Discount partnership arrangements still can be used to reduce transfer taxes.
What is a discount
A discount partnership is a partnership arrangement involving junior and senior family members. The goal of such an arrangement is to have the property contributed to the partnership by the senior family members valued at a discount in their estates by virtue of its contribution to the partnership. This generally is done by placing restrictions on the partnership's liquidation. The discount arises because the estate cannot readily cause the sale of the assets underlying the partnership interest. As a result, the partnership interest must be valued based on the expected future cash distributions from the partnership, which is usually significantly lower than the value of the underlying assets.
Normally, a discount partnership is formed as a limited partnership with the senior family members and at least one other family member as the general partners. A senior family member generally functions as the managing general partner, which ensures that the senior family members retain control over the partnership's assets without creating a retained interest which would cause inclusion in the transferors'gross estates. The general partners normally have a nominal interest (such as 1%) in the partnership. Substantially all of the partnership's value is vested in the limited partnership interests that are owned primarily by the senior family members. At the time of death, the general partnership interest is purchased from the decedent's estate for its then fair market value (FMV). The limited partnership interest owned by the decedent is not purchased. However, because the partnership cannot be liquidated, the decedent's limited partnership interest is valued based on expected future cash distributions. Generally, the present value of the expected cash distributions is significantly less than the true value of the underlying assets - which results in the "discount."
The discount partnership technique is based on the premise that the executor of the decedent's estate cannot cause the sale of the assets underlying the limited partnership interest. This inability to dispose of the underlying assets is the economic reason for the discount. Appraisers typically have used discounts of 30% to 50% from the underlying assets' FMV.
Generally, there is no taxable gift when a discount partnership is created, since all of the partners suffer the same decrease in the value of their respective interests as a result of the inability of the partnership to liquidate. As a result, there is no transfer of property from one partner to another when the partnership is formed. There is no basis for assessment of gift tax without a shifting of value between the partners.
On the death of a senior family member partner, there generally is no estate tax on the difference between the value of the underlying assets and the discounted value of the partnership interest because the difference is not transferred to anyone. The remaining partners' interests are worth the same amount before and after death. In other words, there is no shifting of value at death.
Sec. 2704 was enacted by the Revenue Reconciliation Act of 1990 (RRA) to limit the use of discount partnership arrangements. It provides that the lapse of a voting or liquidation right in a family-controlled corporation or partnership results in a transfer by gift or an inclusion in the gross estate. The amount of the transfer is the value of all interests in the entity held by the transferor immediately before the lapse (assuming the right was nonlapsing) over the value of the interest immediately after the lapse. Thus, in the case of a family-controlled corporation, if the father's stock has a voting right that lapses on his death, his stock is valued for Federal estate tax purposes as if the voting right was nonlapsing.
Sec. 2704 also provides that any restriction that effectively limits the ability of a corporation or partnership to liquidate is ignored in valuing a transfer among family members if (1) the transferor and family members control (immediately before the transfer) the corporation or partnership and (2) the restriction either lapses after the transfer or can be removed by the transferor or members of his family, either alone or collectively. According to the Senate Finance Committee Reports, the reason for this provision was that Congress was concerned about the use of lapsing rights to transfer value free of transfer tax. Because such rights are difficult to value when created and they may not be exercised in an arm's-length manner, Congress believed property transferred at death was more accurately valued by disregarding lapsing restrictions and by adding back the value attributable to the lapsing right to the value of the transferor's interest in the business.
Exceptions to Sec. 2704
Sec. 2704(b)(3) contains two important exceptions to the rule that liquidation restrictions will be ignored in valuing a transfer of a controlled corporation or partnerhip among family members. First, Sec. 2704(b)(3)(a) provides that this rule does not apply to commercially reasonable restrictions that arise as part of a financing with an unrelated party. Consequently, if the lender covenants and the partnership agreement prohibit the liquidation of the partnership until the partnership debt is reduced below a certain limit, the provisions of Sec. 2704 that ignore the restrictions on liquidation for valuation purposes should not apply. Second, Sec. 2704(b)(3)(b) provides that the rule does not apply to a restriction imposed or required to be imposed under state or Federal law. Thus, if under state partnership law a limited partner cannot compel liquidation of the partnership, the value of his interest is determined without regard to Sec. 2704(a).
