Discounts on Family Limited Partnership

The IRS is Challenging the Appropriateness of Discounts when Preparing a Valuation

The current regulations, Revenue-Ruling 93-12, allow for discounts when valuing a Family Limited Partnership (FLP). The proposal is expected to potentially limit the allowed discount and consequently raise the taxable portion of the trust or estate structures. This article reviews the current requirements for FLPs, their history, and the potential exposure to FLP’s in the near future.

The current regulations, Revenue-Ruling 93-12, allow for discounts when valuing a Family Limited Partnership (FLP).  The proposal is expected to potentially limit the allowed discount and consequently raise the taxable portion of the trust or estate structures.  This article reviews the current requirements for FLPs, their history, and the potential exposure to FLP’s in the near future.

What is a Family Limited Partnership?

A FLP is a type of partnership designed to centralize family business.  FLPs pool together a family’s assets into one single family-owned business partnership that family members own shares of.  FLPs are frequently used as an estate tax minimization strategy, as shares in the FLP can be transferred between generations, at lower taxation rates than would be applied to the partnership’s holdings.  A FLP is different from a conventional trust, as family members actually own a share in a business.  Shares can be gifted to family members over years, thus taking advantage of gift tax exemptions on an annual basis.  The assets held in an FLP impact the level of estate tax savings that can be realized by using an FLP.  In general, the more illiquid and complex the asset mix, the more difficult the FLP is to evaluate, and the larger the potential for estate tax savings.

Today, the FLP structure is a highly debated and a heavily scrutinized tax area in estate and trust planning.  FLP’s are viewed by many as one of the most significant and efficient estate and gift tax planning strategies.  This strategy includes freezing or stabilizing the value of what’s owned by a family and transferring the assets at a reduced value, thereby minimizing the taxable portion of the estate or trust in which the assets were placed.  This offers the potential for substantial tax savings when shifting wealth to younger generations.  A popular method of freezing value is to form an entity in which the older members of a family would acquire and hold the preferred interests; this is a value which tends to be stabilized.  Simultaneously, the younger generation would acquire the common interests, which were expected to grow in value.  This is a common way to reduce the valuation of the entity holding the assets.

These are the attributes often found in a FLP:

• FLP’s are frequently used to move wealth from one generation to another;
• FLPs are typically holding companies, acting as an entity that holds the property (business interests, real estate investments, publicly traded or privately held securities) contributed by the members;
• FLPs have several benefits: they allow family members with aligned interests to pool resources, thus lowering legal, accounting, and investing costs;
• FLPs also allow for favorable tax treatment relating to the transfer of the assets; the benefits of the discounts for the lack of control (DLOC), and lack of marketability (DLOM) can translate to a lower tax liability.

However, because of both real and perceived abuses by taxpayers, the Internal Revenue Service (IRS) has repeatedly questioned the validity of FLP transactions and caused setbacks to taxpayers and their advisors.

Relevant Valuation Standards

The AICPA Statements of Standards of Valuation Services (VS 100), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, require that: “during the course of a valuation engagement, the valuation analyst should consider whether valuation adjustments (discounts or premiums) should be made to a pre-adjustment value.”  Examples of valuation adjustments for valuation of a business, business ownership interest, or security include a DLOM and a DLOC.[1]  As a result, FLPs are frequently valued at a discount for lack of marketability which typically ranges between 20% to 40%, and a discount for lack of control which typically ranges between 0% to 10%.

The Current IRS Rules

In 1981, with the issuance of Revenue Ruling 81-253, the IRS took the position that: “ordinarily, no minority shareholder discount is allowed with respect to transfers of shares of stock between family members if, based upon a composite of the family members’ interests at the time of the transfer, control (either majority voting control or de facto control through family relationships) of the corporation exists in the family unit.”[2]  This ruling determined that the use of a minority interest discount was not available in valuing an interest in an entity controlled by family members.  “In light of the following court cases: Estate of Bright v. United States,[3] Propstra v. United States,[4] Estate of Andrews v. Commissioner,[5] and Estate of Lee v. Commissioner,[6] the IRS has concluded that, in the case of a corporation with a single class of stock, notwithstanding the family relationship of the donor, the donee, and other shareholders, the shares of other family members will not be aggregated with the transferred shares to determine whether the transferred shares should be valued as part of a controlling interest.”[7]  Thus, the IRS changed its position in 1993 with Revenue Ruling 93-12.  That ruling involved a shareholder owning 100% of a corporation, who made gifts of 20% of the stock to each of his five children.  The IRS ruled that the family’s control of the entity would not be considered in valuing the gifts of minority interest.  As a result of this ruling, FLPs became popular gift tax and estate planning vehicles due to the valuation discounts that were now available.

