Taxpayers and planners love to use valuation reductions for partial interests in entities as a method for reducing transfer taxes. Such reductions and discounts can be a two-edged sword, however.
The Ahmanson and Chenoweth cases point out that when a majority interest in an entity is included in a taxpayer's gross estate, the valuation discounts will typically be substantially less than will apply to a noncontrolling or minority interest, and that this can have undesirable consequences when a portion of the entity is transferred to a charity or a marital deduction trust. For example, assume that a 100% interest owned by a decedent as his sole asset in an operating corporation is valued at $10 million, with little or no discounts taken.
Then assume that 60% of the corporation will pass to a bypass trust, with the remaining 40% passing to a charity. One might think that there should be no estate tax, because the 60% is covered by the decedent's unified credit exemption, and the 40% is covered by the charitable deduction. However, the case law advises that the value passing to the charity for which the charitable deduction is allowed is not 40% of the company's reported value. Instead, the 40% interest must be valued on its own, and as a minority interest, larger valuation discounts will apply. Thus, if we assume a 25% combined marketability and lack of control discount on the 40% interest, if it has a gross value of $4 million, the charitable deduction is limited to $3 million in the example. This leaves $1 million exposed to estate tax.
In a recent Tax Court memorandum decision, controlling interests in several real estate holding LLCs owned by a decedent were given 75% to one charity and 25% to a different charity. The IRS argued that the 25% piece going to one charity would need to be heavily discounted (citing Ahmanson), thus reducing the charitable deduction for that piece and having the same issue as noted in the previous paragraph.
The taxpayer tried to rebuff the discount's application by claiming that since 100% of the business interests were going to charity (albeit two separate charities), then no discount should be taken for purposes of the charitable deduction. The Tax Court rejected the argument, noting that there were two separate transfers to two separate charities, and standard valuation principles should apply to each gift on its own.
Note that while this decision involved the charitable deduction, the concept similarly applies to the marital deduction. In planning where marital deduction gifts or charitable gifts are likely and closely held business interests are involved, efforts should always be undertaken to anticipate these issues in the planning stage to avoid the division of a majority interest in a business into minority interests that are used to fund these deductible transfers.
Estate of Warne v. Comm., T.C. Memo 2021-17