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The New Paradigm in Trusts and Estates Valuation 2016 Trust and Estate Planning Series

Thursday, April 7, 2016

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American Bankers Association Trust and Estate Planning Briefing Series The New Paradigm in Trusts and Estates Valuation Thursday, April 7, 2016 • 1:00 – 3:00 p.m. ET

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II

Table of Contents

TABLE OF CONTENTS ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . II

SPEAKER & ABA STAFF LISTING ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . III

PROGRAM OUTLINE ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IV

CONTINUING EDUCATION CREDITS INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . . . V

CPA SIGN-IN SHEET & CERTIFICATE OF COMPLETION REQUEST ... . . . . VI

CFP SIGN-IN SHEET & CERTIFICATE OF COMPLETION REQUEST ... . . . VII

INSTRUCTIONS FOR REQUESTING CERTIFICATE OF COMPLETION . VIII

PROGRAM INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ENCLOSED

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Speaker and ABA Staff Listing

Speakers Thomas W. Abendroth Partner Schiff Hardin LLP 233 South Wacker Drive Chicago, IL 60606 (312) 258-5500 [email protected] Charles “Skip” D. Fox, IV Partner McGuireWoods LLP Court Square Building 310 Fourth Street, NE, Suite 300 Charlottesville, VA 22902 (434) 977-2500 [email protected]

ABA Briefing Staff Cari Hearn Senior Manager (202) 663-5393 [email protected] Linda M. Shepard Senior Manager (202) 663-5499 [email protected]

American Bankers Association 1120 Connecticut Avenue, NW Washington, DC 20036

mailto:[email protected]





IV

PROGRAM OUTLINE

TIMES SESSION AND SPEAKERS 12:45 – 1:00 p.m. ET

Pre-Seminar Countdown

1:00 – 1:03 p.m.

Welcome and Introduction 1Source International

1:05 – 1:30 p.m.

Introduction, Valuation Guidelines and Discounts Tom Abendroth Schiff Hardin LLP

1:30 – 1:50 p.m.

Government Attempts to Limit Valuation Discounts Skip Fox McGuireWoods LLP

1:50 – 2:00 p.m.

Questions & Answers

2:00 – 2:25 p.m.

Aggregation of Business Interests and Impact on Valuation Post-Mortem Valuation Planning Tom Abendroth Schiff Hardin LLP

2:25 – 2:50 p.m.

Valuation Savings Clauses Reporting Requirements Skip Fox McGuireWoods LLP

2:50 – 3:00 p.m.

Questions and Answers Wrap-up


V

Continuing Education Credits Information

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The ABA Briefing, “The New Paradigm in Trusts and Estates Valuation” has been

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VI

CPA Required Sign-in/Sign-out Sheet

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VII

Instructions for Receiving Certificates of Completion

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VIII

Certified Financial Planner Sign-In Sheet Program ID #: 223197

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4/1/2016

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The New Paradigm in Trusts and Estates Valuation2016 Trust and Estate Planning Briefing Series

American Bankers Association Briefing/WebinarThursday, April 7, 20161:00 – 3:00 p.m. ET


Disclaimer

This briefing is being recorded with permission and isfurnished for informational use only. Neither thespeakers, contributors nor ABA is engaged in renderinglegal nor other expert professional services, for whichoutside competent professionals should be sought.

All statements and opinions contained herein are thesole opinion of the speakers and subject to changewithout notice. Receipt of this information constitutesyour acceptance of these terms and conditions.

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4/1/2016

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Presenters

• Thomas W. Abendroth, Partner, Schiff Hardin LLP

• Charles D. Fox IV, Partner, McGuireWoods, LLP

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Agenda

• Introduction, Valuation Guidelines and Discounts• Government Attempts to Limit Valuation Discounts• Questions and Answers• Aggregation of Business Interests and Impact on

Valuation• Post-Mortem Valuation Planning• Valuation Savings Clauses• Reporting Requirements• Questions and Answers and Wrap-Up

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Introduction

• Asset valuation is a critically important aspect of estate planning.

• Valuation takes on added importance when closely held business or real estate interests are involved.

• The valuation of closely held assets is a subjective process.

• The basic principles used in the valuation process create unique transfer tax planning opportunities.

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Page 1


Valuation Guidelines from the IRS

• The Internal Revenue Code, Treasury Regulations and IRS rulings, as interpreted by the courts, establish a framework.

• The willing buyer - willing seller rule (neither being under any compulsion and both having knowledge) is found in Treas. Reg. 20.2031.

• Revenue Ruling 59-60, 1959-1 C.B. 237 is the primary source of IRS guidelines for valuing closely held business interests.

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Page 1 - 2

4/1/2016

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Valuation Guidelines from the IRS (cont.)

• The IRS recognizes that valuation is a subjective process for which no one set of rules can be used.

• Factors to consider from Revenue Ruling 59-60 include the past stability or instability of an enterprise, its growth and extent of diversity, the general economic outlook and outlook for the particular industry, the uniqueness and novelty of the product, and the possible effect of the loss of a key manager.

• The discussion in Revenue Ruling 59-60 concerning valuation methods assumes that the stock in question is not publicly traded and that any sales that do occur are irregular and do not reflect fair market value.

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Page 2 - 3


Valuation Guidelines from the IRS (cont.)

• For business interests for which there is no public market, the two primary valuation methods endorsed by Revenue Ruling 59-60 are

(1) capitalization of earnings and (2) net asset value,

with the former being most relevant for operating companies, and the latter being most important for investment or holding companies.

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Page 3 - 4

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Valuation Date

• The valuation date is generally the date of the transfer. Thus, for testamentary transfers, the decedent's date of death is usually the date of transfer.

• Alternate Valuation Date. Six months after the date of death if the overall value of assets and the amount of estate taxes owed are reduced. IRC §2032.

• The valuation date for property transferred by gift is the date of the gift.

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Page 4


Valuation Date (cont.)

• The sales price before or after a transfer date should not be determinative of the value of the property.

• Nevertheless, post-death or post-gift transactions may be relevant to determining value.

• Courts have admitted evidence of values in post-death transactions on this basis.

• A post-death or post-gift sales price also may be considered relevant when the sale is foreseeable at the time of death or the gift.

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Page 4 ‐ 5

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Adjustments to Value

• Lack of Marketability Discount• Blockage Discount• Restricted Securities• Minority Interest Discount• Control Premium• Discount for Unrealized Capital Gains

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Page 5 ‐ 16


Government Attempts to Limit Valuation Discounts

• The Willing Buyer/Willing Seller Rule and Family Attribution

• Swing Votes• Section 2701, Special Valuation Rules for applicable

Retained Interests• Section 2703, Certain Option and Transfer Restrictions

Disregarded• Section 2704, Treatment of Certain Lapsing Rights and

Restrictions

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Page 16 ‐ 26

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Government Attempts to Limit Valuation Discounts

• Prior Legislative Proposals• Fiscal Year 2010 Greenbook• New “disregarded restrictions” to be ignored; and• Replacement valuation presumptions to be defined in regs

• Proposed Section 2704 Regulations• Part of the IRS Priority Guidance Plan• Would regulations under Section 2704 that override legal rights

under state law be valid?• IRS may be reconsidering how far they can go by regulation

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Page 26 ‐ 29


Questions and Answers

If you are participating on the Web:Enter your Question in the Box Below

and Press ENTER / SUBMIT.

If you are participating by Phone:Email your Question to: [email protected]

ORPress *1 on your Telephone Keypad

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4/1/2016

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Aggregation of Business Interest and its Impact on Valuation

• The value of business interests for estate tax purposes is influenced in a major way by the size of the interest relative to the entire business.

• Non-Aggregation of Differently Owned Interests• Estate of Bonner – business interest owned directly cannot be

aggregated with business interest owned by QTIP Trust.• Non-aggregation should be available for any interest in a separate

trust that does not grant absolute control (general power of appointment)

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Page 29 ‐ 32


Lifetime and Post-Mortem Planning to Alter Values

• Lifetime Planning to Take Advantage of Discounts• Create minority interests• Challenge in giving up control• Minority interests may be detrimental for a couple at the first death

• Impact of Valuation in Allocating Business Interests Post-Death

• Restricted Securities and creating an affiliate for securities law purposes

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Page 32 ‐ 37

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Valuation Savings Clauses and Formula Gift Clauses

• Savings clauses used to remove uncertainty from the valuation process or to avoid unintended gift tax consequences of a transfer.

• Formula gift allocation clauses (McCord and subsequent cases).

• Wandry Defined Value Clauses

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Pages 37‐45


Reporting Requirements

• Information Required For Estate Tax Return

• Disclosure and Reporting Requirements for Gift Tax Return

• Penalty Provisions

• Obtaining a Professional Appraisal

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Page 45 ‐ 53

4/1/2016

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Questions and Answers

If you are participating on the Web:Enter your Question in the Box Below

and Press ENTER / SUBMIT.

If you are participating by Phone:Email your Question to: [email protected]

ORPress *1 on your Telephone Keypad

19


2016 Trust and Estate Planning Series

Briefing Date Briefing Topic

May 5, 2016 Fiduciary Litigation Roundtable

Jun 2, 2016 Charitable Tales from the Crypt

Sep 8, 2016 Issues with Art and Other Collectibles in the Administration of Trusts and Estates

Oct 6, 2016 Are You a Fiduciary?

Nov 3, 2016 Twenty Steps to Avoid Fiduciary Litigation

Dec 1, 2016 Recent Developments in Estate and Trust Administration

Recordings Now Available

Life Insurance in a 21st Century Estate Plan

Uniform Fiduciary Access to Digital Assets Act (UFADAA) and Digital Assets

The New Paradigm in Trusts and Estate Valuation

Register Now at www.aba.com/trustbriefings

20

American Bankers Association Briefing / Webinar

THE NEW PARADIGM IN

TRUSTS AND ESTATES VALUATION

Thursday, April 7, 2016 1:00 p.m. to 3:00 p.m. E.T.

Charles D. Fox IV McGuireWoods LLP

Court Square Building 310 Fourth Street, NE, Suite 300 Charlottesville, Virginia 22902

(434) 977-2500 [email protected]

Thomas W. Abendroth Schiff Hardin LLP

233 S. Wacker Drive, Suite 6600 Chicago, Illinois 60606

(312) 258-5501 [email protected]

Copyright © 2016 by Schiff Hardin LLP and McGuireWoods LLP All rights reserved

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CHARLES D. (“SKIP”) FOX IV is a partner in the Charlottesville, Virginia office of

the law firm of McGuireWoods LLP and head of its Private Wealth Services Industry Group.

Prior to joining McGuireWoods in 2005, Skip practiced for twenty-five years with Schiff Hardin

LLP in Chicago. Skip concentrates his practice in estate planning, estate administration, trust

law, charitable organizations, and family business succession. He teaches at the American

Bankers Association National Trust School and National Graduate Trust School where he has

been on the faculty for over twenty-five years. Skip was an Adjunct Professor at Northwestern

University School of Law, where he taught from 1983 to 2005, and is currently an Adjunct at the

University of Virginia School of Law. He is a frequent lecturer across the country at seminars on

trust and estate topics. In addition, he is a co-presenter of the long-running monthly

teleconference series on tax and fiduciary law issues sponsored by the American Bankers

Association. Skip has contributed articles to numerous publications and is a regular columnist for

the ABA Trust Letter on tax matters. He was a member of the editorial board of Trusts & Estates

for several years and was Chair of the Editorial Board of Trust & Investments from 2003 until

2012. Skip is a member of the CCH Estate Planning Advisory Board. He is the author or co-

author of seven books. Skip is a Fellow of the American College of Trust and Estate Counsel (for

which he is Vice President) and is listed in Best Lawyers in America. In 2008, Skip was elected

to the NAEPC Estate Planning Hall of Fame. He is also Chair Emeritus of the Duke University

Estate Planning Council and a member of the Princeton University Planned Giving Advisory

Council. Skip has provided advice and counsel to major charitable organizations and serves or

has served on the boards of several charities, including Episcopal High School (from which he

received its Distinguished Service Award in 2001) and the University of Virginia Law School

Foundation. He received his A.B. from Princeton, his M.A. from Yale, and his J.D. from the

University of Virginia. Skip is married to Beth, a retired trust officer, and has two sons, Quent

and Elm.

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THOMAS W. ABENDROTH is a partner in the Chicago law firm of Schiff Hardin

LLP and practice group leader of the firm’s Private Clients, Trusts and Estates Group. He

concentrates his practice in the fields of estate planning, federal taxation, and business

succession planning. Tom is a 1984 graduate of Northwestern University School of Law, and

received his undergraduate degree from Ripon College, where he currently serves on the Board

of Trustees. He has co-authored a two-volume treatise entitled Illinois Estate Planning, Will

Drafting and Estate Administration, and a chapter on sophisticated value-shifting techniques in

the book, Estate and Personal Financial Planning. He is co-editor of Estate Planning Strategies

After Estate Tax Reform: Insights and Analysis (CCH 2001). Tom has contributed numerous

articles to industry publications, and served on the Editorial Advisory Board for ABA Trusts &

Investments Magazine. He is a member of Duke University Estate Planning Council. Tom is a

frequent speaker on tax and estate planning topics at banks and professional organizations. In

addition, he is a co-presenter of a monthly teleconference series on estate planning issues

presented by the American Bankers Association. Tom has taught at the American Bankers

Association National Graduate Trust School since 1990. He is a Fellow of the American College

of Trust and Estate Counsel.

THE NEW PARADIGM IN TRUSTS AND ESTATES VALUATION

I. Introduction

A. Asset valuation is a critically important aspect of estate planning. Only after the estate planner knows the value of a client's assets can he or she determine whether and to what extent the client will be subject to estate tax. This information enables the planner to make appropriate estate planning recommendations.

B. Valuation takes on added importance when closely held business or real estate interests are involved. Clients who hold such interests often have substantial transfer tax and liquidity problems. In order to resolve these problems, the planner must understand the process for valuing closely held assets and the methods available for transferring them at a minimum transfer tax cost.

C. The valuation of closely held assets is a subjective process. Although valuation typically involves the use of objective financial and market information, such as earnings, asset values, and financial ratios, the manner in which this information is selected and employed is based on subjective and often arbitrary decisions.

1. The selection of appropriate valuation discounts in particular involves subjective judgments. Approaches and opinions, even among experts, can vary widely.

2. This does not mean that there are no limitations on the manner in which an asset is valued. To obtain a value that is defendable for transfer tax purposes, one must operate within generally accepted valuation principles and within the parameters set by the Internal Revenue Service.

3. The valuation process is further complicated by a variety of Internal Revenue Code provisions that alter the economic reality of the value of assets, often by limiting the willing buyer-willing seller principles that are the foundation of the valuation process. As will be discussed in these materials, tax professionals expect another IRS effort to alter fundamental valuation principles with new regulations under Section 2704 of the Code.

D. The basic principles used in the valuation process create unique transfer tax planning opportunities. For example, a taxpayer can take steps to organize ownership of an entity to increase the opportunity to use discounts for lack of control or limited marketability.

II. Valuation Guidelines from the IRS

A. The Internal Revenue Code, Treasury Regulations and IRS rulings, as interpreted by the courts, establish a framework within which one must operate when valuing a closely held business asset for transfer tax purposes. There are two basic rules that are the foundation of this framework:

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1. Fair market value is the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the facts. See Treas. Reg. §§ 20.2031-1(b), 20.2031-3.

