QUALIFIED TERMINABLE INTEREST PROPERTY (QTIP) TRUSTS AND
VALUATION DISCOUNTS

Jerome Landau, JD, CPA

Mathematicians firmly believe that the sum of the parts is always equal to the whole. But, is this necessarily true when valuation discounts are applied to fractional interests transferred by gift or bequest? Many practitioners are now familiar with the concept of valuation discounts when valuing fractional interests, either for gift tax purposes or estate tax purposes. These issues have been discussed at length in various publications and at seminars with reference to the now well-known IRS Rev. Rul. 93-12 and the landmark Bright case in the U.S. Court of Appeals (M. Bright Estate, CA5, 81-2 USTC. S13, 436). Briefly, valuation discounts have been claimed, and are being allowed, due to lack of marketability and for minority interests in various types of entities, such as partnerships, joint ventures, and corporations.

Valuations for both gift tax and estate tax are determined by the fair market value of the asset as of the date of the gift, or the date of death. The often cited definition of fair market values per IRS Regulations Sec.20.2031- l(b) is, "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts." For some time the courts have permitted taxpayers in both estate and gift tax cases to discount full fair market value by a lack of marketability discount (LOMD), as well as, in appropriate cases, a minority discount (MD). Lack of marketability discounts are usually applied to assets for which there is no ready market, either due to the nature of the asset, or due to some restriction on its transfer or sale by reason of some agreement among various parties, such as a first right of refusal by a co-owner, partner, or co-stockholder. Minority discounts are usually applied to a fractional interest of less than 50% in a joint venture, partnership, or corporation, which amounts to lack of control, so as to make it unattractive to any potential purchaser willing to bid for such asset or interest, thereby decreasing its value for sale purposes, as well as its gift tax or estate tax value. Of particular importance are these interests which are owned by several members of a family, each member of the family owning only a minority interest, but taken together the family having a controlling interest.

Beginning as early as 1940, the Tax Court has uniformly valued a decedent's stock for estate tax purposes as a minority interest when the decedent himself owned less than 50% of the stock, and despite the fact that control of the corporation was within the decedent's family. While in most cases the IRS will allow both a "LOMD" and an "MD" where the facts warrant such discounts, the IRS in the past has been loathe to allow such discounts where a family in totality does have a controlling interest. In fact, in some cases the IRS has insisted on a "control premium" added to fair market value where control of the asset or entity is of importance in what a willing buyer will pay for an asset or interest. In these cases, the IRS insists that "the whole is worth more than the sum of the parts." Nevertheless, taxpayers on estate tax or gift tax returns have been taking such discounts of anywhere between 10% to 40%, and, if challenged by the IRS, have either settled on a compromise basis or petitioned or appealed to the courts to have such discounts sustained. As a result of several court decisions, in a 1993 ruling, the IRS exhibited a change of attitude in "family control" situations. In reaching this conclusion in Rev. Rul. 93-12, the IRS finally recognized the force and weight of authority of the Estate of the Mary Frances Bright case in the U.S. Court of Appeals for the Fifth Circuit (cited above), as well as the cases of Estate of Lee vs. Commissioner (69 TC 874) which rejected the concept of family attribution and aggregation of minority interests.

