FLP valuation discounts approved.

In Temple, ED TX, 3/10/06, a taxpayer claimed 58.75% valuation discounts for each of several very large gifts of interests in passthrough entities he gave to family members. The court ultimately allowed the discounts, which ranged from approximately 15% to 60% depending on the particular entity's assets and the size of the gift. Overall, the taxpayer transferred family limited partnership (FLP) and limited liability company (LLC) interests with a gross (undiscounted) value of over $34.9 million, with taxable gifts being assessed at just over $27 million (representing approximately a 22% average discount).

Facts

The taxpayer made the gifts at issue in 1997 and 1998. He created three FLPs and one LLC: Ladera Land was formed in 1992 to hold a South Texas ranch; Boggy Slough West, LLC was created in 1995 to purchase a Napa Valley, CA winery; and two identical Temple partnerships (one for each of the taxpayer's children) were formed in 1997 solely to hold marketable securities.

The taxpayer made relatively small gifts of one or both of the two real estate entities from 1992 to 1996, claiming a 40% discount for each gift. He did not consult an appraiser. For the larger gifts in 1997 and 1998, he hired an appraiser who concluded that the appropriate discount was 25% for lack of control, plus 45% for lack of marketability. When blended together, the taxpayer claimed a combined 58.75% minority/marketability discount for each gift on his 1997 and 1998 gift tax returns. The returns were audited by the IRS.

At trial, four expert witnesses presented valuation information to the district court judge. Three were hired by the taxpayer (including the person who prepared the original appraisal showing the 58% discount); the fourth was hired by the IRS.

The discounts ultimately applied by the court to the various gifts were determined in one of three ways depending on the particular partnership and the gift's size. In each case, the court rejected any additional discount for the potential, unrealized partnership capital gains. It cited Est. of Jones, 116 TC 121 (2001), to conclude a partnership (unlike a C corporation) can use Sec. 754 to increase its assets' basis to equal the basis in the acquired partnership interest.

Court's Analysis

Various discounts of 15% to 60% were determined.

Ladera Land: This FLP owned a South Texas ranch. According to the taxpayer's expert, the discount was 58.75%, based on information from Mergerstat Review, which shows control premiums for acquisitions of publicly traded companies. This approach was rejected by the court in favor of the IRS appraiser's method, which relied on a Partnership Spectrum study showing actual sales of partnership interests that primarily owned real estate. The court allowed a combined 38% discount for lack of control and lack of marketability.

Temple FLPs: These two identical FLPs (one for each of the taxpayer's children) were valued by determining a minority discount independently from a discount for lack of marketability. The discount for lack of control, as calculated by the IRS's expert, was based on a weekly publication that analyzes publicly waded mutual funds by comparing the net asset value to the fund's actual sales price. These discounts ranged from 3.3% to 10.1%, depending on the date of the gift. The court granted a flat 12.5% discount for lack of marketability, based on the IRS expert's analysis of restricted stock studies and other research.

LLC: Boggy Slough West, LLC owned a 477-acre winery located in Napa Valley, CA. The taxpayer was the LLC's "managing member." In 1997, he gave 83% of the membership interests to his daughter and set up trusts for his grandchildren. Specifically, he transferred 76.6% of the entity to his daughter and set up four separate trusts (each a gift of 1.6%) for his grandchildren.

The IRS was willing to allow a 38% blended discount for the small gifts to the grandchildren's masts, the same as for the Ladera Land FLP. However, it barred a discount for the gift to the daughter because, according to the LLC's operating agreement, the "[c]ompany shall dissolve upon the ... vote of Members holding at least fifty one percent (51%) of the Membership Interests." Instead, it proposed to tax the full $1.67 million fair market value of the 76.6% gift.

The court, however, looked to California law (in conjunction with its interpretation of the Boggy Slough West, LLC's agreement provision) and concluded that, although a 51% member may be able to force "dissolution" of the entity, he or she could not necessarily force "liquidation." In other words, the owner of 76.6% of the LLC would have no assurance that the underlying assets would be sold and, thus, a dissolution would merely result in owning a 76.6% undivided interest in the 477-acre winery. The taxpayer's expert witness (a "Senior Real Estate Analyst" and Member of the Appraiser Institute) testified that, based on local zoning restrictions, topography and various land types, the winery could not be subdivided or partitioned. He testified that the sales comparison approach showed that an undivided interest in land is valued at a 60% discount to the full value. The court chose this expert's 60% discount, even though it was larger than the 58.75% discount claimed on the original gift tax return.

One interesting attack the IRS made for disallowing valuation discounts for Boggy Slough West, LLC was that the daughter listed ownership of the LLC at its flail (undiscounted) value on a personal financial statement, to obtain a loan. Although this argument was ultimately ignored by the court, it highlights the importance of being consistent in both the tax and nontax treatments of closely held entities.

Conclusion

The old adage that "pigs get fat, but hogs get slaughtered," is usually true, unless the hog can manage to "dodge the bullets." Although the taxpayer in Temple (who originally claimed over 58% in discounts) was ultimately able to value the gifts at more than $7 million below the assets' underlying values, it is unclear how much weight the district court's decision will carry.

FROM MARVIN D. HILLS, CPA, SOUTH Bend, IN