Bryant - Course 6. Estate Planning. 11. Business Planning Flashcards
Module Introduction
Estate planning strategies for businesses are critical to ensure that business continuity is properly mapped out and arrangements are made in case of the current owner’s death, disability, retirement, or withdrawal from the business. Estate freeze rules can help senior family members of a family corporation or partnership (where family members hold the majority interest) who would like to retain control of the business and pass the baton gradually to the younger generation. They may do so by retaining the preferred stock and passing on the business appreciation to the successors.
The Business Planning module, which should take approximately four hours to complete, will explain the estate freeze rule, valuation techniques, the business continuation process, and intra-family business transfer techniques.
Upon completion of this module, you should be able to:
* Describe the freeze rules,
* Identify valuation discounts,
* Define business continuation and its considerations, and
* Discuss intra-family business transfer techniques.
Module Overview
Family businesses may use estate freeze rules to assure retention of the business in the family at a minimum cost. The freeze rules allow the original owners, the older generation, to retain much of the present value and control, and have some source of revenue while the growth is shifted to the younger generation-the new managers of the business. It is used when the owners want to perpetuate the business or investment within the family.
Valuation techniques and discounts used for business interests reduce the value of the business or shares gifted to family members.
A business continuation planning process helps owners to make decisions regarding the continuation of the business after they end their involvement with the business. Business owners use the plan to decide who will take over the business, how their interest will be sold, how much the interest will be worth, and how the funds needed to purchase the interest being sold will be acquired.
Intra-family business transfer techniques are available to transfer business interests to family members in a most advantageous way.
To ensure that you have an understanding of business planning, the following lessons will be covered in this module:
* Estate Freeze Rules
* Valuation of Closely Held Businesses
* Business Continuation
* Intra-family Business Transfer Techniques
Section 1 - Estate Freeze Rules
How can Estate freeze techniques be performed?
Estate freeze techniques can be performed through installment sales of property, private annuities, premortem stock redemptions, preferred stock recapitalizations, a variety of gift planning techniques, and buy-sell agreements. The freeze is an important planning tool to assure retention of the enterprise in the family at minimum tax cost. Besides family businesses, estate freeze rules may also be used for family investments, particularly real estate.
There are two family business entities that estate freeze rules typically involve. The following table describes how these business entities would apply an estate freeze:
How would a Family Corporation apply an estate freeze?
Family Corporation: A closely held company where most of the voting shares are held by family members
Freeze Rules
* Senior generation typically retains control and an income stream by using voting preferred stock with a fixed liquidation value, usually par value.
* One or more classes of common stock are created either by:
* forming a new corporation, or
* recapitalizing an existing one.
The recapitalized common stock may be nonvoting or at least have limited voting rights.
All or part of this common stock is sold or gifted to the next generation.
How would a Family Partnership (LLC) apply an estate freeze?
Family Partnership (or LLC): A partnership where the controlling interest is held by family members
Freeze Rules
The senior family members can retain control and an income stream by:
* forming a new partnership, or
* restructuring an existing partnership to retain partnership interests that control the management of the business or investments. They can elect to receive preferred profit distributions, but the interest must have a fixed liquidation value.
The remaining non-control partnership interests may be sold or gifted to the next generation.
What is important about the retained stock or partnership interest of the senior generation?
The retained stock or partnership interest of the senior generation must have a fixed liquidation value.
* This makes it impossible for the value of those retained interests to grow (they are frozen).
* Though the retention of preferred dividends or profit distributions is not essential, it adds to the value of the retained interest.
* This increase in retained value reduces the value of the interests transferred (gifted) to the next generation, which results in a lower gift tax value.
* Therefore, the value of the retained interests becomes very important.
To ensure that you have an understanding of the estate freeze rule, the following topics will be covered in this lesson:
* IRC Chapter 14
* IRC Section 2701
Upon completion of this lesson, you should be able to:
* Define IRC Chapter 14 rules, and
* Describe IRC Section 2701 valuation rules.
Describe IRC Chapter 14
Chapter 14 of the Internal Revenue Code became effective on October 8, 1990. This Code section pertains to how to value interests in corporations and partnerships that are controlled by family members, generally where the family holds more than 50% of the value of the corporate stock or partnership interest.
Chapter 14 affects the gift tax valuation for lifetime transfers made to family members when partial interests are transferred.
* Therefore, the owner or family members retain some ownership of the property after the gift is made.
