The valuation of FLPs: what does the tax practitioner need to know?

• Author: Trugman, Linda B.
• Position: Family limited partnerships

Family limited partnerships (FLPs) have grown in popularity as an estate planning tool and a way to depress transfer tax values. Typically, a tax practitioner will ask a valuation expert to perform an analysis to determine the value of FLP interests for tax purposes. The valuation expert also prepares a report that explains the valuation method used in the analysis and why that choice of method is appropriate, as well as showing the actual calculation of the valuation amount.

Tax practitioners should be aware of the issues involved in valuing FLP interests and of how a report should be prepared because they will be relying on these valuations in the preparation of Forms 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The better prepared the analysis and the report, the less likely the IRS is to challenge the valuation; if the IRS does challenge it, it is more likely that the dispute will be resolved in favor of the taxpayer. This article is an overview of the FLP valuation process and the things that practitioners should consider. (1)

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What Is an FLP?

An FLP is a nontaxable entity that is created and governed by statute and whose partners (both general and limited) and assignees consist mainly of family members. A limited partnership is created under and governed by the Revised Uniform Limited Partnership Act (RULPA) of the state in which it is formed. Though the acts are similar in many respects across states, some features differ according to state. The FLP is also affected by various sections of the Internal Revenue Code, as is the valuation of interests in an FLP.

Many of the issues that arise in appraising FLPs become legal interpretations of the partnership agreement rather than "pure" valuation issues. Although it is important that valuation analysts know and understand the issues, it is imperative that they leave the "lawyering" to the lawyers. If there is any doubt in the valuation analyst's mind about the nature of the assignment or the terms of the partnership agreement, the client's attorney should be the one to explain it to the valuation analyst, not the other way around.

Why Are FLPs Attractive?

FLPs are particularly attractive as estate planning tools for several reasons. Through the creation of an FLP:

* Parents or grandparents can indirectly transfer interests in family-owned assets without losing control of them.

* A high degree of protection against creditors can be achieved because a partner's creditor is legally unable to gain access to the assets in the partnership.

* The assets can be kept in the family, which is an objective of many families. This can be achieved by placing restrictions on the transfer of partnership interests, especially in the event of divorce, bankruptcy, or death of a partner.

* Problems pertaining to undivided or fractionalized interests when a property is gifted to several individuals can be avoided. This can be especially important in the case of real estate properties.

* When family-owned assets are placed in a partnership, advantages can arise through economies of scale and diversification.

* A great deal of flexibility can be achieved through the partnership agreement, which can provide broad investment and business powers. These can be amended as the family's needs change, as long as all partners are in agreement.

* The partnership is a pass through entity and does not pay income taxes.

* The gifting or transfer of an ownership interest in a limited partnership may be made at a lower value than that interest's pro-rata share of net asset value because a limited partnership interest is likely to be both noncontrolling and nonmarketable.

Documents Needed to Prepare the Appraisal Report

The practitioner should obtain the following documents in order to perform the valuation and should refer to them in the appraisal report:

* The Agreement of Partnership (or other type of business agreement, depending upon the form of the entity) and a copy of the Certificate of Limited Partnership that has been filed with the state in which the partnership was created. The certificate is an important document because it gives notice of the limited partnership's formation and the limited liability of the limited partners, and it discloses some of the partnership agreement's terms. Without this document, the IRS might not recognize the FLP.

* A list of the assets that were initially contributed to the partnership, as well as documentation about any assets that were contributed after the FLP's formation.

* Valuations of real estate and other assets held by the partnership as of the valuation date (for example, market values of marketable securities). If the partnership owns interests in other closely held businesses or partnerships, these interests must be separately appraised before the value of the LP interest can be determined.

* Financial statements and/or tax returns for the partnership for a reasonable number of years, or since inception. (If it is a new partnership, these will not exist.)

* The general partner's anticipated policies regarding distributions or a Sec. 754 election.

* If the FLP is ongoing, a history of distributions, if any, made to partners.

* Information such as minutes of meetings of partners or other documents, if they exist, may give the analyst some insight into the donor's intent at the time of the partnership's formation.

Rev. Rul. 59-60 Factors

Rev. Rul. 59-60 (2) provides basic guidelines for appraising shares of closely held corporations (the IRS has extended it to apply to interests in other types of entities). Every valuation report of an FLP interest should closely follow Section 4 of Rev. Rul. 59-60, which enumerates the factors the valuation analyst should consider in his or her valuation. The eight factors of Rev. Rul. 59-60 are:

1. The nature of the business and the history of the enterprise from its inception.

2. The economic outlook in general and the condition and outlook of the specific industry in particular.

3. The stock's book value and the financial condition of the business.

4. The earning capacity of the company.

5. The dividend-paying capacity of the company.

6. Whether the enterprise has goodwill or other intangible value.

7. Sales of the stock and the size of the block of stock to be valued.

8. The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market either on an exchange or over the counter.

If the analyst has not enumerated and discussed these factors in the report, he or she may not have done a thorough analysis.

In addition to these eight factors, Section 4 of Rev. Rul. 59-60 states:

(a) ... in general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public; conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued. (b) The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type the appraiser should determine the fair market values of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets. The market values of the underlying assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capitalized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity. The importance of this section is the guidance it provides in the selection of the methodology to use when these types of valuations are performed.

Things to Consider in the Appraisal Process

The basic characteristics of the transferred interest in the FLP, combined with specific provisions in the FLP agreement and state law, form the foundation for the valuation adjustments used in arriving at the fair...