Thursday, January 20, 2022
I recently concluded a five-part series on what I viewed as the “Top Ten” agricultural law and agricultural tax developments of 2021. There were many “happenings” in ag law and tax in 2021 which meant that there were still some significant developments that didn’t make the “Top Ten.” In yesterday’s article, I began discussing some of those. Today’s article continues with another important court decision in 2021 that just wasn’t quite big enough to make the “Top Ten” list.
The “Almost Top 10” of 2021, the second article in a series – it’s the topic of today’s post.
Estate Planning Mistake Costs Family Multi-Million Dollar Charitable Deduction
Estate of Warne v. Comr., T.C. Memo. 2021-17
Warne is yet another case that points out how skilled and knowledgeable estate planners must be to ensure that tax rules are clearly understood and properly accounted for in carrying out client goals. In Warne , improper planning reduced a charitable deduction for an estate by $2.5 million. The case involved the transfer to charity of majority interests in limited liability companies (LLCs) owning real estate, and the resulting reduction in the otherwise available charitable deduction for those interests.
What’s the issue? At its core, Warne involved the issue of the application of a control premium for ownership interests in entities. An estate tax valuation issue that has been battled in the courts and addressed by the IRS for over 60 years is whether a block of stock in an entity that carries with it control of the entity’s operating and dividend policy, corporate salaries and particularly the ability to compel the entity’s liquidation should be valued at a premium above the underlying asset value if offered to the public. See, e.g., Rev. Rul. 59-60, 1959-1 C.B. 242; Rev. Rul. 67-54, 1967-1 C.B. 269; Turner v. Comr., T.C. Memo. 1964-161.
Background. Assuming that a control premium applies to value a block of stock, should it be applied to stock that is split due to language contained in a decedent’s will, trust or other estate planning documents? The issue has arisen in the context of the marital deduction. In Estate of Chenoweth, 88 T.C. 1577 (1987), the decedent owned 100 percent of the stock of a corporation. He left 51 percent of the stock to his surviving wife. The Tax Court held that a control premium should be added to the amount passing to the wife – the marital deduction legacy. But it was not to be spread across 100 percent of the stock. The Tax Court determined that the value of the shares that passed to her should be valued with a control premium of 38 percent over the per share value of the same shares that were included in the decedent’s gross estate. The block of stock funding the marital deduction was valued as a separate block without regard to the context from which it was separated. As a result, the Tax Court applied a control premium to the block of stock that funder the marital deduction, and also applied a minority interest discount to the stock that funded the non-marital bequest.
Note: The principle of Chenoweth is this - where a transfer to a surviving spouse is unrestricted but is less that the decedent’s entire interest in property, the value of the interest passing to the surviving spouse is to be valued as a separate interest in property and not as an undivided portion of the decedent’s entire interest. Valuation, for purposes of the marital deduction, does not have to be the same as for purposes of the gross estate.
The IRS has applied the principle of Chenoweth in Priv. Ltr. Rul. 9050004 (Aug. 31, 1990) and Tech, Adv. Memo. 9403005 (Oct. 14, 1993).These IRS determinations involved the valuation of partial interests distributed to a surviving spouse or to a marital trust. In the 1995 private letter ruling, a qualified terminable interest property (QTIP) interest under a marital deduction formula will was funded with 49 percent of the stock in a closely-held corporation, with 51 percent passing to another trust. The IRS concluded that the stock funding the QTIP should be subject to a minority interest discount when determining the value of the marital deduction. The 1994 private letter ruling involved the valuation of a minority interest of closely-held stock that passed to the decedent’s surviving spouse. The IRS determined that, when valuing the decedent’s gross estate, the decedent’s stock was to be valued as a single interest, but when valuing the marital deduction, the value of the minority interest passing to the surviving spouse should reflect a minority interest discount.
Clearly, the same result obtained in Chenoweth and the private letter rulings could apply in the context of a charitable bequest. Indeed, this is what happened in Warne where it appears the estate planners drafted the client right into a costly trap.
