Fifth Circuit Disallows Discount for Lack of Control

In a recent ruling, (Estate of Strightoff v. Commissioner, No. 19-60244 (March 31, 2020)), the  U.S. Court of Appeals for the Fifth Circuit ruled that the estate wasn’t entitled to discounts for lack of control for a substituted limited partnership interest with control rights.

Estate Claims Discounts

The decedent established: (1) Streightoff Investments, LP (SILP), a Texas limited liability partnership; and (2) the Frank D. Streightoff Revocable Living Trust (Revocable Trust). SILP was funded using the decedent’s assets. The decedent held an 88.99% limited partner (LP) ownership interest in SILP. While the decedent was the grantor and held the power to modify (for example, amend, alter, revoke or terminate) the trust, he didn’t change the Revocable Trust. The decedent was also the beneficiary of the Revocable Trust and remained the beneficiary on his death. On the same day the trust and partnership were created, the decedent assigned his to the Revocable Trust.

The estate listed the LP interest as an unadmitted assignee interest with a purported value of $4.588, million. The valuation reflected claimed discounts for lack of marketability and control.

The Internal Revenue Commissioner determined the estate had a $491,750 tax liability based on the valuation discounts, and the estate challenged this ruling in Tax Court.

Tax Court Ruling

The Tax Court found that the Revocable Trust held a substituted limited partner (SLP) interest in SILP because the assignment validly assigned the LP interest both in substance and form, and, in turn, as the beneficiary of the Revocable Trust, the decedent’s estate included an LP interest in SILP.

The Estate’s Appeal to the Fifth District Appeals Court

The estate challenged the Tax Court’s decision on multiple grounds, including that the court mistakenly found it owned an LP interest. The estate contended that in using a substance over form rationale to conclude that the estate held an LP interest, the Tax Court opinion stands contrary to Texas Partnership law and violated a doctrine set forth in Sec. & Exch. Comm’n v. Chenery Corp. (the Chenery doctrine), 332 U.S. 194, 196 (1947).

The estate’s challenge turns on a determination of the type of ownership interest it held. If the ownership interest is a SLP interest, the owner has control rights to “…enjoy several managerial and oversight powers ...” Conversely, if the ownership interest is an unadmitted assignee interest, no such control rights wound be enjoyed. Therefore, a SLP interest with control rights wouldn’t be valued with the application of discounts for lack of control. However, an unadmitted assignee interest without control rights would be valued with the application of discounts for lack of control.

Appeals Court Ruling

The appellate court reviewed the arguments related to how the SILP Agreement defined a transferee as a  SLP. The first argument related to the transfer being a “Permitted Transfer,” which both the IRSand the estate agreed. The second argument pertained to the rights assigned to the assignee. Given the broad language describing the assignment, the Tax Court concluded, and the appellate court affirmed, that the decedent’s full partnership rights transferred to the Revocable Trust.

The appellate court also considered the economic substance argument. Applying this argument, the Tax Court examined the functional rights of the decedent’s interest compared to other LPs rights, such as managerial and oversight powers. Since none of these LP rights were exercised, there didn’t appear to be any “functional” difference between the decedent’s rights, if the decedent was an unadmitted assignee, and the other LPs’ LP rights. Therefore, the appellate court upheled the Tax Court’s finding that the decedent’s rights weren’t t substantively different than the other LPs’ rights, thus concluding that the decedent’s rights were SLP rights.

In examining the Chenery doctrine, because the Tax Court redetermined the tax deficiency notice de novo and didn’t critique the IRS’ deficiency determination, there’s no agency decision to review, and the Chenery doctrine argument is inapplicable.