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BY GERALD H. ilIORGAilSIEBN AI{D SAM HESKEL

Partial Interest Property Ownership: Minority Discountsn partial interest ownership ol real property,an important question arises as to whetherthe parties are entitled to a minority dis-count in the conte:d of estate planning, real

$tate taxes, the fesale process or any othertransfer oI the property in question.

II the parties are entitled to a minority dis-count, the question becomes how much oI adiscount and how is that discount determined.The range of minority discount amounts var-ies greatly depending on numerous factorsand must stand up under scrutiny by thegovernment, whether in a court of law or bythe Intemal Revenue Service QRS), makingtheprocess used in the determination ol minoritydiscounts a crucial one.

Inaccurate minority discounts, as deter-mined by a governing entity, may resultin higher tax penalties or other fees ln thetransfer of property. It is challenging to findan overarching pattern to guide attomeys andreal estate appraisers on the specific amountof minority discounts, This article provides anoverview of minority discounts and describesthe commonly applied techniques used indetermining minority discounts.

Rationale for Minority Discounts

Partial interest property ownership (the division ofrights associated with the owning or using of real estate)manifests itself in a number of forms. Real property may beheld as a limited partnership interest, general partnershipinterest, REII, joint tenancy, tenancy in common, tenancyby the entirety, family trust, or as units of ownership in alimited liability company.

A minority discount is a reduction in value of partiallyowned property lrom the fair market value of the wholeproperlz due to lack of a controlling interest in the owner-ship entity and the lack of marketability of that interest.

There are a number ol instances when creation of par-tial interest property ownership might be favorable. It iscommon practice in estate planning to use the minoritydiscounts associated with partial interest ownership toeffectively reduce estate and gift tax in the transferringof wealth from one generation to another.

However, the legal and valuation principles used indetermining these discounts have come under increas-ing scrutiny lrom the IRS. Audits of gifts involving limitedpaftnership interests and other types of partial interestownershlp have increased in recent years, The IRS has inseveral instances disallowed a claimed discount where alamily limited partnership was formed shortly before the

Gerafd H, ilforganstern is managing partner at Hof-heimer Gartlir & 6ross cnd Sam l{erkel ls executiueoice president of HMS Associates, a real estate appraisalfirm-

Sam Heshel

death of an indMdual inwhat was determinedto be an artificial attempt to depress the valueof the individual's assets. See lor example:http://wwwappraisaleconomics. comfamily.The overarching rule guiding this decisionmaking is that certain kinds of limited part-nerships must be established for legitimatebusiness purposes, not for the sole purposeof reducing estate taxes.

The rationale for minorit;r discounts for par-tial interest ownership of property is basedon two main factors. First, that partial interestownership allows lor lewer benefits than acontrcilling ownership, and second, that par-tial interest in property translates into lackof marketability.

Noncontrolling partial interest owners haveno control over the management decision process involving the proper$r and therelore donot benefit from the same bundle of rightsthat accrue to the controlling ownership posi-tion, such as decisions about refinancing anddistributing excess proceeds.

Lack oI marketability is a slightly diflerent,

'q{ry*+€r8 but related, issue from lack of control in dec!sion making and arises hom the limited resources throughwhich partial interests, particularly noncontrolling ones,can be sold. Partial interests are not activelv marketed bvthe vast maiority of real estate brokers sinie they are ndtparticularly desirable to buyers. As a result, the owner ofa partial interest has extremely limited resources availableto market the asset. The discount for lack of marketabilitytakes into account the added time, cost and dilficulty ofmarketing a partial interest property.

Courts have upheld the distinction between loss ofvalueIrom partial interest ownership and lack of marketabilitydue to partial interest ownership, ln Estate of An&ews u,Commissioneri 79 TC 938, Nov. 29, 1982, regardlng a closelyheld corporation, the court held the lollowing:

The minority shareholder discount is designed toreflect the decreased value of shares that do not con-vey control oI a closely held corporation, The lack ofmarketability discount, on the other hand, is destgned .

to rellect the fact that there is no ready market forshares in a closely held corporation.Although there may be some overlap between thesetwo discounts in that lack of control may reducemarketabllity, it should be borne in mind that even acontrolling share in a non-public corporatlon suffersfrom lack ol marketability because oI the absence ofa ready private placement market.