* Applicable family members are the transferor’s spouse, and the transferor and spouse’s lineal descendants, and their spouses.
Chapter 14 does not apply to:
* Transfers to third parties who are not related family members,
* A transfer of the entire business or property interest that the owner or applicable family members make to other family members, or
* Partial interest transfers made at death to family members.
There are 4 sections in IRC Chapter 14. Describe sections 2701 and 2702.
- IRC Section 2701. Sec. 2701 applies to valuation of corporate and partnership interests designed for estate freeze purposes. In instances where there are capital interests that have a preference as to income distributions, the valuation of transfers, including recapitalizations among family members, may produce a gift tax.
- IRC Section 2702. Sec. 2702 applies to interests in trusts. For example, Grantor Retained Income Trusts (GRITs), Grantor Retained Annuity Trust (GRATs), and Grantor Retained Unitrust (GRUTs) are split-interest trusts, and do not require consideration in valuing a closely held business.
- IRC Section 2703. Sec. 2703 applies to any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property, without regard to such option, agreement or right, or any restriction on the right to sell or use such property.
- IRC Section 2704. Sec. 2704 applies to lapsed voting and liquidation rights in a corporation or partnership. It applies if the individual holding such right immediately before the lapse, and members of such an individual’s family, hold control of the entity, both before and after the lapse. If lapsed voting or liquidation rights exist, then the amount of the transfer is determined by the value of the interest before the lapse minus the value after the lapse.
Practitioner Advice:
Practitioner Advice: Chapter 14 applies in situations where the older generation is giving something to the younger generation. This was Congress’ response to the abuse it felt was inherent in the corporate freeze arena. Under old laws, there were estate tax issues associated with the freezes where tax payments were deferred until death. Under Chapter 14, the gift tax rules hit inappropriately created freeze techniques with a current gift tax liability.
Describe IRC Section 2701
Once the senior family members of the business determine what they want to keep as a controlling interest of the company, they will give away the remaining interest to the younger generations of the family.
* How will this transfer of interest be treated?
* The Internal Revenue Code Section 2701 is titled, “Special valuation rules in case of transfers of certain interests in corporations or partnerships.”
* You must determine the value of any retained interest using the rules in IRC Sec. 2701 in order to determine the value of the remaining interest, and whether or not the transfer of interest is a gift for tax purposes.
* Under this section of the Internal Revenue Code, there is an attempt at determining whether the older generation is retaining any interest of value or giving it all away – if given all away, with only very tenuous retention of interest, the transfer tax kicks in form of a gift tax.
- IRC Section 2701 also deals with the transfer tax treatment of the interest retained by the senior generation and how that retained interest will be valued for subsequent transfers as gifts or as inheritance.
IRC Section 2701 covered transfers include:
* Contributions in capital,
* Redemptions,
* Other changes in capital structure, and
* Transfers that increase the value of the property or applicable retained interest for the transferor and applicable family members.
Calculation of Residual Interest Value:
Total Value of Corporation or Partnership – Retained Interest = Value of Residual Interest Transferred to Family Member
What is the formula for Calculation of Residual Interest Value?
Calculation of Residual Interest Value:
Total Value of Corporation or Partnership – Retained Interest = Value of Residual Interest Transferred to Family Member
Define the Terms Used in IRC Section 2701
Applicable family members: For purposes of Section 2701, “family members” are the transferor’s spouse, lineal descendant of the transferor or spouse, and the spouse of any descendant.
Applicable retained interest: According to Section 2701(b), what is valued under the statute is an “applicable retained interest,” which is:
* A “distribution right,” if immediately after the transfer the transferor and “applicable family members” “control” the entity, or
* Liquidation, put, call, or conversion rights.
Distribution right: A distribution right is defined as a right to distributions from a corporation with respect to its stock or a partnership with respect to a partnership interest, except:
* Rights in connection with “junior equity interests,” defined as common stock or partnership interests under which rights to income and capital are junior to all other equity interests.
* “Liquidation, put, call, or conversion rights,” defined as any such right, or similar right, which affects the value of the transferred interest. However, the term does not include any right, which must be exercised at a specific time at a specific amount.
* Rights to guaranteed payments from a partnership defined in IRC section 707(c), which are certain payments determined without regard to partnership income.
Control means at least a 50 percent interest in a corporation by vote or value of the corporate stock, or at least 50 percent of the capital or profits in a partnership, or the holding of any partnership interest as a general partner. Control includes interests held by “applicable family members.” It also includes attribution through entities and interests held by brothers or sisters or lineal descendants of an individual.
