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Valuation
Discounts & Family Limited Partnerships
The cost of transferring wealth from one generation to another
can be substantial without proper planning. In addition to
estate and gift taxes, a generation-skipping transfer tax
is imposed on certain transfers to grandchildren and other
"skip-persons." The family limited partnership (or limited
liability company), when coupled with a strategy for gifting
non-controlling interests, may be used to minimize such transfer
taxes. The key transfer tax benefit of the family limited
partnership units may be accomplished at discounted values,
thus allowing a greater amount to be transferred. Expressed
another way, the value of the limited partnership interests
being gifted will be less than the fair market value of the
proportionate share of the assets they represent.
THE FAMILY LIMITED PARTNERSHIP
A family limited partnership is a legal entity most often
formed to manage family wealth and to serve as a building
block for wealth transfer planning. The appropriateness of
establishing a family partnership is dependent on many variables,
including the willingness of the owner to part with a portion
of his or her ownership interest and the identification of
assets with appreciation potential.
Senior family members, typically parents, contribute assets to the family limited partnership in exchange for general and limited partnership units. Generally, no gain or loss is recognized by an individual upon his or her contribution of appreciated assets to a partnership. An exception to this nonrecognition rule is provided if the partnership would be treated as an investment company. This exception is designed to prevent a tax-free diversification of two or more significant portfolios through contribution to a partnership, since such diversification will be a taxable event. The income tax that may result if the partnership is treated as an investment company could be considerable. However, through thoughtful planning and consultation with a tax and legal advisor, most partnerships can be structured in a manner that does not result in investment company treatment.
After formation, the parents often retain the role of general
partner and transfer partial ownership of their assets - via
limited partnership interests - to children, other family
members or trusts for their benefit (the limited partners).
The donor, as general partner, retains control over the partnership
assets, controls cash flows to the limited partners, determines
the ability of the limited partners to transfer their interests
and may even be entitled to a management fee. While almost
any type of property can be placed in a family limited partnership,
the assets assigned most frequently are those with appreciation
potential, such as marketable securities, real estate, family
businesses and interests in non-family businesses (except
stock in an S corporation).
The IRS has ruled that family limited partnerships must be established for valid, underlying business reasons, not for the sole purpose of minimizing taxes. Acceptable business reasons can include enhancing the management of a family-owned enterprise, promoting family involvement in investment decisions for a portfolio of securities (although limited partners do not have ultimate decision-making authority) and ensuring sound decisions regarding family-owned property. In recent years, the IRS has increased its audit activity for gifts of limited partnership interests in an effort to attack perceived abuses of the use of discounts. In several private letter rulings, the IRS has disallowed a claimed discount where a family limited partnership was formed shortly before the death of an individual in what the IRS found to be an artificial attempt to depress the value of the individual's assets. With proper planning, gifts of limited partnerships that are not hastily formed in anticipation of an individual's death should withstand IRS scrutiny.
VALUATION DISCOUNTING
Valuation discounting begins with an analysis of the fair market value of the underlying partnership assets. The analysis is a fairly simple process for marketable securities, as compared to determining the fair market value of a closely held business. Once the fair market value of the assets has been determined, a discount analysis is performed to arrive at the fair market value of the interests being gifted, typically the limited partnership interests. The two discounts applied most often in the family limited partnership context include minority/non-controlling interest and lack of marketability. Generally, the minority interest discount corresponds to the degree of control or influence inherent in the transferred interest, whereas the lack of marketability discount corresponds to the transferred interest's degree of liquidity. The two are interrelated because a minority interest tends to be harder to sell and is therefore less marketable.
In determining the appropriateness and level of each discount,
the rights of the limited partners, as delineated by state
law and the partnership agreement, are reviewed. Specific
attention is focused on the relevant provisions that restrict
transfers and withdrawals by limited partners. Since limited
partners exercise no control over partnership assets and the
marketability of their interests are often limited, the value
of a limited partnership interest is discounted for gift tax
purposes.
DISCOUNT FOR A MINORITY/NON-CONTROLLING INTEREST
The discount for a minority/non-controlling interest is determined
largely by the degree of control that the limited partners
have over the assets in the family limited partnership. This
degree of control, or lack thereof, is often determined by
state law and is typically addressed in the partnership agreement
entered into by the partners. This discount is based on empiricial
market data from various sources.
The impact of the discount for a non-controlling interest can be considerable when a minority (less than 50 percent) business interest is transferred to a family limited partnership. While a general partner can place the entire value of a business in the partnership, the discounting benefit is greater if a minority stake is transferred. If a non-controlling share of the business is transferred into the partnership, those shares are subject to a discount. The partnership interests are also subject to a discount: for the minority status and the lack of marketability of the units being gifted. However, where the donor (general partner) owns all or substantially all of a business and contributes only a minority interest to the limited partnership, he or she may face difficulty demonstrating bona fide business reasons for use of the family limited partnership in the event of an IRS challenge.
