National Paralegal College

Using Entities in Estate Planning for Valuation Discounting

Larry D. Marsh, Esq.

Introduction

Q: When does 10% of $100 equal less than $10?

A: When it is a 10% interest in a limited liability company owning assets worth $100.

This article introduces valuation discounting as used in estate planning. It is not intended as an exhaustive, all-inclusive discussion of the subject, but rather as a presentation of certain concepts that apply in making valuation discounting a useful tool for estate planners. Although valuation discounting is also available for other types of property, such as partial ownership interests in real property, this article focuses on interests in entities because those provide the most planning opportunities. This article also intentionally omits any discussion of Chapter 14 of the Internal Revenue Code, saving that for a more advanced discussion of this subject.

Available Entities

The entities most commonly used are limited liability companies (LLCs) and “family” limited partnerships (FLPs), so-called because ownership is generally limited to members of one family. These entities lend themselves to valuation discounting because of inherent restrictions on the ownership interests, and additional restrictions that can be applied through agreements amongst the owners.

The Three “Lacks”

LLC and FLP interests are inherently subject to:

  1. Lack of Marketability. An interest in an entity that is not registered and readily tradable, e.g. stock in a publicly traded company, cannot be easily sold and converted to cash because there is no market for the interest.
  2. Lack of Transferability. Even if there were a market for the interest, a member of an LLC, or partner in an FLP, cannot readily transfer his or her interest because admitting a new member, or new partner, requires the approval of the other members or partners under state law. Additional restrictions on transfer are often imposed in the LLC operating agreement or FLP partnership agreement.
  3. Lack of Control. Perhaps the most important of the three “lacks,” it is also perhaps the most self-evident. An interest holder in an LLC or FLP cannot compel the entity to liquidate and pay out the value of his interest.

LLCs and FLPs lend themselves in estate planning to taking advantage of lack of control. In a corporation, the owner of the majority of voting stock always has control, and often a majority of the equity ownership as well. In an LLC or FLP, control can be, and often is, divorced from equity.

An LLC is controlled by a manager or managers, who may or may not be members. An FLP is controlled by its general partner or general partners. Managers, and general partners, do not have to be elected by a majority of members or limited partners; they can be named in the operating agreement or limited partnership agreement. An LLC member may own 99% of the equity, and have no control over the LLC because he is not a manager. Likewise, a limited partner in an FLP may own 99% of the equity and have no control because he is not a general partner.

This inherent separation of control from equity ownership allows using an LLC or FLP to gift away almost all of the equity value that would be included in a taxable estate, without relinquishing control of the underlying assets.

Discounting for the “Lacks”

Assume, for purposes of illustration only, that an LLC owns real estate worth $100. Member A, who is not a manager, owns a 10% interest in the LLC. If the LLC were to sell the real estate and liquidate, Member A would receive $10. This $10 is the “liquidation value” of A’s LLC interest, and provides the starting point for discounting.

Now assume that Member A wishes to gift his 10% interest to his daughter, X. Assume that the other members are also family and are willing to admit X as a member. In valuing this interest for gift tax purposes, assume that discounts can be applied as follows:

The math in applying these discounts looks like this:

Liquidation value$10.00
Minus: lack of marketability discount($ 1.00)
Subtotal$ 9.00
Minus: lack of transferability discount($ 0.90)
Subtotal$ 8.10
Minus: lack of control discount($ 1.62)
Discounted value of interest$ 6.48
Cumulative discount applied35.2%

“Leveraging” Annual Exclusion and Lifetime Exclusion Gifting

Discounting can be a very useful tool in designing a gifting program using either the annual exclusion1 or lifetime exclusion from gift tax, or both. Discounting takes maximum advantage of the annual exclusion and lifetime exclusion by allowing more interests to be transferred, and is faster when using the annual exclusion than would be possible using undiscounted values. Accelerated gifting transfers more future appreciation in value of the gifted property to the donee, further leveraging the usefulness of the gift tax exclusions.

