Public documents provide objective evidence of comparability under IRC Section 2703
Since the enactment of Internal Revenue Code Section 2703, the U.S. court system and the business valuation community have debated the meaning of that section and how it applies to estate and gift tax valuations. Increasingly, the government is using IRC Section 2703 to challenge specific provisions within agreements — including limited partnership (LP) agreements — that taxpayers claim restrict value and justify larger valuation discounts.
To date, case law regarding Section 2703 and how it applies to these provisions and the valuation of entities like LPs has been neither extensive nor definitive. While early cases dealt with the applicability of Section 2703 to the partnership form itself, more recently the cases have focused on the section's three safe harbor criteria. Our attention is on the third safe harbor provision — Section 2703(b)(3), which requires that restrictive terms be comparable to those of similar arrangements entered into by parties dealing at arm's length.
How does the taxpayer or government demonstrate comparability? Is it sufficient to present legal experts to opine that based on personal experience the terms in question are comparable to those of arm's length agreements? While this has been one approach taken by parties to tax litigation, courts have found this type of evidence insufficient to meet the burden of proof under the safe harbor provisions.
A more direct means of addressing this issue is to compare the LP terms with those found in arm's length agreements and obtain clear and objective evidence of comparability. Are such documents publicly available? Yes. In fact, a source for these agreements is found in corporate disclosure filings made to the Securities and Exchange Commission. From these filings, we've compiled a searchable dataset of over 1,000 publicly available partnership agreements and develop a methodology to identify and use these agreements to meet the burden of proof in business valuation disputes involving Section 2703.
Section 2703 Overview
Enacted in November 1990, Section 2703 was part of the Omnibus Budget Reconciliation Act of 1990. It was part of a new Chapter 14 of the IRC, which was intended to address certain practices that were perceived to circumvent the full taxation of some transfers of interests in privately held entities (for example, corporations, partnerships and trusts) among and between family members.
Specifically, the terms of Section 2703 disallowed the application of valuation discounts stemming from certain rights and restrictions related to the use or transferability of the property. The general rule outlined in the section is as follows:
For purposes of subtitle B (relating to estate, gift, and generation-skipping transfer taxes), the value of any property is determined without regard to any right or restriction relating to the property.1
The regulations define a “right or restriction” as any provision or agreement that allows for the acquisition or use of the property at a price below fair market value (FMV) or any restriction on the right to sell or use the property. Initially, this section was generally applied to valuation disputes involving buy-sell agreements. But the scope of Section 2703 is broader:
A right or restriction may be contained in a partnership agreement, articles of incorporation, corporate bylaws, a shareholders' agreement, or any other agreement. A right or restriction may be implicit in the capital structure of an entity.2
While Section 2703 can be applied to the rights and restrictions embodied in a range of circumstances, the regulation possesses three safe harbor criteria that exempt certain provisions from the general rule. Specifically, Section 2703 doesn't disregard a right or restriction for valuation purposes that is:
- a bona fide business arrangement;
- not a device to transfer property for less than full and adequate consideration; and
- comparable to similar arrangements entered into by persons in an arm's length transaction.
The rights and restrictions at issue must meet all three of the above criteria independently. If more than 50 percent of the value of the property subject to the right or restriction is owned by individuals who aren't members of the transferor's family, then all three criteria are considered to be satisfied.3 But in the context of family limited partnerships (FLPs), it's unusual to have a partnership that isn't majority owned by the family members. Thus, cases involving family-owned entities will generally need to satisfy all three criteria.
Right of First Refusal
One provision with the potential to negatively impact value is a right of first refusal (ROFR), which grants the partnership or individual partners in an LP the right to acquire another partner's interest in lieu of a sale to a third party.4 ROFR provisions aren't uncommon in FLP agreements, in part because they allow the partners to have more control over who is admitted to the partnership. But the specific terms of ROFRs vary from one FLP to the next. For example, some ROFR provisions simply state that the price and terms of the payment to be made by the acquiring partners/partnership should be the same as, or no less favorable than, those offered by the third party. Of course, the implication is that the seller would be no worse off for transferring the interest under the ROFR than he would be selling the interest to a third party. Thus, FMV isn't impacted. On the other hand, the ROFR terms may specify that the acquiring partners/partnership have the option to pay for the interest over an extended period of time. Such a provision may well impact the price a willing buyer would pay for the interest.
