By M. Read Moore
Imagine an estate with only one asset: a controlling interest in a closely held business that the decedent's will gives in equal shares to his wife and a charity. Although at first glance this estate would seem to be nontaxable, the IRS may suggest that the estate owes federal estate tax. Impossible? Not necessarily, when one focuses on the values used to determine the marital and charitable deductions rather than the public policy that underlies the deductions. The value of an asset included in a decedent's gross estate is its fair market value in the hands of the decedent, determined without regard to the identity of the transferee. Code 2031. See TAM 9432001 (identity of legatee not relevant in determining value under Code 2031). By contrast, the amount of the marital deduction allowable for an asset passing to a decedent's surviving spouse depends on the value of the asset in the hands of the surviving spouse. Code 2056. The different measures of value raise the possibility that an asset may not necessarily have the same value for gross estate purposes as it has for marital deduction purposes. To the extent that the marital deduction value of the asset is less than its gross estate value, an estate plan intended to avoid estate tax may in fact generate tax. For example, the 100% marital-charitable estate described above could become taxable because the spouse and charity each received discountable minority interests.
The courts are split on whether symmetry is required between the gross estate and marital deduction value of an asset, but the weight of authority favors differing values. See Ahmanson Found. v. United States, 674 F.2d 761 (9th Cir. 1981) (estate tax charitable deduction); Chenoweth v. Commissioner, 88 T.C. 1577 (1987) (marital deduction). But see Provident Nat'l Bank v. United States, 581 F.2d 1081 (3d Cir. 1978) (marital deduction). A number of private letter rulings and technical advice memoranda (TAMs) show that the IRS firmly believes that symmetry is not required. This article describes how the "differing values" problem arises in estate planning and administration. What happens when a decedent's estate includes a controlling interest in a closely held business but the surviving spouse receives only a minority interest in the business? Can a similar problem arise when an estate contains a wholly owned parcel of real property but the surviving spouse receives only a fractional interest in the property? What is the effect on the marital deduction of buy-sell agreements that do not set the gross estate value of business interests subject to the agreement? Although the principles discussed below concern the marital deduction, they also apply to the estate tax charitable deduction.
Minority Interest Discounts for Interests in Closely Held Businesses
The differing values problem can arise when a decedent's gross estate includes a controlling interest in a closely held business but the decedent's surviving spouse receives less than a controlling interest. For instance, in TAM 9050004, the decedent owned 100% of the stock of a corporation. His will gave 51% of the stock to his son and 49% to a marital trust. The IRS held that a minority discount was appropriate in determining the value of the marital deduction for the gift of the 49% interest. According to the IRS, it was "appropriate to value the interest passing to the surviving spouse as a separate interest in property rather than as an undivided portion of the decedent's entire interest."
TAM 9403005 illustrates a variation on the principle articulated in TAM 9050004. TAM 9403005 involved an estate that included shares of both common and preferred stock of a corporation, which together constituted a controlling interest in the corporation. The IRS and the estate agreed that, when valued together, the preferred stock had a value of $1,300 per share and the common stock had a value of $13 per share. The IRS and the estate also agreed that when the same person did not hold the preferred and common shares, the preferred shares had a value of $920 per share and the common shares had a value of $7 per share. The decedent's will gave the surviving spouse only the preferred shares. Accordingly, the IRS determined that the preferred shares had a gross estate value of $1,300 per share and a marital deduction value of $920 per share, a difference of $380 per share. The TAM does not indicate the amount of tax caused by the gap.
Finally, the differing values problem can arise when an executor funds a marital gift. Wills and trusts for large estates generally use formulas to fund marital gifts. The composition of the estate at the time of funding may force the executor to fund a marital gift with a minority interest in a closely held business. For instance, assume that a decedent has a gross estate of $1 million, comprised of a wholly-owned company valued at $800,000 plus $200,000 of other assets. If the decedent's will contains a pecuniary marital deduction formula creating a $600,000 credit shelter trust and a $400,000 marital gift, the executor must fund the marital gift with $400,000 worth of assets. If the executor has not sold the stock by the date of funding, he or she may consider funding the marital gift with a 50% interest in the business, assuming that the interest has a $400,000 value for marital deduction purposes, or one-half its gross estate value. The 50% interest, however, is a minority interest and as such, its value might properly be only $320,000, taking into account a 20% minority interest discount. If so, the executor will have underfunded the marital gift. A similar problem can arise when an executor funds a fractional share formula on a non-pro rata basis and allocates a minority interest in a business to the marital share without discounting its value.
