In Brief

Using Discounts to Lower the Tax Burden

Individuals who own interests in closely held businesses can realize substantial transfer tax savings if they gift partial interests in their corporations or family partnerships to the younger generation. There are various methods of determining the values of stock or partnership interests that have been gifted. Such values may then be subject to appropriate discounts for lack of marketability, minority interests, and other factors to determine the fair market value of the gift.

These discounts have been affected by recent favorable rulings and changes in the tax law. Discount opportunities have been bolstered by the IRS's willingness to abandon its normal application of family attribution rules for purposes of gift tax values. A new code section provides that the IRS may no longer revalue gifts that are part of the estate tax base if the gift tax statute of limitations has expired and adequate disclosure of the gift has been made.

Consideration should be given to use of an adjustment clause to protect the transferor from unwanted tax consequences should the fair market value of
the transfer be adjusted
on audit.

By Paul Streer and Caroline D. Strobel

I ndividuals who own interests in closely held businesses can realize substantial transfer tax savings if they gift partial interests in their corporations or family partnerships to younger generation family members. Post-gift appreciation, no matter how significant, will not be included in the donor's transfer tax base at death. In addition, to the extent the $10,000 per donee per year ($20,000 for married donors who elect gift splitting) gift tax annual exclusion is available, gift tax and generation-skipping transfer taxes will be avoided.

Gifts are valued at their date of gift fair market values. This 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 sell, and both having reasonable knowledge of all relevant facts. Recent arms-length selling prices are often the best measure of fair market value. Unfortunately, this information is rarely available if the gifted property represents an interest in a family-owned enterprise.

Gifts of Stock

The valuation of gifts of stock of a closely held corporation, which are not actively traded and for which no arms-length sales prices exist, is a very subjective undertaking. It is an art rather than a science. There usually exists a wide range of opinions as to the fair market value of such securities. The Treasury Department has set forth a number of factors in Regulations section 25.2512-1 that should be considered when determining the fair market value of securities. These factors include the company's net worth, earning power, dividend paying capacity, position in the industry, and management; goodwill of the business; the economic outlook in the particular industry; the value of actively traded securities of companies engaged in the same or similar lines of business; and other relevant factors.

Moreover, the IRS has issued Revenue Ruling 59-60, which presents its general valuation approach. It lists and discusses eight of these factors and the weights to be accorded each, along with an approach to selecting the capitalization rate that can be used in arriving at an acceptable value. The ruling stresses the need to thoroughly consider all relevant facts and circumstances that exist at the valuation date. Recognizing the subjective nature of the undertaking, it advocates using common sense, informed judgment, and reasonableness in the valuation process. Since numerous courts have followed its basic rationale, Revenue Ruling 59-60 has become the underlying authority for determining the factors and methods that can be used to successfully value the stock of closely held corporations.

The broad and general valuation approaches provided by Revenue Ruling 59-60 have spawned numerous more specific valuation approaches, which have gained wide acceptance. They include a book value or asset value approach (focus on the original cost of all assets), an earnings approach (project future earnings and discount back to present value, or capitalize future earnings), a dividend approach (determine dividends paid and dividend paying capacity, and capitalize), and a market approach (analyze similarly situated public companies conducting the same type of business). Regardless of which approach is utilized, the courts will typically make reference to the additional factors spelled out in Revenue Ruling 59-60 in rendering their judgments regarding valuation. Thus, the ruling factors continue to play a crucial role in establishing the fair market value of gifts of closely held business stock.

The valuation approach of Revenue Ruling 59-60 produces an unadjusted stock value for the closely held business. Appropriate discounts for lack of marketability, minority interests, and other factors are then applied to establish the fair market value of the stock gift. Since discounts also apply to gifts of closely held partnership interests, they are discussed in terms of the coverage of partnership gifts that follows.

Gifts of Partnership Interests

In the case of closely held partnership interests (or limited liability company interests), several valuation methods can be used. The partnership interest can be valued by looking at the underlying market value of its assets and subtracting any liabilities (liquidation value). An alternative method involves taking annual cash flows or income and capitalizing it using an appropriate capitalization rate and then subtracting any liabilities (going-concern value). A third valuation method, which is more often used but usually far less defensible, is to simply utilize current net book value as a measure of fair market value.

