• contact@example.com
  • 666 888 0000

Valuation Discounts


 We represent many closely held entities.  These businesses are operating as S corporations, C corporations, family limited partnerships (FLP) and family limited liability companies (FLLC).  For estate planning and gifting purposes, the entities face unique tax situations.  In representing these entities, we often rely on valuation discounts and freezing techniques when implementing estate planning.  The IRS scrutinizes the gifting and valuation discounts applied to these closely held entities, particularly in regard to the following concepts:   gift on formation/indirect gift, step transaction, annual exclusion challenges, Section 2036, valuation, and formula clauses.

 The IRS argument for gift on formation/indirect gift is that where funding of an FLP or FLLC occurs simultaneously or closely with the transfer of LP or membership interests, the gift is measured by value of assets transferred to the partnership limited liability company with no discount.  The taxpayer must prove that the funding occurred before the LP or membership interests were transferred by gift and/or sale.  See Senda.  The taxpayer has the burden of proof to show that capital was contributed and that market risk of ownership was transferred from the taxpayer to the closely held entity for a period of time.  There is no bright line test for how long taxpayers need to wait before gifting LP interests, and one may have to wait longer for non-volatile assets.  For instance, in Holman, 8 days was allowed because the assets contributed to the partnership were Dell stock, and the Dell stock has constant market risk.  The IRS had argued step transaction and indirect gift, but there was significant time (8 days) between funding and the transfer of the LP interests, so there was no gift on formation.

 Similarly, in Gross, 11 days was allowed with marketable securities.  In the Linton and Heckerman cases, bad facts produced bad results.  Simultaneous funding and transfer of an LP interest was not enough time.  Therefore, do not do things simultaneously anymore.  Even though state law says it is permissible, the IRS assertion of gift or formation/indirect gift is an easy argument to avoid and it is advisable to wait 30 to 90 days when possible. 

 In Pierre v. Commissioner, T.C. Memo 2010-106 (May 13, 2010), the IRS argued step transaction.  The issue was basically when a gift and sale of LP or LLC interests occur on the same day, whether the interests transferred should be aggregated for valuation purposes.  In Pierre, some closely held business interest was gifted as a seed gift and the rest sold on the same day.  The Court held that when two transfers occur on the same day, no time elapses, other than the time it took to sign the documents, and nothing of tax-independent significance occurs in the moments between gift and sale transactions, then the transfers should be aggregated.  This could have significant implications on valuation and Sec. 2036 considerations for adequate and full consideration determinations.  Again, there is no bright line for how long to wait. 

 One commentator agrees that the installment sale to a defective grantor trust (DGT) is one of the best estate planning techniques, but he suggests that the seed gift be made in cash (then there is nothing to aggregate), or waiting 60 days between the seed gift and the sale and be aware of property rights in what is being transferred.  In Pierre, the taxpayer still got discounts, but you have to be careful because aggregation could give rights to liquidate, and if that’s the case, then no discounts.

 Fisher and Price have thrown into question whether a gift of an LP interest is a present interest gift that qualifies for the annual exclusion.  The Court has held a number of times that donees do not have immediate substantial economic benefit from the LP interest, and therefore, no annual exclusions are permitted.  The Court argues that where there are transfer restrictions, the donees are assignees and not limited partners, and donees have no right to withdraw capital, as well as the fact that profits are distributed at the discretion of the general partner, donees do not have any right to the immediate use, possession or employment of the LP interest or income.  For planning purposes, consider adding a put right similar to a Crummey withdrawal provision.  In sum, we are generally skeptical about using FLP or LLC interests for annual exclusion gifts, primarily because of the appraisal costs and the IRS’ risks.

 Client communication is of utmost importance here.  The attorney and the client should carefully discuss planning techniques, and correspondence should layout pro-taxpayer intent, non-tax considerations, and timing matters.  For instance, it is advisable to document these items during the planning phase in order to put the client in the best position if one has to testify as to the non-tax reasons for the formation of the closely held entity. 

 Section 2036 is the most litigated issue currently.  This section provides that, as a general rule, the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has, at any time, made a transfer (except in the case of a bona fide sale for adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained…(1) the possession or enjoyment of, or the right to the income from, the property, or (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.  There have been 28 cases since 1995.  Sixty-five percent of these cases have held for the IRS, and 35% have held for the taxpayer.  Generally, if the IRS is successful, all assets of the closely-held entity might be brought back into the estate, even if the interest in the partnerships had been transferred during life.  See Harper and Korby.

