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Time To Act on Valuation Discounts For High-Value Estates

For many high-wealth individuals, effective estate planning is largely motivated by the desire to minimize the estate and income taxes their heirs may pay. Reducing estate taxes often means maximizing the benefits of the unified credit amount through the use of valuation discounts.

The unified credit amount, in laymen’s terms, refers to the dollar figure the Internal Revenue Service and state tax authorities allow a person to transfer to others, either by lifetime gifts or through an estate without incurring estate taxes. Currently, the IRS allows an individual to give away $5.45 million tax-free. New York’s limit is $4.187 million (until March 31, 2017, when it will increase).

Naturally, the lower the value of the gift, the less of the unified credit amount it consumes. A popular strategy for decreasing the value of assets for estate and gift tax purposes is to transfer partial interests in them to more than one individual. Transferring partial interests allows the use of valuation discounts to decrease the dollar value of the gifted asset in question, and preserve more of a gift-giving unified credit for future use. This is a popular strategy utilized when transferring business interests, real property or personal property items such as artwork.

Consider this example: A parent gives each of his two children a 50% percent interest in a $5 million home. Neither child can live in the home without permission from the other, and the home cannot be sold (or leased) unless the two agree to do so. Because the property cannot be enjoyed, used or sold without restrictions, the value of the gift received by each child is reduced (to put it another way, the sum of the parts is less than the whole). To account for this, an appraiser can discount the value of the home by 20 percent. Thus, the $5 million home is worth a total $4 million to the two children. The gift-giver will only utilize $4 million of his or her unified credit to remove a $5 million asset from his or her estate. (The gift-giver may be able to further reduce this amount by using annual exclusion gifts and gift-splitting rules. These techniques are beyond the scope of this article.)

The inability of each child in this example to use the property without permission is referred to as a “lack of control” valuation discount. Limits on selling are referred to as “lack of marketability” valuation discounts. These discounts and others are often used when gifting interests in a family business.

These types of valuation discounts are commonly used to reduce the potential tax burden on high-value estates – and are facing increasingly heavy scrutiny from the IRS and state tax regulators. As the federal government and states have raised the unified credit amount in recent years, all but the highest-value estates are exempt from estate taxes. With fewer estate returns being filed, taxing authorities have had more time to examine those that are submitted.

The IRS has strongly signaled that valuation discounts are in its cross hairs. For instance, the agency has heavily litigated valuation discounts used on artwork, including in Estate of Elkins v. Commissioner of Internal Revenue, a case decided by the U.S. Court of Appeals for the Fifth Circuit in 2014. The IRS ultimately lost in Elkins because it failed to provide sufficient evidence to challenge the amount of the discounts claimed by the taxpayer. However, while the Court ruled in favor of the estate which sought to discount their art holdings, the IRS signaled its intent to aggressively challenge valuation discounts by litigating the case all the way to the appellate level.

The agency has also submitted proposed new regulations under the Internal Revenue Code Section 2704, which, if adopted would greatly restrict the ability of individuals to take valuation discounts for lack of control or lack of marketability – particularly on assets transferred within three years of death. The comment period for the new rules ends on December 1, 2016 and they may well be effective, shortly after that date.

In other words, the framework for what an individual can and cannot do to maximize the estate planning benefits of the Unified Credit is changing rapidly. Taxpayers need to ensure that they have documented evidence, such as an opinion from an appraiser, for the discounts they have taken. If they have an estate that is likely to exceed the unified credit amount, they should be calling their counsel to review their estate plans and to decide if they should make asset transfers and, if so, how best to structure the transfer. Tax authorities are getting tougher on these issues, and the time to take advantage of the current rules may be running out.


This post does not constitute legal advice or establish an attorney-client relationship