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Scylla and Charybdis: Valuation Discounts and Present Interests

Johann Fussli's painting of Odysseus in front of Scylla and Charybdis in the Straits of Messina (c. 1795). Image: The Yorck Project via Wikimedia Commons.

The Petter case recently analyzed by KYEstate$ noted that valuation discounts are “a major goal . . . of contemporary estate planning” because they often “create the possibility of a more taxpayer-friendly valuation.” Petter cautioned, however, that valuation discounts are “often a major problem.”  It’s not surprising that the IRS would see valuation discounts as a problem.  In Price v. Comm’r,  T.C. Memo. 2010-2, 2010 WL 10019 (U.S. Tax Court 2010), however, we see how pursuit of valuation discounts can create unanticipated problems for taxpayers, too.

In Price, the common technique of using limited partnerships as part of an inter-family gifting plan ran ashore on the rocks of the present interest requirement for the annual exclusion under section 2503(b).

Price involved a successful diesel power equipment sales and servicing company near Omaha, Nebraska.  The company was a family business, but Mr. and Mrs. Price had no children interested in entering the family business.  Accordingly, in the late 1990s, they contributed their closely held stock and three parcels of commercial real estate to a Nebraska limited partnership.  The partnership then sold the family business stock to a group of long-term non-family employees.  The partnership invested the sale proceeds in marketable securities.

From 1997 through 2002, Mr. and Mrs. Price made regular gifts of partnership units to their three children.  They made taxable gifts in 1997, and smaller gifts intended to not exceed the then-applicable annual exclusion amount in 1998 through 2002.

The partnership made cash distributions to its limited partners, including the Price children, during four of the six years from 1997 through 2002.  Mr. Price controlled the partnership’s corporate general partner.

The partnership agreement contained relatively standard prohibitions on withdrawal of capital accounts, transfer and assignment of limited partnership interests, and dissolution of the partnership.  The partnership and remaining partners were given a call option to purchase any partnership units that were the subject of a voluntary or involuntary transfer.

The partnership had a 25-year term, and could be dissolved by vote of the partners holding at least two-thirds of the total partnership interest.  The partnership agreement provided for pro rata distribution of profits and losses, but further provided that distributions (including tax distributions) were discretionary.

The Prices timely filed gift tax returns reporting the gifts of limited partnership units, accompanied by valuation reports.  The valuation reports reflected “substantial discounts for lack of control and lack of marketability.”

The IRS audited the 2000, 2001, and 2002 gift tax returns, and issued notices of deficiency disallowing annual gift tax exclusions for transferred partnership interests.  Instead, the IRS asserted that the gifts were of future interests in property.

In its opinion, the Tax Court found that the gifts of limited partnership units were not gifts of present interests, and therefore did not qualify for the gift tax annual exclusion.

Seasoned estate planners reading this post have already begun to think that this case sounds a lot like Hackl v. Comm’r, 118 T.C. 279 (2002), affd. 335 F.3d 664 (7th Cir. 2003), and the Tax Court in Price agreed:

In [Hackl], this Court held that gifts of units in a limited liability company (LLC) were gifts of a future interest that did not qualify for the annual exclusion. The Court rejected the taxpayers’ argument that a gift that takes the form of an outright transfer of an equity interest in a business or property is necessarily a gift of a present interest….The Court held that to establish entitlement to an annual exclusion under section 2503(b), a taxpayer must establish that the transfer in dispute conferred on the donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such immediate use, possession, or enjoyment be of a nature that substantial economic benefit is derived therefrom.

The taxpayers, who hadn’t had the benefit of Hackl‘s example when they made their gifts in 2002 and previous years, valiantly argued that Hackl was decided incorrectly and that Hackl was distinguishable from their facts.  The Tax Court was not amused:

We decline petitioners’ invitation to reconsider our holding in Hackl. Furthermore, we disagree that Hackl is distinguishable from the instant cases in ways that are helpful to petitioners. As explained below, applying the methodology set forth in Hackl, we conclude that petitioners have failed to show that their gifts of interests in the partnership conferred upon the donees the immediate use, possession, or enjoyment of either (1) the transferred property or (2) the income therefrom.

The Tax Court undertook a point-by-point review of the partnership agreement.  Point-by-point, the factors supporting the valuation discounts (good) were the very factors cutting against the gifts qualifying for the present interest requirement (bad).

First, the donees had no unilateral right to withdraw their capital accounts.  Second, transfers were subject to approval contingencies (which “cannot support a present interest characterization”)  Third, the donees had not been clearly admitted as substitute limited partners, which left them (possibly) with status only as assignees.  This meant they lacked the present ability to “access any substantial economic or financial benefit that might be represented by the ownership units.”

The taxpayers made the creative, last-ditch argument that the K-1s issued to donees by the partnership evidenced the donees’ own personal assets, and that this increased their “financial borrowing ability”.  The taxpayer argued this was sufficient to give the donees a present interest in the transferred property.  The Tax Court described this argument as “highly contingent and speculative,” especially in light of the partnership agreement’s restrictions on encumbering partnership units.

The Tax Court also found that the irregular pattern of partnership distributions (and the partnership’s agreement’s provisions that distributions — even income tax distributions — were discretionary) caused income distributions to be “matters of pure speculation”, and that the donees had acquired no present right to use, possess, or enjoy the income from the partnership interests.

The taxpayers attempted to argue that Nebraska law imposed a “strict fiduciary duty” on the general partner to make income distributions to the donees, but the Tax Court was not persuaded that such a duty existed, or such a duty would be sufficient to establish a present interest when the limited partner lacked withdrawal rights.

Accordingly, the Tax Court found in favor of the IRS:

In sum, petitioners have failed to show that the gifts of partnership interests conferred on the donees an unrestricted and noncontingent right to immediately use, possess, or enjoy either the property itself or income from the property. We therefore hold that petitioners are not entitled to exclusions under section 2503(b) for their gifts of partnership interests.

How can estate planners, like Odysseus, run the straits, and obtain the benefits of valuation discounts without losing the annual exclusion?  How can they avoid outcomes for gifts of limited partnership or LLC interests like those in Price and Hackl?  One option is to give donees of limited partnership or LLC interests a put option back to the donor(s) during a 30-day Crummey withdrawal period, at the appraised fair market value for such units found in connection with the gift.  A client memo from Baker Botts here and an article in the Fordham Journal of Corporate and Financial Law here discuss this option and others for avoiding Hackl.

KYEstate$ is sorry to report the taxpayer loss in Price.  Its reprise of Hackl serves as a cautionary tale for estate planners seeking to make the most of limited partnership or LLC gift planning that uses both valuation discounts and annual exclusions.

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