Family limited partnerships (FLPs) and other family business entities can be effective tools to transfer wealth to the next generation — often at substantial discounts from the fair market value of underlying assets. But hiring an experienced valuation professional to value an FLP is critical as a recent appellate court case demonstrates. (Estate of Giustina v. Commissioner, T.C. Memo 2016-114)
To take advantage of this estate planning strategy, a senior family member typically contributes assets — such as marketable securities, real estate and private business interests — to a limited partnership. In exchange, he or she receives general and limited partner interests.
Over time, these interests may be gifted, sold or otherwise transferred to family members and non-family members (including charitable organizations). Limited partner interests may be valued at a discount from the partnership's underlying assets because limited partners can't control day-to-day activities and the interests may be difficult to sell.
Importance of Valuation Expertise
Valuing a limited partner interest starts with the partnership's net asset value, which is the combined fair market value of its assets on a controlling, marketable basis minus any liabilities. Business valuation experts can determine the value of underlying assets, as well as quantifying discounts for lack of control and marketability that apply to the partnership's net asset value.
These discounts are separate from one another and from any discounts taken at the asset level (for instance, if discounts were taken on a private business interest that was contributed to the FLP). Combined, such discounts often reduce the value of limited partner interests by 40% or more, depending on the nature of the FLP.
Case in Point
In Estate of Giustina, the IRS disagreed with the value of the decedent's 41.128% limited partner interest in a land and timber FLP. The estate filed an estate tax return that valued the interest at approximately $13 million. The IRS argued that the interest was worth approximately $33.5 million.
To help bridge the gap, the U.S. Tax Court valued the limited partner interest using two methods:
1. Cost approach. The agreed-upon value of the partnership's underlying assets was approximately $150 million, including a 40% "absorption" discount to reflect the time it would take to sell land. The court assigned a 25% weight to the cost approach.
2. Income approach. The estate's expert estimated that the land would generate only about $6.3 million in normalized annual net cash flows. Using the capitalization of earnings method, the court valued the entire partnership at $51.7 million on a minority, marketable basis, and it assigned a 75% weight to the income approach.
After weighing the two methods and applying a 25% discount for lack of marketability to only the value under the income approach, the Tax Court valued the limited partner interest at about $27.5 million on a minority, non-marketable value.
The U.S. Court of Appeals for the Ninth Circuit disagreed with the Tax Court's weighted-average technique for valuing the interest. The appellate court opined that a hypothetical limited partner couldn't force a sale of the land, because the general and limited partners favored continuing its operations. It directed the Tax Court to recalculate the decedent's interest using only the income approach. And it ruled that the Tax Court needed to reconsider adjustments it made to capitalization rate set forth by the estate's valuation expert.
On remand, relying solely on the income approach and reversing its previous adjustment to the company-specific risk premium of the capitalization rate, the court lowered its value of the limited partner interest to approximately $14 million on a minority, non-marketable basis.
What was the effective discount in this case? The value of remand ($14 million) is significantly less than the interest's pro rata share of the partnership's underlying assets of $61.5 million ($150 million × 41%). Considering that the value of the assets under the cost approach also includes a 40% absorption discount, this estate received a substantial effective discount.
You must ensure that the FLP has a legitimate business purpose, such as efficient asset management and protection from creditors, to qualify for valuation discounts. Partnerships set up exclusively to minimize gift and estate taxes won't pass IRS muster.
A Reason to Review Your Estate Plan Before Year End
On August 2, 2016, the IRS issued proposed regulations which would limit the availability of valuation discounts for transfer tax purposes. The regulations, under section 2704 of the IRS Code, were scheduled to take effect in January 2017. A “final” hearing was held in Washington D.C. on Thursday, December 1, 2016. Strong opposition to the proposed regulations will likely result in a delay, but may lead toa complete withdrawal. The ultimate goal of the IRS is to reduce or eliminate the use of this effective tax-planning tool. Most experts believe the regulations will be take effect some time in 2017.
If you've been considering setting up an FLP or transferring additional interests in an existing one, it may be prudent to act before the regulations become final. Contact Brisbane Consulting Group for more details on this proposal — or to use this strategy before any new restrictions go into effect.
DOUGLAS P. SOSNOWSKI, CPA/ABV, ASA, CFF
Douglas P. Sosnowski provides business valuation, forensic accounting, and litigation support services for Brisbane Consulting Group. He has extensive valuation experience and has served as an expert witness, testifying in courts of law throughout the state of New York. Doug has experience consulting with publicly traded entities and valuing a variety of closely held companies in connection with mergers, acquisition and divestitures, business combinations, estate and gift tax planning, ESOPs and purchase price allocations. He also has experience in the quantification of lost income in determining business interruption claims for insurance adjusters. Doug is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and the American Society of Appraisers. Doug is a licensed financial advisor holding Series 7 and 66 securities licenses. He graduated with honors from the State University of New York at Buffalo earning his Bachelor of Science degree in business administration with concentrations in accounting and finance.