Disappearing and Reappearing Value on a Two-way Street: The Reverse Chenoweth Situation
A major tax strategy in estate planning is to reduce or minimize valuation by creating discounts through gifts of portions of a property or through transferring assets to restrictive entities such as family limited partnerships, limited liability companies, and corporations.1 U sing these techniques, the portion of the value of the assets offset by the discounts “disappears” from the transfer tax base. As a result, the transfer tax that is based on the value of the assets is also reduced or minimized.
In Revenue Ruling 93-12, 1993-1 C.B. 202, the IRS acquiesced to extending the concept of disappearing value to family-owned entities. In the facts of the revenue ruling, the parent owning 100 percent of the family corporation gifted a 20 percent interest to each of his or her five children. The IRS concluded that each gift of a 20 percent interest is to be valued separately as a minority position, allowing the application of a minority discount, as well as a marketability discount.2 A s a result, the portion of the value of the corporation that is reduced by the discounts disappears from the transfer tax base. This is consistent with the basic valuation premise that when valuing the parts separated from the whole, the sum of their values is less than the value of the whole.
In Estate of Chenoweth v. Commissioner,
88 T.C. 1577 (1987), the Tax Court concluded that valuation for purposes of the marital or charitable deductions may not be the same as for purposes of the gross estate. In Chenoweth, the decedent, who owned 100 percent of a closely held company, made a bequest of 51 percent of the stock to his surviving spouse. On the estate tax return, the 100 percent interest was valued at $2,834,033, and a marital deduction was claimed for 51 percent of such amount, or $1,445,357.
In its petition filed with the Tax Court, the estate argued that the marital deduction for the 51 percent bequest to the surviving spouse should be increased by a control premium of 38.1 percent. The IRS accepted the $2,834,033 valuation of 100 percent of the company, but argued that the marital deduction should be limited to 51 percent of such amount. The estate prevailed, with the 51 percent block being valued at $1,996,038 for purposes of the marital deduction, but at $1,445,357 for purposes of the gross estate. The increase to the deduction for the control premium allowed the estate to fund the marital bequest with fewer assets. As a result, more property was allowed to pass to the credit shelter trust that would not be subject to estate tax upon the death of the surviving spouse.
In Chenoweth, the Tax Court assumed that the accepted value of the 100 percent block in the gross estate included a control premium, but if that were the case, the control premium on the 51 percent block could not have exceeded the premium on the 100 percent block. In fact, the control premium for the smaller 51 percent interest would have most likely been less. Rather, the $1,996,038 marital deduction for the 51 percent block was obtained by increasing its $1,445,357 value on the return by 38.1 percent for the control premium, with no control premium or a smaller control premium having been applied in valuing the 100 percent block in the gross estate, which was inconsistent.
Chenoweth drew attention to the need for the valuation of closely held interests passing to the marital and charitable deductions, which led to consideration of the reverse situation of a controlling interest in the gross estate but only a minority interest passing to the surviving spouse or charity. This is the so-called “reverse Chenoweth ” situation. In this situation, the minority interest would be valued for purposes of the marital or charitable deduction at less than its percentage share of the value of the interest in the gross estate, with the difference or “mismatch” constituting an increase to the taxable estate. In this situation, the valuation disappearance occurs on the deduction side consistent with the same valuation principles applicable on the gross estate side.
The reverse Chenoweth issue also exists in the case in which the gross estate includes real estate and a fractional interest in the real estate is distributed to the marital or charitable deduction. In this case, the deduction is reduced by the amount of the fractional interest discount.
Interest in the reverse Chenoweth situation has become more intense now3 a s a result of the recent Tax Court decisions in Estate of Black v. Commissioner,
133 T.C. No. 15 (Dec. 14, 2009), and Estate of Shurtz v. Commissioner,
T.C. Memo. 2010-21 (Feb. 3, 2010), in which an issue was whether the value of limited partnership interests passing to the marital deduction determined the amount of the marital deduction where the underlying assets of the family limited partnership are includible in the gross estate under Code §2036. In this situation, the matter is one of disappearing value that “reappears” when the underlying assets of the entity are included in the gross estate without discounts. However, because the Tax Court in both the Black and Shurtz cases concluded that §2036 was inapplicable, it was unnecessary to reach the issue. Prior to the recent Black and Shurtz decisions, the reverse Chenoweth issue often received little attention by estate planners, resulting in unexpected tax consequences.
