Control Discounts & Gift Taxes
March 21, 2011
Minority discounts are a generally accepted practice used in determining the fair market value of non-controlling, minority interests in corporations. Such discounts are also often deemed valid by the Internal Revenue Service (IRS) when calculating the federal estate and/or federal gift taxes that are associated with interfamilial transfers of interests within a corporation.
Revenue Ruling 93-12
In a significant departure from its previous position, the IRS issued Revenue Ruling 93-12 in 1993 holding that a minority discount is permissible for the gift of a minority interest in an enterprise entirely controlled by the donor or the deceased donor's family. Previously the IRS aggregated the interests of family members in determining whether a minority control discount was valid.
At issue was the validity of minority control valuation discounts taken when a donee who owned 100% of the outstanding shares of a corporation, having one class of stock, simultaneously gave all of his interest, in equal amounts, to his five (5) children. In specific the IRS stated, "[i]f a donor transfers shares in a corporation to each of the donor's children, the factor of corporate control in the family is not considered in valuing each transferred interest."
Private Letter Ruling 9449001
The IRS further acknowledged the position above in a private letter ruling stating that the fair market value standard is used in determining the valuation of gifts, i.e. price at which a willing buyer and willing seller, neither being under any compulsion and both having knowledge of the relevant facts, would exchange property.
In certain circumstances, and in spite of the aforementioned rulings, the IRS has argued that minority control discounts in closely-held corporations are invalid if a corporation or partnership was created principally to produce such discounts. In particular, the IRS has claimed that these transactions lack "economic substance," i.e. there were no substantial changes in the relationships and rights of the parties involved, rather, changes in form.
For example, three years prior to Revenue Ruling 93-12, the tax court disregarded a minority control discount in Estate of Murphy (60 TCM 645). In Murphy, a woman with terminal cancer transferred 2% of her interest in a corporation to her children thereby decreasing her interest just below 50% and she subsequently died 18 days later. The tax court reasoned that no substantial change in the parties positions had occurred despite such a significant change in form.
Although the IRS has effectively prohibited the use of minority control discounts in certain limited situations, such discounts are, more often than not, an approved strategy to reduce federal gift taxes directly and federal estate taxes indirectly.
This brief overview of some important considerations associated with minority control discounts and gift taxation is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.