2. The willing buyer and willing seller must negotiate their deal based on the relevant facts as they stood on the valuation date (the date of the transfer for gift tax purposes and generally the date of death for estate tax purposes).

B. The primary source of IRS guidelines for valuing closely held business interests is Revenue Ruling 59-60, 1959-1 C.B. 237. The Ruling states that its purpose is to "outline and review in general the approach, methods and factors to be considered in valuing shares of the capital stock of closely held corporations for estate and gift tax purposes."

1. The Ruling sets forth the following factors as pertinent to determining the fair market value per share of a closely held business:

a. The nature and history of the business;

b. The economic outlook for the economy in general and for the particular industry;

c. The book value of the stock and the financial condition of the business;

d. The earning capacity of the business;

e. The dividend-paying capacity of the business;

f. The goodwill or other intangible value that the enterprise has;

g. Other sales of the stock and the size of the block of stock to be valued; and

h. The market price of stocks of public corporations engaged in similar businesses.

2. The Service assigns no particular weight to these factors, except as noted below.

3. Although these factors are directed toward stock in a closely held corporation, similar considerations generally apply in valuing partnership and LLC interests or sole proprietorships, except when a particular factor (such as dividends) is uniquely associated with corporate stock.

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4. In valuing a closely held business for federal transfer tax purposes, the hypothetical willing buyer and willing seller should be considered to possess knowledge of the type set forth in Revenue Ruling 59-60.

C. The IRS recognizes that valuation is a subjective process for which no one set of rules can be used. Revenue Ruling 59-60 emphasizes this point and states that a wide variety of facts should be considered, including the past stability or instability of an enterprise, its growth and extent of diversity, the general economic outlook and outlook for the particular industry, the uniqueness and novelty of the product, and the possible effect of the loss of a key manager.

D. The discussion in Revenue Ruling 59-60 concerning valuation methods assumes that the stock in question is not publicly traded and that any sales that do occur are irregular and do not reflect fair market value.

1. If there have been arm's length sales of the stock of the company being valued, or purchase offers, the IRS will assign great weight to them. See The Audit Technique Handbook for Estate Tax Examiners (Internal Revenue Manual, Part IV - Audit), Chapter 7(11)1 (hereinafter "Audit Handbook"). The Audit Handbook suggests that if the decedent prior to death, or the executor, rejected a purchase offer, then that offered price should set a floor on the value of the stock.

2. Revenue Ruling 59-60 also suggests that arm's length sales of small interests in a closely held company may indicate a minimum value, to which a control premium should be added for a majority interest. 1959-1 C.B. at 241-42.

E. For business interests for which there is no public market, the two primary valuation methods endorsed by Revenue Ruling 59-60 are (1) capitalization of earnings and (2) net asset value, with the former being most relevant for operating companies, and the latter being most important for investment or holding companies. The Ruling states:

"In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public; conversely in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.

"The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type, the appraiser should determine the fair market value of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets."

1959-1 C.B. at 242-43. Courts likewise recognize and rely heavily on these two methods. See, e.g., Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002); Central Trust

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Co. v. U.S., 305 F.2d 393 (Ct. Cl. 1962); Bader v. U.S., 172 F. Supp. 833 (S.D. Ill. 1959); Estate of Jephson v. Comm'r, 87 T.C. 297 (1986); Estate of Neff v. Comm'r, 57 T.C.M. (CCH) 669 (1989).

III. Valuation Date

A. The valuation date is generally the date of the transfer. Thus, for testamentary transfers, the decedent's date of death is usually the date of transfer. However, the valuation date may be six months after the date of death if the decedent's executor is able to elect to use the alternate valuation date. IRC §2032.

B. The valuation date for property transferred by gift is the date of the gift. This is generally the date the property is transferred from the dominion and control of the donor.

C. If the transferred property is sold a short time after the transfer, the sales price should not be determinative of the value of the property. Nevertheless, post-death or post-gift transactions may be relevant to determining value, particularly if there are no intervening events that would drastically change the value. Courts have admitted evidence of values in post-death transactions on this basis. See Trout Ranch LLC v. Comm'r., 2012 W.L. 3518564 (10th Cir. 2012) (slip op.) aff'g T.C. Memo 2010-283; First National Bank of Kenosha v. U.S., 763 F.2d 891, 895 (7th Cir. 1985); Estate of Keller v. Comm'r, 41 T.C.M. (CCH) 147, 148 (1980). A post-death or post-gift sales price also may be considered relevant when the sale is foreseeable at the time of death or the gift.

1. In an estate tax audit, the IRS will routinely ask if real estate or closely held stock was sold shortly after death and, if so, what the sales price was. The Audit Handbook states that a sale made within a reasonable time of the valuation date is a proper basis for challenging the taxpayer's appraised value. Audit Handbook, Chapter 620. For real estate valuation, the Audit Handbook provides an even stronger conclusion: "If the real property was sold within a reasonable time of the valuation date in a bona fide arm's length transaction, then, in the absence of some unusual intervening event, the sale probably reflects the fair market value." Audit Handbook, Chapter 630.

2. A post-death transaction can have a very significant impact. In Estate of Giovacchini v. Comm'r., T.C. Memo 2013-27, the court concluded that the post-death sale of a portion of the property in question for $29.5 million was the most probative evidence of fair market value. The sale occurred two and half years after gifts of the property by the decedent, and sixteen months after her death. The taxpayer had valued the property at $7.4 million and $8 million, respectively.

3. If possible, a sale of a decedent's property as to which there may be a valuation dispute should be delayed until a reasonable period has elapsed

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after the transfer, if the sales price is going to be significantly higher than the value reported. If delaying the sale is not practical, the attorney for the estate should be prepared to show that events occurring after the date of death affected value.

4. The disallowance of post-transaction evidence can work against the taxpayer. In Morris v. Comm'r, 761 F.2d 1195 (6th Cir. 1985), the court heard evidence from an appraiser testifying for the government that the agricultural property being valued could be developed within 8 to 10 years of the valuation date. The court refused to allow evidence that the property had not been developed at the time the case was being tried, 8 years after the valuation date.

IV. Adjustments To Value

A. Lack of Marketability Discount

1. The value of a business interest should be discounted if there is no ready market for the interest. A lack of marketability discount reflects the fact that the owner of a closely held business is unable to readily convert the value he owns into cash. The illiquidity renders the stock or other interests less attractive than publicly traded stock and thus justifies a reduction in value. Because the rationale behind the lack of marketability discount is based on the ownership of a closely held interest, and not on the size of the interest, the discount applies to both majority and minority interests in the business.

2. Revenue Ruling 59-60 does not directly discuss the right to discount the value of a closely held stock because it is not readily marketable. A marketability discount is nevertheless almost universally recognized by the courts. See, e.g., Okerlund v. United States, 53 Fed. Cl. 341 (2002) (40% to 45% discount for gifts of stock in operating entity); Estate of Jung v. Comm'r, 101 T.C. 412 (1993) (35% discount for operating entity); Hess v. Comm'r, T.C. Memo. 2003-251 (2003) (25% discount for operating entity); Estate of Lauder v. Comm'r, 64 T.C.M. (CCH) 1643 (1992) (40% discount for operating entity); Estate of Newhouse v. Comm'r, 94 T.C. 193 (1990) (35% discount for operating entity); Estate of Piper, 72 T.C. 1062 (1979) (35% discount from net asset value).

3. The IRS's own expert witnesses in valuation litigation usually acknowledge the existence of a discount for lack of marketability. See, e.g., Estate of Andrews v. Comm'r, 79 T.C. 938 (1982) (12 to 20.75% discount); Estate of Green v. Comm'r, T.C. Memo 2003-48 (2003) (25% discount).

4. Various market studies have indicated that an appropriate discount for the lack of marketability of closely held securities ranges from 25 percent to

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over 60 percent. The studies look at discounts for publicly traded stock that is restricted or stock in private companies before and after an IPO. See Seaman, "Market-Based Discounts for Minority and Lack of Marketability in Closely Held Corporations," Estate and Personal Financial Planning, at 7 (Callaghan, April 1990 Update) (hereinafter "Market-Based Discounts").

a. In Estate of Jung v. Comm'r, 101 T.C. 412 (1993), the Tax Court appeared to place substantial weight on the studies cited by the taxpayer's expert witnesses in concluding that a 35% discount for lack of marketability was appropriate. Accord Okerlund v. United States, 53 Fed. Cl. 341 (2002).

b. Courts have begun to require more evidence from business appraisers than just citation to studies of marketability discounts.

(1) Peracchio v. Comm'r, T.C. Memo 2003-280 (2003), involved a family limited partnership created Peter Peracchio and his son created in 1997. Mr. Peracchio contributed cash and securities with a value of approximately $2,014,000 to the partnership in exchange for a .5 percent general partnership interest and a 99.4 percent limited partnership interest. On the same date that the partnership was created, Peracchio transferred 46 percent of the partnership units to the trust as a gift, and 53 percent of the partnership units to the trust in exchange for a note in the amount of approximately $647,000.

(2) On the gift tax return, Peracchio took the combined 40 percent discount for lack of control and lack of marketability. The IRS argued that the appropriate discount for lack of control was 4.4 percent and the discount for lack of marketability was 15 percent, approximately a combined discount of 20 percent.

(3) The Tax Court largely rejected the testimony of the taxpayer's expert regarding the marketability discount, stating: "While restricted stock studies certainly have some probative value in the context of marketability discount analysis, [the expert] makes no attempt whatsoever to analyze the data from those studies as they relate to the transferred interests. Rather, he simply lists the average discounts observed in several such studies, effectively asking us to accept on faith the premise that the approximate average of those results provides a reliable benchmark for the transferred interests. Absent analytical support, we are unable to accept that premise, particularly

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in light of the fundamental differences between an investment company holding easily valued assets (such as the partnership) and operating companies that are the subject of the restricted stock studies."

(4) The Tax Court determined that a 6% lack of control discount and a 25% lack of marketability discount were appropriate. This resulted in a combined discount for lack of control and marketability of approximately 30%.

5. As economic and market conditions become more and more subject to sudden, significant fluctuations, and flexibility in investments commands an even higher premium among investors, the lack of marketability discount should grow increasingly valuable.

B. Blockage Discount

1. A discount similar to the lack of marketability discount is available in the area of publicly traded securities. Normally, publicly traded securities are valued by multiplying the number of shares transferred by the mean sales price for that stock on the date of the transfer. When a block of stock that is disproportionately large compared to the average trading volume of the stock is suddenly dumped on the market, however, the market may become saturated, forcing the price of the stock down. In that case, a blockage discount is applied.

2. Section 20.2031-2(e) of the Treasury Regulations states that a blockage discount may be appropriate "in exceptional cases." In general, the IRS is reluctant to permit the discount. The Audit Handbook states that the estate tax examiner should not assume that the stock in question will be sold at one time. "If disposition could have been made by the executor over a reasonable period of time without depressing the market, then no discount should be considered." Audit Handbook, Chapter 741.

3. The taxpayer has the burden of proving that the block of stock being valued is sufficiently large to depress the market price for that particular stock. Treas. Reg. §§ 20.2031-2(e); 25.2512-2(e). Among the factors considered in upholding a blockage discount are:

a. quoted price (Wright v. Comm'r, 43 B.T.A. 551 (1941));

b. size of the block (Gamble v. Comm'r, 101 F.2d 565 (6th Cir. 1939);

c. depth of the market (Estate of Folks v. Comm'r, 43 T.C.M. (CCH) 427 (1982));

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d. volume of trading (Wheeler v. Comm'r, 37 T.C.M. (CCH) 883 (1978));

e. total number of outstanding shares; and

f. general market conditions (Estate of Van Horne v. Comm'r, 720 F.2d 1114 (9th Cir. 1983));

4. If a donor makes several gifts to several different donees on the same day, the gifts cannot be aggregated for the purpose of determining the appropriateness and amount of a blockage discount. The blockage discount must be applied separately to each block of stock given to a different donee. Treas. Reg. § 25.2512-2(e). Rushton v. Comm'r, 498 F.2d 88 (5th Cir. 1974). But see Maytag v. Comm'r, 187 F.2d 962 (10th Cir. 1951) (stating that, in valuing simultaneous gifts of stock to several donees, it would be reasonable to consider whether placing all the gifted stock on the market would depress the stock's price).

EXAMPLE. Assume Donor makes gifts of 100,000 shares of ABC, Inc. stock to each of 5 different donees. At the time of the gift, 5,000,000 shares of ABC, Inc. stock are outstanding and 500,000 shares are traded annually. If the five gifts are aggregated, the 500,000 share block equals 10% of the outstanding shares and 100% of the shares traded yearly. However, Donor must treat the gifts as separate blocks, and each block of 100,000 shares represents only 2% of the total outstanding shares and 20% of the shares traded each year. Thus, the blockage discount that might be available to Donor is less than if the gifts were considered in the aggregate.

5. To avoid this problem, the donor should consider a gift to a trust, and provide in the trust that it will terminate after a short period (six months or a year) and divide among the ultimate intended donees.

C. Restricted Securities

1. "Restricted securities" in a publicly traded company are securities that are identical to the company's publicly traded stock, but which cannot be sold publicly because they have not been registered and are subject to restrictions on resale under the federal securities laws. In order to sell the stock, Securities and Exchange Commission requirements must be satisfied.

2. The Courts have upheld discounts from market price to reflect the lack of marketability of stock that is subject to securities law restrictions. See, e.g., Estate of Gilford v. Comm'r, 88 T.C. 38 (1987) (33% discount); Trust Services of America, Inc. v. U.S., 885 F.2d 561 (9th Cir. 1989) (25% discount); Estate of Friedberg v. Comm'r, 63 T.C.M. (CCH) 3080 (1992) (30% discount). The IRS provided guidance on discounts for restricted

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securities in Revenue Ruling 77-287, 1977-2 C.B. 319. The Ruling acknowledges that securities industry studies show that public securities that are subject to securities restrictions trade at a discount in market transactions.

3. The amount of the discount will depend on the extent of the securities law restrictions.

a. Shares that are not registered under the Securities Act of 1933 generally may not be sold to the public. Rule 144 of the Securities Act of 1933 provides a limited exception that permits holders of the restricted stock to sell subject to certain conditions. The Rule also applies to "control securities," stock held by an affiliate of the company such as an officer or large shareholder. Rule 144 first imposes a holding period requirement before shares may be sold. For SEC reporting companies, that period is six months. For companies that are not reporting companies, it is one year. For an affiliate, there are also trading volume limitations. In any three-month period, the holder may sell greater of (i) 1 percent of the total stock of the company outstanding or (ii) the average weekly trading volume during the four weeks immediately preceding the week of the sale. For purposes of applying these limitations, an individual, members of his or her family, and certain related entities are considered to be one person.

b. Stock that cannot be sold pursuant to the Rule 144 exception either must be sold pursuant to a registered secondary offering or in a private offering.

(1) A registered offering requires the cooperation of the company, which it may be reluctant to provide because of financial disclosure requirements, expense, and the tendency of a secondary offering to depress the stock's price.

(2) A private offering is a sale to a limited number of sophisticated investors who have access to material information. The purchaser in a private offering normally will demand a significant discount from market price because he is then subject to further restrictions. The purchaser must agree to hold the purchased stock for one year and, if it sold, it must be sold pursuant to the Rule 144 exception or in another private offering.

c. The discount for stock that must be sold by private offering will be more significant than the discount available for stock sold pursuant to the Rule 144 exception. See, e.g., Estate of Brownell v.

