Valuing Business Interests for Gift and Estate Tax Purposes: Examining the Austen Family

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To best enjoy this post, please be sure to first read A Family History of the Austens

Administering an estate can be time consuming, complicated and overwhelming, particularly when there are different types of assets involved. Additionally, estate administration frequently implicates lifetime gifting by a decedent, which adds another layer of complexity.

Here, Jack gifted a portion of his membership interest in Oceanic Real Estate, LLC to his daughters, Kate and Claire, in 2013 and 2014. Generally speaking, an individual may gift up to the annual exclusion amount without any tax or reporting consequences. These amounts change over time – our hypothetical transfers in 2013 and 2014 would be subject to a $14,000 exclusion amount (per beneficiary, per year). For 2021 gifts, the annual exclusion amount is $15,000. When a gift exceeds the annual exclusion amount in any given year, the individual will use a portion of his lifetime gift/estate tax exemption – which also changes depending on the year – and may need to file a gift tax return. The lifetime gift/estate tax exemption for 2021 is $11,700,000. (In 2019, the year in which Jack died, the exemption was $11,400,000.) These gifting rules do not apply to everyone and everything, so it is important to consult with an experienced estate planning attorney whenever you consider making substantial gifts to others.

Assuming the value of a 1% membership interest in the LLC in 2013 and 2014 exceeded $14,000, Jack should have filed a gift tax return with the Internal Revenue Service for each of those years, reflecting his gifts to Kate and Claire. Any value in the 1% membership interest over $14,000 per year per beneficiary would have used up a portion of Jack’s 2019 $11,400,000 lifetime gift/estate tax exemption. Note that Jack and his spouse, Juliet, would have had the option to split the gifts and the value of each between them, allowing them to double their annual gift tax exclusion amount. The gift tax returns simply would have reported the gifts with no gift tax due. However, to properly report the gift’s value, Jack or his estate planning attorney should have engaged an outside firm to prepare a valuation report.

In light of Jack’s 2019 passing, the value of his remaining interest in Oceanic Real Estate, LLC at the time of his death – and all other assets in which Jack had an interest at the time of death – must be valued and reported on Jack’s Massachusetts and Federal estate tax returns. Estates, like gifts, are subject to tax exemptions that may vary depending on the year of death. Jack’s estate exceeds the Massachusetts exemption amount of $1 million and the 2019 Federal exemption amount of $11,400,000. Massachusetts and Federal estate tax returns must therefore be prepared and filed. These are due within nine months of Jack’s date of death, along with payment of any outstanding estate tax. An extension to file the estate tax returns may be filed providing an additional six month extension. However, the estate tax must be paid within the nine month deadline, absent certain tax elections.

As discussed in the fact pattern, $15,000,000 of Jack’s estate consists of underlying real estate owned by Oceanic Real Estate, LLC. That does not mean that the actual value of Oceanic Real Estate, LLC is $15,000,000. Valuing businesses for gift tax and estate tax reporting purposes can be complicated. The underlying assets need to be considered, along with additional factors such as income, expenses and other liabilities, when determining the fair market value of a decedent’s interest in a business.

Where a decedent owns less than a 100% interest in a business, discounts for lack of control and lack of marketability are typically taken from the fair market value. Control is the ability of a business owner to make decisions within the business. Marketability is the ability of a business interest to be marketed and sold. Discounts for lack of control and lack of marketability reflect the impact these limitations have on the value of an ownership interest, particularly partial interests, by reducing their value below an equivalent share of the company value. For example, a non-controlling or unmarketable one-third interest may not be worth one-third of the company’s actual value. In this instance, if a third party were to purchase Jack’s membership interest in Oceanic Real Estate, LLC, such membership interest would be more valuable if Jack gave the third party the ability to influence and make decisions within the business. Further, because the LLC is a privately held business instead of a publicly traded stock, it has less liquidity, making it more challenging to market and sell.

These discounts may be taken for gift tax and estate tax purposes. Thus, assuming Jack had filed gift tax returns in the years 2013 and 2014, a valuation company may have taken some form of a discount on the gift tax returns.

Given that Oceanic Real Estate, LLC owns real property, a licensed Massachusetts appraiser would need to determine the fair market value of the underlying real estate as of Jack’s date of death.  This information, along with copies of the LLC’s governing documents, financial statements, and recent income tax returns, would be provided to a valuation company to determine the LLC’s fair market value as of Jack’s date of death. The valuation company would then apply discounts for lack of control and lack of marketability to identify the value of Jack’s membership interest in the LLC to report on his estate tax returns.

Although Jack failed to timely file gift tax returns in 2013 and 2014, this does not mean that his estate no longer has to file these documents. Instead, his Personal Representative will be responsible for making sure gift tax returns properly valuing Oceanic Real Estate, LLC are prepared and filed with the Internal Revenue Service, as of the date of each gift.

Administering an estate involves lots of moving pieces. It is important to engage an experienced estate planner to assist with lifetime planning, gifting and administration on death. Failing to do so may result in unintended tax consequences.

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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