What Are Valuation Discounts for Estate and Gift Taxes?

Valuation discounts are a feature of the tax code that allows for a reduction in the fair market value of an asset for gift and estate tax purposes. This reduction is permitted when a characteristic of the asset inherently limits its value compared to a more straightforward holding. These discounts are an established component of estate planning used to lower the taxable value of assets transferred to heirs. This aligns the taxable value of an asset with its true economic reality, acknowledging that not all ownership interests are created equal.

The use of valuation discounts can decrease the transfer tax obligation. Under current tax law, individuals have a lifetime gift and estate tax exemption, set at $13.99 million per person, and transfers of value above this amount are subject to tax. By applying a legitimate discount, a larger percentage of a business or other asset can be transferred before triggering tax liability. This strategy is based on “fair market value,” which the IRS defines as the price at which property would change hands between a willing buyer and a willing seller.

Common Types of Valuation Discounts

Discount for Lack of Control (DLOC)

A discount for lack of control, also called a minority interest discount, applies to an ownership interest that is not large enough to exert control over a company’s decisions and policies. An owner holding a minority stake in a privately-held business cannot direct management, dictate dividend payments, or force the sale of company assets. These decisions rest with the majority owners, leaving the minority shareholder with limited influence.

This lack of power makes the minority interest less attractive to a potential buyer. A third party would pay less per share for a block of stock that carries no meaningful control than for a controlling block in the same company. The DLOC quantifies this reduction in value, and the specific percentage is determined by a valuation professional who analyzes the rights and limitations of the ownership interest.

Discount for Lack of Marketability (DLOM)

The discount for lack of marketability addresses the difficulty of converting an ownership interest into cash. Unlike shares of a publicly traded company that can be sold almost instantly, an interest in a closely-held business has no ready market. Selling such an interest can be a lengthy and uncertain process, requiring time and expense to locate a buyer.

This illiquidity is a drawback that reduces the value of the asset. Even a controlling interest in a private company can be subject to a DLOM because the entire company cannot be sold as easily as public stock. Factors influencing the size of the DLOM include transfer restrictions in shareholder agreements, the availability of financial information, and the market for similar private companies.

Fractional Interest Discount

A fractional interest discount is applied to undivided interests in real property. This situation arises when two or more individuals co-own real estate, with each person holding a percentage share rather than a physically separate portion of the property. For example, siblings might inherit a home, each owning a 50% undivided interest.

Owning a partial interest is less desirable than owning the entire property. A co-owner cannot make unilateral decisions regarding the property, such as selling it or making improvements, without the consent of the other owners. Finding a buyer for a partial interest is harder than selling the property outright, which necessitates a discount to attract a purchaser.

Built-In Gains (BIG) Tax Discount

The built-in gains tax discount is specific to interests in C corporations. It arises when the fair market value of the corporation’s assets is greater than the assets’ original cost or tax basis. If the corporation were to sell these appreciated assets, it would have to pay a corporate-level capital gains tax on the difference.

A potential buyer of the corporation’s stock would recognize this embedded tax liability. A buyer would reduce the price they are willing to pay for the stock to account for this future corporate tax expense. This reduction in the stock’s value is the built-in gains discount, which reflects the deferred tax liability residing within the corporate structure.

Assets Eligible for Discounts

Interests in Closely-Held Businesses

The most common assets qualifying for valuation discounts are interests in closely-held businesses. These entities, including Family Limited Partnerships (FLPs), Limited Liability Companies (LLCs), and private corporations, are prime candidates for both the DLOC and DLOM. Their ownership structure often creates different classes of interest, such as voting and non-voting shares, which naturally lead to minority positions with limited rights.

The governing documents of these entities frequently contain restrictions on the transfer of ownership interests. These clauses may require the consent of other owners before a sale or grant the company a right of first refusal. Such limitations curtail the marketability of an interest, providing a strong basis for a DLOM.

Undivided Interests in Real Property

Undivided interests in real estate are another category of assets eligible for a fractional interest discount. This scenario occurs through inheritance or joint investment, where each co-owner holds a percentage share of the entire property rather than a physically divided part.

The discount is justified by the practical difficulties of co-ownership. A part-owner cannot independently sell or mortgage the property, and major decisions require consent from other owners. These limitations on control and marketability make a fractional interest less valuable than its pro-rata share of the property’s total value.

Restricted Stock

Restricted stock, which refers to shares of a company subject to rules limiting their sale, can also be eligible for valuation discounts. A common limitation is a mandatory holding period during which the shares cannot be sold on the open market. This inability to sell the stock for a specified period creates a lack of marketability.

The holder of restricted stock bears the market risk of the stock’s price declining during the holding period without being able to sell. Therefore, the value of the stock for gift or estate tax purposes can be discounted to reflect this. The size of the discount often correlates with the length of the restriction period.

Substantiating the Discount with a Qualified Appraisal

Claiming a valuation discount requires support from a formal, independent analysis. The IRS mandates that the value of the transferred asset, including any discounts, be substantiated by a “qualified appraisal” conducted by a “qualified appraiser.” Failure to meet these standards can result in the disallowance of the discount and potential penalties.

A “qualified appraiser,” as defined by IRS regulations, must have an appraisal designation from a recognized professional organization and have experience valuing the specific type of asset in question. The appraiser must be independent, meaning they cannot be the person transferring the asset, the recipient, or a party related to either. This independence ensures the objectivity of the valuation.

To perform the analysis, the appraiser will require information from the asset owner. For a closely-held business, this includes several years of financial statements, tax returns, records of all assets and liabilities, governing documents, and a capitalization table.

The final “qualified appraisal” report must contain specific elements to be accepted by the IRS. It must describe the asset being valued, the valuation date, and the purpose of the appraisal. The report will detail the valuation methodologies used and provide a reasoned justification for the specific discount percentages applied, referencing empirical studies and market data.

Reporting Discounts on Tax Returns

After the qualified appraisal determines the discounted value, the transfer must be reported on the appropriate federal tax return. The specific form used depends on whether the transfer is a lifetime gift or occurs at death.

For transfers made during a lifetime, the transaction is reported on Form 709, the United States Gift Tax Return. For assets transferred as part of an estate, the information is reported on Form 706, the United States Estate Tax Return. On either form, the asset is listed with a description, and its value is entered at the final, discounted amount from the appraisal.

A requirement for claiming a discount is attaching the complete qualified appraisal report to the filed tax return. Filing with a discounted asset value but without the supporting appraisal will likely trigger an IRS inquiry and denial of the discount. The appraisal serves as the primary evidence justifying the reported value.

After the return is filed, it is subject to review by the IRS. An agent may examine the return and the attached appraisal to ensure the valuation is reasonable and the discounts are well-supported.