Companies Estate of Warne v. Commissioner

In a gift and estate tax dispute, the estate and Internal Revenue Service agreed to apply discounts for lack of control and marketability to the majority interests in several real estate holding companies. The U.S. Tax Court noted that, in prior decisions, the court found no discount for lack of control applied. However, given the parties’ agreement, the court said it would involve a “slight” or “low” value.

Considerable power over LLCs:

During her lifetime, the decedent gave fractional interests in several limited liability companies to family members. A family trust of which the decedent was the trustee held the majority interest in the LLCs. The LLCs held ground leases in various California properties. During her lifetime, the decedent also served as manager of the company. Under the LLCs’ operating agreements, the majority interest holder had considerable powers, including the right, “in conjunction with the manager,” to elect to dissolve the companies.

The IRS found gift tax and estate tax deficiencies. For both the gift and estate tax calculations, the IRS determined a higher fair market value of the LLCs based on the valuations of the ground leases. In terms of the estate tax, experts for the estate valued the majority interests by applying discounts for lack of control and lack of marketability. For its part, the IRS argued a lower value for lack of control and marketability than the estate had used were appropriate. The estate petitioned the Tax Court for review.

Both parties retained experts to analyze the appropriate discounts for each LLC. Both parties used the adjusted net asset value approach to value the LLCs, but the experts had different approaches to calculating the discounts.

Regarding the discount for lack of control, the estate’s expert used the Mergerstat ControlPremium Study, which measures control premiums on transactions of publicly traded companies. The expert compared premiums paid to acquire 50.1% to 89.9% controlling interests with those paid to receive 90% to 100% interests. He explained that the difference in premiums between the two blocks suggested a discount for controlling interests that lacked total control. He then considered factors specific to the LLCs, including the possibility of costly litigation should the majority interest holder attempt to liquidate and dissolve the companies.

In contrast, the IRS expert used closed-end funds classified as real estate funds to calculate the discount for lack of control. The data indicated a range of 3.5% to 15.7%, with a median discount rate of 11.9%. Comparing the funds to the subject interests, he found that closed-end funds were “minority interests and completely devoid of any control.” Therefore, a discount for lack of control for the subject interests should be at the“bottom of the range” of the closed-end discount rates. He arrived at a 2% rate.

The court noted the LLCs’ operating agreements gave significant power to the majority interest holder and the family trust held a majority interest in every LLC. Therefore, the discount for lack of control “should be low.” The court noted that it had accepted valuations of discounts based on closed-end funds to determine minority-interest discounts, no discounts for lack of control for a majority interest. Further, the closed-end funds the IRS expert used were too dissimilar to the subject LLCs. Therefore, the court rejected the 2% discount rate.

The court also “hesitate[d] to adopt” the estate expert’s range (5% to 8%), finding he proposed a higher rate based on the risk of potential litigation when there was no evidence in the record that minority interest holders would sue in case of dissolution. The court found a 4% discount for lack of control was appropriate.

This case also includes a discussion of the discount for lack of marketability and a charitable contribution discount. In general, the Tax Court found the estate’s experts presented a more reliable discount analysis in valuing the various properties.