Time to Act Now: Family Limited Partnerships and Valuations Discounts Attracts IRS Scrutiny

 

Thursday, June 25 2015

WRM# 15-23

 

TOPIC: Time to Act Now: Family Limited Partnerships and Valuations Discounts.

 

MARKET TREND: The popularity of family limited partnership and LLCs in gift and estate tax planning

continues to attract IRS scrutiny.

 

SYNOPSIS: Family limited partnerships and LLCs have proliferated over the years, with families using them for

multiple purposes, including centralized asset management, creditor protection, and efficient legacy planning. Intrafamily

transfers of interests in these entities often generate valuation discounts. By year-end, however, it appears

that the IRS will issue proposed regulations that restrict these valuation discounts, likely limiting many planning

techniques used to support the acquisition of large life insurance policies. The exact scope and timing for release of

the proposed regulations remain uncertain.

 

TAKE-AWAY: To take advantage of possible “grandfathering” for transactions completed before the effective

date of any proposed regulations, individuals already engaged in transfer planning with family limited partnerships

and LLCs should complete the process in a timely manner, while those seeking to rely on existing laws should begin

planning immediately.

 

MAJOR REFERENCES: Internal Revenue Code (“Code”) § 2704; Proposal to Modify Rules on Valuation

Discounts from General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (“FY2013

Green Book”).

 

Family limited partnerships and LLCs have proliferated over the years, with families using them for multiple

purposes, including centralized asset management, creditor protection, and efficient transfer tax planning. Intrafamily

transfers of interests in these entities often generate valuation discounts for lack of marketability, lack of

control, or other voting or liquidation restrictions, which allow for more efficient tax transfers.

The IRS has consistently scrutinized family limited partnerships and LLCs (collectively, “FLPs”) that are funded

mostly with passive, marketable investments and used primarily as wealth transfer vehicles. Now it appears that the

IRS will issue proposed regulations severely limiting the use of discounts with these FLPs by year-end or sooner,

which could limit many planning techniques that are often used to support the acquisition of life insurance.

 

PRACTIAL BENEFITS OF FLPs

FLPs offer several practical benefits, including centralized family wealth management and succession, the

development of a coherent family investment philosophy, and confidentiality and creditor protection for family

members. The family can use the FLP to teach fiscal responsibility for younger generations by giving them a role in

the FLP’s investment management, with family oversight. FLPs also can facilitate the transfer of diverse

investments among generations by consolidating assets under a single ownership structure. This permits transfers of

FLP interests to family members or trusts for their benefit, rather than a fractional ownership in each underlying

assets that would require re-titling with each transfer. Further, the pooling of assets within the FLP may provide the

family with greater access to certain investment opportunities and the ability to achieve better diversification and

risk allocation for its overall wealth.

 

VALUATION DISCOUNTS & FLPs

Intra-family transfers of the interests, whether through a gift, sale, or bequest, may generate discounts for gift and

estate tax valuation purposes due to their limited marketability and their lack of control over the FLP. The transferor

is not subject to gift or estate tax on the value discounted (or any appreciation thereon). Thus, valuation discounts

can improve the performance of many wealth transfer planning techniques, such as gifts, GRATs, installment sales

to grantor trusts or beneficiary defective inheritance trusts (BDITs), planning with self-canceling installments notes

(SCINs), etc. Many of these techniques are used in tandem with the purchase of life insurance.

Example 1: John owns a FLP funded with marketable investments valued at $10 million. John sells a 20% FLP

interest to an irrevocable, grantor “dynasty” trust in exchange for an interest-only installment note with a 20-year

term, bearing annual interest at 2.3%. The trust anticipates a 5% annual return and may use the annual income

remaining after paying the note interest to acquire life insurance. Compare the benefits if no discount applies to the

FLP interests sold versus a 25% discount.

 

Compare

No Discount

25% Discount

Advantage of Discount

Value of 20% FLP Interest

$2,000,000

$1,500,000

$500,000

“Additional” Value Transferred without Transfer Tax

$0

$500,000

$500,000

Initial Amount Remaining for Premiums after Debt Service

$54,000

$65,500

$11,500

Trust Balance After Note Term

$1,790,000

$2,670,000

$880,000

 

As shown above, valuation discounts can significantly impact the economics of a proposed transaction, and their

availability may determine whether certain clients proceed with planning.

