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Business Valuation Update From the developers of Pratt s Stats Timely news, analysis, and resources for defensible valuations Vol. 17, No. 8, August 2011 FLP Appraisals: Plan for the New Matrix By John Porter, Esq., with BVR staff Recent court decisions have dealt a blow to the effectiveness of family limited partnerships (FLPs) for transfer tax purposes, particularly when the partnership formation and funding fail to respect state law requirements. In these cases, the IRS has successfully attacked the FLPs often nullifying any valuation discounts by focusing on their lack of economic substance/business purpose, or characterizing the asset transfers as indirect gifts/ gifts-on-formation. The IRS silver bullet. The IRS has enjoyed the greatest success in challenging FLPs in cases in which the taxpayers failed to respect the integrity of the entity. In these cases, and based on arguments by the government, the U.S. Tax Court has used I.R.C. 2036 to bring the full fair market value of the partnership assets back into the decedent s estate as a retained life interest. Specifically, Sec. 2036(a) provides that the full value of the property transferred by a decedent in which she has retained the right to possess and enjoy during life shall be included in the estate, unless there has been a bona fide sale for an adequate and full consideration. As a result, Sec. 2036 currently presents the most litigated issue in estate and gift tax cases. In effect, you might consider it the government s silver bullet. Dealing with the IRS at both the audit level and in litigation, I have seen the agency increase its focus on the actual operations of the partnership, to help show the retention of a life interest and the lack of a bona fide, non-tax business purpose. As part of its investigation and/ or discovery in these proceedings, the IRS routinely asks to examine the books and records of the entity, including its bank statements and the formation and funding documents. The IRS is essentially looking to see whether, in forming and operating the entity, the partners have dotted the proverbial i s and crossed the t s, (just as the Tax Court did in Estate of Strangi v. Commissioner (115 T.C. 478 (2000)(Strangi I), aff d in part and rev d in part on other grounds, 239 F.3d 279 (5th Cir. 2002)). Any Sec. 2036 case will ultimately turn on its particular facts and circumstances, but since Strangi, the IRS and the courts have looked to the following: Formation facts Was the partnership operated as a separate legal entity or merely as a second bank account for the founding partner (now decedent)? What were the non-tax reasons for creating the entity? Did the limited and other partners make real contributions of property or services in return for their interests? Were personal use assets placed in the partnership (e.g., the decedent s residence and related mortgage debt)? Did the partnership agreement negate fiduciary obligations? BVResources.com
Business Valuation Update Executive Editor: Jan Davis Legal Editor: Sherrye Henry Jr. CEO, Publisher: David Foster Managing Editor: Janice Prescott Contributing Editors: Adam Manson, Vanessa Pancic, Doug Twitchell Graphic & Technical Designer: Paul Erdman Customer Service: Stephanie Crader Sales and Site Licenses: Linda Mendenhall President: Lucretia Lyons Editorial Advisory Board NEIL J. BEATON CPA/ABV, CFA, ASA GRANT THORNTON SEATTLE, WASH. JOHN A. BOGDANSKI, ESQ. LEWIS & CLARK LAW SCHOOL PORTLAND, ORE. NANCY J. FANNON ASA, CPA/ABV, MCBA FANNON VALUATION GROUP PORTLAND, ME. JAY E. FISHMAN FASA, CBA FINANCIAL RESEARCH ASSOCIATES BALA CYNWYD, PA. LYNNE Z. GOLD-BIKIN, ESQ. WOLF, BLOCK, SCHORR & SOLIS-COHEN NORRISTOWN, PA. LANCE S. HALL, ASA FMV OPINIONS IRVINE, CALIF. JAMES R. HITCHNER CPA/ABV, ASA THE FINANCIAL VALUATION GROUP ATLANTA, GA. JARED KAPLAN, ESQ. MCDERMOTT, WILL & EMERY CHICAGO, ILL. JAMES S. RIGBY, ASA, CPA/ABV IN MEMORIAM (1946 2009) GILBERT E. MATTHEWS CFA SUTTER SECURITIES INCORPORATED SAN FRANCISCO, CALIF. Z. CHRISTOPHER MERCER ASA, CFA MERCER CAPITAL MEMPHIS, TENN. JOHN W. PORTER BAKER & BOTTS HOUSTON, TX. RONALD L. SEIGNEUR MBA CPA/ABV CVA SEIGNEUR GUSTAFSON LAKEWOOD, COLO. BRUCE SILVERSTEIN, ESQ. YOUNG, CONAWAY, STARGATT & TAYLOR WILMINGTON, DEL. JEFFREY S. TARBELL ASA, CFA HOULIHAN LOKEY SAN FRANCISCO, CALIF. GARY R. TRUGMAN ASA, CPA/ABV, MCBA, MVS TRUGMAN VALUATION ASSOCIATES PLANTATION, FLA. KEVIN R. YEANOPLOS CPA/ABV/CFF, ASA BRUEGGEMAN & JOHNSON YEANOPLOS, P.C. TUCSON, ARIZ. Business Valuation Update (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation Update, Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. The annual subscription price for the Business Valuation Update is $359. Low cost site licenses are available for those wishing to distribute the BVU to their colleagues at the same address. Contact our sales department for details. Please feel free to contact us via email at customerservice@bvresources.com, via phone at 503-291-7963, via fax at 503-291-7955 or visit our web site at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. Please note that by submitting material to BVU, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2010, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR. Did partners other than the decedent participate in forming the terms of the partnership agreement and deciding its assets? Were distributions made? If so, were they made in accordance with the terms of the partnership agreement? Operational facts Are the asserted non-tax reasons for creating the partnership consistent with its actual operations? Did the decedent commingle personal