HOW NOT TO OBTAIN A FRACTIONAL OWNERSHIP VALUATION REDUCTION

If more than one person owns a fractional interest in property, the sum of the value of each part may be less than the whole for transfer tax purposes. For example, if Bill and Mary own a parcel of land worth $1,000,000 as 50/50 tenants in common, at Bill’s death his interest is likely to be valued at less than $500,000 to reflect Bill’s lack of control and costs of partition.

In a recent Tax Court case, a decedent during his lifetime transferred 1/5 interests in his ranch to each of his five children. HOWEVER, he retained the “full use, control, income and possession” of the ranch during his lifetime. At his death, his estate sought discounts in value for lack of marketability and control based on the children’s fractional ownership.

Not so fast, opined the Tax Court. The entire value of the ranch was included in the decedent’s estate under Section 2036, due to the decedent’s retained lifetime interest in the ranch. The Court noted that in valuing property with a retained lifetime interest, the change in ownership is deemed to occur at the decedent’s death. Thus, for this purpose, the children did not own an interest prior to death, and their interests could not give rise to a fractional interest valuation reduction to the decedent.

This is consistent with how property is usually valued that is included under Code §2036. What is valued at death is the property transferred in the proscribed manner. Fidelity-Philadelphia Trust Co. v. Rothensies, 324 US 108 (1945). “The idea here is that for tax purposes it is appropriate to treat the lifetime transfer as the equivalent of a testamentary disposition, if the decedent postponed the real effect of the transfer until death (or for a related period) by retention of the income or use or control over who else should have the property.” Stephens, Maxfield, Lind, Calfee & Smith, Federal Estate and Gift Taxation (WG&L) at Paragraph 4.08 (2011). The rights in others that are effectively created at the death of the transferor thus should be ignored for valuation purposes. Otherwise, the gross estate inclusion policy of treating the transferor as having retained ownership during life so as to treat the transferred property as still owned by him or her for estate tax purposes would be thwarted.

While not discussed by the Tax Court, to have ruled otherwise would have opened a large hole in the estate tax regime. If a fractional interest discount could otherwise be obtained under these facts, taxpayers could achieve substantial estate tax savings via the simple expedient of creating lifetime transfers to beneficiaries with a retained life estate or usage. This case did involve a 1965 gift, one that predated Code §2702. Such a gift today of similar property would likely run afoul of Code § 2702, thus resulting in a gift of 100% of the transferred property (that is, without reduction of the value of the interest retained by the transferor). This would be a disincentive to such transfers today, absent structuring to avoid Code § 2702 - so the estate tax regime risks of a contrary ruling are probably not as great as one might expect at first.

If the fractional ownership discount is desired, a transferor could instead gift a direct (and immediately applicable) undivided interest in such property, without retained rights of control or benefits over the transferred portion in the transferor. This would allow for a fractional ownership discount both at the time of conveyance for gift tax purposes, and for the estate tax valuation of the portion retained by the transferor when he or she dies. If the transferor in such circumstances desires to retain the use and benefit of the transferred portion, he could instead rent it back from the donees for fair rental value and still preserve the transfer tax fractional discounts.

Interestingly, the Tax Court did not seemed bothered by the size or types of the discounts sought by the taxpayers - a 32% marketability discount and a 16% minority interest discount. Presumably, this was because it ended up rejecting all discounts by reason of applying Code § 2036. The Tax Court has continued to show hostility to large discounts in context of fractional undivided ownership interests. For example, in 2010 the Tax Court limited such discounts to loss in value relating to time and costs to sell property (as a method of partition), and costs relating to actual partition. Andrew K. Ludwick, TC Memo 2010-104. Therefore, even if the above-described path to discounts is followed via an inter vivos gift of an undivided interest, issues of the appropriate size of the allowed discounts remain.

ESTATE OF AXEL O. ADLER, TC Memo 2011-28 (January 31, 2011)