Article: "Minority Interest, Fractional Interest and Marketability Discounts for Interests in Real Estate. "

Cases:
· LeFrak (T.C. Memo 1993-526)
· TAM 9336002, filed May 28, 1993
· Lauder (T.C. Memo 1992-736, (64 TCM 1643))
· Gray (T.C. Memo 1993-334)
· Bennett (T.C. Memo 1993-)
· Newark Morning Ledger (113SCt 1679 (1993))
· Levin Prince (986 F2d (4th Cir. 1993)

Tax Tip; Charitable Giving In Estate Planning

Minority Interest, Fractional Interest and Marketability Discounts for Interests in Real Estate.

Samuel J. LeFrak and Ethel LeFrak v. Commissioner. T.C. Memo. 1993-526.

The recently decided LeFrak case shows the relevant valuation considerations, and what can go wrong, when an owner attempts to contribute real estate to a partnership. The Court’s decision applied minority interest and marketability discounts to undivided interests in real estate.

On December 30, 1976, Mr. LeFrak conveyed interests in twenty New York City apartment buildings to his children. On the same day, he formed twenty partnerships with them. The partnerships were formed to own the properties and to facilitate gifts to Mr. LeFrak’s children. On the gift tax returns, a 15 percent discount was claimed (presumably for the factors of minority interest and lack of marketability) in valuing the gifted interests.

At trial, the IRS successfully argued that the gifts were of undivided interests in the buildings themselves and not gifts of partnership interests. In the opinion of the Court, LeFrak transferred interests in the buildings which were then placed in the partnerships. Transfers of interests in the buildings were viewed as the relevant conveyance for gift tax purposes.

Nonetheless, the Court concluded that both a minority interest and lack of marketability discount should be applied in valuing the transferred, undivided interests in property for gift tax purposes. Notwithstanding defeats in a series of earlier cases, the IRS argued that no valuation discount was appropriate (the Court noted that Revenue Ruling 93012, which states that family relationships would no longer be taken into account for valuation purposes, was issued after briefs in the case were filed). The business valuation expert employed by LeFrak developed minority interest and marketability discounts applicable to partnership interests. The real estate appraiser retained by the IRS deducted a marketability discount of 10% in valuing the undivided interests.

In its final conclusion, the Court allowed a combined discount of 30% for "minority interest or fractional interest and lack of marketability."

COMMENT: The combined discount of 30% clearly exceeds the 15% discount often arrived at in decisions regarding valuations of undivided interests in real estate. Documented, supportable minority interest and marketability discounts approaching 50%, or more, are not uncommon today. Significantly, this may be the first time that the business valuation concepts of minority interest discount and lack of marketability have been applied in the valuation of undivided interests in real estate.

The LeFrak case also illustrates the importance of exercising care in the formation of family partnerships. The formation of such partnerships can open the door to proper management of family assets and the transfer of partnership interests to family members, at significant discounts, for estate planning purposes.

TAM 9336002 filed May 28, 1993

In Technical Advice Memo 9336002, the IRS analyzes the amount of discount applicable (if any is appropriate) to the value of a decedent’s 50% interest in a ranch property. The Service observes that the lack of unity of ownership of a property is a possible disadvantage if one wishes to sell a property, but is not a disadvantage if all of the owners wish to sell.

While noting that fair market value for estate tax purposes is not equivalent to a forced sale price, the IRS expects willing sellers and willing buyers to act in their own best interests. Since a partition of a property may result in a greater gain to a willing seller, the IRS wonders why a willing seller would accept any lesser, discounted price. The estate’s appraiser had determined that a 30% valuation discount for the undivided ownership interest should be deducted.

The Service concluded that any discount should be limited to the petitioner’s (willing seller’s) share of the estimated cost of a partition of the property. We see a number of flaws in the logic behind this TAM.

Note: Evidence of minority interest discounts for real estate assets is present in the case of publicly-held real estate investment trusts (REITs), as noted in the Berg case (T.C. Memo 1991-279). Minority interests in such REITs trade at up to 50 percent discounts from underlying asset values. In addition, discounts for lack of marketability would also be applicable. Practitioners have suggested that REIT market value evidence is relevant in valuing fractional, undivided interests in property.

With this TAM, the IRS goes on record in suggesting that a discount of some magnitude is required in valuing undivided interests in property. In many recent (Pillsbury 64 T.C.M. 284), and not so recent cases (Propstra 680 F2d 1248, 9th Cir. 1982), IRS attorneys have argued that no discount is appropriate in the valuation of fractional undivided interests in real estate.

Discount Comment: While LeFrak and the TAM support minority discounts, numerous tax commentators have recently pointed out that high on the IRS wish list for legislative action is a limitation on minority discounts in the transfer of minority interests among family members. We believe that such an action would be devastating to family business in America.

Recent Valuation Decisions

Estate of Joseph P. Lauder, deceased, Leonard A. Lauder and Ronald S. Lauder, Executors v. Commissioner, T.C. Memo 1992-736, (64 TCM 1643)

The question decided in the Lauder case was, did the formula price contained in shareholder agreements control the value of Lauder stock for purposes of the federal estate tax?

Joseph H. Lauder died on January 6, 1983. At that time, he owned about 20% of the voting and non-voting shares of his family’s cosmetics and perfume business, EJL Corporation (Estee Lauder, Inc.). For purposes of the estate tax return, his shares were valued in accordance with enforceable shareholder agreements that provided for redemption at book value (exclusive of any value for intangible assets). At trial, Lauder’s son, Leonard, testified that he considered the S&P 400 Index, which was selling at approximately book value at the time, but not the cosmetics companies subset in particular, which was selling at 200% of book, when framing the agreements. No appraisals were obtained when the agreements were written.

The Court recognized that under Section 2031 the value of stock may be limited by buy/sell agreements if:

1. The agreement serves a bona fide business purpose, and
2. It is not a device to pass the decedent’s shares to heirs for less than adequate        and full consideration.

Also, the Court indicated that intrafamily agreements require greater scrutiny because they allow the possibility of passing wealth to subsequent generations at a bargain price.

The opinion of the Court concluded that the agreements did serve the legitimate purpose of preserving family ownership and control. The Lauders testified that their goal was to retain ownership of the company and to pass it to the third generation. The Court did find that the agreements created enforceable obligations for the decedent during his life and after his death. However, the Court concluded that, for federal estate tax purposes, the book value provisions of the Lauder shareholder agreements were an artificial device used to minimize estate taxes.

Management Planning, Inc. served as valuation expert for the IRS in this case. The second phase of the case, heard in November 1993, concerned the fair market value of Joseph Lauder’s stock at his death.

COMMENT: The message in this case is that great care must be used in framing buy/sell agreements in family situations. Failure to develop a sound, supportable fair market value for the stock could result in an expensive challenge from the IRS based on the valuation requirements of Chapter 14, IRC Section 2703.

Estate of James H. Gray, Sr., Deceased, Terry P. McKenna, Executor v. Commissioner, T.C. Memo 1993-334

Determination of the fair market value of a control block of stock was the issue in this case. Gray Communications Systems, Inc., a publicly-held Georgia corporation engaged in newspaper publishing, television broadcasting, transportation services, video systems sales and real estate development, was thinly traded over the counter at the time of Mr. Gray’s death. His shares (50.487% of the total) were unregistered and subject to SEC Rule 144 at his death on September 19, 1986.

After hearing testimony from three business appraisers, the Court found that the underlying net asset value of the Gray Communications stock was $188.27 per share. Taking into account the substantial size of the minority interest held by others (49.513%), the legal complications of FCC rules governing the sale of communications corporations, the potential for dissension and the legal complications of liquidation of large blocks of unregistered stock, a fair market value of $178 per share was determined for the stock owned by Mr. Gray. The reduction represents a 5% discount.

The Court cited the opinion in Estate of Curry v. United States, 706 F2d 1424, 1430 (7th Cir. 1983) which stated "The chief problem with (the government’s) argument is its assumption that the controlling seller, or a party to whom he sold his interest, could automatically liquidate the company to realize its asset value, unconstrained by the rigorous fiduciary duties which attach to possession of a controlling equity interest. While it is true that (Indiana) law permits a majority interest to effect a liquidation of a corporation, it is settled law that the power to cause such extraordinary corporate actions as dissolution or liquidation may not be exercised without scrupulous loyalty to the interests of minority shareholders. Indeed, the fiduciary duty owed to the minority interest is even greater where, as here, the corporation is small, non-public and closely held."

Estate of Charles Russell Bennett, Deceased, Eva F. Bennett and Don R. Paxson, Co-Executors v. Commissioner, T.C. Memo 1993

Mr. Bennett owned 100% of the stock of Fairlawn Plaza Development, Inc., a company which owned and managed a shopping center and other nearby commercial properties.