Annual Exclusion Gifting; Example

Again, for purposes of illustration only, please assume:

  1. It is 2014, and the annual exclusion amount is $14,000.
  2. Blackacre LLC owns real estate valued at $100,000. The liquidation value of a 1% interest in Blackacre LLC is therefore $1,000.
  3. The same discounts apply as in the previous example:
    • For lack of marketability: 10%
    • For lack of transferability: 10%
    • For lack of control: 20%
    • The cumulative discount factor is 35.2%
  4. Member B owns 90% and is manager of Blackacre LLC, while Member Y, her son, owns the remaining 10% interest.
  5. Member B wants to use all of her available 2014 annual exclusion to gift additional Blackacre LLC interests to Y.

If we use liquidation value, the math is simple: B can gift 14% of the total interests, with a liquidation value of $14,000. Y will then hold 24% of the total interests, while B will hold 76%.

If we discount the value of the interests, however, B can give away 21.6% of the total interests. This is the simplified math:

Liquidation value of 21.6%$21,600
Minus: 35.2% cumulative discount($ 7,603)
Discounted value of 21.6%$13,997

The result being that Y now owns 31.6% of Blackacre LLC, while B mow owns 68.4%.

If B’s goal is to shift almost all of the equity ownership in Blackacre LLC to Y using the annual exclusion, using discounted values should shave a few years off of the time needed to complete the gifting.

Lifetime Exclusion Gifting: Example

The effect of leveraging gifts using discounted values is more pronounced when using the lifetime exclusion.

For purposes of illustration only, please assume:

  1. It is 2014, and the lifetime exclusion amount is $5,340,000.
  2. Whiteacre LLC owns real estate valued at $10,000,000. The liquidation value of a 1% interest in Whiteacre LLC is therefore $100,000.
  3. The same discounts apply as in the previous examples:
    • For lack of marketability: 10%
    • For lack of transferability: 10%
    • For lack of control: 20%
    • The cumulative discount factor is 35.2%
  4. Member C owns 90% and is manager of Whiteacre LLC, while Member Z, his daughter, owns the remaining 10% interest.
  5. Member C wants to use all of his available lifetime exclusion of $5,340,000 to gift additional Whiteacre LLC interests to Z.

Using liquidation value, C can transfer 53.4% of the total interests to Z. This would give Z 63.4% of the total LLC interests, and C would have the remaining 36.6%.

If we use discounted values, C can transfer 82.4% of the LLC interests. The simplified math:

Liquidation value of 82.4%$8,240,000
Minus: 35.2% cumulative discount(2,900,480)
Discounted value of 82.4%$5,340,000

This would leave C with only 7.6% of the total LLC interests, and Z would own the remaining 92.4%.

Determining the Applicable Discounts

How do you know your gift should receive discounts of 10% for lack of marketability, 10% for lack of transferability, and 20% for lack of control? The answer is that you don’t. The discount factors used in this article are representative, but not universal. You need a qualified appraiser of LLC and FLP interests to tell you, in writing, what discounts should apply.

Cautionary Notes

The Internal Revenue Service (IRS) is not a fan of valuation discounting. To take advantage, it is important to obtain a written appraisal from a qualified appraiser.

At IRS’s request, the Treasury Department has proposed legislation to do away with valuation discounting on several occasions, going back at least as far as the Clinton Administration. Although these proposals have not gained any traction in Congress to date, they are likely to be proposed again. The next time around, Congress may act on them. Or it may not. But future outlawing of the use of valuation discounts for estate planning purposes is a possibility that should not be ignored.

Lastly, if you fund your LLC or FLP with cash or marketable securities, instead of more illiquid assets such as real estate, the available discounts will be diminished.

Conclusion

Valuation discounting is a very useful tool in estate planning, but it should be employed carefully, with the help of a qualified appraiser.

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[1] For the annual exclusion to apply, the gifted LLC or FLP interest must qualify as a “present interest” in property. What that involves is important in drafting the LLC operating agreement or limited partnership agreement, but is beyond the scope of this article.