Discounted Assets and Funding Challenges in Estate Administration

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Estate of Miriam M. Warne, T.C. Memo 2021-17 (February 18, 2021)  (“Warne”), a recent Tax Court case, illustrates a potential mismatch between the value of an asset for estate tax purposes and the value of the asset for purposes of the marital or charitable deduction from estate tax.  This mismatch can lead to a phantom loss of estate value for purposes of such deductions and cause an inadvertent estate tax surprise.  Although this mismatch can be avoided, it requires those drafting specific gifts and administering an estate to choose assets carefully when making bequests and funding decisions.

The problem typically occurs when the estate’s fiduciaries distribute a decedent’s assets to multiple beneficiaries causing fractionalization of those interests during the estate administration process. In Ahmanson Foundation vs U.S., 674 F.2d 761 (9th Cir. 1981), the decedent owned the only outstanding share of voting stock and all of the outstanding shares of non-voting stock in a company.  Upon distribution, the fiduciary transferred the non-voting stock to a private charitable foundation and transferred the one share of voting stock to an individual.  The Ninth Circuit Court of Appeals held that for estate tax valuation purposes, the estate should value all of the shares together resulting in a control premium for valuation purposes attaching to both the voting and non-voting shares.  However, for charitable deduction purposes, the court held that the shares passing to the foundation, thereby qualifying for a charitable deduction against estate tax, must be valued on a non-controlling basis.  This resulted in a mismatch between the value of the non-voting shares for estate tax purposes (no discount) and the value of the shares for purposes of the charitable deduction (discounted).  The estate tax was imposed on the difference between the two.  The estate could not claim the full charitable deduction offset from estate tax value for the assets passing to charity.  The court set forth the principal that the testator is only allowed a charitable deduction for estate tax purposes with respect to that which the charity receives.  This may or may not be equivalent to the value of those same assets for estate tax purposes.

The same concept was at play in Warne.  The decedent owned a single member limited liability company (“LLC”) with $25.6 million in assets.  For estate tax purposes, the 100% owned LLC was valued without discount at 25.6 million.  The decedent bequeathed the interests in the LLC to two charities, 75% to her family’s private foundation and 25% to her church.  The Tax Court relying on Ahmanson held that the charitable deduction must be based on the value of the assets each charity received.  Since the charities received a minority interest in the LLC, the court agreed with the Internal Revenue Service’s position that the interests should be discounted for purposes of the charitable deduction.  As a result, the estate was only able to deduct the discounted value of the LLC interests, with a combined value of approximately $21 million, for purposes of the charitable deduction.  The mismatch between the estate tax value and the deducted value resulted in an estate tax on over $4 million, even though all of the LLC assets passed to charity.

In both Ahmanson and Warne, the estates incurred estate tax on assets that otherwise passed to charity.  The same potential mismatch can occur with respect to assets that qualify for the marital deduction under Section 2056, if the assets become fractionalized upon distribution.  See Estate of DiSanto v. Commissioner, TC Memo 1999-421 (1999).  It is important that estate planners when drafting testamentary documents and fiduciaries when allocating assets as part of estate administration do not inadvertently fractionalize interests or subject assets to valuation discounts when funding bequests that would otherwise qualify for the marital deduction or charitable deduction.  Otherwise, the estate could incur estate tax on the value lost due to such fractionalization.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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