The liquidation value of a partnership is the amount of cash that would be available to distribute to its partners if its assets were sold on the open market for their fair market values, its liabilities satisfied, and the entity liquidated. For this purpose, all tangible and intangible assets present must be valued. The valuation of intangible assets such as goodwill can be a particularly challenging and necessarily subjective undertaking.

Going-concern or sale value is the amount an unrelated person would pay for the business with the intention to continue operating it rather than liquidating it. Going-concern value is typically less than liquidation value because the purchase price of a partnership often reflects discounts for considerations such as lack of marketability, minority ownership, lack of control, blockage, and loss of key personnel.

Discounts

Once a value has been determined, discounts are applied if appropriate. These discounts are separate and distinct from each other. The combined discounts can be substantial. For example, in Harwood v. Comm'r, [82 T.C. 239 (1984)], the court found that the fair market value of a nine percent limited partnership interest should incorporate a 50% discount. The IRS has acknowledged that such discounts are appropriate in many cases but often disputes their size.

A discount for lack of marketability reflects the fact that it may be very difficult to find a qualified buyer for a minority interest in a closely held partnership. A discount for a minority interest reflects the fact that a potential buyer will usually not have power to compel the liquidation of the partnership. A lack of control discount reflects the reality that the purchaser of a minority interest in a partnership will not have the power to mandate current distributions from the partnership and often will not have any significant management input. Usually control is in the hands of someone unrelated to the purchaser of the minority interest. If the gifted interest is a general partnership interest, the size of the discount may be less. This valuation disparity exists because a general partner may have some degree of control over the business (e.g., the right to bind the partnership contractually or to withdraw from the partnership).

Minority Interest Discounts

A recent ruling has provided a major stimulus for many individuals to implement inter vivos transfers of family-owned business interests because it has afforded them the opportunity to significantly reduce their total transfer tax costs. For many years, the IRS contended that discounts should not be applied to gifts to family members of closely held business interests. The IRS argued that if the entity was controlled by a family unit (as determined by application of the family attribution rules), the family could act together to liquidate the business, sell the business assets, and control distributions. In 1993 (Rev. Rul. 93-12, 1993-1 C.B. 202), the IRS reversed its position and ruled that a minority interest in a family-owned enterprise gifted to a child is eligible for the application of minority discounts. The ruling applies even though the interest gifted, when aggregated with the interests of other family members, constitutes a controlling interest in the entity.

Discounts, however, will only be allowed if all documentation and reporting requirements are met. The Federal gift tax return (Form 709) now specifically asks if a valuation discount has been taken. If it has, the appropriate box on Schedule A of Form 709 must be checked, and the amount of discount claimed must be disclosed. In addition, an explanation setting forth the factual basis for the discount must be attached to the return. Supplemental information such as balance sheets and income statements for each of the five preceding years, along with a record of dividends paid, if any, should be attached to the return to document the underlying value of the property.

Failure to meet these reporting requirements can jeopardize the availability of the entire discount even if it would otherwise be allowed in full. This form-over-substance approach has recently been held to be valid by the Tax Court in John T. Hewitt, et ux v. Comm'r [109 T.C. No. 12 (Tax Ct. Dkt. No. 17146-95)]. In this case, the taxpayer's charitable contribution deduction for the donation of appreciated, non-publicly traded stock was limited to the stock's basis because a qualified appraisal was not obtained as required by regulation.

Impact of the Taxpayer Relief Act of 1997

A new IRC provision, section 2001(f), added by the Taxpayer Relief Act of 1997, makes full disclosure of the method used for valuing business interests even more imperative. It provides that, in computing adjusted taxable gifts that are part of the estate tax base, the IRS may no longer revalue gifts if the gift tax statute of limitations (normally three years) has expired and adequate disclosure of the gift has been made.

Under prior judicial interpretation, for purposes of determining the applicable estate tax bracket and unified credit amount available, the IRS was normally free to revalue any gifts at the time of a donor's death, except in those rare instances where the valuation of the gift had already been subjected to audit. This revaluation option was available to the IRS regardless of the time lapse between the date of the donor's gift and the date of death. In many cases, a significant administrative burden was placed on estate administrators and the passage of time made the IRS's valuation adjustments difficult to successfully contest unless the donor's recordkeeping and document retention practices were unusually comprehensive.

