The Valuation Spectrum - a Winning Valuation Discount Strategy

• Jurisdiction: United States,Federal
• Author: by Owen G. Fiore, Esq.
• Publication year: 2001
• Citation: Vol. 7 No. 2

THE VALUATION SPECTRUM - A WINNING VALUATION DISCOUNT STRATEGY

by Owen G. Fiore, Esq.^*

Recent enactment of the 2001 tax bill (H.R. 1836)¹ underscores the importance of a winning transfer tax valuation strategy in which valid state law entities set the stage for entity equity interest valuation adjustments (discounts). The tax act includes no adverse provision on valuation. In fact, the scheduled increases in unified credit exemption equivalents no doubt will result in more, not less, leveraging through entities. So let us review recent developments in valuation in this article.

I. INTRODUCTION AND SCOPE

Tax practitioners and estate planners recognize that entity-based valuation adjustments or "discounts" often are driven to a large extent by the perceived federal transfer tax savings where multi-generational transfers are part of the plan.² Also, popularization of installment sale transactions, including sales to "defective grantor trusts," has underscored the interest of clients in valuation-based wealth preservation. Recent developments in valuation strategic planning point up the mixed factual and legal nature of the world of transfer tax valuation.

By reason of selected developments reviewed in this article, we now can set forth practitioner guidelines for action to provide our clients a planning and educational process that maximizes the reality of the plan and availability of valuation discounts. At the same time, this process minimizes the opportunity for Internal Revenue Service to successfully challenge entity-driven valuation discounts, especially through ill-conceived attacks on the legal and tax viability of entities.

In recent years, the Internal Revenue Service has exhibited its frustration with transfer tax avoidance using valuation discounts. This is especially evident with the family limited partnership ("FLP"), which has been given much publicity in Technical Advice Memoranda and other rulings, as well as in substantial and targeted litigation efforts of the Service to reduce apparent advantages of the FLP (as well as the limited liability company) as a pass-through entity with significant savings in federal transfer tax.³

Fortunately, recent decisions of the U.S. Tax Court within the past year or so have added to the belief of many advisors that IRS attacks on FLP viability will not be successful in carefully documented, implemented and operated plans. The Tax Court, in a number of reviewed and thus precedent-setting decisions, has provided guidance that generally is not favorable to the Service. For example, in the Strangi opinion,⁴ the Tax Court last fall made a strong statement that hopefully will be taken into account by the IRS in its future audit and litigation initiatives:

"Mere suspicion and speculation about a decedent's estate planning and testamentary objectives are not sufficient to disregard an agreement in the absence of persuasive evidence that the agreement is not susceptible of enforcement or would not be enforced by parties to the agreement. Cf. Estate of Hall v. Commissioner, 92 T.C. 312, 325 (1989)".⁵

The Honorable David Laro, Judge of the U.S. Tax Court, recently put the issue this way in considering the fundamentally uncertain area of valuation, especially in reference to valuation methodology, which is considered by the court to be a factual issue:

"Despite the subjectivity surrounding the issue of valuation, we continually strive to measure value precisely and objectively."⁶

As will be obvious from the discussion in this article, transfer tax "fair market value," when applied to non-public equity interests in entities, is a mixed question of fact and law. While the Tax Court has upheld the principle that state law establishes contract and other property rights, the court has not been willing to accept questionable valuation methodologies or unreasonable legal assumptions in determining value. Further, certain legal issues continue to cause problems for taxpayers, as discussed below.

Thus, it appears that practitioners must continue to deal with the legal and tax issues which have been raised as to the viability of entities and techniques for transfer tax purposes, as well as with the evidence necessary to uphold asserted levels of valuation adjustments or discounts. This article reviews selected recent developments and issues relating to IRS challenges in the context of the use of the FLP and the limited liability company ("LLC"). Then guidelines for action are suggested to assist practitioners to respond effectively to our clients' desires for maximum wealth preservation, minimum transfer taxation and maximum retained control.

Even with major (perhaps short-lived) transfer tax reform, our family wealth planning efforts should proceed for non-tax as well as tax reasons. Wealth preservation and management is the key. First, the article reviews briefly the essential transfer tax valuation principles that should be taken into account in planning for a multi-purpose, tax effective entity program. Next, a summary is presented of judicial responses to IRS legal arguments attacking entity viability and transactional reality. Finally, given the generally favorable outlook for FLP/LLC programs following a number of court decisions, we consider the remaining risk factors and how tax practitioners can deal with them through a process requiring full involvement, understanding and cooperation of our clients. The conclusion is obvious, in the author's view: Carefully designed, documented and implemented entity structures not only are viable for transfer tax purposes, but also should be recommended proactively to our clients as part of an integrated family wealth plan.⁷

II. THE MYSTIQUE OF "FAIR MARKET VALUE"

A. Standard Of Value

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Even though many provisions of the Code⁸ refer to or deal with "value" or "fair market value," no one statutory source provides taxpayers with the definition and scope of these terms for federal estate and gift tax purposes.⁹ Our focus here, of course, is on valuation of non-public securities, in particular, FLP and LLC equity interests, where there are no truly comparable, arms-length sales at or near the valuation date.

Therefore, where equity interests in closely held corporations, non-public partnerships or limited liability companies, or even co-tenancy interests in real property, are involved, the primary authority on valuation of such interests are long-standing Treasury Regulations together with a rather antiquated Revenue Ruling.¹⁰ Such IRS authorities seek to set an objective, "hypothetical party" standard of value; however, over the years, in practice this standard has become one of fiction, the "battle of the experts" and clearly a practical reality of uncertainty.¹¹

B. "Transferred Interest" Focus And Evidence Of Value

The nature of the federal transfer tax system (gift, estate and GST taxes) is that, as an excise tax, it is triggered by the transfer of property without adequate consideration.¹² Both "transfer" and "property" are significant terms here, and we can appreciate that readily marketable property (e.g. cash, marketable securities, and fee interests in real estate), contributed on a tax-deferred basis to an entity,¹³ sets the stage for valuation adjustments (or so-called "discounts") where there are gratuitous or testamentary transfers of the fractionalized entity equity or real estate interests.

Key to valuation strategic planning is the absence of "family attribution." Thus, as was finally confirmed by the Internal Revenue Service¹⁴ (after...