Lapse of Estate Tax in 2010
For decedents dying in 2010, it is possible to elect out of estate tax at the cost of losing the income tax basis step-up. However, there is the additional $3 million basis increase for spousal property which includes QTIP property. The preferred estate plan for a married couple for such year was the QTIP/disclaimer plan. Under this plan, all of the property passes to a QTIP trust, with the ability of the surviving spouse to make a disclaimer of property not needed for the $3 million spousal basis increase or the marital deduction.
The reverse Chenoweth situation should be considered in the disclaimer of assets from the QTIP trust. Estate of DiSanto v. Commissioner, T.C. Memo. 1999-421 (1999), provides guidance in this area.
In DiSanto, the decedent died owning 186,177 shares in a closely held company that constituted a 53.5 percent controlling interest. All of the stock apparently passed to a residuary marital trust for the surviving spouse.
The surviving spouse, who died the following year, disclaimed $1,325,000 worth of the stock based on per share values as finally determined on the estate tax return. The disclaimer resulted in the marital trust receiving a minority interest in the company.
On the estate tax return, the control block of 186,177 shares was valued at $4,803,728, or $25.80 per share, based on an appraisal by the accounting firm that prepared the estate tax return. The accounting firm concluded that, as a result of the disclaimer, the surviving spouse was entitled to receive 121,823 shares, but the opinion states that there was nothing in the record to indicate how the accounting firm calculated that number of shares.
In DiSanto, the Tax Court concluded — accepting the valuations prepared for trial by the estate’s expert witness — that the value of the 53.5 percent control block in decedent’s gross estate was $4,375,160, or $23.50 per share, and that the minority interest value of the 121,823 shares that the surviving spouse received as a result of the disclaimer was $1,583,699, or $13 per share, resulting in $2,791,461 of disappearing value for purposes of the marital deduction.
The situation in DiSanto could have been avoided through a lifetime gift of stock, of more stock, or the sale of stock to family members that would have brought the decedent’s interest below the 51 percent required for control. The transfer would have been valued as a minority interest, and the interest in the estate would then have also been a minority interest.
When the bulk of the estate consists of a single closely held interest that is near to the 51 percent required for control as in DiSanto, planning options may be limited. In order to avoid a reverse Chenoweth situation, the entire controlling interest will have to pass to the marital deduction to avoid disappearing value. The surviving spouse can then gift or sell the stock so that a minority interest instead of a controlling interest is included in his or her gross estate. Alternatively, more stock has to be distributed to the marital deduction to make up for the disappearing value, but this is considered an undesirable result from an estate planning viewpoint because the credit shelter trust will be depleted, and more stock will have passed to the marital deduction that will be included in the surviving spouse’s gross estate.
If the estate consists of assets of substantial value in addition to controlling interests and real estate, funding mechanisms that provide maximum pick-and-choose flexibility may be selected so that the controlling interest or real estate is chosen for the marital or charitable deduction. In this case, the will or trust could contain a direction against funding a marital or charitable share with a minority or fractional interest to prevent an underfunded marital or charitable deduction. Another option would be for the executor to sell the property so that the marital or charitable gift is funded in cash rather than in kind.4 A lternatively, a tax formula disclaimer that is authorized under the regulations5 m ay be used, or perhaps a defined value formula disclaimer may be used under which excess value passes to charity as authorized by the Tax Court in Hendrix v. Commissioner, T.C. Memo. 2011-133 (2011), and Estate of Petter v. Commissioner, T.C. Memo. 2009-280 (2009),
and previously by the Eighth Circuit in Estate of Christiansen v. Commissioner, 104 AFTR 2d 2009-7352 (8th Cir. 2009).
Family Limited Partnerships
In Ahmanson Foundation v. U.S., 48 AFTR 2d 81-6317 (9th Cir. 1981), which was relied upon by the Tax Court in rendering its decision in Chenoweth,6 t he decedent owned a controlling interest in a corporation. The decedent bequeathed all of the nonvoting stock to charity, while bequeathing the voting stock with control to his son. In valuing the controlling interest in the gross estate, no control premium was applied on the basis that there was no evidence that a prospective purchaser would be able to use the voting control to obtain an increased economic advantage worth paying a premium for. An issue in the case was whether the voting and nonvoting stock should be valued in the gross estate as separate blocks or as one block and whether the value of the charitable deduction was determined by the value of the nonvoting stock passing to charity.
