Warne Case gives Insight on Valuation and Gifting

Many know the old adage of “it’s the thought that counts” when it comes to gifting. According to a recent Tax Court opinion, when it comes to charitable contributions, what the recipient receives is significantly more important than what is given by the donor. Charles Allen previously discussed this issue in his article on the Dieringer decision.

Facts

Thomas and Miriam Warne began investing in real estate in the 1970’s and continued to acquire properties during their lives. Eventually, they transferred ownership of the properties they acquired over the years to five separate LLCs (“Five LLCs”) with the most significant one being Royal Gardens, LLC (“Royal Gardens”). The Five LLCs also held various leased fee interests associated with the properties. The operating agreement for each of the Five LLCs contained common provisions regarding the transfer of interests, restrictions on dissolving an interest, and others which vested considerable power in the majority interest holder. In 1981, the Warnes created the Warne Family Trust (“Family Trust”). Over the years, the Family Trust, with Mrs. Warne as trustee, became the majority interest holder of the Five LLCs. The Family Trust was included in Mrs. Warne’s taxable estate at her death.[1]

Mr. Warne died in 1999, and Mrs. Warne died in 2014. On December 27, 2012, Mrs. Warne gave fractions of the five LLCs to her sons and granddaughters. At the time of her death, the Family Trust owned the following majority interests (and in one case, the sole-interest) in the Five LLCs: 78%, 86%, 73%, 87%, and 100% (Royal Gardens). The remainder interests had been transferred to Mrs. Warne’s children and grandchildren or were owned by a sub-trust of the Family Trust. In the Ninth Amendment to the Family Trust agreement, Mrs. Warne left 75% of her interest in Royal Gardens to the Warne Family Charitable Foundation (“Foundation”) and the remaining 25% to St. John’s Lutheran Church (“Church”), both of which were section 501(c)(3) charitable organizations.

Both the gift tax return for the 2012 gifts and the estate tax return were filed on May 19, 2015.[2] On the estate tax return, the values of the Five LLCs owned by the Family Trust were listed as: $18,006,000, $8,720,000, $11,325,000, $10,053,000, and $25,600,000 (Royal Gardens). Those values were determined by valuing the underlying real property interests owned each LLC, and then applying lack of control and lack of marketability discounts to the LLC interests themselves. The estate also listed the value of the 75% of Royal Gardens donated to the Foundation as worth $19,200,000, and the 25% of Royal Gardens to the Church as worth $6,400,000. Combined, those amounts equaled the full value of the 100% ownership interest in Royal Gardens that was shown as being included in the estate.

The IRS determined several deficiencies including one late filing penalty for the 2012 gift tax return,[3] deficiencies related to the value of the leased fee interests held by several of the Five LLCs, deficiencies related to the discounts applied to the majority interests held by the Family Trust in several of the Five LLCs, and a deficiency for the reduced charitable contribution deduction related to the split donation of Royal Gardens.

Analysis

This case was interesting because the parties were each arguing both for and against discounts in different contexts. On one side, the estate wanted the discounts to be as high as possible for the valuation of the LLCs (and the underlying property interest in the LLCs) included in Mrs. Warne’s taxable estate, but it also argued that the discount on the contribution of the Royal Gardens should be as low as possible (or preferably zero). The IRS of course wanted the opposite.

Each side presented appraisers to testify as to the value of the leased fee interests owned by the LLCs.[4] The more important valuation related to the discounts applied to the lack of control and lack of marketability to the LLC interests themselves. The estate argued that a combined 10% discount should apply, and the IRS argued that a 4% discount would be appropriate. The court placed importance on the fact that the operating agreements provided significant control to the holder of the majority interest, including the power to unilaterally dissolve the LLC and appoint and remove managers. The court cited to previous cases under similar facts in which it held that no discount for lack of control applies, but since the parties agreed that a discount for lack of control should apply, found a slight one.[5] For more analysis on this issue please see our article discussing the Streightoff[6] case. The IRS’s expert used nine closed-end funds to estimate a lack of control discount of 2%. Citing Grieve v. Commissioner[7], the court stated that it had previously found closed-end funds to be appropriate for determining the lack of control discount for majority interests. Unlike in Grieve where the majority interest lacked voting power, the majority interests in the LLCs wielded considerable power. The court further stated that the closed-end funds were too dissimilar to the LLCs and more closely akin to minority interests.