Now, for the IRS to revalue a gift made after August 5, 1997, that has been adequately disclosed, a final notice of redetermination must be issued within the applicable statute of limitations period. This rule applies even though the gift does not produce any gift tax liability.

The recently passed IRS Restructuring and Reform Act of 1998 clarifies the statute by providing that, in determining the amount of taxable gifts for prior years, the value of a gift is the value that is finally determined, even if no gift tax is paid. The final determination of a gift's value is either the value--

* reported on a gift tax return (if not audited by the IRS)

* determined by the IRS on audit,

* determined by a court, or

* agreed to by both the IRS and the taxpayer in a written settlement.

From a planning perspective, it may well be prudent to file a gift tax return--even though one is not required--to provide protection from a later IRS revaluation attempt. This is particularly true if the gifted property is difficult to value, such as a partial interest in a closely held business.

The method of valuing a gift and any discounts taken on that gift must be adequately disclosed on a statement attached to the gift tax return to appraise the IRS of the nature of the gift and the methodology used in valuing it. In December 1998, the IRS issued proposed regulations that provide a list of information that taxpayers must report on their gift tax returns (or in an attached statement), if applicable, in order to meet the adequate disclosure standard [Proposed regulations section 301.6501 (f)(2)]. This information includes a full and accurate description of the transaction that incorporates--

* a description of the transferred property and any consideration received by the transferor;

* the identity of and relationship between the transferor and transferee;

* a detailed description of the method used to determine the fair market value of the property transferred including any relevant financial information and a description of any discounts applied; and

* any restrictions on the transferred property that were considered in determining the fair market value of the property.

In addition, the proposed regulations also require the disclosure of any facts affecting the transaction's gift tax treatment in a manner that can reasonably be expected to put the IRS on notice of any potential controversy surrounding the transfer's gift tax treatment. This information should be included in an attached statement or as part of a concise description of the legal issues presented by the facts. Any position taken that is contrary to any Treasury regulation (temporary or final) or revenue ruling must also be spelled out.

The statute of limitations will not run on an inadequately disclosed transfer, regardless of whether or not a gift tax return is filed for other gifts during the same taxable year. The need to make full and careful disclosure of any discounts taken has been buttressed by recent informal indications from the IRS that it will now pay special attention to gift tax returns that show a discount has been taken.

Availability of the Annual Exclusion

A recent technical advice memorandum [PLTR 9751003 (August 28, 1997)] indicates that the IRS will not allow the $10,000 per donee annual exclusion for gifts of family limited partnership interests in situations where the partnership agreement contains substantial restrictions on the donee's right to receive distributions, withdraw from the partnership, and transfer a partnership interest. In this case, the IRS found that the gift was one of a future interest. It determined that because the general partner could choose to retain funds in the partnership, the donee did not receive a present right to the immediate use, possession, or enjoyment of the income.

Interestingly, for purposes of establishing the availability of the annual exclusion, the IRS apparently does not apply this same standard of control to gifts of stock in a family-owned corporation. Most of these entities rarely, if ever, pay dividends. The board of directors has the sole discretion to decide if and when dividends are paid. Nevertheless, gifts of corporate stock will qualify for the annual exclusion absent a total prohibition on their transferability by the donee.

Savings Clauses

Savings clauses are used in several different contexts to create certainty with regard to transfers of property between related parties. There are two kinds of savings clauses: definitional clauses and adjustment clauses.

A definitional clause defines the extent to which a property interest has been transferred in terms of valuation. One example of the use of a definitional clause would be the creation and funding of a trust to hold exactly $1 million, the terms of which would qualify the trust for the maximum generation-skipping transfer tax exemption. Any amounts transferred found to be in excess of $1 million would be subject to a totally different set of provisions applying to the transfer. For example, a definitional clause could provide that $1 million of stock in a closely held corporation be transferred to a generation-skipping trust. Any stock in excess of $1 million would pour over into a revocable trust with children or a charity as the remainderman. The exact value of stock transferred is determined as of the date of the transfer. However, the exact number of shares transferred to the generation-skipping trust is ultimately determined only after the value of the stock is conclusively arrived at. This avoids the possibility that an audit of the gift tax return by the IRS will produce
an unwanted generation-skipping transfer tax.

