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Avoiding
Valuation Understatements for your Family Limited Partnership |
Many
of the techniques currently used for estate planning rely on
minimizing the value of transferred assets to reduce transfer
taxes. Family limited partnerships (FLPs) have become a popular
estate planning strategy because they allow you to do this.
The rationale behind the strategy is simple: When family or
business assets are placed in a partnership, the partnership’s
ownership interests are more difficult to sell than the assets
themselves. FLPs also allow the older generation to retain control
over the assets while transferring some ownership to the younger
generations. The limited partnership interests may be worth
less, due to a lack of control and reduced marketability. Because
investors prefer liquid assets that they control, they will
not pay as much for a relatively illiquid asset that they don’t
control.
The discounts most commonly sought for FLPs include lack-of-control
(minority interest) and lack-of-marketability discounts. Because
one of the benefits of establishing an FLP is to minimize the
taxes on transferring ownership to your children or grandchildren,
many people are tempted to be overzealous in the discounts they
take. The IRS, however, imposes penalties for substantial gift
and estate tax valuation understatements. This makes unreasonable
discounts very costly to take.
What Is an Understatement?
The valuation understatement penalty can apply when the value
of any property reported on a gift or estate tax return is 50%
or less of what the court determines the current value of property
to be. The IRS imposes a penalty of 20% of the amount of tax
underpayment, increasing to 40% for reported value of 25% or
less of the actual current value, as determined by the IRS.
For example, you place an interest in a closely held business
and an interest in real estate into an FLP, at a combined value
of $2 million. You then give your daughter a 2.5% FLP interest.
For gift tax purposes, you take a 60% minority-interest and
lack-of-marketability discount, and value the gift at $20,000
($50,000 x 40%). You and your spouse split the gift, each claiming
a $10,000 annual exclusion gift.
The IRS contests the valuation, and the case goes to court.
The court finds that the fair market value of interests that
went into the FLP was actually $2.5 million and that the proper
discount for the minority interest was 25%. This results in
the gifted 2.5% interest being valued at $46,875, making the
split gifts each about $23,438. The valuation understatement
is by more than 50%, and the IRS could add a penalty of 20%
of the tax underpayment.
Understanding the Valuation Process
Because the penalties for valuation understatements are so high,
it is important for you to understand the valuation process,
and the IRS’s views on FLPs.
The first step an appraiser takes in determining the value of
a limited partnership interest is to find the net asset value,
which is the equivalent of the business’s or other asset’s
(including real estate’s) fair market value if ownership
weren’t divided. Once a net asset value has been established,
the appraiser must determine what adjustments, if any, are appropriate
for control and marketability of the limited partnership interest
being valued.
Control. For a number of reasons, limited partnership
interests are less valuable than a general partnership interest.
Limited partners usually cannot control the day-to-day management
of a partnership or the amount of income they receive from it.
Generally, limited partners cannot amend the partnership agreement,
remove general partners, force the partnership to dissolve or
lay claim to partnership assets other than as specified by the
agreement.
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The
size of the adjustment needed to represent a limited interest
is affected by a number of factors, including: |
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The
projected distribution from the partnership (the number
of partners and the size of the various interests). |
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The
nature of the partnership’s assets and liabilities.
Riskier assets normally receive a higher discount. Alternatively,
the discount may be reduced if the assets are well-diversified. |
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The
projected growth in the net asset value of the partnership. |
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The
projected income for the partnership. A higher discount
may be warranted if little or no cash distributions are
expected from the partnership, since, in this case, the
partners’ return on investment depends mostly on
projected proceeds at sale or disposition. |
Marketability. In addition to the adjustments for the
limited control, the value of a limited partnership interest
may also be reduced for lack of marketability. Privately held
limited partnership interests are generally less marketable
than their publicly held counterparts for a number of reasons,
including:
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The
lack of a public market (pool of interested potential
buyers) for the units. |
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The
lack of a market within the partnership, since other partners
are relatively few in number and generally not obligated
to buy the interest of a partner who wants to sell. |
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The
partnership agreement restrictions on the transfer of
interests. Sometimes transfers are not allowed at all,
while in other cases the transfer must be approved by
the other partners or the general partner. |
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The
investments in undiversified assets by the partnership,
decreasing the interest of willing buyers. |
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The
limited income sometimes generated by FLPs, which typically
are more interested in holding assets than generating
an income stream for their investors. |
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Local
or national economic conditions. |
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The
nature of the business. |
What the IRS says about FLPs
Understandably, the IRS is less than excited about discounts
on the value of limited partnership interests. While the IRS
clearly doesn’t like the reduced values often placed on
them, it has encountered difficulty in the courts trying to
minimize the effectiveness of the discounts. In fact, the history
is one long tug-of-war between taxpayers and the IRS.
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Attribution.
For a number of years, the IRS relied on family attribution
rules in its efforts to discredit discounts for limited
partnership minority interests — the interests of
family members were counted together for valuation purposes.
In most cases, this effectively denied the opportunity
for a lack-of-control discount. Because the court sided
with taxpayers against these rules, the IRS finally relinquished
its family attribution policy in 1993. |
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Anti-abuse
regulations. However, the IRS provoked another
firestorm of protest in 1994 with its anti-abuse regulations
aimed at FLPs. While the anti-abuse regulations were partially
revoked the month after they were issued, the IRS still
stands by its agenda of scrutinizing FLPs, with particular
emphasis on minority discounts and other valuation adjustments. |
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Lack
of business purpose. The most recent round in
the battle occurred when the IRS ruled that it would disallow
any discount on an FLP whose sole purpose appears to be
tax reduction. So while saving taxes is still a legitimate
reason to set up an FLP, it had better not be the primary
or only one. In addition, you should not assume that the
IRS will accept a minority discount for a limited partnership
interest just because the discount is not an aggressive
one. The IRS will challenge any discount it sees as unjustified.
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To stand up in tax court, the rationale behind any adjustment
to value should be well-documented and the FLP itself should
be:
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Part
of a bona fide business arrangement. |
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Comparable
to similar arrangements entered into by people in an arms-length
transaction. |
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Not
an attempt to transfer property between family members
for less than market value.
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Deathbed
FLPs are on shaky ground, but FLPs that establish a business
reason for their existence (such as having limited partners
share responsibility for partnership assets) stand a better
chance of withstanding IRS scrutiny.
Show Reasonable Cause
While the adjustments to value for an FLP are important for
estate tax purposes, being able to defend the value against
IRS challenges is even more critical. The IRS understands the
gift and estate tax implications of adjustments for control
and marketability, and will do its utmost to minimize them.
Therefore, any adjustments made to the value of a limited partnership
interest need to have valid purposes, beyond just saving taxes.
In addition, you will not have to pay the penalty for valuation
understatement if you can show you had reasonable cause and
acted in good faith.
Support Your Valuations
You are not required to have a qualified appraisal to support
the value of gifts to family members or on an estate tax return.
Nevertheless, a professional appraisal can provide reasonable
cause for the waiver of an undervaluation penalty. At minimum,
the valuation process should involve the advice of an experienced
and competent accountant or lawyer.
If you have questions about using an FLP as part of your financial
strategy, please let us know. We can help you establish a partnership
that will accomplish your goals without running afoul of IRS
regulations.
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