The IRS may become aware of a funding problem if an executor indicates on the federal estate tax return that the executor intends to fund a marital gift with a minority interest in a closely held business. Similarly, if during the audit of an estate tax return the IRS discovers that the executor has funded a pecuniary or fractional marital gift with a minority interest, the IRS may reduce the marital deduction. It is more likely that the executor will not fund the marital gift until after the estate tax audit is completed or that the funding issue will not have arisen in the audit. Despite the fact that the statute of limitations has run on the assessment of estate tax, the IRS has a few ways to recover the tax attributable to a reduced marital deduction that arises through funding a marital gift with minority interests. The IRS may attempt to recoup the difference in values by determining that the spouse made a gift to the credit shelter trust if he or she acquiesced in the underfunding of the marital gift. The value of the gift would be equal to the extra assets the credit shelter trust received as a result of the underfunded marital gift.
In Revenue Ruling 84-105, 1984-2 C.B. 197, an executor funded only $160,000 of a $200,000 pecuniary marital gift to a marital trust. The spouse failed to object to the underfunding, even though she had a right to question the executor's failure to fully fund the trust when he filed his final account. The IRS determined that the spouse's acquiescence in the underfunding resulted in a gift from the spouse to the trust's residuary beneficiaries. See also TAM 9116003. This result could have been avoided if the residuary beneficiary were a trust over which the surviving spouse had a limited power of appointment. Under those circumstances, the "gift" resulting from acquiescence in the underfunding would have been incomplete.
The IRS may also attempt to increase the value of the surviving spouse's gross estate in an effort to recover a difference in values not taxed at the death of the first spouse. If the "beneficiary" of the spouse's acquiescence in the underfunding is a credit shelter trust in which the spouse has a mandatory income interest, the IRS could argue that the spouse had made a gift of the underfunded amount to the credit shelter trust but had retained a life income interest in the trust. Accordingly, the underfunded amount would be included in the spouse's gross estate under Code 2036(a). See Simpson v. United States, 92-2 U.S. Tax Cas. (CCH) 60,118 (D. N.M. 1992). The IRS lost on the merits in that case; the court never addressed the propriety of the IRS' attempted collection technique. See also Paul N. Frimmer and Malcolm A. Moore, Sophisticated Post-Mortem Planning, 1995 ACTEC Annual Meeting Materials (1995). The IRS also suggested in TAM 9116003 that it might be able to recapture the underfunded amount under Code 2044, which addresses the inclusion of QTIP trust assets in the surviving spouse's estate. This theory would work, however, only if a QTIP election were made for the residuary credit shelter trust, an unlikely event.
The differing values principle is not for the IRS alone; an estate may be able to use the technique to in-crease the marital deduction. For instance, in Chenoweth, 88 T.C. 1577, the decedent's gross estate included a 100% interest in a corporation with a gross estate value of $5,688 per share. The decedent's will gave 51% of the stock to the decedent's wife. During litigation with the IRS, the estate convinced the Tax Court to add a 38% control premium to the shares passing to the wife. Accordingly, the per share value of the stock the wife received was $2,159 greater than the gross estate value of the stock, making the marital deduction proportionately larger than the value of the stock in the gross estate. An estate might also use the "swing vote" premium described in TAM 9436005 to obtain a premium or at least avoid a discount on a minority interest in a closely held business given to a surviving spouse or used to fund a marital gift.
The differing values problem can also arise if a decedent owned an entire parcel of real property but the surviving spouse receives only a fractional interest in the property, whether by specific gift or by the executor's funding choices. A fractional share discount could even apply to a "majority interest" in real estate. For example, both a 90% and a 10% undivided interest in real property might receive fractional interest discounts.
Assume that the primary asset of a married decedent's $2 million estate is a $1.7 million parcel of real property. Assume further that the decedent's will contains a formula that creates a $600,000 credit shelter share and a $1.4 million marital share. Because the value of the decedent's assets other than the real property is only $300,000, absent an intervening sale, the executor may be required to fund the $600,000 credit shelter share with a fractional interest in the property. As a result, the marital share will also receive a fractional interest. The IRS could suggest that a fractional interest discount is appropriate for the partial interest used to satisfy the marital gift, even if the spouse receives more than 50% of the property, thereby reducing the marital deduction.