In Ahmanson, the estate valued the voting and nonvoting stock separately in the gross estate, applying a three percent discount to the nonvoting stock for its lack of voting rights. The amount of the charitable deduction for the nonvoting stock passing to charity, therefore, matched its value in the gross estate. The Ninth Circuit in Ahmanson concluded that the voting and nonvoting stock should be valued in the gross estate as a single block at the higher value of the voting stock, that is, without the three percent discount for lack of voting rights. The Ninth Circuit also concluded that the amount of the charitable deduction was limited to the value of the nonvoting stock that passed to charity. As a result, the nonvoting stock was valued in the gross estate without a discount, because it was part of a block that included voting control, but was valued for purposes of the charitable discount with a three percent discount reflecting that the voting stock with control had been bequeathed to the son instead of to charity and that only nonvoting stock passed to charity. Thus, there was three percent of disappearing value to the charitable deduction, which resulted in an increase to the taxable estate of the same amount.
The valuation principles articulated in Ahmanson are equally applicable to the valuation of interests in family limited partnerships with voting stock being analogous to a general partnership interest in a family limited partnership, and with nonvoting stock being analogous to a limited partnership interest. Thus, a limited partnership interest held in conjunction with a general partnership interest should be valued at the higher value of the general partnership interest. Therefore, the reverse Chenoweth situation might arise whenever the gross estate includes a block of both general and limited partnership interests, but only limited partnership interests pass to the marital or charitable deduction.7 A part from transferring all of the general and limited partnership interests to the marital deduction, the only way to avoid this situation is for the decedent to transfer all of his or her general partnership interests prior to death.8
Whenever the gross estate includes interests in real estate or in restrictive entities, such as family limited partnerships, limited liability companies, and corporations, a division of the interests at death by distributing a portion to the marital or charitable deduction and a portion to the credit shelter trust may result in a reverse Chenoweth issue. This is so because under the valuation principles articulated in the cases discussed above, the concept of disappearing value is applied consistently on both the gross estate side as well on the deduction side.
However, when Code §2036 applies to include the underlying assets of a restrictive entity in the gross estate and a portion of the interests in the entity pass to the marital or charitable deduction, the matter is one of reappearing value. The discounts on the gross estate side are eliminated resulting in the reappearance of value that was intended to disappear by creating the entities. The issue in the context of Code §2036 is whether this reappearing value should be shared by the marital and charitable deductions, or whether, consistent with the principles developed in the context of disappearing value, the amount of the marital and charitable deductions should be limited to the discounted value of the entity interests that actually pass to the marital or charitable deduction.
In Estate of Bongard v. Commissioner,
124 T.C. 95 (2005), Code §2035(a) applied to include in the gross estate the underlying assets of the family limited partnership. Prior to his death, the decedent had made a gift of a 7.72 percent limited interest in the family limited partnership to his surviving spouse. In footnote 13 of the opinion, the Tax Court states that “decedent’s estate may be entitled to a [marital] deduction under sec. 2056 for his inter vivos gift to Cynthia Bongard [his surviving spouse] that was pulled back into his gross estate under sec. 2035(a).” This statement appears to indicate that the marital deduction should be based on 7.72 percent of the value of the underlying assets that were included in the gross estate under Code §2036 as opposed to the discounted value of the 7.72 percent limited partnership interest actually received by the surviving spouse.
A similar but somewhat different issue was raised in Estate of Lauder v. Commissioner, T.C. Memo. 1994-527, in which the Tax Court concluded that the price for closely held stock in a buy-sell agreement did not fix its estate tax value. The Tax Court concluded that the fair market value of the stock was $50,494,344, whereas the agreement set the value at $29,050,800, representing a difference of $21,443,544. An issue in the case was whether the marital deduction should be allowed for 39.26 percent of this difference by reason of the surviving spouse owning 39.26 percent of the stock on decedent’s date of death, or whether instead no marital deduction should be allowed, because the lower agreement price reflected the price the surviving spouse would actually receive for her stock under the agreement.
In Lauder, the Tax Court allowed the marital deduction for the enhanced value of the stock in the gross estate attributable to the surviving spouse’s percentage ownership interest ($8,418,735), concluding that such enhanced value “indirectly” passed to the surviving spouse and that allowing the marital deduction was consistent with policies underlying the provision. Countering the argument made by the IRS that the value of the indirect gift was illusory, because the surviving spouse would be required to transfer the stock at its buy-sell value, the Tax Court noted that the stock would be included in the surviving spouse’s gross estate at its fair market value and not at its lower buy-sell value.
Based on Bongard and Lauder, it appears that the Tax Court may well hold that in the case of reappearing value under Code §2036, different rules should apply, and that the reappearing value should be shared by the marital and charitable deductions.
