Conservatorhip Substituted Judgment Can be Used to Authorize Fractional Interest Gifts in Real Property with Big Estate Tax Reduction Effect

Clients had previously been appointed as Conservators for their elderly mother who no longer had the capacity to manage her own affairs. Mother’s estate was conservatively valued at $10,000,000, containing income producing rental properties in an affluent area of Los Angeles, her own valuable residence and a significant amount of cash. Mother had an old Will, but did not have a Trust or the other estate planning documents typically appropriate for such a large estate.

Mother’s existing Will left all of the assets to the two children. Unfortunately, as the property passed by way of the Will, Mother’s estate would need to go through the Court’s probate process upon her death, a process which is lengthy, public and often costly. The statutory (Court awarded) attorneys’ fees for a probate of this size would be in excess of $100,000. The fees involved in administering a Trust of this size would generally significantly less, an obvious benefit to the Mother’s heirs.

CJT was requested by the Court’s own reviewing attorney handling the Conservatorship matter to associate as co-counsel with the children’s existing attorney for the purpose of preparing a Petition for Substituted Judgment, a Court procedure whereby the children, as Conservators, are able to establish a Trust for their Mother. The primary purpose of such a procedure is to avoid the costs and delays related to a probate on the Mother’s later death.

CJT prepared the petition and proposed Trust for approval of the Court. CJT recognized an opportunity to at the same time potentially save the heirs of the estate a significant amount of estate taxes. At the time of matter, Mother’s estate tax liability would have been excess of $3,500,000.

Under the same Petition for Substituted Judgment procedure CJT was able to request and receive authorization from the Court to make gifts to Mother’s children and grandchildren which removed both cash and real property assets from Mother’s estate.

CJT was able to receive Court authorization for the Conservators to make annual exclusion gifts to each of the children and grandchildren for a period of 5 years. The annual exclusion amount is the maximum amount that you may give to any individual you like without incurring a gift tax. The amount is currently $13,000 per year. Conservators were now able to effectively remove $52,000 in cash from Mother’s estate each year for a period 5 years (for a total of $260,000 over the 5 years). This cash would otherwise be in Mother’s estate upon her death and subject to estate tax at a rate of 45%. These gifts alone would save $117,000 of estate taxes upon Mother’s death.

More significantly, CJT was able to receive authorization from the Court to make immediate gifts from Mother’s real estate interests to her children, which had a number of significant benefits. Mother’s cash and income far exceeded her expenses, so her lifestyle and standard of care would remain the same. The Court authorized a gift to each child of 10% of each of Mother’s two rental properties. First, this had the effect of immediately removing 20% of the accumulating income from the properties from Mother’s estate and directing it to her children. In an estate of this size each dollar of net income removed saves 45 cents of estate tax upon her later death.

Second, due to the way in which assets are valued for purposes of the estate tax, a huge potential tax savings was created. Mother now owned just 80% of each property. Upon her death, Mother’s estate would in turn own only 80% of each property. But for purposes of estate taxes, the value of an 80% interest in a real property is actually far less than 80% of the whole. This is due to a concept known as Lack of Marketability (marketability being your ability to sell an item). Basically, because the property is partially owned by other people, in practice it is much more difficult to sell that 80% interest. Who would want to buy just 80% of a building? Certainly no one would pay you 80% of the full value of that building because they could not be sure of what the owners of the other 20% would do or agree to do. Because of this, it is widely recognized that partial or fractional ownership of an item is not as valuable as owning the entire item. To get someone to buy your 80% in the property you would need to reduce the price, essentially giving them a discount. The standard discount for this “Lack of Marketability” is in the order of 15%. So, for example, Mother now owns 80% of a building, the whole of which is worth $3,000,000. Many would think that owning 80% of that would be worth $2,400,000. In reality, because it cannot be readily sold, you would likely have to discount the sale of your 80% interest by 15% or so. A 15% discount on $2,400,000 is $360,000, so your 80% is only worth $2,040,000. This is the value you would report to the IRS on the estate tax return. The $360,000 reduction in value saves another $162,000 in estate taxes. And in the end, the children would still own the entire property together. This concept of “fractionalizing” the real property provided the same type of discount on when the 10% gifts were made to the children, reducing the value of the gift by the same 15%. In the above example, a 10% gift of the property would generally be valued at $300,000. But with the same discount, the value for gift tax purposes is only $255,000. Every individual is allowed to give up to $1,000,000 in gifts (on top of the annual exclusion gifts) during his or her lifetime. CJT was able to get Court approval to make gifts of the real estate for this whole $1,000,000. The discounting concept above allowed CJT to remove property with an actual value of almost $1,200,000 from the estate.

The actions of CJT led to, conservatively, likely estate taxes savings, to the beneficiaries upon Mother’s death, in excess of $500,000, while also providing them with immediate cash from the annual exclusion gifts and income from the properties.