March, 2007 | Issue 16
FLP Guidelines Issued
In an action that was little-noted at the time, the IRS, on October 18, 2006, issued Appeals Settlement Guidelines for family limited partnerships and family limited liability corporations (FLPs). These guidelines deal with a number of issues that frequently arise in estate and gift tax audits of transfers of FLP interests. We will focus our discussion here on what the IRS had to say in these guidelines on the issue of discounts used in the valuation of such entities. A copy of the guidelines can be found here.
Background
In the early 1990’s, estate planners began using FLPs to hold, manage and transfer business assets such as real estate, securities and operating companies. The IRS often challenged the validity of such arrangements on a number of grounds. In cases where they were not successful in setting aside the FLP’s existence for tax purposes, they would shift their focus to the question of whether the correct valuation discount was applied to the fair market value of the underlying assets in order to value the FLP interests.
The Government’s position is that under certain circumstances, there should be minimal or no discounts applied to the pro rata value of the assets held by the entity. Taxpayers, on the other hand, claim that the fair market value of the transfers are substantially less than the underlying pro rata value of the assets held by the entity. Taxpayers cite discounts for minority interest, lack of marketability and sometimes portfolio composition, to reduce the value of the assets transferred.
Analysis of Cases
The IRS analyzed five Tax Court cases in its discussion of the discount issue. Knight v. Commissioner, 115 T.C. 506 (2000), involved a Texas limited partnership funded primarily with cash, municipal bonds, and real property. The Court allowed only a 15% overall discount for lack of marketability and minority interest.
In McCord v. Commissioner, 120 T.C. 358 (2003), the Court arrived at a discount of 15% for minority interest and 20% for lack of marketability. The taxpayer’s appraiser had opined that a 22% minority interest discount and a 35% lack of marketability discount were appropriate, in contrast to 8.34% and 7% respectively proposed by the Government’s appraiser. In deciding on the discounts, the Court looked at market price discounts from net asset value of various comparable funds. It determined that an appropriate minority discount for liquid assets was 10%. It based its 20% lack of marketability discount on studies of transactions in restricted stocks.
In Lappo v. Commissioner, T.C. Memo.2003-258, the Tax Court allowed an overall 15% minority interest discount and a 24% lack of marketability discount for an FLP with both active and passive assets. The marketable security portion of the assets was awarded an 8.5% minority interest discount, while the real estate portion received a 19% minority interest discount.
The FLP in Peracchio v. Commissioner, T.C. Memo. 2003-280, contained various types of marketable securities. The taxpayer took a valuation discount of 40%, while the IRS took a 4.4% lack of control discount and a 15% lack of marketability discount. Guided by closed-end investment fund discounts, the Court assigned minority interest discounts as follows:
| Cash and money market funds | 2.0% | |
| U.S. Government bond funds | 6.9 | |
| State and local bonds | 3.5 | |
| National municipal bond funds | 3.4 | |
| Domestic equities | 9.6 | |
| Foreign equities | 13.8 |
The average of the above worked out to 6.02%. The Court allowed a lack of marketability discount 25%, based on an analysis of various restricted stock studies.
The final case discussed on the guideline is Estate of Webster E. Kelley v. Commissioner, T.C. Memo. 2005-235. The partnership in this case consisted solely of cash and certificates of deposit. The Court allowed a 12% minority discount and a 23% marketability discount. The Court relied on appraisals which used general equity closed-end funds as comparables. The IRS criticized this approach in the guideline, pointing out that cash is a more liquid asset than securities. They suggested that money market funds would be a more appropriate comparable. The IRS, in the guideline, says that it regards this case as an anomaly for various reasons, and that it should not be considered valuable guidance.
Conclusion
The table below summarizes the discount results reached in the five cases discussed in the guideline. The guideline discussion concludes with the observation that cases in this area are fact specific, and that each case needs to be individually assessed to determine the appropriate discounts.
| Case Name | Minority Interest Discount | Lack of Marketability Discount | Combined Discount |
| Knight | n/a | n/a | 15% |
| McCord | 10% | 20% | 32% |
| Lappo | 8.5% | 24% | 27% |
| Peracchio | 6.02% | 25% | 29% |
| Kelley | 12% | 23% | 32% |