Extraordinary payment rights are retained put, call, conversion rights, and rights to compel liquidation, or similar rights. A right falls within this definition only if it affects the value of the transferred interest.
Describe Applicable Retained Interest
Section 2701 is designed to determine whether a transfer of an interest in a corporation or partnership to a member of the transferor’s family is a gift based upon the applicable retained interest held by the transferor or an applicable family member immediately after the transfer.
* This is a transfer subject to gift tax rules.
* Sec 2701 is trying to determine whether so much has been given away that the transferor or applicable family member has retained no applicable retained interest in the enterprise.
Applicable retained interests include:
* Extraordinary payment rights: That is, a discretionary liquidation, put, call, conversion and rights to compel liquidation.
* Distribution rights: Right to distributions from a corporation’s stock or a partnership’s interest, and
* Qualified payment rights: Fixed-rate cumulative payment (that is, cumulative preferred stock periodic dividend) or payment which the transferor elects to treat as a payment. Qualified payments are fixed in time and amount.
The valuation of applicable retained interest is zero, except to the extent it consists of the right to receive qualified payments.
* For example, without a “qualified interest” the gift tax on the property transferred is based on the entire value of the business, even though the owner is only gifting a partial interest.
* The owner is considered to have a retained interest of zero in the company, therefore the closely held stock or partnership interest gifted is valued at the full value of the business.
The right to a qualified payment means the transferred interest is valued at fair market value.
* Therefore, if the business owner retains a “qualified payment” in the transaction, the partial interest gifted to family members is valued at its fair market value.
The reasoning behind retained interests is that the business owner has an interest with economic value that will be subject to a gift tax on future gifts, or subject to estate tax if held until death. Because the owner has this retained interest of value, the stock or partnership interests transferred to family members can be valued at their fair market value for gift tax purposes.
* A business owner who retains interests that have no economic value, a retained interest of zero, cannot be taxed on those assets in the future.
* Therefore, when a gift is made, the IRS will tax the transaction according to the full value of the business entity, not the value of the partial interest transferred.
For example, assume a closely held business owner has a large estate that includes a significant amount of stock from his business. The owner wants to transfer some stock to his children to reduce the value of his estate and to give his children ownership and the benefit of the stock’s future appreciation. He also wants to receive some income and retain complete control of his business.
With a Preferred Stock Recapitalization the owner might incorporate his business as a regular C Corp, with two classes of stock: voting preferred, which has a fixed par value, and non-voting common stock.
The owner keeps the voting preferred, with a cumulative right to receive a percentage of the company’s net profits annually.
* The cumulative preferred shares will satisfy the owner’s income needs while providing him with a “qualified payment” under Chapter 14: fixed-rate dividends paid periodically on cumulative preferred stock.
* The owner then gifts the non-voting common shares to his children. The children cannot control the management of the company, and this class of stock does not have a preference in the payment of income.
* The non-voting common shares are removed from the owner’s estate, which avoids estate taxation on the common stock’s value and any future appreciation.
Recapitalization also freezes the value of the preferred shares at par value, no matter how much the business grows, which further reduces the stock’s value in the owner’s gross estate.
* For instance, if the business owner’s company is worth $3 million and he gifts $1 million of common stock to his children and keeps $2 million of cumulative preferred shares, he will use up his applicable credit on the taxable gift and will pay income taxes on the fixed dividends he receives each year.
* When he dies, his company may be valued at $5 million, but only $2 million of the previously “frozen” cumulative preferred shares will be included in his gross estate.
Describe the Minimum Value Rule
If the transferor retains both a qualified payment right and an extraordinary right, the value of all rights is determined by assuming the extraordinary right is exercised in such a way to produce the lowest possible valuation.
* Since the value of applicable retained interest is zero except for qualified payments, then value of the interest gifted to the younger generation of the family business can be determined by:
* Value of family business - Value of retained qualified payment = Value of gift
It is possible that the value of the gift could be a small amount due to a large value for qualified payment. Regardless of the value of the gift determined by the subtraction, the minimum value that can be assigned to the transfer of junior equity interest is determined by:
* 10% of the total value of all equity interests in the partnership or corporation + the total indebtedness of the entity to the transferor or applicable family member
What is the minimum value that can be assigned to a transfer of junior equity interest if the total value of the equity interest is $10,000,000 and the total indebtedness is $5,000,000?