Iletermining Minority Discormts

There are three methods for determining value of partia.linterest ownership.

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NEW YORK T.A!V JOURNAL Tuesday, October 28, 2008

Condnued frono The comparable sales methodinvolves the va.luation of a partialinterest by comparison to unitprices paid for similar partialinterests in the same property orgoup oI projects. These sales areinfrequent and adjusting them lortypical appraisal lactors such asmarket conditions, future growth,balance sheet differences andother assets is extremely di{ficult.. A second method is dividendcapitalization, which involves thedetermination oI future equitycash flow and partnership distri-butions. The difficulty with thismethod involves the derivationof a capitalization rate, which iswholly separate and distinct froma rate derived from real estatetransfers.. The third method, fractionaldiscounting, is the most com-monlyutilized in valuing minority

' real estate interests because thedetermination of property value,discount value and discount rateis property specific.

The fractional discounting tech-nique is a widely recognized tech-nique in determining the fair marketvalue of a minority interest in a realestate partnership. It involves threebasic steps. First, determine the tairmarket value oI the underlying asset;second, calculate the fractional inter-est's pro-rated share ol the asset; andthird, and most complicated, deter-mine and apply a fractional interestdiscount, or minority discount, to theprorated share. (See Brad Davidson,"Valuation of Fractional Interests lnReal Estate Limited Partnerships:Another Approach," The AppraisalJournal, Chicago: the Appraisal Insti-tute, April 1992, p. 184)

Case Review

Numerous authorities supportsubstantial discounts in valuing aminority interest in a partnership orclosely held corporation due to lack ofmarketability and liquidity oI the inter-est, the inability ol a limited partnerto vote on matters such as cash flowdistributions, and restriction that fur-ther limit salability. All of these itemscould potentially result in substantialreduction in value. The lollowing arerepresentative cases:

. Estate of Wodbury G Andreusu, Commissioner of Internal Retse-nue, 79 T.C. 938 (t98D: Comblnednlnorlty ard marketability dlscormtof65 percent allowed.

Decedent held20 percent intercsts infour closely held corporatiors involvedprimarily in the orynership, operation,and management of commercial realestate properties, although they alsoheld some liquid assets such as stocks,bonds, and cash. The real estate hold-ings included warehouses, apartmentbuildings, factories, offices, and retailstores. Decedent's four siblings heldthe remainder ol the stock ol the cor-porations. Together, decedent and histwo brothers constituted the entiremanagement of all four corporations;two sisters (also shareholders) did notactively participate in management.

The court held that the corpora-tions could not be characterized for

Partial Interest Property Outnersbip: Minority Discountsvaluation purposes as solely invest-ment companies or solely operatingcompanies. The corporations werebusinesses, engaged in the main-tenance and management oI realestate properties. Thus, some of thevalue must be based upon the oper-ating nature oI the businesses, withattention paid to their earnings anddividend history, management, andprospects for growth.

The court held that neither petitiorFer nor respondent clearly focused onthe fact that two conceptually distinctdiscounts were involved. one for lackof marketability and the other for lackof control (see above). The court alsoheld that the value of the decedent'sshares of stock should be determinedby considering the net value of theassets owned by the corporationsand the corporations' earnings and-dividend-paying capacity as well asother relevant factors. These includebusiness climate in the area wherethe corporations owned real estate,e)ft remely conservative managementof the corporations, and the natureof the corporations' real estate andliquid assets.

The court discounted the valuesbecause of the restricted market-ability ot the shares and the lack ofcontrol a hypothetical willing buyerof these minority shares would beable to exercise. Based on all thesefactors and on the entire record, thecourt concluded avaluation resultingin combined minority and marketabil-ity discounts of 65 percent.

