Using partnerships to make gifts at a discounted value.

Facts: Alec Shearson, age 63, has been a successful investor. He now wishes to make gifts of publicly traded stock to his children and grandchildren, and has assembled a portfolio with a $1 million value from which he wishes to make these gifts. Alec would like to restrict the donees' access to the stocks (at least for the time being). He also would like to continue to direct trades within the portfolio for the near term. Finally, he wants to ensure that these gifts are made in a tax-effective manner. Alec seeks the advice of his tax adviser as to a gifting program that would best achieve these objectives. * The tax adviser has suggested Alec form a limited partnership, AS Investments L.P., to own and manage the portfolio he wishes to give to his children and grandchildren. Alec would be the general partner during his lifetime, but would own I most of his interests through "limited partnership units." Each of the units would represent 0.1% of the partnership's equity (with a value of $1,000). Alec's wife also would be a limited I partner at the outset (since two partners would be needed to form the partnership). Then, instead of giving shares of stocks to his children and grandchildren, Alec would give them limited partnership units of AS Investments. Issue: How will gifts of units in the limited partnership be valued for transfer tax purposes?

Analysis

For gift tax purposes the value of a gift is its fair market value (FMV), which is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of all relevant facts. If Alec should make gifts of shares of stock, the FMV of those gifts for gift tax purposes would be the value at which the shares traded on the date the gift is made.

In the tax adviser's proposed structure, while each donee would acquire the same proportionate interest in the stock portfolio Alec has assembled, the donee would not have the same control over, or access to, that value. For example, Alec would retain the right to make investment decisions for the portfolio. Additionally, a donee would not be able to liquidate this asset as easily as if he had acquired the underlying stock, so it would be more difficult for a donee to obtain the cash equivalent of his percentage interest in the portfolio. The donee could transfer the interest only in accordance with the terms of the partnership agreement. As a consequence, any would-be purchaser would likely offer considerably less than the net asset value attributable to the interest. For reasons such as these, gifts of interests in corporations or partnerships are often valued at a discount from the FMV of the underlying assets or business because of the minority status/lack of control inherent in the interest and the lack of transferability/liquidity of the interest.

Taxpayers have claimed such discounts in the case of family gifts of partial interests in property or businesses (i.e., stock in a closely held business, partnership interests,undivided interests I in real estate), even when the family, as a group, maintained control over the business or asset. Courts have recognized the lack of control or lack of marketability of these interests, and allowed a discount from the proportionate value of the underlying property in valuing these separate interests. The appropriate discount, however, depends on the facts and circumstances in each case.

Despite acceptance of these discounts by many courts, for some time the IRS took the position that discounts for family gifts of interests in corporations and partnerships were inappropriate in many instances. In the Service's view, as long as control over the assets or enterprise remained within the family group, it was irrelevant that a particular owner of stock or a partnership interest did not separately possess that control.

In Rev. Rul. 93-12, however, the IRS indicated a much greater willingness to accept discounts in the case of intrafamily gifts of stock. The reasoning reflected in this ruling should apply equally to gifts of partnership interests.

To the extent that Alec wishes to claim a discount from net asset value, the tax adviser must remember that the Service views valuation as a "facts and circumstances" question that must be determined separately in each situation. Its framework for evaluating such questions starts with an evaluation of many factors:

* The type of business involved and its history.

* The economic outlook of the economy in general and the sector in which the business operates.

* The business's book value, earning potential and financial condition.

* The presence of valuable intangibles in the business.

* The cash flow to business owners and the size and rights of the interest being valued.

* The FMV of interests in comparable publicly traded companies.

* The price at which similar interests have changed hands in arm's-length transactions. All these factors affect an interest's FMV

Obtaining an appraisal from a competent appraiser may be advisable in many instances to provide support if a discount is claimed and later challenged. If a significant amount may be at stake or an aggressive position taken, a qualified professional appraiser with an established reputation in the field involved, especially one who carries some weight with the IRS, can provide a valuable service. One of the most valuable services a tax adviser can provide to clients is to assist m this selection. The likelihood of sustaining a claimed discount will increase dramatically if the support for the discount is prepared in advance rather than after the Service challenges the valuation.

Conclusion

Based on an appraisal from a competent appraiser, Alec's tax adviser believes a discount in the range of 15% to 25% would be appropriate for the transferred interests in AS Investments. This is based on a comparison to the discount from net asset value reflected in the sale price of interests in closed-end investment companies. If Alec made a direct gift of stocks worth 1% of the $1 million stock portfolio he assembled, he would make a gift with a value of $10,000--the value of the gifted securities. A gift of 1% of the limited partnership interests, however (which would be an indirect interest in that same $10,000 worth of stocks), would likely have a gift tax value of between $7,500 and $8,500. As a result, if Alec wished to take full advantage of the $10,000 annual gift exclusion, he could do so by giving partnership interests representing between 1.17% and 1.33% of the portfolio per transferee each year. By taking advantage of these discounts, and the resulting gift leverage available by giving partnership interests, Alec can transfer the interests in these underlying securities more quickly than he could through direct gifts.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 10th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Martewood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1996.