Tiered Discount Allowed in Real Estate FLP Gift Tax Case
In Astleford, 1 a memorandum decision, the Tax Court permitted a taxpayer to apply a tiered discount in the context of a family limited partnership owning interests in real estate.
On August 1, 1996, Mrs. Astleford formed the Astleford Family Limited Partnership (“AFLP”) to facilitate the continued ownership, development, and management of various real estate investments and partnership interests she owned and to facilitate gifts that she intended to make to her three adult children. On the same day, Mrs. Astleford transferred to AFLP ownership of an elder care facility. Also on the same day, Mrs. Astleford gave each of her three children a 30% limited partner interest in AFLP and retained for herself a 10% general partner interest.
On December 1, 1997, Mrs. Astleford made additional capital contributions to AFLP by transferring to AFLP a 50% interest in Pine Bend Development Co. (“Pine Bend”), a general partnership, and her interest in 14 other real estate properties. The Pine Bend general partnership agreement did not contain any provisions relating to the transfers of interests in Pine Bend or whether such transferred interests would be general partner or assignee interests. Pine Bend owned 3,000 acres of land of which 1,187 acres consisted of agricultural farmland (“Rosemount property”).
As a result of the additional capital contributions made on December 1, 1997, Mrs. Astleford's general partner interest in AFLP increased significantly, and her children's respective limited partner interests in AFLP decreased significantly. However, also on December 1, 1997, Mrs. Astleford gave to each of her three children additional limited partner interests in AFLP. These gifts had the effect of reducing Mrs. Astleford's AFLP general partner interest back down to approximately 10% and increasing the children's AFLP limited partner interests back up to approximately 30% each.
On audit of the 1996 and 1997 gift tax returns, the IRS increased the fair market value of a number of the properties that were transferred to AFLP and also decreased the discounts for lack of control and lack of marketability that were applied to the interests transferred.
There were three issues before the court: first, the value of the Rosemount property; second, whether the 50% Pine Bend interest should be valued as a general partner interest or as an assignee interest; and third, the amount of the discount for lack of control and lack of marketability that should apply to the gift of the 50% Pine Bend general partner interest and to the gift of the AFLP limited partner interests.
With respect to the Rosemount property, the valuation expert for Mrs. Astleford applied an absorption discount based on his opinion that a sale of the entire Rosemount property would flood the local market for farmland and would therefore reduce the per-acre price at which the Rosemount property could be sold. Believing that the Rosemount property would sell over the course of four years and would appreciate 7% each year, the expert performed a cash flow analysis using a present value discount rate of 25%.
The IRS's expert did not apply an absorption discount since he concluded that the entire Rosemount property likely could be sold in a single year without an absorption discount based on the fact that in 1970, the 3,000 acres of land (including the Rosemount property) had been purchased by Pine Bend in a single transaction. The IRS's expert also concluded that even if an absorption discount was appropriate, the 25% present value discount rate used by Mrs. Astleford's expert was excessive. The IRS's expert argued that the present value discount rate should track the 9.2% rate of return on equity which farmers in the area actually earned.
The court believed that due to the size of the Rosemount property in relation to the number of acres sold each year in the area, it was unlikely that all 1,187 acres of the Rosemount property would be sold in a single year without a price discount. However, the court also believed that the present value discount rate of 25% used by Mrs. Astleford's expert was unreasonably high because it relied on statistics relating to developers of real estate who expect greater returns given the greater risks involved in development. Since over 75% of the Rosemount property was leased to farmers, these rental payments would provide a source of future income to a prospective purchaser. The court found that given this low level of risk, a 10% rate of return would be sufficient to induce a purchase of the Rosemount property.
With respect to Pine Bend, the parties disputed the nature of the interest transferred by Mrs. Astleford to AFLP and therefore the appropriate amount of the discount for lack of control and lack of marketability that should apply. Because the other 50% general partner of Pine Bend did not consent to Mrs. Astleford's transfer of her general partner interest in Pine Bend to AFLP, Mrs. Astleford's expert treated the 50% Pine Bend interest transferred to AFLP as an assignee interest and applied a 5% discount. The position of Mrs. Astleford's expert was based on applicable state law that provided that a holder of an assignee interest has only a profits interest but no influence on management.