An adjustment clause attempts to adjust the amount of an asset that has been transferred or the consideration given in exchange for the transferred asset once the value of the closely held asset has been conclusively determined. Adjustment clauses are used to adjust the amount of an asset being transferred. The effect of the clause is to reconvey property from the transferee back to the transferor. An example occurs when there is a transfer of land equal to the amount of the unified credit plus the amount of the annual exclusion to a younger generation family member. The adjustment clause would provide that any portion of the land value found to be in excess of the unified credit plus the annual exclusion would revert back to the donor.

IRS and Courts Discourage Use of Savings Clauses

The courts have not been supportive in the use of savings clauses. The leading case in this area is Proctor [142 F.2d 824 (CA-4, 1944)]. Proctor involved a gift of property subject to a liability to children. The savings clause provided that, in the event the value of the property transferred exceeded the amount of the liability, the excess property would not be considered to have been transferred. The court found the savings clause could not avoid a payment of gift tax for three reasons. First, if the savings clause were upheld it would discourage the collection of gift taxes. Second, the only effect a decision by the court would have would be avoidance of the gift tax. Third, if the clause were valid, the effect would be to force the court to make a declaratory judgment concerning the value of the property transferred without the existence of an adversarial relationship between parties. A true adversarial hearing between the parties involved is unlikely in the case of related parties.

In King [545 F.2d 700 (CA-10, 1977)], an adjustment clause provided that notes issued by a trust would be adjusted to reflect the fair market value of property (a closely held asset) being purchased by the trust. The 10th Circuit upheld the use of a savings clause because the trust was purchasing the property for adequate and full consideration. There was no attempt to recover stock or cancel notes. A savings clause was found to be a proper means of overcoming the uncertainty in determining the fair market value of the closely held asset.

Subsequent court decisions followed the Proctor decision, emphasizing that the courts do not want to issue declaratory judgments as to property rights when all interested parties are not present.

Recently, the Treasury Department has required the inclusion of an adjustment clause in a trust document whenever qualified interests are created under IRC section 2702. It is interesting to note that neither section 2702 nor its legislative history contain any mention of an adjustment clause. Since the use of an adjustment clause in this situation would discourage the collection of gift tax and require the courts to decide a matter of valuation and property rights without all parties being present, the impact of Proctor and subsequent cases is lessened.

Under Regulations section 1.664-2(a)(1), adjustment clauses must also be used in connection with charitable remainder trusts to adjust the fraction or percentage of fair market value of property passing to the trust after fair market value finally has been determined. This particular regulation was finalized in 1972 and clearly contemplates an adjustment clause being triggered due to a judicial decision or even its final appeal. This is another example of a regulation that is the result of government policy and not mandated by statute or legislative history.

It can be assumed that since adjustment clauses are mandated in several situations they will be honored in other instances when interests in closely held businesses are transferred to related parties. The arguments in Proctor are not relevant today. The use of a savings clause may very well prevent the imposition of unwanted gift tax when valuations of closely held interests are challenged upon audit. Because of the unification of estate and gift taxes, taxes not collected during an individual's lifetime will ultimately be collected at death. *

Paul Streer, PhD, CPA, is a professor of accounting at the University of Georgia. Caroline D. Strobel, PhD, CPA, is a professor of accounting at the University of South Carolina.

PROPOSED REGULATIONS ON ADEQUATE
DISCLOSURE OF GIFTS

By John F. Burke, CPA

I n December 1998, the IRS issued proposed regulations relating to the new adequate disclosure requirements for gifts made after August 5, 1997. The proposed regulations indicate the information that must be included either on the gift tax return or in an attached statement for the related transaction to be considered adequately disclosed for purposes of commencement of the statute of limitations.

Such information should include the following:

Adequate disclosure of a transfer reported as a completed gift on the gift tax return will commence the running of the statute of limitations. A transfer reported as an incomplete gift will not.

These various provisions only limit the IRS's ability to make adjustments related to the value of a gift. The IRS can still make adjustments unrelated to value, such as in the erroneous inclusion or exclusion of the property for gift tax purposes. *