Discounting can help save certain clients a large amount of money in estate taxes. But how exactly does discounting work? MHPS is here to help you learn more about discounting and how it can potentially impact your estate taxes.
What is Discounting?
Discounting involves creating a situation that allows the client to value certain assets for estate tax calculations at less than their individual current value. For instance, if an asset receives a discount of 35% and its normal individual value is $4,000,000, then for estate tax calculation purposes, the discounted value would be $2,600,000 ($4,000,000 reduced by 35%). This takes $1,400,000 out of the estate tax equation. With a 40% estate tax rate, this saves the family $560,000 in estate tax.
The concept of discounting is based on (1) the IRS requirement that each asset reported on the estate tax return is to be valued at its fair market value, and (2) different types of ownership interests in a business, such as voting or non-voting, can be valued in different ways.
Fair market value is defined as an amount equal to the asset’s sale price in a negotiated arms-length transaction, which is the price that is the lowest amount a seller is willing to accept, and the same amount that is the highest amount a buyer is willing to pay.
Types of Ownership Interests in a Business
Sometimes a business is set up with two types of ownership interests. One type, the normal type, is voting interests. The second type is non-voting interests. As you can imagine, any ownership interest considered non-voting might have a fair market value less than a voting interest.
For example – Suppose I own a business that is worth $1,000,000. I am going to sell you a 30% interest in my business. How much would you be willing to pay for a 30% interest in my business? From a linear, mathematical calculation, a 30% interest in my $1,000,000 business would be worth $300,000. But is the $300,000 amount considered to be fair market value?
Remember, even though you own 30%, I still own 70% of the business. You own a minority interest while I still own the majority interest in the business. You have no authority to make any decisions. My 70% will always outvote your 30% on any decision, even if my decisions are bad. Are you willing to pay a full $300,000 for the 30% interest in the business, knowing that you have no authority at all in the decisions of the business?
Furthermore, this is my business, and I want to control who my business partners are. Thus, I put a transfer restriction on your 30% business interest. The restriction states that you must receive my permission to transfer the 30% business interest to anyone else. And I can withhold that permission for any reason or no reason at all. If I don’t want the person who desires to buy your 30% business interest to be my new business partner, I can prevent you from selling the business interest. In reality, after buying the 30% business interest from me, you cannot convert that business interest into money without my prior permission.
So, how much are you willing to pay for a 30% interest in my $1,000,000 business when (1) you have no authority in any business decisions, and (2) you cannot sell your interest in my business without my prior approval? Under these circumstances, it is recognized that the value of the 30% business interest is not a linear, mathematical calculation. It is something less.
The inability to have authority to make decisions for the business is referred to as “lack of control.” The inability to transfer the business interest is referred to as “lack of marketability.”
When business ownership has (1) both voting interests and non-voting interests, and (2) the transfer of the non-voting interests is restricted by the voting interests, then the fair market value of the non-voting interests is calculated as less than the linear calculated value. In other words, the fair market value of the non-voting interest is “discounted” compared to the linear calculation.
Learn More About Estate Tax Discounting
While you now know some of the basics of discounting, you may still have many more questions. In our next blog, we will describe how the discounting technique can be applied to an existing business, and to other types of assets, such as real estate and investments.
Don’t hesitate to contact the estate planning lawyers MHPS with any questions you have.