Article on Achieving Horizontal Equity Through Estate and Gift Tax Reformation of Valuation
Imagine a primitive societyin which people store gold nuggets in bags. Neither buyers nor sellers ofnuggets care what color the bags are because the value of the nuggets is setsolely by their weight and purity. The only time anyone cares about the colorof the bag is at death, because for purposes of the estate tax, the governmentassigns nuggets stored in red bags a much lower value than nuggets stored inany other color bag. This means that decedents who have stored their nuggets inred bags will owe substantially less tax than those who have used any othercolor.
The red bag discount flies in the face of economic reality because thecolor of the bag does not change the value of the nuggets. It also violates theprinciple of horizontal equity, which requires that similarly situatedtaxpayers pay the same amount of tax. For any given level of revenues, the redbag discount means that the rate of tax levied on nuggets stored in any othercolor bag must be higher than it otherwise would be. This leads to grossinequity: those who are well-enough advised to store their nuggets in red bagswill pay less than their fair share of the total tax and all others will paymore than their fair share.
In the United States today, family limited partnerships (“FLPs”) are the red bags. The minority and marketability discountsgranted for estate and gift tax to interests in FLPs are as out of touch with economic reality and as unfair as the red bag discount of the hypothetical society.
To illustrate this point and see the inequities it engenders, consider the case of three taxpayers, each of whom has three children and owns $10 million worth of Google stock that she wishes to transmit to her children. Taxpayer A gives the shares directly to her children or leaves the shares to them in her will. Her gifts or estate will be valued at $10 million. Taxpayer B creates an FLP to which she contributes the stock and leaves the interests in the FLP to her children in her will. Her estate will be granted a marketability discount on grounds that an outsider buyer would not pay net asset value for interests in the FLP because the lack of a market for those interests makesthem illiquid, and buyers prefer liquid assets. The discount will be granted even if the FLP immediately distributes the Google shares to the children or sells them for $10 million and distributes the cash to the children. Taxpayer C contributes her Google shares to an FLP and gives one-third interests in the FLP to each of her children. In addition to a marketability discount, she will be granted a minority interest discount on grounds that the value to an outsider of a one-third interest in an FLP isreduced by being a minority partner who has no control over the FLP. Again, the discounts will be granted even if the next day the FLP distributes the Google shares or sells them and distributes the cash.
Taxpayers A, B, and C each give their children stock worth $10 million, which they can easily and quickly turn into $10 million in cash. There is no difference in the value of what is transmitted and received in the three cases. Yet they are treated very differently for estate and gift tax purposes, in flagrant violation of the principle of horizontal equity. In a typical recent case, for example, a family limited partnership that held $1,163,015 in cash and marketable securities and no other assets was valued at only $788,059 for estate tax purposes after minority and marketability. The issue is not a small one. In 2004, over half of all the discounts on estate tax returns were claimed for FLPs.
These bizarre results are the product of the formalism with which thecourts have approached the problem of valuing FLPs. They have focused on theTreasury Regulation’s definition of value as “fair market value,” that is, “theprice at which the property would change hands between a willing buyer and awilling seller, neither being under any compulsion to buy or to sell and bothhaving reasonable knowledge of relevant facts.” The “willing buyer” and “willing seller” in thedefinition, courts have insisted, are hypothetical persons who are unrelated toeach other. On the basis of these definitions, courts have valuedinterests in FLPs by inquiring what an outsider would pay for them. They have concluded that an outsider would require a steepdiscount from the value of the assets, because he would own a minority interestin the FLP and because there is little or no market for interests in the FLP.
It is true that if an outsider were to purchase an interest in an FLP,he would require a discount for the reasons the courts give. In fact, however,interests in FLPs are never sold to anyone outside the family. They are “specifically designed to be given away duringlife or at death . . . .” Subsequently, they are either liquidated, redeemed, ortransferred among family members. The holders of the interests are always related parties,not outsiders. What is bought and sold in transactions with non-familymembers are not the interests in the FLP but the underlying assets. For these reasons, “the notion of fair market value,premised on a voluntary arm’s-length exchange [between unrelated parties], isprofoundly unrealistic” when applied to FLPs.
The reasons given in the organizational documents for theformation of FLPs often include liability protection, succession planning, andcentralization of investment decisions. In a few cases, non-tax purposes may actually matter tothe people who form the FLPs. Three-fourths of all the assets held by FLPs,however, consist of cash, marketable securities, and real estate, and “there is usually little reason to put marketablesecurities in an [FLP] except for the discounts.” My point, however, is not that FLPs should not give riseto discounts because they are tax-motivated. It is, rather, that placing assetsin an FLP should not give rise to discounts because it has no more effect onvalue than placing gold nuggets in a red bag.
The IRS has made numerous attempts to curb this abuse, both by attributing the interests held by one familymember to other family members in a manner similar to what this Articleproposes and by applying various statutory provisions. One of its more interesting approaches involved finding agift on creation of the family limited partnership. The courts have, however, frustrated all these effortsexcept in cases where the taxpayers were poorly advised or excessively greedy. The weight of precedent in this area is so great that itis extremely unlikely that these abuses can be curbed without legislation.
This Article suggests legislation to bring estate and gifttax valuation of assets held by FLPs back in touch with economic reality. Itproposes using family attribution to deny minority discounts for entitiescontrolled by members of a family. It further recommends disallowingmarketability discounts for family-controlled entities that do not conduct anactive trade or business. These measures would restore a measure of horizontalequity to estate and gift taxes, in addition to making the tax system moreeconomically efficient by eliminating the incentive to spend money to form,operate, and wind up entities that generally have little utility other thantheir ability to reduce taxes.
Part I provides essential background on the valuation of closely heldbusinesses. Part I.A gives an overview of the process of valuing a business asa whole, focusing especially on how it applies in the estate and gift taxcontext. Part I.B explores control premiums and minority discounts. Part I.Cexamines the marketability discount. Part II.A discusses minority discounts asapplied to FLPs and proposes legislation to disallow them through familyattribution. Part II.B explores marketability discounts as applied to FLPs andproposes legislation to deny them where the FLP does not conduct an activetrade or business.