1.2 Concept of Fair Market Value
The federal estate and gift tax system rests on the concept of “fair market value.” Fair market value, in turn, is defined in terms of a theoretical willing buyer and a theoretical willing seller. It is not defined with family attribution rules applying – in other words it is applied as if the various parties are unrelated. If a family limited partnership is created and a portion of the partnership – normally a limited partnership unit – is gifted, the value of the gift for gift tax purposes reflects discounts based on what a stranger to the transaction would demand if he or she were purchasing that interest. Obviously, someone is not going to pay full value for a minority interest in the enterprise and it is equally obvious that there is a soft market for an interest in a closely held business. A gift to a child of a partnership interest, because it is based on a fictional third party, reflects these deep discounts.
1.2.1 Ironically, the best “thumbnail” description of this technique is a description by the Treasury Department that accompanied proposed legislation that the Clinton Administration floated a few years ago. Treasury proposed in a legislative “wish-list” the elimination of valuation discounts for real estate and stock portfolio entities. If this proposal became law (and, to my knowledge, it has never moved to the point of being drafted as specific legislation) then it would cover transfers made after the date of enactment. Given the present political climate, it is doubtful that this proposal will go anywhere. The description by the Treasury of the perceived “abuse” is as follows:
Under current law, taxpayers making gratuitous transfers of fractional interests in entities routinely claim discounts on the valuation of such interests. The concept of valuation discounts originated in the context of active businesses, where it has long been accepted that a willing buyer would not pay a willing seller a proportionate share of the value of the entire business when purchasing a minority interest in a non-publicly traded business.
Without legislation in this area, tax planners have carried this concept over into the family estate planning area, where a now common planning technique is to contribute marketable assets to a family limited partnership or limited liability company and make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.
Under the Treasury’s proposal, the use of family limited partnerships and other devices for real estate and/or portfolio assets would be eliminated. As I mentioned, this proposal never got off the ground.