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)

REPEAL OF 1099 REPORTING MAY COME TO FRUITION

The health care reform act including a provision that will require business owners to report to the IRS on Form 1099 all payments in excess of $600 each year. That provision was heavily criticized by business interests for the expensive and time-consuming reporting burden it would impose. Many gold bugs were/are convinced that this was an intentional effort by the government to be able to track their bullion purchases (as a necessary first step towards confiscation in the event of fiscal emergency).

Despite strong support for repeal, the repeal was held hostage to political interests, including possible stratagems to resisting repeal as creating an open door to the repeal of other provisions of the health care act.

On February 2, the Senate voted against the bill that passed the House of Representatives to repeal the health care act. However, it did approve, by a vote of 81-17, an amendment to the FAA Air Transportation Modernization and Safety Improvement Act that repeals the new Form 1099 reporting. The provision now has to go back to the House of Representatives. Hopefully, the House will pass a similar repeal and President Obama will not veto it, so that this burdensome requirement meets its end before its 2012 effective date.

As a political aside, it is interesting to note how the Form 1099 provision was enacted as part of health care legislation, and its repeal is part of air transportation legislation – two subjects that have next to nothing to do with tax reporting. In many states, the legislature is prohibited from legislating on more than one subject at a time. This provides the social benefit of avoiding the enactment of undesirable legislation in a vote because it is paired with or buried in legislation that enjoys broader support in the legislature or to evade a governor’s veto – a common legislative tactic. There are organizations lobbying for a similar federal prohibition on combining legislative subjects in one act – for example, if you are interested,  visit http://www.downsizedc.org/etp/campaigns/83.

BLACKWATER IS NOT PART OF THE ARMY

A recent Tax Court case is interesting, not because of the tax principles involved but because of its unusual subject matter.

In the case, the taxpayer worked for Blackwater Security Consulting (Blackwater), performing dangerous security work in Iraq that related to military operations. Blackwater is an organization that has garnered attention as something akin to a private army. The taxpayer sought to exclude from income his pay under Code Section 112. That provision excludes from gross income compensation received for active service as a member below the grade of commissioned officer in the Armed Forces of the United States while serving in a combat zone.

The Tax Court held that Code Section 112 did not apply since Blackwater is not part of the Armed Forces of the U.S. Prior case law had likewise held the inapplicability of Code Section 112 for a pilot employed by a private airline flying civilian aircraft under contract in support of the U.S. military in the Vietnam War, and for a merchant marine employee of a private company working on a U.S. naval ship in a combat zone.

Given the existing precedent, one would expect penalties to be applied against the taxpayer, and indeed the IRS did assess them. However, the Tax Court struck them down (other than an estimated tax underpayment penalty) since the taxpayer had reasonably relied on an IRS internal memorandum that erroneously described civilian personnel as being able to use the Code Section 112 exclusion.

Nathanial J. Holmes, TC Memo 2011-26