Page 52 - Business Valuation for Estates & Gift Taxes

When discounts are applied to an FLP valuation, valuation analysts should carefully document and be
able to support the magnitude of the discount taken for the simple fact that this is an area that the IRS
scrutinizes. Although the IRS is concerned with excessive discounts, some case law has centered on the
issue of whether the partnership "truly" exists. The IRS has raised this issue by either attacking the rea-
son for the formation of the partnership or by raising Chapter 14 issues, specifically Section 2703 and
Section 2704. The IRS has also had success with Section 2036 arguments. If the IRS can make a suc-
cessful argument on any of these issues, then the FLP could be seen as an invalid entity, and the gifts
could become gifts of the underlying assets directly, rather than partnership interests (in other words, no
discounts) or under Section 2036, the underlying assets could be taxed as part of the estate, rather than
as an FLP interest.

IRC Section 2036—Transfers with Retained Life Estate

FLPs were designed to allow the transfer of assets from a family member into a partnership which in
turn would prevent those assets from being included in the family member’s estate upon death. The val-
uation analyst must use caution whenever dealing with FLPs because if these are not set up properly, as-
sets transferred to the FLP with the intent of removing the assets from an estate could be clawed back in-
to the estate and more than likely result in unintended and unfavorable tax consequences.

When FLPs were first used by taxpayers as an estate planning strategy, the IRS did not agree with the
approach (for obvious reasons) and tried a number of ways to invalidate FLPs, including, but not limited
to, no business purpose, the agreement being more restrictive than state law, and failure to follow the
formalities of setting up the structure and transferring assets. For the most part, these arguments failed in
the courts.

The IRS has achieved (and continues to achieve) success in challenging FLPs through the use IRC Sec-
tion 2036. fn 1 The IRS and the courts thoroughly scrutinize the nature of the transactions conducted by
the FLP and its partners to assess whether any asset transfers to and from the FLP are transfers that al-
low the grantor to retain a life estate interest (which are includable in gross estate). Due to the diversity
of facts and circumstances surrounding how and why FLPs are set up, there are numerous decisions both
for and against the taxpayer. Therefore, while not directly a valuation issue, a valuation analyst who
must evaluate (or possibly even set up) an FLP would be prudent to consult with a subject matter expert
to help ensure the FLP can withstand the challenge of the IRS and the courts if necessary. As previously
noted, failure to do so could result in a significantly larger gross estate, as well as the possibility of a
significantly larger federal (and maybe state) estate tax bill.

Step Transactions and Indirect Gifts on Formation

Valuation analysts should take similar precautions when it comes to understanding when and how an
FLP is funded. This is especially important when the FLP transfers assets to the beneficiaries in a con-
temporaneous transaction to the funding or shortly thereafter. The IRS has prevailed in a number of cas-
es where FLPs were funded by the grantor and then, in close proximity to receiving the assets, distribut-
ed interests in the FLP to beneficiaries. By utilizing the step transaction doctrine, the IRS succeeded in
diminishing or eliminating gift tax valuation discounts on minority positions of FLPs on the premise that

fn 1 The first time the IRS utilized and prevailed using IRC Section 2036 as a way to challenge the FLP structure was in 2003 with the
Tax Court’s decision in Estate of Albert Strangi, et al. v. Commissioner, T.C. Memo 2003-145.

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