The estate’s expert compared premiums from completely controlling interests in companies with premiums from interests that lacked full control and concluded that a lack of control discount of 5% – 8% should apply. This evaluation included considering specific qualities of the LLCs, including the likelihood of opposition and potential litigation in the event a majority shareholder chose to dissolve the LLCs. The court responded by citing Olson v. United States[8] which states that “elements affecting value that depend upon events or combinations of occurrences which, while within the realm of possibility, are not fairly shown to be reasonably probable should be excluded from consideration for that would be to allow mere speculation and conjecture to become a guide for the ascertainment of value.” The court found that the likelihood of litigation from a majority shareholder dissolving the LLCs to be too unlikely to factor into the appraisal, and a such accepted the lower discount rate of 4% put forth by the IRS.

Both experts then presented their lack of marketability discount valuations, with the estate determining 5% – 10% as appropriate and the IRS concluding on 2%. The court concluded that the estate’s expert “considered additional metrics and provided a more through explanation of his process,” and accepted a 5% lack of marketability discount.

While arguing over valuation is always enthralling to non-valuation experts, the real interesting bit of this case came down to the valuation of the charitable deduction discount. The estate insisted that “discounts [were] inappropriate and would subvert the public policy of motivating charitable donations. It claim[ed] that because 100% of Royal Gardens was included in the estate and the estate donated 100% of Royal Gardens to charities, the estate [was] entitled to a deduction of 100% of Royal Gardens’ value.” The court disagreed.

The court quoted Ahmanson Foundation v. United States, “In short, when valuing charitable contributions, we do not value what an estate contributed; we value what the charitable organizations received.”[9] The court also quoted Ahmanson in regard to the inclusion in the estate, “when valuing an asset as part of an estate, we value the entire interest held by the estate, without regard to the later disposition of that asset.”[10] The parties had preciously stipulated that, in the event the court found a discount applied, a 27.385% discount was appropriate for the 25% interest donated to the Church, and that a 4% discount applied to the estate’s 75% donation to the Foundation. This resulted in a reduction in the charitable contribution of over $2.5 million.

Conclusion

The Warne case serves as a Warne-ing to those who are not careful about their charitable contributions of majority interests in closely held entities. The advisors overseeing the estate planning for the Warnes probably never even considered a minority discount applying for the transfer of the Royal Gardens interests because, not only did the taxpayers transfer 100% of the interest, but they also ensured that it all went to charity. The IRS, and the court, did not care. The key was not what was given, but rather what was received. The case did not discuss the practical reasons why the taxpayer or the tax professional for the Warnes decided to split the interests in Royal Garden between the Foundation and the Church, but it clearly was the wrong decision. The whole issue on discounting the majority interest could have been avoided with proper tax planning. If a taxpayer wants to maximize their charitable contribution, they should ensure that they transfer their full ownership interest in similar entities to one beneficiary, rather than splitting the baby. In this case, the trust could have left 100% of the Royal Gardens interest to the Foundation and given some other LLC interest (or a mix thereof) to the Church.

It is important to note that a similar issue can occur in other contexts, such as the marital deduction. One example is the “reverse-Chenoweth” seen in Technical Advice Memoranda 9050004 and 9403005 which resulted in a similarly unfavorable result for the taxpayer.[11]

[1] The case did not discuss why the Family Trust was included in her estate.

[2] The gift tax return was late, and the taxpayer could offer no evidence in support of establishing a reasonable cause for filing late.

[3] The taxpayer did not contest this, and as such it will not be further discussed in this article.

[4] The appraisers presented various methods for appraising the values, but these discussions are not the focus of this article.

[5] See Estate of Jones v. Commissioner 116 T.C. 121, 135 (2001) and Estate of Streightoff v. Commissioner, T.C. Memo. 2018-178).

[6] Estate of Streightoff, TC Memo 2018-178.

[7] Grieve v. Commissioner, T.C. Memo. 2020-28, at *12.

[8] Olson v. United States, 292 U.S. 246, 257 (1934).

[9] Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1891).

[10] Id. at 768.

[11] relying on Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987).