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1 Estate freezes A De nition of estate freezes (1) The primary goal is a reduction in estate taxes by xing the value of estate assets at current levels The owner accomplishes the freeze by transferring the appreciation rights to another individual during the owner s lifetime (2) It often is a transaction involving a corporation or partnership, in which the owner of the business transfers interests in property (ie, common stock) with anticipated future appreciation to a younger family member, while retaining rights in income and principal in the property (ie, preferred stock) B Corporate and partnership recapitalizations (Section 2701) (1) Section 2701 is known as the special gift tax valuation rule, which addresses estate freezes The gift tax value of a transfer is determined by using Section 2701 special valuation rules to value the interests in the property retained by the transferor (2) Code Section 2701 values certain retained interest at zero, resulting in a higher value of the transferred interest, unless an exception exists (3) The special valuation rules of Section 2701 apply if the following occur: (a) A transfer of an interest in a corporation or partnership to a family member of the transferor is made (b) Immediately after the transfer, the transferor or family member holds a retained interest (4) The following types of transfers are excluded from coverage under Code Section 2701: (a) Transfers for which market quotations on an established securities market are readily available on the date of transfer for either the interest transferred or for the interest retained by the transferor (b) Transfers in which the retained interest is of the same class or proportionately the same class as the transferred interest (c) Transfers that proportionately reduce each class of interest held by the transferor and applicable family members immediately before transfer C Transfers in trust (1) In determining the value of a transfer of an interest in trust for the bene t of a family member, the value of the retained interest is zero unless the retained interest is a quali ed interest The rule does not apply to incomplete gifts or a transfer of an interest in a personal residence that is inhabited by the holder of a term of interest (2) A quali ed interest is as follows: (a) Any interest that consists of a right to receive xed payments at least annually (b) Any interest that consists of a right to receive amounts that are payable at least annually and are a xed percentage of the fair market value of the property in trust (c) Any noncontingent remainder interest if all other interests in the trust consist of interests described in the items listed previously 2 Valuation issues with family partnerships and limited liability companies (LLCs) A Purpose and requirements (1) Advantages
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318 - Estate Planning (a) Gifts of family limited partnership interests are advantageous, because discounts for lack of marketability and minority interests are available to reduce the gift tax value of limited partnership interests These discounts mean substantial reduction from the value of the underlying business assets, thereby saving transfer costs (b) Limited partnership interests can provide some protection against creditors (c) The family partnership is more likely to stay intact when there are failed marriages among the owner s children, because the business assets themselves are not under the control of the children (2) A family partnership must meet the following three requirements: (a) Capital invested in the business must be a material income-producing factor A personal service partnership is not a good candidate for a family partnership (b) The donor of the partnership interests must be paid reasonable compensation for services to the partnership (c) The share of partnership income attributed to a donee s interest cannot be proportionately greater than the income interest attributed to the donor s interest Nevertheless, if the donor s interest is a 10 percent general partnership interest and the donees receive 90 percent limited partnership interests, the donees are entitled to 90 percent of the partnership net income (3) Family limited partnerships are generally not recommended unless the owners have a net worth of approximately $3 million Setting up a family limited partnership requires attorney s fees and appraisal fees for the limited partnership interests Appraisal fees are also required at the time gifts are made of limited partnership interests Preparation of partnership returns and K-1s will also require some accounting fees B Minority discounts (1) A minority discount is a valuation discount allowed for an interest in a business because the interest is not a controlling interest (2) In most situations, more than 50 percent of the voting shares constitutes a controlling interest, and less than 50 percent is a minority interest (3) A minority interest discount is based on a number of factors, including the inability of a minority owner to realize his or her pro rata share of the entity s net assets by liquidating his or her interests in the entity and his or her lack of control over corporate policy (4) For transfer tax valuation, minority discounts between 15 and 50 percent are obtainable (5) Factors in uencing the size of the discount include the overall quality of management, composition of other share holdings, size of the business, history of pro tability, existence of business opportunities not currently being exploited, and degree of the company s nancial leverage C Marketability discounts (1) Because of the lack of an established market (ie, restricted stock, stock in a closely held business, and partnership interest), certain stocks are invariably more dif cult to sell than business stock that is publicly traded (2) For transfer tax valuation, marketability discounts between 15 and 50 percent are obtainable (3) These discounts apply to both minority and majority interests (4) Factors in uencing the size of the discount include the extent of the resale restrictions, Securities and Exchange Commission (SEC) restraints on marketability, the dollar
