Holders of stock in closely held businesses often find that estate and gift taxes pose expensive obstacles to transfers of those interests to the next generation. In short, the value of the stock transferred will be taxable. Estate freeze techniques using different classes of stock have been greatly circumscribed by Internal Revenue Code (IRC) § 2701, and similar uses of buy-sell arrangements and options have been curtailed by IRC § 2703. There are, however, a few planning opportunities left.
This article will explain one of those opportunities, which has been provided by the IRS's recent capitulation to the Tax Court's position on intra-familial minority discounts in gratuitous transfers of closely-held stock. It will also touch on some of the peripheral issues and pitfalls associated with planning to make use of the new IRS position.
The value of closely-held stock is affected by various factors intrinsic to the company, such as the dividends traditionally paid by the business, the outlook for the company, and the stock's marketability as influenced by market forces and securities regulations. Factors extrinsic to the company can also affect the value of a block of stock, such as the "blockage discount" applied where a block of stock is so large that it is difficult to liquidate without depressing the stock's price.1 Still other factors can be personal to the shareholder. Where the shareholder's block of stock ensures control, its value can be much higher on a per-share basis than that of a minority interest.2 Until recently, minority interest blocks gratuitously transferred among family members were not valued independently as interests entitled to a "minority discount," if the family had control of the corporation.3 The transferred blocks were instead valued by the Service as a portion of the entire block owned by the family. This position taken by the Service was successfully challenged in a number of court cases.4
In January of 1993, the IRS issued Revenue Ruling 93-12, holding that a sole stockholder of a corporation who gave a 20% interest to each of his five children would not be denied a minority discount in valuing those shares solely due to the factor of corporate control in the family.5 This ruling represents a retreat from the Service's previous position, and is a significant window of opportunity for small business owners seeking to pass those businesses to their designated successors while minimizing transfer tax consequences. In effect, a controlling shareholder who chooses to give away minority stakes in a company can claim they together total much less than the value of the control block for transfer tax purposes. Also, the estate of a shareholder who died owning a minority interest can get a minority discount for that interest, notwithstanding the fact that the decedent's estate and family members together may own a controlling interest.
Understanding the ruling requires understanding how the IRS values closely-held shares in order to apply transfer tax. To apply transfer gift tax, the IRS taxes gifts based on their value on the date of the transfer.6 For estate tax purposes, stock is valued the moment of the decedent's death.7 Where there are no sales prices or bona-fide bid and asked prices for stock, IRS regulations provide that the degree of control represented by the block of stock to be valued is among those factors which must be considered.8
In Revenue Ruling 81-253, the Service took the position that where the stock owned by the family unit constituted a controlling interest, no minority discount would generally be available for intra-familial transfers of blocks constituting less than a controlling interest.9 The ruling did leave open the possibility that family attribution would not be applied where there was evidence of discord within the family unit that would suggest that the stockholders would not act cohesively in controlling the corporation.10 The ruling specifically rejected, among other cases, a 1981 Fifth Circuit case,Estate of Bright v. Commissioner, 658 F.2d 999, (5th Cir. 1981) where a minority discount was allowed in an estate tax context. The Service's position subsequently fared poorly in court,11 and it is the Estate of Bright case that the Service ultimately cited again when it abandoned its former position.12
The Estate of Bright case arose in Texas, a community property state. The decedent and her husband together owned, as community property, 55% of the shares of several businesses. The stock was not publicly traded, nor was there a market for it at the time of the decedent's death. The decedent devised her share of the stock to her husband as trustee of a trust for the benefit of her children. The government argued that the devised property was a half-interest in a control block of stock,13 and that family attribution should be applied to aggregate the estate's interest and the husband's interest.14 According to the government, the stock should then have been valued by valuing the entire control block, and reducing the resulting amount by one-half.
The court held that the estate's right of partition under Texas law made the undivided half interest equivalent to a 27.5% block of stock.15 The court went on to hold that family attribution would not apply to cause the block to be valued as a whole.16 In reaching its holding, the court distinguished two gift tax cases that reached contrary results, and rejected a third.17
The court posited as another ground for its holding the formula that is the touchstone for valuation, the "willing buyer-willing seller" rule set forth in the regulations.18 The court made it clear that the buyer and seller to be considered were hypothetical, and that the value of the interest was to be considered at the moment of death, and not by reference to the value in the hands of the decedent or the recipient.19
As noted above, there are many factors affecting valuation, and these factors are applied in combination. Practical application of discount rules require the practitioner to exercise sound judgment and seek qualified outside help20 in determining a valuation for the stock and whether it qualifies for the various discounts.21 The IRS applies a facts-and-circumstances test. Briefly, the size of the minority discount will be dependent on the rights embodied in the stock--the less valuable the minority shareholder's rights, the larger the appropriate discount. Courts have recently approved discounts as high as sixty-five percent,22 and at least one commentator has argued for combined minority and non-marketability discounts as high as ninety percent.23
Despite Revenue Ruling 93-12 and the Estate of Bright case, practitioners should not conclude that form can control substance for purposes of obtaining the minority discount. In Estate of Murphy v. Commissioner, 60 TCM 645 (1990), the decedent, who had been diagnosed with cancer, made .88% transfers to her two children less than three weeks before her death, nudging her ownership down to just under 50%. There was no reshuffling of the parties' corporate positions, and the tax court found that nothing of substance changed.24 The evidence indicated that the sole purpose of making the transfer before her death was to obtain a minority discount for the stock. The minority discount was denied.
