Lifetime giving remains a powerful planning tool for family business owners.

EXECUTIVE SUMMARY

Recent rulings and TAMs in the area of valuation of closely held stock for estate and gift tax purposes appear to indicate that taxpayers may gain an advantage by transferring such stock during life rather than at death. While a donor or a decedent may transfer, in total, a controlling interest in stock to the same number of recipients, a smaller gift tax valuation may result because of the application of a minority interest discount to the gifts that would not be applied to the bequests. This article examines a number of cases, rulings and TAMs and explains why the disposition of closely held stock during life may minimize valuation.

Of all closely held family businesses, roughly one-third survive to the second generation and only one-ninth survive to the third.(1) The most notable reason for this is the failure to plan for the confiscatory effect of the Federal estate and gift taxes.

Although the estate and gift tax is a unified system, subtle differences in the way each tax is imposed compel wealthy individuals to develop and implement a plan for the transfer of a large portion of their wealth during life. Such differences include the exclusion of gift tax paid more than three years from the date of death from the estate tax base(2); the Sec. 2503(b) $10,000 annual gift tax exclusion; the avoidance of estate tax on the appreciation in gifted property(3); and pre-death use of the Sec. 2010 (a) $192,800 unified credit.(4)

Rev. Rul. 93-12(5) highlighted another contrast in the Federal estate and gift taxes--under certain circumstances, property (including closely held stock) is valued differently (and more favorably) for gift tax purposes than for estate tax purposes. The IRS held in that ruling, a gift situation, that it would no longer attribute to an individual family member shares held by other family members in determining whether transferred shares should be valued as part of a controlling interest. Despite recent IRS attempts(6) to regain some of the ground relinquished in Rev. Rul. 93-12, significant opportunities remain for the owner of a closely held family business to plan for the disposition of stock during life so as to take advantage of this gift tax valuation benefit. This article focuses on Rev. Rul. 93-12 and the recently issued TAMs.

Defining "Value"

Sec. 2512 imposes a gift tax on the value of all lifetime, gratuitous transfers; Sec. 2031 imposes an estate tax on the value of property owned by an individual at death. Under Regs. Sec. 20.2031-1 (b) (estate tax) and Regs. Sec. 25.2512-2(a) (gift tax), "value" is the fair market value (FMV) on the relevant date. In turn, Regs. Sec. 20.2031-1 (b) (estate tax) and Regs. Sec. 25.2512-1 (gift tax) define FMV as 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 to sell and both having reasonable knowledge of the relevant facts ("willing buyer-seller standard").

Valuation Discounts and Premiums

Shares of closely held stock are generally not traded on the open market; thus, the value of such shares is not readily ascertainable. Rev. Rul. 59-60(7) sets forth factors and methods for valuing closely held stock; however, because there are litterally hundreds of factors and numerous valuation methods, a significant amount of valuation litigation has arisen between the IRS and taxpayers.

Regs. Sec. 20.2031-2 (f) (estate tax) and 25.2512-2 (f) (gift tax) indicate that the FMV of closely held stock depends on a number of factors, including the degree of control represented by the block of stock to be valued. As a result, closely held stock may be assigned different values depending on the extent of control it represents.

For example, if a block of stock represents less than 50% of the voting interests in a corporation, the per share value of the stock will be less valuable than the per share value of a controlling block in the same corporation.(8) The difference in the per share value of each block can be attributed to a minority interest discount (MID) accorded to the noncontrolling block and a control premium (or the lack of a MID) accorded to a controlling block. The theory is that the controlling block has a greater opportunity to realize its pro rata share of the entity's assets (through dictating corporate policy, payment of bonuses, salaries, etc. than does the noncontrolling block, and is thus more readily marketable.(9) Both MIDs and control premiums are economic realities well documented in the case law.(10)

Estate Tax Valuation vs. Gift Tax Valuation

For estate tax purposes, the value of closely held stock depends on, among other things, what the decedent owned at the time of death (e.g., a controlling or noncontrolling interest). Except for marital and charitable deduction purposes, the number of legatees and the sizes of the blocks into which the stock is divided under the estate plan are irrelevant.(11)

In contrast, for gift tax purposes, the value of closely held stock transferred during life depends on, among other things, what the donee receives (e.g., a noncontrolling or controlling interest). If gifts of stock are made to a number of donees, each gift will be considered separately in determining the value received by each.(12)

