The document discusses minority discounts for partial ownership interests in real property. It provides an overview of the rationale for minority discounts, which are reductions in value due to lack of control and lack of marketability. There are three main methods for determining the size of minority discounts: comparable sales analysis, dividend capitalization, and fractional discounting. The document reviews several court cases that establish precedents for allowing substantial minority discounts, typically in the range of 20-45%, for lack of control and marketability. It concludes that the most accurate appraisal would come from a credentialed expert appraiser.

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BY GERALD H. ilIORGAilSIEBN AI{D SAM HESKEL
Partial Interest Property Ownership: Minority Discounts
n partial interest ownership ol real property, death of an indMdual inwhat was determined
an important question arises as to whether to be an artificial attempt to depress the value
the parties are entitled to a minority dis- of the individual's assets. See lor example:
count in the conte:d of estate planning, real http://wwwappraisaleconomics. comfamily.
$tate taxes, the fesale process or any other The overarching rule guiding this decision
transfer oI the property in question. making is that certain kinds of limited part-
II the parties are entitled to a minority dis- nerships must be established for legitimate
count, the question becomes how much oI a business purposes, not for the sole purpose
discount and how is that discount determined. of reducing estate taxes.
The range of minority discount amounts var- The rationale for minorit;r discounts for par-
ies greatly depending on numerous factors tial interest ownership of property is based
and must stand up under scrutiny by the on two main factors. First, that partial interest
government, whether in a court of law or by ownership allows lor lewer benefits than a
the Intemal Revenue Service QRS), makingthe contrcilling ownership, and second, that par-
process used in the determination ol minority tial interest in property translates into lack
discounts a crucial one. of marketability.
Inaccurate minority discounts, as deter- Noncontrolling partial interest owners have
mined by a governing entity, may result no control over the management decision pro
in higher tax penalties or other fees ln the cess involving the proper$r and therelore do
transfer of property. It is challenging to find not benefit from the same bundle of rights
an overarching pattern to guide attomeys and that accrue to the controlling ownership posi-
real estate appraisers on the specific amount tion, such as decisions about refinancing and
of minority discounts, This article provides an distributing excess proceeds.
overview of minority discounts and describes Sam Heshel Lack oI marketability is a slightly diflerent,
the commonly applied techniques used in
determining minority discounts. 'q{ry*+€r8 but related, issue from lack of control in dec!
sion making and arises hom the limited resources through
which partial interests, particularly noncontrolling ones,
Rationale for Minority Discounts can be sold. Partial interests are not activelv marketed bv
the vast maiority of real estate brokers sinie they are ndt
Partial interest property ownership (the division of particularly desirable to buyers. As a result, the owner of
rights associated with the owning or using of real estate) a partial interest has extremely limited resources available
manifests itself in a number of forms. Real property may be to market the asset. The discount for lack of marketability
held as a limited partnership interest, general partnership takes into account the added time, cost and dilficulty of
interest, REII, joint tenancy, tenancy in common, tenancy marketing a partial interest property.
by the entirety, family trust, or as units of ownership in a Courts have upheld the distinction between loss ofvalue
limited liability company. Irom partial interest ownership and lack of marketability
A minority discount is a reduction in value of partially due to partial interest ownership, ln Estate of An&ews u,
owned property lrom the fair market value of the whole Commissioneri 79 TC 938, Nov. 29, 1982, regardlng a closely
properlz due to lack of a controlling interest in the owner- held corporation, the court held the lollowing:
ship entity and the lack of marketability of that interest. The minority shareholder discount is designed to
There are a number ol instances when creation of par- reflect the decreased value of shares that do not con-
tial interest property ownership might be favorable. It is vey control oI a closely held corporation, The lack of
common practice in estate planning to use the minority marketability discount, on the other hand, is destgned .
discounts associated with partial interest ownership to to rellect the fact that there is no ready market for
effectively reduce estate and gift tax in the transferring shares in a closely held corporation.
of wealth from one generation to another.
