Article: "Survivor – The Limited Partnership Challenge "
Cases:
· Jones(116 T.C. No. 11)
· Strangi (115 T.C. No. 35)
· Knight (115 T.C. No. 36)
IRA VALUATIONS: Estate Taxes
Survivor – The Limited Partnership Challenge
The issues in the decisions below remind us of "Survivor," the popular television show. The IRS "tribe" challenges the validity of partnerships, but the partnerships survive. However, the taxpayer valuation experts did not survive unscathed. In fact, the taxpayer valuation expert in Knight was essentially "voted out of the tribe."
Two of the decisions have created a stir because modest valuation discounts (31% in one case and 15% in the other) were allowed in valuing limited partnership interests. The IRS has been pointing to the discount results in these cases when it examines limited partnership valuations.
The three cases discussed here show that limited partnerships remain quite valid for planning purposes. They also show that weak valuations will not survive IRS challenges.
RECENT VALUATION DECISIONS
Estate of W.W. Jones II v. Commissioner, 116 T.C. No. 11. Filed March 6, 2001.
The formation of two family limited partnerships under Texas law and gifts of limited partnership interests occurred on January 1, 1995. The primary asset of both partnerships was arid ranch land in southwest Texas. W.W. Jones gave an 83.08% limited partnership interest in one partnership ("JBLP") to his son. Each of four daughters received a 16.915% interest in the other partnership ("AVLP"). Mr. Jones died in 1998.
Before dealing with valuation discount issues, Judge Cohen rejected IRS "gift on formation" and 2704(b) arguments by relying on decisions in Strangi (following) and Kerr, respectively. She also reviewed the facts and circumstances under which the gifts were made and decided that limited partnership interests, not assignee interests, had been transferred.
JBLP
Mr. Jones’ valuation expert deducted a 66% discount from net asset value in valuing
an 83.08% limited partnership interest. The discount’s sequential components were
"secondary market" (55%), lack of marketability (20%) and tax on built-in gains
(5%). The IRS expert argued that no discounts applied.
The partnership agreement had a provision that allowed a 51% or more partner to remove the general partner and either designate a successor or else allow the partnership to dissolve. Judge Cohen said the provision gave effective control of the partnership to an 83.08% limited partner because he could force liquidation and get a pro rata share of net asset value. As for the tax on built-in gains, the judge decided that the partner would "influence" a general partner to make a 754 election, thereby avoiding the tax. For these reasons the total discount was reduced to 8%.
AVLP
Jones’ expert valued each 16.915% limited partnership interest using a secondary
market discount of 45%, a lack of marketability discount of 20% and a capital gains
discount of 5%. The combined discount was 58%. The IRS countered with 38% (secondary
market) and 7.5% (lack of marketability), for an overall discount of 42.65%.
The secondary market discount is based on a study of transactions in the market where publicly registered real estate limited partnership interests are traded. The study is from The Partnership Spectrum, a bi-monthly publication of Partnership Profiles, Inc. of Dallas, Texas. Business appraisers use it as a source for developing discounts for minority interest considerations due to lack of control. Even though an active secondary trading market exists, Jones’ expert acknowledged "a large discount for lack of marketability is already built into the secondary market discount." In fact, the study says otherwise:
"Although it is not possible to precisely quantify the amount of discount attributable to marketability versus minority interest considerations, it is the opinion of The Partnership Spectrum – as well as many appraisers - that most of this discount is due to minority interest considerations."
Based on the discount evidence presented, Judge Cohen reduced the taxpayer’s marketability discount from 20% to 8%. Her acceptance of a 40% secondary market discount and rejection of the capital gains discount meant an overall discount of 44.8%, slightly more than the 42.65% sought by the IRS but well below Jones’ 58%.
COMMENT: Over many years, real estate investment trusts with active trading on the N.Y.S.E. and A.S.E. have sold at significant minority discounts from net asset value. This evidence buttresses the discounts seen in the secondary markets for real estate limited partnerships.
The judge in Jones certainly supports the notion that both minority interest
and marketability discounts should be deducted in valuing limited partnership interests.
This case, and others, also illustrates the varying abilities of both the taxpayer and IRS
valuation experts to effectively support their conclusions. Attorneys should ask tough
questions of their experts in preparation for trial.
Estate of Albert Strangi v. Commissioner, 115 T.C. No. 35. Filed November 30, 2000.
Mr. Strangi’s interests in various assets, consisting of 75% cash and marketable securities, were transferred to a newly formed Texas family limited partnership (SFLP) by a son-in-law acting under a power of attorney. The total value of the contributed assets was a little under $10 million for which a 99% limited partnership interest and a 47% interest in the 1% corporate general partner (Stranco) were received in exchange. The son-in-law managed Stranco and SFLP for Strangi and his children. Strangi, who was seriously ill at the time, died two months later.
In determining the value of Strangi’s SFLP interest the estate’s valuation expert applied a 25% discount for minority interest and a 25% discount for lack of marketability for a total effective discount of 43.75%.