* $5,000,000
* $6,000,000
* $15,000,000
* $10,000,000
$6,000,000
- The minimum value that can be assigned to the transfer of a junior equity interest is determined by:
10% of the total value of all equity interests in the partnership or corporation + the total indebtedness of the entity to the transferor or applicable family member - (0.10 x $10,000,000) + $5,000,000 = $6,000,000
Describe Transfer Taxation of Distributions
If corporations or partnerships fail to make the required cumulative distributions or have noncumulative distributions that the transferor elected to treat as cumulative, then when the taxable event occurs, the taxable gifts or estate of the transferor are increased by the value of such unpaid distributions.
A taxable event is the death of the transferor if the applicable retained interest is included in his or her estate, or the transfer of such applicable retained interest. In addition, the transferor can choose to treat late payments as a taxable event.
This value of the distributions is determined on the assumption that all payments are made when due. Then the distributions are compounded as if reinvested at the same discount rate used in valuing the retained interest, less actual distributions paid, based on the date actually paid, but with a four-year grace period for late payment.
However, the additional amount subject to federal transfer tax is limited to the actual growth in the enterprise that was shifted.
If the transfer to a spouse is not taxable due to marital deduction, or because the transfer was for full and adequate consideration, then the distribution is not taxable. But the spouse will inherit the tax consequences on a subsequent taxable event.
Applicable family members other than the transferor are subject to the same taxable event rule with respect to their retained interests. If the applicable retained interest is transferred to such an applicable family member, he or she is subject to the same rules as to distributions accumulating after the transfer.
Qualified payments can be made in the form of debt instruments if they are for not more than four years and the compound interest is at a rate no less than the appropriate discount rate payable from the due date of the payment.
The value of the unpaid distribution is added to the taxable estate or taxable gifts of the transferor along with the value of the retained corporate stock or partnership interest.
* According to the IRC Section 2701, the amount subject to transfer tax is reduced by any amount (unpaid distributions) subject to transfer tax with respect to the same rights to prevent double taxation.
Describe Value of Retained Frozen Interests for Subsequent Transfers
Sec. 2701 only deals with the value of the retained interest for purposes of the valuation of a transferred interest at the time the interest is transferred.
The retained preferred stock or partnership interests are valued under normal rules for purposes of any subsequent transfers.
* This means any retained put, call, conversion, or liquidation right valued at zero for the purpose of determining the value of the gift under Sec. 2701 is subsequently valued when the retained interest is transferred.
This results in double taxation since an interest valued at zero when retained is subsequently valued at fair market value when the transferor dies or transfers the retained interest.
* To avoid this, there is an adjustment to the decedent’s and possibly the transferor’s spouse’s adjusted taxable gifts.
* This is done by reducing adjusted taxable gifts to reflect the amount by which the decedent’s taxable gifts were increased due to Sec. 2701 over the increase in the estate or adjusted taxable gifts attributable to the inclusion of the applicable retained interest in the estate.
Describe when a Freeze is a Viable Alternative?
Although a corporate or partnership freeze through the use of common and preferred stock or partnership interests is possible, many believe it has less utility in present times.
* In order to avoid a zero valuation for retained interests and minimize the value of the gift, it is necessary to make distributions with respect to the retained interests.
However, if the company is a C corporation, there is a double tax on corporate distributions (once at the corporate level and once at the shareholder level). The income tax will be paid now, while the estate tax is deferred, often until the death of a surviving spouse. If the entity is a partnership with a good cash flow, the freeze may be a good option because the distribution is only taxed once.
If the qualified payments are not made, the resulting inclusion of accumulated distributions in the transferor’s taxable gifts or estate could easily exceed the value of the retained interest for federal gift tax purposes.
Retained Interest and Taxable Gift Calculation Example:
Assume the applicable discount rate is 10%, and the retained dividend is 8%. Based on the assumption that the present value of the annual dividend is its fair market value, the value of the retained interest is 80% of the value of the transferred property. Thus, if the business is valued at $1,000,000, the retained interest is valued at $800,000, the gift at $200,000.
If the dividends are not paid for 10 years, and the grace period does not apply, the value of these unpaid dividends plus accrued interest at the same 10% is approximately $1,275,000 (n = 10, i = 10, PV = 0, PMT = 80,000, solve for FV). This would be the amount of the taxable gift under Sec. 2701(d)(1).
