For the past two and a half years, advisors to family business owners have been somewhat uncertain about valuation discount planning for transfer tax purposes because of a September 1994 letter ruling by the Internal Revenue Service. The ruling is sometimes referred to as the "Swing Vote TAM." This article reviews the role of minority discounts in valuation and estate planning, discusses relevant cases and rulings and gives possible reasons why many professionals, including business appraisers, are not overly concerned about the Swing Vote TAM.

Most family business owners would prefer to see their businesses survive to the next generation, particularly where a child or children are active in the business. However, due to the confiscatory nature of the federal estate and gift tax with a top bracket of 55 percent, businesses are often sold to help pay the tax bill. Proper planning during lifetime could avoid this unfortunate result.

Fair Market Value

A starting point for valuing property for estate and gift tax purposes is found in applicable Treasury Regulations, which use a "fair market value" standard for value, defining it as "the price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." This language would seem to indicate that the willing buyer and willing seller are not specific transferor and transferee but hypothetical people who have no relationship to each other.

Revenue Ruling 59-60 deals with valuing interests in closely held businesses. It states that "all relevant factors affecting fair market value, should be considered" and lists seven financial-related factors, one of which mentions "the size of the block of stock to be valued." The ruling goes on to say:

Although it is true that a minority interest in an unlisted corporation’s stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock.

If control adds value, division of control reduces it. For example, assume that the sole owner of a business worth $1 million gives one-third interests to each of three children. The sum of the values of the children’s interests is clearly less than $1 million because none of the children has control. This reduction in value is the minority interest discount.

Discounting to reflect minority interests or lack of control is an effective estate planning tool to reduce estate and gift taxes. When combined with a second discount for illiquidity (lack of marketability), it is easy to see why discounts are a lever to maximize the $600,000 estate and gift tax unified credit, $10,000 gift tax annual exclusion and other gifts.

Using the previous example of the sole owner of a business worth $1 million who has three children, the owner could give stock valued at $30,000 each year without gift tax consequences. If the owner is married and appropriate elections are made, stock valued at $60,000 could be given. Although $60,000 would appear to be 6 percent of the business, a 40 percent discount for a minority interest gift would allow the owner to give a higher percentage of the business, in this case 10 percent. If this gift program were to continue annually and the value of the business were to remain constant, the owner would have less than 50 percent in the sixth year, enabling his or her estate also to have the advantage of a minority discount.

Discounts facilitate the shifting of business interests which are expected to appreciate from senior to junior generations. Assume that a business is currently worth $600,000 but expected to double in value during the owner’s lifetime. A current gift of the business would be tax-free because of the unified credit, whereas the more expensive alternative of a bequest would subject an extra $600,000 to estate tax.

Even when gift taxes are incurred because a gift is in excess of the annual exclusion and/or the unified credit has been used up, it is still better to transfer assets by lifetime gifts than by bequests. The reason is simply that the gift tax is imposed on the value of what is transferred while the estate tax is imposed on the entire estate, including the amount used to pay the estate tax. It is "icing on the cake" when a gifted asset is expected to appreciate and yet is discounted for valuation purposes.

The size of a minority interest discount varies, depending on the specific facts and circumstances related to the business or business interest being valued. The essential question is what rights and benefits does the minority interest possess. Obvious elements of control are the ability to set policy, determine management compensation, pay dividends and liquidate. Other criteria to consider are corporate articles and bylaws and applicable state law affecting minority rights. Since New York requires a two-thirds vote of the shareholders in order to liquidate, a simple majority owner of fewer shares may be deemed to have less than a control block.

Empirical Evidence

Business appraisers consider various types of empirical evidence to support minority interest discounts. When closely held stock of an operating company is valued with reference to similar publicly traded "guideline companies, the minority discount is already built in. This is because the trading prices of the guideline companies are minority interest transactions themselves and these prices are used in the financial ratios applied to the closely held companies.

Similarly, if an income valuation approach, such as capitalizing earnings, is used, the discount is reflected in the analysis because public market evidence of the rate a minority investor would demand for a particular risk is relied upon in selecting the capitalization rate.

Another source of evidence to help quantify lack of control is public merger and acquisition activity where pre-merger or pre-acquisition prices of public companies are compared to transactions reflecting their control prices.

Where the closely held business is an asset-based entity such as a real estate and/or investment holding company, the minority discount is derived from the relationship between the trading prices of publicly held real estate and investment companies and their net asset values. With individual exceptions, the market prices of these public companies have over the years sold at significant discounts from their net asset values.

Business appraisers use the hypothetical buyer-seller standard from the Regulations in valuing intra-family transfers for transfer tax purposes. They do not assume that a transferee will vote his or her shares with the family. On the other hand, the IRS must assume that shareholders within a family join and act together in order to argue that the family remains in control after the transfer(s) and therefore a minority discount is not appropriate. This was the IRS’s traditional position. In Revenue Ruling 81-253, it held that a minority interest discount would not be allowed in valuing gifts of stock by a majority shareholder to family members. The theory (known as "family attribution") behind the ruling was that continued collective ownership by the family allowed it to maintain control of the business. Proof of discord among family members would be necessary to avoid treating the shares as part of a controlling block.

The Bright case, decided by the Fifth Circuit just prior to the issuance of Revenue Ruling 81-253, involved the estate tax value of a 27 percent undivided community property interest in the stock of several corporations. The IRS sought to combine the decedent’s interest with that of the surviving spouse, arguing that a 55 percent block represented control and therefore no minority discount was allowable. However, the court rejected family attribution, saying its was "logically inconsistent" with the hypothetical seller rule.

