"Swing vote" attributes of transferred stock: implications for minority interest discounts.

• Author: Vorsatz, Mark L.

Last year, in Letter Ruling (TAM) 9436005,(1) the IRS attributed value for transfer tax purposes to the "swing vote" characteristics of stock transferred to family members. While the Service did not specify how much value to attribute or whether such value reduced or eliminated otherwise allowable minority interest discounts (MIDs), it was the first IRS ruling directly to assign value to gifts of stock considered to have swing vote characteristics.(2)

For years, the IRS has tried to eliminate MIDs for transfers of stock in family-owned corporations; without judicial intervention, such discounts would now be completely disallowed. Despite the directive from the courts to allow discounts in such cases, the IRS has stated a desire to disallow them.(3) The use of swing vote value as described in TAM 9436005 is but one of the ways the IRS is attempting to reduce or eliminate the amount of MIDs being applied.

Given the IRS position that swing vote attributes must be taken into account when valuing minority stock interests, it is important for taxpayers and practitioners to understand how the IRS defines a swing vote attribute. This article examines TAM 9436005 and the support the IRS used in issuing its decision, reviews the history of swing vote attributes (as applied in the context of gift and estate taxation) and discusses the strengths and weaknesses of the IRS's argument to attribute value to such characteristics.

MIDs

Historically, the IRS has taken the position that family attribution should apply to transfers of minority interests when the transferee and transferor are members of a family-controlled company. In Rev. Rul. 81-253,(4) the IRS held that a MID would not be allowed for transfers of shares among family members when the family controlled the corporation at the time of the transfer, because the restrictions that generally create a MID did not apply.(5) Thus, there was no need to value characteristics such as swing vote value because, under family attribution, no discount would be allowed.

However, after repeated losses in the courts,(6) the IRS issued Rev. Rul. 93-12,(7) stating that it would follow the Fifth Circuit's decision in Est. of Bright.(8) The IRS indicated in that ruling that it would no longer attribute to an individual family member shares held by other family members in determining whether the transferred shares should be valued as part of a controlling interest. In Bright, the decedent held 27.5% (an undivided one-half interest of 55% held as community property) of the stock of several nonpublicly traded corporations. The IRS sought to value the 27.5% interest by using one-half of the value of a 55% interest, computed with a control premium. The Fifth Circuit ruled that the 27.5% interest should be valued not with a control premium, but with a MID, because the decedent's death effectively severed the stock ownership into two minority interests. Further, the court stated that family attribution rules do not apply for gift and estate tax valuation purposes.(9)

Practitioners and taxpayers heralded the arrival of Rev. Rul. 93-12, believing it represented the IRS's final acquiescence to the use of MIDs for transfers of interests in closely held, family-controlled corporations. Unfortunately, the issuance of TAM 9436005 shows that the IRS is now attempting to eliminate (or at least reduce) MIDs when the interests transferred include swing vote attributes.

TAM 9436005

In TAM 9436005, the donor, who owned all the outstanding common stock of a corporation, transferred 30% of such stock to each of his three children and 5% to his spouse. On a timely filed Federal gift tax return, the stock was valued at approximately $50 per share, representing the net asset value of the corporation less a 25% MID and LOMD.

The IRS ruled that the swing vote attributes of each block had to be considered in determining fair market value (FMV). The IRS believed the value of the stock transferred had to be increased for the value of the stockholder's ability to join with the owner of any of the other transferred blocks and control the corporation; thus, any one of the 30% blocks, whether owned by an individual related or unrelated to the family, could be critical in controlling the corporation.

The IRS also addressed whether the value of each 30% block would be different if the transfers had been made at different times (e.g., one month apart). The first 30% block transferred might have no swing vote attributes because, after the initial transfer, the donor would continue to control the corporation through his ownership of the retained 70% block. In the Service's view, only on the transfer of the second 30% would the donor lose control over the company (by reducing his owner-ship to 40%), thereby creating the potential for swing vote attributes in the block transferred.

However, the IRS ruled that even if the three transfers were made at different times, the result would ultimately be the same. Although the IRS agreed that the value of the first 30% transferred would not contain any swing vote value, the second and third transfers of 30% would. Further, the IRS stated that the value of the 30% interest held by the first transferee would increase in value, because that block would acquire enhanced voting control as a result of the second transfer, constituting an indirect gift to the first transferee at the time of the second transfer. The third 30% block transferred would also have swing vote value, both before and after the transfer.

Est. of Winkler

The IRS's ruling in TAM 9436005, that swing vote attributes have value for transfer tax purposes, was based almost exclusively on the holding of Est. of Winkler.(10) In that case, the decedent owned through a living trust 10% of the Class A voting common stock and 1.055% of the Class B nonvoting common stock of Rock Island Refining Corp., a closely held corporation. At the time of the decedent's death, the Class A voting stock was owned equally by the Winkler and Simmons families. The living trust provided that on the decedent's death, the trustee was to distribute all shares of the Class A voting stock equally to the decedent's two daughters and son.

On a timely filed Federal estate tax return, the estate valued both the Class A voting and the Class B nonvoting stock at $22.43 per share, by applying a 45% MID and LOMD. The estate did not differentiate between the value of the voting and nonvoting stock, as it believed that neither block had an effective voice in determining company policies or in making decisions; nor did it attribute value to the swing vote characteristics of the transferred stock. The estate's appraiser considered it unlikely that the Simmons family, which owned 50% of the company, would attempt to buy the decedent's 10% interest to gain control, because no transactions had taken place between the families in 40 years and there were no indications that a transaction between the families was likely to occur in the immediate future.

The IRS's expert determined the voting stock to be worth 10% more than the nonvoting stock, because of the ability of the owner of the voting stock to vote for a board of directors who would run the company. However, that appraiser applied only a 25% MID and LOMD, because he believed that the decedent's 10% of the Class A voting stock had some swing vote characteristics and could create majority control in the hands of the Simmons family, and that the sale of the decedent's shares might cause the two families to compete for the stock, thereby increasing its sales price.

The court agreed with the...