Valuation discounts could be on the chopping block

The estate tax provisions of the American Taxpayer Relief Act of 2012 (ATRA) are more generous than some pundits expected. The top estate tax rate, though higher than in 2012, is still historically low. ATRA also permanently extends the inflation-adjusted $5 million gift and estate tax exemption. With the estate tax less imposing, it might be tempting to put estate planning on the back burner.

Not so fast. Family limited partnerships (FLPs), among the more popular estate planning tools, could be on the chopping block as Congress looks for ways to cover the budget deficit. Already, there’s talk of eliminating FLP valuation discounts. Let’s look at some of the key issues involved.

2 primary discounts

With an FLP, a donor transfers assets – such as stocks, bonds, real estate and private business interests – in exchange for general and limited interests in the partnership. Family members, employees and charities then are given (or buy) limited partner interests at substantial discounts from the net asset value of the partnership’s underlying assets. Two primary types of valuation discounts apply to limited partner interests:

  1. Lack of Control. FLPs enable general partners to continue managing the partnership’s assets. This works well when senior family members aren’t ready to fully relinquish control or when they’re testing whether the next generation has what it takes to manage the FLP’s assets. Because limited partners can’t control daily operations, including liquidating assets and declaring dividends, their interests warrant a discount from net asset value. When quantifying minority interest discounts, appraisers typically look at publicly traded closed-end mutual funds, Partnership Profiles studies of real estate limited partnerships and Mergerstat control premium studies. Partnership-specific attributes – such as historic and expected distributions, minority rights granted or restricted by the partnership agreement, and the nature of the underlying assets – affect the discount’s size.
  2. Marketability. There’s no active market for trading privately held limited partner interests. And most partnership agreements restrict transfers of limited partner interests and assignee rights. So, prospective buyers typically expect a discount from the FLP’s publicly traded equivalent value to reflect the difficulty associated with selling privately held limited partner interests.

Examples of studies used to quantify marketability discounts include restricted stock, initial public offering and put option studies. But appraisers must be careful not to double-count identical factors when quantifying discounts for lack of control and marketability.

Because they’re taken sequentially, the combined effect of the two discounts is multiplicative – not additive. Suppose the net asset value of a limited partner interest is $100, and the appraiser selects discounts for lack of control and marketability of 10% and 20%, respectively. The value of the limited partner interest on a minority, nonmarketable basis is $72. In other words, the effective combined discount is 28%, not 30%.

Administrative matters

The Achilles’ heel of any FLP is Internal Revenue Code Section 2036(a), which invalidates transfers in which the donor retains the right to possess or enjoy assets contributed to the partnership or income from those assets. Among the best ways to thwart a Sec. 2036(a) inquiry are to ensure that:

  • The FLP is created for business purposes, such as centralized management or asset diversification;
  • The FLP makes only pro rata partnership distributions – cash should never be distributed to partners on an “as needed” basis;
  • The FLP doesn’t allow donors to use partnership assets or pay personal expenses, including estate taxes, from the FLP’s bank account;
  • All partnership formalities are respected, such as maintaining a separate bank account, holding annual meetings, and keeping accurate books and records; and
  • The donor retains sufficient assets outside of the partnership to pay his or her living expenses.

Deathbed transfers – those that occur almost simultaneously with the creation of the FLP – also attract IRS attention. At least 30 (and preferably 90) days should pass before a transfer of interests.

Appraisal expertise

As of this writing, the FLP is still an effective estate planning tool. But this holds true only if partnerships avoid administrative pitfalls and stand ready to defend their valuation discounts – in whatever form those discounts may take. A qualified appraisal expert can be of great help.

If you have questions about this, or any other matter, visit http://warrenaverett.com/services/advisory/valuation-services to learn more about our Forensic, Valuation and Litigation Support Services.