The court agreed with the IRS that the substance-over-form doctrine applied to treat the interest in Pine Bend that Mrs. Astleford transferred to AFLP as a general partner interest. The court based its conclusion on its finding that since Mrs. Astleford was the sole general partner of AFLP, she was essentially in the same management position relative to the 50% Pine Bend interest whether she is to be viewed as having transferred to AFLP a Pine Bend assignee interest (and thereby retaining Pine Bend management rights) or as having transferred those management rights to AFLP as a result of the transfer of a Pine Bend general partner interest(in which case she reacquired those same management rights as sole general partner of AFLP). The court also noted that the transfer documents treated Mrs. Astleford's Pine Bend transfer as a transfer of all of her rights and interests in Pine Bend, thereby suggesting that a general partner interest—not an assignee interest—was transferred.
Next, the court addressed the amount of the discount for lack of control and lack of marketability that should apply (1) to the limited partnership interests in AFLP given to Mrs. Astleford's three children, and (2) to the 50% Pine Bend general partnership interest she transferred to AFLP. In determining these discounts, Mrs. Astleford's expert relied on data for real estate limited partnerships (“RELPs”) while the IRS's expert relied on data for real estate investment trusts (“REITs”). The court did not believe that either the RELP data or the REIT data was superior to the other. According to the court, RELPs more closely resembled AFLP, and the RELP secondary market is not so low as to render the available RELP data unreliable. However, the court also said that that the large number of REIT sales transactions tended to produce more reliable data compared to the limited number of RELP sales transactions. In addition, the court stated that the differences between REITs and AFLP may be minimized given the large number of REITs from which to choose comparables.
But REITs sometimes trade at prices higher than net asset value. The court recognized that this fact does not mean that a lack of control discount is nonexistent but suggests that a REIT's share price is in part affected by two factors, one positive (the liquidity premium) and one negative (lack of control). Therefore, in analyzing REIT comparables and their trading prices, the court found it is appropriate to quantify and then to reverse out of the trading prices, any liquidity premiums that are associated with REIT comparability data. The court stated that this calculation results in a REIT discount for lack of control that can be applied to the partner interests gifted.
To determine the appropriate liquidity premium to apply to the REIT, the court examined the difference in average discounts in private placements of registered and unregistered stock—reasoning that the difference represents pure liquidity concerns since a public market is available to owners of registered stock but not to the owners of unregistered stock. After performing these calculations, the court applied a lack of control discount of 16.17% for the 1996 gifts and a discount of 17.47% for the 1997 gifts of AFLP by Mrs. Astleford to her children.
With respect to the discount for lack of marketability, the expert for Mrs. Astleford applied a discount of 15% and the IRS expert applied a discount of 21.23% for the 1996 gifts. The court, without any discussion, used the higher discount applied by the IRS expert. For the 1997 gifts, the court applied a lack of marketability discount of 22%.
In valuing the 50% Pine Bend general partner interest, the IRS's expert concluded that because the Pine Bend partner interest was simply an asset of AFLP, the discounts he applied at the AFLP level obviated the need to apply an additional and separate discount at the Pine Bend level. The court disagreed and held that a 30% combined discount for lack of control and lack of marketability was appropriate. In a footnote, the court mentioned that the Tax Court has rejected multiple discounts in the context of tiered entities where the lower level interest constituted a significant portion of the parent entity's assets. However, in this case, the 50% Pine Bend interest constituted less than 16% of the net asset value of AFLP and was only one of 15 real estate investments that were held by AFLP.
Astleford is noteworthy for several reasons. First, this case demonstrates that the Tax Court in appropriate situations will allow substantial discounts. While the IRS has had victories in the context of Section 2036, if the taxpayer is able to satisfy the requirements of that section, substantial discounts will be available. Second, the court allowed discounts for lack of control and lack of marketability at both the subsidiary partnership level and at the parent partnership level. Third, Astleford illustrates that when large tracts of land are involved, practitioners should consider applying absorption discounts. Fourth, this case illustrates one method of determining the amount of the discount for lack of control when analyzing REIT data. While this case does not necessarily make new law, it reminds us of some concepts with which we should all be familiar.
1 TC Memo 2008-128, RIA TC Memo ¶2008-128, 95 CCH TCM 1497.
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.