Challenges to the FLP Valuation:

Since the 1990s, the Internal Revenue Service was concerned that wide spread abuse existed within the gift and estate tax system which manipulated the value of transferred property to artificially low levels.  In reaction, Chapter 14 of the Internal Revenue Code was enacted in 1990 to curb some of the perceived abuses in intra-family transactions.  Any discussion on FLPs would not be complete without an analysis of the potential problems and pitfalls of Chapter 14 of the Internal Revenue Code, specifically IRC sections 2701, 2703, and 2704, and the current position of the IRS on certain aspects of FLPs.

The Internal Revenue Code (IRC) sections that discuss the discounts appropriate for an FLP are as follows:

• IRC Section 2701 provides guidance to determine whether a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor’s family is a gift.[8]
• IRC Section 2703 states that the fair market value of property shall be determined without regard to any agreement to acquire or use the property or any restriction on the right to sale or use of the property.[9]
• IRC Section 2704(a) provides that if there is a lapse of voting or liquidation right(s) in an entity controlled by a family before and after the lapse, then the lapse shall be disregarded and the interest transferred shall be treated as if there had been no lapse.[10]
• IRC Section 2704(b) addresses applicable restrictions. An applicable restriction is any restriction that limits the FLP’s (parent’s) ability to liquidate which then lapses (or can be removed by the family) after a transfer of a FLP interest has been made.[11]

In several recent Technical Advice Memorandums (TAM) and court cases, the IRS has expressed its hesitancy to accept the validity of valuation discounts related to FLPs.  The IRS has focused on the following areas of concern:

• the formation of the FLP and subsequent gift of a partnership interest and the treatment of such transactions as a single integrated “step transaction”;
• the lack of legitimate business purpose for the FLP pursuant to IRC section 2703;
• the integrity and true nature and character of the FLP operations; and
• the applicable restrictions of IRC section 2704 and their impact on value.

Court Cases:

In TAM 97-19006 and TAM 97-19009 the Service has advanced several avenues of attack on FLPs.  In these TAMs, the creation of FLPs and the subsequent assignment of limited partnership interests occurred in very close proximity to the taxpayers’ death.  In one case, the death occurred two days after creation of the partnership and transfer of the partnership interest; and in another, only 54 days had lapsed.  In challenging the formation of the FLP and the subsequent transfer of a partnership interest in the FLP, the Service concluded in both cases that the formation of the FLP, the transfer of assets to the FLP, and the subsequent transfer of partnership interests to the taxpayers’ heirs should be viewed as part of a single testamentary transfer.  In other words, the arrangement merely conveyed assets to family members who would have received the assets in any event under the testamentary instruments of the taxpayer.  The Service asserted that nothing of substance was intended by the transactions and no discernible purpose was served by the partnership arrangements other than the intent to depress the value of the decedents’ estate and avoid estate taxes.  Since the decedents’ beneficiaries were left with the same basic property they otherwise would have received had they not formed the FLP, the Service concluded that: (i) the FLP should be ignored; (ii) the assets transferred were the underlying assets themselves and not fractional partnership interests; and (iii) no valuation discounts were allowed.

