TAX COURT UPHOLDS VALIDITY OF DISCOUNTS

In a recent decision, the United States Tax Court approved a 46% discount in valuing bank stocks held in an estate.

In the case of Estate of Green v. Commissioner, decided on December 29, 2003, the U.S. Tax court was asked to decide the proper allocation of federal and Missouri estate taxes to property bequests in the Will of Mildred Green, the proper allocation of federal generation-skipping transfer taxes to property bequests in Green's Will, and, most important for our purposes, the fair market value of Green's shares of stock in Royal Bancshares, Inc.

The Tax Court established the value of this unlisted stock by applying a 17% minority interest discount and a 35% discount for lack of marketability. It began by establishing the pre-discount value of the stock which it calculated by taking the average of the values from three different valuation approaches, the first being the income approach, the second a guideline analysis market approach, and the third a transaction analysis market approach.

The IRS was unable to persuade the Tax Court that the appropriate minority interest discount should be less than the 17% proffered by the estate and in the absence of any strong proof to the contrary, the Tax Court approved the requested 17% minority interest discount.

The Tax Court also approved a 35% discount for lack of marketability, which was within the range of 25% to 40% offered by the IRS and the estate, respectively.

The Facts

Since we are not concerned about the other issues addressed by the Tax Court, I’ll focus on the discounts.

The Decedent died on September 26, 1997, domiciled in St. Louis, Missouri. At her death, she owned slightly more than 3,000 of the more than 64,000 shares of issued and outstanding common stock of Royal Bancshares, Inc. (RBI). Her shares represented 5.09% of the outstanding shares of the company.

On November 9, 1998, the estate filed a federal estate tax return and reported the gross value of her estate as being $3,331,853. The estate valued her shares of RBI stock at $50 per share or $163,800.

The IRS sent the estate a notice of deficiency, partially due to the IRS’s disallowance of a significant portion of the claimed discounts, resulting in a deficiency of approximately $1.2 million.

In arriving at the amount of deficiency, the IRS took a hard line on the discounts claimed by the estate. Rather than accept the estate’s proposed valuation for the 3,276 shares of $163,800, the IRS valued the Decedent’s shares at $1,048,320, some six times greater than what was claimed by the estate on its tax return.

The standard rule on valuing property is that its fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

There isn’t a magic formula for valuing stock in a closely held entity. The value of each company’s stock is based on the company’s performance–how much money it makes, how well it is positioned in its particular market, its projected future growth, and so on. If you believe a company is going to do better than it has in the past, you’ll pay a premium for its stock, and if enough of you do this it will drive the value of the stock higher.

In this case, the parties disputed the fair market value of Decedent's RBI stock. The IRS originally contended the fair market value of the shares was $1,048,320 ($320 per share), but conceded its initial estimate was too high and the shares should only be valued at $860,000 ($262.52 per share). The estate, which reported the value of the shares as $163,800 ($50 per share), conceded this value was too low and the shares were actually worth $655,200 ($200 per share). Each party relied on an expert opinion in arguing for the respective valuations.

The Tax Court may accept or reject expert testimony, in whole or in part, based on its own evaluation of the facts. The estate’s expert valued 100% of the shares of RBI stock at $25,900,000, then applied a 17% minority interest discount and a 40% lack of marketability discount. The government’s expert valued 100% of the shares of RBI stock at $26,500,000 and allowed a 15% minority interest discount and a 25% discount for lack of marketability.

The Tax Court split the difference and valued the RBI stock at $26,266,667. It then concluded that the fair market value of Decedent's shares of RBI stock was $721,297 ($220.18 per share), only slightly more than the final valuation argued by the estate. The tax savings for the Decedent’s estate exceeded $150,000.

While the IRS consistently challenges lack of marketability and minority interest discounts, it regularly loses in the U.S. Tax Court. If you or your family members own or are thinking about forming or acquiring an interest in a closely held family corporation, limited liability company or family limited partnership, your ownership interest may qualify for substantial discounts on the final estate tax return. The tax savings can be significant. Be sure to confer with a qualified estate planning attorney or CPA who can advise you whether your family can benefit from discount planning.

© Jerry E. Shiles 2004

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