Special report on estate planning for farmers: Part 4 of 7

In a special report prepared in conjunction with a presentation at the University of Iowa College of Law's 2011 Spring Tax Institute, David Repp takes in in-depth look at estate planning considerations for farmers.  Part 4 of 7, below, explores valuation discounts including the minority interest discount, the lack of marketability discount, and other valuation discount factors of special interest to farmers. Valuation Discounts Minority Discount Courts have long recognized that the shares of stock of a corporation which represent a minority interest are usually worth less than a proportionate share of the value of the assets of the corporation.¹  The theory of the minority interest discount is that the owner of less than a majority interest in an enterprise cannot, alone, control day-to-day or long-range managerial decisions, affect future earnings, control efforts for growth potential, establish executive compensation, or compel a liquidation to reach the corporate assets.  Because the owner of a minority interest lacks these benefits of control over the business, an acquirer of such an interest will pay less for it on a pro rata basis than for a controlling interest.  Where the holder lacks the ability to exercise control over the operations of the enterprise, his or her interest may be worth significantly less than its "liquidation" value.  In determining the size of the minority interest discount to be applied, it is a well-established rule that each case must take into consideration all the relevant facts and circumstances.  The discount applied in other cases is not usually determinative of the proper discount to be applied in a given case.  The Tax Court generally will not take into consideration the amount of discounts awarded in other cases.² A crucial factor in establishing a minority interest discount is the bundle of rights possessed by the holder of the corporate or partnership interest.  Such rights are based on a combination of applicable state law, corporate articles and bylaws, and the partnership agreement, as well as other rights and restrictions agreed to by the parties.  In Moore v. Commissioner,³ the Tax Court examined in detail the rights of donees of gifts of general partnership interests to share in profits and losses, manage and control partnership assets, be paid salary, admit new partners, withdraw from the partnership, assign the interest, dissolve the partnership, and institute legal proceedings to resolve conflicts among partners.  Moore provides an excellent analysis of the factors that must be addressed to support a minority interest discount and should be read closely by practitioners. Marketability Discount The lack of marketability discount is based on the fact that stock in a closely-held business enterprise is less attractive and more difficult to sell than publicly traded stock.  Where an active trading market does not exist, other factors may be used as valuation benchmarks, and the lack of marketability discount becomes operative and applicable.  Lack of marketability discounts relate to the inherent lack of flexibility in getting in and out of investments with no ready market.⁴  Unlike the discount for lack of control (the minority interest discount), the marketability discount can be applied in cases of gifts of more than 50 percent.  In the Estate of Wildman,⁵ the Tax Court granted a ten percent discount on the decedent's interest in farm land partially for the reason that the farms were not contiguous properties.  The court is essentially applying a marketability discount for the reason that contiguous farms are more marketable than small, noncontiguous farms.  Clearly, this type of marketability argument would exist regardless of the size of the interest gifted.⁶  In most cases, however, the distinction between marketability discount and minority discount is blurred for the reason that the minority interests in closely-held businesses are naturally less marketable than controlling interests. Valuation Discount Factors of Special Interest to Farmers Absorption Discount.  The concept of an absorption discount is that a reduction in price of an asset occurs by the sale of a large quantity of the homogeneous assets in a one-year period of time.  In the context of farming, the asset is farmland.  In Astleford v. Commissioner,⁷ involving a gift of a limited partnership interest, the Tax Court applied a 20 percent absorption discount to 1,187 acres of Minnesota farmland originally valued at $3,500 an acre.  The Tax Court said that an absorption discount is a discount in the value of real estate if the sale of such real estate within a short period of time would reduce the price for which real estate otherwise would sell.   A short period of time was considered to be a year.  Essentially, the court said that flooding the local real estate market with 1,187 acres of farmland all in one year would require a price reduction of 20 percent to accomplish the sale. The Astleford case is important for another reason.  The Tax Court applied the 20 percent absorption discount before it applied the regular minority and marketability discounts.  The minority and marketability discounts were an additional 30 percent (combined). The Internal Revenue Service, in the distant past, has defended against an absorption discount when the facts suggest that there is no reasonable prospect for liquidation of the farmland.  Estate of Andrews v. Commissioner, 79 T.C. 938 (1982).  An absorption discount is much more difficult if the valuation method of an interest in a limited liability company or corporation is based on a capitalization of earnings method.  An absorption discount would seem to be proper if the valuation method is based on the net asset value of the assets.  Generally, for farm corporations and farm limited liability companies owning farmland, the net asset valuation method returns a higher valuation (even after application of an absorption discount) than the capitalization of earnings method simply because, historically, farming the land has not generated significant earnings. Chapter 9H.  An important factor in qualifying for a large marketability discount is sale restrictions.  Frequently, those sale restrictions reside in buy-sell agreements between the owners of the business entity.   The more sale restrictions, the larger the marketability discount.  Owners who are family members may be tempted to implement the most restrictive provisions possible in order to manufacture a larger marketability discount.  However, Internal Revenue Code Section 2703 nullifies any such discount if the restrictions go overboard.  Code Section 2703 provides that any restrictions on the sale and use of property, including interests in an LLC, are ignored for estate and gift tax valuation purposes⁸ unless:

1. it is a bona fide business arrangement;
2. it is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and
3. its terms are comparable to similar arrangements entered into by persons in an arms' length transaction.

