Expert Opinion

Valuation Discounts for FLPs and LLCs, and Use of Appraisers in Transfer Tax Matters.

Excerpts from Stacy Eastland & Shannon Pratt Interviews

Over the past year or so, those subscribing to Shannon Pratt's excellent Business Valuation-Update newsletter have been treated to a number of outstanding lecturers/practitioners in the transfer tax & business appraisal fields; namely, Owen Fiore, and Stacy Eastland, prominent tax attorneys.

They have been interviewed on the subjects of valuation discounts, particularly those for Family Limited Partnerships ("FLPs"), and on use of appraisal experts in transfer tax matters.

Here are excerpts of a Stacy Eastland interview by Shannon Pratt, covering the sizeable discounts being taken in valuing FLPs. Likely, the following discount-related remarks could apply to other entities, like LLCs, similarly structured as to limited transferability of interests.

Stacy Eastland and Shannon Pratt Interview Regarding Family Limited Partnerships:

SP: I've often heard you mention the concept of an "assignee". What does that mean?

SE: The partnership can be set up so that the limited partners are prohibited from withdrawing before the partnership dissolves and liquidates, and if any general partner tries to withdraw before the end of the term, his or her general-partnership interest will be converted to a limited-partnership interest.

Then make it so that any transferee of a partnership interest, unless admitted to the partnership as a partner by the unanimous consent of the existing partners, has no right other than succeeding to the distributive share of the transferring partner; in other words, assuming the transferee is not admitted as a partner, he or she will be a mere "assignee" with no management rights, withdrawal rights, or even rights to inspect books and records.

I always ask my valuation experts to recognize and reflect on the fact that the hypothetical buyer will recognize the fact that he is only entitled to an assignee interest.

SP: What are the implications of this "assignee" provision?

SE: From a business purpose point of view, it would discourage ownership by a party that others would consider undesirable. From a valuation viewpoint, you're the expert, but I would think it would tend to exacerbate the discount for lack of marketability.

SP: So what is the implication for the value of the partnership interest transferred?

SE: In general, a partner's interest in a limited partnership is worth much less than its share of the partnership's "liquidation value" if the partner does not have the unilateral right to liquidate his or her interest. Tax case law supports the positions that minority and marketability discounts are applicable, as shown by the market. Either the income approach or the market approach to value generally will support a substantial discount compared to the liquidation value of the underlying assets.

SP: How great might this difference be?

SE: In situations where a taxpayer does not have unilateral liquidation control of a family partnership, depending on the partnership's distribution cash flow, courts have found that the taxpayer's interest in the partnership may have a value as much as 40 to 85% lower than if a hypothetical willing buyer had liquidation control. For analysis of valuation factors relevant for partnership interests, I suggest seeing IRS's Valuation Guide for Income, Estate and Gift Taxes - Valuation Training for Appeals Officers, pp. 9-1 to 9-51 (CCH Federal Estate and Gift Tax Reports, Number 239, January 28, 1994, available from CCH (800) 248-3248, $25).

SP: Can you give us a specific example where the discount from net asset value was as high as 85%?

SE: Sure. A good example is Estate of Watts v. Commissioner¹, in which I think you testified for the taxpayer. Although decedent had full dissolution rights during her life, the court reasoned that an assignee would assume the partnership would continue. The court said, "the property to be valued for estate-tax purposes is that which the decedent actually transfers at this death, rather that the interest held by the decedent before death."

SP: I would say that the consultant performing an FLP valuation would need to study the partnership law in the state of registration and take it into consideration in the valuation, especially in quantifying the discount for lack of marketability.

SE: Absolutely. I like to see the valuation report make specific reference to the relevant state law.

SP: What is the most important characteristic of the partnership that distinguishes it from direct ownership of the assets?

SE: Lack of free transferability. This also distinguishes a partnership interest from a stock interest. The essence of partnership law is that partners get to pick who their partners are. Both the articles of partnership and state partnership laws inhibit transferability. This means that discounts for lack of marketability are much greater than for direct fractional ownership of assets.

SP: You compared the partnerships with "fractional ownership" of assets. Could you explain to our readers how the minority interest factor fits in?

SE: My experience is that, if you start with net asset value, business valuers like yourself like to separate the discount into two stages:

• Discount for lack of marketability
• Discount for minority interest.

These discounts are usually taken consecutively. For example:

Net asset value	$100
Minority interest discount, 30%	-30
Publicly tradable minority value	$ 70
Marketability discount, 40%	-28
Net minority nonmarkebable value	$ 42

SP: You mentioned support data. From your experience working with the IRS, what is your advice regarding supporting data to quantify your discounts?

SE: The IRS heavily favors the market approach for gift and estate tax valuations. You generally will be most successful if you lean heavily on your "guideline company" method. (See Valuing a Business, 3^rd edition, Chapter 10.) Use guideline companies that are as close as possible to your subject in terms of their characteristics, such as asset composition, degree of leverage, concentration or dispersion of holdings and so forth.

SP: I've seen some valuation reports that cited past cases as support for their level of discounts. Is that a good idea?

SE: Absolutely not. Every company and every report has to stand on its own with its own data. You should be familiar with the relevant case law, and use it for guidance on the court's positions on issues, but not for quantification of market variables such as value multiples and discounts.

Note:

1: 823 F 2^nd 483 (11^th Cir. 1987), aff'g. 51 T.C.M. 60.

Coming Next Column

OK. Now we know that two leading practitioners believe that some hefty discounts should likely be taken under appropriate circumstances. Next time, we'll hear from Shannon Pratt & from Owen Fiore, another distinguished tax practitioner & lecturer, on how the attorney & the appraiser must "partner-up" regarding the needed entity characteristics & objective, market-based support & fact patterns that call for these sizeable valuation discounts.

Ralph E. Ostermueller, CPA, ASA, ABV, CBA, CFE, MAE, is a St. Louis-based Business Valuer & Economic Expert Witness. He is regularly retained in U.S. Federal, State(s), Tax, Probate & Bankruptcy Court-related matters, and has given testimony in economic damages disputes in the Canadian Supreme Courts. For business valuation matters, he serves as external counsel to CPA firms & as an independent arbiter. He is the Managing Member of The Ostermueller Group, LLC.