In Letter Ruling (TAM) 9449001,(13) the Service recognized the different focus of each tax, stating that, unlike the estate tax, which is imposed on the aggregation of all the decedent's assets, the gift tax is imposed on the value of the property passing from the donor to each donee. The value of the property passing from the donor to the donee is the basis for measuring the tax. Accordingly, the value of property that is the subject of several gifts may differ from the value it would have if it were instead included in the donor's gross estate at death. (14)

Thus, the Service has apparently accepted the fact that value for gift tax purposes may be less than that for estate tax purposes. For example, if an individual died holding a controlling interest in a closely held corporation, the value of that interest for estate tax purposes might be subject to a control premium (or be denied a MID), resulting in a higher tax than necessary. On the other hand, if that person divided that controlling interest into several minority blocks and transferred them during life to the same recipients, the value of the transferred interests might be reduced by a MID, resulting in a smaller transfer tax. The result is that the value of the interests transferred during life is less than the value of the same interests transferred at death. The conclusion to be drawn is that greater wealth can be transferred through lifetime gifts than through bequests.(15)

Pre-Rev. Rul. 93-12 Use of MIDs

Prior to the issuance of Rev. Rul. 93-12, despite a majority of pro-taxpayer cases, the IRS's position was that MIDs would never be allowed on gifts of minority interests in closely held corporations if, after the transfer, control remained in the family. For example, in Rev. Rul. 81-253,(16) the Service articulated this "unity of ownership" theory as follows:

[O]rdinarily no minority discount will be allowed with respect

to transfers of shares of stock among family members where, at

the time of the transfer, control ... of the corporation exists in

the family. However, when there is evidence of family discord or

other factors indicating that the family would not act as a unit

in controlling the corporation, a minority discount may be

allowed.

The Service rejected Regs. Sec. 25.2512-1 (b)'s willing buyer-seller standard and refused to consider each gift separately in determining value. Thus, in family business situations, the Service incorrectly valued transferred interests for gift tax purposes by valuing them the same way as for estate tax purposes--by looking at what the donor transferred versus what each donee received.

Rev. Rul. 93-12

After a number of court defeats,(17) the IRS conceded the failure of the unity of ownership theory in Rev. Rid. 93-12. In that ruling, a parent owned 100% of the stock of a corporation and made simultaneous gifts of 20% interests to each of his five children. The IRS conceded that a MID for each gift should not be disallowed "solely because the transferred interests, when aggregated with interests held by family members, would be a part of a controlling interest." In effect, the Service accepted the willing buyer-seller standard and agreed to value each gift separately. This is the correct methodology, because if a minority interest is given, it should be entitled to a MID.

Post-Rev. Rul. 93-12 Use of MIDs

Transfer of Control During Life

In Rev. Rul. 93-12, the Service did not state that a MID would be allowed, just that it would not be disallowed solely because of family control. Nor did the Service articulate how value would be determined if the 20% gifts were made over a number of years, rather than simultaneously. In Letter Rulings (TAMs) 9436005(18) and 9449001, the Service attempted to answer these questions, and in the process, positioned itself to regain some of the ground relinquished in Rev. Rul. 93-12. These TAMs show how the Service will attempt to lessen a MID when control is transferred within the family during life; however, they also show that significant planning opportunities remain.

Swing vote premium: TAM 9436005 advanced the valuation questions raised by Rev. Rul. 93-12. In the TAM, the donor, who owned 100% of the stock of a family business, transferred 5% to his wife and 30% to each of his three children. The IRS stated that it would value each gift separately, but would reduce a claimed 25% MID and lack of marketability discount because each 30% block carried a "swing vote" opportunity that required a valuation premium. The swing vote premium reflected the fact that each donee had the ability to combine with any other donee to exert control. With respect to the issue of value if the 30% blocks were transferred in different years, the IRS ruled that the second gift of a 30% block would carry a swing vote premium and cause the value of the first gift of 30% to be indirectly increased. This would constitute another gift to the first donee at the time of the second gift.

No premium: TAM 9449001 involved essentially the same facts, except that the donor's 1 1 children were the donees. The IRS again stated it would value each gift separately. However, it made only passing reference to swing vote considerations, presumably because five other children would have to combine with a sixth to exert control, making any control premium de minimis at best.

