Estate planners often find themselves in a quandary: They follow all known rules and guidelines in devising a family limited partnership (FLP) plan for their client, but still have to cross their fingers that the Internal Revenue Service will accept the plan. The valuation of FLP interests is a particularly tricky area. What's the IRS thinking when it rejects the valuation attached to your client's FLP? Such rejections are a recurring problem. But I have a solution that, hopefully, will satisfy all parties: valuation assurance clauses.

There's no dispute that the IRS fervently believes that taxpayers routinely undervalue their FLP interests. A host of Tax Court decisions reveal that the court at least partially accepts the Service's viewpoint. Is the dispute really about FLP valuation theory? I don't think so. Rather, the valuation “problem” is really a debate over the sanctity of the FLP itself. The IRS sees the FLP as a device to avoid taxes. Given the string of “split the baby” decisions in FLP valuation cases, the Tax Court appears somewhat sympathetic to this perspective.

The essence of the FLP valuation problem boils down to the battle over the discount for lack of marketability. The IRS believes FLP interests shouldn't be subject to a significant discount, based on what's been known as the “recycling of value” argument. Ironically, the IRS doesn't contest significant discounts applied to closely held operating businesses. Again, the Tax Court is in agreement here. So it's the FLP structure itself that raises the red flag.

The inability of a limited partner to compel distributions or liquidate the FLP is a crucial valuation factor affecting the magnitude of the discount for lack of marketability. However, the IRS' viewpoint is that despite this inability, there is an implicit familial understanding that the partnership is to be short-lived.

What's an advisor to do?

I suggest he consider inserting what I call a valuation assurance clause in clients' FLP agreements to counteract the recycling of value argument and eliminate any concerns that the structure is purely a tax-avoidance plan.

RECYCLING OF VALUE

Let's look at what really bothers the IRS: Its notion that value is simply being recycled. In 2002, the term “recycling of value” gained notoriety in the Tax Court case, Estate of Harper v. Commissioner.1 In Harper, the court used the “recycling of value” phrase in its analysis of whether there had been adequate consideration under Internal Revenue Code Section 2036 in the context of a sale of partnership interests between different family generations. Recycling of value infers that a particular transfer is deemed to have been effected solely for the purposes of avoiding taxes. But, because a transfer (valid or not) is based on a single price at a moment in time, does the sale truly result in the “recycling” of value?

Clearly, the court is assuming that there will be a second event that will complete the “cycle” in a way that readjusts the value to the pre-transfer status quo. That is to say, proponents of the recycling of value theory assume that the buyers or donees of the partnership interest will liquidate the entity as soon as practicable, thereby receiving their pro rata share of the partnership's assets. This non-discounted value is what the first generation seller or donee started with prior to the transfer. So the argument is that the cycle has been completed and the assets have been successfully placed in the second generation's hands at a greatly reduced value.

Unfortunately for taxpayers and their advisors, the IRS' complaint about the recycling of value has found its way to Capitol Hill. On Jan. 27, 2005, the Joint Committee on Taxation published a report entitled “Options to Improve Tax Compliance and Reform Tax Expenditures.”2 As I understand it, the purpose of the report is to present options to improve tax compliance and reform tax expenditures. The report proposes legislation that would reduce the size of the U.S. federal deficit by narrowing the “tax gap” created by tax shelters and unintended loopholes. The report also addresses other areas of noncompliance in present law.3 Specifically, the report disparages the FLP as a device whose sole intent is to avoid taxes.

It says, “Under present law, valuation discounts can significantly reduce the estate and gift tax values of transferred property. Minority and marketability discounts in particular often create substantial reductions in value. In some cases these reductions in value for estate and gift tax purposes do not accurately reflect value. For example, a taxpayer may make gifts to a child of minority interests in property and claim lack-of-control discounts under the gift tax even though the taxpayer or the taxpayer's child controls the property being transferred. A taxpayer also may contribute marketable property such as publicly-traded stock to a partnership (such as a family limited partnership) or other entity that he or she controls and, when interests in that entity are transferred through the estate, claim marketability discounts even though the heirs may be able to liquidate the entity and recover the full value by accessing the underlying assets directly.”

We know, without question, that there have been many FLPs established with exactly the ulterior motives the IRS decries. However, my 15 years of experience with FLPs has shown me that such false FLPs are in the minority and usually found in plans for smaller estates, those devised by less sophisticated professional advisors.

Congress, the Tax Court and the IRS should recognize that, if there is no reason to believe a partnership will liquidate any sooner than the stated termination date, then the partnership does fulfill its validly stated business purpose. Therefore, valuation discounts for non-distributing partnerships are entirely appropriate.

