by Craig D. Hasenbalg (Winter 2016)
The goal of “discount planning” is to supply an answer to the following riddle: how does one make $1 million worth only $600,000 (or less)? Correctly answering this riddle – especially in large estates – is more than an academic exercise given that the federal estate tax rate is equal to 40% as of January 1, 2016. For example, a $10 million estate which, after the application of valuation discounts, is worth only $6 million for estate tax purposes, saves a family $1.6 million in taxes. For anyone seeking to minimize, or in the right circumstance, eliminate estate taxes, “valuation discounts” have a real-world application.
Any attempt to explain the methodology used by the IRS when applying valuation discounts must start with Treasury Regulation section 20.2031-1(b). That section of the tax code’s regulations provides that the value of any property for estate tax purposes equals the property’s “fair market value” on the date of the taxpayer’s death. Section 20.2031-1(b) also defines “fair market value” as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” This “willing buyer/willing seller” test provides the logical underpinning for valuation discounts.
To implement the regulation’s willing-buyer\willing-seller test, the IRS, in Revenue Ruling 59-60, stated the factors to be considered when valuing a business interest. The factors articulated in Revenue Ruling 59-60 are varied and numerous, but the goal of discount planning is to require the IRS to consider those factors that would reduce the price of an asset (usually an interest in a business) on the open market. For example, assume a partner with a 20% partnership interest is seeking to sell his or her interest. Assume further that (as is typical) the partnership agreement severely restricts the ability of an individual partner to sell that interest, and also makes it difficult or impossible for any partner to terminate the partnership. The selling partner will find that an informed buyer – if a buyer can be found at all, will not pay a price equal to 20% of the partnership’s assets. Since the buyer is purchasing a minority interest in a partnership that restricts the ability of the partners to “cash out” by selling or liquidating the interest, the buyer will pay some price less than 20% of the partnership’s assets. The lack of control that accompanies any minority interest, together with the restrictions placed upon a partner’s ability to sell his or her interest, or to cause a liquidation of the partnership, give rise to valuation discounts.
Naturally, the IRS has pushed back on valuation discounts, and over time, a large body of law has developed that articulates when discount planning succeeds, and when a taxpayer’s best efforts fail. Recently, the U.S. Tax Court decided Estate of Purdue v. Commissioner, 145 T.C. Memo. 2015-249, which summarizes the major pitfalls taxpayers and their advisors should strive to avoid. Even a cursory reading of the case indicates clearly that tax savings should at least appear to be a secondary (or tertiary) goal. The presence of real and provable non-tax motives can make an estate planning transaction designed to benefit from valuation discounts stand up to tax court scrutiny.
The fact pattern presented by Purdue has become a familiar one. Mr. and Mrs. Purdue possessed a net worth of approximately $28 million. Some $24 million of the total consisted of marketable securities. The Purdues owned a one-sixth interest in commercial real estate located in Hawaii (with a value of $480,000), and approximately $865,000 of cash held in various CD’s. The cash and marketable securities were held in several different brokerage firms. The couple’s estate planning attorney advised that these various assets be contributed to a newly created limited liability company (the “LLC”).
The purposes of the LLC were stated to be: (i) to consolidate the management and control of certain property and improve the efficiency of management by holding the assets in a single entity; (ii) to avoid fractionalization of ownership; (iii) to keep ownership of the assets within the extended family; (iv) to protect assets from unknown future creditors; (v) to provide flexibility and management of assets not available through other business entities; and (vi) to promote education of, and communication among, members of the extended family with respect to financial matters. Importantly, shortly after the LLC was created, a single investment manager was hired to manage all the assets contributed to the LLC, and equally as important, approximately $3.2 million worth of assets was retained by Mr. and Mrs. Purdue individually, and was not contributed to the LLC.
At the time the LLC was created, Mr. and Mrs. Purdue enjoyed good health (another key to the outcome of the case). However, less than a year after creating the LLC, Mr. Purdue unexpectedly passed away, and Mrs. Purdue’s health began to deteriorate shortly thereafter, culminating in her death approximately five years after the death of her husband. An estate tax return was filed, and the value of the LLC interest owned by Mrs. Purdue was included in her taxable estate, but was discounted substantially.
Perhaps not surprisingly, the IRS identified the return for audit. In the audit, the IRS ignored the existence of the LLC, and attempted to include Mrs. Purdue’s share of the assets contributed to the LLC in her taxable estate. This would have the effect of eliminating all discounts, and would have resulted in a tax deficiency of approximately $4 million.
The tax court did not agree with the IRS. The Court first recited the age-old rule that the burden of proof lies, first and foremost, with the taxpayer. Second, in response to the IRS’ argument that the LLC should be ignored and the assets contributed into it should be included in Mrs. Purdue’s taxable estate without discounts of any sort, the tax court found that the creation of the LLC and the contribution of assets was a valid, “bona fide” transaction containing significant non-tax motives. Thus the IRS’ arguments were rejected. To reach this conclusion, the court relied upon two aspects of the LLC. First, the court relied heavily on the fact that after the LLC was formed, the investments held at various brokerage firms prior to the creation of the LLC were consolidated with one investment advisor. This, to the court, showed that the “desire to have the marketable securities and the [Hawaii building] interest managed as a family asset constituted a legitimate nontax motive” for the transfer of assets into the LLC. Additionally, the LLC formalities were respected, as the LLC established its own bank accounts, properly maintained its corporate book, conducted annual meetings with established agendas, and in general, acted as an LLC owned by unrelated members would act. To the court, the professed desire of Mr. and Mrs. Purdue to centrally manage their investments was more than just a theoretical justification for the estate plan. Instead, the creation and operation of the LLC provided an “actual” non-tax motive for the Purdues’ actions.
Second, the tax court viewed the $3.2 million of assets retained personally by Mr. and Mrs. Purdue as further proof the LLC was not created simply as a vehicle to avoid taxes. Because there were substantial assets left in the individual pockets of Mr. and Mrs. Purdue, the Purdues were not dependent on distributions from the LLC. This fact reinforced the court’s conclusion that the creation of the LLC had significant non-tax motivations, and was an “arms-length” transaction, offering legitimate, non-tax reasons for the estate plan.
The tax court’s opinion in Purdue is useful reading for anyone seeking to receive the substantial benefits of an estate plan based on valuation discounts. Legitimate non-tax reasons must be present, not simply in the estate planning documents themselves, but in the actions of the family members involved. While no estate plan is completely bullet-proof, the established legal rules summarized in Purdue provide a clear roadmap for success.