Pitfalls in Charitable and Marital Deduction Planning for Bequests of Fractional Property Interests

Planning in the context of the estate tax charitable or marital deduction is a complex area, particularly when making bequests of fractional interests in a single asset intended to qualify for one of these deductions. A recent case in this area highlights potential pitfalls that can result in the reduction of these estate tax deductions and consequently in unforeseen estate taxes.

Charitable Deduction Planning: Estate of Warne v. Commissioner

The recent case of Estate of Warne v. Commissioner illustrates how making testamentary bequests of interests in a single illiquid asset among multiple charities can cause a mismatch between the value of the asset included in the gross estate of the decedent and the amount allowable as a charitable estate tax deduction. 

In Warne, the decedent’s revocable family trust owned 100% of a limited liability company (LLC) with a fair market value of $25,600,000 on her date of death. The terms of the revocable family trust provided for the donation of 75% of the LLC to one charity and 25% to another charity, for which the decedent’s estate claimed a combined charitable deduction of $25,600,000 (the LLC’s value in her estate). The Tax Court held that, even though the value of the estate must include 100% of the value of the LLC, it may only deduct the value of the assets that were actually received by the charities (the separate 75% and 25% interests), which were subject to valuation discounts for lack of marketability and control. The combined discounted value of the separate charitable interests was over $2.5 million less than the LLC’s total value included in the estate. Because of the mismatch between the value included in the decedent’s gross estate and the value of the estate tax charitable deduction, the estate owed an estate tax with respect to an asset that passed entirely to charities.

With careful estate planning, the decedent could have avoided this unfortunate result. For example, the decedent could have given the entire LLC to a private foundation, which then could have transferred some or all of the LLC interests to other charities. The estate tax charitable deduction for the bequest of the LLC to a single charity would have matched the value of the LLC as included in the decedent’s estate. 

Marital Deduction Planning: Estate of Disanto v. Commissioner

A similar potential mismatch can arise in the case of marital deduction planning, as was the case in Estate of Disanto v. Commissioner, where a surviving spouse disclaimed assets from the deceased spouse’s estate, such that only a minority interest in a closely held entity (which was subject to a valuation discount) remained eligible for the marital estate tax deduction. 

Plan With Care

These cases demonstrate potential hazards in constructing bequests of fractional interests in non-marketable property to achieve an estate tax charitable or marital deduction. Care must be taken to engage experienced counsel and appraisers to avoid inadvertently reducing or eliminating the intended deduction.