Implications of the Proposed Limit on Valuation Discounts

Take-Away: The House Ways and Means Committee has proposed the elimination of valuation discounts for non-business assets held in an entity. If this proposal becomes law, it could wreck-havoc with existing buy-sell agreements and possibly cause unanticipated taxable transfers.

Background: The House Ways and Means Committee proposes to eliminate valuation discounts for non-business assets held in an entity. The obvious target of this proposal is the common estate planning practice of ‘wrapping’ an investment portfolio in an LLC or limited partnership, after which LLC membership or limited partnership interests are gifted to younger family members, for which a valuation discount is claimed for a lack of marketability or a lack of control of the gifted interest, thus lowering the transfer-tax cost of the gift. Specifically, the proposed bill adds a new subsection (d) to IRC 2031 in order to eliminate discounts for certain transfers of non-business assets owned by entities, unless they are actively traded under IRC 1092.

Non-business Asset: The definition of non-business assets under the proposal adopts a passive-asset test for income tax purposes. [IRC 469.] As part of the requirements to avoid the passive asset classification, the transferor must have materially participated in the activity, which means at least 750 annual hours. [IRC 469(h).] Inventory assets and notes and receivables from the sale of inventory assets are treated as assets held by a trade or business, i.e. not passive. Consequently, real estate developers who recognize sales of real property as ordinary income do not appear to fall within the scope of the proposed new rule’s elimination of valuation discounts.

Let’s use an example of how this proposed new definition of fair market value would affect real estate.

Example 1: Jerry, Michael, Julia, and Jason own a parcel of real estate together as a long-term investment. They each own a 25% tenant-in-common interest. These owners have also entered into a tenant-in-common agreement that spells out the obligations of the other co-tenants to purchase the interest of a departing co-tenant (either a lifetime sale or on the co-tenant’s death) for its fair market value as determined by an appraiser. Jerry dies (or even if he wants to sell his interest in the real estate.) Jerry’s co-tenant interest will be valued using customary valuation principles adopted by certified appraisers. Such an appraisal will reflect the reality that a one-quarter interest in a single parcel of real estate will be a non-controlling interest and it will also be difficult to market a 25% tenant-in-common interest in a single parcel of real estate. Assume, therefore that the sale of Jerry’s 25% tenant in common interest in the parcel will attract a 20% valuation discount. Jerry wishes to sell his interest, and thus under the existing tenant-in-common agreement his estate has his 25% interest valued by an appraiser. The appraiser places a fair market value for the real estate at $4.0 million. The appraiser then concludes that Jerry’s 25% tenant-in-common interest in the real estate is subject to the two valuation discounts [lack of control; lack of marketability] which aggregate the 20% valuation discount. Accordingly, under the tenant-in-common agreement, the other co-tenants will pay Jerry’s estate $800,000 for his interest in the real estate, as that is its fair market value using the customary ‘willing buyer-willing seller’ test found in the IRS’ Regulations.

Example 2: The same facts as in Example 1, except that the four tenant-in-common owners previously decided to convey their respective interests in the real estate to a partnership (or maybe an LLC, if limiting their liability is a concern.) Now an entity owns the non-business real estate. Again, Jerry dies. The other ‘partners’ must purchase his 25% interest in the partnership for its ‘fair market value’. Under the House Ways and Means Committee’s proposal, Jerry estate’s partnership interest will be valued at $1.0 million; both of the valuation discounts will be lost. If the other partners pay Jerry’s estate $800,000 for his interest, Jerry’s estate will be deemed to have made a taxable bequest (or gift if Jerry wishes to sell his interest during his lifetime) to the other partners of $200,000.

Pending Valuation Proposal: Under the House Ways and Means Committee proposal, each 25% partnership/membership interest is worth $1.0 million, following the example. That is because the proposal directs that: (i) non-business assets are valued without any discount; and (ii) the entity value (unless actively traded) is determined without taking into account the value of non-business assets. If the partnership/LLC also owns business assets, traditional valuation principles apply to the value of the transferor’s ownership interest in the entity and traditional valuation principles apply to the valuation of the underlying business assets. Accordingly, if a buy-sell agreement provides a purchase price, following the example of $1.0 million for Jerry’s interest of $800,000 for a 25% interest in the entity, yet the estate or gift tax law calls for a $1.0 million non-discounted value, consider the following possible results:

• Tax Consequence to Seller: The seller, who receives less under the proposal’s definition of fair market value, but identical to the fair market value under normal valuation principles for a business entity  and required by the existing buy-sell agreement, could be viewed by the IRS to have made a taxable gift or bequest to the buyer(s), unless the ordinary course of business exception applies. This will certainly be the case if family members are the other partners/LLC members. Under the proposal, Jerry’s partnership interest will be valued at $1.0 million, since valuation discounts will be eliminated. If the other partners pay Jerry’s estate $800,000 for his interest as required by the partnership agreement, Jerry will be deemed to have made a taxable bequest to the other partners of $200,000.
• Tax Consequence to Buyer: In a decedent’s estate setting, the  buyer who pays less under traditional fair market value principles than the gross estate value when an estate is the seller, will now also be charged with the federal estate tax on the ‘bargain sale’ under traditional estate tax equitable allocation rules. If the decedent’s estate tax is charged to the residue of the deceased owner’s estate, the residuary beneficiaries will pay the federal estate tax on the ‘bargain sale.’
• More Litigation?: Confusion may arise from the vagueness or inconsistency of what constitutes ‘fair market value.’ That might mean more litigation due to the new definition of ‘fair market value’ in a gift or estate tax setting, while state law may follow the customary definition of ‘fair market value.’ In short, there will be two possible definitions of fair market value.
• Co-Ownership Treated as an Entity?: Suppose the Jerry, Michael, Julia and Jason have adopted a tenant-in-common agreement; they have not formed a separate entity like a partnership or an LLC. They may not be completely ‘safe’ from this new fair market value rule. The IRS announced in Revenue Procedure 2002-22 standards that it will follow to determine if a co-ownership arrangement [like a tenant-in-common agreement] is, in fact, a partnership, aka an entity, thus triggering the non-discounted fair market value for federal transfer tax purposes.

Conclusion: Co-owners of fractional interests in real estate would seem to be able to continue to follow conventional valuation principles where valuation discounts are appropriate and accepted by the courts and appraisal profession. Yet when those same fractional interests are transferred by the co-owners to an entity like a partnership or an LLC, the fractional interests that applied at the pre-contribution level will be eliminated for federal estate and gift tax purposes relative to the real estate if classified as passive. Note that this is the result, even if the co-owners were not trying to pull a ‘fast one’ on the IRS, since a built-in valuation discount already existed with regard to their fractional interests. This is not the same as ‘wrapping’ a marketable securities portfolio inside an LLC or partnership and creating valuation discounts through the use of the ‘wrapper.’ Yet, here we are with a proposal that will dramatically affect valuations if cc-owners decide for a variety of sound business reasons, to transfer their interests in the real estate to a partnership or an LLC.