Valuation of FLP interests.

A recent Tax Court decision has affirmed the use of valuation discounts in the determination of fair market value for gifted family limited partnership (FLP) interests. In Kerr, 113 TC No. 30 (1999),the court upheld the use of discounts for lack of control and lack of marketability. While the use of valuation discounts is quite common when valuing gifted FLP interests, the court's analysis sheds light on the factors necessary to support such treatment.

In the case, a husband, wife and their children formed two FLPs, by transferring life insurance policies, stocks, bonds and real estate to the partnerships in exchange for general and limited partnership interests in each FLP. Each partnership agreement contained identical restrictions on liquidation of the FLPs. Subsequent to the partnerships' formation, the husband and wife each created separate grantor retained annuity trusts (GRATs) and transferred a significant portion of their limited partnership interests to the GRATs. The taxpayers filed their gift tax returns and computed the value of the FLP interests transferred to the GRATs by applying discounts for lack of marketability and control. The Service argued that Sec. 2704(b) barred the taxpayers from applying a discount for lack of marketability in computing the value of the FLP interests transferred to the GRATs.

In the first of its three holdings in the case, the court rejected the taxpayers' argument that the interests transferred to the GRATs were "assignee interests." The court carefully examined the partnership agreement and the other evidential matter surrounding the transfers, and determined that "partnership interests," not "assignee interests," were transferred. The court cited the following reasons for its determination:

* The taxpayers failed to comply with the new partner admission rules contained in the agreements when making transfers of interests to their children.

* The documentation supporting the transfer of the FLP interests to the GRAT trustees (the taxpayers) indicated that a partnership interest was transferred, not an assignee interest.

* The economic rights of an assignee were not sufficiently different from those of a true partner.

* The record showed that the desired treatment as an assignee was tax motivated.

The court also clarified that the "willing buyer/willing seller" standard of Regs. Sec. 25.2512-1 should be applied to the transferred property objectively and after the character of the property had been determined under state law principles. In this case, the transferred FLP interests were determined to be partnership interests (under state law principles). Moreover, the court held that the willing buyer/willing seller are purely hypothetical persons, each of whom seeks to maximize his profit on the hypothetical transaction. The court rejected the taxpayers' argument that a willing buyer would have to be an assignee (due to the restrictive partnership admission rules contained in the agreement). Therefore, it rejected the theory that the FLP interests must be valued as assignee interests. The court indicated that this was an improper expansion of the willing buyer/willing seller standard.

Finally, the court agreed with the taxpayers and held that the liquidation provisions comprising the agreements were not "applicable restrictions" based on the exception contained in Sec. 2704(b)(3)(B). This holding was significant, because the taxpayers looked to the liquidation restrictions in the FLP agreements to determine the discounts claimed in valuing the gifts. Had the court ruled differently, the liquidation restrictions would have had to be ignored in valuing the gifts of the FLP interests, resulting in a substantially larger amount of gift tax. The court determined that the liquidation restrictions in the agreements were substantially identical to those under Texas Limited Partnership law. Accordingly, because there were no restrictions in the agreements that were more restrictive than Texas law, the liquidation restrictions were not considered "applicable restrictions."

When drafting limited partnership agreements in which a taxpayer wants to claim valuation discounts, care should be taken to ensure that the liquidation restrictions therein do not exceed the restrictions under applicable state law. Further, the record should be clear that all procedural steps required under the partnership agreement are, in fact, taken and documented appropriately.

FROM DENNIS J. SZYMKOWIAK, CPA, PARTNER-IN-CHARGE OF TAX SERVICES, D'ALBA & DONOVAN, CPAs, P.C., WILLIAMSVILLE, NY (NOT ASSOCIATED WITH BDO SEIDMAN)