The Tax Court ruled, contrary to the IRS’s argument, that the step transaction doctrine did not apply where gifts of interests in a family limited partnership (FLP) were made only six days after the funding of the partnership with stock. However, the court also partially denied the taxpayers’ discounts for lack of control and marketability of those interests.
FLPs are often used for estate tax planning and reduction and asset protection. But they need to establish a significant nontax reason for transfers of assets to them and operate in a businesslike manner (see “FLPs That Flop,” JofA, April 08, page 72).
Thomas H. and Kim D.L. Holman transferred more than 70,000 shares of stock in Thomas’ then-employer, computer maker Dell Inc., to an FLP on Nov. 2, 1999. On Nov. 8, 1999, they made gifts of FLP interests to an account established for the benefit of their minor children and reduced the value of the interests by 14.25% for minority interest and by 35% for lack of marketability. The gifting program continued through 2001. The partnership could be dissolved only by written consent of all partners for the next 50 years and allowed limited partners (the children) to withdraw or assign their interests only by prior written consent of all partners.
The IRS, citing the step transaction doctrine, treated the 1999 transaction as an indirect gift of the stock. It assessed deficiencies of more than $232,000 for the three years. The court, however, concluded that even in the six days between the funding of the FLP and the gifts the assets were exposed to real economic risk from a potential market decline, because of the relative volatility of Dell shares. “We draw no bright lines,” the court said, although in a footnote, it added it might look less favorably on more stable assets, such as long-term government bonds or preferred stock.
The taxpayers fared less well in arguing for valuation discounts for transfer restrictions. Under section 2703(a), a transfer restriction is disregarded for purposes of the gift tax unless it meets the three requirements of section 2703(b). The court found that the FLP did not meet the first two requirements because it was not a bona fide business arrangement and was designed to transfer assets within the family at less than full and adequate consideration. Consequently, the court said, it did not need to determine the third factor, whether the restrictions were comparable to those of a similar arrangement entered into by persons in an arm’s-length transaction.
The government abandoned its initial reliance on section 2704(b) to disregard liquidation restrictions and instead provided its own, lower, discounts, which the court generally favored over the plaintiffs’. For lack of control, the court accepted both experts’ approach of comparing a basket of closed-end investment funds’ ratio of share price to pro rata net average value. For the three gift dates at issue, the court accepted discounts of 11.32%, 14.34% and 4.63%, respectively. As for the lack-of-marketability discount, the court found the plaintiffs’ figure was little more than “a guess.” Under the terms of the partnership agreement, any would-be buyer would have to persuade all the partners to admit him or her as a substitute partner—a prospect so uncertain that the partnership interests might as well be incapable of being valued for that purpose, the court said. Still, the court accepted the government’s figure of 12.5%, based on a comparison made by both experts to private placement discounts of stock subject to disposition restrictions of SEC Rule 144
Thomas H. Holman Jr. v. Commissioner, 130 TC no. 12
By Bob Jennings, CPA/CITP, president of Jennings Advisory Group LLC, Clarksville, Ind.