In the example, the amount included in the taxable transfers of the transferor cannot exceed the actual growth in the business.
The Congressional Committee Reports acknowledge that all existing discounts are preserved. This makes it possible to state that the value of the transferred interest for federal gift tax purposes must be reduced to reflect discounts for minority interests and lack of marketability.
How do you Calculate Taxable Gift Value Reflecting Discount?
- Determine the FMV of all family-held interests in the entity.
- Subtract all senior equity interests held by the family other than applicable retained interests held by the transferor or applicable family members, with a pro-rata adjustment for any control premium, followed by the subtraction of the value of all applicable retained interests held by the transferor and applicable family members.
- Allocate the remaining value among the transferred interests and any other family-held junior or subordinate interests.
- Reduce value for consideration received, and for any minority or similar discounts (including a discount for lack of marketability) determined by subtracting the FMV of the family-held interests from the value of the transferred interest determined without regard to Sec. 2701.
What are Alternatives to the Freeze?
If the transferor retains common stock or partnership interests and transfers the preferred interests, Sec. 2701 does not apply.
* This is sometimes called a reverse freeze.
* When the transferor dies, the value of the common stock will reflect growth.
* However, the common stock would be substantially discounted in value because of the burden of the preferred stock with its prior claim to dividends and liquidation proceeds.
A variety of other techniques may be used to freeze growth. These include:
* Installment sales of business interests to family members
* Use of the private annuity, and
* Premortem stock redemptions or partnership liquidations of interests of senior family members, giving senior family members a cash flow and transferring the growth in the value of the enterprise to the next generation.
Under some circumstances, if the transferor receives a debt instrument issued by a family partnership or corporation, the IRS may seek to treat it as retained preferred stock.
Section 1 - Estate Freeze Rules Summary
Freeze techniques are used in closely held family corporations and partnerships to retain control and authority. The older generation may pass on only the additional benefits to their successors, the younger generation. Or they may create common stock that has nonvoting or limited voting rights. The retained stock or partnership interests of the senior generation have to have a limited liquidation value. Valuation of businesses and properties transferred is a blend of the estate planning, appraiser’s skills, IRC, and court judgments.
In this lesson, we have covered the following:
* Chapter 14: IRC Chapter 14 is used to value interests in corporations and partnerships. Chapter 14 affects the gift tax value of partial interests of corporate stock or partnership interests that are transferred to applicable family members, who hold more than 50% of the value of the corporate stock or partnership interest.
- Section 2701 determines whether interest transfers in partnerships or corporations to family members are gifts. It applies to the applicable retained interest, which consists of: the extraordinary payment right, the distribution right, and the qualified payment right. The minimum value of a gift is ten percent of the total value of all equity interests, plus the total indebtedness of the entity to the transferor. If a taxable event occurs, the taxable gifts or estate of the transferor increases by the value of unpaid distributions. Corporate distributions are liable for double tax. As preferred stock is involved, the use of freeze eliminates qualification for the S-Corp election. The various freeze techniques include: installment sales of business interests to family members, use of a private annuity, and pre-mortem stock redemptions or partnership liquidations of interests.
Harold Bates would like to gift some part of his stock in the corporation to an applicable family member, after which he would retain some interest in the corporation. To which of the following members could he gift a part of his stock? (Select all that apply)
* Harold’s wife Sandra
* Harold’s great-aunt Hilda
* Harold’s son Jake
* Harold’s brother Michael
* Harold’s niece Cindy
Harold’s wife Sandra
Harold’s son Jake
- Harold can gift the stock to Sandra and Jake. Under Sec. 2701, family members are the transferor’s spouse, lineal descendant of the transferor or spouse, and the spouse of any descendant
Lynn is an owner of a closely held business that is appreciating rapidly. She decides to transfer $400,000 of stock to her children who work in the family business to reduce the value of her estate, and have her children benefit from the company’s growth. Lynn wants to receive income from the business but she does not structure the income payments as qualified payments. Therefore, her retained business interest is valued at zero.
* False
* True
True
* Under Chapter 14, a qualified payment is needed to have the stock transferred to her children valued at $400,000. With a retained business interest of zero, the gifted shares are valued at the full value of Lynn’s business interest. If Lynn had recapitalized her stock into non-voting common and cumulative voting preferred shares, and gifted the common stock to her children, she would have “qualified payments” and the common stock would be valued at $400,000 when transferred.
