Rethinking the valuation of family limited partnerships holding passive assets.

• Author: Del Duca, George F.

Appraisers often ask the question, "What is the appropriate amount of the valuation discount for an interest in a family limited partnership (FLP)?" To this writer, the question is thought-provoking because it is raised only in the context of FLPs, and not in the case of business entities where appraisers routinely and without extreme difficulty are able to independently determine what the size of the discounts should be.

The difficulty with FLPs may be that appraisers recognize that FLPs are more in the nature of estate planning arrangements, such as family trusts, as opposed to business entities such as publicly traded partnership interests. Being experienced only with business valuation, many appraisers have difficulty in arriving at the appropriate amount of valuation discounts for FLPs because of their inherent non-business nature.

As a practical matter, appraisers know that a nonfamily member would never want to buy an interest in an FLP any more than an interest in a family trust and, therefore, that it would not be inconceivable that such a purchaser would demand a discount of as much as 80 percent to buy into the arrangement. At the same time, appraisers know that an owner of an FLP interest would never sell his or her interest at an 80 percent discount, and that an 80 percent discount in valuing a business interest is normally excessive and would not be accepted by the IRS. This resulting quandary on the part of appraisers leads to the search for some "standard discount" for FLPs.(1)

The courts have also appeared to impose somewhat of a double standard with respect to valuation discounts for FLPs. Although declining to disregard the partnership form to deny the discounts under the various legal theories advanced by the IRS, the courts have nonetheless been rather consistent in reducing the discounts for FLPs claimed by taxpayers to amounts that are substantially below the discounts the courts have allowed in the past for even general partnership interests.(2) Judge Laro of the Tax Court has advised appraisers to use valuation discounts in moderation in the case of FLPs.(3) Discounts are what they are, and Judge Laro's advice to use them in moderation in the case of FLPs may be interpreted as being some recognition, on his part at least, that discounts for FLPs should be smaller than discounts for interests in real business entities.

Resolution of the Issue

The issue of valuation discounts for FLPs holding passive assets was actually resolved almost 60 years ago in Richardson v. Commissioner, 2 T.C.M. 1039 (1943). Richardson involved gifts of minority interests in a family corporation holding marketable securities, but the rationale is equally applicable today to the valuation of interests in FLPs holding passive assets. The Tax Court denied the 50 percent discount claimed by the taxpayer on apparent public policy grounds:

If the arguments of petitioner were to prevail, any cohesive family owning securities having a market value readily ascertainable from trading on the open public market could organize a family holding corporation, transfer to such corporation the securities which it owns, and then deal with the stock of the family corporation on the basis that it has by reason of petitioner's arguments a market value of only approximately half of the market value of the securities owned by such a corporation, thus cutting in two gift taxes and estate taxes which would otherwise be payable on the transfer of the securities themselves.

We cannot agree. Closely held stock of a family holding company which was never sold on the open market and was never intended by the organizers of the corporation to be sold, but was intended to be held by members of the family to evidence their respective beneficial rights in securities which were bought and sold by the corporation and which were dealt in on the open market, can only be valued in any real or practical way by primarily considering the value of the securities owned by the corporation. Any other approach would, in our opinion, be futile.(4)

At present, the entity of choice is the FLP rather than the family holding company that was popular at the time of Richardson. However, nothing else of substance has changed in the past 60 years that would inform valuation discounts today for FLPs that the Tax Court was prone to reject in Richardson because of the clear abuse they would present.(5)

Subsequent Confusion of the Issue

The taxpayer in Richardson appealed the decision. Although the decision was affirmed on appeal,(6) the judge writing the appeals court opinion indicated that the Tax Court may have erroneously used some notion of "intrinsic value" rather than "fair market value" required under the regulations. However, the opinion states that the other two judges hearing the appeal felt that the Tax Court used the proper valuation standard. A second appeal was filed, but the Supreme Court declined to review the matter.(7)

The statutory provisions of the Internal Revenue Code provide that the amount subject to estate and gift tax is the "value" of property owned at death or transferred by gift.(8) The regulations explain that the "value" of property for these purposes is its "fair market value." The regulations define "fair market value" as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."(9) "Intrinsic value" (also called "actual value," "investment value," or "value in use") is the value of the property to the actual transferor or transferee, and equals the proportionate interest of the transferor (in the case of the estate tax) or transferee (in the case of the gift tax) in the value of the underlying assets owned by the entity without any entity-level discounts.(10)

Although the courts have interpreted the regulations as requiring a hypothetical sale between hypothetical parties in the case of business interests, the courts have also held that intrinsic value may be used as a substitute for, or an equivalent to, a hypothetical fair market value in valuing nonbusiness interests when appropriate, such as in valuing interests in trusts,(11) and in valuing successive interests in trusts or other property like life estates, terms of years, reversions, and remainders:

[T]he record before us fails to show the existence of any market in which remainder or reversionary interests such as the one here to be valued are regularly bought and sold and fails to show any actual sales of such interests which may be properly used as comparisons. Therefore not only is the "market" a hypothetical market, but the willing seller with full knowledge of the pertinent facts under no compulsion to sell and the willing buyer with like knowledge of the facts and similarly under no compulsion to buy are also hypothetical .... Accordingly, the fair market value to be determined in this case is a hypothetical fair market value which is equivalent to "intrinsic or actual value."(12)

Further, even in the case of business interests, although black-letter law may hold that the willing buyer and willing seller...