Now Is Time To Utilize Valuation Discounts for Gift and Estate Tax Savings
By Shelley Adams Drury, CPA, CVA, ABV, CFF
Partner and Director, Business Valuation and Litigation Support
As a valuation expert, I am often called upon by clients, estate planning attorneys, and other CPAs to provide my opinion as to discounts applicable to gifts of minority interests in limited liability companies (LLCs) and Family Limited Partnerships (FLPs).
LLCs and FLPs often hold real estate (commonly referred to as “holding companies”) and are often used as an estate planning tool to transfer wealth from one generation to the next by making annual gifts of minority ownership interests. These entities are controlled by operating agreements with varying degrees of restrictions, allowing the gifter to retain control of the entity and the assets while transferring value to the next generation.
The standard of value for gift and estate tax purposes is “fair market value”, generally defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
When gifts of minority interests are made in an LLC or FLP, valuation discounts are allowed by the Internal Revenue Service in determining the fair market value of the gifted interest. Accordingly, the values of minority ownership interests in these entities are lower than outright ownership in the assets held by the entity because of the restrictions contained in the operating agreement. The most common valuations discounts are discounts for lack of marketability and lack of control. These discounts typically range from 25% to 45% depending on several factors.
An opinion relative to the appropriate size of the discounts should be determined by a skilled valuation analyst based on an analysis of the assets held by the entity and the condition thereof, size of the interest being gifted, and restrictions outlined in the operating agreement. The restrictions usually significantly limit the power of minority interest holders to vote, participate in management, replace the manager(s), force distributions, liquidate assets, and transfer or sell their ownership interest.
The IRS allows an annual exclusion gift of $15,000 (nontaxable) per person, per gift. Many clients choose to make annual nontaxable gifts of $15,000 per recipient. Others make larger single or multiple gifts of minority ownership interests.
The examples that follow illustrate the benefits of having a good estate plan:
Scenario 1
Mom and Dad own an apartment building outright, valued at $1,000,000, with no debt against the property. They want to gift the property equally to their four children. They each make gifts of 12.50% to each of their two children, gifting a total 100% ownership interest (eight individual gifts of 12.5%). Under this scenario, the gifts would be subject at gift tax with eight gifts valued at $125,000 each. In total, the fair market value of the gifts is $1,000,000.
Scenario 2
Mom and Dad own the same apartment building with no debt against the property, but instead of owning the building outright, they place it in an FLP. An operating agreement is drafted by an attorney placing significant restrictions on the rights of minority partners. Mom and Dad each make gifts of 12.5% in the FLP to each of their four children, gifting a total of 100% in the FLP. Based on these restrictions in the operating agreement, the valuation expert performs and analysis and determines that a combined discount for lack of marketability and lack of control of 38% is appropriate to be applied to individual gifts of 12.5% in the FLP. Under this scenario, the gifts would be subject to gift tax with eight gifts valued at $77,500 each. In total, the fair market value of the gifts under Scenario 2 is $620,000, which is $380,000 less than the fair market value of the gifts in Scenario 1. Scenario 2 significantly reduces potential gift and future estate tax liability and allows Mom and Dad to execute their estate plan in less time.
If you already have an LLC or FLP in place and want to make gifts, now is the best time to get a valuation as to the appropriate discounts applicable to gifts of minority interest. Why? Because valuations are generally valid for six months, allowing clients to make gifts in two calendar years (December 31 of this year and January 1 of next) while only incurring the cost of a single valuation, saving thousands of dollars in professional fees.