Estate Taxes: Proper Planning Avoids Overpaying Taxes

Estate Taxes
Estate taxes are often referred to as the death tax. Few Americans are subject to estate taxes due to the exclusion on the first $2,000,000 of an estate (2006, 2007, and 2008). Taxpayers with estates substantially in excess of this amount should consider estate planning to minimize estate taxes. For family businesses, it is important to ensure adequate liquidity is available to pay estate taxes (so the business does not have to be sold to pay the taxes).

Estate Tax Reduction
Estate taxes can be sharply reduced or eliminated through advanced planning. Options to reduce estate taxes include trusts, family limited partnership, gifts prior to death, gifts at death, and skillful use of partial interests. This summary focuses upon partial interests. A partial interest is worth less than the proportionate share of the underlying asset. Partial interests can result from ownership of a portion of an asset or entity, or can be designed during the estate tax planning process. Skillful use of partial interests can dramatically reduce estate taxes. In some cases, tiers of partial interests can reduce estate taxes even further. For example, an entity that owns a series of partial interests can be owned by multiple people. Partial interest valuation values the ownership of a portion of a property, limited partnership, general partnership, corporation, LLC or LLP.

Partial Interest Valuation
Valuing a partial interest involves first valuing the underlying asset and then determining a discount for a partial interest. The valuation of a partial interest involves two separate appraisals. Partial interest valuation is more complex than most valuation problems and requires intense analysis and seasoned judgment. Reasons for performing a partial interest valuation are typically related to estate tax valuation or estate tax planning but could involve divorce, business dissolution or valuation of collateral for a bank.

Partial Interests are Worth Less
Partial interests are almost always worth less than an undivided interest. This is because they are illiquid and lack control. Partial interests are illiquid since it is difficult to sell a limited interest in a property or nonpublic company. In addition, the sale of a partial interest in many entities is subject to approval by other owners. In many cases, other owners can choose to not allow the sale in their sole discretion without providing a reason.

Limited or Non-Control
The owner of a partial interest has less control than the owner of the entire property or entity. Even if someone owns a controlling interest, their actions are subject to review and scrutiny by the owners of the balance of the property or entity. The owner of a non-controlling interest typically has very limited ability to control decisions or influence the management and policies for a property or entity. Following are some of the detrimental effects of not having control of a property or entity:

• Cannot make decisions regarding selling the property, perhaps in advance of a declining market or for personal reasons
• Limited or no ability to impact the quality of management or to choose a different management company
• Limited or no ability to impact business policies
• Limited or no ability to impact strategies or tactics
• Limited or no ability to impact refinancing the property
• Limited or no ability to impact the level of financial leverage
• Discounts for a partial interest are often 20% to 50% of the proportionate value of the entire property or entity. These are considered a typical level of discount.

Some of the factors determining the degree of discount for a partial interest include the percentage of ownership, whether it is a controlling interest, asset performance, the number of partners, the relationship between the partners, issues with the property (such as risk, condition and financing), market conditions and trends, and the quality of the general partner.

The steps involved in a simple partial interest valuation are as follows:

1. Value the entire property or entity
2. Calculate the value of the proportionate share in the property or entity (value of the entire property times percentage owned)
3. Determine the appropriate discount for the partial interest
4. Calculate the value of the proportionate share after the discount for a partial interest.

Partial interest valuations are more complicated when there are preferred returns and multiple types of partners.

Consider the following example. John and Sally Jones are 70 years old and own an apartment complex worth $10 million. They owe $6 million in debt. They transfer ownership to a limited partnership and start giving their three children, their spouses and their seven grandchild (in trust) each the maximum annual gift not subject to tax ($12,000 per year per person in 2006 - 2008). This allows them to gift $156,000 per year (13 people x $12,000 per person).

The partnership is structured so the parents retain cash flow during their lifetime. The appraiser valued their property at $10 million. This left equity of $4 million. The partial interest discount was 40%, reducing the taxable value to $2.4 million.

The second parent dies when they are 85. The parents retained all cash flow during the previous 15 years. They have also had the exclusive right to control capital events (sale or refinancing). At this point, they have transferred $2.34 million of the $2.4 million of equity in the property. There were no taxes incurred during the transfer, and the taxable estate is reduced substantially.

Based upon a 45% estate tax rate, they reduced their estate taxes by $1.773 million (($4 million - $0.06 million) x 45%).

It is possible to substantially reduce estate taxes. However, most meaningful strategies require advance planning.

Sage Group is a national network of appraisers working together to provide a single source of information and analysis for
commercial real estate professionals across the country. Their expertise includes valuing partial interests, business personal property, real estate, business enterprise value, purchase price allocation for businesses, valuation for property tax appeals, estate tax valuation, expert witness testimony and valuation for condemnation.

To obtain a quote or further information for a Estate Tax Appraisals, contact John Fisher at 713-375-4300,
1-800-856-7325 x 4300, or fill out our online form.