7.5 Special Valuation Rules

• Library: Limited Liability Companies in Virginia (Virginia CLE) (2017 Ed.)

7.5 SPECIAL VALUATION RULES

7.501 Transfers of LLC and Partnership Interests.

A. In General. I.R.C. § 2701 applies special valuation rules to determine the value of a subordinate equity interest in a partnership or corporation that is transferred to a member of the transferor's family (spouse, descendants, and spouses of descendants) if the transferor or an applicable family member (spouse, ancestors, and spouses of ancestors) retains a senior equity interest in the entity that confers on the holder an "applicable retained interest." An "applicable retained interest" is either a put, call, conversion, or liquidation right, or, in a controlled entity, a distribution right other than a qualified payment right. These rights may be valued at zero under the special valuation rules of I.R.C. § 2701. ³⁵

B. Definition of "Control" and "Equity Interests." A controlled entity is a corporation or partnership controlled immediately before the transfer by the transferor, applicable family members, and any lineal descendants of the parents of the transferor or the transferor's spouse. ³⁶ "Control" means the holding of at least 50 percent of either the capital interest or profits interest in a partnership. ³⁷ In the case of a limited partnership, "control" also means the holding of any interest as a general partner. ³⁸ A "subordinate equity interest" is an equity interest in the entity as to which an applicable retained interest is a senior equity interest. ³⁹ A "senior equity interest" is an equity interest in the entity that carries a right to distributions

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of income or capital that is preferred as to the rights of the transferred interest. ⁴⁰

C. Subtraction Method. The value of a transferred interest under I.R.C. § 2701 is determined by the so-called subtraction method, under which the value of the transferred interest is determined by subtracting from the value of the family-held equity interests in the entity the equity interests retained by applicable family members, based on the special valuation rules. ⁴¹ Thus, the gift tax value of the transferred interest will be increased when the value of the applicable retained interest is reduced under the special valuation rules.

D. Exceptions. The special valuation rules do not apply to a "qualified payment right" or a "guaranteed payment right." ⁴² A qualified payment right is the right to receive a fixed amount on a periodic basis. ⁴³ However, if the qualified payment is not actually made in a timely manner, there will be an increase in either the taxable gifts or the federal gross estate of the transferor, depending on whether the transferor transfers the equity interest conferring the qualified payment right during his or her lifetime or holds the interest at death. ⁴⁴ A guaranteed payment right is a right to receive a fixed amount from a partnership or LLC described in I.R.C. § 707(c), which refers to a right to receive a payment without regard to the income of the partnership or LLC. The right to the payment cannot be contingent as to amount or time. ⁴⁵

Special valuation rules also do not apply if there is only one class of equity interest, or the only difference between the equity interests are non-lapsing voting rights, rights to management, or limitations on liability. ⁴⁶ Consequently, a transfer of a limited partnership interest or an interest in an LLC will not be subject to the special valuation rules if the items of income, gain, loss, deduction, and credit are allocated among all the partners, including limited partners, or members, based on their capital accounts. As discussed

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in paragraph 7.504(C) below, a transfer of an interest that causes the transferor to lose the right to cause a liquidation of the entity or to liquidate his or her retained interest will not be treated as a lapse under I.R.C. § 2704(a) if there is only one class of equity interest. In addition, by basing allocations of income, gain, loss, deduction, and credit and distributions of cash and other property on capital account balances (so-called straight-up allocations), the partnership agreement can ignore the complex provisions of I.R.C. § 704(b), dealing with the substantial economic effect test that applies when there are special allocations. Finally, if the allocations are based on capital account balances after allowance for reasonable compensation for the services of the donor partner, they should satisfy the requirements under the family partnership rules that allocations be based on capital.

7.502 Transfers of Interests in Trusts. I.R.C. § 2702 applies to transfers of interests in trusts if the transferor or an applicable family member retains an interest in the trust. I.R.C. § 2702 generally will not be an issue in planning for a family limited partnership or LLC unless the older family members intend to use interests in a family limited partnership or LLC to fund a grantor-retained annuity trust. Using a partnership or LLC interest to fund a grantor-retained annuity trust could result in transfer tax savings if the distributions of income from the entity to the trust and the increase in the value of the interest itself exceed 120 percent of the midterm federal interest rate used in determining the amount of the gift. The value of the gift would be reduced if the interest transferred to the grantor-retained annuity trust is a minority interest, because the value of the retained annuity interest would be subtracted from the discounted value of the interest transferred to the trust in determining the value of the gift.

7.503 Rights or Restrictions, Including Buy-Sell Agreements.

A. In General. For purposes of estate, gift, and generation-skipping transfer taxes, the value of any property is determined under I.R.C. § 2703 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 (determined without regard to the option, agreement, or right), or any restriction on the right to sell or use that property. ⁴⁷ A right or restriction may be contained in a

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partnership or operating agreement or may be implicit in the capital structure of the entity. ⁴⁸

B. Exceptions. There is a statutory exception and a regulatory exception to the general rule. Under the statutory exception, 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; and
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 arm's-length transactions. 49

Meeting the third requirement, that the terms of the right or restriction be comparable to similar arrangements entered into by...