Facts of Warne. In Warne, a married couple started investing in real estate in the 1970s, continuing to acquire properties during their remaining lifetimes. Their estate plan involved them transferring ownership of the properties to five separate LLCs. The LLCs also held various leased fee interests associated with the properties. In 1981, they created a Family Trust with the wife named as trustee. The Family Trust became the majority interest holder of the five LLCs. The husband died in 1999 and the wife in 2014 with the Family Trust included in her estate. In late 2012, the wife gifted fractional interests in the LLCs to her sons and granddaughters.
Upon the wife’s death, the Family Trust owned majority interests in each of the five LLCs. Remainder interests were transferred to the wife’s children and grandchildren as well as a sub-trust of the family trust. She also left 75 percent of her interest in an LLC that the Family Trust owned 100 percent of to the family charitable foundation. The remaining 25 percent was left to a church. Her estate valued the LLCs by applying discounts for lack of control and lack of marketability. The estate also claimed a charitable deduction for the full 100 percent value of the LLC interests donated to charity which matched the value of that LLC that was included in the decedent’s gross estate.
The IRS challenged the amount of the discounts and also reduced the charitable deduction because of the split donation of the LLC interests between the foundation and the church. On the valuation of the LLC interests, the Tax Court noted that the LLC operating agreements gave much control to the holder of the majority interest, including the power to unilaterally dissolve the LLC and appoint and remove managers. The Tax Court was inclined to allow no discounts, but the parties had stipulated that some discount for lack of control applied. Hence, the Tax Court determined that a lack of control discount of four percent should apply. The Tax Court also allowed a five percent discount for lack of marketability.
On the charitable donations, the Tax Court noted that the proper valuation focused on what the charities received. Because each charity received only a fractional interest in the LLC, the Tax Court reasoned that a discount should apply. The Tax Court accepted the parties’ stipulated discount of 27.385 percent for the 25 percent LLC interest donated to the church and a four percent discount for the 75 percent LLC interest donated to the charitable foundation. The effect of the discounts reduced the total charitable contribution by more than $2.5 million.
Implications. What was overlooked in Warne was the decades of caselaw and IRS rulings mentioned above indicating that a minority interest discount could likely apply to the transfer of what ultimately was passage of the entire estate to charity. The key to understanding the discount issue in the case is not what was transferred to the charity. It is in understanding what the charity received. The interests were split, with each charity receiving a minority interest, but with 100 percent of the decedent’s estate passing to charity. The court didn’t explain why the interests were split between the family foundation and the church, but the result of structing the estate plan that way didn’t work. That was very flawed estate planning. I doubt the client wanted it that way – there wouldn’t have been litigation if that were the case.
To maximize a charitable contribution deduction, full ownership in entities must be transferred to a single charitable beneficiary. The gifted interests should not be split. In Warne, the trust could have given a full 100 percent ownership interest in an entity to the foundation, and then some other interest or interests could have been given to the church.
When the matter involves the marital deduction, the estate plan should attempt to have both spouses in a minority position so that shares of stock applied to the marital deduction would be at the same value as the value of the stock in the decedent’s gross estate. When doing estate planning for a farmer/rancher (or other person) that holds majority control of a closely-held business (such as a farm or ranch), the goal is to shelter the full unified credit amount (currently $12.06 million) in a credit shelter trust while still obtaining the desired funding of the marital bequest (which carries out the marital deduction) from the other stock. To avoid underfunding the marital bequest, consideration should be given to issuing or recapitalizing enough non-voting stock to allow the marital bequest to be funded with voting stock, or have the marital bequest always receive a controlling interest.
Estate planning is very complicated when a closely-held family business is involved, such as a farm or a ranch. It will become even more complex if the Congress lowers the federal estate tax exemption, or simply does nothing. Simply by doing nothing, the exemption is set to fall to $5 million (in inflation-adjusted dollars) at the start of 2026. Thankfully, the estate tax and trust provisions proposed last summer did not become law. Will pieces of those proposals come back in 2022? Time will tell.
If the goal is to keep the family farm or ranch in the family as a viable economic operation in the hands of subsequent generations, don’t short-change estate planning.
I will continue the journey through other significant 2021 developments in ag law and tax next time.