3-Mar-19
Valuation Discounts: A Loss and a ‘Win’ in the Tax Court
Take-Away: While we are far less concerned about the value of transferred assets these days due to the large federal estate and gift tax exemptions, valuation discounts are still relevant when we consider the sunset of those large exemptions beginning in 2026 (or even sooner if there is a ‘blue wave’ in the 2020 election.)
Background: Valuation discounts have always been an important part of estate planning to reduce the exposure to federal estate and gift taxes. Historically those discounts have taken the form of reductions in fair market value of the transferred interest due to its lack of control with regard to an entity like a corporation or partnership, or a lack of marketability associated with a transferred interest in the entity.
Chapter 14: In response to this ‘valuation discount game’ Congress adopted several valuation ‘penalty’ rules in 1991- Chapter 14 of the Tax Code, e.g. IRC 2701 through IRC 2704. Despite Congress’ efforts to curb deliberate ‘valuation discount’ maneuvers with its Chapter 14 rules, the planning with regard to valuation discounts continues, some taxpayers failing miserably in the Tax Court, while others enjoying modest success. Yet others find a mixed bag.
Straightoff Decision: Such was the situation with the recent Tax Court decision Estate of Frank D. Straightoff v. Commissioner, Tax Court Memo, 2018-178.
Facts: Frank’s daughter [when children act on behalf of their parents relying on a durable power of attornrey, a ‘red flag’ always seems to go up with the IRS] created a limited partnership for her father. Marketable securities worth $8.2 million were transferred to the partnership. Frank took a 88.99% limited partnership interest in the entity. Frank’s daughter and her siblings and a former sister-in-law took the balance of the limited partnership interests. A 1% general partnership interest was held by an LLC that the daughter formed with, surprise!, the daughter acting as the manager of the LLC.
Revocable Trust: The important fact was that Frank, actually his daughter doing the heavy lifting, then transferred his 88.99% limited partnership interests to a revocable trust, where those limited partnership interests remained at the time of Frank’s death 3 years later.
Valuation Claims: Frank’s estate claimed that the value of his interest in the limited partnership was worth $4.588 million on his death, claiming a 37.2% valuation discount for his lack of control and marketability over the partnership [13.4% for lack of control and 27.5% for lack of marketability, applied sequentially, for a combined valuation discount of 37.2%.] That’s going from $8.2 million to $4.588 million in three years.
Assignee’s Interest: Of relevance was that Frank’s estate claimed that what should be valued was not a limited partnership interest but an assignee’s interest, since the limited partnership agreement provided that any transfer, in this case from Frank to his revocable trust, resulted in a non-voting assignee’s interest under Texas’s limited partnership statute. The limited partnership agreement also provided that a transferee of a limited partner’s interest in the partner would also be treated as a non-voting assignee only.
Lack of Marketability Discount: Of some interest was that while it was expected that the IRS would challenge the valuation discount claimed on the Form 706 filed by Frank’s estate, the IRS conceded a valuation discount for lack of marketability of 18% for Frank’s interest.
Tax Court: The Tax Court rejected the estate’s “it’s an assignee’s interest, not a limited partnership interest” argument. It used several facts to assert a substance over form conclusion, and it observed that Frank owned, in effect, a limited partnership interest, not a non-voting assignee’s interest, at the time of his death. Some of the facts that the Tax Court noted were: (i)the assignment instrument transferring the limited partnership interest to Frank’s trust said the assignee was entitled ‘to become or to exercise the rights of a partner’ so that the partnership agreement’s rights, not Texas’s limited partnership statute, applied: (ii) since the transferee of the limited partnership units was a revocable trust, Frank could revoke his trust and regain title to the limited partnership interests at any time, thus making the ‘assignee’s interest’ illusory; and (iii) despite the limited partnership having been in existence for three years, there had never been a partnership meeting or a partnership vote [again, taxpayers create legal entities, then go forward ignoring the legal compliance requirements of the entity that they created -if they choose to ignore the formalities, expect the IRS to do the same.]
Lack of Marketability Discount: What was surprising was that the Tax Court accepted the IRS’s appraiser’s lack of marketability valuation discount of 18% applied to Frank’s 88.99% limited partnership interest. This was surprising from the standpoint that the limited partnership agreement provided that limited partners owning at least 75% limited partnership interests could vote to remove the general partner and terminate the limited partnership. Frank owned 88.99% of the limited partnership interests. The partnership held marketable securities. As such, Frank at the time of his death, could have voted to remove the general partner, terminate the limited partnership, liquidate its assets, and walk away with 88.99% of the assets. In short, Frank could have unilaterally terminated the partnership at any time. As such, to apply an 18% valuation discount to Frank’s interest in the limited partnership was, in effect, a big ‘win’ for Frank’s estate.
Substance over Form: Frank’s estate lost on the assignee interest vs limited partner interest on a substance over form analysis used by the Tax Court. In prior court cases this assignee argument has met with limited success by taxpayers [ McLendon v. Commissioner, Tax Court 1995-624 (5th Cir. 1995) and Nowell v. Commissioner, TC Memo, 1999-15] and in other situations the its only an assignee’s interest has been summarily rejected [Kerr v. Commissioner, 113 Tax Court No 30 and Astleford v. Commissioner, Tax Court Memo, 2008-128.]
Conclusion: We are less likely to encounter aggressive valuation discount planning these days due to the focus on obtaining an income tax basis ‘step-up’ on an individual’s death and the availability of large estate and gift tax exemptions (and also portability of a deceased spouse’s unused transfer tax exemption.) But valuation discounts continue to be relevant when we consider the ‘sunset’ of the large transfer tax exemptions in 2026. The claimed valuation discount for the assignee’s interest in Streightoff falls into the ‘nice try’ category. Of more relevance was the success of the 18% lack of marketability valuation discount that the Tax Court accepted when the decedent could, practically speaking, liquidate his interest in the limited partnership without any limitations. Then again, maybe Streightoff is a victory for the IRS, if its focus will now be on arguing for a lower ‘step-up’ in the income tax basis of inherited assets due to the presence of a lack of marketability discount any time a closely held entity is owned by the decedent or donor. Only time will tell.