Such holding would appear to be consistent with the fact that the underlying assets of an entity are inseparable from interests in the entity itself. For example, to avoid double counting, the Tax Court has required that adjusted taxable gifts attributable to gifts of interests in a family limited partnership be excluded from the estate tax computation when the underlying assets of the partnership are included under Code §2036.9 E xcluding these adjusted taxable gifts would be unnecessary, if the family limited partnership interests were considered to be separate from the underlying assets of the partnership.
As another example, in the case of some gifts of partnership interests, the transfers may be treated as being indirect gifts of the underlying assets of the partnership as opposed to gifts of the partnership interests themselves under Code §2511.10 S uch treatment is consistent with treating the reappearing value as an indirect gift for purposes of the marital or charitable deduction.
Further, the fact that the value of partnership interests will be included in the surviving spouse’s gross estate, as opposed to the value of the partnership’s underlying assets that were included in the first spouse’s estate under Code §2036, may not be considered significant given that the interests in the partnership are inseparable from the underlying assets of the partnership.
Resolution of the reappearing value issue under Code §2036 must await future decisions. In this regard, it should be noted that subsequent legislation may eliminate discounts in valuing interests in family controlled entities, which may eliminate the mismatch issue.
The reappearing value situation may be avoided or minimized by distributing to the marital trust of the first spouse the entire general partnership interest, assuming such interest either alone or in conjunction with the limited partnership interests also distributed to the marital trust, has the power to liquidate the partnership. In this case, there would be little or no discount11 a nd, therefore, little or no difference between the value of the underlying assets in the gross estate versus the value of the partnership interests passing to the marital deduction. reason of the marital deduction in the first estate, discounts may be relatively unimportant. After the first spouse’s death, the surviving spouse could then gift or sell interests in the general partner so that the surviving spouse’s estate would include only limited interests.
The reverse Chenoweth situation should not be a cause of alarm assuming family members were adequately advised of the issue in advance and all possible steps were taken to avoid or minimize the situation in the first place.
1 See Gazur Phillips, Estate Planning, Principles and Problems, Ch. 16 at 393-401 (2d ed.).
2 T here is disagreement in the valuation community as to whether there exists a valid, conceptual basis for applying a marketability discount in valuing a controlling interest in a closely held company, but there is no disagreement that a marketability discount should be applied, in addition to a minority discount, in valuing a minority interest. There is also no disagreement that the marketability discount for a minority interest should be larger than that applied to a controlling interest, assuming the valuator is of the school of thought that believes a marketability discount is applicable in valuing a controlling interest.
3 See, e.g., N. Angkatavanich, Black Shirts (Black, Shurtz) and the Marital Deduction Mismatch,
Trusts & Estates at 37-42 (June 2010).
4 M. Moore, Gross Estate vs. Marital Deduction Valuation, Honey, Who Shrank My Deduction?,
Probate & Property Magazine
at 8, ABA Section of Real Property, Trust & Estate Law, (Jan./Feb. 1997).
5 E xample (20) of IRS Treasury Regulation §25.2518-3(d).
6 I n that the Tax Court relied on Ahmanson in reaching its decision in Chenoweth, it is probably more correct to state that the issue addressed in this article of consistent valuation on both the gross estate side and the deduction side is the “ Ahmanson situation” as opposed to the “reverse Chenoweth situation,” but the latter term has gained popular acceptance.
7 S imilarly, in the case of family limited liability companies, the reverse Chenoweth situation might arise whenever the gross estate includes a block of both managing and nonmanaging member interests, but only the nonmanaging member interests pass to the marital or charitable deduction.
8 See D. Markstein III, S. Eastland, et al., Administration of Family Limited Partnerships at 22-26 (Vermont Bar Association Continuing Legal Education, May 2005).
9 Estate of Thompson v. Commissioner, T.C. Memo 2002-246.
10 Shepherd v. Commissioner, 283 F.3d 1258 (11th Cir. 2002).
11 T he discount might be in the range of the 8 percent applied by the Tax Court in valuing an 83.08 percent limited partnership interest in a real estate family limited partnership that was valued in the nature of a general partnership interest by reason of its power to remove the general partner. See Estate of Jones v. Commissioner, 116 T.C. 121 (2001). The discount would be less in the case of a family limited partnership holding marketable securities.
George F. Del Duca is of chas an LL.M. in tax from George Washington University and an LL.M. in estate planning from the University of Miami and is a member of the Tax Section. The author thanks John J. Pankauski, J.D., LL.M., for his assistance with this article.
This column is submitted on behalf of the Tax Section, Frances D. McCoid Sheehy, chair, and Michael D. Miller and Benjamin Jablow, editors.