General Practice, Solo & Small Firm DivisionMagazine

 
Volume 17, Number 2
March 2000

TAX LAW

NO ESTATE TAX FRACTIONAL INTEREST OR LACK OF MARKETABILITY DISCOUNT ALLOWED ESTATE OF YOUNG

BY JONATHAN S. BATTEN

In Estate of Young v. Commissioner, the Tax Court held that property owned by a husband and wife as joint tenants was not subject to discounts for fractional interest and lack of marketability in the valuation of the decedent's gross estate. The court rejected the estate's position that its situation was analogous to Propstra v. United States, where a fractional interest discount of 15 percent was allowed. The court also rejected the estate's interpretation of section 2040 of the Internal Revenue Code (Code), which deals with the estate tax consequences of jointly owned property, and grounded its decision on the unique aspect of a joint tenancy-the right of survivorship.

Factual Background. At the time of decedent's death, he and his wife owned parcels of property as joint tenants with right of survivorship. Decedent and his wife were not U.S. citizens. The tax return excluded one-half of the property's value as community property and claimed an additional 15 percent fractional interest discount. The Internal Revenue Service found that the estate was not entitled to the fractional interest discount and determined a deficiency.

The estate's position was based on the Ninth Circuit's decision in Propstra v. United States, which was decided under section 2033 of the Code. The estate argued that section 2040 merely determines the interest to be included in the gross estate. Once determined, the estate is then valued using the hypothetical buyer-seller transaction of Regulation section 20.2031-1(b), at which point fractional interest discounts can be applied. The estate relied on the similarity in language between section 2040(a) and section 2033. In Propstra, the Ninth Circuit allowed a 15 percent fractional interest discount to be applied to the one-half share of a community property marital estate that passed to the surviving spouse despite the fact that the wife held 100 percent of the property in question upon her husband's death. The husband's one-half community property interest was valued separately from that of his surviving spouse.

The Applicable Law. Section 2040(a) includes in the gross estate "the value of all property to the extent of the interest therein held as joint tenants with right of survivorship by the decedent and any other person, or as tenants by the entirety." It excludes from the gross estate the proportional amount of the joint property that belongs to or arises from the consideration provided by the other joint tenants. Section 2040(b) treats property held by married couples as tenants by the entirety or as joint tenants as a "qualified joint interest" for which only one-half of the value is included in the gross estate.

The fractional interest discount recognizes the difficulties inherent in valuing a fractional undivided interest in property which arise from the unities of interest and possession that characterize undivided interests in property. Because these unities make the fractional interest less attractive to a hypothetical purchaser due to the control and possession of the property by the other owners of undivided interests in the property, the value of the interest in the piece of property is discounted accordingly.

The Decision. The Tax Court disagreed with the estate's interpretation of section 2040 and Propstra, emphasizing the distinctive feature of joint tenancy (the right of survivorship) in arriving at its result. It questioned the estate's comparison of the language of section 2033 and section 2040, noting that the latter section includes in the gross estate "the value of all property to the extent of the interest therein held as joint tenants with right of survivorship by the decedent and any other person." From that language, the court concluded that section 2040, like section 2031, is a valuation section and not merely an includability section, rejecting the estate's fractional interest discount claim based on identity in statutory language. The court further distinguished section 2040 from section 2033, stating that because of joint tenancy's unique aspect, the decedent no longer holds an interest in the property at the time of death for purposes of section 2033. Therefore, section 2040 is a necessary artificial inclusion of the joint tenancy property without which the property would avoid taxation. The amount includable does not depend on a valuation of the property transferred at death as is the case in section 2033; rather, it includes the entire value of the property. The court held inapplicable the fractional interest and lack of marketability discounts in Young.

