Chapter 16 - § 16.5 • IRS ATTACKS ON FLPS AND FLLCS

• Jurisdiction: Colorado

§ 16.5 • IRS ATTACKS ON FLPs AND FLLCs

§ 16.5.1—I.R.C. §§ 2703 and 2704

The IRS has mounted several attacks on the use of limited partnerships and LLCs to achieve the valuation discounts discussed above. The IRS issued six Technical Advice Memoranda (TAMs) in 1997 and one in 1998 in which it refused to recognize limited partnerships and, in one case, an LLC, for transfer tax purposes.³² In the alternative, assuming that the entities were recognized for transfer tax purposes, the TAMs held that restrictions on transferability and liquidation would be disregarded for valuation purposes under I.R.C. § 2703 and, in six of the TAMs, I.R.C. § 2704(b).

For federal estate, gift, and generation-skipping tax purposes, I.R.C. § 2703 requires that the value of any property be determined without regard to any restriction on the right to sell or use the property other than a bona fide business arrangement. The arrangement must not be: (1) a device to transfer the property to members of the decedent's family, and (2) must be comparable to similar arrangements entered into in arm's-length transactions.³³

I.R.C. § 2704 provides for the disregard of certain restrictions on the right to liquidate a corporation or partnership.³⁴ However, a limitation on the right of an owner of an interest in an entity to cause the entity to be liquidated or to have the owner's interest liquidated historically has not been an applicable restriction if the limitation is no more restrictive than the state's default rule.³⁵ In other words, the state's default rule was a baseline by which to measure the application of I.R.C. § 2704(b). The LLC Act³⁶ and CULPA³⁷ require unanimity for liquidation in the absence of a contrary agreement by the members or partners. Therefore, any liquidation provision that a client was likely to desire for a Colorado LLC or limited partnership would not have been disregarded under I.R.C. § 2704.³⁸

In any event, where a client's planning includes using an entity to provide valuation discounts for federal estate and gift tax purposes, the taxpayer who is seeking the discounts should not possess the power to liquidate the entity without the consent of at least one other member. If the taxpayer possesses the right unilaterally to liquidate an entity, discounts will not be effective for federal estate and gift tax purposes even where the taxpayer waives the power or it is cancelled at death if the taxpayer and the taxpayer's family control the entity.³⁹

Based on the foregoing, it appears likely that a single-owner LLC will not provide any valuation discount from the value of the assets owned by the entity because the owner could liquidate the entity at any time without the consent of any other person.⁴⁰

However, the same could be said of a wholly owned corporation. The Tax Court has allowed a 35-percent lack of marketability discount for a decedent who owned a 100 percent holding of stock in a corporation holding real estate.⁴¹ The Tax Court stated that the valuation of an investment company would not always be in proportion to the company's net asset value.⁴² In an earlier case, the Tax Court stated that "even controlling shares in a nonpublic corporation suffer from lack of marketability."⁴³

The IRS usually has not succeeded in its attacks based on I.R.C. §§ 2703 and 2704 if the taxpayer has observed the formalities of forming and operating the entity.⁴⁴ However, if the taxpayer does not observe the formalities, the IRS may succeed in arguing that the entity should be disregarded.⁴⁵ Recently, however, as discussed in § 16.5.2, "The Strangi Case," and § 16.6, "Developments Since Strangi," the IRS has achieved some success in its assault on limited partnerships and LLCs using other theories, primarily I.R.C. § 2036(a):

The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end

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