As with interests in closely held businesses, the differing values technique is not just for the IRS when an estate has certain types of real property, such as real property valued under Code 2032A. Section 2032A allows an estate to value certain family farm and business property based not on its highest and best use, but rather on its use for farming or business purposes. If a decedent's will or trust uses a pecuniary marital formula to be satisfied at date of distribution values, the executor may use the full fair market value of the property when funding the marital gift, even though the executor used the property's 2032A value for gross estate purposes. Simpson, 92-2 U.S.T.C. 60,118.
The IRS position on the validity of this technique is equivocal. The national office specifically approved the technique in TAM 8314001. The district director involved in the re-lated audit unsuccessfully asked the national office to reconsider the determination. See TAM 8314005. By contrast, in 1994 the IRS privately ruled that an executor must use special use values when funding a pecuniary marital gift. PLR 9407015.
The ability to fund a pecuniary marital gift with 2032A property at its fair market value, rather than at its special use value, allows an executor to effectively increase the size of the credit shelter residue by allocating proportionately more assets to the residue than would be possible in the absence of 2032A property. This technique is understandably popular with lawyers who represent the estates of farmers and ranchers, despite the uncertainty of the IRS' position.
The differing values problem can also arise when an executor funds a marital gift with an interest in a business subject to a buy-sell agreement. If the interest remains subject to the agreement in the hands of the surviving spouse and the agreement sets a binding price at which the company or the other shareholders must purchase the spouse's interest, whether fixed or by formula, the value of the interest for marital deduction purposes will be determined with respect to the agreement. TAM 9327005; TAM 9147065. If the agreement meets the requirements of Code 2703 or, in the case of agreements grandfathered from Code 2703, the Treasury Regulations and cases under Code 2031, the agreement will also set the value of the interest for gross estate purposes, resulting in identical gross estate and marital deduction values. If, however, the buy-sell agreement is not binding for gross estate value purposes but nevertheless requires the surviving spouse to sell the stock for a lower price, the IRS could assert that the value of the interest for marital deduction purposes is less than its value for gross estate purposes. PLR 9636008 (no differing values because agreement relied on fair market value).
For instance, in TAM 9327005, the trustee of a decedent's revocable trust owned stock in a closely held business subject to a buy-sell agreement that used book value to determine the price of shares of stock in the company. The trustee funded a marital gift with some of the stock, using book value to determine the amount used to satisfy the marital gift. The IRS later determined that the buy-sell agreement was not binding for gross estate purposes and imposed a higher per share value of the stock but refused to adjust the marital deduction value of the stock from book value.
In TAM 9147065, the decedent's estate included a controlling interest in a closely held corporation. The estate valued the stock for gross estate purposes at $11,000 per share. The stock was subject to a buy-sell agreement that gave the decedent's sons the right to purchase the stock for $1,000 per share. Before filing the estate tax return, the estate used the proceeds of the sale to fund a pecuniary gift to a marital trust. The estate, however, computed the marital deduction based on the $11,000 per share gross estate value. The IRS determined that the sons' rights under the buy-sell agreement reduced the value of the stock for marital deduction purposes. This bargain purchase right effectively reduced the stock value in the hands of the trustee of the marital trust. Thus, the marital trust received less than one-tenth of the gross estate value of the stock and the IRS adjusted the marital deduction accordingly. The IRS also observed that the agreement allowed the sons to pay the purchase price with a note that may not have carried the minimum interest rate necessary to avoid imputed interest under Code 7872. The IRS concluded that the financing arrangement meant that the estate could not even value the stock at $1,000 per share for marital deduction purposes.
As in the case of minority interests in closely held businesses, an estate may be able to use differing values to its advantage when a buy-sell agreement does not set gross estate value for an interest in a business and the surviving spouse also owns an interest in the business. In Estate of Lauder, 1994 R.I.A. T.C. Memo. 94,527, the Tax Court determined that a buy-sell agreement did not set the gross estate value of stock in a closely held corporation. The court found that the fair market value of the decedent's stock was $50,494,344 while the agreement set the value at $29,050,800, a difference of $21,443,544. The decedent's surviving spouse, however, owned 39.26% of the company's stock. The estate asserted that the surviving spouse had indirectly received 39.26% of the $21,443,544 difference between the two values because the company was able to purchase the decedent's stock at a value well below its fair market value.