Although there may be some overlap between these
However, the legal and valuation principles used in two discounts in that lack of control may reduce
determining these discounts have come under increas- marketabllity, it should be borne in mind that even a
ing scrutiny lrom the IRS. Audits of gifts involving limited controlling share in a non-public corporatlon suffers
paftnership interests and other types of partial interest from lack ol marketability because oI the absence of
ownershlp have increased in recent years, The IRS has in a ready private placement market.
several instances disallowed a claimed discount where a
lamily limited partnership was formed shortly before the
Iletermining Minority Discormts
Gerafd H, ilforganstern is managing partner at Hof- There are three methods for determining value of partia.l
heimer Gartlir & 6ross cnd Sam l{erkells executiue interest ownership.
oice president of HMS Associates, a real estate appraisal
firm- Condnued on page 6

2. NEW YORK T.A!V JOURNAL Tuesday, October 28, 2008
Partial Interest Property Outnersbip: Minority Discounts
Condnued fron valuation purposes as solely invest- Finally, the MP and MPz partnership
ment companies or solely operating agreements provided for the buyout of
o The comparable sales method companies. The corporations were a deceased partner's interest, and that
involves the va.luation of a partial businesses, engaged in the main- no interest could be transferred with-
interest by comparison to unit tenance and management oI real out consent of the partnership. The IRS
prices paid for similar partial estate properties. Thus, some of the acknowledged that such restrictions
interests in the same property or value must be based upon the oper- were Iimitations on transferability
goup oI projects. These sales are ating nature oI the businesses, with that increased the marketability dis.
infrequent and adjusting them lor attention paid to their earnings and count.
typical appraisal lactors such as dividend history, management, and After assessing both parties' analy-
market conditions, future growth, prospects for growth. ses, the court held that the market-
balance sheet differences and The court held that neither petitiorF abilitydiscount should be in the 2G22
other assets is extremely di{ficult. er nor respondent clearly focused on percent range.
. A second method is dividend the fact that two conceptually distinct . Estate of James Barudln o.
capitalization, which involves the discounts were involved. one for lack C.LR, T.C. Memo 199&395. A.llowed
determination oI future equity of marketability and the other for lack comblned discount of45 percenl
cash flow and partnership distri- of control (see above). The court also At issuE was the estate tax value
butions. The difficulty with this held that the value of the decedent's of one of the 95 ownership units of
method involves the derivation shares of stock should be determined a general partnership owning com-
of a capitalization rate, which is by considering the net value of the mercial real estate in New York City.
wholly separate and distinct from assets owned by the corporations In allowing a combined minority aDd
a rate derived from real estate and the corporations' earnings and marketability discount of 45 percent
transfers. -dividend-paying capacity as well as from "net liquidation value," the iudge
. The third method, fractional other relevant factors. These include said a general partner's right to dis-
discounting, is the most com- business climate in the area where solve under New Ycrrk law "would
monlyutilized in valuing minority the corporations owned real estate, have little impact" since one of the
' real estate interests because
the e)ft remely conservative management general partners owned a majority of
determination of property value, of the corporations, and the nature the units and effectively controlled the
discount value and discount rate of the corporations' real estate and partnership. The decision probably
is property specific. liquid assets. would have been less favorable lor the
The court discounted the values taxpayer had there been no majorit5r
The fractional discounting tech- because of the restricted market- partner. Note however in McCormick,
nique is a widely recognized tech- ability ot the shares and the lack of supra, the court seemed to buy the
nique in determining the fair market control a hypothetical willing buyer argument that practically the wind-
value of a minority interest in a real of these minority shares would be ing and liquidation of the assets of a
estate partnership. It involves three able to exercise. Based on all these general partnership would by lengthy
basic steps. First, determine the tair factors and on the entire record, the and therefore have little elfect on the
market value oI the underlying asset; court concluded avaluation resulting minority discount.