. Estate of Lucile Marie McCor-mick u C.LR, T.C. Memo 1999371:Allowed 2332 percent minority atrd20-22 percent marketabillty dls-counta.

Valuation of percentage interestsin real estate partnerships owned bydecedent and her husband were deter-mined lor estate and gift taxpurposes.The minority interests were createdby gifts to 23 donees.

McCormick Properties (MP) andMcCormick Properties II (MPz) arepartnerships engaged in the realestate business. McCormick Construc-tion (MCC), a corporation engaged inconstruction in Arizona, was owned14.78 percent by decedent. At tlte timeof decedent's death. she owned a 14.78percent interest in MP, a 6.81 percentinterest in MP2, and a 16.67 percentinterest in Lazy S Ranch partnership.

The court exarnined both parties'"comparables ana.lyses" to determinethe minority discount. Petitioners'minority discounts ranged from 30 per-cent to 40 percent, and respondent'sranged from l0 percent to 25 percent,The court held that the minority dis-count should be in the 2332 percentrange,

In the court's assessment of a mar-ketability discount, the court closelyexamined the lR.S' and estate's market-ability analyses. The IRS retognizedthree factors impacting the magnitudeof the marketability discount: theextent or relative size of the interest,the risks inherent in the business con-ducted by the entity, and restrictionson transferability of the interest. Forexample, with respect to the 14.78percent interest in MB its relative sizeto the remaining interests called for asmaller discount. Also, the location ofthe land in a small geographical arearequired increases in the discount.

Finally, the MP and MPz partnershipagreements provided for the buyout ofa deceased partner's interest, and thatno interest could be transferred with-out consent of the partnership. The IRSacknowledged that such restrictionswere Iimitations on transferabilitythat increased the marketability dis.count.

After assessing both parties' analy-ses, the court held that the market-abilitydiscount should be in the 2G22percent range.

. Estate of James Barudln o.C.LR, T.C. Memo 199&395. A.llowedcomblned discount of45 percenl

At issuE was the estate tax valueof one of the 95 ownership units ofa general partnership owning com-mercial real estate in New York City.In allowing a combined minority aDdmarketability discount of 45 percentfrom "net liquidation value," the iudgesaid a general partner's right to dis-solve under New Ycrrk law "wouldhave little impact" since one of thegeneral partners owned a majority ofthe units and effectively controlled thepartnership. The decision probablywould have been less favorable lor thetaxpayer had there been no majorit5rpartner. Note however in McCormick,supra, the court seemed to buy theargument that practically the wind-ing and liquidation of the assets of ageneral partnership would by lengthyand therefore have little elfect on theminority discount.

The taxpayer's expert relied on aprior sale ol a fractional interest tojustily a combined discount of 67.5 per-cent while the govemment's 28 percentcombined discount was derived hom\arious market studies." Interestingly,45 percent is iust below the mid-pointbetween the taxpayer's and govern-ment's numbers. The court reiectedthe prior sale as an indication of valuebecause insr:Ificient facts about its cir-cumstances were presented. On theother hand, a 28 percent discount didnot reflect the absence of a voice inmanaging the partnership's alfairs.(Source MPI).

Conclusion

Assets and property should beappraised by a qualified valuationconsultant in accordance with theUniform Standards oI ProlessionalAppraisal Practice of the AppraisalFoundation, which is authorized byCongress to set appraisal standardsand qualifications. In some cases, asinwhen an indMdual e-xpects to makegifts ol additlonal limited partnershipinterests each year, it is wise to updatethe appraisal annually.

The best way to secure the mostaccurate minority discount is throughthe expertise of a well-credentialed,accredited senior appraiser. Thistypically means a professional with aMember ol theAppraisal Institute, orMAI, designation. Such a designationindicates an appraiserhas passed sub-stantial levels of education, qualilyingo<aminations, and has retained signn-cant expertise and experience in thevaluation and analysis of commercial,residential, industrial and other bpesoI property, and in advlsing clientson real estate investment decisions.Typically, courts and the IRS have notbeen inclined to dispute someone withthese credentials.