According to the estate, the sur-viving spouse received a benefit because the agreement did not require the company to lay out cash equal to the full fair market value of the decedent's stock to redeem the stock. The estate argued that the proportionate benefit from the bargain price that the spouse received as a shareholder in the company qualified for the marital deduction. The IRS, on the other hand, contended that the "value" of the indirect marital gift was illusory because the spouse would be required to transfer the stock for the value determined under the buy-sell agreement, not its fair market value. The Tax Court found for the estate. The court agreed with the estate that property passing indirectly to the surviving spouse in this case a percentage of the difference between the fair market value and the agreement value_could qualify for the marital deduction. The court dismissed the IRS' terminable interest argument, noting that the spouse's estate would be subject to estate tax on the stock at its fair market value, not its buy-sell agreement value.
An estate could apply Lauder when both the decedent and his or her spouse own stock subject to a buy-sell agreement that requires the company to redeem the stock at a value that is not controlling for gross estate purposes. As in Lauder, the estate could argue that a marital deduction is appropriate for the proportional increase in the value of the spouse's stock that resulted from the corporation's ability to purchase the decedent's stock at a bargain price. The indirect marital deduction, however, will never fully close the gap in values unless each spouse owned 50% of the stock. Note that a Lauder-type marital deduction would probably not be available if the company's option was discretionary rather than mandatory, because as of the decedent's date of death the company's exercise would be speculative, preventing the executor from assigning a value to the deemed marital gift.
RPPT Committee Survey
In the summer of 1995, the Marital Deduction Planning and Drafting Committee of the Section's Probate Division surveyed the more than 2,000 members of the division's committees to determine the extent to which practitioners had encountered the differing values issue.
More than 200 practitioners re-sponded to the survey. Two-thirds of the respondents indicated that they had not encountered or addressed the differing values issue in either estate planning or administration. About 15% indicated that they had encountered the issue in estate planning only, while 2% indicated that they had seen the issue only in estate administration. About 12% had encountered the differing values issue in both estate planning and estate administration.
Of greater interest to the committee were the respondents who had encountered the differing values issue in an estate tax audit, appeal or litigation. About 7% of respondents indicated that the issue had played a role in an estate tax audit. The responses indicated that the differing values issue had usually arisen in the context of the marital deduction and more often than not involved minority interests in closely held businesses, although some respondents reported that the issue had arisen in controlling interest situations as well. Other than a large number of responses from the San Francisco area, no geographic pattern emerged for the differing values issues in audits.
The committee compiled some anecdotal evidence on the differing values problem in audits. Several lawyers in the San Francisco area indicated that some IRS estate tax lawyers routinely solicit marital gift funding information during estate tax audits. The respondents noted that most of the time they fund marital gifts with the decedent's one-half share of a couple's community property. These one-half interests will have the same value for gross estate purposes and marital deduction purposes because they are both 50% interests. Thus, the funding of the marital gift does not exactly raise the differing values problem. The IRS' goal is to argue that the new basis of the community property in the hands of the surviving spouse is the sum of the discounted value of the two halves, rather than the full fair market value of the asset at the death of the first decedent to die. See Code 1014(a), (b)(1) and (b)(6).
One respondent described an IRS attempt to use the differing values theory in a recent unreported U.S. Claims Court case. In Estate of Fisher v. United States, No. 91-1087T, slip op. (Cl. Ct. Feb. 16, 1995), rev'd on unrelated issue, 80 F.3d 1576 (Fed. Cir. 1996), the decedent's estate included a 50% interest in a personal holding company, the assets of which consisted solely of publicly traded securities. The decedent's will gave 80% of this interest, or a 40% overall interest in the corporation, to the decedent's wife. The estate valued the decedent's stock at $8,580 a share for both gross estate and marital deduction purposes. Throughout the audit, the IRS asserted that the per share value of the 50% interest included in the decedent's gross estate exceeded the per share value of the 40% interest that passed to the wife, based on Chenoweth and Ahmanson Foundation.
