Expert Opinion

By:

Ralph Ostermueller

CPA, ASA, ABV, CBA, CFE, MAE

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

Excerpts from Owen Fiore & Shannon Pratt Interview

Last time, we heard from Stacy Eastland and Shannon Pratt regarding some rather sizeable discounts (40%-85%) from net asset value of property held in Family Limited Partnerships and in similarly structured entities (e.g., LLCs), for transfer tax purposes.

Now, let's look in on another recent Shannon Pratt interview (originally reported in Shannon's Business Valuation Update). This time it's with attorney Owen Fiore, one of today's top lecturer/authors on transfer taxation and related issues, discussing the need for tax attorneys and appraisers to "partner-up" in effectively structuring entities & transactions for which the level of discounts suggested by Stacy Eastland are likely appropriate:

SP: Owen, I heard you say recently, "The IRS has adopted the 'hyena pack' approach to transfer tax audits and tax litigation," believing there is tax abuse in the FLP area. What do you mean by that?

OF: IRS National Office technical and litigation personnel, as well as field personnel, like a pack of animals in a frenzy, are attacking transfers involving family members, especially where a family limited partnership is involved. It's clear from my Schauerhamer case, as well as cases recently handled by Stacy Eastland in Texas, that the IRS is trying every possible way to destroy entity viability, especially Family Limited Partnerships (FLP's), directly or indirectly. This is the case in spite of clear state and federal tax law to the contrary.

SP: How do they think they can do that?

OF: The service is taking the position that the partnership entity should be ignored in many fact patterns, such as FLP formation and gifting of partnership interests shortly prior to a donor's death. That is, ignore the fact that the property actually being transferred is a partnership interest, and just value the underlying assets as if direct ownership of the underlying assets is what is being transferred.

SP: Is their position articulated in writing where our readers can see exactly what they're saying?

OF: Absolutely. There are the IRS' briefs in the Schauerhamer case, and they've issued two Tax Advice Memoranda.

SP: Do you think the IRS' position will prevail?

OF: No, not ultimately. The Service's position that is termed "the partnership wrapper should be ignored" flies straight in the face of a person's constitutional right to deal with his or her property as the person sees fit, where such action is within legal alternatives. Long ago, in Gregory v. Helvering, 293 U.S. 465 (1935), it was established that tax avoidance by legal means is permissible and, more recently, in Estate of Frank, T. C. Memo, 1995-132, the Tax Court rejected IRS challenge of gifts shortly before death as being tax avoidance motivated. In addition, as to FLPs, we should remember that Congress, as part of the Revenue Act of 1951, over 45 years ago, provided a "safe harbor" for FLPs as an income tax savings technique with no requirement for "business purpose," clearly recognizing that partnership interests can be owned as the result of gift transfers.

SP: Does all the furor mean that you've suspended recommending FLPs to your clients?

OF: Not al all. I believe that FLP's and also LLCs, can be ideal wealth-preservation vehicles. But if the client is not willing to invest the requisite time and money to set up the partnership or LLC correctly, don't be surprised if the IRS comes along and upsets the applecart. The key to success is careful analysis in planning situations, development of a valid multipurpose partnership entity, complete documentation and operational follow up. And, of course, the business valuation appraiser is a necessary team player.

SP: So what is involved in setting it up correctly?

OF: The essential concept is to have a valid entity to split up the ownership for a purpose or purposes other than solely for tax avoidance. Setting it up properly requires a working partnership between the attorney and a well-qualified appraiser who is knowledgeable about transfer-tax valuations for FLPs from the outset.

SP: Let's pause for a moment on non-tax reasons for these family entities. What reasons would you normally think would qualify?

OF: There are lots of good reasons that have substance. For example:

• Sharing the equity on one basis and concentrating the management and control on another basis
• Protection of assets against outside creditors
• Avoidance of liability for limited partnership interests and LLC members. Having an LLC as a general partner in a FLP also avoids the personal liability of a general partner.

The non-tax reasons should be spelled out in the partnership agreement and have real substance.

SP: Can you elaborate on the concept of the attorney/appraiser partnership?

OF: The appraiser needs to be a consulting expert at the time of structuring the entity and the gifts. The appraiser will opine on valuation implications of various structural features and provisions, but these opinions necessarily are based on legal assumptions provided by the attorney.

SP: What are the relevant legal assumptions that the appraiser needs to glean from the attorney?

OF: The most critical is the tax lawyer's opinion as to what property is being transferred - is it assets, partnership interests, assignee interrests or what? The attorney needs to opine that the partnership or LLC will be recognized as an entity both under state law and also for tax law purposes.

The attorney needs to provide the appraiser the fundamental interpretation of the relevant state law and tax law, and an analysis of the partnership or LLC agreement previsions. Thus, now IRC Sec. 2703 needs to be factored into the analysis by competent tax counsel. The appraiser absolutely must know what assumptions in these respects the valuation opinion will be based on.

SP: Then what is the appraiser's role in this process?

OF: Based on the assumptions provided by the attorney, the appraiser will develop a full report that is reasonable, well documented, and can be used in tax litigation. This requires, of course, an understanding between the attorney and the appraiser as to Federal Rules of Evidence and Tax Court Rules respecting experts' reports and testimony, as well as issues on attorney-client privilege.

You should look at it as if any potential tax litigation begins with filing the return, and I like to attach the whole appraisal. "The business valuation report should contain within its four corners all the major points, including expanded presentations of the assumptions underlying the report. The report must stand on its own legs, not a letter report with the rest of the material in the work papers. In short, the report should conform to USPAP.

SP: Can you give us a few summary-concluding comments?

OF: There is no requirement that families maximize taxes, as long as what they do is real and done in a legally acceptable way. Discounts of various kinds will be based on state laws regarding the entities as well as tax-law principles, so the partnership between the appraiser and the tax attorney must fully reflect the relevant legal context in the valuation analysis.

There is nothing in the IRS's stepped-up-scrutiny to say that families can't engage in legitimate transactions. However, legal costs will go up, and we won't see the "cookie cutter" entity structures and valuations that have been propounded in some popular seminars.

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.