An extended payout arrangement generally involves the use of a promissory note that calls for the payment of principal plus interest over a set length of time. Interest is typically charged at the federal long-term rate or some other measure based on an interest index, such as the prime rate. In the course of our valuation work, we've seen related-party FLPs that allow for installment payments extending over five, 10, or even 15 years.
The exercise of an extended payout option may adversely affect the value of the transferred interest. For example, assume that a partner wishes to sell his interest and the partnership exercises its ROFR. The parties agree on a $1 million purchase price, but the partnership agreement allows for the partnership to pay the purchase price with a five-year promissory note payable in equal annual installments at an interest rate of 5 percent. Consequently, the selling partner is locked into a 5 percent return and can't participate in any excess gains achieved by the partnership in the subsequent five-year period. In effect, the seller has become a compulsory lender. And if the promissory note is secured by the transferred interest, the expected return (and related investment risk) on that collateral may be higher than the interest rate paid on the note.
In “Extended Payouts,” p. 35, you can see the potential impact that the extended payout arrangements would have on the value of the partnership interest using the facts outlined above. If the interest rate paid by the acquiring partnership isn't commensurate with market yields for investments of similar risk (that is, expected return), the total present value of annual payments under the note is worth less than the FMV of the partnership interest.
Thus, depending on the particular fact set, one could argue that extended payout provisions within ROFRs for LPs justify the use of larger valuation discounts.5 But are such extended payout provisions found in arm's length agreements? Do they satisfy the third safe harbor exception under Section 2703? Before exploring these questions, it's useful to examine the case law history of Section 2703 and how the courts have applied its safe harbor provisions.
Evolving Case Law
One of the first tests of Section 2703 came in Estate of Church v. United States, an estate tax dispute involving an FLP that held undivided interests in a ranch as well as cash and marketable securities.6 In this matter, the government first argued that the term “property” used in Section 2703 referred to the partnership's underlying assets. Under this interpretation, the government asserted that the partnership form itself constituted a restriction on this property and should be disregarded under the section. The court rejected this argument, stating that there was “no statutory basis for this contention” and that on the valuation date, Church owned an LP interest — not the underlying assets. As a result, it was the LP interest that should have been the focus of the valuation for estate tax purposes.
Within months of the Church decision, the U.S. Tax Court issued an opinion in Estate of Strangi v. Commissioner in which the government had asserted the same “property” argument.7 Citing Church, the Tax Court rejected this argument — reinforcing the district court ruling that the FLP structure itself wasn't the kind of restriction Section 2703 was addressing.
A seminal case that considered the application of the safe harbor requirements of Section 2703 — Estate of Blount v. Comm'r — didn't involve an FLP at all.8 Rather, the focus was a buy-sell agreement involving stock in a construction company. When preparing its tax return, the estate relied on the terms of a modified buy-sell agreement between the company and its shareholders to establish the value of the company. The government, however, argued that the modified buy-sell agreement — which established a fixed price of $4 million — should be disregarded for estate tax valuation purposes. As support for its argument, the government cited, among other reasons, that the agreement didn't satisfy all three of the safe harbor exceptions under Section 2703.
In its evaluation of Section 2703, the section's legislative history and the regulations, the Tax Court concluded:
…section 2703(b)(3) requires a taxpayer to demonstrate that the terms of an agreement providing for the acquisition or sale of property for less than fair market value are similar to those found in similar agreements entered into by unrelated parties at arm's length in similar businesses.
The court clearly wanted to see “production of evidence” of real-world agreements with terms comparable to those of the modified buy-sell agreement at issue in the case. The estate's expert instead argued that the price established by the modified buy-sell agreement was in fact representative of the shares' FMV — thus Section 2703 shouldn't be applicable at all. The court wasn't persuaded by this argument, and — citing the absence of evidence of actual arm's length agreements with comparable terms — determined that the estate failed to meet the burden established under Section 2703(b)(3) and disregarded the buy-sell agreement for estate tax purposes.
