Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

GIFTING STRATEGIES & FRACTIONAL INTEREST DISCOUNTS
(Part 1 of a 2-part series)
(4/7/02)

In Early March, Gary Brown and I taught our Semi-Annual Estate Planning Seminar at Autry Tech. At it, we discussed some of the major changes in the Internal Revenue Code, especially in the estate and gift tax area. One of the questions raised there was whether these changes eliminated the need for people to make annual exclusion gifts. I told them gifting might be even more necessary than it was before as we don't know if the Estate Tax repeal will last or what Congress will do next.

Key to effective gifting is the availability of fractional interest discounts. If you can take advantage of these discounts, you can give more to your family during your lifetime and reduce your taxable estate at your death.

What Do You Mean When You Talk About Fractional Interest Discounts?

Let me give you a simple example. If you, your brother and your sister inherit a farm from your parents as tenants in common, you each own an undivided 1/3 interest in the farm. Since you cannot do anything with the farm without the consent of your brother and sister, you probably would qualify for a fractional interest discount. You own an interest in property that you do not unilaterally control. Put another way, if the farm was worth $300,000.00 and your third was worth $100,000.00, could you find someone willing to pay you the full price for your share? Or do you think a buyer would insist on a lower price since your brother and sister could freeze him out of the decision-making process and control what was done with the property?

This same rule applies if you own a partial interest in a company, an investment account, an automobile, or anything else. Because you do not own it outright, you cannot sell it and, without the consent of the other owners, you cannot make decisions on how it is to be used.

Can you give me an Example using an investment company?

Sure. Let's say Dad (or Dad's Trust) owns some $2 million worth of investments. He's beginning to feel his own mortality and wants to give some of his money to his children while he is still alive. He may just want to "share the wealth," but if he has talked to an estate planner, he knows he can also reduce taxes on his estate at his death.

Dad comes to us to form a limited liability company and then transfers all his investments to it. He now has a limited liability investment company worth $2 million. Here comes the fun part. Dad gives each of his two children a 10% interest in this company. Dad retains 80% of the limited liability company which equals $1.6 million, right? Wrong! Dad is no longer the sole owner of the company. Depending on the terms of the LLC operating agreement, he probably does not have the right to terminate the LLC and have his proportionate share of the LLC assets distributed to him without the consent of one or both of his children. In this case, Dad no longer "controls" the right to liquidate the company, so his ownership interest is entitled to a lack of control valuation discount.

In addition, his share of the company isn't worth as much to a prospective purchaser. Would you give him $1.6 million if you knew you couldn't make key decisions regarding the underlying investments of the LLC unless his children agreed? Because of this, Dad's 80% interest in the LLC also qualifies for a lack of marketability discount. Taken together, these discounts could total 30% or more. Dad's original $2 million investment has been reduced to a value of $1.6 million through direct gifting and then to perhaps as little as $1.12 million through fractional interest discounts.

Dad isn't home yet. Because of the size of these gifts he has to file a gift tax return when he transfers LLC interests to his children, so part of each gift will be added back into his taxable estate when he dies. Even so, you can see that the tax bite has been reduced significantly. And remember that Dad can give each child up to $11,000 per year without having to file a gift tax return. Plus whatever he has gifted to his children continues to grow in value (hopefully) "outside" of his estate, not "inside" of it. If Dad continues to make gifts to his children, after a time he may be able to eliminate estate taxes altogether.

I need to ask you a Question...

"You're telling me I can take $2 million in investments, transfer them to an LLC,
and my investments are no longer worth $2 million to the IRS?"

That's exactly what I'm telling you. Most of the reported cases involve fractional interest discounts in real property interests, but the same rules apply to interests in tangible (automobile, racehorse) and intangible (investments) personal property.

For example, the Ninth Circuit Court of Appeals found that the holder of an undivided interest in property had to secure the consent of the remaining owners to sell the property as a unit, and "this factor alone could affect valuation regardless of whether real or personal property is involved."

This isn't easy, though. Don't think the IRS just rolls over and gives in to everyone asking for fractional interest discounts. You must prove that the fractional interest cannot easily be divided and marketed and therefore is usually sold at a discount. Merely saying this is not enough, but this rule is no different than those applied in any discount situation. For example, if you own an interest in a closely-held company, you must provide an appraisal which explains why your closely-held stock would sell at a discount and not at the full price for your proportional share.

How Do I Know How Large This Discount Should Be?

That's a good question, but one that will have to wait until next week. Check back then and I'll explain the role of the professional appraiser in documenting claims to fractional interest discounts and what the IRS will require the appraiser to look at in arriving at his or her evaluation.

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