Discount for FLP Funded with Cash and CDs
In Estate of Kelley,1 the Tax Court allowed an overall discount of 32.2% for the decedent's interest in a family limited partnership (“FLP”) that owned cash and certificates of deposit and that was formed only eight months before the decedent's death.
The decedent, his daughter, and her husband formed an FLP and a limited liability company (“LLC”). The decedent contributed approximately $1.1 million, and the decedent's daughter and her husband contributed a total of $50,000 to the FLP. The only asset of the LLC was a 1% interest in the FLP. The decedent died approximately three months after his last contribution to the FLP. At the time of his death, the decedent owned a one-third interest in the LLC and a 94.83% interest in the FLP.
On the decedent's estate tax return, the estate valued the decedent's interest in the FLP and the LLC by applying a discount of 53.5%. On audit, the IRS contended that the estate was entitled to a discount of 25.2%. The statutory notice of deficiency also set forth alternative arguments based on Sections 2035, 2036, 2038, and 2703. However, prior to trial in the Tax Court, the IRS conceded all the alternative arguments. Therefore, the sole issue before the court was the proper amount of the discounts for lack of control and lack of marketability to apply in valuing the decedent's interests in the FLP and the LLC.
The court stated that of the three most commonly used valuation methods, where the interest to be valued is in a non-operating investment company the net asset value method should be given the greatest weight and the income method should not be given more than minor weight.2 The court also found that it was appropriate to apply a discount for lack of control and lack of marketability to the decedent's proportionate share of the net asset value of the FLP and the LLC because a hypothetical willing buyer would demand a reduction in the purchase price since the interests being valued lack control and because there is no ready market for the interests.
In determining the amount of the discount for lack of control, the court said that it was appropriate to look to closed-end funds. Closed-end funds typically trade at a discount relative to their net asset value. Because closed-end funds are marketable, said the court, the discount to net asset value must be attributable to the fact that the shareholders in such funds have no control over the underlying assets.
The appraiser for the estate, in computing the amount of the discount for lack of control, determined that the FLP was most comparable to closed-end funds that were in the fourth quartile in terms of the size of the discount from the fund's net asset value. The funds in this fourth quartile had the largest discount relative to net asset value. The estate's appraiser believed that the comparison to fourth quartile funds was appropriate because: (1) the FLP was smaller than most closed-end funds, (2) the FLP did not have a full-time professional staff of analysts and professional managers, (3) the FLP was not diversified, and (4) the FLP did not have a performance history.
The court believed that the estate's exclusive use of fourth quartile closed-end funds overstated the amount of the discount for lack of control because the discount at which such funds trade includes a significant discount for lack of marketability due to the low demand for such funds. Instead, the court believed that the correct analysis would be to take the arithmetic mean of all closed end funds.
The court applied a discount of 12% for lack of control, holding that the IRS effectively conceded that a discount of at least 12% was appropriate since that was the testimony of the IRS appraiser. The court indicated, by parenthetically citing to Peracchio3 which applied a 2% discount for lack of control for the cash and money market funds portion of an FLP, that had it not been for the testimony of the IRS appraiser, the court would have applied a lower discount. The court next turned to determining the amount of the discount for lack of marketability and concluded that the appropriate valuation method to be used where interests in an investment company are to be valued is not the initial public offering approach but rather the private placement approach that compares the private placement value of unregistered shares to that of registered shares.
The court rejected the appraisals of both parties regarding lack of marketability and instead relied on the court's analysis in McCord.4 In McCord, the court, relying on a study prepared by Dr. Mukesh Bajaj, concluded that a discount of 20% was appropriate for interests in an FLP classified as an investment company. The Kelley court, relying on Lappo,5 also found that an increase of 3 percentage points in the discount for lack of marketability (bringing the total discount for lack of marketability to 23%) was appropriate to account for characteristics specific to the entities, including the facts that the entities had no prospect of becoming public, the entities were small and not well known, there was no market for the interests in the entities, and the entities had a right of first refusal to purchase the interests.
The opinion in Kelley sets forth a concise summary of the valuation principles applicable to closely held businesses where the primary assets are marketable securities. The facts of this case are similar to the facts in Strangi. 6 In both cases, the decedent's ownership position in the entities was similar, and in both cases, the entities were formed shortly before the decedent's death. However, despite these factual similarities, prior to trial the IRS in Kelley dropped the alternative arguments based on Sections 2035, 2036, 2038, and 2703.
The opinion does not give any reason for the IRS's action. One explanation may be that there were factual differences between Strangi and Kelley. For example, Mr. Kelley may have retained sufficient assets outside of the partnership to live on and, even though he died within three months of funding the partnership, Mr. Kelley's death may have been sudden and not the result of a terminal illness.
Kelley may have limited relevance due to the fact that the alternative arguments of the IRS were not addressed by the court. Nevertheless, Kelley demonstrates that discounts are available if a taxpayer can prevail on the Section 2035, 2036, 2038, and 2703 issues. With respect to the size of the available discounts, the court strongly suggested that it would have applied a lower discount for lack of control (possibly as low as 2%) but for the testimony of the IRS witness. It can be anticipated that the IRS will revise its audit and trial strategy accordingly.
1 TC Memo 2005-235 , RIA TC Memo ¶2005-235 , 90 CCH TCM 369.
2 The third method is the market approach.
3 TC Memo 2003-280 , RIA TC Memo ¶2003-280 , 86 CCH TCM 412.
4 120 TC 358 (2003).
5 TC Memo 2003-258 , RIA TC Memo ¶2003-258 , 86 CCH TCM 333.
6 Estate of Strangi, 115 TC 478 (2000), aff'd in part, rev'd in part sub nom. Gulig, 89 AFTR 2d 2002-2977 , 293 F3d 279 (CA-5, 2002), on remand, TC Memo 2003-145 , RIA TC Memo ¶2003-145 , 85 CCH TCM 1331 aff'd 96 AFTR 2d 2005-5230 , 417 F3d 468 (CA-5, 2005).
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.