensing of 100 percent of certain depreciable assets acquired. The 100 percent deduction applies to qualified property acquired from September 27, 2017, through December 31, 2022. Immediate expensing of these capital expenditures results in a deferral (and not elimination) of tax; the day of reckoning will come on the ultimate taxable disposition of the property. For the five calendar years following 2022, the depreciation deduction phases out in 20% increments.

“In Conjuction With” Threat

In 2017, Estate of Powell v. Commissioner[3] ("Powell") was a full Tax Court case that expanded the reach of IRC Section 2036(a)(2)[4] to a decedent that only held a limited partnership interest. In Powell, a son using a power of attorney for his mother contributed approximately $10 million of cash and marketable securities on her behalf to a family limited partnership (FLP) in return for a 99% limited partner (LP) interest. Her two sons contributed promissory notes to the FLP for the 1% general partner (GP) interest. On the same day that the FLP was formed, the son transferred all of his mother’s LP interest to a charitable lead annuity trust with the remainder to the two sons. The mother died seven days after formation of the FLP.

Applying Section 2036(a)(2), the court found that the decedent, as only an LP in conjunction with other partners, could dissolve the partnership and control distributions. This resulted in gross estate inclusion that previously only applied in the Estate of Strangi v. Commissioner [5] and Estate of Turner, Sr. v. Commissioner[6] cases in which the decedents also held a GP interest. There was some hope that the “bad facts” in Powell may effectively insulate against a broad extension of Section 2036(a)(2) to apply whenever an LP interest possibly could act “in conjunction with” the other partners to dissolve the partnership and provide the basis for a retained interest inclusion in the gross estate.

It didn’t take long before the Section 2036(a)(2) inclusion argument from Powell resurfaced in a new case. In Estate of Cahill v. Commissioner[7] ("Cahill"), the son of the decedent as trustee of the decedent’s revocable trust and through a power of attorney for the decedent “advanced” $10 million to an irrevocable trust (the decedent’s nephew who was also his son’s business partner was the trustee) to fund premiums for split-dollar life insurance policies. The policies were on the lives of the decedent’s son and his son’s wife with the estate’s reimbursement occurring on the death of the insured. The split-dollar agreements were executed approximately one year before the decedent died, but when he was 90 years old and unable to manage his own affairs.

The estate valued its reimbursement interest at less than $200,000 due to the long life expectancy of the insureds. The Internal Revenue Service (IRS) valued the reimbursement right at about $9.6 million or the full cash surrender value of the policies, in part, because of retained rights under IRC Sections 2036 and 2038.

The estate moved for a partial summary judgment contending that Sections 2036(a)(2) and 2038(a)(1) don’t apply. The court rejected the motion for summary judgment citing its decision in Powell and reasoning that Sections 2036(a)(2) and 2038(a)(1) could apply because the decedent “in conjunction with” the irrevocable trust trustee could agree to terminate the split-dollar arrangement, which would entitle the decedent to reimbursement of the then cash-surrender value of the policies.

The Cahill case now proceeds to trial after the tax-payer’s summary judgment motion was denied with the same “in conjunction with” reasoning of Powell.

Noncash Charitable Contributions

Effective July 30, 2018, the IRS released final regulations (final regs)[8] under IRC Section 170 on substantiation and reporting requirements for cash and noncash charitable contribution deductions. The final regs are consistent with proposed regs issued in 2008 that addressed qualified appraisal and qualified appraiser requirements for noncash contributions of more than $5,000. For noncash contributions of more than $5,000, in addition to a contemporaneous written acknowledgment, the donor must obtain a qualified appraisal and file Form 8283 with the return. For contributions of more than $500,000, the donor must also attach a copy of the qualified appraisal to the return.

A qualified appraisal remains defined as one conducted by a qualified appraiser in accordance with generally accepted appraisal standards. The final regs don’t require strict compliance with the Uniform Standards of Professional Appraisal Practice (USPAP), but retain the requirement of consistency with the substance and principles of USPAP.

The importance of adhering closely to these substantiation requirements is emphasized in a string of unhappy cases [9] for taxpayers in which charitable deductions were disallowed because the taxpayer failed to satisfy the substantiation requirements under Section 170(f)(8).

