The historically low interest rates of the past decade have played a crucial role in shaping lifetime giving strategies. During this period, families were able to attain their wealth transfer objectives using just the future growth of their current wealth. Rather than a significant principal gift, they made modest gifts of principal fueled by “leveraged strategies.”
Such strategies, which use borrowed funds to enhance future returns, worked well in low interest rate environments because the cost of borrowing was negligible. But now that interest rates have surged, families must compensate for the higher cost of capital.
That’s where “valuation discounts” come in.
The Way We Were
Valuation discounts involve a partial interest in an entity or asset that has a decreased value (generally due to lack of marketability and/or lack of control), which may offset today’s higher borrowing costs. When interest rates were low, discounted valuations were useful, but not critical. Since the IRS has the power to challenge them, reporting a discount valuation felt like tempting fate.
Take installment sales. Most estate planning practitioners believe that a 10% gift of “seed” capital is sufficient to establish a trust’s creditworthiness prior to an installment sale. Assuming this holds, a gift to a trust of $13.61 million (the current basic exclusion amount) would support a subsequent sale of nine times that amount—more than $122 million of value.
So why push your luck by asserting a 30% valuation discount? Instead, you could simply sell 30% more nondiscounted assets to an intentionally defective grantor trust (a “grantor trust”). So long as you purchased insurance to hedge your risk of dying before the loan was fully paid, you were likely to achieve a great wealth transfer result with minimal risk.1
What’s Changed?
With today’s higher interest rates, the cost of capital has skyrocketed. But valuation discounts can help shoulder the increased interest expense.2
For instance, assume you want to sell $10 million of assets to a grantor trust in exchange for an installment note bearing interest at 4.66% (the mid-term applicable federal rate for June 2024). The annual cost of capital, or interest due on the loan, would be $466,000. But if those assets are put in a family limited liability company—and a nonvoting member interest is discounted by 30% due to a lack of marketability and control—the annual cost of capital drops to $326,200.3 This would roughly equate to an installment sale funded by a loan at 3.26% on nondiscounted assets.
A Match Made in Heaven
Valuation discounts may prove even more useful when dealing with leveraged assets. Consider the case of a real estate investor, Lando, who holds a 45% interest in a family limited partnership that owns a shopping center (the “LP”). The shopping center is worth $100 million, with a net value of $50 million after outstanding debt. The LP’s annual cash flow, after paying debt costs, is just under $2.5 million. That means Lando’s equity is worth 45% of $50 million (or $22.5 million).
But what if Lando’s 45% interest entitles him to a 25% discount based on his noncontrolling interest and lack of marketability? Now the transfer tax value of Lando’s LP interest is worth only about 34% of his $50 million of equity, or $16.9 million.
Let’s assume Lando wants to sell his LP interest to a grantor trust in exchange for a nine-year, interest-only loan at the mid-term AFR, which was just over 2% at the time (May 2017).4 What are the chances that Lando’s share of the LP’s income will allow him to pay off the loan during its nine-year term? And how does the level of valuation discount impact these outcomes?
The results may surprise you (Display). A 25% valuation discount provides a less than one-in-five chance that the LP’s income, supplemented by investment returns, will be sufficient to fully pay off the note.5 Yet if the valuation discount increases by just 2%, the probability of success doubles. And a 32% valuation discount puts the likelihood of full repayment at 90%. While high valuation discounts carry risk, even modest increases can produce outsized benefits when the underlying asset is subject to an intrafamily loan. The relationship isn’t linear; it’s exponential.
A Solution to Consider
When you consider making a gift, be sure to ask whether the asset you are giving qualifies for a valuation discount. Discounted valuations can mitigate the impact of high interest rates and have no mortality risk, unlike installment sales. When these discounts are applied to assets subject to intrafamily loans, their impact can exponentially increase the probability of paying off debt used to fund wealth transfer strategies. Yet even though discounted valuations can be a powerful wealth transfer tool, it is important to weigh the risks and quantify the potential benefits before proceeding.6
- Katie Gardner
- Director—Institute for Trust and Estate Planning
1 If the holder of a promissory note used to fund an installment sale to a grantor trust dies before the note is repaid, interest payments become taxable to the holder’s estate (rather than nontaxable).
2 There is some speculation that the Treasury Department may attempt to curtail the use of valuation discounts by regulation at some future date, though nothing concrete has materialized. Nevertheless, this bears watching.
3 Note that any valuation discount must be determined as part of a qualified appraisal and the percentage applied will vary by type of asset held and entity type, among other factors.
4 While this case study dates to May 2017, today’s higher rates do not impact the key lessons we can learn from it.
5 Assuming Lando’s grantor trust reinvests income received from the shopping center above interest payments due on the note.
6 Thank you to Thomas Pauloski, whose “Overrated” article provided foundation for this piece. https://www.bernstein.com/content/dam/bernstein/us/en/pdf/article/LISI_Steve_Leimbergs_Estate_Planning%20Newsletter_122023_Thomas_J_Pauloski_Overrated.pdf