How to Slash Gift, Estate, and Generation-Skipping Transfer Taxes: Part I
Good to Know
Your high net worth clients may have two seemingly contradictory goals: Reducing or eliminating gift, estate, and generation-skipping transfer taxes and maintaining control over their net worth. Why do these goals seem contradictory? We have bad news and good news. First, the bad news—the Internal Revenue Code requires that the value of any asset owned or controlled by a client at their death must generally be included in their Federal gross estate. Now, the good news—there are strategies available that simultaneously reduce transfer taxes and preserve significant control.
This blog is the first of a three-part series that includes:
- Part I: Reducing the IRS valuation (but not the real value) of Client Assets,
- Part II: Creative Use of Installment Sales and Specialized Trusts, and
- Part III: Using Annuities, Charitable Trusts, and Other Techniques.
Reducing the IRS Value of Client Assets
The IRS forces our clients to value gifts, bequests from an estate, and generation-skipping transfers at fair market value. For example, assume your client Sue owns 100% of the shares of ViralVeil, Inc., a privately held corporation valued at $100 million. There are 100 shares of voting common stock issued and outstanding. There are no other classes of stock. If Sue gifts 90 shares of voting common stock to her children, there will be two unwelcome results.
- She would incur gift taxes of over $24 million even if she is married and can use her husband’s gift and estate exclusion amount.
- She would lose control of the business.
This three-part blog series will demonstrate how to eliminate Sue’s transfer tax and maintain her control over the business. There are two caveats, however.
- This blog and the subsequent blogs in this series are intended to raise awareness and open a dialog, not provide specific guidance for specific clients. Consultation with an experienced estate planning professional is mandatory when discussing these issues with clients.
- These blogs are based on current law. At the time of this writing, there are attempts in Congress to eliminate or weaken several of the strategies we will discuss.
The first phase in reducing or eliminating transfer taxes in this series is Valuation Discounts. Two powerful examples are “lack of control” and lack of marketability” valuation discounts.
Lack of Control Valuation Discount
Picture this—your friend just offered a 99% Limited Partnership (LP) interest in her LP to you for $500,000. Her LP interests are not publicly traded. The partnership’s only asset is Amazon stock valued in the market at $505,051. Marie will keep a 1% General Partner’s interest in the LP. Would you rather pay $500,000 for a 99% LP interest or buy $500,000 in Amazon shares directly from the public market? The answer is obvious! You would have little to no control over your investment in the partnership because General Partners control LPs. You would have complete control over the Amazon shares if you owned them personally.
What is the point? Control has value. The odds are that even if you chose to buy LP interests from Marie, you’d pay less (potentially much less) than $500,000 because limited partners lack control. Next up is “lack of marketability.” The ownership of commonly used business forms such as corporations, partnerships, and LLCs can generally be structured as voting and non-voting interests.
Lack of Marketability Valuation Discount
There is no question that Amazon shares are marketable. You can turn the shares into cash just by logging on to your brokerage account and placing a sell order. Assuming your order is a market order, your shares would sell at the market price at the time the order was executed.
In sharp contrast, the LP interests in Marie’s LP are not marketable. Her LP interests are not publicly traded.1 Assume for a moment that you purchased LP interests from Marie for $500,000. Is it possible you’d have to reduce the price to sell your LP interests? It’s not only possible; it’s highly likely. Voila! Another valuation discount is born—the lack of marketability discount.
Next, how do valuation discounts help your client Sue?
Transfer Tax Impact of Valuation Discounts
Sue needs non-voting shares to take full advantage of valuation discounts. For the sake of example, assume she converts 90 of the voting shares into non-voting shares. Next, she gifts the 90 non-voting shares to her children. Further, assume that the appraiser she hires suggests a 20% discount for lack of control and a 20% discount for lack of marketability.2 This strategy reduces the valuation of her gift by $36 million, from $90 million to $54 million. The result is a gift tax savings of $14.4 million (40% gift tax rate). Refer to the chart below for the valuation calculation. Note that Sue still controls the company because she owns all of the voting common stock.
| $90 million | Value of the Gift with No Valuation Discounts |
| -$18 million | Less 20% Lack of Control Discount |
| -$18 million | Less 20% Lack of Marketability Discount |
| $54 million | Value of the Gift for Gift Tax Purposes |
Coming Attractions
Our next blog will illustrate how Sue can eliminate all transfer taxes on the transfer of the 90 non-voting shares to her children and still remain in control of the business.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide gift, estate, generation-skipping, or financial planning advice of any kind. An experienced estate planning attorney should advise clients in these transfer tax issues. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
1 However, certain Master Limited Partnership interests and Publicly Traded Partnership interests can be publicly traded if appropriately registered with the SEC.
2 An objective, professional appraisal of non-marketable assets is vital in defending the valuation discounts in case of an IRS challenge.
