Nov 1, 2005 12:00 PM, Rorie M. Sherman Editor in Chief

By: Rorie M. Sherman Editor in Chief

From David A. Handler, partner with Kirkland & Ellis LLP in Chicago, we have this report:

• Limited partnership interests allowed 32 percent discount

  Practitioners might consider whether Estate of Kelley creates a new floor for valuation discounts of family limited partnerships (FLPs). The assets of the FLP involved were cash and CDs, which usually are associated with the smallest discounts (as opposed to more volatile or less liquid assets). Yet, the U.S. Tax Court permitted a total net discount of 32.24 percent.

  In Estate of Kelley, T.C. Memo. 2005-235 (Oct. 12), the decedent had formed an FLP and a limited liability company (LLC), as the general partner. The decedent, his daughter and his son-in-law (the Loudens) each contributed cash to the LLC so that each had one-third. The decedent contributed $1,101,475 in cash and certificates of deposit to the FLP for a 94.83 percent limited partnership interest and the Loudens contributed $50,000 cash for a 4.17 percent limited partnership interest. The decedent died eight months later.

  At issue in the Tax Court memo was the value of the decedent's limited partnership interests for estate tax valuation purposes. (Interestingly, Internal Revenue Code Section 2036 was not at issue.) The Tax Court noted that there are three common methods used to measure the value of an interest in a closely held entity: the income approach, the net asset value (NAV) approach, and the market approach. But the court found that, because the FLP was primarily engaged in investment activities, the NAV method should be afforded the greatest weight.

  In determining the minority interest discount, the estate's appraiser compared the interests to those closed-end funds that are in low demand and trade at higher discounts: the fourth quartile, or bottom 25 percent of closed-end funds based on price-to-NAV ratios. Those funds had price-to-NAV discounts of 21.8 percent to 25.5 percent. The appraiser for the Internal Revenue Service applied a minority discount of 12 percent by calculating an arithmetic mean of the entire data set for closed-end funds, not just the fourth quartile. The court agreed with the IRS appraiser's approach, because shareholders of all closed-end funds lack control, and by using only the funds in the fourth quartile (which had the lowest demand and therefore the highest marketability discount), elements of the lack of marketability discount would be combined with the minority discount. As a result, the court applied a 12 percent minority discount.

  The court noted that there are several ways to determine a marketability discount. Two of the most common are the initial public offering (IPO) approach and the restricted stock approach. Citing McCord v. Commissioner, 120 T.C. 358 (2003) and Lappo v. Comm'r, T.C. Memo. 2003-258, the court held that the private placement approach is appropriate when the interest to be valued was part of an investment company, as the assessment and monitoring costs would be relatively low in the case of a sale of an interest in such a company. The FLP was held to be an investment company, as 100 percent of its assets consist of cash and certificates of deposit.

  The IRS appraiser argued that a 15 percent marketability discount was appropriate, based on a study by Mukesh Bajaj, professor at the University of California at Berkeley, Haas School of Business, which found that private placement of unregistered shares has an average discount of about 14.09 percent more than the average discount on registered placements. However, the court held that the 14.09 percent discount was not solely a reflection of marketability discount, but also was influenced by such additional factors as the fraction of total shares offered in the placement, business risk, financial distress of the firm, and total proceeds from the placement. In McCord, the Tax Court had focused on the Bajaj study, and found that a 20 percent marketability discount was appropriate for interests in an FLP classified as an investment company. In Lappo, the Tax Court found a 21 percent initial discount appropriate for an interest in an FLP consisting of marketable securities and real estate subject to a long-term lease, but made an upward adjustment of 3 percent to the marketability discount to account for characteristics specific to that partnership. The characteristics at which the court pointed were: the partnership was closely held with no real prospect of becoming publicly held; the partnership was relatively small and not well known; there was no present market for the partnership interests; and the partnership had a right of first refusal to purchase the interests.

  The characteristics of the decedent's FLP were similar to those in Lappo. As a result, the court held that a 3 percent upward adjustment was appropriate and a 23 percent marketability discount was applied. The total net discount was 32.24 percent.

• Failure to exercise withdrawal right is not a constructive addition to a trust

  In Private Letter Ruling 200540004 (issued June 2, released Oct. 7), a settlor created and funded an irrevocable trust on Date 1 for the primary benefit of his child. The trust provided that, when the child turned 21, its income was to be paid to the child at the trustee's discretion. On the child's death, the corpus would be distributed pursuant to the child's limited power to appoint the principal among his descendants. In addition, the child had the right to withdraw one-sixth of the trust principal when he turned 30, one-fifth at age 35, and one-fourth at age 40. The withdrawal right is cumulative and does not lapse.

  The child reached age 35 and was entitled to withdraw $Y. The IRS held that because the withdrawal right is cumulative and does not lapse, failure to exercise that right does not constitute a constructive addition to the trust for generation-skipping transfer (GST) tax purposes within the meaning of Treasury Regulations Section 26.2601-1(b)(1)(v). However, upon the child's death, the withdrawal power will lapse, and any amount subject to that withdrawal power will be included in the child's gross estate under IRC Section 2041; then the child will become the transferor of this amount for GST tax purposes.

• Gift with debt assumption is treated as part of a sale

  In PLR 200540008 (issued June 24, released Oct. 10), taxpayers owned residential property as community property encumbered by a recourse loan. The taxpayers wanted to give their daughter a 50 percent tenancy-in-common interest in the property. The taxpayers would retain a 50 percent undivided community-ownership interest in the property, and remain sole obligors for the loan encumbering the property. However, the daughter would enter into a written agreement with her parents, making her responsible for repaying one half of the loan's principal balance (computed when interest in the property was transferred to her).

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