In the Estate of Dorothy Morganson Schauerhamer v. Commissioner (TC Memo 1997-242, 73 TCM 2855) a taxpayer established three FLPs to hold interests in various business holdings.  The taxpayer transferred these holdings to the FLPs and also made gifts of partnership interests to her children.  Although each of the three FLPs established its own bank account, the taxpayer, who controlled the business holdings prior to the establishment of the FLPs, continued to deposit all partnership income into her personal bank account.  No records were maintained to account separately for partnership and non-partnership funds.  She utilized the account as her personal checking account, and from this account she paid personal and partnership expenses.  The taxpayer died a year later.  The Court, however, ruled that the value of the assets transferred by the decedent to the three family partnerships should be included in the estate because she retained the possession and enjoyment of the assets.  In the Court’s opinion, the term enjoyment refers to the economic benefits of the property.  The fact that the partnership income was deposited into her personal account even after the transfer of the assets to the FLPs was evidence that she retained the “possession or enjoyment” of the property.  As a result, by not respecting the integrity and nature of the operating entities (the FLPs in this case) the estate tax planning back fired on the taxpayer.

IRS Reacts to the Valuation of FLPs

To challenge these issues and to dissuade valuation analysis working around the requirements of Section 2704(b), the Department of the Treasury has made/issued the following proposal, in its annual Greenbook and Tax Expenditure publication:[12]

“legislation has been proposed that would create an additional category of restrictions (disregarded restrictions) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family.”[13]

And:

“Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations.  A disregarded restriction also would include any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity.”[14]

However, the 2014 and 2015 Greenbooks dropped this legislative proposal.  It is understood by many that the proposal was dropped because the Treasury intends to issue other regulations instead.  These regulations are expected to produce the same result to the valuation process of FLPs.  The Treasury is within its rights to do so; section 2704(b)(4) provides that: “The Secretary [of the Treasury] may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”[15]

It is possible operating companies will be exempt from the forthcoming regulations; while holding entities (e.g., a FLP with the traditional structure) would be covered by these regulations, which are yet to be announced.  For example, if a brother and sister own a car dealership, discounts would be allowed.  But if they form a FLP that holds real estate, marketable securities, hedge funds, and other portfolio type investments, the discounts could be denied.  Perhaps, the regulations will rely on the distinction made under Section 6166 (relating to the deferred payment of estate tax on certain active closely held enterprises) between active companies and ones that are just holding entities.

It is also possible that some taxpayers (or their families) would benefit from any new regulations.  That is because the property will be worth more at death of the principal holder (often the older generation) without applying any discounts.  The result could mean a higher “step-up” in basis under Section 1014.  A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance.  With a step-up in basis, the value of the asset is determined to be the higher market value of the asset at the time of inheritance, not the value at which the original party purchased the asset.  In most cases, when an asset is passed on to a beneficiary, its value is worth more than when the original owner acquired it.  The asset therefore receives a step-up in basis so that the beneficiary’s capital gains tax is minimized.  For example, say your father purchased some shares at $5 in 1971 and he left them to you upon his death, at which time the shares are $20.  For tax purposes, the shares would receive a step-up in basis, meaning your cost basis for the shares would become the current market price of $20.  So, any capital gains tax you pay in the future will be based on the $20, not on the original purchase price of $5.

Example:

Consider the following scenario: A father wishes to transfer $1 million in marketable securities to his son.  If the father gives the son this amount in cash, the father will have to pay gift tax on the $1 million, or use that amount of his exemption, as that is the fair market value of the property given.  One million dollars is worth exactly one million dollars.

Now consider this alternative scenario: The father creates a FLP with himself the General Partner holding a 75% interest and also holds the Limited Partner interest of 25%.  He contributes the $1 million in marketable securities, and then gives his son the 25% Limited Partner interest.  Although at first it might seem that the fair market value is 25% of the $1 million, this is not the case.  In an open and available market, a hypothetical willing buyer of the 25% LP interest would not be willing to pay $250,000.  This is due to the lack of control and lack of marketability of the minority shares.  Someone getting $250,000 in cash can do with it as they please, but not so with stocks that lay a claim to a cash deposit.  Accordingly, a shareholder in this partnership can only receive cash when the GP declares a distribution (which may be many years away).  This is not as desirable a structure for a hypothetical buyer, and our hypothetical and savvy buyer would factor this into their calculation of what they are willing to pay for the minority shares.  Similarly, this asset cannot be sold or converted, and as a result, is less desirable than an equivalent amount of cash or marketable assets.