Bright is just one in a long list of minority discount and family attribution cases the IRS has lost over the years. An exception is the 1989 Winkler estate tax case where the decedent’s family and another family each owned 50 percent of a closely held corporation. Since a holder of the decedent’s 10 percent voting stock interest could block corporate action by voting with her family or vote with the other family to give it control, the stock had "swing vote" characteristics. Accordingly, the estate’s request for a minority interest discount was denied and a swing vote premium applied. Because there was a potential market for the decedent’s shares among existing shareholders, the court thought a strict hypothetical buyer-seller standard was not appropriate. The decision actually goes beyond family attribution in point out that someone unrelated to the two families could bid up and buy the 10 percent interest because of its presumed importance to each family.

In a dramatic reversal of position, the IRS issued Revenue Ruling 93-12 in January 1993, stating that it would follow the Bright case and would no longer deny minority interest discounts solely because a transferred interest, when aggregated with interests held by family members, would be part of a controlling interest. Revenue Ruling 81-253 was specifically revoked. Although Bright and other cases cited as authority are estate tax cases, the ruling’s facts are in a gift tax context with the example of a parent, owner of all of X Corporation’s stock, making simultaneous gifts of 20 percent of the shares to each of five children.

It is important to note that the gifts in Revenue Ruling 93-12 were simultaneous. Suppose the parent decided instead to make 20 percent gifts to one child each year for five years. Would a minority interest discount be denied in valuing the third-year gift because it left the child in a control position? The willing buyer-seller standard would suggest that the identity or characteristics of the donee are not to be considered. In August 1994, one month before the Swing Vote TAM, the IRS issued a letter ruling in which it found that a decedent’s 48.59 percent interest in a corporation, bequeathed to a son who already had the remaining 51.41 percent, was a minority interest and could be valued without regard to the son’s ownership.

Finally, this somewhat uneven history of cases and rulings has concluded for the time being with the Swing Vote TAM. The facts are virtually the same as in Revenue Ruling 93-12 except the donor-parent retained 5 percent of the stock and gave 30 percent to each of three children and 5 percent to the spouse. The IRS said each child’s 30 percent block had swing vote characteristics which enhanced its value because any two of the blocks’ owners, related or unrelated, could join and control the corporation.

The ruling does not discuss the extent to which value was enhanced or whether such value reduced or eliminated minority interest discounts. However, there is heavy reliance on Winkler where the discount was denied because of swing vote potential. The ruling also deals with the donor-parent’s objection that attributing swing vote value was "arbitrary," by analyzing gifts of 30 percent blocks at different times. In this case the first 30 percent gift would have no swing vote attributes while the second and third gifts would cause all three blocks’ values to be enhanced.

There are obvious problems with the Swing Vote TAM. The value attributable to a swing vote, if it exists, would be highly speculative. Aside from the buyer’s need for ongoing cooperation from the other 30 percent owner, the ability of both to control a corporation is restricted by fiduciary obligations to other minority shareholders. Lastly, a combined 60 percent block might only represent working control in states where a two-thirds vote is required for absolute control.

Conclusion

Although the Swing Vote TAM has created some uncertainty, it has not affected the flow of work by business appraisers in providing discounted values for intra-family transfers. There are several possible reasons. The TAM contradicts Revenue Ruling 93-12, is inconsistent with the hypothetical buyer-seller standard in the Treasury Regulations and is not in line with established case law rejecting family attribution. It would also cause executors, appraisers and judges to engage in speculation and subjectivity by delving into the "feelings, attitudes and anticipated behavior" of individuals and families.

Because of its past record of failures and the risk of being liable for litigation costs, the IRS will probably not litigate again if the key to its case is family attribution. It also might need more than a swing vote argument to be successful. Sometimes the facts and circumstances show that gifts of business interests to family members were not actually made, as in the recent Cidulka case. This could be fertile ground for the IRS.

Short of judicial intervention to clear the air on minority discounts and swing vote value, an alternative would be new legislation. However, because most families and their advisors continue to press ahead and succeed with estate plans that include discounted gifts of minority interests, Congress would be advised to leave well enough alone.

Footnotes:

1. Tech. Adv. Mem. 94-36-005 (Sept. 9, 1994).
2. Treas. §Reg. 20.2031-1(b); Treas. Reg. §25.2512-1.
3. 1059-1 C.B. 237.
4. I.R.C. §2513(a)
5. This example is from James R. Repetti, "Minority Discounts: The Alchemy in Estate and Gift Taxation," 50 Tax L. Rev. 415, 431 (1995).
6. N.Y. Bus. Corp. Law §1001 (McKinney).
7. 1981-2 C.B. 187, revoked by Rev. Rul. 93-12, 1993-1 C.B. 202.
8. Estate of Bright, 658 F2d 999 (5th Cir. 1981).
9. John A. Propstra, 680 F2d 1248 (9th Cir. 1982); Estate of Andrews, 79 T.C. 938 (1982); Estate of Lee, 69 T.C. 860 (1978).
10. Estate of Winkler, 57 T.C.M. (CCH) 373 (1989), T.C. Memo. 1989-231.
11. 1993-1 C.B. 202.
12. Tech. Adv. Mem. 94-32-001 (Aug. 12, 1994).
13. For practitioners who wish to avoid swing vote issues altogether, a possible way around them is to recapitalize the corporation and give nonvoting stock.
14. John A. Propstra, 680 F2d 1248, 1252 (9th Cir. 1982).
15. Victor J. Minahan, 88 T.C. 492 (1987).
16. Estate of Cidulka, 71 T.C.M. (CCH) 2555 (1996); T.C. Memo. 1996-149; see also Estate of Murphy, 60 T.C.M. (CCH) 645 (1990), T.C. Memo. 1990-472.

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