Discount for Lack of Marketability

There is a concept in estate and tax planning called Discount for Lack of Marketability. Basically, it says that assets in a company are not as valuable as assets owned directly by a person.  This can save a family a ton of money in estate taxes if it applies.

Would you rather have a million dollars in cash or a million dollars in the stock of a little company that has 10 owners?   The million dollars in stock probably isn’t worth much, because you can’t sell it.  There isn’t any market for the stock in a small company. In addition, the bylaws or operating agreement of the company may have a provision that prevents the sale of equity interests in the company.

On the books of the company, your stock is worth a million dollars, but in your hands it isn’t worth nearly that. The IRS recognizes this and lets you “discount” the value of your stock. Obviously, the IRS will not let you discount a publicly traded stock like Exxon, but stock in a closely held company is subject to discounting.

How does this help? If you have an estate that is big enough to be subject to an estate tax, discounting becomes very valuable. When an estate is calculated, it takes all of your assets into account–bank accounts, vehicles, investments, life insurance, your little company.  All of that can add up pretty quickly to an amount much greater than you may have expected.

The federal estate tax kicks in at $5.48 million this year. That’s pretty high, but 16 states have estate taxes that kick in at only $1 million dollars. State estate taxes are often in the 16% range. So, if you live in one of those states and have a two million dollar estate, your state could take $160,000 from your family (where the first million is not taxed, but the second million is taxed at 16%).

If one million in the estate is in real estate, you could put the real estate into a company (family limited partnership, corporation, or LLC), and suddenly it isn’t worth as much money in the taxman’s view. When it is held in the company, it will be valued less because the value of the assets in the company are measured by the value of the stock or ownership interests.  Which, in a small company, can be discounted.

The true value of the asset to you is the same.  You are just holding it in a different legal structure, one that allows you to take advantage of discounting for purposes of estate evaluation.

The discount on a small company is usually around 25%. For the example above, that means using the discount for lack of marketability on the company stock reduces the estate by $250,000. The estate tax will be levied against an estate of $1.75 million instead of $2 million. If the state estate tax rate is 16%, that saves your family $40,000 in estate taxes (0.16 X 250,000). In addition, if the estate is large enough to be subject to the federal estate/gift tax and you can reduce the estate value by just $250,000 that will save $112,500 (0.45 X 250,000) in taxes.

In typical form, it takes the IRS 111 pages to describe discounting and tell their agents how to apply the discount. If you want the full 111 pages, have at it. The 2009 IRS Discount for Lack of Marketability Job Aid for IRS Valuation Professionals is available online here.  If you would instead like some less esoteric and good solid how-to-save-a-ton tax advice, check out my Advanced Tax Tactics.