The significance of TAMs 9436005 and 9449001 is threefold: [] First, the IRS recognized that, for gift tax purposes, value is determined by the interest received by the donee (e.g., minority interest) rather than the interest transferred by the donor e.g., controlling interest). Thus, the valuation starting point is the discounted value of the minority interest, to which is added a slight premium to reflect the ability to combine with others to exert control. [] Second, if TAMs 9436005 and 9449001 are any indication, the swing vote premium should almost always be smaller than the MID.(19) TAM 9449001, in particular, highlights the opportunity to mitigate or avoid the swing vote premium through proper planning--the greater the number of shareholders needed to exercise control, the smaller the swing vote premium that can be imposed. At least in the IRS's view, this opportunity was not available prior to the issuance of these TAMs. [] Third, the IRS made an unsupported claim in TAM 9436005 that if the gifts were made over a number of years, the transfer of control would constitute an indirect gift to the prior donee by the creation of swing vote characteristics in the already transferred stock. By making this claim, the Service is either evidencing a total lack of understanding of the willing buyer-willing seller standard (which it embraced in the TAMs), or is intentionally revisiting a quasi-unity of ownership theory (that it discarded in Rev. Rul. 93-12). Using the willing buyer-seller standard, taxpayers should be successful in challenging the deemed gift to a prior donee.

Origin of swing vote premiums: Like the unity of own theory the IRS employed prior to the issuance of Rev. Rul. 93-12, the swing vote premium has not been widely recognized.(20) However, unlike the unity of ownership theory, the swing vote premium is based on the Regs. Sec. 25.2512-1 (b) willing buyer-seller standard. In Est. of Bright,(21) the IRS unsuccessfully tried to impose a control premium on the decedent's undivided one-half interest in a 55% block of stock held as community property. The Fifth Circuit held that family attribution was not applicable for estate and gift tax valuation purposes. In discussing and rejecting the IRS's swing vote premium argument, the court stated:

The "willing buyer-seller" rule renders irrelevant only the real

seller and buyer, not the other stockholders. Thus, while the identities

of decedent, the decedent's estate and the decedent's legatee 

are irrelevant, the remaining stockholders in the corporation

are not hypothetical. Thus, the government argues that such

facts are among the "relevant facts" of which the hypothetical seller and

buyer have knowledge.(22) (Emphasis added.)

In Est. of Winkler,(23) the decedent owned 10% of the voting stock of a closely held corporation. The balance of the voting stock was owned 40% by other members of the Winkler family and 50% by members of the Simmons family. The Tax Court recognized that the decedent's block constituted a minority interest; however, because neither family possessed control, the decedent's minority block had special characteristics that enhanced its value. The court described these swing vote characteristics as follows:

Looking at this even split between the two families, the 10%

block of voting stock in the hands of a third party unrelated to

either family, could indeed become critical. While it is difficult

to put a value on this factor, we think it increases the

value of die Class A voting stock by at least the 10% that [the

IRS's] ... appraisers found. (Emphasis added.)(24)

Thus, despite the differences in valuation methodology between the estate tax (e.g., what the decedent owns) and the gift tax (e.g., what the donee receives), the swing vote premium analysis (i.e., the holdings of other shareholders, whether or not related to the donor) adds an additional factor to consider in each case.

Transfer of Control in Contemplation of Death 

TAM 943200125 exemplifies the results that can occur when lifetime transfers are properly planned. Issued less than three weeks after TAM 9449001, TAM 9432001 involved a father who died owning 48.59% of the stock of a family corporation. The remaining 51.41 was held by his son. The father bequeathed all of his stock to the son. The Service ruled that the son's interest was not to be aggregated with the father's; therefore, the estate was entitled to a MID. There was no discussion of a swing vote premium to reduce the MID, which is correct because the son already had control. A hypothetical buyer would recognize that the son would have to part with some of the control before the father's interest could be subject to a premium. Stockholders do not generally part with control voluntarily and an assumption to the contrary solely to impose a valuation premium would have been incorrect. Of course, assuming the father had control during his life, it would have been difficult to have transferred control to the son during life without incurring a swing vote premium.

In contrast, Est. of Murphy(26) and TAM 9504004(27) highlight the dramatic effect of not planning lifetime transfers of control. According to those rulings, if a deathbed transfer is needed to take advantage of the gift tax valuation benefit, the Service will most likely be successful in disregarding the transfer and disallowing the discount.