Although the Estate of Murphy case was decided prior to Revenue Ruling 93-12, the IRS's ability to rely on Estate of Murphy has probably not been greatly affected. The Estate of Murphy decision distinguished Estate of Bright and its progeny's rejection of family attribution,25 holding instead that the inter vivos transfers would be aggregated with the post mortem transfers under the step transaction doctrine,26 and that issues of control and tax avoidance also militated against allowing the discount. After Revenue Ruling 93-12, however, the latter reasons for the holding probably carry less weight than the IRS's traditional step-transaction and form-over-substance arguments. But practitioners should be cautious in recommending any course of transfers that fails to substantially affect beneficial ownership of the stock, that occurs during a short span of time, or that clearly occurs in contemplation of imminent death.
The most obvious cost of using the minority discount is involved with the expert appraisals necessary to support it in the event of examination by the IRS. The value of both the company and the minority interests to be transferred must be calculated. If the gifting program involved is to occur over time, the appraisals will need to be periodically updated. Although inter vivos use of the minority discount is an attractive course for the smaller company, especially where the annual exclusion can be combined with a gifting program over time to avoid using any of the donor's unified credit, gifting the stock precludes the opportunity to step-up the basis of the shares to fair market value on the donor's death.27 Where the unified credit would shelter the value of a large portion of the donor's entire estate even in the absence of a gifting program, an aggressive gifting program could ultimately be counter-productive, especially if the donee might want to someday sell his or her interest in the company. These concerns will have to be balanced, and the gifting program tailored accordingly to minimize the tax consequences of any anticipated transactions.
The minority discount strategy approved by the IRS in Revenue Ruling 93-12 represents an important planning opportunity for the astute practitioner. Care must be taken, however, that the company is properly appraised, the discounts are appropriate, the transfers are substantial and separated in time from each other and from the moment of death, and that gifts are an appropriate vehicle for accomplishing the client's estate planning objectives.
16. Id. at 1002. The court specifically relied on Estate of Lee v. Commissioner, 69 T.C. 860 (1978). In that case the Tax Court held that upon the death of one spouse in a community property state, the estate's 1/2 interest in a control block of stock would be valued as a minority interest. Id. at 874.
17. Id. at 1004-1005. The court considered H. Smith Richardson, 17 T.C.M. 43,496 (1943), aff'd 151 F.2d 102 (2nd Cir. 1945). It found that on appeal the Second Circuit Court, even while upholding the Tax Court's result, specifically identified the block of stock in question as a minority interest and disapproved the Tax Court's approach to valuation. Next the court considered Blanchard v. United States, 291 F.Supp. 348 (S.D. Iowa 1968). It noted that the court in that case had found an informal agreement among the donor and donees to sell the stock as a block prior to the gift, and declined to follow the case to the extent its language suggested that family owned stock would be attributed to a decedent's stock interest. Finally, the court considered Driver v. United States, 76-2 U.S.T.C. ¶ 1355, 38 AFTR 2d 76-3615 (W.D. Wis. 1976), a case in which gifts of stock to family members over two days were aggregated and valued as a control block of 66% of the stock, even though no single family member was given as much as 50%. The court concluded that Driver stood alone in judicially engrafting a family attribution doctrine upon the standards governing gift or estate tax valuation, and declined to follow it.
20. Failure to do so can lead to problems. See, e.g. Estate of Berg v. Commissioner, 61 TCM 2949 (1991), aff'd in part, rev'd in part, 92-2 U.S.T.C. ¶ 60,117 (8th Cir. 1992). The taxpayer's valuation expert was held to have improperly relied on Estate of Andrews, supra n. 4, and was found to have failed to discuss the size of the minority interest, the equity structure of the corporations, and the types of properties that made up the company's assets, etc., all of which were covered by the IRS expert's study, which was based on comparable properties adjusted for relevant factors.
21. Although valuations are best left to experts, for good discussions of this subject, see Hitchner & Rudd, The Use of Discounts In Estate And Gift Tax Valuations, TR. & EST., August 1992, p. 49., Emory, John D., A professional appraiser's approach to fair market valuation of closely-held securities, EST. PLAN., July 1981, p. 228, and Steele, Philip, How to Value the Privately Owned Business,COM. L.J., December 1985, p. 639. One of the most-cited sources in this area is G. DESMOND & R. KELLEY, BUSINESS VALUATION HANDBOOK (2d ed. 1979).