Business valuation is an increasingly important element in family succession and estate planning. Family Limited Partnerships have become a widely used planning tool in recent years. This confluence raises a host of valuation issues.

FLPs appeal to clients because they can transfer limited partnership interests to children and grandchildren while retaining a degree of control over partnership assets by retaining general partnership interests. Gifts can be made without creating fractional interests in property. The partnership structure may protect assets from creditors. FLPs have many other advantages and much has been written and said about them. Supportable valuations of gifted limited partnership interests are viewed as indispensable by most attorneys. What follows are some frequently asked questions.

• What kinds of assets do clients use to fund FLPs? Real estate and/or marketable securities are used most often, although clients have used mortgages, private business interests, partnership interests, race horses and carried interests in money management partnerships, among other things. Real estate ranges from raw land to retail and commercial space. Securities include traded common stocks, Rule 144 stock, bonds (including tax-free) and interests in privately managed portfolios. Generally, vacation homes, collectibles, jewelry or antiques are not used to fund FLPs.

• Which is used more frequently, real estate or securities? Between these two, usually about 70% of the FLPs involve real estate and about 30% are securities partnerships.

Some attorneys shy away from securities partnerships based on concerns about business purpose and a belief that the ready liquidity of the underlying assets may undermine valuation discounts. Other attorneys are not so concerned about these things.

• What kinds of clients are doing FLPs? The typical valuation services client is a family business owner who wants to value the business for estate planning or other purposes. As people of wealth, however, their assets may also include real estate or securities and an FLP is a good vehicle for facilitating transfers of such assets. Many FLP clients, though, are professionals or executives with accumulations of real estate or securities and who have estate planning needs. Holders of unregistered or Rule 144 stock, often members of founding families of companies now publicly traded, are also using FLPs.

• In what state is the partnership formed? Most of the FLPs are formed in the state where the client resides. But Delaware's revised partnership statute will be available for use later this year, so it may get a lot of attention.

• What partnership provisions are important from a valuation perspective? Contrary to expectations, there are no magic valuation bullets. The normal limitations on the rights of a limited partner (no say in management, no control over cash contributions, transferability restrictions, the fact that a donee may be an assignee) are sufficient to permit the deduction of normal minority interest and lack of marketability valuation discounts.

• Do people use a corporate general partner? This scheme is an interesting and academic exercise, but talking a client into forming an FLP can be difficult enough. The prospect of also forming a corporation and then filing its tax returns every year looks too expensive and cumbersome to most people.

• What about the relatively new Limited Liability Companies? Few LLCs have been formed but there is great interest in them because no one is stuck with the unlimited liability of a general partner. As a practical matter, though, clients and attorneys are more familiar with partnership law and LLCs are fairly new and untested. Partnership and LLC statutes should be compared on a state-by-state basis. Tennessee, for example, has an LLC statute which is particularly suitable for planning purposes. Under New Jersey law, according to experts, a client's planning goals can be achieved with either a partnership or an LLC.

• As an appraiser, what concerns do you have about the valuation significance of the "applicable restrictions" provisions of IRC Section 2704(b)? Appraisers are not qualified to interpret 2704(b). Basically, though, an applicable restriction is a provision in a partnership agreement which is more restrictive than state law. If, for example, a family-controlled partnership has a restriction on liquidation which is more restrictive than state law, that provision is to be disregarded for valuation purposes. On the other hand, a provision in a partnership agreement that is required or permitted by state law is not an applicable restriction and can be considered for valuation purposes.

The most common issue regarding applicable restrictions involves the selection of a term of years option in a state which does not mandate a term of years. New Jersey is an example of such a state and the concern is that, by selecting a term of years, a provision more restrictive than state law has been selected and the long-term nature of the partnership might then have to be disregarded for valuation purposes. In a term of years partnership a limited partner has no right of withdrawal. Absent a term of years, a limited partner can withdraw by giving six months notice and may then receive the fair value of his interest in the limited partnership.

It is advisable to give weight to the partnership's term for valuation purposes, which implies that it is not an applicable restriction.

• How often are charitable organizations included as partners? It has been suggested that having a non-family member or a charity as a partner, along with a provision calling for unanimous consent to a partner's withdrawal, may be a way to circumnavigate the potential of an applicable restrictions problem.