Regulations indicate that all three parts of the exception must be present in order to avoid the effect of Code Sec. 2703(a)(2).⁹  Section 2703 applies to LLC operating agreements as well as buy-sell agreements.¹⁰ Chapter 9H of the Iowa Code provides that any limited liability company or corporation that owns in excess of 1,500 acres of Iowa farmland must be owned by a majority of individuals who are related to each other.¹¹  A violation of Chaper 9H results in the imposition of a civil penalty on the entity in the amount up to $25,000 and the entity is required to divest itself of all its Iowa farmland. Thus, a farming entity that owns more than 1,500 acres of farmland, or aspires to own more than 1,500 acres of farmland in the future, must comply with Iowa Code Chapter 9H.  A reasonable way that an entity can assure itself of compliance by its owners is to require its owners to agree not to sell its ownership interest to a nonqualifying individual.  Such restrictive provision should comply with Internal Revenue Code Section 2703.  Cases Involving Farmland.  In Astleford v. Commissioner¹² (discussed above), involving a gift of a limited partnership interest, the Tax Court applied cascading discounts on many different layers of assets.  The taxpayer gifted an interest in a newly created limited partnership which owned a 50 percent interest in a general partnership which owned 1,187 acres of Minnesota farmland valued at $3,500 an acre.  The Tax Court first applied a 20 percent "absorption" discount to the farmland owned by the general partnership.  The Tax Court said that an absorption discount is a discount in the value of real estate if the sale of such real estate within a short period of time would reduce the price for which real estate otherwise would sell.   A short period of time was considered to be a year.  Essentially, the court said that flooding the local real estate market with 1,187 acres of farmland all in one year would require a price reduction of 20 percent to accomplish the sale. After applying a 20 percent absorption discount to the farmland owned by the general partnership, the Tax Court then applied a combined 30 percent minority and marketability discount to the one-half general partnership interest owned by the limited partnership.  The Tax Court then applied a combined 39 percent minority and marketability discount to three gifts of 30 percent blocks of the limited partnership to the taxpayer's children.  The end result of all the cascading discounts is that the farmland originally valued at $3,500 per acre was reduced to $1,269 per acre with an effective discount rate of nearly 64 percent. In Smith v. Commissioner,¹³ the Tax Court allowed a 76 percent combined minority and marketability discount on a decedent's one-third stock interest in a corporation containing 1,300 acres of Ohio farmland.  The combined 76 percent discount consisted of a 64 percent minority discount and a 35 percent marketability discount.  To determine the minority discount, the Tax Court first analyzed 15 publicly-traded, real estate investment trusts and noted that the shares of the trusts typically traded for approximately 50 percent of their net asset values.  The Tax Court did not indicate how it chose the 15 REITs or what characteristics it considered important.  The Tax Court then computed the value of the farming business using an earnings capitalization method.  Because the farm was only marginally profitable, the discount that the Tax Court derived was 96 percent!  The Tax Court then applied a weighting to the two methods, applying a 70 percent weight to the REIT method and a 30 percent weight to the earnings capitalization method for a total combined minority discount of 63 percent (50% discount * 70% weight + 96% discount * 30% weight = 64%).  To determine the marketability discount, the Tax Court analyzed private sales of unregistered stock in publicly traded companies and noted that the stock sold at a discount of approximately 29 percent of its registered counterpart.  