Julia Douglas at 55 would like to hand over the reigns of her multi-billion dollar enterprise to her son Eddie. But as he is very new to the business, she would like to give him some more time to learn the tricks of the trade. She plans to freeze growth of the enterprise and pass on the benefits to Eddie. Which of the following methods can she adopt to bring about the freeze? (Select all that apply)
* Installment sales of business interests to family members
* Use of the private annuity
* Preferred stock recapitalization
* Buy-sell agreements
* The transferor retains common stock or partnership interests and transfers the preferred interests
Installment sales of business interests to family members
Use of the private annuity
Preferred stock recapitalization
Buy-sell agreements
* There are a variety of freeze growth techniques that Julia can use. Installment sales, private annuities and preferred stock recapitalizations give business owners cash flow and they transfer the growth in the value of the enterprise to the next generation. Buy-sell agreements also freeze the value of the business interest for estate tax purposes.
Match the section with the correction description:
Sec. 2701
Sec. 2702
Sec. 2703
Sec. 2704
* Applicable to lapsed voting and liquidation rights in a corporation or partnership.
* Applicable to valuation of corporate and partnership interests designed for estate freeze purposes
* Applicable to any agreement or right to acquire or use the property at a price less than the fair market value
* Applicable to interests in trusts
- Sec. 2701 - Applicable to valuation of corporate and partnership interests designed for estate freeze purposes
- Sec. 2702 - Applicable to interests in trusts
- Sec. 2703 - Applicable to any agreement or right to acquire or use the property at a price less than the fair market value
- Sec. 2704 - Applicable to lapsed voting and liquidation rights in a corporation or partnership.
Section 2 - Valuation of Closely Held Business
To be effective, what 3 elements must an estate freeze plan contain?
Lower valuation for the business interest may result from interest that does not fully participate in the future growth of the business, such as preferred stock and frozen partnership interests, and long-term installment sales. A failure to properly undertake valuation planning for a family business can leave an estate at the mercy of the IRS and may make it impossible to retain the enterprise.
To be really effective, any estate freeze plan must contain the following elements:
* A present transfer of interests in the business from family members in the older generation to those in younger generations, either by sale, gift, or both.
* A shift of all or part of the future growth of the enterprise to the younger generation.
* The owners of the family business should consider making full use of their applicable credit and even their GST tax exemption for lifetime transfers of family business interests.
On the other hand, retention of the value of business interests in the estates of the older generation may facilitate stock redemptions, particularly under IRC Sec. 303, deferred payment of tax under IRC Sec. 6166, and special-use valuation for real property under IRC Sec. 2032A, to meet the minimum percentage requirements in the gross and adjusted gross estates.
Describe Valuation Discounts
The IRS has recognized that valuation of interests in closely-held businesses and family limited partnerships must take into account the difficulty of transferring property that has a limited market, or property that has limited rights.
* Discounts can be applied when these business interests are transferred to family members to reflect the proper valuation of these limited interests.
The two most common discounts available for family and closely-held businesses are the discounts for
* Lack of marketability, and/or
* A minority interest.
A lack of marketability discount is used when valuing transfers of business interests to junior family members during the business owner’s life or at death. A discount is allowed because investors are not interested in closely held stock or family limited partnership shares, and the cost of taking this stock public or selling it on an exchange to potential investors is very expensive. Therefore, a discount for the lack of marketability is allowed by the IRS.
In valuing interests in corporations, which hold investment assets such as real property, marketable securities, and coins, consider whether there are potential capital gains that will be taxed at the corporate level.
* The existence of potential capital gains is considered a factor that increases the lack of marketability discount.
A minority interest discount is allowed when transferring business interests to minority shareholders because these shareholders have no influence or control over business operations or management policy. Specifically, minority shareholders cannot compel dividend payments or obtain the company’s assets through liquidations, mergers, or sales.
* A discount is applied to a percentage of the appraised value of the stock which reduces its value for a gift or estate tax purposes.
A lack of marketability discount and a minority interest discount can be combined together when calculating a discount on shares of closely held stock.
* Typically the IRS will scrutinize discounts that exceed the 35-45% range, so business valuations should be conducted by professional appraisers.
Describe Lock-In Discount
A discount that reflects a circumstance in which a limited partner cannot withdraw from the partnership and is locked into his investment, is known as a lock-in discount.
For partnerships, always consider whether the partnership interest can be liquidated through the enforcement of withdrawal rights.
