Business Valuations: Estate Tax Reduction Techniques

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Paul Sundin, CPA

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Under current case law, one of our best strategies in estate tax reduction planning is the use of discount valuation. This works by fractionalizing our clients’ interests in an asset, usually real estate, and taking a fractional interest discount on the remaining interest.

This can best be illustrated by example. The most common scenario involves a client selling one-half of their real estate holdings to a Trust for the benefit of their beneficiaries (usually the children). First, we place the assets to be held under the ownership of a Limited Liability Company. Next, the client sells one-half to the beneficiary’s Trust and the client takes back a promissory note. For the term of the note (no more than 13.5 years), half of the income from the property is distributed to the beneficiary’s Trust and then passes back to the client as payment on the promissory note. At the end of the term of the note, the beneficiaries own part of the LLC.

When we are settling the client’s estate after they pass away, they only own one-half of the real estate and we can take a discount on the remaining half. For example, if a client owns $10,000,000 of real estate, this leaves an estate tax liability of $4,500,000. By selling half of the real estate to the beneficiaries who would eventually receive the property anyway, the client now owns $5,000,000 of real estate when they pass away, leaving an estate tax liability of $2,250,000. However, because the client only owns a one-half interest in an LLC, we can successfully argue to the IRS that this represents a lack of control and lack of marketability. This is when we take a fractional interest discount, often times at 40%. This means that we submit to the IRS that the remaining one-half is not worth $5,000,000; it is worth $3,000,000. The estate tax liability would then be $1,350,000. The estate tax savings in this example would be $3,150,000.

Internal Revenue Code section 2704(b)(4) limits the discount that we can take when the client owns a fractional interest. However, over the past few decades, the taxpayers have won several cases in tax court limiting the scope of this law. There is an impending change to IRC 2704 that will no longer allow us to take this 40% discount. The bottom line is simple, this strategy works too well for the taxpayer and the government is looking for sources to build revenue. Time is of the essence.

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Estate CPA

Gilbert, AZ