Then, the Tax Court added an additional 6 percent as an adjustment factor because unregistered shares of publicly traded stock can be generally be sold in the public market after two or three years.  The total marketability discount, then, was 35 percent. The combination of a 64 percent minority discount, applied first, plus a 35 percent marketability discount on the remainder, equated to a 76 percent total, combined discount. In Litchfield v. Commissioner,¹⁴ the Tax Court granted 17.4 percent built in gains discount,¹⁵ a 14.8 percent minority discount and a 25 percent marketability discount for a combined discount of 47.6 percent.¹⁶   The decedent owned a 43.1 percent interest in an S corporation that owned Iowa farmland that it rented to local farmers under a crop share arrangement.  The Tax Court referenced Iowa's corporate farming statute, Chapter 9H, but the decision is not clear whether the Tax Court relied on shareholder restrictions contained in Chapter 9H as a factor in determining the marketability discount. Planning for Maximum Step Up in Basis For those farmers who do not own 1,000 acres of farmland and are convinced that they will never have an estate tax problem, serious consideration should be given to disqualifying for valuation discounts.  Majority control of entities owning farmland should be acquired by the taxpayer and argue for a valuation premium.  The operating agreement could provide each member a right to withdraw from membership of the limited liability company in exchange for payment of an amount equal to the net undiscounted value of the company's assets.  Alternatively, the farmland could be held outright by the taxpayer rather than in an entity so that no discount would apply. ¹ Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981); Estate of Newhouse v. Commissioner, 94 T.C. 193 (1990); Ward v. Commissioner, 87 T.C. 78 (1986); Cravens v. Welch, 10 F. Supp. 94 (Cal. 1935). ² Estate of Berg, 1991 T.C. Memo 279. ³ 1991 T.C. Memo 546. ⁴ Estate of Berg, 1991 T.C. Memo 279. ⁵ 1989 T.C. Memo 667. ⁶ See also Estate of Murphy, 1990 T.C. Memo 472 (allowing discount for marketability for decedent constructively owning 51 percent of stock); Estate of Dunn, 2000 T.C. Memo 12 (allowing a 15% marketability discount for a 62.96 percent block of stock); Estate of Maggos, 2000 T.C. Memo 129 (allowing a 25% marketability discount for a 56.7 percent block of stock but imposing a 25% control premium which offset the marketability discount); Estate of Jameson, 1999 T.C. Memo 43, rev'd. 267 F.3d 366 (5th Cir. 2001). ⁷ T.C. Memo 2008-128 (May 5, 2008). ⁸ A right or restriction may be contained in a partnership agreement, operating agreement or buy-sell agreement.  Treas. Reg. § 25.2703-1(a)(3).  See also, Citizens Bank and Trust Co. v. Commissioner, 839 F.2d 1249 (7th Cir. 1988) [88-1 ¶ 13,755], aff'g Northern Trust Co. v. Commissioner, 87 T.C. 349 (1986) [CCH Dec. 43,261]; Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981) [81-2 USTC ¶ 13,438]. ⁹ Treas. Reg. § 25.2703-1(b)(2). ¹⁰ See Appendix A for a more complete discussion of IRC § 2703 and accompanying case law. ¹¹ The owners must be related to each other as spouse, parent, grandparent, lineal ascendant of grandparents or their spouses and other lineal descendants of the grandparents or their spouses, or persons acting in a fiduciary capacity for persons so related.  Iowa Code §9H.1 (2011). ¹² T.C. Memo 2008-128 (May 5, 2008). ¹³ T.C. Memo 1999-368 (Nov. 5, 1999). ¹⁴ T.C. Memo 2009-21. ¹⁵ The discount was granted despite the fact that the corporation had elected S corporation status nine months prior.  Unlike the Jelke case (see footnote 20, supra), the Tax Court did not grant a dollar-for-dollar reduction for built in capital gains because the petitioner estate did not request it. ¹⁶ The Tax Court used solely net asset value as the valuation method.  The net asset value of the corporation's assets was $33.2 million.  The decedent's 43.1% share is $14.31 million.  After applying the discounts, the Tax Court determined the decedent's interest was valued at $7.5 million.