The IRS said the partnership should be disregarded for tax purposes because it had no business or economic purpose other than tax avoidance. The Service also thought the partnership was "a restriction on the sale or use of property" which must be ignored under Code Section 2703 (a) (2). Another argument was that the difference between the value of the partnership assets and partnership interest should be treated as a taxable gift to Strangi’s children. As for valuation discounts, the IRS expert used a combined 31% discount in valuing the SFLP interest.
Despite a deathbed partnership scenario, the Court rejected IRS arguments and ruled that the partnership was legitimate. It questioned any non-tax motives for forming the partnership but nonetheless said a potential purchaser of Strangi’s assets would surely recognize the existence of a partnership "validly formed under State law."
The Court went along with the IRS and allowed a 31% discount. It felt strongly that Strangi controlled the partnership by virtue of his son-in-law’s power of attorney and management of Stranco. It said SFLP and Stranco were "created as a unit," "operated as a unit," and were "functionally inseparable" and therefore the relationship between the two interests must be considered in valuing the SFLP interest. Given the Court’s clearly expressed view that Strangi never gave up control over his assets and its suggestion that the IRS might have successfully used a Section 2036 argument, the estate was lucky to get 31%:
"We believe that the result of respondent’s expert’s discounts may...be overgenerous to petitioner, but that result is the one that we must reach under the evidence and under the applicable statutes."
COMMENT: According to the judge, the facts show that the decedent controlled the partnership. Under this view, using a minority discount in valuing the limited partnership interest is a risky proposition. Nonetheless, our question is: would the willing buyer of a 47% general partnership interest and a 99% limited partnership interest have control? Strangi is a "bad facts" case, where the estate fared much better than it deserved.
Ina F. Knight v. Commissioner, 115 T.C. No. 36. Filed November 30, 2000.
In December 1994 Herbert and Ina Knight funded a family limited partnership with real estate (24%) and "financial assets" consisting of cash, insurance and marketable securities (76%). The total value of contributed assets was about $2.1 million. A management trust of which Ina was trustee became the 1% general partner and Ina and Herbert each received 49.5% limited partnership interests. Gifts of most of the limited partnership interests were then made to trusts for two daughters.
A total discount of 44% was used in valuing the limited partnership interests on 1994 gift tax returns.
As it did in Strangi, the Court rejected an IRS argument that the partnership should be disregarded for tax purposes because it lacked economic substance. It also held that certain "lock-in" provisions in the partnership agreement were not "applicable restrictions" under Code Section 2704(b). However the Knights’ 44% discount was reduced to 15% due to a weak appraisal. The Knights’ valuation expert "gave no convincing reason" why there should be a 10% portfolio discount, "unconvincingly" used "data from noncomparable entities" in support of a 10% discount for minority interest and "did not show" the connection between cited restricted stock and IPO studies and an estimated 30% discount for lack of marketability.
COMMENT: The IRS rarely takes a case all the way through Tax Court to a decision. It has to believe it will win in order to do so. A deathbed partnership formed solely for tax reasons by someone who remained in control (Strangi) must have looked promising. Similarly, an unknowing taxpayer with a weak appraisal (Knight) was fair game. Strangi and Knight are special situation cases with bad facts and weak appraisals, which should not discourage the proper use of limited partnerships in personal planning.
IRA VALUATIONS – ESTATE TAXES
We were recently asked to determine the estate tax values of three decedents’ IRA accounts. The valuation process mainly reflects the income tax bite to be absorbed by a recipient of IRA distributions. Even though income taxes are calculated after a Section 691(c) deduction for estate tax attributable to the IRA, the IRA’s estate tax value is still reduced significantly. Lawyers for each estate were motivated by the impact of income taxes on valuation in the recent Davis and Eisenberg cases and by the following language in a recent Fifth Circuit case [Estate of Algerine Allen Smith v. Commissioner of Internal Revenue (Nos. 98-60241, 98-60313)]:
We perceive no reason to believe that a seller seeking to make the best possible trade would ignore the income tax benefit associated with a set of transactions; to the contrary, we agree with the Second Circuit that ‘a hypothetical willing [seller], having reasonable knowledge of the relevant facts, would take some account of the tax consequences … in making a sound valuation of the property’ [FN60]—here, the income tax benefit afforded to the Estate by § 1341. [FN61].
FN61. Obviously, the position of a defendant in a pending lawsuit is not a thing commonly bought and sold. There is certainly no ready market in which the Estate could pay another to assume its place as the subject of Exxon’s claim. We have held, however, that the willing buyer-willing seller method applies to all questions of valuation, even when, as a realistic matter, the subject property might not be sold or assigned at all. See United States v. Simmons, 346 F.2d 213, 216 (5th Cir.1965); cf. United States v. Cartwright, 411 U.S. 546, 549, 93 S.Ct. 1713, 36 L.Ed.2d 528 (1973) (applying the willing buyer-willing seller valuation role although ‘private trading in mutual fund shares is virtually nonexistent.’)
This language was interpreted to suggest that the inability to buy and sell an IRA should not preclude the discounting of its net asset value for estate tax purposes.
Among other things, the Smith case involved the valuation of a contingent award arising from litigation with Exxon over oil and gas royalties. To discuss your specific valuation needs, please contact your Regional MPI Representative.
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