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Comm'r, 44 T.C.M. (CCH) 1550 (1982) (33a% discount for private placement stock, 3.3% discount for Rule 144 stock).

4. The restricted securities in a decedent's estate often represent a significant interest in the company. The IRS sometimes has argued that any discount for securities restrictions on a large block of stock would be offset by the premium that a potential acquiror of the company would pay to obtain the block. Generally, the courts have rejected this argument as conjecture. See Trust Services of America, Inc. v. U.S., 885 F.2d 561, 568 (9th Cir. 1989); Estate of Brownell v. Comm'r, 44 T.C.M. (CCH) 1550, 1557 (1982).

D. Minority Interest Discount

1. Courts will permit a discount for minority interests in a closely held business to reflect the lack of control and influence of a minority shareholder. See Estate of Andrews v. Comm'r, 79 T.C. 938 (1982); Estate of Winkler v. Comm'r, 57 T.C.M. (CCH) 373 (1989). The minority shareholder is often deprived of any return on his investment because dividends are withheld either to finance future expansion or because the majority shareholders do not want to be subjected to the double tax on dividends. The shareholder also may be denied involvement in the operations of the business.

2. The minority interest discount and the discount for lack of marketability are sometimes combined by the courts. See Central Trust Co. v. U.S., 305 F.2d 393 (Ct. Cl. 1962). The two discounts are distinct, however, as explained by the Tax Court in Estate of Andrews v. Comm'r, 79 T.C. 938, 953 (1982):

". . . two conceptually distinct discounts are involved here, one for lack of marketability and one for lack of control. The minority shareholder discount is designed to reflect the decreased value of shares that do not convey control of a closely held corporation. The lack of marketability discount, on the other hand, is designed to reflect the fact that there is no ready market for shares in a closely held corporation."

3. A minority discount is not justified if the valuation method being employed uses the prices of minority interest stock in publicly traded comparable companies. This occurs if value is being derived from a capitalization of earnings approach (using P/E ratios of publicly traded securities) or a discounted future earnings or cash flow approach (using a discount rate developed from data from publicly traded securities). The IRS alerts its estate tax examiners to this fact. See Audit Handbook, Chapter 7(11)5.

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4. The amount of the discount or premium will depend on the number of elements of control that the interest possesses or lacks. Some of the more important elements of control include:

a. The right to elect directors and select management.

b. The right to set policies for the business and control major business decisions.

c. The right to acquire or liquidate assets.

d. The right to liquidate or recapitalize the company.

e. The right to declare and pay dividends.

5. The ability of the owner of an interest to exercise or influence one or more of the elements of control will depend on state law. For example, the inability of a minority shareholder to prevent elimination of cumulative voting under state law is a factor to consider in determining the minority discount. Minority shareholders' dissenting rights vary from state to state, as do the fiduciary obligations imposed on majority shareholders.

6. The ownership interests of the other shareholders also can affect the minority discount. For example, an individual who owns 30 percent of a company may be entitled to a substantial discount if there is one other owner who has 70 percent. That same individual may be entitled to a much smaller discount if there are ten other owners each of who hold 7 percent. The Audit Handbook suggests that if there is no controlling shareholder of a corporation, then each shareholder will have more or less equal say and a minority discount is not appropriate. Audit Handbook, Chapter 7(11)6.

7. Nonvoting stock is entitled to a minority discount because of the owner's inability to influence corporate decision-making. However, if the owner of nonvoting stock also owns a controlling interest in the voting stock, then, at least for estate tax purposes, the two classes will be considered together and no discount for the nonvoting stock will be allowed. See Rev. Rul. 67-54, 1967-1 C.B. 269, modified by Rev. Rul. 81-15, 1981-1 C.B. 457; Estate of Curry v. U.S., 706 F.2d 1424 (7th Cir. 1983); Ahmanson Foundation v. U.S., 674 F.2d 761 (9th Cir. 1981).

a. The courts in Curry and Ahmanson treated the two classes of stock together in part based on the willing buyer/willing seller rule. The courts concluded that a willing buyer would not purchase just the nonvoting interest in a company without also purchasing the controlling voting interest. The argument that the voting interest would not be sold because it passes to a different individual or entity under the decedent's estate plan is considered contrary to the

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willing seller requirement. In addition, the courts in Ahmanson and Curry pointed out that neither the estate tax statutes nor case law suggest that the valuation of property for federal estate tax purposes should take into account who is receiving the property.

b. The result in these cases points to an important estate planning technique for majority owners of a business. The owner can make gifts of minority interests or nonvoting stock during life and take advantage of the minority interest discount. The discount for that stock disappears if the owner retains it and dies with a controlling interest. This is a strong inducement for making lifetime gifts.

8. Market studies of discounts, and of premiums paid for controlling interests, show that minority discounts (or control premiums) can range from 5 to 40 percent. See "Market-Based Discounts," at 10. Some courts have permitted significant discounts. Ward v. Comm'r, 87 T.C. 78 (1986) (33% discount); Clark, Jr. v. U.S., 75-1 USTC (CCH) ¶ 13,076 (D.N.C. 1975) (40% discount).

a. In Moore v. Comm'r, 62 T.C.M. (CCH) 1128 (1991), the taxpayers had created a partnership to own various real estate holdings and conduct farming and ranch operations. The taxpayers made gifts of limited partnership interests to their children, spouses of children and trusts for their grandchildren, claiming a 40% discount from net asset value for gift tax purposes. The Tax Court ruled that a 35% discount was appropriate to reflect the lack of control associated with the partnership interests.

b. In Estate of Campbell v. Comm'r, 62 T.C.M. (CCH) 1514 (1991), the appraiser for the estate valued a one-third interest in a corporation at a 90% discount from net asset value by relying heavily on the earnings of the company. The corporation owned substantial land holdings but also ran grain and cattle production operations and farm supply distribution operations. The Tax Court significantly reduced the discount but still permitted a combined lack of marketability and minority discount of 57% from net asset value.

9. In cases involving family limited partnership or limited liability company interests, the methodology for determining the appropriate minority interest discount that seems to have become widely accepted is to look at discounts from net asset value in the market prices of closed end mutual funds. The appraiser creates a blended discount figure by looking to the asset mix of the partnership, or LLC (stocks, fixed income, real estate), and determining the discount for closed end funds with similar characteristics for each asset class. See, e.g., Lappo v. Comm'r, T.C. Memo 2003-258 (2003) (partnership held stocks and real estate; appraiser

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determined 7.5% minority interest discount for stocks and 35% for real estate).

E. Control Premium

1. The flip-side of the minority discount is the control premium. The control premium reflects the fact that a controlling stockholder can indirectly control day-to-day and long-range management decisions and, depending on state law, may be able to access corporate assets by causing liquidation. Both Revenue Ruling 59-60 and the Treasury Regulations (§ 20.2031-2(f)) state that the degree of control represented by a block of stock is a relevant factor in determining its value. Courts have applied control premiums in a number of cases. See Estate of Feldmar v. Comm'r, 56 T.C.M. (CCH) 118 (1988) (15% premium); Estate of Salsbury v. Comm'r, 34 T.C.M. (CCH) 1441 (1975) (38.1% premium); Makoff v. Comm'r, 26 T.C.M. (CCH) 83 (1967) (1% of stock, which had voting control, valued to equal about 40% of the total capitalized value of the company).

2. The same factors that are relevant for determining the extent of lack of control of a minority interest are relevant in determining the amount of a control premium. The representative of a taxpayer can defend against an IRS attempt to add a control premium to stock by arguing that corporate law constrains majority stockholders from self-dealing to the detriment of minority stockholders. See Estate of Curry v. U.S., 706 F.2d 1424, 1430-1431 (7th Cir. 1983). An individual may be able to employ a buy-sell agreement to avoid application of a control premium.

3. In Estate of Newhouse v. Comm'r, 94 T.C. 193 (1990), the IRS asserted that a control premium should apply to the decedent's 44% interest in a broadcasting company, on the grounds that it represented the largest single block of stock and therefore permitted the decedent to exercise a great deal of control over company affairs. The Tax Court ruled that a control premium applies only in situations in which unilateral control exists.

4. The most significant case in the area of control premiums in the last 20 years is Estate of Simplot v. Comm'r, 112 T.C. 130 (1999), reversed, 249 F. 3d 1191 (9th Cir. 2001). It illustrates that the IRS may attempt to aggressively apply a premium to a small voting interest in a company.

a. In rulings, the IRS has asserted that stock should be valued at a premium if it represents a swing vote or a sufficient percentage of the company to possibly influence the management. This position generally has not been adopted by the courts, at least until Estate of Simplot was decided in the Tax Court. The Tax Court held that the federal estate tax value of a 23.55% interest in the voting stock of a company should be determined by applying a premium for control. This was true, even though the stock interest being valued carried

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with it no control. The effect of the Tax Courts' decision was to increase the value of the decedent's voting stock by more than $3.8 million.

b. In a split decision, the Ninth Circuit rejected the decision of the Tax Court. It found that the Tax Court had not applied the hypothetical willing buyer/willing seller test that is used for valuation purposes. The Tax Court departed from this standard because it assumed a hypothetical sale should not be constructed in a vacuum isolated from actual facts that affect value. As the Ninth Circuit put it, "in violation of the law" the Tax Court constructed "particular possible purchasers" when it looked at family members who might be willing to pay a premium for control as possible purchasers. This, in turn, influenced its determination of a premium.

c. The Ninth Circuit also found that the Tax Court erred by determining a premium for all the Class A shares as a block and then dividing this premium per each Class A share. According to the Ninth Circuit, there was no basis for supposing that whatever value attached to complete control, a proportionate share of that value attached to each fraction of the whole.

d. The Ninth Circuit finally found that the Tax Court committed a third error. A controlling block of stock is not to be valued at a premium for estate tax purposes unless the IRS can show that a purchaser could use the control to assure an increased economic advantage worth the payment of a premium. Here, there was no evidence presented of the economic benefits of owning the 18 shares of Class A stock so as to justify a premium for the stock. The Ninth Circuit found that much of the IRS's argument and the Tax Court's decision was based on speculation. However, as the Ninth Circuit put it, "speculation is easy but not a proper way to value the transfer at the time of the decedent's death."

e. Simplot represents a significant victory for taxpayers because it upholds the basic valuation principles of the willing buyer/willing seller test which says that one determines what a hypothetical buyer would pay a hypothetical seller without taking to account who possible potential purchasers might be.

F. Discount for Unrealized Capital Gains

1. For many years, the courts refused to permit a discount for built-in capital gains in assets owned by the corporation. The position of the courts was that no reduction should be made unless the evidence established that a liquidation or sale of the corporation or its assets was likely to occur.

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2. The position of the court changed in 1998 with Eisenberg v. Comm'r, 155 F.3d 50 (2d Cir. 1998) (reversing 74 T.C.M. (CCH) 1046 (1997), and Estate of Davis v. Comm'r, 110 T.C. 552 (1998). The courts in those cases noted that a willing buyer would take potential capital gains into account in some manner, even if liquidation was unlikely or steps might be able to be taken to avoid the gains.

3. In Davis, the court did not take into account the full amount of the tax on unrealized gain. Rather, it allowed a discount for a portion of that tax. This has been followed in some subsequent court decisions. Unless liquidation is imminent, these courts in the effect use a present-value of the future possible tax. See Estate of Litchfield v. Comm'r, T.C. Memo 2009-21; Estate of Jameson v. Comm'r, 77 T.C.M. (CCH) 1383 (1999).

4. In Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002), the court used a more objective approach for taking potential capital gains tax into account.

a. The case involved the valuation of stock in Dunn Equipment, Inc., a company that was in the business of renting out heavy equipment and providing related services. The IRS had asserted an estate tax deficiency based on an alleged under-valuation of the stock. It based its claim on an asset-based valuation of the company. The estate had relied primarily on an earnings-based valuation method.

b. On appeal the Fifth Circuit reviewed both the Tax Court's determination of weights given to the two valuation methods and how the Tax Court factored in potential tax liability for capital gain. The court first determined that the built-in gains tax liability is not relevant at all in an earnings-based valuation calculation. However, it stated that it must be taken as a dollar-for-dollar reduction in an asset-based valuation. Thus, in the asset-based method, the built-in gains tax liability resulted in a reduction equal to 34% of the unrealized appreciation on corporate assets.

c. The court found liquidation of Dunn Equipment unlikely, and therefore assigned 85% weight to the earnings-based value and 15% weight to the asset-based value.

5. Several subsequent cases have followed the approach of the court in Dunn and adopted a dollar-for-dollar discount. See, e.g. Estate of Jelke v. Comm'r, 507 F.3d 1317 (11th Cir. 2007).

6. As illustrated in Estate of Richmond v. Comm'r, T.C. Memo 2014-26, the courts continue to disagree over the treatment of built-in capital gains.

a. Richmond involved the valuation of a 23.44% interest in Pearson Holding Company (PHC), a family owned company which owned about $52 million of publicly traded stock. About 87% of that

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value was unrealized capital gains, with a built-in tax liability of about $18 million.

b. The Court agreed that the built-in capital gains attributable to the company's stock holdings needed to be taken into account, but held that the estate was not entitled to a dollar-for-dollar discount for the tax liability. Instead, it concluded that the tax liability should be discounted to its present value based on a reasonable holding period. When the Court calculated the present values using a few holding periods and discount rates, it found that the IRS discount of $7.8 million was reasonable, and upheld the IRS discount.

c. The Court acknowledged that other Circuits (notably the 11th and 5th) have determined that a dollar-for-dollar discount is appropriate. However, it reasoned that in a case where a hypothetical buyer of an interest in the company would probably retain the stock held in the company for at least some time, it was not likely that the capital gains would be triggered immediately and therefor a dollar-for-dollar discount was inappropriate.

d. Other courts have used this analysis. It ignores the fact that an assumed passage of time before the gains are incurred should be accompanied by assumed continued appreciation in the assets. If the appreciation rate is assumed to be equal to the present value discount rate (a logical assumption) the discount should be dollar-for-dollar.

e. Given the lack of uniform approach in the courts, this issue will continue to be litigated.

V. Government Attempts to Limit Valuation Discounts

A. The Willing Buyer/Willing Seller Rule and Family Attribution

1. For many years, the IRS has tried to find ways to avoid application of the willing buyer/willing seller rule because it creates hypothetical buyers and sellers even in transactions that involve only family members. The IRS has contended that if an asset is family owned, the bundle of rights constituting ownership can be more easily manipulated, and various rights parceled out to family members, with confidence that the rights will not be exercised to the detriment of the other family members.

a. Thus, if a preferred stockholder has the ability to liquidate a family held company, but in so doing would jeopardize his carefully designed estate plan, the IRS has concluded that the liquidation right should not be taken into account in valuing the preferred stock. Ltr. Rul. 8401007 (Sept. 15, 1983).

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b. Likewise, the IRS has successfully argued that the gift tax value of a class of common stock should be determined without regard to the possibility that another class of preferred stock will be converted into the common stock, when that conversion would be at variance with the donor's estate plan. Wallace v. U.S., 82-1 USTC (CCH) ¶ 13,442 (D. Mass. 1981).

c. Although the IRS' assumptions about family cooperation is accurate in many circumstances, any veteran wealth professional knows that it is far from a universal reality.

