Posted on 05/06/2011 at 12:55 PM by David Repp
In a special report prepared in conjunction with a presentation at the University of Iowa College of Laws 2011 Spring Tax Institute, David Repp takes in in-depth look at estate planning considerations for farmers. Part 4 of 7, below, explores valuation discounts including the minority interest discount, the lack of marketability discount, and other valuation discount factors of special interest to farmers. Valuation Discounts Minority Discount Courts have long recognized that the shares of stock of a corporation which represent a minority interest are usually worth less than a proportionate share of the value of the assets of the corporation.1 The theory of the minority interest discount is that the owner of less than a majority interest in an enterprise cannot, alone, control day-to-day or long-range managerial decisions, affect future earnings, control efforts for growth potential, establish executive compensation, or compel a liquidation to reach the corporate assets. Because the owner of a minority interest lacks these benefits of control over the business, an acquirer of such an interest will pay less for it on a pro rata basis than for a controlling interest. Where the holder lacks the ability to exercise control over the operations of the enterprise, his or her interest may be worth significantly less than its "liquidation" value. In determining the size of the minority interest discount to be applied, it is a well-established rule that each case must take into consideration all the relevant facts and circumstances. The discount applied in other cases is not usually determinative of the proper discount to be applied in a given case. The Tax Court generally will not take into consideration the amount of discounts awarded in other cases.2 A crucial factor in establishing a minority interest discount is the bundle of rights possessed by the holder of the corporate or partnership interest. Such rights are based on a combination of applicable state law, corporate articles and bylaws, and the partnership agreement, as well as other rights and restrictions agreed to by the parties. In Moore v. Commissioner,3 the Tax Court examined in detail the rights of donees of gifts of general partnership interests to share in profits and losses, manage and control partnership assets, be paid salary, admit new partners, withdraw from the partnership, assign the interest, dissolve the partnership, and institute legal proceedings to resolve conflicts among partners. Moore provides an excellent analysis of the factors that must be addressed to support a minority interest discount and should be read closely by practitioners. Marketability Discount The lack of marketability discount is based on the fact that stock in a closely-held business enterprise is less attractive and more difficult to sell than publicly traded stock. Where an active trading market does not exist, other factors may be used as valuation benchmarks, and the lack of marketability discount becomes operative and applicable. Lack of marketability discounts relate to the inherent lack of flexibility in getting in and out of investments with no ready market.4 Unlike the discount for lack of control (the minority interest discount), the marketability discount can be applied in cases of gifts of more than 50 percent. In the Estate of Wildman,5 the Tax Court granted a ten percent discount on the decedent's interest in farm land partially for the reason that the farms were not contiguous properties. The court is essentially applying a marketability discount for the reason that contiguous farms are more marketable than small, noncontiguous farms. Clearly, this type of marketability argument would exist regardless of the size of the interest gifted.6 In most cases, however, the distinction between marketability discount and minority discount is blurred for the reason that the minority interests in closely-held businesses are naturally less marketable than controlling interests. Valuation Discount Factors of Special Interest to Farmers Absorption Discount. The concept of an absorption discount is that a reduction in price of an asset occurs by the sale of a large quantity of the homogeneous assets in a one-year period of time. In the context of farming, the asset is farmland. In Astleford v. Commissioner,7 involving a gift of a limited partnership interest, the Tax Court applied a 20 percent absorption discount to 1,187 acres of Minnesota farmland originally valued at $3,500 an acre. The Tax Court said that an absorption discount is a discount in the value of real estate if the sale of such real estate within a short period of time would reduce the price for which real estate otherwise would sell. A short period of time was considered to be a year. Essentially, the court said that flooding the local real estate market with 1,187 acres of farmland all in one year would require a price reduction of 20 percent to accomplish the sale. The Astleford case is important for another reason. The Tax Court applied the 20 percent absorption discount before it applied the regular minority and marketability discounts. The minority and marketability discounts were an additional 30 percent (combined). The Internal Revenue Service, in the distant past, has defended against an absorption discount when the facts suggest that there is no reasonable prospect for liquidation of the farmland. Estate of Andrews v. Commissioner, 79 T.C. 938 (1982). An absorption discount is much more difficult if the valuation method of an interest in a limited liability company or corporation is based on a capitalization of earnings method. An absorption discount would seem to be proper if the valuation method is based on the net asset value of the assets. Generally, for farm corporations and farm limited liability companies owning farmland, the net asset valuation method returns a higher valuation (even after application of an absorption discount) than the capitalization of earnings method simply because, historically, farming the land has not generated significant earnings. Chapter 9H. An important factor in qualifying for a large marketability discount is sale restrictions. Frequently, those sale restrictions reside in buy-sell agreements between the owners of the business entity. The more sale restrictions, the larger the marketability discount. Owners who are family members may be tempted to implement the most restrictive provisions possible in order to manufacture a larger marketability discount. However, Internal Revenue Code Section 2703 nullifies any such discount if the restrictions go overboard. Code Section 2703 provides that any restrictions on the sale and use of property, including interests in an LLC, are ignored for estate and gift tax valuation purposes8 unless:
- it is a bona fide business arrangement;
- it is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and
- its terms are comparable to similar arrangements entered into by persons in an arms' length transaction.