DISCOUNT FOR LACK OF MARKETABILITY
The discount for lack of marketability derives from the limited
liquidity of the limited partnership interest or how readily
it can be converted to cash. If a parent gifts shares of an
investment portfolio directly to his or her children, the
recipients may sell the shares at their discretion. The same
portfolio of shares held in a family limited partnership represent
a unit of the partnership that cannot be sold as readily.
The discount for lack of marketability is subtracted from
the value of an asset that is otherwise comparable but carries
greater liquidity.
DETERMINING THE PERCENTAGE DISCOUNT
The valuation method and degree of discount are determined
by the attributes of the assets transferred to the family
limited partnership as well as the degree of control and marketability
of the interest being gifted. Before determining what is an
appropriate discount, one must obtain a valuation of the assets
owned by the partnership. If the partnership consists of marketable
securities, the value of the partnership equals the market
value of the securities. Minority limited partnership interests
in family limited partnerships owning principally marketable
securities tend to carry a lower discount than other asset
classes.
The value of real estate holdings is more difficult to determine
than that of marketable securities, and potential problems
involving management and maintenance of a property must be
considered in the valuation process. A house or an apartment
building cannot easily be divided and sold. Therefore, real
estate holdings in a family limited partnership are often
awarded a deeper discount.
It can be even more complex to value a closely held business.
A minority interest in a closely held business may be valued
by reference to trading prices of publicly held stocks (also
minority interests) or by another approach such as capitalization
of earnings, book value or adjusted book value. Depending
on the valuation methodology used, the discount for a closely
held business may be even higher that the typical range for
real estate. The determination of an appropriate percentage
discount requires an expert understanding of comparable markets
and a current knowledge of the applicable tax and other court
cases. To be valid, the discount must be determined by an
appraiser skilled in business valuations.
THE APPRAISAL
Partnership assets should be appraised by a qualified valuation consultant in accordance with the Uniform Standards of Professional Appraisal Practice promulgated by the Appraisal Foundation. The Appraisal Foundation is authorized by Congress as the source of appraisal standards and qualifications. If an individual expects to make gifts of additional limited partnership interests each year, it is generally prudent for the appraisal to be updated annually.
In appropriate situations, two separate valuation experts
may need to be employed, one skilled in valuing the assets
contributed to the family limited partnership (this is especially
true in the case of real estate) and a second to determine
the value, and to support the appropriate discounts, for the
limited partnership interests. Appraisal Economics has the
expertise to value real estate, so we can provide a "one-stop"
solution to most appraisal projects.
Internal Revenue Service audits of gifts of discounted interests
in family limited partnerships are on the rise. Overly aggressive
discounting can result in increased gift tax, as well as the
imposition of a penalty of 20 to 40 percent of the understatement
of the tax due to a substantial valuation misstatement. While
there is no standard valuation formula, an appraisal must
meet IRS requirements for establishing discounts and include:
DETAIL The appraisal report must include a comprehensive discussion of the specific assets, when the partnership was formed and the studies used to support the discounts.
DOCUMENTATION The valuation consultant may be called on by the IRS to justify the discounts that have been determined. Therefore, work papers behind the supporting studies must be included in the appraisal report.
CONCLUSION
A family limited partnership, when established for valid business purposes, may provide significant transfer tax savings while allowing the donor, as general partner, to retain control over the partnership assets. The main transfer tax benefit lies in the ability to apply a discount to the limited partnership interests transferred. Valuation discounting allows for gifting of a greater amount of partnership interests from one generation to another. The two factors that typically influence the valuation discount from the fair market value of the underlying partnership assets include minority/non-controlling interest and lack of marketability. The appropriate percentage discount will vary based on the circumstances of each case and no discount may be applied unless supported by an adequate and convincing appraisal of the partnership assets.
ADDITIONAL CONSIDERATIONS
Anyone considering the family limited partnership vehicle should also take note of the following:
Limited partnership documentation must be carefully drafted.
Professional fees will include legal fees to cover the drafting of the limited partnership agreement and fees of the independent appraisal firm.
Reporting requirements include the annual filing of income tax returns for the partnership with the IRS and with each state in which the limited partnership does business and providing each limited partner with a Form K-1. The partners will have to file returns in those states, even if they don't live there. An accountant will need to be retained for these purposes.
IRS penalties for using an excessive discount rate can range from 20 to 40 percent of the understatement of the tax arising from the valuation misstatement.
Filing a gift tax return setting forth the nature of the gift and the basis for the value applied to the gift should be considered for years when gifts are made, even when no gift tax is due. Proper disclosure may prevent the IRS from using 20/20 hindsight to revalue the lifetime gift as of the time of the donor's death.
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