2. The IRS has generally been unable to sustain this approach consistently in the courts, but it has found some success through legislation, as discussed in the paragraphs on Sections 2701 to 2704, under Chapter 14 of the Code.

3. After many years of trying, however, the IRS reluctantly abandoned its "unity of ownership" or "family attribution" theory as it applies to minority discounts. The theory was set forth in Revenue Ruling 81-253, 1981-2 C.B. 187, in which the Service ruled that intra-family transfers of stock should be valued without minority discounts, because, absent evidence of family discord, there is a presumption that members of the family will share control.

a. Most courts rejected the Service's argument that family members' stock should be attributed to the shareholder whose stock is being valued. See, e.g., Estate of Bright v. U.S., 658 F.2d 999 (5th Cir. 1982); Minahan v. Comm'r, 88 T.C. 492 (1987); Ward v. Comm'r, 87 T.C. 78, 108 (1986); Estate of Andrews v. Comm'r, 79 T.C. 938, 956 (1982).

b. In Revenue Ruling 93-12, 1993-1 C.B., the IRS officially revoked Revenue Ruling 81-253. Revenue Ruling 93-12 holds that intra-family transfers of closely held stock are valued for estate and gift tax purposes without consideration of the fact that control of corporation rests in the family. The Ruling considers a hypothetical situation in which a parent transfers 100% of the stock of his corporation in five simultaneous gifts of 20% of the stock to each of his five children. The Ruling states that "[f]or estate and gift tax valuation purposes . . . a minority discount will not be disallowed solely because the transferred interest, when aggregated with interests held by family members, would be part of a controlling interest."

B. Swing Votes

1. The IRS has tried to expand this concept by arguing that minority blocks of stock are sometimes entitled to much smaller discounts because they

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have "swing vote" powers – they could influence company actions by affiliating with another block of stock to exercise control. See Letter Ruling 9436005 (1994).

2. Usually, courts reject this assertion as speculative or inconsistent with the willing buyer/willing seller principle. See, e.g., Estate of Green v. Comm'r, T.C. Memo 2003-348 (2003) (IRS claim that 5% interest had "swing vote" influence too speculative); Estate of Wright v. Comm'r, T.C. Memo 1997-53 (1997) (Court rejects IRS attempt to apply premium to 23.8% interest in bank because of size of interest compared to other shareholders).

C. Section 2701, Special Valuation Rules for Applicable Retained Interests

1. Section 2701 generally provides that, where an individual transfers an equity interest in a family-controlled business (usually common stock or an equivalent partnership interest) to younger family members, and retains preferred stock or certain other senior equity interests in the business immediately after the transfer (called “applicable retained interests” or “ARIs”), the retained interest will normally be assigned a zero value for gift tax purposes unless it provides for cumulative preferred distribution rights (called “qualified payments”) or meets certain other requirements. If the retained preferred stock or other interest is assigned no value, the amount of its actual value will constitute an immediate gift from the transferor to the person receiving the common stock. Section 2701 applies to transfers occurring after October 8, 1990.

2. To determine whether Section 2701 applies to any given transaction and whether any exceptions are available, one must contend with a number of defined terms and meet several threshold requirements.

a. First, there must be a transfer of an equity interest in the corporation or partnership to or for the benefit of a “member of the transferor’s family.” This term includes the transferor’s spouse, lineal descendants of the transferor or the transferor’s spouse, and spouses of those descendants. IRC § 2701(e)(1).

b. Second, immediately after the transfer, the transferor or an “applicable family member” must retain an interest in the entity. An applicable family member includes the transferor’s spouse, ancestors of the transferor or the transferor’s spouse, and the spouses of those ancestors. IRC § 2701(e)(2).

c. For purposes of the statute, an individual is treated as holding any interest to the extent that the interest is held indirectly by such person through a corporation, partnership, trust, or other entity.

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3. The following two examples indicate how attribution of retained interests to the transferor may trigger the statute:

Example 1. Father owns all of the 100 outstanding shares of common stock of ABC, Inc., worth $500,000. Grandfather owns all of the 100 outstanding shares of noncumulative preferred stock, also worth $500,000. Father gives his common stock to Son after October 8, 1990. Under Section 2701, Grandfather’s preferred stock is given a value of zero in determining the amount of Father’s gift to Son. Thus, the amount of the gift to Son is $1,000,000. Note that this result would be the same whether Grandfather’s and Father’s stock interests were created by a recapitalization completed before or after October 8, 1990.

Example 2. An individual owns common stock of a closely held corporation, while a QTIP marital trust for the benefit of his mother owns noncumulative preferred stock. The common and preferred stock are each worth $500,000. The individual transfers all the common stock to his children. Under Section 2701, for purposes of the transfer, the preferred stock is deemed to have no value. Therefore, the individual has made a gift of $1,000,000 to his children.

4. A transfer for purposes of the statute is not limited to property law transfers or conveyances. It may include a redemption, recapitalization, contribution to capital, or other change in the structure of the entity if the taxpayer, or an applicable family member, receives an ARI pursuant thereto, or otherwise holds an ARI thereafter. IRC § 2701(e)(5).

a. Thus, for example, a conversion of one shareholder’s common stock to preferred stock, while the other shareholder continues to hold common stock, would be a transfer to which the section may apply. The regulations provide a number of additional examples. Treas. Reg. § 25.2701-1(b).

b. The formation of a new entity can be a transfer to which Section 2701 applies. The Senate Finance Committee Report on S. 3209 (which ultimately became Chapter 14) contains the following example:

Father and son form a partnership to which each contributes capital and in which the father receives a preferred interest and the son receives a residual interest. [Section 2701] applies in determining whether, and the extent to which, the capital contributions result in a gift.

5. As a third prerequisite to the application of Section 2701, the interest retained by the transferor or applicable family member must be an ARI.

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There are two types of ARIs, as defined by the regulations: extraordinary payment rights and distribution rights. Treas. Reg. § 25.2701-2(b).

a. An extraordinary payment right is any put, call, or conversion right, any right to compel liquidation, or any similar right, the exercise or nonexercise of which affects the value of the transferred interest.

b. Distribution rights are essentially a right to receive stock dividends or partnership income distributions. However, distribution rights do not include a guaranteed payment from a partnership under Code Section 707, a nonlapsing conversion right (that is, the right to convert into a fixed number or percentage of shares of the same class as the transferred interest), a right to distributions with respect to any “junior equity interest” (basically, common stock or other similar interests which participate in the growth of the entity and are not preferred as to distributions), or certain rights dubbed “mandatory payment rights” and “liquidation participatory rights.” See Treas. Reg. § 25.2701-2(b)(4).

c. Thus, for example, preferred stock may represent a distribution right, while common stock usually will not. An installment promissory note from the corporation generally will not represent a distribution right or be covered by Section 2701 unless it constitutes equity rather than debt.

6. In valuing the retained interest, extraordinary payment rights will be valued at zero unless they meet one of two exceptions. The first exception applies to any such right which must be exercised at a specific time and in a specific amount. The second exception applies to a right to convert into a fixed number or percentage of shares of the same class of stock (or partnership interest) as the transferred interest (or a class similar thereto but for nonlapsing differences in voting power), provided that the conversion right is nonlapsing, is subject to proportionate adjustments for splits, combinations, reclassifications, and similar capital changes in the entity, and is subject to compounding adjustments if not exercised. This type of conversion right is excepted because it will appreciate at the same rate as the transferred interest. In these cases, Section 2701 will not apply to these rights, which by implication would be valued under normal valuation principles.

7. If the transferor and applicable family members control the entity immediately before the transfer, a retained distribution right will be valued at zero unless it consists of the right to receive qualified payments.

a. A “qualified payment” is any dividend or partnership distribution payable on a periodic basis which is cumulative and determined

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either at a fixed rate or at a rate which bears a fixed relationship to a specified market interest rate. IRC § 2701(c)(3).

b. Thus, for example, preferred stock which provides for an 8 percent, cumulative annual dividend gives the owner a qualified payment right.

c. Control for these purposes means (1) with respect to a corporation, the holding of at least 50 percent (either by vote or value) of the stock, and (2) with respect to a partnership, the holding of at least 50 percent of the capital or profits interest, or in the case of a limited partnership, the holding of any interest as a general partner.

d. For these purposes only, special attribution rules treat the transferor as holding any interests held by siblings or lineal descendants. If the transferor and applicable family members did not possess the requisite control, or if the distribution right consists of the right to receive qualified payments, Section 2701 will normally not apply to value that right. Rather, by implication, that right is to be valued under normal gift tax valuation rules.

8. Even though a transfer occurs and rights in the entity are retained by the transferor or an applicable family member, Section 2701 will not apply to value the retained rights if one of the following three exceptions is met:

• Market quotations on an established securities market are readily available for either the transferred interest or the retained interest.

• The retained interest is of the same class as the transferred interest, such as where preferred stock is transferred and preferred stock of the same class is retained, or where a partnership interest is transferred where all items of income and loss are shared in the same proportion by all partnership interests.

• The retained interest is proportionally the same as the transferred interest, without regard to nonlapsing differences in voting power (or, for a partnership, nonlapsing differences with respect to management and limitations on liability, unless the transferor or an applicable family member has the right to alter the transferee’s liability with respect to the transferred property).

9. The last exception would apply, for example, where the retained and transferred interests consist of two classes of common stock that share in all distributions, liquidations, and other rights in the same ratio, regardless of which class was transferred or retained.

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10. Section 2701 imposes some additional limitations on the valuation process. First, a special rule provides that a retained interest that confers both (1) an extraordinary payment right, and (2) a right to a qualified payment, is valued on the assumption that each right is exercised in a manner resulting in the lowest value for all such rights. IRC § 2701(a)(3)(B).

11. A second special rule will frustrate attempts to place only a nominal value on transferred common stock in a preferred stock recapitalization. This rule provides that if the transferred interest represents a “junior equity interest” (basically, common stock or an equivalent partnership interest), then in determining whether the transferor has made a gift under Section 2701, the value of all the junior equity interests in the entity can never be less than 10 percent of the sum of (l) the total equity of the entity, plus (2) the total indebtedness of the entity owed to the transferor and applicable family members. IRC § 2701(a)(4).

D. Section 2703, Certain Option and Transfer Restrictions Disregarded

1. Section 2703 addresses the treatment of transfer restrictions and options to purchase entity interests granted in the entity's governing documents or by contract (such as a buy-sell agreement). Historically, no Code section governed the effect of such provisions on value. Rather, the general valuation principles under Sections 2031 (for estate tax purposes) and 2512 (for gift tax purposes) applied. The IRS has long recognized that the existence of a buy-sell agreement is one factor that should be considered in valuing a closely held business interest for estate tax purposes.

2. The courts consistently were willing to go further than the IRS in giving effect to buy-sell agreements. Indeed, a host of cases indicated that the price determined under the agreement fixed the estate tax value of the business interest if the factors present in Treas. Reg. § 20.2031-2(h) were present ((1) agreement represents a bona fide business arrangement, and (2) it is not a testamentary device), and the following additional requirements were met:

a. The agreement contained restrictions on disposition of the business interest which were binding during the owner's life, as well as at death;

b. The agreement obligated the owner's estate or beneficiaries following death to sell the interest at the price established under the agreement, either without any choice or at the option of the other parties to the agreement; and

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c. The price set in the agreement either was fixed, or determinable according to a formula, and was reasonable when the agreement was made.

3. Section 2703, was enacted to override the case law. It creates a presumption that restrictions under a buy-sell agreement are ignored for transfer tax purposes. The rule applies to agreements entered into after October 8, 1990, and those that are substantially modified after that date. This rule can be avoided, and the value specified in the agreement may be recognized for estate tax purposes if the case law requirements are met plus additional requirements contained in the statute. The statute sets out the following three requirements:

• the agreement is a bona fide business arrangement;

• the agreement is not a device to transfer the business to members of the owner's family for less than full and adequate consideration; and

• the terms of the agreement are comparable to similar arrangements entered into by persons in an arm's-length transaction.

a. The bona fide business arrangement and not a testamentary device requirements are similar to those under the case law.

b. The key factor in satisfying the requirements is to have an agreement that is a "fair bargain," comparable to what would have been entered into by unrelated business partners. The existing case law and regulations suggest that the method used to determine the price set in the agreement is an important element in this determination. A price determined by an appraiser will be far more likely to be treated at arm's length than an arbitrary use of book value or another factor.

c. In addition, the price in the agreement is more likely to be accepted if the agreement requires that it be updated on a regular basis. This does not necessarily mean that annual updates are necessary. It may be commercially reasonable to have modifications to the price every two or three years.

4. The most difficult aspect of the Section 2703 rules is the apparent high burden placed on the taxpayer to establish that the agreement and its transfer and price restrictions, are "comparable to similar arrangements entered into by persons in an arm's length transaction." Treas. Reg. § 25.2703-1(b)(4).

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a. The regulations state that the taxpayer does not establish this "by showing isolated comparables." The IRS has asserted that general testimony as to accepted business practices is insufficient proof under the regulations. Rather, it is necessary to provide evidence of actual use of similar approaches in specific fact situations. Since there are no published studies of buy-sell agreement restrictions, this is virtually impossible to do.

b. In Estate of Amlie v. Commissioner, T.C. Memo 2006-76, the court suggested that the burden is not as high as the IRS asserts. There, the court accepted as persuasive the testimony of the estate's expert, an attorney with extensive experience in the purchase and sale of non-marketable business interests. In response to IRS arguments that the attorney's testimony was insufficient, the court stated:

"While the regulations caution against using 'isolated comparables,' we believe that in context the regulations delineate more of a safe harbor than an absolute requirement that multiple comparables be shown."

5. Section 2703 is an especially dangerous provision in that it causes the price for closely held interests set in a buy-sell or option agreement among family members to rarely be binding for estate tax purposes. Yet, the agreement usually is binding for contractual purposes with the other owners. As a result, a family of a deceased shareholder can be hurt by a price in the agreement that is found to be substantially below fair market value.

EXAMPLE: Sister owns 1,000 shares of stock in XYZ Co., a family corporation. The other shareholders are her three siblings and a trust created by her parents. The stock is subject to a buy-sell agreement that gives the company an option to buy the stock at a shareholder's death for $2,000 per share. The company exercises the right at sister's death and pays her estate $2,000,000. The IRS determines that the fair market value of the stock for estate tax purposes is $3,500 per share. If sister is in a 48% combined federal and state estate tax bracket, the estate pays estate tax on the stock of $1,680,000, but receives only $2,000,000 for it. Sister's family nets only $320,000 after estate tax.

a. The agreement also can have a detrimental impact in an estate that will not incur a tax because of an optimum marital deduction plan.

b. Assume that in addition to the XYZ Co. stock, sister had other assets of $2,000,000 and that she died in 2008, survived by her husband and with an optimum marital deduction plan. Her executor may have anticipated allocating $2,000,000 to a marital

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trust and $2,000,000 to a family trust. Instead her estate allocation is as follows, given the effect of the buy-sell agreement and estate tax valuation of the stock:

Stock value passing to family under buy-sell: $1,500,000 Assets that pass to family trust: 500,000 Assets that pass to marital trust: 2,000,000

c. In effect, the provisions of the agreement waste $1,500,000 of sister's exemption amount. If the spread between the agreement value and the estate tax value is large enough, it may cause an estate tax to be due in an optimum marital deduction plan.