The Blount ruling was one of the first to emphasize the importance of producing documented evidence of arm's length agreements to satisfy the comparability test under Section 2703(b)(3). It was followed shortly thereafter by another judicial decision that involved an FLP.
Estate of Smith v. U.S. was a gift tax dispute involving interests in an FLP, the sole asset of which was 100 percent of the common stock of an operating company.9 The partnership agreement at issue in this case contained a ROFR provision that allowed the partnership and/or partners to purchase another partner's interest before it could be sold to a third party. In particular, the terms allowed for promissory notes payable over a period of up to 15 years and bearing interest at the long-term applicable federal rate. Both sides agreed that the use of an extended payout in the event the ROFR was exercised would have a depressing effect on the value of the LP interest. The government argued, however, that the extended payout provision should be disregarded under Section 2703. Citing Church and Strangi, the taxpayer disputed the government contention that Section 2703 could be applied to a specific provision within a partnership agreement. The issue was brought before the court in a partial motion for summary judgment made by the government.
The court found that the issue of whether Section 2703 applied to a specific restrictive provision within a partnership agreement was a case of first impression. In the end, the court concluded:
…a plain reading of Section 2703(a) and the regulations promulgated thereunder make clear that the restrictive provision set forth in the Smith FLP partnership agreement is precisely the type of restriction to which Section 2703(a) was intended to apply.
The court next considered whether the provision satisfied all three of the safe harbor provisions. While the court found that the provision was a bona fide business arrangement, there wasn't enough evidence in the record for it to determine whether the provision was a device to transfer property for less than full and adequate consideration. As for the third safe harbor requirement, the court reviewed affidavits from two attorneys submitted by the taxpayer that stated that extended payout provisions like the one in the Smith partnership agreement were common in agreements among unrelated parties. However, the court found that to satisfy the third safe harbor requirement:
Plaintiffs are required to show that, when the agreement was made, it was “one that could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arms' length.”
Ultimately, the court concluded that the opinions of testifying attorneys were “conclusory in nature” and not sufficient to satisfy the third safe harbor requirement. The court granted partial summary judgment in favor of the government on the issue of whether Section 2703 applied to a specific provision in an LP agreement, but denied the motion to exclude the extended payout provision since there wasn't enough evidence to conclude whether the provision satisfied all three safe harbor requirements.
A more recent Tax Court case — Holman v. Comm'r — involved subjecting an extended payout provision in an FLP agreement to the Section 2703 safe harbor tests.10 In this matter, the court found that the provision didn't meet the first two safe harbor requirements and thus excluded it for valuation purposes. Both parties retained legal experts to testify about general practices in drafting LP agreement terms. While the taxpayer's expert attempted to introduce sample LP agreements purporting to show ROFR terms with extended payout options, the IRS challenged these agreements on the grounds that they involved related parties. Because the court decided the provision in question didn't satisfy the first two requirements of Section 2703(b), it didn't rule on whether the arm's length standard for comparability was met under the third safe harbor criterion.11
As demonstrated in the Blount, Smith and Holman cases, the Section 2703 safe harbor provisions are coming under closer examination by the courts and the business valuation community. And while the trier of fact may be persuaded that the arrangement is bona fide and not motivated solely by tax considerations, clearing the third hurdle will require the parties to produce concrete evidence of real-world agreements negotiated by unrelated parties.
Publicly Available LP Agreements
In light of the courts' indicated preference for documented evidence in cases involving Section 2703, we gathered and evaluated over 1,000 publicly available partnership agreements on file with the SEC. Recent case law suggested that the ROFR extended payout provisions would provide a relevant example of how to implement the comparability test mandated by Section 2703(b)(3). We reviewed these filings to see if ROFR provisions found in FLP agreements are consistent with unrelated-party agreements.
Building a dataset of agreements
To identify a population of LP agreements, we utilized Westlaw's LIVEDGAR — an online research tool that has the ability to conduct detailed searches for specific documents contained in SEC filings.
