The formation, intergenerational transfer, and valuation of family limited partnership interests.

In recent years, family limited partnerships (FLPs) have become a commonly used instrument in family estate tax planning. This popularity of FLPs is due both to (1) their flexibility as a property ownership transition and intergenerational wealth transfer planning tool and (2) their potential to materially reduce federal estate taxes.

FLPs have become widely accepted family estate planning mechanisms because they allow parents (1) to transfer ownership interest in property to their children (2) while still retaining operational control of the property. In the typical FLP structure, the parents hold the general partnership interests and, over time, make gifts of limited partnership interests to their children. This structure allows the parents to maintain complete operational control of the subject property (e.g., the stock in a family-owned, closely held corporation).

For federal income tax purposes, an FLP has two distinct advantages. The first advantage is avoiding the compressed tax rates imposed on trusts. The second advantage is avoiding the double level of income tax imposed both on corporations and on shareholders. For gift tax purposes, valuations of the gifts of FLP ownership interests can frequently be discounted for (1) lack of control (or minority ownership interests) and (2) lack of marketability. When structured and implemented correctly, FLPs can be enormously beneficial estate planning instruments. Of course, the ultimate measure of the effectiveness of the FLP is the formation of an entity that will withstand Internal Revenue Service scrutiny.

First, this article will summarize the practical factors that are important in the formation of the FLP. These factors are important to ensure that the Service recognized the economic substance of the FIP formation. Second, we will address the practical factors that are necessary in order to ensure that the Service favorably recognized the intergenerational transfer of the FLP ownership interests. And, third, we will summarize the application of valuation discounts with respect to the appraisal of FLP ownership interests. Of course, these discounts make FLPs an attractive estate planning tool.

Service Recognition of the Partnership

It is noteworthy that a partnership that is valid under state law will not necessarily be valid for purposes of the federal tax laws. As articulated in federal tax law judicial precedent, the test that distinguishes the formation of a partnership from a co-ownership arrangement can be stated as follows: 1. If two or more persons have actively joined together with the intent to carry on an enterprise, and

2. There is a community of interest in the profits and losses of that enterprise, then

3. The persons have formed an association.

An association or arrangement must meet all of the above requirements in order to be recognized as a valid partnership for federal taxation purposes. It is noteworthy that the mere passive receipt of income does not constitute the carrying on of an enterprise (or, accordingly, the formation of a partnership).

Service Recognition of the Partner

For federal taxation purposes, the rules which determine whether family members will actually be recognized as partners in the FLP depend upon whether the FLP is a capital-intensive business or a service-intensive business.

First, if capital is a material income-producing factor in the business, then each family member: (1) must have acquired his or her capital interest in a bona fide transaction (even if acquired by gift or by purchase from another family member), (2) actually own the partnership equity interest, and (3) actually control the ownership interest. Second, if capital is not a material income-producing factor in the business, then family members must have joined together in good faith to conduct a business. In addition, the family members must have agreed that the contributions of each entities them to a share in the profits.

Accordingly, either capital or service must be provided by each family member in order for the Service to recognize the formation of the FLP. Also, the services provided by the family members must be more than merely incidental to the ownership of the property. In other words, in order for the FLP formation to be recognized for taxation purposes, it is vital that there be a valid business purpose for each family member's participation in the partnership.

During the past few years, the tax court has invalidated a large number of FLPs on one of two grounds. In the first set of cases, the Tax Court concluded that the family member did not contribute capital or services to the FLP. Therefore, the family member's FLP ownership interest was determined to be a "conditional gift." In the second set of cases where there was no question that there was a completed gift, the Tax Court found that the FLP lacked a bona fide business purpose.

It is also recommended that the family members/FLP partners respect both (1) the gifts of ownership interests made and (2) the partnership as a separate entity. For example, an otherwise valid FLP will not be recognized for estate tax purposes if the donor continues to hold any "strings."

Active v. Passive Business Purpose

Unfortunately, there are no unambiguous rules as to what constitutes an "active trade or business." Likewise, there are no unambiguous rules as to what level of business activity must be present to exceed the mere co-owner qualification. However, it is clear that simple sharing of expenses is not a partnership. Likewise, the mere co-ownership of a property that is maintained, kept in good repair, and rented out does not constitute an active trade or business.