second, calculate the fractional inter- in combined minority and marketabil- The taxpayer's expert relied on a
est's pro-rated share ol the asset; and ity discounts of 65 percent. prior sale ol a fractional interest to
third, and most complicated, deter- . Estate of Lucile Marie McCor- justily a combined discount of 67.5 per-
mine and apply a fractional interest mick u C.LR, T.C. Memo 1999371: cent while the govemment's 28 percent
discount, or minority discount, to the Allowed 2332 percent minority atrd combined discount was derived hom
prorated share. (See Brad Davidson, 20-22 percent marketabillty dls- arious market studies." Interestingly,
"Valuation of Fractional Interests ln counta. 45 percent is iust below the mid-point
Real Estate Limited Partnerships: Valuation of percentage interests between the taxpayer's and govern-
Another Approach," The Appraisal in real estate partnerships owned by ment's numbers. The court reiected
Journal, Chicago: the Appraisal Insti- decedent and her husband were deter- the prior sale as an indication of value
tute, April 1992, p. 184) mined lor estate and gift taxpurposes. because insr:Ificient facts about its cir-
The minority interests were created cumstances were presented. On the
Case Review by gifts to 23 donees. other hand, a 28 percent discount did
McCormick Properties (MP) and not reflect the absence of a voice in
Numerous authorities support McCormick Properties II (MPz) are managing the partnership's alfairs.
substantial discounts in valuing a partnerships engaged in the real (Source MPI).
minority interest in a partnership or estate business. McCormick Construc-
closely held corporation due to lack of tion (MCC), a corporation engaged in Conclusion
marketability and liquidity oI the inter- construction in Arizona, was owned
est, the inability ol a limited partner 14.78 percent by decedent. At tlte time Assets and property should be
to vote on matters such as cash flow of decedent's death. she owned a 14.78 appraised by a qualified valuation
distributions, and restriction that fur- percent interest in MP, a 6.81 percent consultant in accordance with the
ther limit salability. All of these items interest in MP2, and a 16.67 percent Uniform Standards oI Prolessional
could potentially result in substantial interest in Lazy S Ranch partnership. Appraisal Practice of the Appraisal
reduction in value. The lollowing are The court exarnined both parties' Foundation, which is authorized by
representative cases: "comparables ana.lyses" to determine Congress to set appraisal standards
. Estate of Wodbury G Andreus the minority discount. Petitioners' and qualifications. In some cases, as
u, Commissioner of Internal Retse- minority discounts ranged from 30 per- inwhen an indMdual e-xpects to make
nue, 79 T.C. 938 (t98D: Comblned cent to 40 percent, and respondent's gifts ol additlonal limited partnership
nlnorlty ard marketability dlscormt ranged from l0 percent to 25 percent, interests each year, it is wise to update
of65 percent allowed. The court held that the minority dis- the appraisal annually.
Decedent held20 percent intercsts in count should be in the 2332 percent The best way to secure the most
four closely held corporatiors involved range, accurate minority discount is through
primarily in the orynership, operation, In the court's assessment of a mar- the expertise of a well-credentialed,
and management of commercial real ketability discount, the court closely accredited senior appraiser. This
estate properties, although they also examined the lR.S' and estate's market- typically means a professional with a
held some liquid assets such as stocks, ability analyses. The IRS retognized Member ol theAppraisal Institute, or
bonds, and cash. The real estate hold- three factors impacting the magnitude MAI, designation. Such a designation
ings included warehouses, apartment of the marketability discount: the indicates an appraiserhas passed sub-
buildings, factories, offices, and retail extent or relative size of the interest, stantial levels of education, qualilying
stores. Decedent's four siblings held the risks inherent in the business con- o<aminations, and has retained signn-
the remainder ol the stock ol the cor- ducted by the entity, and restrictions cant expertise and experience in the
porations. Together, decedent and his on transferability of the interest. For valuation and analysis of commercial,
two brothers constituted the entire example, with respect to the 14.78 residential, industrial and other bpes
management of all four corporations; percent interest in MB its relative size oI property, and in advlsing clients
two sisters (also shareholders) did not to the remaining interests called for a on real estate investment decisions.
actively participate in management. smaller discount. Also, the location of Typically, courts and the IRS have not
The court held that the corpora- the land in a small geographical area been inclined to dispute someone with
tions could not be characterized for required increases in the discount. these credentials.