Valuation Discounts An Update

Since Internal Revenue Service (IRS) Rev. Rul. 93-12, the government has begun to take steps to stop the flood of cases where estate planning practitioners attempt to fractionalize the ownership of assets among family members. The estate planners’ goal is to take advantage of increasing aggressiveness in the valuation area, particularly discounts for lack of marketability and ownership of minority interest.

In recent years, the areas of valuation discounts for lack of marketability and for minority interests have been in the forefront of estate planning techniques. Recent cases have proven what many practitioners already knew — that the sum of the parts may not equal the whole. As a consequence, estate planning practitioners spent a lot of time and effort attempting to fractionalize the ownership of assets among family members in order to take advantage of these discounts.

Minority Interest Discounts
For many years, the IRS contended that the minority interest discount did not apply where family members’ interests taken together were not a minority interest. After losing a long line of cases, the IRS finally acquiesced in Rev. Rul. 93-12, stating that it would no longer assert family attribution in the valuation area.

Since that ruling, the government has begun taking steps in the opposite direction to stop the flood that it perceives has been created.

In one ruling, the IRS opined that where an interest in an asset had “swing vote attributes,” there should be no minority interest discounts and a previous gift that would attain swing vote attributes as a result of the second gift could result in an additional gift to the first donee.

Another ruling by the IRS asserts that where a decedent owns property outright and is the spousal beneficiary of a qualified terminal interest property (QTIP) trust that would also be included in his or her estate, the interest of both the trust and the individual are aggregated such that there would be no minority interest discount applicable to either block.

The IRS Means Business
Whether the IRS’s position in these ruling has merit has yet to be litigated. However, it is clear that the IRS is hostile to aggressive discounting and it is also clear that practitioners have been emboldened by recent taxpayer victories to take larger and larger discounts for valuation purposes.

Discounts may be a double-edged sword: While they will reduce the value in the estate for purposes of paying estate tax, they may also have a negative impact on the marital deduction and the charitable deduction where minority interests or fractional interests in property are set aside for these purposes.

Example: Assume that Bob Smith dies with an estate of $2.6 million. He leaves $600,000 in cash, CDs and marketable securities in a credit sheltered trust for the benefit of his family. The remaining $2 million is all made up of his 100% interest in X Corporation, a closely held business. In his will he leaves half of the company to his wife outright and the other half to the charity of his choice. Ordinarily, under this circumstance the full unified credit will be used up and because of the charitable deduction and the marital deduction, no federal estate tax will be payable.

However, the IRS might assert that a 50% interest in X corporation is not worth $1 million but, in fact, is worth only 65% of that because it is not a controlling interest in the corporation. As a consequence, the IRS might assert that the marital deduction is really $650,000 instead of $1 million and the charitable deduction is also $650,000 instead of $1 million. Thus, potentially $700,000 of the estate that was previously shielded from tax by the marital and charitable deductions might, under this theory, be exposed to estate tax.

Some practitioners are worried that the IRS might take this approach as a reaction to overly aggressive practitioners in their use of discounts. Other practitioners believe that the aggressive use of minority interest discounts is warranted and defensible.

Take Steps To Reduce Exposure
Regardless of what camp you are in, steps can be taken to reduce any exposure in this area. Some of those steps include reducing the decedent’s ownership in assets where market value is affected by minority interest ownership to a minority interest before death. Another way is to be careful when fractionalizing interests after death between bequests.

With these thoughts in mind, valuation discounts should be a weapon in your estate planning arsenal. Just be careful because it is an ever-changing area. Try to anticipate surprises. But minority interest discounts have become an accepted planning technique that all families should consider when doing their estate planning.