2. (§10.4) Issues With Valuation Discounts
The IRS generally objects to any estate planning technique that, in its opinion, subverts the transfer tax system. The problem with FLPs and FLLCs, from the IRS’s viewpoint, is that substantial transfer tax value is simply lost or “disappears” when family wealth is transferred through the use of an FLP or FLLC. To counter this problem, the IRS may challenge an FLP or FLLC—or the discounts claimed in valuing an interest in them—under several theories.
Generally, the IRS has challenged FLP and FLLC valuation discounts under either (1) Chapter 14 of the Internal Revenue Code (the Code) or (2) I.R.C. § 2036(a).
Chapter 14 of the Code was enacted as part of the Revenue Reconciliation Act of 1990, Pub. L. No. 101–508, 104 Stat. 1388–400. Chapter 14 replaced § 2036(c), which was designed to prevent abusive estate-freezing techniques.
Under I.R.C. § 2703(a), for purposes of all transfer taxes, the value of any property is determined without regard to any right or restriction relating to the property. A right or restriction means any option, agreement, or other “right” to acquire or use the property at a price less than the fair market value of the property (determined without regard to the option, agreement, or right) or any “restriction” on the right to sell or use the property.
For the estate planner, the primary focus of § 2703 is § 2703(b), which provides that a “right, or restriction” will not be disregarded if it satisfies the following three requirements:
1. The right or restriction is a bona fide business arrangement.
2. The right or restriction is not a device to transfer the property to the natural objects of the transferor’s bounty for less than full and adequate consideration in money or money’s worth.
3. At the time the right or restriction is created, the terms of the right or restriction “are comparable to similar arrangements entered into by persons in an arms’ length transaction.”
At first glance, § 2703 would appear to be focused primarily on buy-sell agreements among owners of closely held entities that value the interests of the owners at less than fair market value. But the IRS has indicated that, if § 2703(a) is applicable to an FLP or FLLC, the existence of the FLP or FLLC may be completely disregarded on the ground that any agreement that effectively limits the ability of the entity to liquidate is ignored in valuing a transfer among family members. This has the effect of applying the transfer tax to the value of the assets held by the FLP or FLLC without consideration of the characteristics of the FLP or FLLC.
To avoid this result, the FLP or FLLC should be structured to fit within the § 2703(b) exception. A bona fide business purpose for the FLP or FLLC should be established. Any restrictions on an owner’s ability to sell, pledge, or liquidate the owner’s interest in the entity should be commercially reasonable. But even with these provisions, it is possible that the IRS may argue that no FLP or FLLC, by its very nature, could ever fit within the § 2703(b) exception.
Under I.R.C. § 2704(a), a lapse of a voting or liquidation right is treated as a transfer for gift or estate tax purposes if the individual holding the right and members of the individual’s family control the entity both before and after the lapse. A voting right is a right to vote with respect to any matter of the entity and the right of a general partner to participate in partnership management. A “liquidation right” is the right or ability to compel the entity to acquire the holder’s equity interest in the entity, regardless of whether its exercise would result in the complete liquidation of the entity. A “lapse” of a voting or liquidation right occurs at the time a presently exercisable voting or liquidation right is restricted or eliminated. The amount of the transfer is the value of all interests in the entity held by the individual immediately before the lapse—determined as if the voting and liquidation rights were not lapsing—over the value of these interests immediately after the lapse.
Section 2704(a) can arise with respect to FLPs and FLLCs in several ways. In an FLP, the parents may hold general as well as limited partnership interests. Of course, the general partnership interest should be minimal. In an FLLC, the parents may act as the managers as well as hold membership interests. Under the RULPA, when a general partner dies (an “event of withdrawal”), the general partner ceases to be a general partner of the partnership. Section 359.241, RSMo 2000. In a typical FLP, the general partnership interest at that time will be converted into a limited partnership interest. This conversion may constitute a lapse of voting rights under § 2704(a). Often, to maximize discounts that may be available for estate tax purposes upon the death of a parent holding a limited partnership interest, the parent may transfer the general partnership interest the parent holds to a child before the parent’s death. The transfer of the general partnership interest may constitute a lapse of voting rights under § 2704(a). The transfer tax impact of this conversion or transfer may be negligible, however, if the general partnership interest is relatively small in relation to all outstanding partnership interests.
Under § 2704(b), an “applicable restriction” on the right of an individual to liquidate the individual’s interest in a partnership may be disregarded for transfer tax purposes. In other words, if an interest in an FLP or FLLC is transferred, the interest in the entity transferred will be valued without considering the restriction. An “applicable restriction” is a limitation on the ability to liquidate the entity—in whole or in part—that is more restrictive than the limitations that would apply under the state law generally applicable to the entity in the absence of the restriction. A restriction is an applicable restriction only to the extent that either the restriction by its terms will lapse at any time after the transfer, or the transferor—or the transferor’s estate—and any members of the transferor’s family can remove the restriction immediately after the transfer. Section 2704(b)(2)(B).
Section 2704(b) generally arises in connection with a gift of a limited partnership or membership interest in an FLP or FLLC by a parent to a child. In valuing these gifts, the parent wants to maximize the available discounts, including a discount based on illiquidity of the interest transferred. To determine whether § 2704(b) is applicable with respect to a particular FLP or FLLC arrangement, the estate planner must be familiar with applicable state law.
With respect to transfers of partnership or membership interests, and the rights of partners or members to liquidate their interests in the entity or the entity itself, for purposes of § 2704(b), the estate planner must review the “default” provisions of the RULPA and the LLCA, which are generally applicable if the partnership or operating agreement does not deal with the issue. Generally, restrictions on transfer and withdrawal contained in the partnership or operating agreement will be disregarded under § 2704(b), and the...