The Bright Case

In the 1981 Bright case, a husband and wife together owned 55% of the common stock of Texas Motor Freight Lines, Inc. and 55% of the common stock of 27 affiliated corporations. During Mrs. Bright's lifetime, they held the 55% block of stock as their community property under Texas law. The remaining 45% of the stock was owned by unrelated parties. When Mrs. Bright died, Mr. Bright became the executor of her estate. Since Mrs. Bright's interest was subject to a right of partition under Texas law, she willed her interest (27.5%) in the stock to a trust for the primary benefit of her children, and Mr. Bright was the trustee of that trust. Mr. Bright, after his wife's death, continued to own his own community share (27.5%) of the corporation's stock. The IRS assessed a deficiency of estate tax by asserting a control premium on Mrs. Bright's 27.5% interest, over and above the interest's appraised value, by reason of the family owning the 55% interest. The estate paid the deficiency and then sued for refund in the District Court. The District Court ruled as a matter of law that "no element of control can be attributed to the decedent in determining the decedent's interest in the stock." On appeal by the IRS, the Court of Appeals affirmed the District Court ruling. In its decision the Appeals Court said, "we reject any family attribution to the estate's stock because established case law requires this result." Of note is the reference, in passing, in the court's decision to a Court of Appeals, Second Circuit, case in 1945, H. Smith Richardson, 45-2 USTC 1110, 225, which involved a holding company owning readily marketable securities. The controlling shareholder gifted shares of stock, each of which were minority interests, to his four children. In its decision, the Court of Appeals expressly labeled these interests as minority interests, to be valued as such for tax purposes.

Revenue Ruling 93-12

Rev. Ruling 93-12 (1993-1 CB 202) considered a situation in which P owned all of the single outstanding class of stock of X corporation. P transferred all of P's shares by making simultaneous gifts of 20% of the shares to each of P's five children, A, B, C, D, and E. Bowing to the authority of "Bright" and other cases, and reversing the position it held in Rev. Rul. 81-253, the IRS ruled that "a minority interest discount will not be disallowed solely because a transferred interest, when aggregated with interests held by family members, would be part of a controlling interest." Although the IRS has since said unofficially that it will still look at each set of facts individually to determine whether, in point of fact, control still rests in the hands of a single person, Rev. Rul. 93-12 is being relied on very frequently as a basis for getting discounted values for a gift or a bequest of a fractional interest. Many practitioners are recommending that clients set up limited partnerships of businesses or investments, the senior member of the family being the general partner who gifts limited partnership interests to his children at discounted values, with the additional goal of removing from the donor's estate future appreciation in value. The use of family limited partnerships for estate planning purposes is very worthwhile but it is not the subject of this discussion.

The QTIP Trust and the Bonner Case

The issue of the value of a fractional interest in a QTIP trust includable in a taxable estate arose in the 1996 case of Estate of Charles L. Bonner, Sr. (CA-5, USTC 1996-2 ¶60,237). At the time of his death in 1989 Charles Bonner owned a 62.5% undivided fractional interest in a Texas ranch and 50% interests in a boat and real property. The remaining interests in the above assets were held by a QTIP trust established in his wife's Will, which became effective upon her death in 1986. The value of the QTIP trust at the time of Mr. Bonner's death was includable in his taxable estate per IRC section 2044. On his Federal estate tax return (Form 706), his executor claimed a 45% fractional discount on the values of the undivided interest that he himself owned at the time of his death. The IRS disallowed the discount saying that the two interests represented a 100% ownership by his estate at the time of his death, and that the two interests were merged into a single interest, not permitting any discount. In a refund suit, the District Court agreed with the IRS. On appeal, the Court of Appeals for the Fifth Circuit reversed the decision of the District Court, citing and agreeing with the Bright case, (cited above), and ruled that the two interests did not merge and that a fractional discount was allowable. The court rejected the family attribution reasoning, and held that whether the remaindermen of the QTIP trust and Charles Bonner's own beneficiaries under his own will were the same persons, was not determinative of the issue since at the moment of his death there were two separate interests, the QTIP interests and his own interests in the same entities.

The Whole Is the Sum of the Individual Parts, or Is It?

Opportunities may exist for future estate tax planning where interests in an entity are owned by both husband and wife. Consideration should also be given to the effect of these court decisions and rulings where estate tax returns have already been filed with full appraised values being reported where the fact patterns are similar to those discussed here.

Yes, with proper estate planning in regard to fractional interests, the sum of the parts can equal less than the whole! *

Editors:
Marco Svagna, CPA
Lopez Edwards Frank & Company

Laurence Foster, CPA/PFS
KPMG Peat Marwick LLP

Contributing Editors:

Richard H. Sonet, JD, CPA
Marks Shron & Company LLP

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

Eric Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.