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Topic 94: Valuation Issues - 319 value of the stock, the rm s growth expectations, and the size of the company s total assets and equity D Blockage discounts (1) Large quantities of a stock listed on an exchange can receive a blockage discount if selling them at one time could have a depressing effect on the market price (2) If the block represents a controlling interest in the corporation, possibly even triggering a higher price, a premium may be attached to its value (3) Blockage discounts may be available for other property, such as a large number of paintings left in the estate of a prominent artist E Key person discounts (1) A discount may be allowed for a business that lost a key person (ie, the decedent) who was responsible for its goodwill (2) In practice, the IRS will require an executor to show that the loss could not have been avoided by such actions as the purchase of key person life insurance or by other means 3 Valuation techniques and the federal gross estate tax A Selecting valuation date for estate accounts (1) Date of death (2) Alternative valuation date B Fair market value: For federal transfer taxes, the fundamental principle of valuation is that tax is generally imposed on the fair market value of the property as of the date of the transfer Fair market value is de ned as the price that a willing buyer would pay a willing seller where both had reasonable knowledge of the relevant facts of the transaction and neither was under any compulsion to buy or to sell C The principle of fair market value applies to a wide variety of properties and situations, but there are important exceptions (1) Valuing real estate (a) The value of real property depends on the location, size, shape, condition, defects, physical quality, zoning laws, and any other factors unique to the land (b) A co-ownership discount is available where one of the co-owners refuses to sell his or her interest either to the estate or to a third party and refuses to buy the interest held by the estate This lack of cooperation impairs the marketability, and thus the value, of the real property, so a discount is allowed (2) Valuing insurance policies (a) When the donor (owner) of a life insurance policy is not the insured, the value of the gift is the replacement cost of the policy (b) Replacement cost is determined in different ways for different policies i On a paid-up or a single-premium policy, the value is the replacement cost, which is the single premium the insurer would charge for a comparable contract of equal face value on the life of a person who was the insured s age (ie, at the time of death) ii On an established whole life policy, the value is found by adding any unearned portion of the last premium to the interpolated terminal reserve The interpolated terminal reserve is the value of the reserve held by the insurer for a policy and calculated as of a given date
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320 - Estate Planning iii For a term policy, the value of the policy is the unused premium The same rules apply to valuing a life insurance policy when the deceased owned the policy but was not the insured Valuing annuities (a) Commercial annuities are annuity contracts issued by companies regularly engaged in sales of annuities, and they are valued at the price at which the company issues comparable contracts (b) For a private annuity contract, the value is determined by the present value of the future payments required under the contract Valuing bonds (a) The fair market value of publicly traded bonds is the mean between the highest and lowest quoted selling price on the date of death (or alternate valuation date) (b) If there was no trading in the bond on the valuation date, the mean prices on the closest trading dates are weighted inversely by the number of days from the valuation date (c) Series EE bonds are valued at their redemption price (market value) as of the date of death These bonds are neither negotiable nor transferable, and the only de nitely ascertainable value is the amount at which the Treasury will redeem them (d) Certain US Treasury bonds, called ower bonds, may be redeemed at par value if they were owned by the decedent at date of death and are used to pay federal estate taxes These bonds are valued at the higher of market price or par value Valuing stock (a) The fair market value of publicly traded stock is the mean between the highest and lowest quoted selling prices on the applicable valuation date (b) If there was no trading of the stock on the valuation date, IRS regulations require use of the mean of the high and low prices on the nearest trading dates before and after the valuation date and then weighting these mean prices The mean price calculated for a trading date two days from the valuation date will be weighted twice as much as a mean price for a trading date four days from the valuation date (c) Example: If the mean price was $10 two days after (or before) the valuation date and was $11 four days before (or after) the date, the valuation date price will be $1033 (d) Solution: ($10 4 + $11 2) / 6 = $1033 Valuing closely held stock Valuing the stock of a closely held corporation is dif cult because of the lack of an organized market As with real estate, there are many factors to consider in valuing closely held stock Among of the factors to consider are the following: (a) Nature of the business and history of the enterprise (b) Outlook for the economy and for the speci c industry in which the company operates (c) Book value of the stock (d) Earning capacity of the company (e) The company s dividend paying capacity (f) Goodwill (g) Any recent sales of the stock and the size of the block of stock being valued
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Topic 95: Marital Deduction - 321 (h) Fair market value of the stock of comparable companies in the same or similar business and whose stock is publicly traded (7) Valuing life estates, remainders, and reversions (a) The fair market value of life estates, remainders, and reversions is their present value (b) The calculation of present value is done by consulting the appropriate IRS tables for the present worth of an annuity, of an income interest, and of a remainder interest The tables show the factors for these three present worth calculations at various interest rates (or discount rates) (c) There is a separate table showing the factors to use when the annuity or income interest is for a term certain ( xed number of years) and when the annuity or income interest is payable for the life of a designated person Another table provides the factors to use when an annuity or income interest is payable for the joint lives of A and B ; that is, the income is paid to A and B and then to the survivor for life
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