8945 / What valuation discounts may be available to family limited partnership interests and how are the discounts applied?

Transfers of property are generally valued at the fair market value of the asset being transferred. The term fair market value has been defined in the regulations as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the facts.”¹ However, the interests of a properly structured FLP can be subject to discounts relative to fair market value. The two most common discounts available to FLP interests are the discount for minority interests and the discount for lack of marketability.

The discount for minority interests reflects the notion that the owner of such an interest lacks the ability to exert complete control over the asset. For example, minority owners lack control over management of the asset, disposition or liquidation, and distributions. Valuing an interest is a fact-specific question that turns on an assessment of the particular asset being valued and, therefore, there is not a fixed minority discount amount that can be anticipated (and, in fact, minority discounts are not guaranteed if the courts find they are not warranted based on the particular facts and circumstances of the case). Although minority discounts are not uniformly applied, case law has shown that the typical minority interest discount ranges from 10 percent to 30 percent.² For example, a 10 percent minority interest in a business worth $1,000,000 might be valued at less than $100,000 (i.e., less than the minority interest owner’s pro-rata share of the asset).

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Planning Point: The transfer tax value is based on the fair market value taking into account discounts, which allows a grantor to gift assets while paying tax on a value that is less than the underlying value of the asset. Tim G. Skinner, JD, CPA.

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In the example above, if the appropriate discount for the minority interest is 20 percent, the donee receives an asset worth $100,000, but the value transferred for estate tax purpose is $80,000 (($100,000 – ($100,000 × 20%)). The $20,000 is not included in the estate tax base and therefore escapes taxation, yet the underlying value of the asset in the hands of the transferee is unchanged.

The second discount potentially available to FLPs is the discount for lack of marketability, which reflects the idea that a ready market does not exist for the interest being valued. In terms of the fair value definition discussed above, a “willing buyer” will take into account the cost and effort involved in eventually converting his minority interest to cash. In other words, the degree to which an ownership interest can be converted to cash is diminished and the illiquidity associated with the interest warrants a discount. Similar to the minority interest discount, the discount for lack of marketability requires an assessment of the facts and circumstances and, therefore, a fixed lack of marketability discount does not apply. However, case law has shown that the typical minority interest discount ranges from 15 percent to 40 percent.

For example, in Estate of Barudin v. Commissioner, the court allowed a 26 percent marketability discount in the decedent’s minority interest in a general partnership owning real estate. Further, in Estate of Lauder v. Commissioner, the decedent received a 40 percent discount in his minority interest in a corporation. The courts have also allowed the lack of marketability discount where the decedent owned a controlling interest and all of the interests in an asset or business. In Estate of Luton v. Commissioner,³ the decedent’s 78 percent interest in an unincorporated ranch received a 20 percent marketability discount. Notably, the court also allowed a 25 percent discount to the decedent’s 100 percent ownership of the stock of a holding company.⁴ Given the prevalence of closely held businesses in the context of FLPs, the court in Mandelbaum v. Commissioner⁵ discussed a list of factors to assess when valuing a closely held business that should prove useful to a taxpayer trying to establish the appropriate marketability discount for a closely held business. The case law that has developed around the lack of marketability discount emphasizes that when an interest holder cannot readily liquidate his or her investment, a discount is appropriate.