assets with partnership assets? Did the partnership assets pay for the decedent s personal expenses and/or personal needs? Did the partnership directly pay estate taxes and administration expenses? To withstand this high level of scrutiny requires careful planning, documentation, and operation of the partnership. This includes ensuring that the partners respect the entity and that qualified, supportable, and well-reasoned appraisals are obtained when valuing the transferred interests. Each person on the planning team is part of the gatekeeping function, including and perhaps most importantly, the experienced valuation analyst. If appraisers see some of the factors listed above, they will want to bring them to the attention of the tax-planning attorneys and financial advisers. In their reports, and if it is relevant to the valuation analysis, appraisers may want to discuss the reasons why the partnership was created. They should take care that it s not a boilerplate discussion, but truly fits the facts of the entity at issue. Valuation discounts are real. Anyone who acquires an interest in an FLP, particularly a non-controlling interest, lacks the ability to dictate how the partnership will be run and how (or if) Reprinted with permissions from Business Valuation Resources, LLC 2 Business Valuation Update August 2011
distributions will be made. There is no established market on which to trade these interests. As a result, discounts for lack of marketability and lack of control related to FLP interests are real and the case law has acknowledged this. At the same time, it s important to understand how to view these interests in the tax law context. The first task for appraisers, CPAs, and attorneys is to figure out the nature of the interest at stake from a state law property transfer perspective. The second task is to determine the value of those state law property rights that are subject to transfer. That s not always easy, of course. There is no one-size fits all discount, and no empirical certainty when it comes to determining discounts in every case. Nevertheless, I have worked with some IRS agents and appeals officers during the settlement process who come to the discussion with a matrix that sets out the range of discounts permitted by the IRS FLP Appeals Settlement Guidelines (ASG, 2006). The agents may even insist that they can t go higher than the range regarding family limited partnerships and LLPs (making the process seem a little like buying a used car). Using prior case law, I ve also created a demonstrable matrix of discounts in the FLP arena. As the table below illustrates, taxpayers have sustained substantial valuation discounts in cases in which the court has found their experts valuation testimony more persuasive than the valuation testimony put forth by the government s experts. Accordingly, appraisers should remember (and attorneys be reminded) that valuation reports are the most important piece of evidence in a transfer tax dispute. Because the valuation filed with the transfer tax return constitutes an admission of value by the taxpayer, it is important for the taxpayer to obtain a well-reasoned appraisal from a qualified appraiser when the return is filed. Case* Assets Court Discounts from NAV/ proportionate entity Strangi I securities Tax 31% Knight securities/real estate Tax 15% Jones real estate Tax 8%; 44% Dailey securities Tax 40% Adams securities/real estate/minerals Federal District 54% Church securities/real estate Federal District 63% McCord securities/real estate Tax 32% Lappo securities/real estate Tax 35.4% Peracchio securities Tax 29.5% Deputy boat company Tax 30% Green bank stock Tax 46% Thompson publishing company Tax 40.5% Kelley cash Tax 32% Temple marketable securities Federal District 21.25% Temple ranch Federal District 38% Temple winery Federal District 60% Astleford real estate Tax 30% (GP) 36% (LP) Holman Dell stock Tax 22.5% Keller securities Federal District 47.5% Murphy securities/real estate Federal District 41% * Note: cases are available at BVLaw. August 2011 Business Valuation Update 3
Moreover, even when an appraisal will only initially be used to establish the fair market value of an asset in connection with the filing of a tax return, the appraisal report should be in a form that will allow its introduction in subsequent litigation. That s because Rule 143(g)(T.C.R.) provides that the report will be received into evidence as the direct testimony of the expert, with additional testimony permitted only to clarify or emphasize matters in the report or to cover events arising after its preparation; or otherwise at the court s discretion. It is therefore imperative even before entering the matrix of valuation discounts in the transfer tax arena that the appraisal contain all the facts, data, and reasoning on which the appraiser bases the valuation conclusions. Don t judge the report by how the IRS, the court, or other sophisticated user of the report might read it. Instead, put yourself in the position of the uninformed reader who is attempting to use the appraisal to determine the fair market value of the property interest. Ultimately, the most credible (and possibly successful) appraisal will contain all of the information in a clear, rational, and logical manner that allows the reader to fully understand and determine that the conclusions are correct. John Porter is a leading tax attorney with Baker Botts LLP (Houston). This paper is based on his recent remarks and presentation materials at the 25th annual meeting of the San Francisco Valuation Roundtable in Orinda, Calif. (June 2011). 4 Business Valuation Update August 2011