Looking Forward

On November 6, 2018, the electorate chose to return Democrats to a majority in the U.S. House of Representatives. The tax writing committee, Ways and Means, is now chaired by a Democrat. The implications of this change is that existing tax legislation is likely to be frozen in place for at least the next two years. Although the Democrats may introduce bills to raise corporate taxes or reduce the unified credit on estates and gifts, the likelihood of such bills being enacted in law is infinitesimal. However, the majority position in the House conveys on the Democrats the power to prevent making current personal tax rates and estate and gift tax rates and credit amounts permanent. Gridlock has returned to the legislative process. Provisions in the Tax Code that sunset after 2025 are now more likely to do just that. The unified credit being cut in half in future years has an increased probability as does the sunsetting of Section 199A tax reductions.

A new benefit from the Act that may draw the attention of planners and their clients is the Opportunity Zone (OZ) program[10] that encourages investors to reinvest capital gain proceeds into low income areas. This program permits individual and corporate taxpayers to defer capital gains on the sale of stock, business assets or any other property by investing the proceeds in an Opportunity Fund (OF), which in turn must invest at least 90% of its assets, directly or indirectly, in businesses located in certain low-income communities designated as OZs.

A taxpayer who invests proceeds from a sale in an OF within 180 days from the date of the sale may defer the capital gains. If an individual sells stock with a tax basis of $1 million for $5 million, the entire capital gain of $4 million could be deferred if at least $4 million of proceeds were timely invested in an OF. If the taxpayer instead invested only $2 million of the proceeds in an OF, then that amount of gain could be deferred and the other $2 million of gain would be taxable in the year of sale. The deferred gains are taxable the earlier of when the investment in the OF is sold or December 31, 2026.

In addition to the time deferral, 10% of the deferred gain is forgiven for OF investments held for five years, and 15% is forgiven if the investment is held for seven years. For an OF investment held for 10 years, the tax basis of the new investment is deemed to be its fair market value on sale, resulting in any appreciation on the investment being tax free.

Political winds change rapidly, making 2026 seem long into the future. There are two presidential elections and four Congressional elections before current tax provisions sunset. Predicting the course of events years from now is humbling. The benefit of gridlock is that we’re likely to have a breather from new legislation and may plan on minimal tax law changes during the next two years.

A version of this article originally appeared in the January 2019 issue of Trusts & Estates magazine.


  1. The official name of the legislation is “An Act to provide for reconciliation pursuant to Titles II and V of the concurrent resolution on the budget for fiscal year 2018,” but the Treasury and Internal Revenue Service refer to the Act as the “Tax Cuts and Jobs Act.”
  2. The Byrd Rule is a U.S. Senate rule that amends the Congressional Budget Act of 1974 to allow senators during the Reconciliation Process to block legislation if it possibly would increase significantly the federal deficit beyond a 10-year term.
  3. Estate of Nancy H. Powell v. Commissioner, 148 T.C. No. 18 (May 18, 2017).
  4. Internal Revenue Code Section 2036(a)(2) – the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
  5. Estate of Albert Strangi v. Commissioner, T.C. Memo. 2003-145, aff’d 417 F.3d 468 (5th Cir. 2005).
  6. Estate of Clyde W. Turner, Sr. v. Commissioner, T.C. Memo. 2011-209 (August 30, 2011).
  7. Estate of Richard F. Cahill. v. Commissioner, T.C. Memo. 2018-84 (June 18, 2018).
  8. 83 FR 36417.
  9. Cari Barnes v. Commissioner, T.C. Memo. 2016-212 (November 22, 2016); Stewart Thomas Oatman and Shirley Ann Oatman v. Commissioner, T.C. Memo. 2017-17 (January 17, 2017); Joe Alfred Izen, Jr. v. Commissioner, 148 T.C. No. 5 (March 1, 2017); RERI Holdings I, LLC, Jeff Blau, Tax Matters Partner. v. Commissioner, 149 T.C. No. 1 (July 3, 2017); and Marc Chrem and Esther Chrem, et. al. v. Commissioner, T.C. Memo. 2018-164 (September 26, 2018), in which taxpayer’s summary judgment motion contending substantial compliance was denied and case will head to trial.
  10. Internal Revenue Code Section 1400Z-1 and Section 1400Z-2.

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