* In some states, if the partnership agreement does not provide a time for when capital will be returned, a limited partner is given the right to withdraw from the partnership six months after giving notice to the general partner.
In other states, applicable state law prohibits the return of capital to a limited partner except upon the occurrence of certain events specified in the partnership agreement, for example, upon expiration of the partnership term.
If the partnership agreement or state law does not confer upon the limited partner any right to withdraw capital, then the interest may remain in the partnership until the expiration of the partnership term, often 35-50 years in length.
* In such a case, the limited partner is locked in to maintain his investment in the partnership and a lock-in discount is appropriate.
Describe Key Person Discount
and Blockage Discount
A key-person discount is allowed to reduce the value of an estate to less than fair market value upon the death of a key employee in a closely-held business. The key person in many businesses is the founder of the business, who typically owns most of the stock and controls the management of the company.
* Since the value of the company’s stock would sharply decline at the owner’s death, the IRS may allow a discount for the impact that this loss might have on the business.
A blockage discount is allowed by the IRS if the immediate sale of a substantial amount of publicly traded stock that the decedent owned would adversely affect the stock’s market price.
* The blockage discount would reduce the value of the stock held in the decedent’s estate, and reduce the estate tax liability.
Match the following with it’s correct descrption:
Minority Interest
Lack of Marketability
Key Person Discount
Blockage Discount
* Sale of sizable amount of publicly traded stock at the owner’s death which depresses its market price.
* Closely held business stocks with no readily available market.
* Discount for the loss to the business due to the owner’s death.
* A shareholder has less than majority interest and has no control over the business.
- Minority Interest - A shareholder has less than majority interest and has no control over the business.
- Lack of Marketability - Closely held business stocks with no readily available market.
- Key Person Discount - Discount for the loss to the business due to the owner’s death.
- Blockage Discount - Sale of sizable amount of publicly traded stock at the owner’s death which depresses its market price.
Describe the Fractional Interest Discount
A fractional interest discount or a “co-ownership discount” is available in the decedent’s estate for real property that is owned with another party, who is unwilling to sell their partial interest to a third party or to the decedent’s estate, or who will not buy out the decedent’s partial interest in the property.
* The co-owner of the property cannot be the decedent’s spouse, heirs, business partners, or joint tenants under JTWROS.
The courts recognize that the value of a fractional interest in real property may be less than the pro-rata value of the same real property if it were held as full fee simple property.
* The discount is a percentage of the value of the real property included in the decedent’s estate, which reduces the decedent’s gross estate.
Among the factors cited by the courts in justifying the application of a discount to the pro-rata value of a fractional interest in real property are the following:
* The owner of a fractional interest has greater difficulty in finding a ready market for the sale of the interest due to the fact that a buyer of the interest will have to share ownership with another.
* The owner of a fractional interest cannot sell the fee interest in the property or lease the property without the consent of the holder of the remaining interests.
* The owner of a fractional interest by himself generally cannot obtain a loan from normal sources of credit secured by only a partial interest in the real property.
* The owner of a fractional interest may not have the right to exclusive use of the property so as to put it to its highest and best use.
* An action by an owner of a fractional interest to partition real property does not guarantee that the partitioning co-owner will receive property whose utility is equal to that of the entire parcel from which the partition took place.
* The cost of bringing an action to partition real property is often substantial and fee interest in a portion of the property received may be worth less than the proportionate share of the whole property or the sales proceeds. If the property is not fairly partitioned it may not equal the property’s fair market value.
* The existence of an undivided fractional interest is a legal matter affecting title to real property and often cannot be solved without obtaining legal counsel and commencing legal proceedings at significant cost.
For these reasons, many courts have allowed a discount to the proportionate value of real property in order to arrive at the value a willing purchaser would be willing to pay for an undivided fractional interest in real property. If the taxpayer asserts that a discount from the proportionate value of the entire property is warranted, he or she must prove that a willing buyer would purchase the property and a willing seller would sell the property at a price that is less than its proportionate value.
The extent of ownership rights is determined under state law. Though the IRS Valuation Manual states that the fractional interest discount is generally based on the cost of dividing the land, such as survey costs, court costs, and legal fees, the following other factors must be considered:
* Size of the fractional interest
* Number of owners
* Size of tract and likelihood of partition
* Use of land
* Access to financing
What are the pitfalls to avoid in Fractional Interest Discount?
In the valuation of closely-held businesses, there are some potential pitfalls.
