Discounts: A Complex Matter

Estate planning attorneys often strive to obtain valuation discounts. We set up Family Limited Partnerships and carefully supervise their administration, at least in a perfect world. We advise clients to fractionalize their real estate to obtain a fractional interest discount. 

But, discounts may not make sense for many clients. Remember, discounts must be taken consistently. In other words, if you are taking a discount for estate tax purposes, the same discounts will apply for income tax purposes. The problem is the client will want a low valuation for estate tax purposes and a high valuation for income tax purposes in setting the basis of the property. 

Let’s look at an example:

John has assets of $4 million, consisting entirely of Blackacre. The property is currently held in his sole name and no valuation discount may be taken. If John fractionalizes the ownership to tenancy-in-common and gifts a portion to his children (or an irrevocable trust) it may qualify for a discount of 10%-20%. So, the valuation could be reduced to $3.5 million, let’s say. 

Getting that reduction in valuation may make sense if we are looking at a 55% estate tax rate and a $1 million applicable exclusion. However, if the applicable exclusion is $5 million, fractionalizing the real estate could unnecessarily reduce the basis for the heirs without any estate tax benefit. 

Assuming an estate tax will be due, it would be necessary to weigh the state and federal estate taxes to be saved at death against the present value (at date of death) of the future state and federal capital gains taxes which would be owed by the heirs. Of course, this is a complex calculation which requires knowledge of the heir’s state of residence and the timing of the heir’s sale of the property. 

As you can see, in John’s case, if the applicable exclusion is at or above $4 million, his heirs would be better off if he does not fractionalize the real estate. If his estate is above the applicable exclusion amount, a calculation would have to be done to determine if discounting is beneficial. 

Obtaining a discount may be complex (such as an FLP) or simple (such as fractionalized tenant-in-common interests), but the decision is quite complex.