E. Section 2704, Treatment of Certain Lapsing Rights and Restrictions

1. Section 2704 applies to any type of entity but was enacted specifically in response to unique provisions being included in partnership agreements, where there is much greater flexibility in creating different classes of equity. LLCs, which largely have emerged since 1990, are in the same category. Section 2704 has two parts.

a. Section 2704(a) provides that the lapse of a voting or liquidation right in a family controlled entity is itself treated as a transfer by the transferor or decedent in the case of a lapse at death.

b. Section 2704(b) provides that certain "applicable restrictions" in a family controlled entity will be disregarded for valuation purposes.

2. Section 2704(b) is the primary valuation battleground.

a. An "applicable restriction" is defined as a restriction that limits the ability of the entity to liquidate, where the restriction either lapses after a transfer or the transferor and members of the transferor's family, alone or collectively, can remove the restriction. IRC § 2704(b)(2)(B) and Treas. Reg. § 25.2704-2(b). An applicable restriction does not include "any restriction imposed, or required to be imposed, by state law." IRC § 2704(b)(3)(B).

b. Subparagraph (4) of the statute gives the Treasury the ability to add other types of restrictions to list of disregarded restrictions:

"(4) OTHER RESTRICTIONS – The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the

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transferor's family, if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee."

c. As the wording of this provision indicates, it is not an open invitation for the IRS to write broad valuation regulations. It applies only to other restrictions not already covered in the core part of the statute, and only "if such restriction has the effect of reducing the value of the transferred interest . . . but does not ultimately reduce the value of such interests to the transferee."

3. Section 2704(b) also focuses only on ignoring the delineated offending restrictions. As Richard Dees so capably explains in his letter to the Department of Treasury on potential changes to the Section 2704 regulations, this is why the regulations under Section 2704 exclude restrictions that are no more restrictive than state law.

4. Thus the classic case to which Section 2704(b) applies is the family controlled partnership that requires all the partners to consent to liquidation, created in a state where the statute requires two-third majority of the partners for liquidation. A taxpayer cannot create the partnership, transfer 5% to a trust for descendants, and claim a large valuation discount on her 95% interest at death based on inability to liquidate. However, if the taxpayer owned only a 55% interest, less than the ownership percentage required by state law to liquidate, a discount for lack of marketability based on the inability to liquidate would be justified.

5. The IRS advocated for an expansive reading of Section 2704(b) in Kerr v. Commissioner, 113 T.C. No. 30 (1999). It asked the court to ignore restrictions on liquidation and withdrawal in a partnership that had a fixed liquidation date of December 31, 2043. The service argued that Texas law did not require partnerships to have a fixed liquidation date, and that, in a partnership without a fixed liquidation, the restrictions were more restrictive than state law. The Tax Court rejected the argument.

F. Prior Legislative Proposals

1. In May of 2009, the Obama Administration published its Fiscal Year 2010 Revenue Proposals (the "Greenbook") and included proposed statutory changes to Section 2704(b).

2. The Greenbook proposal was to expand the reach of Section 2704(b) by creating new "disregarded restrictions" that would be ignored in valuing interests in a family controlled entity.

3. Instead of simply ignoring disregarded restrictions, the legislative proposal would substitute certain valuation assumptions for it. Thus, a limitation

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on a right to liquidate a holder's interest that is more restrictive than a standard to be identified in the regulations would be ignored and replaced with another standard, not one necessarily tied to being no more restrictive than state law.

4. The proposal also stated that a limitation on a transferee's ability to be admitted as a full partner would be a disregarded restriction.

5. Finally, in determining whether the members of the family could remove the restriction, certain interests in charities or non-family members, as identified in regulations, would be deemed held by the family.

6. Thus, the proposal not only would change the rules on disregarded restrictions, it would significantly expand the Treasury's regulatory authority.

7. The proposal was dropped from the Greenbook starting with fiscal year 2014. No actual legislation was brought before Congress.

G. Proposed Section 2704 Regulations

1. At the same time, IRS Priority Guidance plans began to include an item on additional guidance on new regulations under Section 2704. As is often the case, the Section 2704 project languished on the list for many years.

2. Attendees of the May, 2015 meeting of the ABA Tax Section reported that a representative of the IRS Office of Tax Policy stated that the Section 2704(b) regulations would be issued in the near future, and reportedly would be similar to the Greenbook proposal.

3. Treasury and the IRS have continued to be vague on the precise nature of the regulations beyond these or similar unofficial statements. It is not clear whether the new regulations would be limited to passive investment entities, or whether and how the definition of control would change.

4. Many practitioners believed regulations would be issued during the late summer or early fall of 2015, or by year end. No new regulations have been issued as of March 25, 2016.

5. On August 31, 2015, Richard Dees submitted a letter to Mark Mazur, Assistant Secretary of Tax Policy, and William J. Wilkins, Chief Council of the IRS, with the subject line "Possible New Regulations under Internal Revenue Code Section 2704(b)". Mr. Dees prepared the letter with input from several of well-known transfer tax authorities, including Stacy Eastland and Dan Hastings.

a. The letter provided a forceful argument that new regulations issued under the existing regulatory authority granted in Section

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2704(b)(4) which created rules similar to those in the Greenbook proposals would be inconsistent with the existing statutory language and therefore invalid.

b. Many practitioners suspect that the letter in fact has caused the IRS not to issue whatever regulations it was ready to propose, and has caused the Service to rethink the project.

6. The gist of the letter's argument is that, absent statutory changes, any regulations along the lines of the Greenbook proposal would be inconsistent with the statute's origin and purpose, as reflected in the legislative history of Chapter 14, and would not be a reasonable extension of the regulatory authority Congress granted to the IRS under Section 2704(b)(4).

a. The Dees letter reviews legislative history going back to the passage and subsequent repeal of Chapter 14's predecessor, Section 2036(c).

b. Based on this history, and case law on valuation of interests in family held entities, Dees makes clear that Section 2704(b) focused on ignoring certain restrictions but did not allow replacing such restrictions with other valuation assumptions.

c. Instead, it preserved the fundamental principle that the legal rights and interests inherent in property first are determined under state law. Hence, if a restriction written into a governing document is ignored under Section 2704(b), it is valued as if the restriction did not exist, which necessarily falls back on what property rights exist with respect to the interest under state law.

d. This principle is reflected in the statute, with its provision that an applicable restriction does not include "any restriction imposed, or required to be imposed, by any Federal or State law." IRC § 2704(b)(3).

7. Dees notes that Congress never undertook an effort to write, much less consider for passage, any statutory revision to Section 2704. Therefore, it must be presumed that the congressional intent underlying the original statute continues.

8. Dees closes with two paragraphs that capture the force of his argument:

"The author has written this lengthy and detailed letter to make the case that Proposed Regulations under IRC Section 2704(b) are more likely to be invalid than valid if they reflect the Greenbook Proposal. The letter, however, does not stop with presenting the technical arguments

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against their validity. Rather, the letter also reminds its readers of the failed history and the enormous costs resulting from the IRS' history of repeated failed efforts to accomplish similar objectives in other ways. Before Congress repealed Section 2036(c) retroactively, taxpayers, professionals, Congress, Treasury and the IRS expended substantial resources needlessly at an immeasurable cost. The government's decision to keep the terms of Section 2704(b) out of the public debate prior to its enactment represents a costly missed opportunity to rationalize the valuation of partnership interests. The IRS litigated the validity of one example in the Chapter 14 regulations in Walton for eight years before the courts invalidated it. After implementing the legislative history of Chapter 14 for years after its enactment in 1990, the IRS reversed course in litigation only to lose in Kerr Estate. If Treasury and the IRS promulgate new regulations modeled on the Greenbook Proposal, this sad and costly history will likely repeat itself again."

VI. Aggregation of Business Interests and its Impact on Valuation

A. As described above, the value of business interests for estate tax purposes is influenced in a major way by the size of the interest relative to the entire business.

1. It is well-accepted that minority interests in a business will be worth less than their proportionate share of the whole business value, due to lack of ability to control business operations and distributions.

2. By contrast, a controlling interest may be valued at a premium.

3. Large blocks of stock in corporations that is traded in a thin market will be entitled to a discount because the sale of the stock at one time would overwhelm the market and depress the price.

4. Lifetime estate planning often is aimed at fractionalizing business interests to take advantage of discounts.

5. Post-death administration can involve the same type of planning, as business interests are allocated among marital and non-marital trusts or among trusts for descendants to try to put the successors to the interests in more advantageous valuation situation.

6. This is a challenging area to navigate. For some transfers, such as marital deduction transfers at the first death, higher values (to achieve a higher tax basis) are desirable; while lower values are the goal in taxable transfers.

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B. Non-Aggregation of Differently Owned Interests

1. The courts have taken the non-attribution rule one step further, by requiring that business interests included in the estate for tax purposes but owned separately for property law purposes not be aggregated for valuation purposes.

2. For many years, the IRS had taken the position that the starting point for determining whether a closely-held asset should be valued on a discounted basis is calculation of how much of the asset is included in the decedent's gross estate. The division of ownership of the asset was considered irrelevant. Thus, if an asset is owned 40% by the decedent, 30% by a trust included in the decedent's estate under Section 2036, and 30% by a marital trust included in the decedent's estate under Section 2044, the IRS would treat the decedent as owning 100% of the asset. Accordingly, minority interest or fractional share discounts would not be permitted. See, e.g. Letter Rulings 9608001 (February 23, 1996); 9550002 (December 15, 1995).

3. In 1996, the Fifth Circuit Court of Appeals rejected this position in Estate of Bonner v. United States, 84 F.3d 196 (5th Cir. 1996). The court held that a fractional interest discount was applicable in valuing the decedent's interests in real property for federal estate tax purposes, even though the ownership was divided between the decedent and a QTIP trust that was also included in his estate. Two Tax Court cases followed the result in Estate of Bonner.

4. In Estate of Mellinger v. Comm'r, 112 T.C. 4 (1999) the decedent was the widow of the founder of Frederick's of Hollywood, Inc. At her death, she held 27.8% of the stock in the company in a revocable trust. Another 27.8% was held in a QTIP created at Frederick Mellinger's death.

a. The estate and the IRS agreed that the blocks were less marketable, and subject to a larger discount, if valued separately rather than as a combined majority holding. The estate valued the stock as two separate, minority blocks at $4.79 per share. In its Notice of Deficiency, the IRS valued the stock at $8.46 per share, and at trial it argued for a value of $6.94 per share.

b. The court found that there was nothing in Section 2044 that required QTIP property to be treated as owned by the decedent for valuation purposes. It concluded that Section 2044 only required that a QTIP trust be taxed as part of the decedent's estate.

c. The decedent in this case did not have actual control over the QTIP trust or a power of disposition over the shares in the trust. The court held that each block of stock should be treated as a separate

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minority interest for valuation purposes. The Court ultimately applied a 25% discount and valued the stock at $5.2301 per share.

5. The court reached the same result in Estate of Nowell v. Comm'r, T.C. Memo 1999-15 (1999), which involved the valuation of interests in two limited partnerships.

6. These cases left open the question of what level of control over property included in a decedent's estate should cause the decedent to be treated as controlling it. In neither Mellinger nor Bonner did the decedent have any power of appointment over the QTIP trust. In Nowell, the decedent was a co-trustee of the QTIP trust with her grandson, and apparently also did have a limited power of appointment over the trust. However, this is not mentioned in the opinion and it is not clear whether the IRS raised the issue.

7. The IRS addressed this question in Field Service Advisory 200119013 (May 11, 2001). The Service concluded that a 50 percent interest in a corporation owned directly by the decedent and a 44 percent interest held in a general power of appointment marital trust should be aggregated for valuation purposes. The IRS relied in part on case law indicating that a general power of appointment over property has been treated as the equivalent of outright ownership. The Field Service Advisory stated that marital trust property subject to a general power of appointment is fundamentally different from a QTIP trust.

8. In Estate of Fontana v. Comm'r, 118 T.C. 318 (2002), the Tax Court followed the IRS's Field Service Advisory and determined that property owned outright and property in a general power of appointment marital trust should be aggregated for valuation purposes.

9. The more difficult question is whether a power of appointment that is broad, but is not a general power of appointment (for example, a power of appointment to any person or organization other than the decedent, his or her estate or the creditors of either), would constitute sufficient control to cause aggregation. In the Field Service Advisory, the IRS appears to concede that a limited power of appointment, even a broad one, is not the equivalent of outright ownership. The IRS acknowledges in its Field Service Advisory that the decedent in Nowell possessed a testamentary limited power of appointment. It then states:

We recognize that in some situations, a limited power of appointment may afford the holder broad powers of disposition. However, the power holder would not, in any event, be authorized to appoint the property to his or her estate (or his or her creditors) as is the situation presented with a general power. . . . Given the nature of a limited

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power, and the fact that a limited power is not recognized for estate and gift tax purposes as affording the power holder sufficient control to generate any transfer tax consequences when possessed or exercised, the court in Estate of Nowell was justified in treating a QTIP trust subject to a limited power in the same manner as a QTIP trust where the remainder beneficiaries are designated by the first spouse to die.

This is a significant concession by the Service. However, to avoid aggregation, QTIP marital trusts and not life estate/power of appointment marital trusts will have to be used.

VII. Lifetime and Post-Mortem Planning to Alter Values

A. Lifetime Planning to Take Advantage of Discounts.

1. The previously discussed valuation principles create a number of planning opportunities for the owner of closely held assets, and a number of opportunities for mistakes.

2. As previously discussed, lifetime gifts of small interests in the asset should permit the donor to use minority interest discounts. These discounts may not be available if the donor dies with the same property and is the majority owner.

EXAMPLE. F owns all 1,000 shares of the outstanding common stock of a closely held corporation. He recently had a formal appraisal of the company completed that valued the entire company at $4 million, or $4,000 per share. F, with the consent of his spouse, could make annual exclusion gifts to each of his 3 children and 3 grandchildren of 7 shares of stock if he uses a value of $4,000 per share (a total of $28,000 to each child and grandchild). Because he is transferring minority interests, he applies a 25 percent discount to the stock and values it at $3,000 per share. This permits him to transfer 9 shares to each of his children and grandchildren (9 x $3,000 = $27,000), or a total of 54 shares, instead of only 42. If F dies owning all 1,000 shares, he will not receive a minority discount for any of the stock.

3. Equally valuable are transfers that reduce the control of a majority shareholder and thereby reduce or eliminate any control premium that would be applicable to the interest at the majority shareholder's death. See Whittemore v. Fitzpatrick, 127 F. Supp. 710 (D.C. Conn. 1954). But see Estate of Murphy v. Comm'r., 60 T.C.M. (CCH) 645 (1990) (minority discount denied where decedent made gift 18 days before death in order to reduce her interest below 50 percent).

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EXAMPLE. D owns 640 shares in a closely held corporation. D's brother owns the remaining 360 shares. The corporation has a value of $10 million or $10,000 per share. D transfers 50 shares to each of his three children (a total of 150 shares), and values the transferred shares at a 20 percent discount because they are minority interests so that the total value of the gifts is $1,200,000 instead of $1,500,000. In addition, because D has retained only 490 of the 1,000 shares after the gifts, he no longer possesses a majority interest and may have eliminated application of a control premium to his stock for estate tax purposes.

a. The detriment of such a technique is that D has given up actual control. D's brother and D's three children as a block could outvote D and take control of the corporation.

b. In many situations, however, the parent who is contemplating gifts of this type can count on cooperation from family members. Alternatively, the parent can put the stock in trust for the children with a reliable third party as trustee.

c. It may not be necessary for a controlling stockholder to reduce his interest below 50 percent to affect the control premium. For example, in some states, a two-thirds vote of the shareholders is required for liquidation. By reducing his interest below two-thirds, a controlling shareholder can eliminate this aspect of control and possibly reduce the amount of the premium that the IRS would attempt to apply to his stock.