There is clearly a distinction between a "business activity" and an activity that is incidental to ownership. However, it is not easy to determine when a taxpayer crosses the line between the two. For example, the Tax Court recently held that a family partnership formed to purchase lottery tickets in the hopes of winning the jackpot was a valid business purpose (see the Estate of Winkler, CCH Dec. 51,805(M)). The Tax Court has also held that a family partnership that owned rental real estate and collected rent through rental agents and paid the cost of repairs, commissions, insurance and appraisals did not have a sufficient business activity (see Powell, CCH Dec. 28,348(M)).

The anti-abuse regulations regarding partnerships require that an FLP have a substantial business purpose, as discussed above. In addition, if the principal purpose of the FLP formation is to substantially reduce the present value of the partners' aggregate federal tax liability in a manner inconsistent with the intent of Internal Revenue Code subchapter K, then the Service can and will recast the FLP formation transaction. This poses a particular concern for FLPs that hold solely - or even primarily - passive activities or investments.

For FLPs owning securities, the marketability of the underlying securities coupled with the power to vary investment strategy should ensure a finding of a valid business purpose. The formation of FLPs that own illiquid investments, or investments, the conversion of which would defeat the purpose of the arrangement, will likely be subject to serious scrutiny on the part of the Service.

Accordingly, the formation of such FLPs should be avoided if possible. Similarly, members of FLPs who own real estate need to be actively involved with the needs of the subject real estate beyond the mere incidental ownership concerns. Of course, this does not mean that outside contractors cannot be allowed to perform certain functions. However, the more activities delegated to outsiders, the more likely that the FLP may fail the Service's business activity test.

Timing of the FLP Formation

Recently, the Service issued two private letter rulings that addressed the timing of FLP formation. Both recent rulings involved terminally ill parents who gave a power of attorney to their children - the same children who would inherit under the terms of inter vivos trusts. In each case, the children invoked their power of attorney, and formed a FLP in order to receive transfer tax benefits. In one of the instances, the FLP was created two days before the parent's death. In the other instance, the FLP was formed two months before the parent's death.

In the two letter rulings, the Service did not even enter into a discussion of business purpose or capital contributions. Rather, the Service invalidated both FLPs on the basis of the substantial valuation discounts that were claimed by the FLP. According to the Service, the very magnitude of these valuation discounts indicated that (1) depressing the value of the FLP assets and (2) reducing the amount subject to estate tax were the motivating factors behind the FLP formation transactions.

As with the business activity test, there is no clear cut rule as to how long an FLP must be in existence in order to receive a favorable recognition on the part of the Service. Common sense dictates, of course, that the sooner the FLP formation has been finalized prior to the death of a family member, the more credible the FLP formation appears.

Parent generation business or property owners should keep in mind that if they retain the general partner interest, then they essentially remain in control. This is because the limited partners are restricted in their ability to direct the business. It is always best if the FLP is formed while the donor is still in complete control of his or her faculties. At that time, the donor is still able to enter into the partnership agreement directly - and does not require the service of an agent.

FLPs as Part of an Intergenerational Wealth Transfer Program

Once the FLP structure is in place, the parents can gift to each child, gift tax-free, a limited partnership interest valued up to $10,000 per year. An important economic advantage in this gifting of limited partnership interests is the fact that the noncontrolling (or minority) ownership interests in the partnerships are usually valued by applying a substantial lack of control discount. The amount of the lack of control valuation discount is based upon the facts and circumstances of each business interest. There is no simple test or formula that may be used to estimate the appropriate discount amount. And, many taxpayers have encountered rigorous scrutiny from the Internal Revenue Service after applying excessive and insupportable lack of control valuation discounts.

Annual tax-free gifts can be an effective component of a family's intergenerational wealth transfer program. However, under Internal Revenue Code Section 704(e), gifts of FLP ownership interests are only recognized under certain circumstances. If capital is an income-producing factor, then a gift or other transfer of an FLP ownership interest among family members is recognized. However, if capital is not an income-producing factor, then the family member receiving the FLP ownership interest must provide substantial or vital services to the partnership. (For example, this could happen when Doctor Dad gifts a partnership interest in his medical practice to Doctor Son, a young physician.)

