TRA 97 is not the only reason to review existing estate plans involving closely held stock.

• Author: Tiernan, Peter B.

When closely held stock is involved, dividing ownership between marital and credit shelter trusts to obtain a control premium or a minority interest discount can, in certain circumstances, maximize overall tax planning.

The Taxpayer Relief Act of 1997 provided an exclusion from a decedent's taxable estate for a "qualified family owned business."(1) Deciding whether to take advantage of this new tax benefit is one reason that all estate plans involving closely held stock should be reviewed. In addition, there have been three significant cases and various IRS rulings over the last 15 years that affect estate planning when closely held stock is involved. The purpose of this article is to discuss how these cases and rulings might affect estate planning for closely held stock and what steps might be taken so as to best provide for the family's retention of the corporation.

The following facts are assumed for purposes of this article. This is a first marriage. The husband is the sole owner of all of the 1,000 shares of a successful closely held corporation which is appraised at $3,000,000 before any discounts. Both the clients' adult son and daughter are active in the business, and the clients want to retain the corporation for them and possibly future generations. In addition to this business, the wife owns in her name alone a residence worth $300,000, and $600,000 of bank accounts and mutual funds. Husband also has $600,000 of the same kind of assets solely in his name. It is assumed that the husband dies first, survived by his spouse and two children. It is further assumed that the requirements of the "qualified family owned business" tax benefit have been met, and the husband's personal representative has specific authority granted to him in the husband's will (or revocable trust) to make the necessary election.

Taxpayer Relief Act of 1997

The Taxpayer Relief Act of 1997 included new [sections] 2033A which purports to provide a $1,300,000 exclusion for family owned businesses. This section and its impact on marital deduction drafting were addressed in detail in articles in the December 1997(1) and June 1998(2) issues of Estate Planning. Thus, a detailed explanation of this new provision will not be addressed herein.

Minority Discounts and Control Premiums

In Revenue Ruling 93-12(3) the IRS reversed its prior position on the issue of minority interest discounts, and stated that "in the case of a corporation with a single class of stock, notwithstanding the family relationship of the donor, the donee, and other shareholders, the shares of the other family members will not be aggregated with the transferred shares to determine whether the transferred shares should be valued as part of a controlling interest."(4) The significance of this ruling as it relates to this article is its statement that the IRS will follow cases like Bright, 658 F.2d 999, 48 AFTR 2d 81-6292, 81-2 USTC Par. 13,436 (CA-5 1981); Propstra, 680 F. 2d 1248, 50 AFTR 2d 82-6153, 82-2 USTC Par. 13,475 (CA-9, 1982); Andrews, 79 T.C. 938 (1982); and Lee, 69 T.C. 860 (1978), in the future. This decision created certain possibilities for estate tax planning purposes.

Even though most attorneys are quite knowledgeable about minority interest discounts, they are less aware of the significance of control in valuing closely held stock. In Rev. Rul. 59-60,(5) the IRS ruled that the size of the block of stock in a closely held corporation is a relevant factor in calculating the value of that block. In reaching this conclusion the Service stated that "[a]lthough it is true that a minority interest in an unlisted corporation's stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock."(6) In Newhouse Est. v. Comr, 94 T.C. 193 (1990), nonacq. 1991-1CB 1, the Tax Court in defining control stated "[c]ontrol means that, because of the interest owned, the shareholder can unilaterally direct corporate action, select management, decide the amount of distribution, rearrange the corporation's capital structure, and decide whether to liquidate, merge or sell assets."

Regarding the percentage of stock necessary to be deemed to have control, the Tax Court has held that notwithstanding language to the contrary in both the regulations(8) and Rev. Rul. 59-60, the term control for purposes of applying a control premium to stock only exists where numerical control is present as opposed to effective control.(9) This assumes, of course, that a simple majority of the shares is all that is necessary under state law to exercise control. Concerning the potential increase in value of a stock interest that is determined to be a "controlling interest," an example is Salsbury Estate v. Comr, 34 T.C.M. 1975-333, in which the Tax Court applied a 38.1 percent control premium to a 51.8 percent block of stock owned by a decedent.

Bearing in mind just how much the existence or absence of control may affect the value of an individual's stock interest in a closely held corporation, the next question concerns the points in time that the value of the stock is relevant and how does control or lack of control affect the stock's value at these times. One relevant time is, of course, at the shareholder's date of death for purposes of figuring his gross estate. In this regard if one person owns 100 percent of a corporation consisting of 1,000 shares of stock valued at $3,000,000 (after a lack of marketability discount), then this would normally be the value of his interest for figuring the gross estate. However, if the decedent owns less than 100 percent, then the existence or absence of control comes into play in valuing his interest. For example, if a decedent owned 50.1 percent of the outstanding shares of this corporation, these 501 shares would not be valued at $1,503,000, but under the rationale of Salsbury might be increased by 38.1 percent to reflect a control premium inherent in this controlling interest. In such a situation, the IRS could argue based on Salsbury that the value of these 501 shares is $2,075,643 for estate tax purposes. But, if the individual gave away just two of these 501 shares prior to his death, his estate would no longer have a controlling interest in the corporation. As a result these 499 shares would be a minority interest entitled to a minority interest discount. If the applicable minority discount was 20 percent, these 499 shares would be valued at only $1,197,600. By giving away just two shares, the individual has reduced his gross estate by $878,043.

The second point in time when the value of closely held stock can have significance is the date the stock is distributed from the estate or revocable trust to its ultimate recipient. In this respect if either the marital share or the credit shelter share is stated as a pecuniary amount, then there are possible tax consequences that must be...