 The bona fide sale for adequate and full consideration exception is a two part test.  The adequate and full consideration means that interest must be proportionate and value of contributed property is properly credited to capital accounts.  It is pretty hard to screw this up.  The bona fide sale test requires a “significant and legitimate non-tax reason” for creating the entity.  Stone, Kimbell, Mirowski and Black all used centralized asset management as a significant and legitimate non-tax reason for forming the FLP.  Stone, Mirowski and Murphy cited involving the next generation in management, and educating the next generation of family members.  Kimbell, Black, Murphy and Shurtz cited protection from creditors and failed marriages.  Schutt, Murphy and Miller argued preservation of investment philosophy.  Church, Kimbell and Murphy cited avoiding fractionalization of assets.  Murphy and Black argued the avoidance of imprudent expenditures by future generations and protecting against bad spending habits of certain descendants.  Courts look at how an entity was actually operated after formation. 

 As for §2036(a)(1), there are a litany of cases with bad facts that found a retained right to possess or enjoy.  These include non-pro-rata distributions, personal expenditures with partnership funds, personal use of assets in the partnership, payment of estate tax and expense when assets transferred to the partnership close to death, accurate books and records not kept, and insufficient assets outside the partnership.

 To avoid Section 2036(a)(1) challenges:   (1) document non-tax reasons; (2) respect the partnership agreement; (3) maintain accurate books and records; (4) no personal use assets in the partnership; (5) pro-rata distributions; (6) avoid distributing all income; and (7) avoid “as needed” distributions and set up a distribution policy. 

 Even the most skilled tax planners and estate planners may get audited.  So it is important to prepare for an IRS audit at the planning stage.  When the IRS decides to audit, they issue broad requests. Your files can be subpoenaed, including emails. You might have to testify about reasons for creating the entity.  As stated earlier, the best evidence of non-tax reasons come from contemporaneous correspondence.  It is certainly permissible to discuss tax attributes, but talk about the non-tax attributes and reasons too. 

 Finally, using formula clauses to get around Proctor has been successful in a number of cases.  In Proctor, the tax court held the formula value clause was contrary to public policy since any attempt to collect the tax would defeat the gift.  However, in Christiansen and Petter, defined value clauses based on values “as finally determined for estate-gift tax purposes” were successful.  McCord and Hendrix were decided for the taxpayer, but in the context that the taxpayer agreed to be bound by what the donee parties confirmed and agreed was their appropriate and respective interest in the property.  All four cases involved the use of charities, and seemed to support the notion that a public policy for charity overrides the Proctor public policy.  It does seem significant that there is an independent trustee of the spill-over charitable entity.  Technically, none of these cases would really apply to our formula gifts, etc. since we very seldom use spill-over charitable donees.

 The litany of the legislative challenges to the valuation discounts in the recent past leaves one with the sense that they might not be around for very much longer.  Therefore, use them, and use them wisely, the sooner the better.

 If Section 2704(b) is expanded or interpreted to remove the impact of valuation discounts with our sophisticated estate planning techniques, we still have GRATs (although there have been proposals to eliminate the short-term and zeroed-out GRAT techniques).  We still have gifts and sales to grantor trusts (although Obama’s 2013 proposed Budget would basically eliminate DGTs), we still have intra-family loans, which is too often ignored and is a very simple technique.  It may become of increased importance if discounts are eliminated, it is generally considered a “sleeper” technique because it is not as “sexy” as a gift/sale to a DGT or a GRAT, but it can be an effective freeze technique because it limits the lender’s upside to the AFR rate (currently about 1.4%) and allows the borrower to invest the principal at hopefully higher rates of return. 

 In addition, fractional interest discounts for tenant-in-common interests in real estate have typically been viewed favorably by the Courts.  Planning options do not necessarily require a 50/50 division.  Any fractional amount should receive some discount.  Co-ownership agreements should be considered for the general management of the property. 

 Fractional interest discounts are available by making an inter-vivos transfer or special bequest to a QTIP trust of one-half the property.   Chenowith allows that there is no aggregation between the amount of property in the surviving spouse’s marital trust and the 50% that is owned outright or in another trust.  A fractional interest discount can also be available to a single person making an inter-vivos transfer of a portion of property and a specific bequest of the remaining property at death.  And, when using QPRTs, consider the husband having a QPRT and wife having a QPRT for their respective interests in the home, or separate QPRTs for each child, again, introducing fractional discounts for valuation purposes and preventing aggregation. 

 It remains an open issue whether fractional interests discounting is available for fractional interests in tangible property, such as artwork, collectibles, etc.  It is generally perceived that discounting, other than the potential costs of partitioning the artwork, is not allowed.  For now, authority permitting fractional interest discounts is limited to real estate; however, if Congress or the IRS attempts to eliminate other valuation discounts, we may see how far the limits can be pushed in other areas.

 *IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.


  • Mike Hoffman

    Mike is the founding and managing partner of Hoffman & Associates and oversees the general operations and personnel of the firm. He works primarily in the estate planning practice helping clients minimize the effect of the estate tax, ensure orderly transition of generations in family businesses, and maximize asset protections. Mike also devotes a considerable amount of his efforts to the business law and tax planning needs of the firm’s clients. He is licensed to practice in the States of Georgia, Ohio, and Tennessee, and is a Certified Public Accountant.

    View all posts