Example. Mr. Senior owns 80% of Deflated Inc. His son and daughter who work in the business own 10% each. Deflated was worth $3 million in 2007. By the end of 2008, it was worth $2.5 million. Senior talks to tax counsel and, after exploring the tax strategies and planning tools discussed below, decides to give each child shares worth $500,000 representing 20% of the business. Now each child owns 30%, and Senior owns 40% of the business. The tax advantages are:
The stock gifted to each child was previously worth $600,000. If Deflated Inc. goes back up in value once the economy recovers, Senior has in effect transferred $200,000 to his children ($100,000 each) free of estate and gift taxes. At a current marginal estate tax rate of 45%, Senior’s family can save $90,000 (45% x $200,000).
The gifts still leave each child with a minority interest in Deflated Inc. Estate and gift tax valuation practices can include discounts for a lack of controlling interest as well as for a lack of marketability due to the limited market for such shares. Advisers should be aware, however, that these discounts are often contested by the IRS, and their success often depends on factors that include the types of assets underlying the business interest and the method, experience and qualifications of the appraiser. See, for example, Appeals Coordinated Issue Settlement Guideline UIL 2031.01 and Tax Court cases summarized in “Valuation Discounts for Estate and Gift Taxes,” JofA, July 09, page 32. Also, be aware that Congress could limit this tax strategy. President Barack Obama’s fiscal 2010 budget blueprint includes a proposal to disregard such discounts for restrictions that will lapse or may be removed by the transferor or family. Also, a bill to reform the estate and gift tax (HR 436) currently in the House Ways and Means Committee would forbid minority interest discounts for assets “not used in the active conduct” of a trade or business. While these proposals have a long way to go before they could become law, they’re worth watching.
In some cases, discounts for minority interests and lack of marketability can be 25% or more (for a recent example of a large family farming operation successfully claiming a 25% discount for lack of marketability and a significant discount for lack of control, see Litchfield v. Commissioner, TC Memo 2009-21). If Senior is able to claim a similar discount, the gift of each $500,000 would be reduced by another $125,000. At a current marginal estate tax rate of 45%, Senior’s family can save another $112,500 (45% x $250,000).
Outright gifts of stock are eligible for the annual done exclusion of $13,000. In addition, Senior has a wife who will join in this gift, which will allow for a second $13,000 exclusion. So the taxable gift to each child is reduced by another $26,000. Additional savings to the family are $23,400 (45% x $26,000 x 2 children).
If Senior makes no further gifts and dies with his reduced ownership interest of 40%, his estate can claim the minority interest and lack of marketability discounts against his remaining shares. Suppose that Senior dies in a future year, after Deflated inflates in value to $4 million. His family might be able to take a 25% lack of marketability or minority interest discount, saving them another $540,000 (45% x [$1,600,000 value of 40% interest at date of death - $400,000 discount]).
Bottom line. Mr. Senior can take advantage of the lousy economy, the discounts for lack of marketability and minority interest, plus the annual donee exclusions with a spousal joinder to save his family a sizable amount of estate and gift taxes. Of course, actual results depend on the facts for each client, and this example doesn’t take into consideration state inheritance taxes.
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