Preliminary Value before discounts

	Current Regulation	Alternative scenario under proposed Regulation
Preliminary value 25% before discounts	$250,000	$250,000
Discount for Lack of Control	5%	0%
Preliminary value before Discount for Lack of Marketability	$237,500	$250,000
Discount for Lack of Marketability	25%	0%
Concluded value after discounts	$178,200	$250,000
Tax on distribution, assuming a 20% Federal Tax rate	$  35,640	$  50,000

In this example, the discounts taken for lack of control and lack of marketability can save the taxpayer $14,360 ($50,000 less $35,640), or about one third of the tax liability if the asset were distributed through a FLP.

New Information:

For the past year, the Treasury has been working on new rules limiting the ability of family-owned businesses to apply minority discounts under certain circumstances.  There has been a lot of speculating going around as to what the new regulations will be and the impact they will have on valuations.

According to a senior IRS official, Leslie Finlow: “Guidance on restrictions on estate valuation discounts for certain corporations and partnerships is expected very soon and won’t be based on previous administration proposals.  Tax code Section 2704(b) gives the Treasury Department the power to issue new regulations disregarding additional restrictions on liquidations of interests if the restrictions reduce the value of the transferred interest but not the value of the interest to the transferee.”

Finlow further indicated: “that the Internal Revenue Service isn’t looking to a 2013 Obama administration proposal that called for further restrictions on valuations of family business interests.”  Instead, she said the guidance will focus on “the statute as it looks now.”

Exactly what this means, when the regulations will be released, and what these regulations will actually do, is still a mystery.

Conclusion:

If used properly, the FLP is a powerful tool in gift and estate tax planning.  Valuation discounts can save significant tax dollars.  The partnership agreement can have all of the appropriate bells and whistles in place to maximize valuation discounts.  However, it is likely the substance of the FLP will be reviewed by the IRS.  There should be a balance between minimizing the value of the gift or estate, and the economic reasoning in the formation of the FLP and the actions of the partners.  The key to success in any succession or gifting plan is careful analysis of the facts and advanced planning.

It is important to note that while FLPs are completely legal, deliberately engaging in any practice the IRS deems to be specifically undertaken to evade paying taxes is illegal.  This though is what the IRS is looking to change.  As of this writing we are not sure what impact it will have if passed.  Will it affect all FLP’s?  Or will it be geared to certain FLP’s only?

For CPAs who are valuation analysts or those relying on valuation analysis performing valuations of FLPs and are considering any discounts, it may be prudent to take action before there are any changes in the law, which might occur as early as the beginning of 2016.

CPA’s should be cognizant of the requirement that the determination of the fair market value must be performed by a qualified appraiser; typically defined as someone certified to perform such work, someone who routinely performs this type of work as a normal course of business, and in compliance with federal and state laws, as well as VS 100, the Uniform Standards of the Professional Appraisal Practice (USPAP), Standards of Professional Appraisal Practice, and any other standards that are required by the professional organization to which the appraiser is a member of.  In understanding these developments, CPAs can both advise clients on the import of the timeliness of creating and valuing FLPs, and how to properly comply with future IRS inquires about valuation of estates and trusts which contain a FLP.

[1] SSVS # 1 paragraph 40

[2] Revenue Ruling 81-253

[3] Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981)

[4] Propstra v. United States, 680 F.2d 1248 (9^th Cit. 1982)

[5] Estate of Andrews v. Commissioner, 79 T.C. 938 (1982)

[6] Estate of Lee v. Commissioner, 69 T.C. 860 (1978)

[7] Revenue Ruling 93-12

[8] IRC Section 2701

[9] IRC Section 2703

[10] IRC Section 2704(a)

[11] IRC Section 2704(b)

[12] The Greenbook and Tax Expenditures is an annual publication prepared by the U.S. Department of the Treasury which provides general explanations of the administration’s fiscal year revenue proposals.

[13] The Greenbook and Tax Expenditures Fiscal year 2013

[14] Ibid

[15] IRC Section 2704(b)(4)

Pasquale Rafanelli, CPA, ABV, CVA, CBA, ASA, CFE is Valuation Manager of Grassi & Co.’s Jericho, NY office.
Mr. Rafanelli can be reached at: (516) 336-2415, or e-mail to: PRafanelli@grassicpas.com.