The court articulated a method for determining the value of joint tenancy to be included in the decedent's gross estate. Valuation begins with section 2031, which, by Regulation 20.2031-1(a), mandates that sections 2033 through 2044 be considered. The court then turned to section 2040, which includes the entire value of the property. Subtracted from this value is a formulaic amount, which represents the exclusion, dictated by the remainder of section 2040(a). This formula multiplies the entire value of the property by the ratio of the survivor's consideration over the entire amount of consideration paid for the property. The court applied its valuation method to Young's estate, including the full value of the estate less a proportional share of the estate based on consideration paid for the estate that was traceable to the surviving spouse. While no proof of the consideration provided by the wife was given, the amount was set at one-half due to the Internal Revenue Service's mistaken initial reliance on section 2040(b), which halves the value of the gross estate if the decedent and spouse are the only joint tenants.

In determining that fractional interest and lack of marketability discounts are inapplicable in the valuation of joint property upon the death of the penultimate joint tenant, the Tax Court reached the correct decision in Young. The death of a joint tenant, in a case where there are only two joint tenants, leaves the surviving joint tenant with a full undivided interest in the property. Using a fractional interest discount in the valuation of a full interest in property is a contradiction in terms. Furthermore, when a single party owns a complete, undivided interest in a piece of property, none of the difficulties in selling that piece of property are present to merit a lack of marketability discount.

Estate Planning Implications. Because of the marital deduction for property descending to a surviving spouse under section 2056(a), the impact of Young may be minimized. Section 2056(a) allows a deduction from the gross estate for the value of any interest in property that passes or has passed from the decedent to the surviving spouse. Due to this deduction, in most cases, marital joint property would escape estate taxation upon the death of one spouse. However, the marital deduction is not applicable in cases where the surviving spouse is not a U.S. citizen. Married couples with at least one resident alien have the incentive to limit the value of the gross estate that has the potential to pass to the resident alien spouse. Unless the majority of the consideration used to purchase jointly owned property can be traced to the resident alien spouse, estate tax implications must be considered before making a decision to own property as joint tenants. Because of Young's denial of fractional interest and lack of marketability discounts, where an election is possible for married couples between different modes of concurrent ownership, the benefits of choosing joint ownership should be carefully weighed against the potential for greater estate tax exposure.

Another class of property owners impacted by the Young decision is unmarried joint tenants. For these property owners, the marital deduction is unavailable upon the death of the first joint tenant. The estate tax scheme embodied by section 2040 and the Young decision makes the estate tax consequences of joint tenancy for unmarried joint tenants potentially quite severe. Unless contribution by the surviving tenant of consideration to the purchase of the property can be proven, section 2040(a) exposes the entire property to estate taxation. Also, unlike a tenancy in common, fractional interest discounts are unavailable to reduce the amount of the tax that must be paid. Consequently, nonmarried concurrent owners should consider other modes of ownership. However, the desire to obtain a fractional interest discount must also be measured against the practical costs of proving and sustaining the appropriateness of the discount.

Jonathan Batten, a senior staff member of The Tax Lawyer, is currently a third-year student at Georgetown University Law Center and expects to receive his J.D. in May 2000. He has accepted a position at Arnold & Porter in Washington, D.C., starting in the fall.

For More Information about the Section of Taxation

  • This article is an abridged and edited version of one that originally appeared on page 391 of The Tax Lawyer, Winter 1999 (52:2).
  • For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.
  • Website: www.abanet.org/tax/home.html.
  • Periodicals: The Tax Lawyer, quarterly journal; quarterly newsletter. The Practical Tax Lawyer (published by ALI-ABA in cooperation with the Section), subscription available to Section members at a significant discount; The State and Local Tax Lawyer, annual journal.
  • Books and Other Recent Publications: Sales and Use Tax Deskbook, 1998-99 ed.; State and Local Taxation of Banks and Other Financial Institutions; Property Tax Deskbook, 1998-99 ed.; TaxCite: A Federal Tax Citation and Reference Manual; Value Added Tax: A Model Statute and Commentary; A Comprehensive Analysis of Current Consumption Tax Proposals.

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