July 19, 2005
Given the budgetary constraints facing congress, it appears unlikely that the federal estate tax will be permanently repealed in the near future. In addition, the value of real estate has risen very rapidly in the last few years and has thus become among the most significant assets in many people’s estates.
This structure was generally put into place to reduce the value of the assets for estate tax purposes through the use of valuation discounts for lack of marketability and for lack of control. In a series of recent cases, the IRS has attacked the claimed valuation discounts. It is vital that anyone holding interests in property through FLPs review and potentially revise their organizational documents to defend against this IRS line of attack.
The value of any interest in real estate owned by a decedent at the time of their death is included in the decedent’s estate for estate tax purposes. The value of an asset is defined by the IRS as the amount a willing buyer would pay a willing seller with both being knowledgeable of the relevant facts and circumstances and neither being under a compunction to buy or sell. This value can be greatly impacted by the form of the ownership of the asset. Assets owned individually would be valued at the full fair market value of the asset, whereas the value of assets held through an entity may be subject to discounts for lack of marketability and for lack of control. These discounts can often exceed 50% of the fair market value of the underlying property. The magnitude of the relevant discounts used to determine the fair market value depends on a variety of factors including earnings and distribution history, the existence of a readily available market for the interests and the respective rights under the agreements and state law for the minority owner to demand distributions, expectations regarding sales of the underlying assets or dissolution of the entity. A factor in determining the discounts used to value interests in entities is whether the interest has voting rights or is nonvoting. Nonvoting minority interests that have little or no control rights under state law are valued at substantial discounts.
Many FLPs were formed to specifically take advantage of these discounts and created nonvoting limited interests as part of their structure to maximize the available discounts for gift and estate tax purposes. In a recent trend in the courts, the IRS has been able to use the control features retained by the founders of these types of entities to pull back the full value of the property into their estates. In these cases the decedent had retained the sole voting authority over the entity that held the property. This triggered a provision in the estate tax law which deals with the inclusion of property in the estate where the decedent has retained the right to control the beneficial enjoyment of property including voting control of stock in closely held corporations.
In light of these recent cases, anyone who holds real estate through a closely held family entity must review the organizational documents to ensure that voting rights have not been retained by the senior generation, and that the agreements comply with the latest line of case law. When establishing family owned entities to hold interests in property, the agreements should be crafted to avoid these new pitfalls. This may be easier said than done. Very often, the founding member of the family real estate business is more concerned with the retention of control than with a potential estate tax. There are other means to effectively provide the founder with the control they need to run the business without running afoul of the estate tax rules. The founder can establish trusts for family members with a “friendly” trustee to hold interests for other members of the family. These trusts may provide the additional protection of providing the family members with asset protection features, insulating the assets from attack by creditors and spouses in case of divorce.