QTIP and non-QTIP asset aggregation for estate tax valuation purposes rejected.

In Estate of Mellinger, 112 TC No. 4 (1999), the Tax Court recently held that two minority interests in a corporation's common stock should not be aggregated to create a controlling interest for estate tax valuation purposes, even though the decedent owned 28% of the stock in a revocable trust and a qualified terminable interest property (QTIP) interest in another 28% block. The court rejected a control premium and instead allowed a 25% discount for lack of marketability as a minority interest for each stock block. Estate of Mellinger is a very important case, because it reduces estate taxes for decedents owning less than a controlling interest in family businesses.

Sec. 2031 provides that property specified in Secs. 2033-2044 is included in a decedent's gross estate at its fair market value (FMV) on the date of the decedent's death. Sec. 2033 includes all property to the extent of the decedent's interest in the property at death. Sec. 2038 includes revocable transfers made for less than FMV. Sec. 2044 includes property in which the decedent had a qualified life income interest and for which a marital deduction was allowed in the estate of the first spouse to die under Sec 2056(b)(7) (QTIP property).

Regs. Sec. 20.2031-1(b) defines FMV as the price a "willing buyer" would pay a "willing seller," both persons having reasonable knowledge of all the relevant facts and neither under compulsion to buy or sell. The willing buyer and willing seller are hypothetical persons; therefore, they do not necessarily have the same characteristics as an actual buyer and seller.

Prior cases have established that undivided fractional interests in property included in an estate have been valued at a discount to reflect lack of marketability and minority interests. Included are any undivided interests in real estate and noncontrolling interests in corporate stock. The IRS has opposed these discounts, arguing that a decedent's fractional interest should be aggregated with fractional interests owned by family members in the same property. The Service has based this position on the practical point that families are likely to cooperate and sell the fractional interests together rather than separately.

In Estate of Bright, 658 F2d 999 (5th Cir. 1981), the decedent owned a 55% control block of stock as community property with her husband. The Fifth Circuit held in an en banc decision that family attribution could not be applied in valuing the decedent's 27.5% interest, even though the owner of the other 27.5% interest--her husband--took control of the decedent's interest as executor of her estate and as trustee of a trust for their children under her will. The court emphasized that the ownership of the stock with her husband prior to her death and the identity of the legatee (the husband) are irrelevant, because the hypothetical seller of Regs. Sec. 20.2031-1(b) is "related to no one." In Propstra, 680 F2d 1248 (1982), the Ninth Circuit rejected aggregation in a similar community property case involving real estate. In Rev. Rul. 93-12, the IRS conceded that it would follow Estate of Bright and Propstra for gift and estate tax purposes.

In Estate of Bonner, 84 F3d 196 (5th Cir. 1996), all of certain real property parcels were included in the decedent's estate; therefore, the Service's aggregation position did not depend on the family attribution argument. The decedent had owned 50% to 63% of the parcels outright. The remaining ownership interests were held in a QTIP trust established by his wife, who died first, and were included in the decedent's estate under Sec. 2044. The Fifth Circuit, relying on its ruling in Estate of Bright, reversed the district court and ruled that Sec. 2044 does not require aggregation of Sec. 2044 assets with other estate assets. Although Sec. 2044 treats the QTIP assets as having passed from the decedent for estate tax purposes, the court concluded that neither the decedent nor his estate had any control over the disposition of the QTIP assets. Instead, the decedent's wife controlled the disposition of these assets in her will. The Fifth Circuit remanded the case to the district court to determine the appropriate fractional interest discounts.

Estate of Mellinger also addresses the aggregation issue in a QTIP context; however, the property at issue was common stock. Frederick and Harriett Mellinger, husband and wife, owned 56% of Frederick's of Hollywood (FOH) common stock as community property. At his death, Frederick left his 28% community property interest in the stock in a QTIP trust, with life income to Harriett and remainder to descendants and charities. His estate claimed a marital deduction for the QTIP trust. Harriett had placed her 28% community property interest in the FOH stock in a revocable trust (the Harriett trust). On her death, the Harriett trust shares were included in her estate under Sec. 2038, and the QTIP trust shares were included under Sec. 2044. Therefore, 56% of the FOH stock was included in her gross estate. (The Tax Court stated that the Harriett trust shares were included under Sec. 2033, but this did not affect the outcome of the case.)

Harriett's estate valued her shares and the QTIP shares at $4.79 each, which reflected a 31% minority interest discount per share from the appraised value for each 28% stock block. The Service aggregated both blocks of stock for valuation purposes, claiming they were both owned by Harriett's estate. Consequently, the IRS applied a control premium that resulted in a value of $8.46 per share and a resulting tax deficiency of over $10 million.

The Tax Court held that the two blocks of stock should not be aggregated and that, based on expert testimony, a 25% discount for lack of marketability as a minority interest should be allowed for each stock block. In its examination of the statutes, regulations and prior cases, the court found no support for aggregation. The court emphasized that, because neither Sec. 2044 nor its legislative history indicates that the estate of the second spouse to die is the owner of QTIP assets for aggregation purposes, the court would not apply aggregation. Also, the Tax Court agreed with Estate of Bonner that the second spouse to die has no control over the QTIP assets and, therefore, could not act as a hypothetical seller of the assets. Consequently, because Harriett's estate controlled only the 28% interest in the revocable trust, minority discounts could apply to each stock block. The Tax Court noted that if Frederick had left his 28% interest in the stock to Harriett outright, the two 28% blocks would have been aggregated for valuation purposes. Sec. 2044 produces different consequences, the court observed.

Many businesses are owned by a small number of individuals. To avoid a control premium and be eligible for a minority discount, the decedent's estate must not own a majority of the stock. In determining the amount of stock owned, the Service will follow Estate of Bright and not apply family attribution. If Estate of Mellinger is appealed and upheld, a QTIP interest in the stock in the estate of the second spouse to die will not be aggregated with stock otherwise owned by the estate. If the Ninth Circuit follows Propstra (as Estate of Bonner followed Estate of Bright in the Fifth Circuit), Estate of Mellinger will be upheld. At the appellate level, only the Fifth Circuit has ruled on the QTIP aggregation issue.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, AND CLAYTON R. SAGER, PH.D., ASSOCIATE PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI