Estate Tax Valuation Discounts

The assets in your estate must be valued by the executor or administrator of your estate based on their “fair market value” at the date of your death or at an alternate valuation date six months later. Fair market value (FMV) is generally defined as the price that would be paid by a willing buyer to a willing seller, neither being under any compulsion to buy or sell and both having full knowledge of the facts relating to the asset. 

The FMV of a stock listed on the New York Stock Exchange would be the price at which the security could be sold on the date of death or the alternative valuation date. That price is based on the fact that the buyer will be a minority shareholder, with little power to influence the affairs of the corporation. If someone had enough money to buy a controlling interest in a corporation listed on a major stock exchange, the buyer would have to pay a  premium because of the added value of the controlling interest.

With a family owned corporation, the situation is reversed. Usually, the value of the business is based on the sale of a controlling interest in the corporation. The buyer would be able to select the board of directors, officers and employees of the company. If the buyer so desired, he could even force a liquidation of the company and a sale of it’s assets with a distribution of  the proceeds. Where a minority interest is being valued, there is a discount from the price of the shares of the total company because the minority shareholder would not have any control over the operations of the business. In some cases, there are legal restrictions on the transfer of shares without the consent of the corporation, which reduces the value of the minority shares even further. 

In the case of a limited partnership (LP) or limited liability company (LLC), the ownership interest is very similar to that of a minority shareholder in a corporation that has restrictions on the transfer of shares - even if the interest is a majority interest. With the LP or LLC, the partners or members can’t be forced to accept anyone else as a partner or member. The transfer of the partnership or LLC interest is restricted and therefore is worth less than the assets owned by the enterprise. Thus, it’s possible to have a partnership or LLC with $100,000 worth of readily marketable bonds or cash but an 80% interest in the partnership or LLC might require a discount factor of up to 30%. Thus, the FMV of the partnership interest is not $80,000 but is only $56,000. In some cases, the discounts can be as much as 40% from the value of the assets owned by the partnership or LLC. 

By organizing some of your family assets into a limited partnership or LLC, you can reduce the value of your estate by 20% to 40%.   With a valuation discount of 40%, the FMV of a $2 million estate would be reduced to $1,200,000 and that value would be offset by the lifetime estate tax exemption. With a couple, an estate of $4 million could be arranged so that there would be no estate tax. (The exemption is scheduled to change each year until 2011.)

The IRS has been trying for the past ten years to find some way to deter taxpayers from using valuation discounts of family controlled entities to reduce their estate and/or gift taxes.

Thus far, the courts have sided with the taxpayers in most of the cases. Even so, the IRS has a reputation for persistence and if they can't find a way to eliminate an effective tax saving device through the courts, they often turn to the Congress to make changes in the law. Until then, they are continuing to pursue novel theories in the courts in order to reduce or eliminate discounts for estate and gift tax purposes. In most cases, they are attacking arrangements that involve very aggressive discounts or situations where the entity was formed at the last minute -- often by a child of the taxpayer acting on a power of attorney.

A case in 2003 (Strangi, TC Memo 2003-145) has caused some consternation among estate tax professionals because it denied valuation discounts where the senior member of the family retained excessive control over the income and assets in the family limited partnership. Thus, the use of valuation discounts for estate tax savings require the help of professionals who are current with the latest court rulings in this area of tax law.

Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/  

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