Are We Nearing the Demise of
Valuation Discounts?
The issue of whether valuation discounts should be allowed for transfers of family-held interests has once again found its way into the spotlight.
The issue of whether valuation discounts should be allowed for transfers of family-held interests has once again found its way into the spotlight. On January 9, 2009, Representative Earl Pomeroy introduced a bill in the U.S. House of Representatives, cited as the “Certain Estate Tax Relief Act of 2009” or “H.R. 436.” Among other provisions with implications for the estate planning world, the bill proposes to eliminate valuation discounts for transfers of family-held interests related to non-business interests owned by entities. Similar proposals have been made before in Congress, in several of the Clinton Administration’s budget proposals and even by the Treasury Department under President Reagan, all to no avail. It remains to be seen whether conditions will be right in 2009 for what would be a significant change in the tax law.
At issue is the concept of fair market value as it applies to family-held interests. Federal regulations provide that the value of property for gift tax purposes shall be the fair market value of the property on the date of the gift. Fair market value is defined as the price at which the property would change hands between a willing buyer and willing seller, neither being under compulsion to buy or sell, and both having reasonable knowledge of relevant facts. Inherent in the premise of fair market value is the concept that a willing buyer would not pay as much for a minority interest as he or she would for a controlling interest. Additionally, the transferee could not easily sell his or her interest on an open market. The fair market value premise leads appraisers to consider discounts for lack of control and lack of marketability in the valuation of closely held interests.
H.R. 436 is targeted at preventing the use of family limited partnerships and limited liability companies, which often are not true operating businesses, for discounted transfers to younger family members. The bill proposes to:
- Eliminate discounts for lack of marketability related to non-business interests/assets in transfers of family-held interests. A non-business asset is defined as “any asset which is not used in the active conduct of one or more trades or businesses.” Non-business assets could include passive assets such as marketable securities, cash and cash equivalents, debt instruments, commodities, collectibles, certain royalty-producing assets, and passive real estate activities (i.e., where the transferor does not materially participate). Working capital is considered a business asset.
- Eliminate minority discounts (i.e., discounts for lack of control) related to the transfer of ownership interests in non-actively traded entities - even those conducting an active trade or business - where the transferee and members of the transferee’s family have control of the entity.
Not only does the bill seek to ignore the concept of fair market value in the case of family-held interests, it revives the related debate over aggregation of interests, which was addressed in Revenue Ruling 93-12. Under current rules, an appraiser must value the subject interest on a standalone basis, without regard to any potential common ownership existing in the entity. For example, an appraiser would value a five percent minority interest in a family limited partnership, considering relevant discounts for lack of control and lack of marketability, from the perspective of a hypothetical buyer of the five percent interest. The appraiser would not consider who actually owns the remaining 95 percent interest in the partnership. The proposed bill would force appraisers to consider common ownership (often reflective of control) in a family-held entity.
If passed, H.R. 436 would most likely become effective on the enactment date, although it is possible the bill would be applied retroactively. The bill has been referred to the House Committee on Ways and Means and to date there has been no indication of whether the bill is likely to pass or when it might even be considered. The legislation has been much discussed in the estate planning and appraisal communities. The American Society of Appraisers Governmental Relations has already met with senior staff on the Congressional Joint Committee on Taxation and the tax staffer for Congressman Pomeroy to express their opposition to the elimination of valuation discounts.
The uncertainty of the proposed legislation and the current economic downturn provide an impetus to consider family gifts or transfers in the next few months. Not only are asset values currently depressed, but studies such as one by FMV Opinions, Inc. have shown that discounts for lack of marketability have typically been 5 percent to 15 percent higher in periods of high market volatility. During periods of high volatility, investors naturally seek liquidity and illiquid asset prices exhibit greater discounts relative to their more liquid counterparts. The current market environment presents a unique, and perhaps limited, opportunity to take advantage of discounted asset values and valuation discounts for family transfers.