4. This type of lifetime planning is important for any taxpayer who will have a taxable estate. If the taxpayer is married, and his or her estate will be non-taxable, it may make sense not to take all the steps that could be taken, in order to achieve a greater basis step-up. Then, after the taxpayer's death, the spouse can complete the planning.

EXAMPLE. In the example above, D who owns 640 shares in a closely held corporation, is dying of cancer. He is married and his wife is in good health. D plans to transfer 150 shares of stock to a trust for his three children in order to reduce his ownership interest below 50%. His attorney advises him to transfer only 130 shares, to reduce his interest to 51%. His attorney also advises that D amend his estate plan to give D's wife a limited withdrawal right over marital trust assets. D dies and his stock is valued as a controlling interest, with a basis step up to its value as such. His 510 shares pass to the marital trust. D's wife exercises her withdrawal right to withdraw 20 shares from the trust. D's wife then gifts those shares to the trust for their children. She can make additional withdrawals and gifts over time. At her death, the marital trust has a minority interest and it is valued as such.

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5. A client may not be willing to transfer the stock in his closely held corporation because it will reduce his percentage vote in the company. This is often an issue in a family business owned by siblings or a business with some non-family shareholders. It may be important from a business perspective that the client not reduce his voting interest. The same issue sometimes arises in a wholly owned corporation; the client may be unwilling to let anyone else become a voting shareholder.

a. In these situations, the client should consider reorganizing the corporation to create a class of nonvoting stock. This could be accomplished by a stock split with the company issuing one share of nonvoting stock for each outstanding share of voting stock.

b. The client can use the nonvoting stock for gifts without diluting his voting interest. The gifts of nonvoting stock should be subject to valuation discounts just as minority voting interests would be.

c. The creation of a class of nonvoting stock is also useful if the client wants to set up a family partnership. If the client transfers voting stock in his closely held business to a family partnership, his right as general partner to vote the stock will cause it to be included in his estate under Section 2036(b). This problem is eliminated if nonvoting stock is transferred to the partnership.

d. A class of nonvoting stock can be created in S corporations.

B. Impact of Valuation in Allocating Business Interests Post-Death

1. The control premium can work to the benefit of a taxpayer who desires to maximize the value of a majority interest which qualifies for a marital or charitable deduction. See Estate of Chenowith v. Comm'r, 88 T.C. 1577 (1987).

EXAMPLE. D was the sole stockholder of Y Corp. At her death, 51% of the Y Corp. stock passed under D's will to her husband. D's personal representative and the IRS agreed that Y Corp. should be valued at $2,000,000, and that amount was included in D's gross estate. D's estate is entitled to a marital deduction for the 51% interest in Y Corp. bequeathed to D's husband. When calculating the amount of the marital deduction, D's personal representative is entitled to apply a control premium above the purely mathematical 51% of the value of all the Y Corp. stock. Thus, D's personal representative can claim a marital deduction for more than $1,020,000.

a. The Tax Court approved this result in Estate of Chenowith.

b. After D's death in the foregoing example, her husband could transfer 2 percent of the stock to a child or other descendant in

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order to reduce his interest below 51 percent and eliminate the control premium for purposes of valuing the stock in the husband's estate.

2. The same principles can work to the taxpayer's detriment if assets are not thoughtfully allocated. In Letter Ruling 9403005 (October 14, 1993), the IRS ruled that (1) a control premium applied to a decedent's majority interest in a corporation even though the stock would be split under his estate plan and pass as two separate minority interests, and (2) the minority interest passing to the surviving spouse should be valued as a minority interest for purposes of determining the marital deduction. The Tax Court reached the same result in Estate of DiSanto v. Comm'r, 78 T.C.M. (CCH) 1220 (1999).

EXAMPLE. F owned 80% of the stock of Z Corp. at her death. Z Corp. had an appraised value of $5,000,000 at F's death. An appraiser determined that F's controlling interest was worth $4,500,000. F's estate plan allocates half of the stock of Z Corp. to a marital trust for her spouse and half of the stock to her children. The IRS determines that each 40% interest, valued separately, is worth only $1,900,000. F's estate is entitled to a marital deduction of only $1,900,000, and the remaining $2,600,000 is taxable.

3. The result seems unfair, but the subtraction method inherent in the estate tax calculation (gross estate – deductions = taxable estate) mandates the result.

4. A corporate reorganization, to create voting and nonvoting stock, as described in A.5 above, can be accomplished post-death also. Doing this may facilitate additional post-mortem planning to minimize values in the survivor's estate.

EXAMPLE. J's estate plan resulted in 60 shares of the stock of his business being allocated to a marital trust and the remaining 40 shares of the stock allocated to a non-marital trust. After the trusts are funded, the corporation undertakes a stock split, issuing 1 share of nonvoting stock for each share of voting stock. The stock has appreciated only nominally since J's death. After the stock split, the marital trust exchanges 40 shares of voting stock for 40 shares or nonvoting stock from the nonmarital trust. After this exchange, the stock is owned as follows:

Marital Trust 20 shares voting stock 100 shares nonvoting stock Family Trust 80 shares voting stock 40 shares nonvoting stock

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C. Restricted Securities

1. As noted above, "restricted securities" in a publicly traded company are securities that are identical to the company's publicly traded stock, but are subject to restrictions on sale because they have not been registered or because they are owned by an affiliate.

2. Estate of McClatchy v. Comm'r, 147 F. 3d 1089 (9th Cir. 1998), illustrates an issue that can arise with restricted stock. The question before the court was whether the value of stock in a decedent's estate should take into account Rule 144 restrictions that applied during his life. Charles McClatchy was CEO and a director of McClatchy Newspapers Inc. ("MNI"). He owned more than 2,000,000 shares of MNI's class B common stock. Since McClatchy was an "affiliate" of MNI, the class B stock was restricted under Rule 144.

a. Upon McClatchy's death in 1989, the class B shares were valued by the estate as restricted securities. The stock was reported at $12.34 per share. The IRS asserted a $5.8 million estate tax deficiency, claiming that the value of the stock should be determined without consideration of any securities law restrictions. The IRS argued that McClatchy's death altered the value of the stock because the stock was transferred to his estate, which was not an affiliate of MNI for Rule 144 purposes. In the Tax Court, the parties agreed that if the Rule 144 restrictions were taken into account, the stock had a date of death value of $12.34 per share; if not, the stock had a value of $15.56 per share. The Tax Court ruled in favor of the IRS. It reasoned that the Rule 144 restrictions lapsed at the moment McClatchy died.

b. The Ninth Circuit disagreed. The court concluded that the value of the stock had been transformed only because the estate was a non-affiliate. If the executor or personal representative had been an affiliate, the estate also would have been an affiliate. According to the court, "making the amount of the estate tax depend on the affiliate or non-affiliate status of the executor contradicts the principle that valuation should not depend on the status of the recipient."

c. Next the court rejected the Service's contention that under the "willing buyer/willing seller" method, the valuation of the MNI stock depended on a hypothetical buyer purchasing the stock from the estate which was not subject to the Rule 144 restrictions. The court concluded that such an approach required both a hypothetical buyer and a hypothetical seller while here the IRS was not using a hypothetical seller. As a result, any increase in the stock's value because of the removal of the Rule 144 restrictions was occasioned

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not by McClatchy's death, but by the transfer to the non-affiliate estate. Death alone did not alter the value. Instead, the identity of the recipient did. Since the value of the estate is determined by the interest of the decedent at the time of death, the court held that the stock should be valued in the hands of the decedent, taking account of the Rule 144 restrictions.

d. The Ninth Circuit's decision has been controversial. There is conflicting case law on the application of the willing buyer/willing seller principle in the context of property passing at death.

3. This case suggests that the most effective way to preserve discounts based on securities law restrictions is to name an affiliate as fiduciary. This is an important planning consideration for taxpayers that hold large amounts of restricted stock. It is always possible to replace the affiliate at a later date if doing so would facilitate sale of the securities.

VIII. Valuation Savings Clauses and Formula Gift Clauses

A. Taxpayers have used savings clauses in an attempt to remove uncertainty from the valuation process or to avoid unintended gift tax consequences of a transfer. In its simplest form, a savings clause (sometimes also referred to as a "revaluation" or an "adjustment" clause) is a provision included in a deed of transfer or a purchase agreement which adjusts the amount of property being transferred or the amount of consideration being paid if it is later determined that the property has a value different from that originally assigned to it.

EXAMPLE. An individual wishes to transfer 25 shares of closely held stock to each of his three children. The individual values the stock at $2,000 per share. In connection with the gift, the individual enters into the following agreement with each child:

"Each party hereto agrees that if it should be finally determined for federal gift tax purposes that the fair market value of each share of stock of the Corporation exceeds or is less than $2,000, an adjustment will be made in the number of shares constituting the gift so that Donor will give to Donee the maximum number of full shares of stock of the Corporation the total value of which does not exceed $50,000. Any adjustment so made which results in an increase or decrease in the number of shares transferred will be made effective as of the date of this Agreement, and any dividend paid thereafter shall be recomputed and reimbursed as necessary to give effect to the intent of this Agreement."

If the IRS determines that the stock has a fair market value of $5,000 per share, then each child would return 15 shares pursuant to the agreement and retain only 10 shares.

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B. Treatment of Traditional Savings Clauses

1. The IRS historically has been successful in contesting the validity of savings clauses that are in this form on the grounds that such clauses are against public policy, since they frustrate enforcement of tax laws. See Comm'r v. Proctor, 142 F.2d 824 (4th Cir. 1944) (clause void as against public policy because it discouraged the collection of gift tax, would require the court to rule on a moot case, and would have effect of invalidating a final judgment); Ward v. Comm'r, 87 T.C. 78 (1986) ("a condition that causes part of a gift to lapse if it is determined for Federal gift tax purposes that the value of the gift exceeds a given amount, so as to avoid a gift tax deficiency, involves the same sort of trifling with the judicial process condemned in Proctor").

2. In Revenue Ruling 86-41, 1986-1, C.B. 300, the IRS stated it will ignore savings clauses for gift tax purposes. In that ruling, the IRS examined two situations in which a gift was subject to a savings clause.

a. In the first situation, if the IRS determined that the gifted property was worth more than $10,000 (the amount that can pass free of gift tax due to the annual exclusion), the savings clause required that a fractional share of the property equal to the excess was to be refunded to the donor.

b. In the second situation, if the value of the property exceeded $10,000, then the savings clause required the donee to pay the donor consideration in the amount of the excess.

c. The IRS said both savings clauses violate public policy because they discourage enforcement of the federal gift tax laws.

3. Savings clauses occasionally were successful, primarily where there was evidence that the parties intended to create an arm's length transaction or had other motives unrelated to the avoidance of tax. See King v. U.S., 545 F.2d 700 (10th Cir. 1976); Estate of Dickinson, 63 T.C. 771 (1975).

C. Development of Formula Allocation Clauses

1. Taxpayers and their counsel continued to search for ways to bring certainty to the value of gift and estate tax transfers. New types of clauses have emerged that have, so far, withstood court scrutiny.

2. The first has been referred to as a "defined value clause" but may be better described as a "formula gift allocation clause." It is used to make a gift of a defined asset, with a formula that allocates it among multiple recipients.

3. The first case to validate the use of this form of gift clause was McCord v. Comm'r, 461 F.3d 614 (5th Cir. 2006), reversing 120 T.C. 358 (2003).

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a. On January 12, 1996 the McCords entered into an assignment agreement to transfer Class B limited partnership interests in McCord Interests, Ltd. (MIL). The agreement set forth an order for the transfers, with first, interests equal to the McCords' remaining GST exemptions going to GST exempt trusts; next, $6,910,932.52, less the GST transfers and less any gift tax owed by their sons, passing to their sons; next $134,000 of Class B interests would go to the Shreveport Symphony, and finally any remaining interests going to the Community Foundation of Texas.

b. The McCords valued their interests at $89,505 per 1% interest for gift tax purposes. But under the agreement the donees had to confirm the correct allocation of the units. Hence, the total value of the gift was not subject to adjustment, only the allocation among the recipients of the transfer.

c. The McCords argued that when the court adjusted the fair market value of the gifted interest, the amount transferred to the Foundation for Federal gift tax purposes changed pursuant to the formula. The Tax Court held that the language of the assignment agreement was in effect a savings clause, and ineffective under the Proctor line of cases.

d. The Fifth Circuit Court of Appeals disagreed. It concluded that the formula gift was valid, and the donees subsequent division of the property by agreement was valid. The taxpayers were entitled to a charitable deduction for any excess Class B interests passing to the Community Foundation.

4. Several cases followed in which courts approved similar uses of formula allocation clauses.

a. In Christiansen v. Comm'r, 130 T.C. 1 (2008), the court approved the use of a formula defined value disclaimer, in which the decedent's daughter disclaimed the amount of the estate exceeding $6,350,000. The disclaimer was designed to work with the estate plan, so any excess over the designated amount (including any excess by reason of the IRS revaluing the limited partnership interests in the decedent's estate) would pass to a charitable lead trust and a Foundation. While the disclaimer proved ineffective with respect to the charitable lead trust for Section 2518 reasons, the court concluded that the formula disclaimer worked with respect to the Foundation. The court stated that a formula provision such as the one in this case, that merely reallocated property among the designated recipients based on the value of the property, was very different than a Proctor type clause that caused property to revert to the donor. The Eight Circuit confirmed this

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result in Estate of Christenson v. Comm'r, 586 F.3d 1021 (8th Cir. 2009).

b. In Estate of Petter v. Comm'r, T.C. Memo 2009-280, aff'd. 653 F.3d 1012 (9th Cir. 2011), the court approved defined value clauses that allocated a LLC units transferred in both a gift and a sale between an irrevocable grantor trust and donor advised funds. The court rejected the precedent of Proctor. It noted that a savings clause is void because it allows a donor to take property back. A formula clause is valid because it transfers a "fixed set of rights with uncertain value."

c. Hendrix v. Comm'r, T.C. Memo 2011-133 approved a similar clause in another transaction involving a gift and sale to trusts. The other recipient of the transfer was a donor advised fund at the Greater Houston Community Foundation.

5. Self-adjusting formula clauses are much more common and accepted in the estate tax context. A marital formula is such a clause. The Code and regulations recognize formula disclaimers and formula partial QTIP elections.

6. In each of the cases mentioned above, the clause gave the taxpayer certainty about the amount of the gift because the formula allocated any increase in value determined by the IRS to charitable donees.

a. The courts specifically noted that the charities had a vested interest in receiving what they were entitled to receive and would defend their interests, either because they were independent entities or because the managers of the entity had fiduciary obligations subject to regulation by the state attorney general.

b. Several courts also noted the public policy considerations in favor of supporting charitable gifts.

