MORE ON GIFTING & FRACTIONAL INTEREST DISCOUNTS
Part 2 of a 2-part series
(4/14/02)

Last week I introduced you to the concept of making gifts in order to diminish the size of your estate and to qualify for lack of marketability fractional interest and lack of control valuation discounts. I left off with the question of just how large a discount you might qualify for and how you could establish this discount to the satisfaction of the IRS. Let's pick up that thread and continue our discussion.

How Do I Know How Large My Discount Should Be?

This can be a problem if you intend to claim a fractional interest or valuation discount.It is the point at which an appraiser can be of great value.

First, the appraiser will look at the estimated cost of partitioning the property. The appraiser will evaluate how difficult it will be to break the property up into individual parcels and how much this partition will cost. Let's look at my example from last week in which two brothers and a sister each own a 1/3 interest in the family farm. In order to sell a 1/3 interest, a buyer might want you to divide that farm into three equal parcels. That sounds simple, right? But is it? If the farm totals 300 acres, can you just divide it into three 100-acre parcels? What if some of the land is more productive than the rest? What if some of it consists of ravines and impenetrable brambles? Now you have to apply an "economic factor" in parceling up the farm, rather than just breaking it up into equally sized pieces. You can see that the cost of partitioning property such as this can be far greater than you might originally have imagined.

In addition, the appraiser will look at your factual situation to see if the transfer of this ownership interest will also qualify for a discount in excess of the partition cost.

Even the IRS has recognized that this is sometimes appropriate. In a 1997 technical advice memorandum, the IRS said a taxpayer must provide evidence to support his assertion that his fractional interest in certain property was worth less than its pro rata share of the property's value. The IRS didn't tell the taxpayer how to prove his right to this additional discount, but it certainly left the door open for those who could.

One way appraisers justify such discounts is by looking at comparable sales. If the appraiser can show similar property was sold for less than its proportionate share of the total, this is usually sufficient.

What Factors Does the IRS Look At?

The IRS has recognized that a discount can be based on several different factors, including the following:

• The size of the fractional interest (smaller interest = larger discount)
• The number of owners (more owners = larger discount)
• The size of the tract (smaller tract = larger discount)
• The use of the land (farmland = larger discount)
• Availability of financing for the purchase of an undivided interest (tighter financing = larger discount)

Have the Courts Approved Fractional Interest and Valuation Discounts?

The Courts have sided with taxpayers who have produced adequate evidence to support their claims to fractional interest or valuation discounts. Most courts which have heard these types of cases have recognized that the sum of the fractional interests is less than the whole and have upheld fractional discounts in valuing undivided interests.

In 1998, the U.S. Tax Court, which is usually a taxpayer's first line of defense, expressly rejected the IRS's argument that absent evidence of actual sales, the discount for a fractional interest must be limited to its partition costs. The crux of the decision was that the taxpayer's entitlement to a fractional interest discount would depend on the quality of the taxpayer's evidence, including the formal appraisal. The Court said that limiting the discount to the actual partition costs did not give adequate weight to other relevant factors, such as the lack of control inherent in co-ownership and the difficulty of selling an undivided fractional interest. While this case involved real property, the same factors should come into play in any co-ownership situation.

Over the years, the Tax Court has upheld fractional interest and valuation discounts of 15%, 20%, 30%, and even 35%. Given the right set of facts, even larger discounts should be possible.

Where Do We Go From Here?

Given the relative ease of qualifying for fractional interest and valuation discounts, if you have a taxable estate, you should consider adding gifting and discount planning to your estate planning arsenal.

If you have a cabin in New Mexico that has great emotional significance to you and you want to be sure it remains in the family for the foreseeable future, you may be able to kill two birds with one stone. All you need to do is gift a small fractional interest to each of your children and watch the cabin's estate tax value shrink by 15% to 30%.

At the same time, you have made it more difficult for your family to sell the property after you are gone since you can require that all the owners have to agree. If you really want to muddy up the waters and make sure the property stays in the family for a long, long time, just give fractional interests to each of your grandchildren, too, or even to each of your nephews and nieces. I don't know of any family in which everyone can agree, so you probably have effectively erected an unpassable roadblock to the disposition of the property before or after your death.

We don't know what Congress will do to the tax rules over the next few years. What we do know is that the rules will probably change and that nothing written today is guaranteed to be in place in 2011 or thereafter. During these uncertain times when the estate tax structure is in a state of transition, gifting to family members can be an effective way to minimize the estate taxes due at your death.

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