Planning for an Optimum Estate Tax Discount
| Publication year | 1998 |
| Pages | 10 |
L.S. McCullough, Jr. and Lee S. McCullough III
SECTION I. INTRODUCTION
For years, estate planners have been creating limited partnerships or limited liability companies to provide for the management of assets and for the purpose of obtaining a discount on estate taxes. The source of the discount is often taken for granted and misunderstood. In recent years, the IRS has begun to scrutinize and challenge some discounts.[1] The tax court also seems willing to challenge some discounts.[2]In response to this challenge, estate planners need to understand and apply valuation principles so as to appropriately justify optimum estate tax discounts for their clients. The purpose of this paper is to explain the legal justification for an estate tax discount when a partnership interest is transferred by reason of the owner's death. The principles explained in this paper should assist planners in creating entities that optimize estate tax discounts. The words "partnership" or "partnership interest" will be used to apply to limited liability companies as well as limited partnerships, except as stated otherwise.
Section II of this paper describes the valuation methods and the factors that should be used in calculating the value of an interest. Section III analyzes the tools that are currently being used by the IRS to reduce or eliminate discounts on partnership interests. Section W discusses the effect of state law on the valuation of a partnership interest and suggests that it is an assignee interest, not a partnership interest, that must be evaluated for purposes of applying the estate tax because, under state law, the only interest that a partner can transfer unilaterally and without the consent of the other partners is an assignee interest, not a partnership interest. This argument is based on the fact that the federal estate tax is a tax on the "transfer" of property from the person who dies to his or her living heirs; it is not a tax on the property the decedent owned at death or on the partnership interest which ceased by reason of a partner's death. The federal estate tax is a transfer tax and taxes the value of what is being transferred. Section V concludes by summarizing the steps that should be taken in creating an entity that will yield an optimal discount that will hold up when evaluated by the Internal Revenue Service.
SECTION II. CALCULATING THE VALUE OF AN INTEREST
A. Valuation Methods
The method used to value closely held corporations for estate tax purposes is also used to value partnership interests and "assignee interests."[3] The value of an assignee interest in a partnership, for estate tax purposes, is the price that a willing purchaser would pay to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.[4] An arms-length transaction between unrelated parties is generally the surest way to satisfy this test. In the absence of an arm's length transaction, the regulations provide that:
The net value is determined on the basis of all relevant factors including -
(1) a fair appraisal as of the applicable valuation date of all assets of the business, tangible and intangible, including good will:
(2) the demonstrated earning capacity of the business; and
(3) The other factors set forth in paragraph (f) of § 25.2512-2 relating to the valuation of corporate stock, to the extent applicable.[5]
The IRS valuation manual lists six commonly accepted methods for valuing an interest: adjusted book value, comparable price, excess earnings, capitalization of earnings, discounted future earnings, and discounted cash flow.[6] Adjusted book value is computed by taking the book value of the business and making adjustments for the fair market value of the assets, excess depreciation, and other items which affect the fair market value of a business, such as LIFO reserves.[7] The comparable price method multiplies the net income of the company against the price earnings ratio of the industry.[8] The excess earnings method begins with the value of the net tangible assets, subtracts any earnings not based on operations, and adds the value of goodwill.[9] The capitalization of earnings method capitalizes the five year weighted average of adjusted earnings.[10]
The discounted future earnings method and the discounted cash flow method attempt to forecast earnings for five years into the future based on the average growth of the prior five years. The discounted future earnings method uses accounting profits and the discounted cash flow method converts profits into estimated cash flows.[11]
Often, many or all of the approaches described above are used simultaneously, taking the average of them as the reported value of the company in question. Once the entity has been valued, an interest in the entity must be evaluated to see whether it is worth more or less than its proportionate share of the entire entity.
B. DISCOUNTS
Factors that reduce the value of an interest below its proportionate share of the entity are commonly referred to as "discounts." Commonly accepted discounts include a minority interest discount, a lack of marketability discount, a fractional interest discount, and a lock-in discount.
(1) The lack of control feature of a minority interest makes it less attractive to investors than a majority interest. The reduction in price from what a willing buyer would pay for an interest with control to what the same buyer would pay for an interest with no control, is called a minority discount. Under the limited partnership statutes, limited partners generally do not have control over the management or distribution of partnership assets; this control is reserved to the general partners.[12] A minority member of a limited liability company may have a similar lack of control. A person who receives an interest in a limited partnership or limited liability company is merely an assignee and has no rights of control, even if the transferor was a general partner or a majority owner of the entity. This is a very important point to remember. The only thing that a deceased partner can transfer to his or her heirs is an assignee interest, the heirs cannot become partners without consent from the other partners.
Prior to 1993, the IRS attempted to attack minority discounts on inter-family transfers if members of the family held a majority interest.[13] In Rev. Rul. 93-12, the IRS reversed this position, stating that it will apply the same asset value discounting rules to family transfers as it does to unrelated parties.
(2) A lack of marketability discount reflects the fact that there is no market in which the interest could easily be sold. The asset is worth less because its value cannot easily be obtained. For example, an investor would pay more for publicly traded stock t hat is trading for $100 than for an assignee interest in a partnership that represents $100 in underlying assets because the cost and time involved in selling the assignee interest reduces its value.
A right of first refusal seemingly limits the marketability of an interest. However, rights of first refusal that do not include a fixed price have generally been found not to affect the lack of marketability discount because they do not limit the buyers to whom the partner could sell, or the price the buyers would pay for the interest. The right of first refusal merely governs the order in which prospective buyers can purchase the interest.[14]
(3) A fractional interest discount reflects the costs and hassles of dividing up the assets if the partnership is liquidated. If a partnership owns nothing but marketable securities, very little fractional interest discount would be available, because they can easily be distributed to the various partners without any effect on the value of the individual securities. If the partnership owns nothing but equipment used in a trade or business, the cost and time involved in selling the equipment will reduce its value.
(4) A lock-in discount reflects the fact that the holder of the interest may be prohibited from selling, transferring, or liquidating the interest due to restrictions found in the partnership agreement or in state law. This is often considered as part of the lack of marketability discount. In a limited partnership, a general partner normally can withdraw at any time and receive that value of his interest less any damages if the withdrawal was in breach of the partnership agreement.[15] A limited partner can generally only withdraw and receive the value of Ills interest if permitted by the partnership agreement.[16] If the partnership agreement is silent about the rights of limited partners to withdraw and does not designate a time for dissolving the partnership, a limited partner may generally withdraw only upon 6 months notice to each general partner.[17]An assignee of an interest in a partnership is not a substitute partner in a limited partnership, or a substitute member in a limited liability company, and has no ability to transfer such interests or to withdraw from the partnership, nor can the assignee force the partnership to buy him out or to liquidate. Differences in the governing instrument of an entity, or the state laws under which an entity is formed, determine the amount of lock-in discount that is appropriate.[18]
The withdrawal of a general partner usually causes the dissolution of a limited partnership.[19] The dissolution of a partnership entitles the other partners and assignees to receive the liquidation value of the partnership. Thus, the value of an interest inherited by an assignee would not receive a lock-in discount if he inherited it from the sole general partner of the partnership.
SECTION III: IRS TOOLS FOR ATTACKING DISCOUNTS
The Internal Revenue Service...
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