Estate Gifts

New attack on valuation discounts

I have written various articles with regards to valuation issues concerning utilizing family limited partnerships (FLP), and other methods to obtain valuation discounts, in order to reduce either gift or estate taxes by transferring wealth from an older generation to a younger generation. More disputes between taxpayers and IRS involve valuation of property than any other issue. This is especially true in connection with estate and gift taxes where valuation directly affects the bottom line tax liability. Many taxpayers try to minimize value and transfer taxes by claiming a discount for some reason or another.

IRS historically has challenged various types of discounts. Even where it agrees that a discount is appropriate in a given case, IRS typically will challenge the size of the discount sought. Valuation controversies have just taken on a new dimension in that IRS has created a new weapon in its fight against discounts - the gift tax return itself. The recently-revised (Dec. 1996) gift tax return, Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, now specifically asks whether a valuation discount is being claimed. A yes or no box must be checked and those who claim a discount must supply additional information.

Typically, when a taxpayer files either, Form 709 and/or Form 706 (used for the estate tax return) they have appraisals attached to show the range of discounts taken by the donor or the decedent on valuation issues. Some tax preparers, would use the appraiser's report to show the range of discount, but not show it on either Form 709 and/or 706. This is the change that IRS is now requiring with regards to disclosure on the face of Form 709, and more than likely Form 706, in the future.

What must be disclosed
Information about gifts is reported on Schedule A of Form 709. Part 1 is for gifts subject only to gift tax and part 2 is for gifts that are subject to both gift tax and generation skipping transfer tax. Each part requests similar information about the donee, the gift, the donor's basis in the gift, the date of the gift and its value on that date. The question about whether a valuation discount is being claimed appears at the top of Schedule A just above Part 1. The instructions to Form 709 state that a donor must answer yes to this question if the value of any gift reported in either Part 1 or Part 2 of Schedule A reflects a discount for lack of marketability, a minority interest, a fractional interest in real estate, blockage, market absorption, or for any other reason. Those claiming a discount also are instructed to attach an explanation giving the factual basis for the claimed discount and the amount of the discount taken.

Understanding the various discounts
In light of this new development, it is a good time to review the various types of discounts that may be available for gifts of property during life or at death and what is needed to support them. The following are the most common types of discounts. Many of those discounts normally arise in the context of transfers of closely held stock or other business interests, including limited partnership interest of FLP.

Discount for lack of marketability
A sizeable discount may be available for an interest in a closely held corporation or other business entity on the ground that there is an absence of a ready market for the sale or purchase of the interest being valued. The Tax Court, in Mandelbaum, Bernard, TC Memo 1995-255, listed the following elements of value as facts to be taken into account in determining the appropriate discount for limited marketability of closely held stock:
The value of the corporation's privately traded securities vis-a-vis its publicly traded securities (or, if the corporation does not have stock that is traded both publicly and privately, the value of a similar corporation's public and private stock); an analysis of the corporation's financial statements; the corporation's dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends; the nature of the corporation, its history, its position in the industry, and its economic outlook; the corporation's management; the degree of control transferred with the block of stock to be valued; any restriction on the transferability of the corporation's stock; the period of time for which an investor must hold the stock to realize a sufficient profit; the corporation's redemption policy; and the cost of effectuating a public offering of the stock to be valued, e.g., legal, accounting, and underwriting fees.

Minority interest discount.
In valuing a minority interest in a closely-held corporation, a discount is generally taken to give proper weight to both the limited market for the stock and the difficulties for a minority shareholder to either influence management, acquire control, or bring about a liquidation to convert the asset value into cash.

Fractional interest in real estate
Because of the limited marketability of a fractional interest in real estate, a more or less considerable discount from the proportionate value of the entire property may be shown to be proper in order to arrive at what a purchaser would be willing to pay for an undivided fractional interest. The most desirable and effective evidence of the discount factor is the opinion of competent and experienced real estate dealers or appraisers, backed by records of actual sales of fractional interests in the same or similar property.

Last year the Fifth Circuit held that undivided fractional interests in real and personal property owned outright by a decedent did not have to be aggregated with the remaining interests in the same properties that were included in his estate under Code Sec. 2044 because of a QTIP marital deduction allowed to the estate of his predeceased wife. The bottom line result was that even though 100% of each of the properties was included in the estate, the interests owned outright qualified for fractional interest discounts. (Bonner, Louis Sr. Est v. U.S., (1996 CA5) 1996 US App LEXIS 13493).

Notwithstanding the Bonner case, IRS has consistently taken the view that aggregation is required in determining estate tax value in situations similar to those involved in Bonner. For example, the IRS Letter Ruling 9608001, IRS concluded that a partnership interest included in an estate under Code Sec. 2044 had to be aggregated with an interest in the same partnership held through a revocable trust. In IRS Letter Ruling 9550002, IRS reached the same result for stock held outright and stock of the same company held by a QTIP trust. Thus IRS can be expected to challenge the Fifth Circuit's view in other jurisdictions.

Because significant wealth (underlying assets of a company or FLP) can be transferred by taxpayers, when utilizing the above mentioned valuation discounts on either stock or limited partnership interests, IRS will constantly be looking at different methods at controlling the reporting and disclosing of these valuation discounts. Despite this new reporting requirement by IRS, as shown in both the Mandelbaum and Bonner cases, with proper planning, a taxpayer can prevail in court against IRS on reducing either gift or estate taxes in their efforts to transfer wealth onto their children.