Using pre-defined search criteria for LP agreements, our search yielded over 1,100 exhibits that were contained within a broader filing — for example, annual report (10-K), quarterly report (10-Q) or registration statement (S-1). The filing dates of these exhibits range from March 1988 through December 2007. Further review of these documents revealed that some weren't LP agreements but rather other business arrangements, such as credit agreements, lease agreements or merger agreements involving LPs. We removed these from consideration, reducing the pool of partnership agreements to 1,006 exhibits.
Comparability of agreements
According to the Section 2703 regulations, a right or restriction is considered comparable if it “could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm's length.” The fair bargain criterion is met if it conforms with the “general practice” of unrelated parties to negotiated agreements.12 Although the regulations state that evidence of general business practice isn't met by showing isolated comparables, they acknowledge that comparables may be difficult to find for unique businesses. In such cases, comparables from similar businesses may be used.13
The partnership agreements identified through SEC filings cover a range of industries, including real estate development, telecommunications and oil and gas production. Nevertheless, it may be impractical to identify arm's length partnership agreements that are in the same or similar business to that of the partnership under examination. For example, many private partnerships aren't operating companies at all, but rather investment-holding companies with investments in marketable securities.
Clearly, comparability as to business line is more relevant for those transaction terms that are dependent on the underlying business activity. For example, the duration and transfer rights of a real estate partnership may depend on the timeline of property development. ROFRs, on the other hand, are financial rights that are less tied to underlying assets or the nature of the business activity. Thus, the focus is properly on the economic comparability of the partnership right rather than business function similarity. Would rational parties at arm's length agree to the same types of ROFR provisions as those being examined? A review of ROFR terms across all industries provides more robust evidence of the economic considerations that factor into the granting of such rights.
Observed frequency of extended payout options
In an effort to identify LP agreements with ROFR provisions, we performed seven independent keyword searches of the full text of the 1,006 exhibits. The seven phrases used in the full text searches were: first refusal, purchase option, option to purchase, option to acquire, right to acquire, first offer and first option. We reviewed over 500 agreements that contained one or more of these phrases to identify those that involved the transfer of business ownership interests. In some cases, agreements were amended and/or restated and were identified more than once in the total dataset. In these instances, we included only the most recent agreement in our review. Ultimately, the keyword search yielded a total of 68 unique LP agreements that included ROFR provisions.14
Thus, a review of over 1,000 publicly available LP agreements suggests that while ROFRs themselves aren't uncommon, it's rare to find ROFR terms that restrict the liquidity of transfers through installment payments. We examined the terms of the 68 agreements with ROFR provisions to identify payment characteristics — namely, whether extended payout options were included. As noted, the regulations define a “right or restriction” as any provision that allows for the acquisition or use of property at a price below FMV. The ability to pay a partner with a promissory note or some other extended payout mechanism would arguably adversely affect the FMV of a partner interest (See “Limited Partnership Agreements: What We Found,” this page.)
In our review, we found that nearly three of four agreements with ROFR provisions mandate that interests be purchased at the same price and terms as the offer from a third-party buyer. The remainder generally provide for pricing to be determined by negotiation or independent appraisal. We identified only five instances in which the purchaser held the option of choosing extended payment terms. Three of these agreements involve FLPs between related parties and thus don't meet the arm's length standard. One agreement for a real estate investment trust allows for a short-term (180 days) note payable, with interest due at a rate equal to the total dividend yield on the shares. A second unrelated-party agreement provides for a four-year installment payment, but only for the portion of purchase price in excess of the selling partner's net capital contributions.
Burden of Proof
As the government continues to challenge certain agreement provisions under Section 2703, taxpayers and appraisers need to be aware of the heightened burden of proof being enforced by the courts. Although this article focused largely on the FLP area, specifically in regard to ROFR provisions, Blount and other cases have shown that Section 2703 can be applied in a number of situations involving the valuation of private interests.
