Take-Away: While valuation discounts, e.g. lack of control, lack of marketability, can effectively reduce the value of assets for federal estate and gift tax purposes, those same valuation discounts can come back and haunt a decedent at the time of his or her death when it comes to valuing assets that create estate tax deductions, thus possibly causing a federal estate tax liability when none was anticipated.

Background: A few weeks back we covered the potential ‘mismatch’ in values when the value of assets that were gifted using valuation discounts were later included in the donor’s taxable estate by virtue of IRC 2036 (one of the so-called string provisions of the Tax Code.) The same type of valuation ‘mismatch’ can arise when a decedent’s estate claims a marital or charitable estate tax deduction when a fractional, or non-controlling, interest is transferred to the decedent’s surviving spouse or to the charity.

Ahmanson Foundation:  This valuation principle, or acknowledged ‘mismatch’ first surfaced in Ahmanson Foundation v. U.S. (1981). In that case the decedent owned, through a revocable trust, 100% of the shares of a corporation, consisting of 1 voting share and 99 non-voting shares. Accordingly, the decedent owned 100% of the corporation, so no valuation discounts were appropriate. The decedent bequeathed the 1 voting share to his son and the 99 non-voting shares to a family charitable foundation. The federal appeals Court held that the two distinct assets (1 voting share and the 99 non-voting shares) should not be viewed for estate tax valuation purposes as two distinct assets to be valued separately; rather, all 100 shares were to be combined and held as one block by the decedent’s estate at the decedent’s death and thus were to be valued as a single asset.

In support of this conclusion, the Court observed: “There is nothing in the statutes or the case law that suggests that valuation of the gross estate should take into account that the assets will come to rest in several hands rather than one.” Therefore, if the decedent owned the entire asset, it was to be valued without discounts, and the Court will ignore who receives that entire asset under the decedent’s estate plan.

In addition, the Court noted: “IRC 2055, under which Congress provided for the estate tax charitable deduction, does not ordain equal valuation as between an item in the gross estate and the same item under the charitable deduction. Instead, it states that the value of the charitable deduction ‘shall not exceed the value of the transferred property required to be included in the gross estate.’” [IRC 2055(d).] Thus, the 99 non-voting shares were subject to  a 3% valuation discount for lack of control.

In short, there was no valuation discount with regard to the stock held by Mr. Ahmanson, but valuation discount would be applied to the transfer of the non-voting stock to the family charitable foundation for which a charitable estate tax deduction was claimed, resulting in a valuation ‘mismatch’ that resulted in estate tax liability, even though a charity received 99% of the stock.

Estate of Miriam M. Warne:  The perceived unfairness of this valuation ‘mismatch’ for estate tax purposes was again on full display in a recent Tax Court decision, Estate of Miriam M. Warne v. Commissioner, Tax Court Memo 2021-17 (February 18, 2021).

  • Facts: Miriam died in 2014. Her gross estate include a 100% membership interest in Royal Gardens, LLC, a single member LLC. Royal Gardens, LLC owned an interest in a mobile home park that was valued at $25,600,000. The LLC interests were held in a revocable trust of which Miriam was trustee (and manager of the LLC.) Therefore, the full value of the LLC was included in Miriam’s taxable estate because it was treated as if she owned individually the membership interest. [IRC 2038.] On Miriam’s death, her trust provided that a 75% membership interest in Royal Gardens was to be distributed to the Warne Family Charitable Foundation. The remaining 25% membership interest was to be distributed to the St. John’s Lutheran Church. Both the Foundation and the Church were IRC 501(c)(3) charitable organizations. Miriam’s estate claimed that the two charitable bequests qualified for the federal estate tax charitable deduction, i.e. her estate claimed a charitable estate tax deduction of $25,600,000 under IRC 2055;  the charitable gift to the Foundation was valued at $19,200,000 and the charitable gift to the Church was valued at $6,400,000.
  • Dispute: On audit, the IRS reduced the estate tax charitable contribution deduction to $21,405,796, which resulted in a $4.0 million reduction in the claimed charitable estate tax deduction. The IRS applied a 27.385% valuation discount for the charitable bequest to the Church, and a 4% valuation discount was applied to the 75% LLC interest bequeathed to the Foundation. The Service’s position was that the charitable bequests to both the Foundation and the Church were subject to valuation discounts due to lack of control and lack of marketability- “the value of the charitable deduction should reflect the benefit received by the respective donees.” Miriam’s estate argued that the application of valuation discounts to charitable bequests would subvert public policy to motivate charitable deductions. 
  • Tax Court Decision: Relying on Ahmanson Foundation, the Tax Court judge stated that when valuing an asset as part of a decedent’s estate, the Court must value the entire interest held by the estate without regard to the disposition of that asset. Also echoing the Ahmanson Foundation decision, the Tax Court judge noted different principles apply when property held by a decedent’s estate is split as part of a charitable contribution:

“The valuation of these same sorts of assets for the purpose of the charitable deduction, however, is subject to the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity- a principle required for the purpose of the charitable deduction….It is the value of the property received by the donee that determines the amount of the charitable deduction available to the donor”

Valuation ‘Mismatch:’ The result in this Tax Court decision was that there was a ‘mismatch’ between the value of the asset included in Miriam’s taxable estate used to determine the estate’s federal estate tax liability, and the value of the available charitable estate tax deduction due to applied valuation discounts of $4.0 million. With the federal estate tax rate of 40% on that ‘additional’ $4.0 million resulted in an additional $1,600,000 owed in federal estate taxes by Miriam’s estate, even though two charities received the asset that caused the federal estate tax liability.

Miriam probably went to her grave thinking that her entire interest in the LLC would not result in any federal estate tax liability, since charities were to receive the entire asset, yet by dividing that bequest between two charities, her estate incurred an additional $1.6 million in federal estate taxes.

Planning for Discounts: Miriam’s bequest of the LLC membership interests between two charities created the situation where the IRS was able to claim valuation discounts in order to reduce the amount of the federal estate tax charitable deduction. This resulted in the ‘mismatch’ in values between the asset causing the federal estate tax liability and the value of the same asset for federal estate tax charitable deduction purposes. Had Miriam simply bequeathed the entire LLC membership interests to the Foundation, the amount of the charitable estate tax deduction would have equaled the value of the LLC in her gross taxable estate; the Foundation could then have gifted 25% of the LLC to Miriam’s Church, thus saving $1.6 million in federal estate taxes.  This same valuation ‘mismatch’ can occur if a decedent who owned real estate, or any other asset,  conveyed tenant-in-common interests to two or more charities.

This valuation ‘mismatch’ problem is exacerbated even further if the decedent’s estate plan shifts the burden to pay federal estate taxes onto the charities receiving the charitable bequests. The effect would be to increase the federal estate tax to a large degree since the Tax Code directs that any tax paid by a disposition in favor of the charity must be reduced by the estate tax that must be paid by the charitable recipient [IRC 2055(c).]

Conclusion: While the results in Ahmanson Foundation and Estate of Miriam M. Warne may seem unfair, they are consistent with what the Tax Code requires. When looking at charitable bequests, thought needs to be given to the possibility of unintentionally creating a valuation ‘mismatch’ between the value of the asset included in the decedent’s gross estate, and the value of the charitable bequest on which the federal estate tax charitable deduction is based. Dividing assets among charitable recipients is a sure-fire way to create a valuation ‘mismatch,’ which may become even more important if we soon find ourselves back to worrying about federal estate taxes with much lower federal estate tax exemptions.