 

PERCEIVED INADEQUACIES OF CURRENT REGULATIONS

For intra-family gifts or bequests of interests in family-controlled entities, Code § 2704(b) generally requires that

certain “applicable restrictions” be ignored when valuing the interests transferred. Current regulations under Code

§2704(b) define an “applicable restriction” as a restriction: (1) on the ability to liquidate a family-controlled entity

that is more restrictive than would apply under state law, and (2) that, by its terms, will either lapse or may be

removed by the transferor or a family member of the transferor immediately after the transfer.

According to the IRS and the Obama Administration, although Code §2704(b) should limit application of valuation

discounts for intra-family transfers of FLP interests due to lack of marketability or control, various judicial decisions

and state statutes interpreting “applicable restrictions” have made this Code section ineffective in many of these

situations.

 

EXPECTATIONS FOR PROPOSED REGULATIONS 

Code § 2704(b) also provides that the IRS may issue additional regulations that provide other restrictions that should

be disregarded in valuing intra-family transfers of family-controlled entities. After appearing on the IRS’s priority

guidance plan for the past 11 years, it seems that the IRS will finally issue such proposed regulations by year-end or

sooner, based on the following proposal set forth in the Obama’s Administration’s FY2013 Green Book:

• Creation of an additional category of “disregarded restrictions” that would be ignored in valuing family entity

interests if, after a transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s

family.

 

• Valuation of the transferred interest by substituting certain assumptions (to be specified) in place of the

disregarded restriction. 

• Classification as disregarded restrictions of any limitation on:

 

            o An owner’s right to liquidate a family entity interest that is more restrictive than a standard to be

            identified in regulations, or

            o A transferee’s ability to be admitted as a full partner or to hold an equity interest.

 

• Attribution of ownership of interests held by certain charities or non-family members (to be identified) when

determining whether the “family” can remove restrictions, post-transfer.

• Grant of authority to the IRS to create safe harbors to avoid application of Code § 2704.

 

Clearly, the FY2013 Green Book only provides a broad outline of the proposed regulations, leaving most specifics

to the IRS’s discretion. Thus, it is difficult to predict with certainty the full scope of the regulations. However,

minimizing or eliminating valuation discounts for FLPs concentrated in marketable securities and

investments appears to be a primary goal, based on the IRS’s continuous challenges to use of these FLPs in

family wealth transfer planning.1

 

POTENTIAL IMPACT 

• Valuation discounts for interests in FLPs, particularly those holding marketable securities, will likely be

severely restricted. This could reduce the use of FLPs in transfer tax planning and/or their ability to support life

insurance acquisitions, to the extent that the projected economics of a proposed technique rely on the discounts.

• The larger value for many of these transactions will be found in the long-term planning benefits of using grantor

trusts. The resulting growth within the trust can often become a more valuable feature than an initial valuation

discount.

• FLPs also will still provide many practical benefits for the long-term management of family wealth, particularly

as family governance, creditor protection, and wealth consolidation mechanisms.

 

TAKE-AWAY

To take advantage of possible “grandfathering” for transactions completed before the effective date of any proposed

regulations, individuals already engaged in transfer planning with FLPs should complete the process in a timely

manner, while those seeking to rely on existing laws should begin planning immediately.

 

NOTES

1 To name just a few of the cases the IRS has litigated in recent years, see Knight v. Commissioner, 115 T.C. 506

(2000), Dailey v. Commissioner, T.C. Memo 2001-263 (2001), Strangi v. Commissioner, T.C. Memo 2003-145

(2003); Holman v. Commissioner, 130 T.C. 170 (2008), affd without discussion of this issue 601 F.3d 763 (8th Cir.

2010); Keller et al v. U.S., 104 AFTR 2d 2009-6015 (DC TX 2009), affd (CA5 2012) 110 AFTR 2d 2012-6061.

 

DISCLAIMER

This information is intended solely for information and education and is not intended for use as legal or tax

advice. Reference herein to any specific tax or other planning strategy, process, product or service does not

constitute promotion, endorsement or recommendation by AALU. Persons should consult with their own

legal or tax advisors for specific legal or tax advice.

 

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