* For example, in planning for discounted asset values, the calculation of adjusted taxable gifts may force the value of all lifetime gifts to be reconsidered. The result of the reconsideration could increase the estate’s tax bracket.
- Another pitfall may come in over-reliance on expert valuations. The following cases illustrate how the courts are closely examining the approach used by experts in valuing business interests and the qualifications of the appraisers:
- In Estate of Murphy, TC Memo 1990-472, 18 days before death the decedent transferred less than 1% to each of two children to bring her percentage below 50%, and her estate claimed a minority discount. The Tax Court allowed a discount for lack of marketability, but rejected the minority discount, noting that the decedent gave up control on paper, but not in reality.
- In Estate of Campbell, TC Memo 1991-615, the court emphasized the importance of evaluating both earnings and net asset values in arriving at the actual value and allowed a substantial discount.
- In Estate of Berg, TC Memo 1991-279, a 60% discount in the value of the closely-held stock was claimed to represent both minority and lack of marketability discounts. The appraisal was by petitioner’s CPA, Mr. Whalen, an experienced practitioner who had served on the faculty of several universities and had testified as an expert witness in several cases on lack of marketability and minority discounts, but as the court noted, with no formal education as an appraiser.
Describe Controlling Interest
If the business interest being valued is a controlling interest, then you must add a premium to the valuation to reflect control. The IRS has applied this concept to situations where the transfers to individual family members were of minority interests, but they could collectively exercise control over the business entity.
Controlling Interest Example:
An owner of a closely held business owned 100% of the stock in a family corporation. He transferred 30% to each of the three children and 5% to his spouse. The gifts were valued at net asset value less a 25% discount for minority interest and lack of marketability.
* Since the blocks were transferred simultaneously, each of the children had a swing vote characteristic.
* This meant that the owner of any 30% block could join with the owner of any other 30% block to exercise control.
* As the controlling interest increases, premiums should be added to each block accordingly.
Section 2 - Valuation of Closely Held Business Summary
In this lesson, we have covered the following:
* Valuation of a Closely Held Business cross-purchase or redemption plans and partnership liquidation agreements have a substantial impact on the valuation of a business, including restrictive agreements. Lower valuation for the business interest may result from retained interests that do not fully participate in the future growth of the business, such as preferred stock and frozen partnership interests, and long-term installment sales. Valuation discounts are available for transfers made to junior family members, such as minority discounts and lack of marketability discounts, which reduce the value of the gifted shares. Other discounts are available to reduce a person’s gross estate such as key person discounts, blockage discounts, and fractional interest discounts.
* Valuation Discounts are available for transfers of closely held business interests and family limited partnership interests to family members. Discounts can be taken for lack of marketability and minority interests that reflect the limited public value of the gifted shares, and the limited partner’s lack of control and influence over the company.
- Lock-In Discount is permitted when a limited partner cannot withdraw from a partnership and is therefore “locked-in” to maintain his investment.
- Other Discounts can be taken to reduce the value of a decedent’s estate after 2010. A key-person discount is taken upon the death of a key employee in a closely held business to compensate for the loss to the business. A blockage discount is permitted if a sizeable amount of a decedent’s publicly traded stock would depress the stock’s market price if sold.
- Fractional Interest Discount or “co-ownership” discount is available at the owner’s death when the fractional interest owned in the property cannot be readily sold.
- Avoiding Pitfalls such as over-reliance on expert valuations, and having gifted property brought back into the estate tax calculation as adjusted taxable gifts.
- Controlling Interests: a premium is added to each unit of stock transferred to limited partners when the collective value of their shares control the business or partnership.
Choose the most appropriate valuation technique to reduce federal estate taxes.
* Fractional interest discount can be taken for property the decedent held as tenants in common with a neighbor, who refuses to sell the property.
* A blockage discount is available when an executor sells 100% of the decedent’s partnership shares to the remaining partner.
* A minority interest discount is available for the decedent’s ownership in a house he co-owns with his father.
* A key man discount can be used in the limited partner’s estate.
Fractional interest discount can be taken for property the decedent held as tenants in common with a neighbor, who refuses to sell the property.
- A fractional interest discount can be taken at the property owner’s death when the neighbor refuses to sell his partial interest in the tenancy in common property.
- A blockage discount only applies to sales of publicly traded stock that would depress market price if sold.
- A minority interest in a home is not a closely held business interest.
- A key man’s discount is only available for the loss to the business upon a key employee’s death.