HOLDING PERIODS

Discussions of FLP valuations often include four valuation cases: McCord,4Lappo,5Peracchio,6 and Kelley.7 In all four, taxpayers thought the discount for lack of marketability for a limited partnership (LP) interest should be in the range of 35 percent to 38 percent. But the Tax Court concluded that there should be discounts in the range of 20 percent to 25 percent, because the court wasn't convinced that the studies relied upon by the taxpayers' experts were comparable for purposes of determining the discount for lack of marketability of an LP interest in an entity holding investment assets. Specifically, the court's decisions in these cases rested on challenging the taxpayers' appraisers use of older restricted stock studies to justify the 35 percent to 38 percent discounts. These older restricted stock studies were compiled in times of longer-than-expected holding periods for the restricted stock. These longer periods existed because: (1) the capital markets were not as liquid as they are today, and (2) Securities and Exchange Commission Rule 144, which governs the resale of restricted securities, had stricter provisions before 1990.

Indeed, the court in McCord and Peracchio noted that the assets held in the partnerships were not risky and, in fact, were easily valued, while the subjects of the restricted stock studies were frequently small, volatile operating companies.8

But what's missing from the court's decision is any discussion at all of the holding period of the investment. In McCord, the court accepted the restricted stock transactions of the Bajaj study,9 which were all completed between 1990 and 1995. Applying Rule 144 at that time, the expected holding period of institutions purchasing blocks of about 15 percent of shares outstanding, was probably about three to five years. Assuming that an FLP is not expected to make interim distributions other than for income tax purposes, the expected economic holding period of an FLP interest is about three to five decades!

Let me illustrate this point: Assume the average expected rate of return of the small, volatile companies in the Bajaj study was 15 percent, and the average expected holding period was four years. The discounted price indicated by the court's discount for lack of marketability of 20 percent suggests the buyer would receive a rate of return of about 21.5 percent during this four-year period. So, in this case, the illiquidity premium, or, cost determined by the McCord judges was 650 basis points.

Now, let's assume our FLP holding large cap common stock assets is expected to earn 10.5 percent per year and that the required rate of return due to illiquidity risk commands a cost factor of only 150 basis points, based on the relative volatility of the assets of the two partnerships. That is, because of the illiquidity of the investment, the investor will be looking for a return of 12.0 percent instead of 10.5 percent. Assuming an average expected holding period of 30 years, the derived lack of marketability discount is 34 percent — very close to what was suggested by the taxpayers' experts. This illustration should prove the importance of the holding period to the valuation of an interest in an FLP.

This point was made by every taxpayers' appraiser.

So, why did the court ignore it?

I suggest it's because the taint created by the recycling of value theory caused the IRS and the Tax Court to disbelieve there really would be a long FLP holding period.

There's a way to break down this invisible barrier and possibly convince both the Service and the courts that an FLP truly is a long-term investment vehicle worthy of a reasonable valuation discount.

A LONG LIFE

Let's start with the reality that FLPs are typically established as vehicles to provide for long-term, intergenerational capital appreciation. In most instances, interim distributions from FLPs are small — often only enough to pay income taxes. Liquidation is the economic event providing the return on investment sought by the holder. Most FLPs are set up for a term of 50 years. While there can be no guarantee the partnership will, in fact, endure for 50 years, there is the understanding that the partnership's life will be a very long one.

What if the partnership couldn't be liquidated for 50 years? Would this defeat the recycling of value argument? Of course. But this solution is extreme, unreasonable and impractical.

So, what would be a reasonable period of time to restrict the limited partner from benefiting from a premature liquidation and still be long enough to alleviate concern that the taxpayer estate plan contemplates a recycling of value?

I suggest a period of 10 years.

Why 10 years? In financial terms, an investment term of 10 years is considered long term. It's unlikely that anyone would enter into a scheme to avoid taxes that would take 10 years to unfold. Too much can happen in such a relatively long period of time.

We know that the financial penalty for being locked into an investment for 10 years is great. Most private equity funds have a 10-year duration and are illiquid. The expected returns of these funds are quite high. One reason for the excess returns is the risk taken. Another reason is to compensate for suffering from illiquidity.

A useful comparison for a 10-year restriction on liquidation is IRC Section 1374 relating to S corporations. The Tax Reform Act of 1986 subjected distributed capital gains of C corporations to double taxation. To prevent C corporations from avoiding these rules by electing S corporation status, Congress enacted Section 1374, which imposes a deferred tax on the built-in gains of assets held by a C corporation on the first day that it makes an election under subchapter S. This built-in gains tax must be paid if the S corporation disposes of the appreciated asset within 10 years after electing S status. After 10 years, however, the capital gains tax liability vanishes. Similarly, IRC Section 302 permits corporate stock redemptions at capital gains rates but prohibits repurchase of the same shares by the distributee within a 10-year period.

Why did Congress and the U.S. Treasury use a 10-year period for these two important issues? Presumably, both bodies accept that this period is sufficiently long enough to thwart any plan to escape taxation by clever planning. Accordingly, the same should be true for the holding period of an FLP interest.

