Fractional interest in estate tax turns on type, timing of gift

Estate of Adler v. Commissioner of Internal Revenue, T.C. Memo. 2-11-28, 2011 WL 300144 (U.S. Tax Court) (Jan. 31, 2010)

A father owned a California ranch on more than 1,000 acres. In 1965, he gifted undivided one-fifth interests to his five children as tenants-in-common, reserving his own “full use and control” of the property throughout his life. After the transfer, the father used the ranch and paid all its taxes, expenses, and costs of improvement—but not any rent to his children. None of the children lived on the ranch or interfered with the father’s use.

Estate applies 48% combined discount. When the father died nearly 30 years later, the property had a fair market value of $6.39 million. To reflect the decreased value caused by the children’s fractional interest, the estate applied a 32% discount for lack of marketability and a 16% discount for lack of control at the time of death. During the father’s life, the estate applied a 22% marketability discount and 16% minority discount to each of the undivided interests.

The IRS stipulated to the $6.39 million fair market value of the property, but disallowed the discounts and assessed a deficiency. The estate appealed to the U.S. Tax Court, which began by reviewing the applicable statutes. If a decedent owns a life estate—i.e., a grant of property for the duration of his life—then at the time of death it has no value under Sec. 2033 IRC, the court explained. “But if the decedent gratuitously transferred a remainder interest in property and retained a life estate,” then the full, fair market value of the property would be included in the gross estate pursuant to Sec. 2036.

Specifically, Sec. 2036(a)(1) includes the value of transferred property if: 1) the decedent transferred the interest during life; 2) the transfer was not a sale; and 3) the decedent retained possession or enjoyment of the property for life (citing Estate of Bongard v. Commissioner 124 T.C. 95 (2005)).

At the same time, “the owner of a fractional interest in property often lacks the ability to control the property or to sell the interest freely,” the court noted, citing Estate of Amlie, T.C. Memo. 2006-76. Further, when a person dies holding a fractional interest in property, discounts are often appropriate to reflect the lack of control and marketability. Whether the property is valued as a whole or discounted “depends on when the interests are separated,” the court held. If the ownership is split during the person’s lifetime, the decedent’s interest is valued separately. “If the split occurs only at death, the property is valued as a whole—without a discount.”

The court gave the following examples. Suppose an owner of land gives a one-half interest to a child. When the parent dies holding the one-half interest, it would be valued separately from the child’s half-interest. On the other hand, suppose that a landowner continued to own property until death, at which time each of two children took an interest. Because ownership continued until death, no discount would apply to the account for the fractional ownership acquired by the children at death.

Control is key. In support of its falling closer to the former example, the estate cited Estate of Mellinger, 112 T.C. 26 (1999), in which a husband and wife owned a block of stock. At the husband’s death, he left the wife his interest in trust, for her lifetime benefit. When the wife died, she still owned her 50% interest, but the IRS also included the value of the other 50% interest held in trust. The Tax Court disagreed, however, finding that the interests should be valued separately, because “at no time did the wife possess, control, or have any power over the interest held in trust.”

Unlike the wife in that case, however, the father in this case controlled the ranch property from his transfer of the remainder interests in 1965 until his death in 2004, the court found. Under these facts, the better precedent was Estate of Fontana v. Commissioner, 118 T.C. 318 (2002). There, the decedent owned two blocks of stock, one outright and one by a testamentary trust power of appointment. Because the decedent controlled the disposition of stock in trust, its value was aggregated with the stock he held outright.

For these reasons, the court considered that the ownership of the ranch was split up after the father’s death. “Thus it was as if [the father] had retained the entire interest in the land during his life and transferred the property to his children at death,” the court held, in finding that no discounts were appropriate to the $6.39 million fair market value of the land.

Note: All precedent cited by in Tax Court’s opinion is available at BVLaw.