This means that the parents' ability to transfer an FLP ownership interest to their children often depends on the kind of business that is being operated. For example, if the FLP is a manufacturing business, then a gift of an ownership interest in the FLP - at least an ownership interest that is not hedged with limitations that convey less than a full partnership interest, such as restrictions on selling the interest - will be recognized.

The regulations call this condition having "dominion and control" over the FLP ownership interest. The question of whether or not, for estate tax purposes, the donor has retained such control over the FLP ownership interest is governed by Section 2036.

Dominion and Control Over the FLP Ownership Interest

This question can create a problem for closely held business owners and for their estate tax planners. Ideally, to be certain that the gift of an FLP ownership interest is recognized for income tax purposes, it is best if the donee has the right to sell the ownership interest without restriction (see Regulation 1.704-1(e)(2)(ii)(d)). However, the right to sell the subject FLP interest to outsiders is the one right that the other FLP owners may not want to grant. One solution to this conflict may be to give the other FLP owners - or the FLP itself - the right of first refusal in the event that the children wish to sell their FLP ownership interests.

Although the Service has not ruled on this specific issue, this right of first refusal should substantially reduce the ability of the Service to allege that there is a restriction on selling the subject FLP interests. This is because this right of first refusal does not restrict the right of a donee to liquidate his or her ownership interest. Rather, even with this right of first refusal, the donee is still able to sell the FLP ownership interest at the highest price.

Also, in FLPs, restrictions on the sale of the FLP ownership interests provide considerable evidence that the donee does not really have "dominion and control." The Service has specified two instances where lack of control could be inferred: (1) if the FLP ownership interest is not assignable in a real sense, and (2) where the FLP ownership interest is required to be left in the business for a considerable number of years (see Regulation 1.704-1 (e) (2) (ix)).

Gifts of FLP Ownership Interests to Minor Children

Minor children cannot legally be partners in the FLP until they are able (1) to manage their own property and (2) to participate in partnership activities (see Regulation 1.704-1(e)(2)(viii)). In assessing whether a minor child can manage his or her own affairs, the Service examines age and maturity on a case-by-case basis. State law does not control who is - or who is not - a "minor" for this purpose.

If the minor child is too young to manage his or her own property, then the gift of the FLP ownership interest should be made to a trust for the child's benefit. As a practical matter, however, almost all gifts to minor children are made through a trust.

Although the donor (or any other family member) can be the trustee, the transfer of the FLP ownership interest is easier to substantiate as a gift if the trustee is not either (1) the general partner or (2) someone under control of the general partner.

A gift of an FLP partnership ownership interest in trust for the benefit of a minor child is usually not recognized unless there is at least the level of judicial supervision on the conduct of the trustee as is required by state law.

The Retention of Earnings Within the FLP

Another important issue in the intergenerational gifting of FLP ownership interests is whether the FLP income is actually distributed to the donee (see Regulation 1.701-1(e)(v)). Accordingly, the FLP will not be able to retain "other than that held for the reasonable needs of the partnership business." One response to this regulation is to require that all of the FLP income not reasonably needed for the subject business be distributed to the partners. Clearly, the FLP should not go overboard in declaring that huge sums of cash need to be retained for business expansion. Nonetheless, nothing precludes the FLP from adopting a fiscally conservative position with respect to the retention of earnings for the subject business's future cash needs.

Other FLP Ownership Interest Transfer Issues

No single issue determines whether a gift of an FLP ownership interest will be recognized or not. As with all gifts, all of the relevant facts and circumstances need to be considered. Some of these FLP ownership interest transfer issues will be discussed below.

Management Powers. The subject FLP should have a management arrangement that complies with the established norms among similar partnerships (see Regulation 1.01-1(e)(2)(iv)). Of course, the selection of certain partners as managing partners is common among large partnerships. However, this selection would probably come under closer examination in a two- or three-person partnership. Fortunately, this management power issue may be conveniently ignored if the gift is of a limited partnership interest. Limited partners cannot participate in the management of the FLP. (If it is important to the family that an adult child participates in the management of the family-owned business, then a limited liability company form of business may be the preferred alternative to the FLP form.) Of course, if the FLP ownership interest is given to a minor child, then the child is not expected to participate in the management of the family-owned business.

