We are seeing and hearing a high volume of IRS audit activity—for gift tax and estate tax returns alike. On the gift tax returns especially, the challenge is on the discounts. While every case is different, the following is a general description of the types of challenges we are seeing.
The Minority Interest Discount
For the minority interest discount, the favored IRS approach is simply to take the mean discount on closed-end funds out of a list in the Wall Street Journal. They will usually separate their analysis into closed-end funds holding equity and those holding bonds. No further analysis is done. The problem with this is that many of the closed-end funds have instituted policies of guaranteeing their investors a current yield of eight to 10 percent. Of course, the only way this is possible is by having the distribution include a significant amount of return of capital. Sophisticated investors would see this “current return” for what it is—a gimmick by fund sponsors to make their investors feel better about their investment return. From a rate of return standpoint such practices are counter-productive. That is why institutional investors usually do not buy closed end funds. In fact, the noted economist Burton Malkiel who has studied closed-end funds in detail is quoted as saying: “Closed end funds aren’t bought—they are sold!”
The correct approach here is to disregard closed end funds with manipulated current yields. In addition, closed end funds which are planning to convert to an open format mutual fund should also be ignored. The price discount for lack of control will soon disappear in these stocks as open ended fund holders may redeem their shares at net asset value.
Lack of Marketability
We have seen several tactics taken here but the most common is for the IRS to resort back to the Bajaj Study and its 20% lack of marketability discount from the McCord case. After the Tax Court decision was rendered in McCord, the taxpayer appealed to the Fifth Circuit. In this filing, we did our best to bring to light the numerous errors in the Bajaj Study. However, our efforts were unnecessary. First, the Fifth Circuit ruled that the testimony of the IRS expert was to be excluded. Next, the Fifth Circuit ruled that the Tax Court erred by conflating the fair market value we determined for the valuation date with the valuations used for transfers made some six months later. Thus, the question of the Bajaj Study was not reached in the opinion which completely reversed the Tax Court’s findings.
The Bajaj Study has been used time and again by the service as the cornerstone of its LOM arguments. The problems that existed with it earlier still exist. Further, in the many years since its issuance, we have found several other flaws. In researching the transactions underlying the Bajaj Study, we found that in a representative sample, that every one of these transactions would not pass an arm’s length test. They are all tainted for one reason or another.
The IRS likes to use the 20% LOM discount of the Bajaj Study as its benchmark and adjust upwards or downwards based on the Mandelbaum Factors. We agree that the Mandelbaum factors are a good framework for adjusting discounts but who ever said 20% was the benchmark? No one, except the IRS.
In Mandelbaum, Judge Laro remarked that the benchmark prior to considering the effects of his adjustments was 35-45%. In Peracchio, however Judge Halpern warned appraisers that the result in Mandelbaum was not being used as a benchmark for determining the discount for other companies. The facts and circumstances of Mandelbaum were unique.
Why then should the IRS use the result the Tax Court found in the McCord case serve to inform the discount for all other FLPs it audits? The financial characteristics of FLPs can vary drastically. In fact, the Tax Court in two 2009 cases, Holman and Astleford, determined very disparate discounts in large measure due to the different types of assets held by the FLPs.
The Tenuous Existence of the Valuation Discount
The national tax policy implications of the valuation discount have been the subject of controversy for many years. Interestingly, in the President’s budget for 2013, no mention of the valuation discount was to be found. Has this been forgotten? No. The Government Relations Committee of the American Society of Appraisers has reported that members of the Senate Finance Committee and the House Ways and Means Committee have valuation discounts on the agenda as possible topics whenever they next take up a serious discussion of tax reform. When might that be? That is a question which cannot be intelligently answered at this point. Also, whenever such meetings do take place, it is not very likely that such a low priority item as valuation discounts might even be reached.
Myths about Valuation Discounts
The Greenbooks of President Obama for the fiscal years 2010-2013 did state that the elimination of valuation discounts would raise about $18 billion. These numbers were calculated at a time when future statutory exemptions were far lower and tax rates were far higher than they are currently. Even, at the time, the veracity of these figures was questionable. The June 11, 2009 Joint Committee on Taxation (“JCT”) revenue estimates skipped this revenue-raising proposal because of its lack of clarity and definition. After this “failure to score,” the JCT has not since provided any estimate of revenues created by the modification of rules for valuation discounts.
In 2008, taxable gift tax returns showed cash held in FLPs was just 6 percent of the total. Stocks, both publicly-traded and closely-held, and real estate comprised 70 percent of the assets held in these FLPs. For estate taxes, a 2004 date-of-death study by the IRS showed that for the wealthiest taxpayers, cash was just over 9 percent of FLP assets.1
While in many cases, discounts of this much or more are justifiable, in a November 12, 2012 report, the JCT found, that for the wealthiest taxpayers, the average discount taken in 2008 for estate tax filings was 18%. The same report, revealed that the average discount taken in gift tax filings in 2008 for the wealthiest taxpayers was 24%.2
1 Melissa J. Belvedere. 2008 Gifts. Statistics of Income Bulletin. Spring 2011, Internal Revenue Service.
2 Modeling the Federal Revenue Effects of Changes in Estate and Gift Taxation. Joint Committee on Taxation. JCX-76-12. November 9, 2012.
3 Raub and Belvedere, p.387.