FLP discounts
What’s the IRS up to now?

The IRS has opposed family limited partnerships (FLPs) — largely unsuccessfully — since they came into vogue in the 1990s. Originally, its attacks centered on substance over form and gift on formation arguments. But now the agency has a new strategy, targeting three types of abusive practices: 1) excessive, unsupported discounts, 2) administrative abuses, and 3) retained control under Internal Revenue Code Sections 2036(a) and 2038.

The Tax Court is likely to reduce or eliminate valuation discounts on interests in FLPs found guilty of these transgressions. But those who are aware of the new IRS strategy can take steps to preserve discounts.

FLP overview - FLPs, along with family limited liability companies (which are included in our references to FLPs in this article), provide a mechanism for achieving important business objectives, such as professional portfolio management and transition to second-generation management. As an added benefit, FLPs can serve as estate planning tools that enable donors to transfer wealth at substantial discounts from the net asset values of the partnerships’ underlying assets.

The logical starting point for valuing an FLP is determining the partnership’s net asset value, based on market values of its underlying assets. The adjusted net asset method typically generates a controlling, marketable value. To convert this preliminary value to the minority, nonmarketable basis required for limited partner interests, valuators must apply two additional discounts:

1. Lack of control - This discount consists of an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control.

Specifically, FLP interests warrant discounts for lack of control, because limited partners don’t participate in management. In addition, generally they can’t dissolve the FLP, liquidate assets or mandate distributions.

2. Lack of marketability - This consists of an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability, which is the ability to quickly convert property to cash at minimal cost.

In the case of FLP limited partner interests, marketability is limited because not only are FLPs privately held, but also partnership agreements may restrict transfers of limited partner interests. For instance, the general partner may have the right of first refusal or severely restrict transfers to (nonfamily) third parties.

Supporting discounts - Valuators have historically used empirical studies as one supporting indicator for valuation discounts. Control premium studies may serve as the basis for lack of control discounts for typical private business interests. Appraisers also have relied on restricted stock, initial public offering (IPO) and Bajaj studies as indicators of the need for marketability discounts for traditional private businesses.

But because FLPs differ from traditional businesses, their discounts are typically supported by evaluating discounts from net asset value (NAV) observed on closed-end mutual funds as well as annual studies of NAV discounts for real estate limited partnerships traded on a secondary market, published by Partnership Profiles.

Regardless of what empirical support is used, judges rarely accept median discounts from empirical studies. Both the Tax Court and the IRS have raised the bar on what’s expected as support for valuation discounts.

The first step in correctly applying any outside empirical research is to understand the specific characteristics of the entity being valued. By combining this knowledge with in-depth research and documentation of the specific applicability of the empirical data, valuators can better quantify valuation discounts.

They accomplish this by delving into the specific investments underlying an empirical study — using targeted selection criteria based on investment type, size, distribution history and financial performance. When the unique characteristics of the entity being valued are linked to the specific characteristics of the empirical research, appraisers can provide more specific and defendable results.

Comprehensive analyses - In compliance with Revenue Ruling 59-60, a valuation expert typically considers all three valuation approaches for valuing any private business interest, including an FLP — which often operates as a holding company. These three techniques include the asset-based (or cost), market and income approaches.

In some cases, valuation methodology may implicitly include valuation discounts. For example, suppose an expert values an FLP without making discretionary adjustments to the entity’s income stream. Because this method reflects earnings available to an owner without the ability to alter discretionary expenses, it may implicitly include a discount for lack of control. But it does not contain a marketability discount.

Valuation experts take into account any discounts implicit in the valuation methodology. They also recognize that limited partner interests may possess even less control and marketability. In short, they understand the basis of value the valuation methodology produces and avoid imprudent double discounting.

FLP best practices - The Tax Court may substantially reduce overly aggressive valuation discounts. And if the IRS can successfully demonstrate that the donor retained control under Sec. 2036(a) or Sec. 2038, the undiscounted net asset value of the FLP’s underlying assets may be included in the donor’s gross estate.

To gain additional insight into the current IRS position on FLPs, download a copy of the IRS Appeals Settlement Guidelines for FLPs (www.irs.gov/pub/irs-utl — click on the link that begins with “asg_penalties”).

Steep accuracy-related penalties may apply for substantial valuation understatements resulting from negligence or disregard of IRS regulations. Therefore, taxpayers have significant financial incentives to get it right the first time.

Sidebar: Knowledge is power - Here are some additional ways to protect family limited partnership (FLP) valuation discounts and prevent penalties:

Form the FLP properly. The donor should follow these steps when creating an FLP: 1) form the partnership, 2) contribute assets, and 3) gift limited partner interests. Otherwise, the IRS may argue that transfers occurring before or shortly after formation are indirect gifts of FLP assets.

Run it like a business. It’s also imperative to establish a legitimate business purpose for the FLP and continue to operate the FLP in accordance with that purpose throughout its existence.

Separate personal assets from FLP assets. This is key. For example, the FLP should have its own bank account. It should also refrain from funding general partner living expenses or estate tax liabilities.

Limit general partner control. An FLP must strike a balance between maximizing valuation discounts and preventing Section 2036(a) challenges. A donor who continues to possess or enjoy the benefits of FLP assets is likely to raise a red flag with the IRS.

Make only pro rata distributions. Non-pro-rata distributions or distributions that coincide with a general partner’s personal cash flow requirements may trigger a Sec. 2036(a)(2) challenge — especially if the donor retains sole discretion over payouts.

In addition, obtain the advice of a qualified appraiser to ensure the FLP will withstand IRS scrutiny. There is no substitute for a formal written appraisal by an independent valuation professional.