The exceptions to Sec. 2704 appear to provide at least three situations in which a discount partnership arrangement can still be used to reduce the value of the senior family members' interests in a family partnership.
First, a restriction that requires the unanimous consent of all of the partners to be removed should be respected, provided there is at least one unrelated partner in the partnership. If one or more of the partners are not family members and the liquidation restriction does not lapse in whole or in part after the transfer, the restriction should be respected because it cannot be removed by the transferor or members of his family either alone or collectively (Sec. 2704(b)(2)(b)(ii)). Therefore, if a partnership interest is given to a charitable organization and the organization's consent is required to liquidate the partnership, it is possible that Sec. 2704 will not apply and the value of the partnership interests held by senior family members will be valued based on the expected cash flows (and not based on the liquidation value of the underlying assets). This technique also could be used by giving an interest to a nonfamily member-employee, rather than to a charitable organization. The use of an unrelated party to fall outside of the provisions of Sec. 2704(b)(2)(b)(ii) may be subject to challenge if the use of the unrelated party has no substance or if the unrelated party simply acts as an agent for the family. However, in the income tax area, the Service has respected the independence of charitable organizations to whom stock is transferred shortly before its redemption. In Rev. Rul. 78-197, the Service held that a taxpayer with control of a corporation and an exempt private foundation who donated shares of the corporation's stock to the foundation and, pursuant to a prearranged plan, caused the corporation to redeem the shares from the foundation did not realize income as a result of the redemption. According to the ruling, the IRS will treat the proceeds as income to the donor under facts similar to those in Palmer, 62 TC 684 (1974), acq. 1978-2 CB 2, only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption. It is uncertain whether the Service would adopt a similar view in dealing with the provisions of Sec. 2704.
Second, a restriction that is imposed as a result of commercially reasonable restrictions that arise as part of a financing with an unrelated party is not ignored for valuation purposes. Consequently, if the lender covenants and the partnership agreement prohibit the liquidation of the partnership until the partnership debt is reduced below a certain limit, the provisions of Sec. 2704 that ignore the restrictions on liquidation for valuation purposes should not apply.
Example: Father, F, and his son, S, and daughter, D, owned an undivided one-third interest in undeveloped land in a rapidly growing suburban area. The undeveloped land was worth $3,000,000 in 1990, and was pledged as collateral for a $2,000,000 bank loan. Shortly thereafter, F, S and D decided to contribute the land to a limited partnership. Each received a 3.33% general partnership interest and a 30% limited partnership interest for their respective contributions to the partnership. After considerable discussions with the bank, F, S and D agreed that the lender covenants and the partnership agreement would provide that the partnership could not be liquidated until the bank debt was reduced to $200,000 or less. After the partnership was formed, the partners developed a shopping center on the property. Although the shopping center is successful, the distributable yields on the partnership interest are insignificant because virtually all of the cash generated by the partnership has been reinvested in developing new shopping centers. The average distributable yields on the respective partnership interests are equal to approximately 6% of the underlying asset values of the partnership. By the time F dies in 2010, the partnership assets are worth $70,000,000 and the partnership debt is $10,000,000. If F's executor attempted to sell F's general and limited partnership interests, a valuation expert determined that they would yield only $12,000,000 (a 40% discount from the underlying asset value of the partnership), as a result of the low distributable yields of the partnership interest and the fact that a transferee would receive only a limited partnership interest with no management rights and no liquidation rights until the partnership debt is reduced to $200,000 or less. If F had not encumbered his property with the partnership agreement, his estate's interest in the enterprise would be worth approximately $20,000,000.
Third, a restriction that is imposed, or required to be imposed, by any Federal or state law is not ignored for valuation purposes. Thus, if under state partnership law a limited partner cannot compel liquidation of the partnership, the value of his interest should be determined without regard to Sec. 2704(a).
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|Author:||Taylor, Rick J.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 1992|
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