Indirect Controls. The Service will look past "mere formalities" in order to judge whether a donee has true "dominion and control" over the FLP ownership interest. For example, if control in the FLP is given to a corporation, and, in reality, the donor controls the corporation, then the control of the FLP ownership interest will probably be deemed to be in the donor.

Conduct of the Business. Whether the donee is held out to the public, to customers, or to sources of financing as a partner is of primary significance. Other business conduct factors include: compliance with state partnership statutes; recognition of the donee's rights to income distributions; recognition of the donee's interest in business contracts; legal documentation of the subject gift; and the filing of partnership income tax returns with the donee's ownership interest noted.

The Application of Valuation Discounts to FLPs

A significant consideration in the intergenerational transfer of an ownership interest in a family limited partnership (FLP) - or in a family-owned closely held corporation (CHC) - is the application of valuation discounts in the appraisal of the gift or the estate interests. The following sections will present an overview of the application of valuation discounts to the appraisal of FLP (and CHC) ownership interests for intergenerational wealth transfer purposes. This discussion will attempt to answer the following three questions:

What are Typical Valuation Discounts Within the Context of FLPs and CHCs?

What is the basis for the Internal Revenue Service allowing - or not allowing - these discounts within the context of gift and estate tax valuations? And what are some examples of situations where valuation discounts have been allowed in estimating the fair market value of transferred ownership interests in family-owned businesses for gift and estate tax purposes?

What are the Typical Valuation Discounts?

There are a number of decremental valuation adjustments - or discounts - that may apply to the valuation of FLP or CHC ownership interests. Of these, the most common valuation adjustments fall into two categories: (1) discount for lack of control and (2) discount for lack of marketability.

Lack of control discounts are those appropriate to the holders of a noncontrolling - or minority - ownership interest. Recognizing that such security holders lack control over corporate policy, dividends and liquidation of corporate assets, the courts have generally allowed a discount - compared to the pro rata value of the subject business entity - in order to reflect these negative factors.

The same justification for a lack of control valuation discount is appropriate for limited partners. This is because FLP limited partners are not permitted to participate in management, usually lack unrestricted transferability of their ownership interests, and may not withdraw their capital accounts at will.

On the other hand, lack of marketability discounts are valuation adjustments that are made in order to reflect the decrement in value - compared to a pro rata value of the subject business entity - attributable to the lack of a ready market for the subject security. The lack of marketability discount is typically applicable to the valuation of FLP and CHC equity interests because such equity interests cannot be readily sold on an organized securities exchange.

Depending on the particular facts and circumstances of the ownership interest subject to appraisal, these two valuation discounts may be applied independently of, or in conjunction with, each other.

The Valuation of Transferred Ownership Interests for Gift and Estate Tax Purposes

The Internal Revenue Code requires that property that is included in the gross estate of a decedent, or that is the subject of a gift, will be taxed on the basis of the fair market value (1) at the time of death of the decedent, or on the alternate valuation date if so elected, or (2) in the case of a gift, at the date on which the gift was completed.

The Treasury regulations define fair market value as the price at which the property would change hands between a willing buyer and a willing seller, with neither being under any compulsion to buy or sell, and with both having reasonable knowledge of relevant facts.

Recent Tax Court decisions have added that the hypothetical buyer and seller should be assumed (1) to be able - as well as willing - to transact and (2) to be well informed about the subject property and about the market for such subject property. In addition, the price the hypothetical buyer and seller would arrive at should be representative of a bona fide arm's-length transaction.

The Service's Basic Approach to CHC Valuation

Before 1993, the Service did not allow minority shareholders to apply discounts for lack of control to the valuation of shares of stock transferred between family members if, based upon a composite of the family members' ownership interests at the time of the transfer, control of the subject corporation existed in the collective family unit. In 1993, however, the Service reconsidered this position. As articulated in Revenue Ruling 93-12, the Service concluded that in the case of a corporation with a single class of stock - notwithstanding the family relationship of (1) the donor, (2) the donee, and (3) other shareholders - the shares of other family members will no longer be aggregated with the transferred shares in order to determine whether the transferred shares should be valued as part of a controlling ownership interest.