Case law dictates that taxpayer and government appraisers faced with a Section 2703 challenge need to demonstrate comparability of terms with arm's length agreements by pointing to specific examples. Testimony by an expert based solely on personal experience is not likely to be viewed as sufficient evidence. Fortunately for tax counsel and appraisers, a population of publicly available partnership agreements exists from which to build a position on comparability. The analysis of ROFR terms illustrates how appraisers may use publicly available LP agreements to ascertain common business practices. Clearly, other provisions such as transfer restrictions, length of term and rights to withdraw could be tested in a similar manner. When challenged by the government, it's the responsibility of the taxpayer seeking a reduction in value to demonstrate that the discount-generating provisions are not unusual. An investigation of public partnership agreements and presentation of hard evidence in the form of documented transactions will provide the best chance of satisfying Section 2703's safe harbor requirements.
- Treasury Regulations Section 25.2703-1(a)(1).
- Treas. Regs. Section 25.2703-1(a)(2)(i).
- To meet this exception, the property owned by those individuals must be subject to the right or restriction to the same extent as the property owned by the transferor. Treas. Regs. Section 25.2703-1(b)(3).
- A right of first refusal (ROFR) may also be referred to as a purchase option, right of first offer or option to acquire, among others.
- Note that the extent of any discount would be affected by other factors, including the nature and amount of the collateral securing the promissory note. Unfortunately, detailed terms addressing such factors are conspicuously absent from many family limited partnership (FLP) agreements.
- Estate of Church v. United States, 85 A.F.T.R.2d 2000-804 (W.D. Tex. 2000).
- Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), aff'd in part, rev'd on other issues, 293 F.3d 279 (5th Cir. 2002).
- Estate of Blount v. Comm'r, T.C. Memo. 2004-116, aff'd in part, rev'd on other issues, 428 F.3d 1338 (11th Cir. 2005).
- Estate of Smith v. U.S., 94 A.F.T.R.2d 5283 (2004), rehearing on other issues, 96 A.F.T.R.2d 6549 (W.D. PA 2005).
- Holman v. Comm'r, 130 T.C. 170 (2008).
- On April 7, 2010, the U.S. Court of Appeals for the Eighth Circuit issued an opinion affirming the Tax Court's decision that the Holman FLP didn't satisfy the requirements of Section 2703(b)(1). As a result, the court determined that it didn't need to address the additional requirements of Section 2703, including the comparability test under Section 2703(b)(3).
- Treas. Regs. Section 25.2703-1(b)(4)(i).
- Treas. Regs. Section 25.2703-1(b)(4)(ii).
- While agreements generally appear to be fully executed, some were filed without formal signature.
Francis X. Burns, far left, is a vice president, Gabriel T. Ratliff is a senior associate and Julia R. Rowe is an associate in the Chicago office of Charles River Associates
These terms may impact the value of the partnership interest
If the interest paid by the acquiring partnership isn't commensurate with expected returns, the total present value of annual payments under the note is worth less than the partnership interest's fair market value.
|Payment Number||Outstanding Principal||Principal Received||Interest Received||Total Received||Discount Cash Factor at 8%||Present Value|
|Present value of promissory note:||$922,282|
|Present value as a percent of purchase price||92.2%|
|Interest rate of promissory note:||5.0%|
|Required rate of return on collateral:||8.0%|
— Francis X. Burns, Gabriel T. Ratliff & Julia R. Rowe
In Profile — Gerard Pieter Adolfs' 40 cm. by 30 cm. oil on canvas, “Vrouw uit Oost Java, Soerabaja,” sold for £3,250 (approximately $4,164) at Christie's “Nineteen to Now, Art from the 19th, 20th and 21st Centuries Including Topographical Observations,” in Amsterdam on Sept. 7, 2010. Adolfs spent his childhood in Java and used the Javanese people and landscape as subjects for his paintings.
Limited Partnership Agreements: What We Found
Here are the results of our review of over 1,000 publicly available LP agreements
|Total partnership agreements||1,006|
|Agreements with right of first refusal provisions||68|
|Agreements allowing installment payments||5|
|Unrelated-party agreements allowing installment payments||2|
— Francis X. Burns, Gabriel T. Ratliff & Julia R. Rowe