In Murphy, the decedent controlled 51.41% of the stock in a family corporation. Eighteen days before her death, she transferred 0.88% of the stock to each of her two children, leaving her with a 49.65% interest. She remained chairman of the board after the transfers. The Tax Court denied a MID for the 0.88% gifts and on the 49.65% included in the decedent's estate. The court concluded that the transfer was made solely for tax purposes and that nothing of substance had changed.

In TAM 9504004, the decedent had transferred 30% of her stock to her son for an annuity and had her remaining 30% redeemed by the corporation. The transfer and the redemption occurred less than one month before death and five months after the decedent had been diagnosed with cancer. Under very complicated facts, the Service collapsed the transfers and treated the decedent as having transferred her entire interest to her son simultaneously, thereby disallowing any claimed MID.

Transfer of Control at Death

In addition to the inability to fragment interests at death (and thus losing out on MIDs), TAM 9403005(28) shows how devastating a testamentary transfer of control can be. In the TAM, the decedent died owning controlling blocks of voting common stock and nonvoting preferred stock. He bequeathed the common to a credit shelter trust and the preferred to his surviving spouse. The Service and the estate agreed that the per share value of each block was higher when they were valued together than when valued separately reflecting the voting power of the common. Citing Regs. Sec. 20.2031-2(a), the Service concluded that both blocks would be included in the gross estate as a single controlling interest; but, citing Regs. Sec. 20.2056(b)-4(a), the Service concluded that the preferred stock passing to the surviving spouse would be treated as a separate minority block at the lower per share value for marital deduction purposes. This "double-edged sword" results in an underfunded marital deduction, creating an unnecessary estate tax at the first spouse's death, without any opportunity for a valuation discount for estate tax purposes. TAM 9403005 illustrates that the Service will exploit the valuation discount when it is beneficial for it to do so.

Additional Considerations

[] MIDs are not new, nor are they controversial.(29) Therefore, practitioners should not hesitate to use them when appropriate. [] Protections afforded to minority shareholders and trust beneficiaries under state law may lessen the size of a MID.(30) [] Because the amount of a MID turns on the facts, seeking the assistance of a competent tax adviser and a qualified appraiser is highly recommended. [] Valuation discounts can be enhanced when used in conjunction with other techniques, such as family limited partnerships, grantor retained annuity trusts, charitable remainder unitrusts and nonvoting stock recapitalizations. [] Valuation discounts also apply to assets other than stock.(31) Consider splitting ownership of such other assets to obtain the same benefits. [] Where possible, split ownership and control between spouses so that neither has control at death and underfunding the marital deduction can be avoided. In addition, structure each spouse's estate plan so that neither acquires absolute control after the first death.

Conclusion

In Rev. Rul. 93-12, the Service finally formally recognized that gifts of closely held stock among family members should be valued separately. This was seen as a capitulation by the Service on the MID issue. However, in recent TAMs, the Service has tried to limit this opportunity by imposing a swing vote premium, collapsing transfers made in contemplation of death and exploiting the discounts in marital deduction scenarios. Nonetheless, it is still possible to obtain a MID on lifetime transfers. As a result, the closely held family business owner has been given a significant opportunity to avoid Federal estate and gift taxes and to give the business its best chance of surviving to the next generation. However, these benefits are only available through proper lifetime planning and implementation.

