The U.S. Tax Court recently provided an example of how not to get a fractional-interest discount. In early 2011, Judge Morrison decided on Adler v. Commissioner (click to read the Tax Court Memorandum). In the case, Judge Morrison concluded that a fractional-interest discount was not applicable to the property held by the estate. Below is a quick summary of the facts of the case and the decision:
- On December 8, 1965, the decedent executed a grant deed transferring undivided one-fifth interests in the property, known as the Rancho Aguila property, to his five children as tenants in common.
- The deed, however, expressly stated that the decedent "[reserved] unto himself the full use, control, income and possession of [the Rancho Aguila property] and every part thereof for and during [his] natural life." The transfer was gratuitous, as the decedent received no consideration.
- After the transfer, the decedent continued to use the Rancho Aguila property, paying all expenses associated with the property, including taxes, upkeep, and maintenance. Further, the decedent did not pay rent to the children, nor did the children interfere with his use, possession, or enjoyment of the property.
- The decedent died on June 20, 2004 and the estate reported a one-fifth interest in the Rancho Aguila property subject to a 32% marketability discount and a 16% minority-interest discount.
- The Tax Court concluded that the entire value of the Rancho Aguila property should be included in the decedent’s estate under Section 2036, due to the decedent’s retained lifetime interest in the ranch.
In its opinion, the Tax Court noted that it is often appropriate to discount the value of a fractional interest in property because the lack of control and the lack of liquidity decrease the property’s value. It further provided the following guidance as to when discounts for fractional interest are appropriate for estate-tax purposes: “Whether property should be valued as a whole or as separate fractional interests — with appropriate discounts for split ownership — depends on when the interests are separated. If ownership is split during the decedent's lifetime, the interest the decedent retained is valued separately. If the split occurs only at death, the property is valued as a whole — without a discount for split ownership.”
The Tax Court concluded that the ownership of the property should be considered split at the decedent’s death, and thus a fractional-interest discount was not appropriate. If, however, the decedent had instead gifted an undivided interest in the property, without retained rights of control or benefits, it would have allowed for a fractional-interest discount. Thus, when utilizing fractional interests of property in an estate plan, make sure to consider if the rights of control and benefits are retained.