Tax Law Update 2005Tax Law Update 2005

Transfer restrictions in a family limited partnership agreement are disregarded

In Estate of Sidney E. Smith III v. United States, No. 02-264 Erie (issued July 22), the U.S. District Court for the Western District of Pennsylvania — under Internal Revenue Code Section 2703 — disregarded transfer restrictions in a family limited partnership (FLP) agreement for gift tax valuation purposes, because the donor retained the unilateral power to amend an FLP agreement, thereby making the restriction non-binding during his life.

Sidney Smith and his children, Sidney and Jill, formed Smith FLP, to which they collectively contributed 100 percent of the common stock of an operating company. Smith the father owned a 2 percent general partnership interest and a 95.15 percent limited partner interest, Sidney the son owned a 1 percent general partner interest and a 0.90 percent limited partner interest, and Jill owned a 0.95 percent limited partner interest. In 1998, Smith made gifts of limited partnership interests to his son Sidney and daughter Jill. On his gift tax return, Smith reported that the total value of the limited partner interests transferred was $1,025,392, and paid a gift tax of $262,243. The Internal Revenue Service issued an assessment to Smith in which it increased the value of the gifts to $1,828,598, assessing Smith an additional gift tax of $360,803. Smith paid the additional tax and filed a refund suit.

The sole issue of the case was the valuation of the limited partner interests transferred to the children. The partnership agreement contained provisions restricting transfers of partnership interests; it also granted the partnership a right of first refusal (ROFR) in the event of a prohibited transfer. The ROFR limited the price that the partnership would be required to pay a partner for his limited partnership interest (the amount was not stated in the opinion), and permitted the price to be paid over 15 years with interest at the applicable federal rate.

The IRS and the Smiths agreed that such a restriction ordinarily would subject the limited partnership interest to a significant marketability discount. The Smiths' appraisal took this provision into account to discount the value of the limited partner interests. Yet the IRS disregarded the provision in determining the fair market value of the limited partnership interests and disallowed the marketability discount. Why?The Service's answer: IRC Section 2703(a).

IRC Section 2703(a) generally provides that, for purposes of calculating estate, gift and generation skipping taxes, the fair market value of property is to be determined without regard to (1) any option, agreement, or other right to acquire or use the property at a price less than its fair market value; or (2) any restriction on the right to sell or use such property. Section 2703(b) contains three requirements to fall within a “safe harbor” exception to Section 2703(a). The Smiths argued that the Smith FLP agreement was in the safe harbor.

In 2004, a district court granted partial summary judgment in favor of the IRS, finding that Section 2703(a) applied to the Smith FLP agreement's restrictive provision. The court also granted a partial summary judgment in favor of the Smiths, finding that the restrictive provision satisfied the first safe harbor requirement set forth in IRC Section 2703(b)(1) (“bona fide business arrangement”). But partial summary judgment was denied to the Smiths regarding the issue of whether the restrictive provision satisfied the safe harbor requirements set forth in Section 2703(b)(2) and (3) (not a device to transfer property for less than fair market value and comparable to similar arms' length arrangements).

The parties re-filed cross-motions for partial summary judgment regarding whether the Smith FLP agreement's restrictive provision satisfied the safe harbor requirements set forth in Section 2703(b)(2) and (3). The court found genuine issues of material fact existed as to whether the safe harbor requirements of Section 2703(b)(2) and (3) were satisfied. But it held that the restrictive provisions would be disregarded under Section 2703 on other grounds.

Before Section 2703 was enacted in 1990, restrictive agreements were required to meet certain requirements set forth in Treasury Regulations Section 20.2031-2(h) and Revenue Ruling 59-60, 1959-1 C.B. 237, which were summarized in Estate of Lauder v. Commissioner, T.C. Memo. 1992-736: “It is axiomatic that the offering price must be fixed and determinable under the agreement. In addition, the agreement must be binding on the parties both during life and after death. Finally, the restrictive agreement must have been entered into for a bona fide business reason and must not be a substitute for a testamentary disposition.”

Citing legislative history and Estate of Blount v. Comm'r, T.C. Memo. 2004-116, the Smith district court held that the agreement must meet the requirements of the pre-Section-2703 law to control value for federal estate tax purposes. Section 2703 was intended to supplement, not supplant the existing legal requirements, and in particular, the rule requiring that an agreement have lifetime restrictions in order to be binding on death. Moreover, citing Blount and Bommer Revocable Trust v. Comm'r, T.C. Memo. 1997-380, the Smith court held that “the unilateral authority of the transferor to alter the terms of a restrictive agreement during his lifetime renders the agreement non-binding. Under such circumstances, the restrictive agreement is to be disregarded for purposes of determining value for Federal estate and gift tax purposes.”

Because Smith owned two-thirds of the general partnership interests and a majority of the limited partnership interests at all times before his death, he had the power to unilaterally amend the partnership agreement and remove the ROFR. As a result, the court held that the partnership agreement and the ROFR were not binding on Smith during his lifetime — and should be disregarded when determining value for federal gift tax purposes.

2006 inflation adjustments

In Revenue Procedure 2005-70, 2005-47 IRB 1 (issued Oct. 28), the IRS set forth certain inflation-adjusted tax items for 2006. The inflation adjustments include the following, which are effective Jan. 1, 2006:

Simplified procedures for automatic extensions

In Treasury Decision 9229 (issued Nov. 4), the IRS issued temporary and proposed regulations regarding the simplification of procedures for obtaining automatic extensions of time for filing certain returns.