Chapter 8. Special Dispositive Provisions: Discountable Interests

• Author: Jerold I. Horn
• Pages: 261-309

8

Special Dispositive Provisions

Discountable Interests

A person can transfer control of a family business (that is, stock of

corporations and interests in partnerships) with, paradoxically, a discount in

value for lack of control and without including any of the discount in any

taxable transfer at the level of the generation of the transferor. The

principles apply also to undivided interests in property (usually real

property and tangible personal property) that is not partitionable in fungible

portions or of which the whole is more than the sum of fungible parts.

Although a discount for undivided interests also has some aspects that

resemble a discount for lack of marketability, a discount for lack of control

and a discount for undivided interests are functional analogues in important

respects. The transfer tax and planning principles that apply to one tend to

apply also to the other.

Despite the similarity, for purposes of valuation discounts, of corporate

stock, partnership interests, and undivided interests, important distinctions

do exist. Whereas, for example, ownership at death of no more than 50

percent (or, in some cases to some extent, such larger percentage that is the

largest which does not control liquidation) of the voting stock of a

corporation is necessary to produce a lack-of-control discount for both the

voting stock and for any nonvoting stock that the owner also owns, and,

whereas, at least in some jurisdictions, ownership of any general

partnership interest (no matter how small) in a limited partnership tends (at

least in the view of this writer) to undermine a lack-of-control discount for

both the general partnership interest and for any limited partnership interest

that the owner also owns, ownership of any undivided interest (no matter

how large) in real property tends to justify a discount. Seen from this

perspective, generation of a discount is most difficult with partnership

interests (because ownership of any general partnership interest seems to

preclude it), and is more difficult with voting stock (because ownership of

more than one-half seems to preclude it) than with undivided interests

(because only ownership of 100 percent seems to preclude it). One

implication is that a taxpayer who has a choice should avoid ownership of a

general partnership interest in a limited partnership and, instead, should

own less than a majority of voting stock in an S corporation that is the

general partner in the partnership.

I. FIRST SCENARIO

The first scenario is lifetime planning for a person who possesses control. It

is the most common. Arguably, it also is the most important.

Consider, first, gifts to any donee. If a gift, per se, does not consist of

control, a discount for lack of control reduces the value of the gift for gift

tax purposes. Rev. Rul. 93-12, 1993-1 C.B. 202. The discount facilitates the

transfer of an increased interest, representing a greater value of underlying

assets, within a given amount of exclusion, deduction, gift tax, or applicable

credit.

The donor can retain control and yet claim a lack-of-control discount

for any gift that, per se, does not consist of control. Conversely, a gift of the

smallest interest that deprives the donor of control can allow the donor to

transfer control without including the value of control in any taxable

transfer at the level of the generation of the donor.

Consider, next, gifts to the spouse of the donor. If a gift to the spouse of

the donor does not represent control, it, too, receives a discount for lack of

control. Rev. Rul. 93-12, 1993-1 C.B. 202. Because the gift qualifies for the

marital deduction, it defers the payment of tax. Thus, the discount tends to

become academic. Again, however, as in the case of a gift to any donee

other than a spouse, a gift of the smallest interest that deprives the donor of

control can allow the donor to transfer control without including the value

of control in any taxable transfer at the level of the generation of the donor.

If the donor were the owner of 100 percent of the stock of a corporation, the

owner during his or her life could give 50 percent to his or her spouse.

Upon his or her death, as explained more fully in the discussion of the third

scenario at III, the predeceasing spouse could leave his or her 50 percent to

a QTIP-style trust for the benefit of his or her surviving spouse. Without

more, according to the theory of Bonner v. United States, 84 F.3d 196 (5th

Cir. 1996), and its progeny, the gross estate of the surviving spouse would

include two noncontrolling interests, each subject to a discount.

What type of gift from one spouse to the other is appropriate? An

outright gift is appropriate if the donor is satisfied about how his or her

spouse will manage the gift. If the donor cannot rely upon the spouse’s

management, the donor instead can use a transfer to a QTIP trust. The

donor cannot serve as a trustee with a right to vote. Code § 2036(b). The

spouse is not an appropriate trustee, because the very purpose of using the

trust is to address the lack of confidence of the donor in the spouse’s

management. The donor can name as trustee any other person (arguably

even someone who, according to Code Section 673(c), is a related or

subordinate party for income tax purposes) whom the donor does not

control, and is not deemed to control, for estate tax purposes. See Rev. Rul.

95-58, 1995-2 C.B. 191; Code §§ 2036, 2038; Estate of Helen S. Wall v.

Comm’r, 101 T.C. 300; Byrum v. United States, 311 F. Supp. 892 (S.D.

Ohio 1970), aff’d 440 F.2d 949 (6th Cir. 1971), aff’d 408 U.S. 125 (1972);

United States v. Winchell, 61-1 USTC ¶ 12,015 (9th Cir. 1961); Phipps v.

Comm’r, 137 F.2d 141, 144 (2d Cir. 1943); Newman v. Comm’r, 1 T.C.

921, 924 (1943). Cf. Gutchess v. Comm’r, 46 T.C. 554, 558–59 (1966).

A donor’s use of lifetime gifts to relinquish control requires the donor to

make the gifts before the donor dies. Additionally, the donor’s use of

nontaxable gifts for this purpose requires the donor to make the gifts before

his or her spouse dies. Therefore, the donor should consider making the

gifts sooner rather than later.

II. SECOND SCENARIO

The second scenario is testamentary planning for a person who possesses

control. It often involves a person who has not made sufficient use of

lifetime gifts. Taxable transfers at the death of a person who dies while

possessing control are unavailing to create a discount for lack of control.

Therefore, if a decedent owns a controlling interest and has no surviving

spouse, the object of transferring control without including the value of

control in the transfer tax base of the decedent is unattainable. The

principles of Revenue Ruling 93-12, 1993-1 C.B. 202, apply only to inter

vivos transfers. If the gross estate of a person for estate tax purposes

includes control, no discount for lack of control is available for purposes of