Factors to Consider in the Valuation of FLPs and CHCs

Even though they were issued years ago, Revenue Rulings 59-60 and 83-120 still provide the current benchmarks with respect to the Service's guidance regarding the valuation of CHCs for gift and estate tax purposes. And, although both of these revenue rulings relate to CHCs, the applicable guidance is easily adaptable to the valuation of FLP ownership interests.

Generally, these revenue rulings recognize that the estimation of fair market value is a fact-based and fact-specific analysis. This estimation may only be resolved based upon consideration of the circumstances of each individual case. In the valuation of the stock of a CHC or of a limited partnership interest in an FLP, all available financial data - as well as all relevant factors affecting the market value - should be considered.

As articulated in Revenue Ruling 59-60, the Service considers the following factors to be relevant to the valuation of closely held business interests:

* the nature of the business and the history of the enterprise;

* the economic outlook in general and the outlook of the specific industry;

* the book value of the stock and the financial condition of the business;

* the earning capacity of the company;

* the dividend-paying capacity;

* the value of goodwill or other intangibles;

* sales of the stock and the size of the block of stock; and

* the market price of stocks of corporations engaged in the same or a similar line of business for which their stocks are actively traded either on an exchange or over-the-counter.

Effect of Restrictive and Repurchase Agreements 

Often, the stock in a family-owned CHC, or an ownership interest in an FLP, is subject to an agreement restricting the sale or other transfer of these equity interests. In those cases where the subject equity ownership interest was acquired subject to an option by the subject business entity to repurchase at a certain price, that option price will usually be accepted as indicative of fair market value for estate tax purposes. However, that option price would not be indicative of fair market value - or binding on the Service - for gift tax purposes.

In those instances where the transferability restrictions only become effective upon the shareholder's death, then the Service has ruled that fair market value is not limited to the option price. On the other hand, where the repurchase option is a result of a voluntary action by the shareholders of the family-owned business entity, and the option retains its power through the life and death of the shareholder, then such a repurchase option may or may not be indicative of value for estate tax purposes. Nonetheless, the Service has concluded that, at least, it would be a relevant factor to consider in estimating fair market value.

The consideration of the relationship of the parties, the relative number of shares held by the decedent, and other material facts are used by the Service to determine whether the repurchase option represents a bona fide business arrangement. However, the repurchase option will not be considered indicative of value if the Service concludes that it is a device to pass the decedent's shares to the natural objects of his or her bounty for less than full and adequate consideration.

Fractional Interests in Real Estate

The Service has generally argued that holders of fractional ownership interests in real property have the power to compel the property's partition. Therefore, according to the Service, any valuation discount for fractional ownership interest should be limited to the cost of such a partitioning.

The Tax Court, however, has generally allowed more substantial fractional ownership interest valuation discounts. The Tax Court has allowed these valuation discounts in order to reflect (1) the cost of delay, (2) the uncertainty that would be inherent in the property partitioning procedure, and (3) the cost of the partitioning itself.

Valuation Discounts Have Been Allowed When the Decedent Owned 100% of the CHC

Occasionally, the courts have allowed valuation discounts in cases where the decedent owned 100% of the common stock of the CHC.

In the Estate of Jephson (87 T.C. 297), the decedent owned all the stock of two investment corporations - the assets of which consisted of publicly traded stocks, publicly traded bonds, and cash. Because neither CHC had any liabilities, all of the underlying assets were totally liquid. And, the decedent was the sole shareholder of the two CHCs. Accordingly, the Tax Court valued the stock at net asset value less the costs of liquidation. The Tax Court concluded that a "willing buyer" would have paid the liquidation value (less costs) of the companies in order to save significant brokerage commissions. A lack of marketability valuation discount was not allowed in this case because (1) the underlying assets were readily marketable, and (2) complete ownership of the underlying liquid assets could be obtained through a partial or complete liquidation or through a dividend in kind.

In contrast, the Tax Court in the Estate of Mosher (T.C. Memo. 1988-24) allowed a lack of marketability valuation discount where the decedent owned 100% of the common stock in an investment company. The assets of the investment company consisted of real estate held outright and in co-tenancy.

Robert Reilly, CPA, CFA, ASA, and Bob Schweihs, ASA, are managing directors of Willamette Management Associates, where they are both resident in the firm's Chicago office. They both perform valuation consulting and financial advisory services related to estate planning for closely held business owners.