Discounting FLP interests.

Early in 2003, the Service received significant victories in its ongoing battle against the use of a family limited partnership (FLP) as a strategy for gifting family assets at a discount, During the past six years, the Service has tried to attack the strategy in various ways, with little success; see, e.g., Kerr, 113 TC 449 (1999); Knight, 115 TC 506 (2000), and Est. of Jones, 116 TC 121 (2001). However, the IRS did succeed in cases presenting particularly egregious facts; see, e.g., Est. of Schauerhamer, TC Memo 1997-242; Est. of Reichardt, 114TC 144 (2000); and Est. of Harper, TC Memo 2002-121.

The tide began to turn in the Service's favor in early 2003, in Est. of Strangi, 115 TC 478 (2000), aff'd in part and rev'd and rem'd in part, 297 F3d 279 (5th Cir. 2002), on remand, TC Memo 2003-145, and Kimbell, Sr., 244 FSupp2d 700 (ND TX, 2003).These two cases solidified Sec. 2036(a) as the IRS's weapon of choice--perhaps its only weapon--in its quest to vanquish FLP discounting (although Strangi, in particular, raises significant questions as to the proper application of Sec. 2036(a)(2) in this context).

Although the Service has been successful with its use of Sec. 2036, that provision is applicable only when valuing an estate; if the donor is alive, it does not apply. For living taxpayers seeking to use FLPs for discounted gifting, two recent Tax Court cases presented situations in which the court valued discounts to be applied to transferred limited partnership interests.

Lappo

In Lappo, TC Memo 2003-258, a taxpayer contributed marketable securities and real estate to a limited partnership, then gave limited partner interests representing 98.7% of the outstanding units to her daughter and a variety of trusts for her grandchildren. She claimed approximately 54% minority-interest (MI) and lack-of-marketability (LOM) discounts on the transferred interests.

The only issue before the Tax Court was the valuation discount. Footnote 1 in the opinion states that the IRS's original deficiency notice had also presented economic substance, Sec. 2703(a)(2) restriction and taxable-gift-on-partnership-formation arguments; all of those were subsequently withdrawn. In other words, the Service retired a number of weapons it used in various 1990s rulings (see, e.g., Letter Rulings (TAMs) 9719006, 9723009, 9725002, 9730004, 9735003 and 9736004), all of which proved relatively useless. This leaves the Service only two forms of ammunition: (1) Sec. 2036(a) (for an estate) and (2) attacking the amount of a claimed discount, by challenging partnership interest valuation.

A unique feature of Lappo is that it presents a very detailed analysis of the valuation process the taxpayer's and the Service's appraisal experts used; no previous case had dissected valuation methodology as thoroughly. The valuation analysis presented in the opinion provides useful insight on (1) successful execution and implementation of a FLP transaction and (2) preparing a situation to withstand IRS challenge.

Lappo also demonstrates that a FLP transaction can be accomplished, despite the victories the Service achieved earlier in 2003. The Tax Court held that the transferred interests should be discounted from the underlying net asset value by 15% for the MI and another 24% for the LOM. These amounts clearly represent a very solid valuation discount and a successful use of the FLP strategy.

Peracchio

Decided after Lappo, Peracchio, TC Memo 2003-280, also involves the correct MI and LOM to apply in determining the value of gifted FLP interests. However, while the Lappo FLP assets consisted of significant amounts of marketable securities ($1.3 million) and real property ($1.8 million), in Peracchio, the FLP held only cash and marketable securities. Consistent with Lappo, the only issue before the Tax Court was the valuation discount.

Peracchio, like Lappo, also presents an informative and detailed analysis of the valuation process used by the taxpayer's and the IRS's appraisal experts; the court permitted a 6% MI and 25% LOM discount. The MI discount was lower in Peracchio because the FLP contained only cash and marketable securities.

Annual Exclusion FLP Gifting

One final FLP case from mid-2003 is Hackl, Sr., 335 F3d 664 (7th Cir. 2003), aff'g 118 TC 279 (2002), in which the Service emerged victorious. The case provides further support for the IRS's position on whether FLP-interest gifts are gifts of a present interest in property eligible for the annual gift tax exclusion. Prior to this case, there was essentially no direct court authority on this issue.

At first blush, the Hackl facts appear to be the key reason for the IRS's success. Following his retirement from a public company as chief executive officer, the taxpayer created a limited liability company (LLC) to purchase several large tree farms. He sought to begin a tree farming business that he eventually planned to pass to his children. It was expected that the business would not have harvestable trees (and, hence no cashflow) for perhaps a decade or more (a factor critical to whether the donees received a current economic benefit from gifts of LLC interests). The taxpayer was the LLC's managing member; the LLC operating agreements included the typical prohibitions and limits on transfer. The taxpayer commenced a program of making gifts of LLC interests to his children and their spouses subject to the annual gift tax exclusion.

On examination, the Service asserted that the gifts did not represent a present interest in property. The taxpayer argued that he had given up all his legal rights and had placed no restrictions on the interests gifted, so that the transfers involved no postponement of rights, powers or privileges that could cause the gifts to constitute future interests. However, both the Tax Court and the Seventh Circuit upheld the IRS's position that restrictions in the LLC operating agreement failed to confer on the donees the requisite immediate and unconditional rights to use, possess or enjoy the property or the income therefrom; thus, the gifts did not convey any immediate economic benefit.

Commentators suggested that perhaps the long-term nature of the tree farm business would confine the decision to cases with similar facts. However, a closer reading of the Tax Court and Seventh Circuit opinions confirms that the principles embodied in the IRS's position are more closely connected to the operating agreement's terms than the underlying business operation. Consequently, use of a FLP for annual exclusion gifting requires closer attention to detail and may make it more difficult to obtain full valuation discounts as to those interests, as several of the restrictions used to support the discount may need to be eliminated for the interests to constitute a present interest in property for gift tax purposes. Thus, when gifts of FLP interests are made, transferring all of the donor's interests is insufficient; the tax adviser must consider the rights and restrictions of the interests contained in the entity's operating agreement, as well.

FROM JOSEPH F. SCHLUETER, MINNEAPOLIS, MN