Right of First Refusal in Partnership Agreement Subject to Section 2703
In Smith, 1 the U.S. District Court for the Western District of Pennsylvania adopted as its opinion the report and recommendations of a magistrate judge that Section 2703(a) was applicable to a provision of a partnership agreement that set the payment terms if a right of first refusal in a partnership agreement was exercised to acquire a partner's interest in the partnership.
Sidney E. Smith and his two children formed a limited partnership on 12/29/97. The sole asset of the partnership was 100% of the common stock of an operating corporation that until then had been owned by Smith. Smith and his son owned general partner and limited partner interests and Smith's daughter owned limited partner interests in the partnership.
In January and December of 1998, Smith gave limited partner interests to each of his two children. Smith timely filed a gift tax return reporting the gifts and paid a gift tax. The IRS assessed additional gift tax against Smith. Smith paid the additional tax and filed a refund claim. After waiting the required six months without receiving a refund, Smith filed a refund suit in the District Court for the Western District of Pennsylvania.
The parties agreed that the sole issue was the value of the limited partner interests that Smith gave to his two children. The partnership agreement granted the partnership and the partners a right of first refusal upon a transfer by a partner of his interest in the partnership. If the right of first refusal was exercised, the purchaser, in payment of the purchase price, was to issue to the selling partner a promissory note with a term selected by the purchaser (not to exceed 15 years) at a rate of interest equal to the long-term applicable federal rate. The appraisal report prepared for Smith, and attached to his gift tax return, took this provision into account and discounted the value of the limited partner interests given by Smith to his children.
The IRS, relying on Section 2703(a), disregarded the right of first refusal provision for valuation purposes. Section 2703(a) provides that for estate, gift, and generation-skipping transfer tax purposes, the fair market value (“FMV”) of property is to be determined without regard to: (1) any option, agreement, or other right to acquire or use the property at a price less than its FMV; or (2) any restriction on the right to sell or use such property. Smith argued that Section 2703(a) was not applicable to partnership agreements for partnerships validly formed under state law, but rather applied to buy-sell agreements that grant a person the right to purchase property at a bargain price.
The court said that the case was one of first impression because there had been no reported decision that addressed whether Section 2703(a) applies to a provision of a partnership agreement that fixes the price of a partnership interest at less than FMV. According to the court, the legislative history provides that Section 2703(a) was intended to “apply to ... restrictions implicit in the capital structure of the partnership or contained in the partnership agreement.” 2
The court noted that Reg. 25.2703-1(a)(3) provides that Section 2703(a) applies to a restriction “contained in a partnership agreement, articles of incorporation, corporate bylaws, a shareholders' agreement or any other agreement.” The court held that Section 2703(a) should be applied to disregard the restrictions contained in the partnership agreement unless the partnership agreement satisfied the requirements for the safe harbor set forth in Section 2703(b).
Section 2703(b) provides that Section 2703(a) does not apply if the option, agreement, right, or restriction: (1) is a bona fide business arrangement; (2) is not a device to transfer property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and (3) has terms that are comparable to similar arrangements entered into by persons in an arm's-length transaction. The court examined whether the restriction in question satisfied each of these three requirements.
Discussing the first requirement, the court observed that while the term “bona fide business arrangement” is not defined in either the Internal Revenue Code or the Regulations, “courts have consistently recognized that an arrangement to facilitate the maintenance of family ownership and control of a business is a bona fide business arrangement.” The court found that the partnership agreement satisfied the first requirement because the restriction in the partnership agreement was designed to maintain control and ownership of the partnership by the Smith family.
Addressing the second requirement, the court said that since it was clear that the restrictive provision in question had the effect of passing property to Smith's family for less than full and adequate consideration, the only issue was whether the restrictive provision was a testamentary device used by Smith to transfer property to his family. According to the court, the issue of whether a restrictive provision was a testamentary device is determined by examining the following factors: (1) the intent of the parties at the inception of the agreement, (2) the transferor's health, (3) significant changes in the business, (4) the parties selective enforcement of the restrictive provision, and (5) the nature and extent of the negotiations that occurred among the parties regarding the terms of the restrictive provision.
The court concluded that there was not sufficient evidence in the record to determine whether the restrictive provision in the partnership agreement was a testamentary device by Smith to transfer property to his family. Therefore, the court held that genuine issues of material fact existed that must be resolved at trial.
With respect to the third requirement of Section 2703(b), concerning whether the restriction is comparable to similar arrangements entered into by parties in arm's-length transactions, the only evidence submitted on this issue consisted of affidavits of two attorneys which stated that installment payments and charging interest at the applicable federal rate are common in partnership agreements among family members and in transactions among unrelated parties. The court dismissed these affidavits as merely stating opinions that were conclusory in nature. Consequently, the affidavits were not sufficient to resolve the question of whether the restrictive provision is similar to arrangements entered into by parties in arm's-length transactions. Thus, the court did not grant the parties' motions for summary judgment.
Smith is instructive for several reasons. First, it is another example of the high evidentiary standard that taxpayers must meet to satisfy the “comparability test” of Section 2703(b)(3). Smith is reminiscent of Estate of Blount, 3 a recent Tax Court case in which the court also held that the taxpayer-estate failed to meet its burden of proof under Section 2703(b)(3). Valuation experts must be able to support their testimony that the restrictions at issue are comparable to those contained in similar arrangements entered into by persons in arm's-length transactions.
Second, valuation experts should address discounts that are attributable to restrictions that apply as a result of state law rather than relying solely on those restrictions that are contained in the agreement and therefore subject to challenge under Section 2703. Third, agreements entered into prior to 10/9/90 should be amended very carefully because Section 2703 applies only to those agreements entered into or substantially modified after 10/8/90. Finally, we should anticipate that the IRS will continue to challenge discounts by attempting to apply Section 2703.
The authors acknowledge the assistance of Frank S. Baldino, Esq. in the preparation of this article.
1 94 AFTR 2d 2004-5627 (DC Pa., 2004), adopting the report and recommendations of a magistrate judge reported at Smith, 94 AFTR 2d 2004-5283, 2004-2 USTC ¶60488 (DC Pa., 2004).
2 136 Cong. Rec. S15,629, S15,682 (10/18/90).
3 TC Memo 2004-116, RIA TC Memo ¶2004-116, 87 CCH TCM 1303 . For a discussion of Blount, see Madden and Hayes, “Current Tax Developments: Buy-Sell Agreement Disregarded for Estate Tax Valuation Purposes,” 31 ETPL 458 (Sept. 2004).
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 email@example.com.