Business Entity Discounts
Business entity discounts can be a valuable tool in farm succession planning. This strategy provides a method of reducing the values of assets that will be in an estate without the need for gifting. Discounting can be used with any kind of entity; the key is to draft the entity’s controlling agreement to maximize the discount.
Discounting is based on two important factors: lack of marketability and lack of control. Lack of marketability reflects the disinterest that an outside buyer would have in buying into a closely held entity. Lack of control reflects the inability of an owner to singularly control the entity. These two factors overlap somewhat but they essentially measure the discount that would be needed to make an arms-length buyer interested in buying an ownership interest in the entity.
The amount of discount is scrutinized by the IRS. Owners of entitles have abused the discounting strategy in the past as a scheme to transfer ownership without incurring gift taxes or estate taxes. A typical discount for an ownership interest that is fully subject to lack of marketability and lack of control may be around 35%. Discounts in excess of 35% may be challenged by the IRS as excessive. The discount is usually determined by an accountant or other financial professional that has expertise in determining business entity discounts.
Discounting can best be explained using examples. Let’s say Mom and Dad own 400 acres of farmland valued at $3 million. If Mom and Dad were to die with the land titled in their names, the land would be valued at $3 million in their estates. The land is valued at its full value because either Mom or Dad can cause the land to be sold at any time through partition and they would presumably receive full, fair market value.
Now, let’s say Mom and Dad transfer the land into an LLC. The LLC’s operating agreement includes the following provisions:
- Land may not be sold without majority consent of ownership
- Money cannot be distributed out of the LLC without majority consent
- The LLC cannot be dissolved without majority consent
- Ownership may only be transferred to the descendants of Mom and Dad
Additionally, Mom and Dad gift a 0.5% ownership interest to each Son and Daughter. After the gift, Mom and Dad are each 49.5% owners of the LLC. Now, neither Mom nor Dad can singularly control anything that happens with the LLC. Due to the lack of marketability and lack of control created by the terms of the LLC operating agreement and the minority ownership (49.5%), Mom and Dad can expect to receive around a 35% discount on their ownership.
Using discounting, Mom and Dad have reduced the value of their estate by over $1 million by setting up an LLC and transferring their land to the LLC. At a 40% estate tax rate, Mom and Dad have potentially saved Son and Daughter over $400,000 in estate taxes. Entity discounts can same many thousands, if not millions, of dollars in estate taxes for some farm families.
The primary downside of using a business entity for discounts is the cost of establishing and maintaining the LLC. An LLC will need to be established, an operating agreement drafted and deeds executed to transfer the land to the LLC. Perhaps the initial startup and deed expense will be around $5,000. The LLC will need to maintain a bank account to collect rent and pay expenses such as real estate taxes. Additionally, the LLC will be required to file a tax return each year. While there are startup and maintenance costs for the LLC, the savings in estate taxes usually makes establishing business entity discounts and easy decision.
It should be noted that some presidential administrations have sought to eliminate the entity discounts for family-held businesses. So, the business entity discount can be abolished with a stroke of a pen at any time. However, as long as discounts are available, they can be a very valuable tool in farm transition planning.
For those farmers and landowners who may be concerned about estate taxes, a business entity may be a relatively simple but effective tool to reduce the value of the estate. An attorney should be included in the process of establishing the LLC to be sure that the necessary provisions are included in the operating agreement to maximize the discount. Also, a tax advisor should be consulted to ensure a thorough understanding of the tax ramifications of establishing an LLC.