7. These cases gave taxpayers a roadmap for eliminating the risk of a large tax bill from an audit. But the formula allocation clause creates its own complexities and challenges.

a. It is more complicated because of the need to have an alternate gift recipient.

b. The fact that all the taxpayers in all the cases used charities left taxpayers wondering if a charitable donee is a necessary prerequisite to success.

c. A taxpayer could theoretically obtain the same result by having the secondary, or alternate donee be a lifetime QTIP trust, a zero-out

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GRAT, or an incomplete gift trust. In each case, the taxpayer would avoid a larger taxable gift because of the recipient of the excess value in the transfer. But the favorable court treatment of charitable gifts then would not be a factor that the taxpayer could cite in support of the transaction.

d. It also is possible that an actual adjustment to the gift allocation may be necessary, either due to an IRS audit or the demand of a donee. In that case, ownership records will have to be corrected, and both the donees and the entity, interests of which were transferred, might have to file amended income tax returns. If one or all of the donees are grantor trusts, this may reduce the complexity of such retroactive adjustments.

D. Wandry Defined Value Clause

1. The second type of formula clause that has emerged won court approval in Wandry v. Comm'r, T.C. Memo 2012-88. The term "defined value clause" probably more accurately describes this type of clause because it defines the gift in terms of a defined dollar amount rather than a specific number of shares or units. Most people, however, refer to it now as a Wandry clause.

a. For example, a gift of $14,000 worth of LP units in XYZ Family Partnership is a Wandry clause. It refers to the amount being given, not the number of units.

b. In describing how the clause works, many practitioners have used the analogy of going to the gas station and asking to buy $20 worth of gas.

2. In many situations, practitioners had to use a Wandry defined value clause by necessity, because the value of the asset transferred could not be determined as of the date of the gift.

a. This could be the case even when transferring interests in an entity that were not subject to valuation discounts.

EXAMPLE: John wishes to make annual exclusion gifts of interests in an investment partnership on December 31, 2013. The partnership holds marketable securities and cash. Any partner can withdraw from the partnership at any time, so no valuation discounts are available. At the time John signs the Assignment forms, he does not know the exact value per LP unit because markets are still open. He signs assignments transferring $14,000 of LP units to each of his children. Within the next few days, the net asset value of the partnership is calculated and John signs additional assignments confirming the exact number of units

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transferred.

b. If the investment entity holds interests in hedge funds or other private third party investment funds, the actual value may not be known until the entity reports quarter-end values. That may not occur for several months.

c. A Wandry defined value clause also is used for gifts where the donor is having an appraisal prepared as of a certain date and needs to make the gift on that date.

EXAMPLE: Alice owns a substantial interest in a family investment LLC. The LLC owns marketable securities and several parcels of commercial real estate. The family has an annual appraisal prepared as of December 31 of each year. It includes updated appraisals for the real estate and fixes valuation discounts for LP units. The appraisal report generally is issued two to three months after the end of year. On December 31, 2013, Alice gives $1,000,000 of LLC units to an irrevocable trust, with the value to be based on the appraisal report. When the appraisal report is issued, the LLC documents the actual number of LLC units transferred.

d. In each of these situations, the defined value gift is being used to facilitate the transfer. It is not designed to also adjust if the IRS challenges the value of the property on audit. As described below, Wandry approved the validity of the defined value gift in both the context just described and in the audit context.

3. Wandry v. Commissioner, T.C. Memo 2012-88

a. In 1998, Joanne and Dean Wandry formed a Colorado limited partnership to which they contributed cash and marketable securities. In 2001, they formed an LLC, also for investment purposes. The Wandrys' attorney advised them that they could institute a tax-free gift-giving plan through transfers of limited partnership and LLC interests utilizing the gift tax annual exclusion as well as additional gifts in excess of the annual exclusion. The Wandrys' attorney advised the Wandrys to give gifts of a specific dollar amount rather than a set number of LP units or LLC member interests. He also advised them that all gifts should be transferred on December 31 or January 1 of any given year so that a mid-year closing of the books would not be required.

b. In January 2004, each petitioner transferred $1,099,000 of LLC units representing $261,000 of units to each of the four children and $11,000 of units to each of five grandchildren. The

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assignment provided that each donor intended to have a good faith determination of the value made by an independent third party professional. The number of units transferred would be based on that appraisal. If the IRS challenged the valuation and a final determination of a different value was made by the IRS or a court, the number of gifted units was to be adjusted accordingly so that the value of units given to each person equaled the dollar amount specified in the assignment. The assignments specifically stated that the formula was to work in "the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law."

c. The gift tax return described the gifts to the children and grandchildren in terms of percentages of membership interest in the LLC. These percentages were derived from the value determined by an independent appraiser. The IRS claimed that the gifts of 2.39% interests to each child and a .101% interest to each grandchild saying that the membership interest should have been valued at a higher amount. The IRS and the taxpayers agreed that the 2.39% and the .101% LLC membership interests were worth $315,000 and $13,346. The IRS argued that the formula did not work to reduce the amount transferred, as the taxpayers claimed.

d. The court noted that in Estate of Petter, it had examined the difference between savings clauses, which had been rejected by Comm'r v. Proctor and which a taxpayer may not use to avoid the gift tax, and a formula clause, which is valid. A savings clause is void because it creates a donor that tries to take the property back. A formula clause is valid because it merely transfers a "fixed set of rights with uncertain value." The difference, according to court, depends on an understanding of exactly what the donor is trying to give away.

e. In this case, the donees were entitled to receive predefined interests which were essentially expressed as a mathematical formula in which the one unknown was the value of an LLC unit at the time the transfer documents were executed. However, though the value per unit was unknown, the gift value was a constant. The court noted that absent the audit, the donees might never have received the proper LLC percentage interests to which they were entitled. That did not mean that parts of petitioners' transfers depended upon an audit. Instead an audit merely ensured that the children and grandchildren would receive the interest that they were always entitled to receive.

f. The court said that it was "inconsequential" that the adjustment clause reallocates membership units among petitioners and the

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donee rather than a charitable organization as in prior cases such as Christensen and Petter. In the court's view the gift documents did not allow petitioners to take property back. Rather the gift documents corrected the allocation of the membership units among donors and donees because the independent appraiser's report understated the value. As a result, the assignments contained valid formula clauses.

g. The court also rejected the public policy concerns expressed in Proctor. It stated that there is no well-established public policy against formula clauses. The role of the IRS is to enforce the tax laws, not to maximize tax receipts.

4. The Wandry case is a major development in establishing the validity of defined value clauses. But it is only a Tax Court Memorandum opinion, so its precedential value is limited.

a. The IRS initially filed a Notice of Appeal in the case but then dropped the appeal. The appeal would have gone to the Tenth Circuit, which is where one of the few pro-taxpayer savings clause cases was decided, King v. United States.

b. The Service published a non-acquiescence to Wandry in I.R.B. 2012-46. Thus, it appears that the IRS is waiting for a more favorable opportunity to challenge the case.

c. In certain respects, it does seem that Wandry is contrary to the Proctor line of cases. The IRS certainly will argue that a defined value clause results in the donor taking property back and that this is a condition subsequent of the type prohibited in Proctor.

d. However, the IRS must overcome the many circumstances in which it has either directly sanctioned, or declined to challenge, formula clauses. Formula disclaimers, formula marital deduction provisions, formula GST exemption allocations, formula annuity provisions in GRATs and charitable split-interest trusts are common.

5. If a taxpayer uses a Wandry-type clause, the gift tax return should describe the gift as a dollar amount not a specific number of shares or units, or percentage interest. The taxpayer in Wandry did not do this, and this oversight gave the IRS its most powerful argument.

a. In order to satisfy the adequate disclosure rules, it still probably is necessary to identify the number of shares or units that the taxpayer is claiming to have transferred.

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b. This can be done by describing the gift first as a dollar amount but with an additional explanation: "The taxpayer transferred $2,500,000 of her interest in Dough Family Limited Partnership. Based on the appraisal by Honest Lee Valuation Group, the amount transferred equated to a 2.5% interest in the Partnership. However, the amount the taxpayer transferred a fixed dollar amount of limited partner interest, and the percentage interest will be adjusted if there is a final determination of a different value, so that the value of the interest transferred equals $2,500,000."

6. There may be situations where it is not advisable to use a Wandry defined value clause.

a. Many clients will make gifts well under the $5,450,000 (current) applicable exclusion amount. The unused exclusion amount provides some protection against audit (since the IRS receives no immediate return from challenging the value of the gift). And a Wandry provision may call unwanted attention to the return.

b. If the client is transferring an asset with extreme potential to increase in value, such as stock in a company that may be going public, it is worth considering whether it is better to accept a possible adjustment in value, and even pay gift tax, rather than receive some of the asset back at a much higher value.

IX. Reporting Requirements

A. Information Required For Estate Tax Return

1. The instructions accompanying the estate tax return, Form 706, refer only to Section 2031 for valuing closely held stock. The instructions for Schedule B state:

"Apply the rules in the Section 2031 regulations to determine the value of inactive stock and stock in close corporations. Send with the schedule complete financial and other data used to determine value, including balance sheets (particularly the one nearest to the valuation date) and statements of net earnings or operating results for each of the 5 years immediately before the valuation date."

2. The instructions accompanying Schedule F state:

"If the decedent owned any interest in a partnership or unincorporated business, attach a statement of assets and liabilities for the valuation date and for the 5 years before the valuation date. Also, attach statements of the net earnings for the same 5 years. Be sure to include the EIN of the entity. You must account for goodwill in the valuation. In general,

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furnish the same information and follow the same methods used to value close corporations. See the instructions for Schedule B."

3. Surprisingly, the instructions do not reference Revenue Ruling 59-60 or the use of a professional appraisal, which most tax preparers accept as a necessary part of any tax filing that reports the value of a closely-held business interest.

4. There are no direct penalties for failing to include an appraisal or failing to provide the information requested. Unlike gift tax returns (discussed later), a filed estate tax return will start the statute of limitations running, even if information about the business interest is not adequately disclosed. There are, however, a number of potential negative ramifications if the tax preparer fails to provide adequate valuation information.

a. Incomplete or inadequate information will increase the likelihood of an audit.

b. Under the burden of proof rules, if the estate fails to provide an appraisal or financial support for the value of a business interest, all the IRS has to do is state its position on the value and the burden is on the taxpayer to refute that. If the estate tax return includes an appraisal, the IRS must come up with its own analysis or appraisal of the value to keep the burden of proof on the taxpayer.

c. As described later, the use of an appraisal can help avoid under-valuation penalties.

5. The current Form 706 asks specifically about valuation discounts, with the following two questions in Part 4 – General Information:

"10a Did the decedent, at the time of death, own any interest in a partnership (for example, a family limited partnership), an unincorporated business, or a limited liability company; own a fractional interest in real estate; or own any stock in an inactive or closely held corporation?"

"10b If "yes" was the value of any interest owned (from above) discounted on this estate tax return? If "yes", see the instructions for Schedule F on page 20 for reporting the total accumulated or effective discounts taken on Schedules A, F, or G."

a. Note that question 10b does not ask the tax preparer to report the total effective discount for a stock interest reported on Schedule B. It nevertheless is good practice to do so.

b. The instructions (page 20) provide the following example of how the tax preparer is expected to report the total discount taken:

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Example of effective discount: a Pro-rata value of fractional interest (before any discounts) $100.00 b Minus: 10% discounts for lack of control (10.00)

c Marketable minority interest value (as if freely traded minority interest value)

$90.00

d Minus: 15% discount for lack of marketability (13.50) e Non-marketable minority interest value $76.50

Calculation of effective discount: (a minus e) divided by a = effective discount ($100.00 - $76.50) / $100.00 = 23.50%

B. Impact of Prior Taxable Gifts of Business Interests

1. Most business owners who are serious about succession planning will have started the process before death. They will have made lifetime gifts or engaged in other planning (GRATs, installment sales, use of additional discounting with partnerships or LLCs).

2. These lifetime transactions, and the accuracy and defensibility of the reporting of them, usually will have an impact on the estate tax return.

3. The IRS clearly is interested in lifetime transactions, especially those that it may not have been necessary to report on a gift tax return. Part 4 – General Information of the Form 706 includes the following question:

"12e Did the decedent at any time during his or her lifetime transfer or sell an interest in a partnership, limited liability company, or closely held corporation to a trust described in question 12a or 12b?" [covering any trusts created by the decedent during his or her lifetime and any trusts not created by the decedent under which the decedent possessed any power, beneficial interest or trusteeship]

4. Recent gifts reported on gift tax returns filed within 3 years, and other transactions for which a gift tax statute of limitations did not commence, are subject to review and audit as part of an estate tax audit. Therefore, the executor or tax preparer for the executor should be familiar with the rules for gift tax return reporting and should review lifetime transfers by the decedent.

C. Disclosure and Reporting Requirements for Gift Tax Returns

1. The IRS generally has three years from the filing of a gift tax return to assess a deficiency. See IRC § 6501(a). Prior to 1997, this statute of limitations applied to all gifts made during a calendar year for which a return was filed, including gifts not reported on the return. Only gifts

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subject to the special valuation rules under Sections 2701 and 2702 had to be adequately disclosed to start the three-year period.

a. However, other Code provisions limited the benefit of the statute of limitations. Section 2504(c) permitted the IRS to revalue gifts from a prior year on a subsequent gift tax return, even if the statute of limitations for assessing a deficiency on gifts from that year had run, unless a gift tax had been paid or assessed for that prior year. This allowed the IRS to adjust values for previously made gifts on a subsequent gift tax return and thereby push a taxpayer into a taxable situation or a higher gift tax bracket.

b. The IRS also took the position that it could always revalue prior gifts when determining the amount of a decedent's adjusted taxable gifts on an estate tax return. The courts supported this position. See, e.g., Estate of Smith v. Comm'r, 94 T.C. 872 (1990); Estate of Prince v. Comm'r, T.C. Memo 1991-28. This again allowed the IRS to push a taxpayer into a higher tax bracket. A revaluation would have no impact on an estate that already was in the top estate and gift tax bracket.

2. Congress amended Section 6501 to provide that the statute of limitations will not run for any gift that is not adequately disclosed on a gift tax return. See IRC § 6501(c)(9). This provision was effective for gifts made in calendar year 1997 or later.

3. It also amended Section 2504(c) so that the IRS cannot revalue a previously disclosed gift in a subsequent year's return, if the limitations period has expired. Finally, Congress added Section 2001(f) which states that, if the limitations period on a gift has expired, and if the value of the gift is shown on a gift tax return or disclosed "in a statement attached to the return, in a manner adequate to appraise the Secretary of the nature of such gift," then the value reported is binding for estate tax purposes. These two changes were effective for gifts made after August 5, 1997.

4. Under these provisions, a gift must be reported on a gift tax return and disclosed in a manner sufficient to apprise the IRS of the nature of the item in order for the period for assessing gift tax to run. However, once that period has run, the gift cannot be questioned or revalued on any later return. These rules apply to any issues with respect to the gift, including both valuation issues and issues involving interpretation of the gift tax law (such as whether a gift is a present interest qualifying for the annual exclusion). See Treas. Reg. § 20.2001-1(b); 25.2504-2(b).

5. Section 301.6501(c)-1(f) of the regulations sets forth a lengthy set of requirements for what constitutes adequate disclosure, sufficient to start the statute of limitations. Under Treas. Reg. § 301.6501(c)-1(f)(2),

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adequate disclosure is defined as a disclosure that adequately apprises the IRS "of the nature of the gift and the basis for the value so reported." The disclosure must include:

a. A description of the transferred property and any consideration received for it;

b. The identity of the transferor and transferee and how they were related;

c. If the transferee is a trust, the trust's tax identification number and a brief description of the trust terms (or instead of a description, a copy of the trust instrument);

d. A detailed description of the method used to determine the fair market value of the property; and

e. A statement describing any position that is contrary to IRS regulations or Revenue Rulings.