The business appraisers retained by the estate and by the IRS did not differ significantly regarding the net asset value of the company, but they arrived at very different values for its stock. Different weights were applied to the company’s earnings capacity and net asset value. In addition, the estate’s appraiser deducted a 33% allowance from net asset value for liquidation costs and then applied a 15% discount for lack of marketability. The IRS appraiser made no such adjustments.

The Court held that the primary valuation determination should be the company’s net asset value and that no discount should be allowed for liquidation costs since there was no realistic prospect of this occurring. The Court did allow a 15% discount for lack of marketability because the varied and nonliquid character of the company’s assets generated management costs and made it more difficult to find a buyer who would be interested in acquiring all of the properties owned by the company.

The Court found the rationale used in the Estate of Dougherty v. Commissioner to be relevant (T.C. Memo 1990-274). In Dougherty, a 10% discount for management costs and a 25% discount for lack of marketability were deducted in valuing 100% of the stock of a company with a portfolio of notes, receivables, fixed assets, long term investments and realty partnership interests. This was based on the Court’s observation that it would be difficult to find a buyer for such a "mixed bag" of assets.

COMMENT: Bennett, Gray and Dougherty concluded that discounts are applicable in the valuation of controlling interests in closely-held investment companies. Professional advisors should consider the arguments of these cases in their client’s valuation situations.

Newark Morning Ledger Company v. United States, 113SCt 1679 (1993)

The basic question in this case was whether or not a newspaper subscriber list which had an ascertainable value and a limited useful life was therefore distinguishable from goodwill so that the list could be amortized under Internal Revenue Code Section 167.

The Supreme Court held that: "… a taxpayer able to prove that a particular asset can be valued and that it has a limited useful life may depreciate its value over its useful life regardless of how much the asset appears to reflect the expectancy of continued patronage…", i.e. to reflect goodwill.

The future importance of this decision has been limited, however, by new statutory rules for the amortization of purchased intangibles over fifteen years which were enacted as Internal Revenue Code Section 197.

Marc Alan Levin, Executor, Estate of Myrtle S. Levin Prince, v. Commissioner 986 F2d (4th Cir. 1993)

This case is similar to the Stalcup and Smith cases that have been discussed in other issues of MPI’s Business Valuation Report. All three address the issue of revaluing gifts made during the life of the decedent for estate tax purposes.

In the Levin case, the statute of limitations on certain untaxed lifetime gifts had expired. However, the Court held that the IRS was not barred from including the value of these gifts in computing the decedent’s adjusted taxable gifts for estate tax purposes. As in Smith and Stalcup, the Court found that there was nothing in the statute which prevented the revelation of lifetime transfers when determining adjusted taxable gifts for estate tax purposes where the estate tax limitations period has not expired.

TAX TIP

Nearly 56% of estate tax returns based on a gross estate of more than $5,000,000 were audited in 1992. This was up slightly from 1991 when 54.5% of returns in this category were audited. These statistics were compiled by the Research Institute of America from the 1992 Fiscal Report from the Commissioner of the Internal Revenue Service. Clients that fully understand the risk also understand the benefit of basing their gift and estate tax planning on a well documented history of sound, supportable valuation analyses.

CHARITABLE GIVING IN ESTATE PLANNING

The contribution of appreciated assets has always been a good tax planning idea. Besides serving humanitarian needs, the contribution of closely-held stock provides attractive estate and income tax planning benefits. Under the 1992 Omnibus Revenue Reconciliation Act, the capital gains portion of a deductible charitable contribution is no longer a tax-preference item for Adjusted Minimum Tax (AMT) purposes (Internal Revenue Code 57(a)).

Congress believes this will encourage taxpayers to make additional charitable contributions of appreciated capital gain property.

Any charitable contribution must meet specific IRS guidelines with respect to documentation and substantiation of the fair market value of the contributed property. The credentials of the valuation expert should be of paramount importance to you because the burden of establishing fair market value is on the taxpayer. The expert establishes the credibility of the valuation documentation to both the IRS and the court. Failure to have the appraisal prepared by a qualified business appraiser can result in the loss of the charitable contribution deduction regardless of whether or not the property was correctly valued.

IRS Form 8283, which must be filed with the donor’s income tax return, requires the signature of a qualified appraiser like Management Planning and a statement indicating that he presents himself to the public as an appraiser and that he performs appraisals on a regular basis. The appraiser may not be employed by the donor or the donee or be a party to the transaction. (Regulations require that the valuation date of a prior appraisal be no earlier than 60 days before the date of the charitable contribution.)

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