At trial, the estate's expert testified that a control premium was not appropriate for the 50% interest includable in the gross estate because, under Washington law, a 50% shareholder could not compel a dissolution or liquidation of the corporation. Similarly, the estate's expert pointed out that even if a 50% shareholder could compel a liquidation of the corporation, the liquidation would trigger significant built-in capital gains, meaning that a prospective purchaser would probably not assign any value to the ability to compel a liquidation. The government's expert testified that the gross estate value of the stock was $12,580 per share but its marital deduction value was $11,192, reflecting a minority interest discount. The government's expert conceded that he had no knowledge of Washington corporate law or the tax effects of a liquidation of a personal holding company. The court found that the government's expert lacked credibility and held for the estate on the valuation question. Although the case was reversed on an unrelated issue, the appellate court did not disturb the decision on the valuation issue.
Practitioners can often effectively anticipate and address the differing values problem in estate planning. At the most basic level, a practitioner should counsel a client against specifically giving a minority interest in a business to the client's spouse when the client's estate includes a controlling interest in the business. Similarly, if a client is the sole owner of a parcel of real property, the client should not specifically leave a fractional interest in it to his or her spouse. If a client wishes to give either of these types of interests to his or her spouse, the client should make a lifetime gift of the interest.
The gift will presumably qualify for the marital deduction and will avoid the aggregation of the transferred minority interest with the client's other interests in the business in the estate. A resulting benefit is that the client's retained interest may be eligible for a minority interest discount in the gross estate. Deleting specific gifts from an estate plan, however, will not eliminate the risk of a differing values problem on funding, particularly if real estate or a controlling interest in a business makes up a large part of a client's estate. If a practitioner spots a potential funding problem before the client's death, certain estate planning techniques may reduce the risk of the problem arising. For instance, a direction in a will or trust against funding a marital share with a minority or fractional interest could prevent an underfunded marital gift, assuming the estate has sufficient other assets to properly fund the marital gift. Alternatively, a client could specifically give his or her spouse a controlling interest in a business or an entire parcel of real property to avoid the application of a minority interest discount or fractional interest discount to the assets used to fund the marital gift. In modest estates, however, these techniques might result in the overfunding of a marital gift and a loss of the benefit of some of the decedent's unified credit.
Another approach is for the practitioner to encourage the client to make lifetime gifts to his or her spouse and others so that the client will not have a controlling interest in a business or an entire parcel of real property in the gross estate. Because the client's gross estate will include only minority or fractional interests, the executor can fund the marital gift with only minority or fractional interests, which will have the same proportionate value for gross estate and marital deduction purposes.
An executor can also take certain steps during estate administration to avoid a differing values problem that could arise on funding a marital gift. The executor should not list the assets used to fund the marital gift on the estate tax return because it could raise a red flag with the IRS. See PLR 9116003 (executor not required to list assets with which he or she intends to fund marital gift). The executor could sell enough of the estate's assets so that it is possible to fund the marital gift in cash, rather than in kind, thereby avoiding a minority discount. If the executor has no alternative but to fund the marital gift in kind, the executor should consider the possibility of adding a swing vote premium to the minority interest used to satisfy the marital gift. Finally, the executor could take a minority interest discount into account when funding a marital gift. When an executor must fund a marital gift with a fractional interest in real estate, the executor could attempt to limit the discount to the costs of partition of the property, based on an IRS pronouncement to this effect. See TAM 9336002.
The differing values problem can also arise when a buy-sell agreement is binding for marital deduction purposes but not for gross estate purposes. If a married client owns an interest in a business subject to a buy-sell agreement, the practitioner should carefully review the agreement in the context of the client's estate plan to determine whether a differing values problem may arise on the client's death. The practitioner may advise the client to alter the terms of the buy-sell agreement if agreement is likely to generate different values for the client's interest for gross estate purposes and marital deduction purposes. If the buy-sell agreement cannot be amended, the practitioner should consider including a clause in the decedent's will that apportions any death taxes that result from a reduced marital deduction to the persons who purchased the stock at a bargain price under the agreement. Finally, an indirect marital deduction based on the Tax Court's decision in Lauder may be available to an estate if the surviving spouse owns stock in the company.
Obtaining the optimum marital deduction is often an important part of a married couple's estate plan. Interests in closely held businesses and real property can give rise to differing values problems in drafting and funding marital gifts that may result in a decrease in the marital deduction. Nevertheless, the practitioner and the client can reduce or eliminate these risks through careful predeath and postmortem planning.
M. Read Moore is an associate with Miller, Nash, Wiener, Hager & Carlsen LLP in Portland, Oregon and is a co-chair of the Probate and Trust Division's Marital Deduction (B-2) Committee.
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