6. The key requirement for gifts of closely held business interests for which there is not a readily determinable market value is the description of how fair market value was determined. Section 301.6501(c)-1(f)(2)(iv) states that the return must include a detailed description of the method used to determine the fair market value, including financial data used in making the determination. Thus, if the value of closely-held stock was derived by using the company's financial statements and projections, those statements and projections should be attached.

7. Any restrictions that were considered in valuing the property also must be disclosed, and any valuation discounts applied must be disclosed. If the value of the entity or interest in an entity being transferred is determined based on the net asset value of the entity, the gift tax return must include a statement providing the fair market value of 100 percent of the entity before any discounts.

a. For example, if T makes a gift of 10% of the stock in a business owned by his family, and values the gift based on the net asset value of the business less a discount, the net asset value of the entire entity would have to be disclosed. The return also would have to identify the discount being applied and describe how it was derived.

b. This requirement can have the effect of giving the IRS a useful guide as to which gift tax return it might wish to audit. Even if a particular gift is not large, if the return disclosed a large value for 100% of the entity, the IRS might decide that the return is worth investigating based on the overall family wealth, and the

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possibility that there are other gifts in other years and by other family members.

8. The regulations do not address what disclosure is required in situations in which the value of an asset is not based on particular financial data. For example, if T makes a gift of 100 shares of stock in a closely held corporation and bases the value solely on the value used in a recent arm's length sale of the stock, is it sufficient to disclose that fact and the date of the sale? Or, must T also provide financial information about the corporation or information about how the price used in the arm's length sale was derived? It would appear that the additional information is not necessary. If the reported value is based on a prior sale, reporting that fact, the date of the sale, and the parties involved in the sale, should constitute a "description of the method used to determine the fair market value of property transferred" as required by the regulations.

9. The regulations state that if the entity that is the subject of the transfer owns an interest in another non-actively traded entity, then the information required by the regulations showing how the gift was valued also must be provided for the indirectly owned entity "if the information is relevant and material in determining the value of the interest [transferred in the gift]." Treas. Reg. §301.6501(c)-1(P)(2)(iv).

a. For a holding company-type entity that owns several layers of interests in other entities, this requirement could require the taxpayer to include a significant amount of financial data with the return.

b. The "relevant and material" standard in the regulations likely will be subject to further interpretation in rulings and cases. For example, if a closely-held entity owns a 5% interest in another entity, and that interest constitutes only about 2% of the assets of the closely-held entity, the value of the underlying interest might be judged not material, so that disclosure of financial information on the value of that interest is not necessary.

c. Many family entities own interests in private venture capital or hedge funds owned by independent third parties. These funds often provide limited interim financial information to investors. If the taxpayer provides whatever financial information is available (even if out-of-date) and explains how the value used for the interest was derived, this hopefully will satisfy the disclosure rules.

10. The regulations state that a taxpayer may satisfy the disclosure requirements for the value of a gift by submitting an appraisal, if the appraisal is prepared by a qualified appraiser (meaning an appraiser "who is qualified to make appraisals of the type of property being valued" and

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who is independent of the donor), and the appraisal contains a description of the property appraised, the appraisal process, the assumptions used, and the financial data used "that is sufficiently detailed so that another person can replicate the process and arrive at the appraised value." Treas. Reg. §301.6501(c)-1(f)(3). On its face, this appears to be a greater level of detail than normally is found in an appraisal.

11. In some cases, a taxpayer will want to report a transaction that is not treated as a gift by the taxpayer, in order to start a statute of limitations on the transaction. For example, if an asset is sold for an installment note to a family member, the taxpayer may want to report it, even though it is a sale for adequate and full consideration, in order to eliminate any future questions about the proper valuation of the asset sold. The disclosure requirements are not as burdensome in these situations. The taxpayer must provide basic factual background (a description of the property, the parties involved, etc.) and explain why the transfer is not a gift, but the taxpayer does not have to describe the method used to value the property or provide supporting financial data. Treas. Reg. § 301.6501(c)-1(f)(4).

D. Penalty Provisions

1. In any tax return preparation situation, it is important to be aware of the penalty provisions that could apply.

2. Section 6662 of the Internal Revenue Code imposes a substantial valuation understatement penalty for undervaluing property on an estate or gift tax return if the value reported on the return is 65 percent or less of the value ultimately determined to be correct, and the tax underpayment as a result is at least $5,000. If applied, a penalty of 20 percent of the underpayment will be added to the tax. IRC § 6662(g).

3. If the value claimed on the return is 40 percent or less of the amount determined to be correct, a gross valuation understatement penalty of 40 percent of the underpayment will be added to the tax. IRC § 6662(h).

4. The penalty for an underpayment attributable to fraud is 75 percent of the portion of the underpayment due to fraud. If the IRS establishes that any portion of the underpayment is due to fraud, the entire underpayment is presumed to be due to fraud, unless the taxpayer can prove otherwise. See IRC § 6663.

5. In addition, a 20 percent negligence penalty can apply to the portion of the underpayment attributable to negligence. IRC § 6662.

6. Pursuant to Section 6664(c), an underpayment penalty is waived if the taxpayer shows that there was a reasonable basis for the valuation position and that the taxpayer acted in good faith. Reliance on an appraisal often will help the taxpayer qualify for this waiver provision.

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7. In legislation enacted May 25, 2007, Congress expanded the penalties that can apply to tax return preparers, including specifically applying the penalty provisions to preparers of estate, gift or generation-skipping transfer tax returns. IRC § 6694.

a. It is not entirely clear how the IRS will apply the rules in practice to valuation understatements.

b. To avoid the preparer penalty for an unreasonable position, the position must be adequately disclosed (on either Form 8275 or 8275-R) and there must be a reasonable basis for the position. Reasonable basis means a position that is based on tax authorities (tax code, case law, legislative history but legal opinions). It is considered a relatively high standard.

c. If the position is not disclosed, the preparer must have a reasonable belief that the position "more likely than not" (greater than a 50% chance) will be sustained on the merits.

d. The preparer penalty is the greater of $1,000 or 50% of the preparer's income with respect to the return. This could be a significant number in the case of an estate tax return.

e. There are two types of return preparers, signing return preparers and non-signing return preparers. A signing return preparer is the individual/firm that actually signs the return. A nonsigning preparer is treated as a return preparer under Section 6694 even though he or she did not prepare the actual return. An individual is a preparer of a return if he or she gives advice on specific issues of law if the advice is directly relevant to the determination of the existence, characterization, or amount of an entry on a return. For instance, if a trust officer gives a CPA an opinion on a transaction to satisfy the CPA that the taxpayer's reserve for taxes is satisfactory, the advice is not relevant to the determination of the existence, characterization, or amount of an entry on a return.

E. Obtaining a Professional Appraisal

1. As noted in preceding paragraphs, a professional appraisal of the business interests is not mandated in the filing requirements for a Form 706. However, a professional appraisal will provide an added level of certainty to the valuation process, and help avoid penalties for valuation understatements. The process of retaining the appraiser and working with him to develop a final product should be handled carefully to minimize the IRS's opportunity to obtain information.

2. The IRS may subpoena an appraisal obtained by a taxpayer. See McKay v. U.S., 372 F.2d 374 (5th Cir. 1967). It also may attempt to obtain the

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work papers or preliminary reports done by the appraiser. In order to minimize the risk that the IRS would obtain the appraiser's work papers, the attorney can retain the appraiser rather than the client. Although it is not firmly established, if the appraiser is treated as a consultant to the attorney, his preliminary work arguably is protected by the work product doctrine. See Hickman v. Taylor, 329 U.S. 495 (1947); Fed. R. Civ. P. 26(b)(3).

CH2\18027461.2

ABA BRIEFING SERIES

2016 Trust and Estate Planning Briefing Series February – December 2016 ▪ 1:00–3:00 p.m. ET

The 2016 Trust and Estate Planning Series featured presenters are, Thomas W. Abendroth, partner, Schiff Hardin LLP and Charles “Skip” D. Fox IV, partner, McGuireWoods LLP. These nationally-recognized trust and estate attorneys and tenured teachers from the ABA Trust Schools will provide you and your staff with critical information on estate planning and trust administration topics. This series is an excellent business development opportunity; invite outside counsel to attend these informative programs at your location. Fiduciary Litigation Roundtable Thursday, May 5, 2016 – 2.5 CISP, 2.5 CRSP, 2.5 CTFA (FID), 2.0 CPEs for CPAs (Business Law), 2.0 CFP A panel of attorneys will discuss current trends in fiduciary litigation and how to minimize a trustee’s exposure. Topics will include: Current fiduciary litigation cases Diversification and Other Investment Disputes Keeping Beneficiaries Informed Decanting Closely-Held Assets in Trusts Charitable Tales from the Crypt Thursday, June 2, 2016 2.5 CISP, 2.5 CTFA (TAX), 2.0 CPEs for CPAs (Taxes), 2.0 CFP Frequent misuse of the charitable deduction, and the most recent errors made in charitable planning will be discussed during this briefing. Qualifying for the Estate Tax Charitable Deduction Qualifying for the Income Tax Charitable Deduction Avoiding the Imposition of Capital Gains on a

Charitable Foundation Problems with Private Foundations Challenges with Charitable Remainder Trusts Issues with Art and Other Collectibles in the Administration of Trusts and Estates Thursday, September 8, 2016 2.5 CTFA (INV), 2.0 CPEs for CPAs (Finance), 2.0 CFP Artwork and other tangible collectibles are unique assets that present many challenges to fiduciaries. Best practices in dealing with these unique assets and protecting their value in the trust and estate administration context will be discussed. Confusing Legal Environment of Local, State, Federal and

International Rules Verifying Authenticity and Good Title Limitations on Sales of Art such as Endangered Species

Restrictions and Cultural Heritage Limitations Rights of Artists Ways to Sell Art Securing Art Special Considerations with Collectibles such as Guns

Are You a Fiduciary? Thursday, October 6, 2016 – 2.5 CISP, 2.5 CRSP, 2.5 CSOP, 2.5 CTFA (FID), 2.0 CPEs for CPAs (Administrative Practice), 2.0 CFP The role of the fiduciary is far more complicated than it was 25 years ago. In the trusts and estates context, the fiduciary role is often now bifurcated in any number of ways. In the non-trust asset management context, fiduciary obligations have been greatly expanded. This session will discuss some of the major issues surrounding the fiduciary role in wealth management. Fiduciary Role in Trusts

o Co-Trustees o Delegation of Authority o Directed Trusts

Non-Trustee Fiduciary Roles in Trusts o Trustee Appointers and Removers o Trust Protectors o Distribution Committees

Fiduciary Roles under ERISA and New DOL Proposed Rules Fiduciary Roles for Investment Advisers Outside of ERISA Twenty Steps to Avoid Fiduciary Litigation Thursday, November 3, 2016 – 2.5 CISP, 2.5 CRSP, 2.5 CSOP, 2.5 CTFA (ETH), 2.0 CPEs for CPAs (Admin. Practice), 2.0 CFP The best defense against claims of a breach of fiduciary duty is to have procedures that prevent them in the first place. Best practices for minimizing claims will be discussed. Duty of Loyalty Steps to Take in Opening Relationships Steps to Take when Taking Over Another Trust Department Communications with Beneficiaries Fees Accountings Seeking Court Approval Recent Developments in Estate and Trust Administration Thursday, December 1, 2016 2.5 CISP, 2.5 CTFA (TAX), 2.0 CPEs for CPAs (Tax), 2.0 CFP A review of recent legislation, regulatory developments, cases, and public and private rulings in the estate, gift, generation-skipping tax, fiduciary income tax, and charitable giving areas will be provided. Some of the subjects to be discussed include: Marital Deduction Planning Portability Possible changes in the Estate Tax Laws

Valuation Issues Gifts The Availability of Discounts Charitable Planning Post Mortem Planning The Generation-Skipping Tax Asset Protection Insurance Fiduciary Income Tax Life Insurance in a 21st Century Estate Plan Aired: Thursday, February 4, 2016—Recording Now Available Recording eligible for 2.5 CRSP, 2.5 CTFA (Fin. Plan.) Life insurance products have become increasingly sophisticated and personalized. At the same time, the role of life insurance in estate planning has changed. This briefing will help listeners understand the role of life insurance in current estate plans. Reasons for having Life Insurance Types of Life Insurance and Specially Designed

Insurance Products Who Can Be Insured Private Placement Life Insurance Estate Tax Planning with Life Insurance

o Irrevocable Life Insurance Trusts o Qualifying the Payment of Premiums for the

Annual Exclusion Premium Financing

o Split Dollar Insurance o Third-Party Loan Arrangements

Uniform Fiduciary Access to Digital Assets Act (UFADAA) and Digital Assets Aired: Thursday, March 3, 2016—Recording Now Available Recording eligible for 2.5 CTFA (FID) The laws on the disposition of tangible and financial assets are well-defined and well-understood. By contrast, there is little uniformity or even agreement about the rights of persons to dispose of digital assets, and grant control over them to others. The current uniform law proposals, and planning options under current law will be reviewed during this program. Uncertain Current Federal and State Legislative Environment Different Approaches of Tech Industries and Estate, Trust,

and Financial Planning Professionals Uniform Fiduciary Access to Digital Assets Act Personal Expectations Afterlife and Choices Act Provisions in Wills, Trusts, and Powers of Attorney to Deal

with Digital Assets The New Paradigm in Trusts and Estates Valuation Aired: Thursday, April 7, 2016—Recording Now Available Recording eligible for 2.5 CISP, 2.5 CRSP, 2.5 CTFA (TAX) The estate planning community is waiting with nervous anticipation for expected new IRS regulations that are likely to impact the use of valuation discounts in estate and gift transfers, in particular for family owned investment entities. This briefing will discuss the new regulations and implications on estate planning. Topics to be discussed are:

Legal and Economic Basis for Valuation Discounts Past IRS Attempts to Regulate Discounts Section 2704 Rules and Application to Family LPs and LLCs New Valuation Regulations Planning Under the New Regulations Who Should Attend? Trust Officers Estate Planners Trust Counsel Trust Department Managers Wealth Managers

Private Bankers Trust Tax

Professionals Financial Planners CTFAs, CPAs, CFPs

Registration/Site License Fee PER Briefing Purchased

ABA/ICB Member/Service Member: $265 Non-Member: $395 Each registration entitles one registrant a single connection to the Briefing by Internet and/or telephone from one room where an unlimited number of participants can be present. Any transmission, broadcast, retransmission or re-broadcast of this event to additional sites/rooms by any means or recording is a violation of U.S. copyright law and is strictly prohibited.

Register Today! Register online at www.aba.com/briefings or call 1-800-BANKERS (1-800-226-5377). Continuing Education Credits? The Institute of Certified Bankers has approved each of these programs for continuing education credits. In addition, these briefings are eligible for CPE credits for CPAs and Certified Financial Planners credits—see descriptions for listing of approved credits.

American Bankers Association is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional educational on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: learningmarket.org.

Questions? Contact Linda Shepard at [email protected]. Or, call 1-800-BANKERS (1-800-226-5377).

http://www.aba.com/briefings


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