(1.) American Family Business Survey 1995 (Arthur Andersen & Co., S.C., 1995). (2) See Sec. 2035(c). (3) See Sec. 2033. (4) However, both Section 6351 (a) of H.R. 1215 and Section 12032 of S. 1357 contain provisions to increase the unified credit to $248,300 over a phase-in period with indexing thereafter for inflation. See the Conference Report on H.R. 2491, The Seven-Year Balanced Budget Act of 1995, 104th Cong., 1st Sess. 76 (1995). (5) Rev. Rul. 93-12,1993-1 CB 202. (6) See IRS Letter Rulings (TAMs) 9432001 (3/28/94), 9436005 (5/26/94), 9449001 (3/11/94) and 9403005 (10/14/93). (7) Rev. Rul. 59-60, 1959-1 CB 237. (8) According to Todd and Hemphill, "Valuation of Corporate Stock," 831 TM., p. A-30, in most situations, more than 50% of the voting shares is a controlling interest, and less than 50% is a minority interest. If state law requires a greater percentage vote for corporate liquidation, and liquidation control is considered significant, then the higher percentage may be relevant. Similarly, if the corporate charter provides that a higher percentage is required for major corporate decisions, presumably, that higher percentage will be necessary to constitute a control block. (9) Id., p. A-29. See Regs. Secs. 20.2031-2(e), (f) and 25.2512-2(e), (f). (10) See, e.g., Mildred Myers Cravens, 10 F Supp 94 (S.D. Cal. 1935)(15 AFTR 452, 35-1 USTC [paragraph]9181); Est. of Joseph E. Salsbury, TC Memo 1975-333. Although there are other bases for valuation discounts (e.g., lack of marketability), this article focuses on MIDs. (11) See, e.g., Ahmanson Foundation, 674 F2d 761 (9th Cir. 1991)(48 AFTR2d 81-6317, 81-2 USTC [paragraph] 13,438). (12) See, e.g., Est. of Charles W Heppenstall, 8 TCM 136 (1949), and Harris Whittemore, Jr. v. Fitzpatrick, 127 F Supp 710 (DC Conn. 1954)(47 AFTR 77, 1954-2 USTC [paragraph] 10,976). (13) IRS Letter Ruling (TAM) 9449001, note 6. (14) The Service also noted that the phrase "separate gifts" in Regs. Sec. 25.2512-2(e) (gift tax) is missing from Regs. Sec. 20.2031-2(e) (estate tax), thus underscoring the different focus of each tax. As is discussed in the text below, this represents a reversal by the Service when compared, for example, to its position in IRS Letter Ruling (TAM) 8010017 (12/6/79), in which it cited Est. of Charles Henry Sanford, 308 US 39 (1936) (23 AFTR 756, 39-2 USTC [paragraph]9745), and H.R. 94-1380, 94th Cong., 2d Sess. 11 (1976), 1976-3 CB (vol. 3) 745, for the proposition that there is congressional intent for equal tax bases for lifetime and death-time transfers of the same amounts of wealth. (15) This conclusion must be tempered by the loss of the step-up in tax basis resulting from a gift. (16) Rev. Rul. 81-253, 1981-1 CB 187, revoked by Rev. Rul. 93-12, note 5. (17) See, e.g., Est. of Mary Frances Smith Bright, 658 F2d 999 (5th Cir. 1981) (48 AFTR2d 81-6292,81-2 USTC [paragraph]13,436);John A. Propstra, 680 F2d 1248 (9th Cir. 1982) (50 AFTR2d 82-6152, 82-2 USTC [paragraph]13,475); Est. of Woodbury G. Andrews, 79 TC 938 (1982). See also Vorsatz and Woodson, "`Swing Vote' Attributes of Transferred Stock," 26 The Tax Adviser 519 (Sep. 1995). (18) IRS Letter Ruling (TAM) 9436005, note 6. (19) 1f that is the case, making lifetime gifts will always be more tax efficient than making bequests. In TAM 9436005, note 6, the Service cited Est. of Winkler, TC Memo 1989-232 (in which the swing vote premium negated the discount), and offered an example of a 2% interest sold at a premium to one of two remaining 49% shareholders. With proper planning, it is possible to avoid the situations presented in both the TAM and Winkler. (2O) See Est. of Bright, note 17. (21) Id. (22) Id., 81-2 USTC at 88,814. (23) Est. of Winkler, note 19. (24) Id., at 57 TCM 381. (25) IRS Letter Ruling (TAM) 9432001, note 6. (26) Est. of Elizabeth B. Murphy, TC Memo 1990-472. (27) IRS Letter Ruling (TAM) 9504004 (10/20/94). (28) IRS Letter Ruling (TAM) 9403005, note 6. (29) For example, the Conference Committee Report on the Revenue Reconciliation Act of 1990 (RRA '90), which created the Chapter 14 special valuation rules, provides that the ability to use discounts was not affected by the RRA '90. See RRA '90 Statement of the Managers (Oct. 27, 1990), p. 157. (3O) See Est. of William F Luton, TC Memo 1994-539. (31) See Nancy N. Mooneyham, TC Memo 1991-178 (fractional interest in real estate); John R Moore, TC Memo 1991-546 (partnership interests).