ASSURANCE

To validate that an FLP is indeed a long-term investment vehicle designed to promote capital appreciation, professional asset management and intergenerational family wealth retention, I recommend that a valuation assurance clause be added to the partnership agreement. The clause will ensure that, if the FLP is liquidated before the tenth year of the date of a transfer, the transferee limited partners will not receive their full pro rata share of the partnership's net asset value (NAV). During the 10-year period, any amount distributed in liquidation that exceeds the amount expected based on the limited partner's fair market value (FMV) would be forfeited and distributed to a qualifying charity.

Let me explain: Assume in an estate plan, four 20 percent LP interests are transferred from the father general partner to his four children. (See “Prove Your Sincerity,” p. 44.) Using Revenue Rulings 93-12, 77-287 and 59-60, a qualified appraiser determines that the FMV of the interests represents a 40 percent discount from NAV. By adding a valuation assurance clause to the partnership agreement, if the partnership is liquidated within 10 years of the date of transfer, some portion of the NAV attributable to the sibling limited partners will be forfeited in favor of a charity. The amount of this “penalty” is based upon a sliding scale that decreases with the passage of time. The discount amortizes over a 30-year period, which is the weighted average life of the partnership between years 10 and 50.10 In other words, the appraiser doesn't know when the partnership might liquidate, so the discounts used reflect this “unknown.” If the appraiser knew, for example, that the partnership would liquidate in year 50, the discount would be greater, and vice versa.

Note that even though the required holding period for the valuation assurance clause is 10 years, I am in no way suggesting the partnership will liquidate soon after the tenth year. Quite the contrary, the general assumption is that the partnership will exist for a very long period of time. However, the partnership may not liquidate before year 10 without the limited partners forfeiting the valuation discount realized at transfer.

This solution should be agreeable to all. For taxpayers with the “right” motives (that is to say, they set up FLPs as an intergenerational vehicle, for capital preservation), liquidating within 10 years would be an unreasonably short time frame. And if financial advisors can moot the recycling of value argument, perhaps, finally, the IRS and Tax Court can, as they should, consider the true valuation impact of the lengthy holding period associated with an interest in an FLP.

As an appraiser, you do not need a valuation assurance clause. You can determine the most reasonable expected holding period based on the normal due diligence done at the time of the appraisal. However, the contractual nature of the clause must mitigate any doubts as to the reality of a holding period pricing penalty.

Endnotes

  1. T.C. Memo 2002-121 (May 15, 2002).
  2. Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax Expenditures (JCS-02-05), Jan. 27, 2005.
  3. Ibid.
  4. Estate of McCord v. Commissioner, 120 T.C. Memo No. 13 (May 2003).
  5. Lappo v. Comm'r

    , T.C. Memo 2003-258 (Sept. 3, 2003).
  6. Peracchio v. Comm'r, T.C. Memo 2003-280 (Sept. 25, 2003).
  7. Estate of Kelley v. Comm'r, T.C. Memo 2005-235 (Oct. 11, 2005).
  8. For a general discussion of this topic, see Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business,, 4th ed., McGraw-Hill, New York, 2000, at pp. 395-406.
  9. Mukesh Bajaj, David J. Denis, Stephen P. Ferris, and Atulya Sarin, “Firm Value and Marketability Discounts” (Feb. 26, 2001), available from Social Science Research Network, at http://ssrn.com/abstract=262198.
  10. We assume the partnership will not liquidate in year 10 but, not knowing otherwise, we assume an equal probability for liquidation in years 11 to 50. Thus, while the average holding period is 25 years (i.e., years 0-50), the average economic holding period is 30 years. Note that the sliding scale of the “penalty” is geared to the expected holding period of the partnership interest — not the 10-year penalty period. Thus, even in year 10, the penalty is substantial.

PROVE YOUR SINCERITY

Include a value assurance clause in a partnership agreement that would penalize any liquidation within 10 years of a transfer by giving the named charity more — and the limited partners less

The Set Up
Net asset value (NAV) of partnership = $10 million
Fair market value (FMV) of limited partnership (LP) interest = $1.2 million
Percent transferred = 20 percent
Discount = $800,000
NAV interest = $2 million
Total discount = 40 percent
Average life = 30 years
NAV growth = 10.5 percent
Discount amortization = $26,667
What the Partners Would Lose and the Charity Gain If There's an Early Liquidation
In Year… 1 2 3 4 5 6 7 8 9 10
What an LP is worth $2,210,000 $2,442,050 $2,698,465 $2,981,804 $3,294,894 $3,640,857 $4,023,147 $4,445,578 $4,912,364 $5,428,162
What a limited partner would get 1,436,667 1,695,383 1,978,465 2,288,471 2,628,227 3,000,857 3,409,814 3,858,911 4,352,364 4,894,828
What the charity would get 773,333 746,667 720,000 693,333 666,667 640,000 613,333 586,667 560,000 533,333
William H. Frazier

SPOTLIGHT

Great Impressions: Pablo Picasso's odal-isque “Femme accroupie au costume turc (Jacqueline),” painted in 1955, went for $30.84 million at Christie's “Impressionist and Modern Art Evening Sale,” on Nov. 6, 2007, in New York.