This suggestion sounds plausible, but experience suggests that no one has actually done it.

Assignee Interests

• How are assignee interests valued? As seen above, the limited rights of limited partners suggest that such interests are subject to valuation discounts. An assignee does not have even the limited rights of a limited partner, except for the right to receive any distributions that may be made.

Assignee limited partnership interests are worth somewhat less than limited partnership interests. Assignee general partnership interests are worth much less than general partnership interests

• How much lower are the values of assignee interests? In Estate of Gordon B. McLendon v. Commissioner, T.C. Memo 1993-459, the taxpayer and the IRS stipulated values for general partnership interests under the various withdrawal and liquidation options in a partnership agreement. In one fact set, a 30 percent general partnership interest had a liquidation value of $37.8 million and a fair market value of $13.4 million. As an assignee interest, it had a value of $3.6 million. One can readily calculate that the fair market value of $13.4 million is at a 65 percent discount from the liquidation value and that the assignee value is at a 90 percent discount from liquidation value. Remember that the IRS agreed to these values.

This case, and the subsequent appeal of it (U.S. Court of Appeals, Fifth U.S. Court of Appeals, No. 94-40584 (96-1 USTC Par 60 Dec. 28, 1995), are required reading for those interested in FLPs.

• What new techniques are employed in valuing limited partnership interests? None, really. The techniques used are time-honored and well accepted in the appraisal profession and by the IRS. They can, however, be applied incorrectly, carelessly or without sufficient due diligence.

FLPs are, essentially, investment companies. Net asset value is given important weight in the valuation of minority interests in investment companies. Minority interest and marketability discounts must be determined and deducted from net asset value in arriving at the fair market value of limited partnership interests.

• What is a minority discount? How is it quantified? As defined by the American Society of Appraisers in its Business Valuation Standards, a minority discount is the "reduction from the pro rata share of the value of the entire business, to reflect the absence of the power of control." In an investment company or FLP context, the value of the entire business is usually net asset value (the value of all securities or real estate, less any liabilities).

In quantifying minority discounts, as in all aspects of our valuation work, an appraiser looks to public securities markets for independent and objective evidence. Minority interests in publicly traded, closed-end funds, which hold marketable securities such as common stocks and/or bonds, generally sell at a discount from net asset value. Analyses of certain publicly traded real estate investment trusts and of the auction market for interests in publicly registered limited partnerships demonstrate that minority interests in real estate companies sell at significant discounts from net asset value.

In its own Valuation Training Manual for Appeals Officers, the IRS endorses the use of closed-end funds to develop minority discounts. Several court decisions, among them the Estate of Berg v. Commissioner, T.C. Memo 1991-279, and Estate of McCormick v. Commissioner, T.C. Memo 1995-371, have accepted the real estate investment trust approach to developing minority discounts in real estate companies.

Marketability Discounts

• What is a marketability discount? How is it quantified? As also defined by the American Society of Appraisers, a marketability discount is "an amount or percentage deducted from an equity interest to reflect lack of liquidity." Marketability discounts are generally deducted when the values of closely held assets are determined by reference to publicly traded securities (which have ready liquidity).

The best and most widely accepted methodology used to quantify marketability discounts is the analysis of private placements of unregistered or Rule 144 restricted stock. These unregistered or restricted shares generally sell at a discount from their freely traded counterparts because they do not have ready liquidity. While there are a number of published restricted stock studies, they are considered to be unreliable by many experts. We have done our own proprietary study of restricted stock private placement transactions for almost twenty years and we update it annually.

The recent decision in Bernard Mandelbaum v. Commissioner, TC Memo 1995-255, implicitly accepted the reliability of the restricted stock discount approach to the determination of marketability discounts for closely held securities. The decision made it clear, though, that specific factors affecting the marketability of the closely held security in question must be considered and particularly with reference to the companies and transactions in the restricted stock data base. The Mandelbaum allowed a 30 percent marketability discount on the common stock of a large retail chain, when the shares were valued for gift tax purposes.

Limited partnership interests are closely held by nature and lack liquidity. Their transferability is typically restricted in a number of ways by the partnership agreement. Partnership interests are prime candidates for marketability discounts.

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