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Friday, November 28, 2008

Discount Wars, Part I

The Family Limited Partnership ("FLP") is often used to transfer interests to family members on a "discounted" basis, thereby lowering or sometimes even eliminating transfer taxes. The idea is to use a "discount" so that the value of the property appears to appraisers -- and therefore on your tax form -- to be much less than the underlying asset actually is.

Here is an example: Suppose you have 10,000 shares of IBM, and you wanted to give it to your children. If the stock is now worth $10 per share, and if you have no lifetime gift tax exemption left (which is currently $1 million for your life) and if you are single (i.e., you could not split gifts with your spouse), the amount subject to taxes would be $88,000 because you also have available an annual gift tax exclusion of $12,000. Therefore, the $100,000 gift minus the $12,000 yearly exemption equals $88,000. You would use this $88,000 figure as our taxable base in figuring out the tax.

Assume that you form a FLP and then transfer the $100,000 into that partnership. Ultimately it is your desire to give away $100,000 in limited partnership interests to your children instead of the stock. Clearly, a willing buyer might want to purchase the stock directly from you for the $100,000. But the FLP interest is a different story.

In fact, no one would ever pay $100,000 for the FLP interests from your children. First, because it is a limited partnership interest, FLP interests are not controlling interests. A limited partner (by definition) cannot exercise authority in changing investments, buying, selling, etc. Lack of control is an aspect of being a "limited" partner.

Second, there is no market for an FLP interest. Sure, there is a BIG market for the underlying shares of IBM - it is called the New York Stock Exchange. But, there is absolutely no market for the FLP shares. Therefore, an appraiser would discount the value of the FLP interests for lack of control (i.e., a "control discount") and for lack of marketability (i.e., a "marketability discount") to an amount less than the $100,000. In fact, the discount would probably be substantial.

An appraiser might say, for example, that the FLP interests have a fair market value of $60,000 even though the underlying stock is worth $100,000 - a 40% discount. The reasoning is simple: A willing buyer would be willing to pay only that smaller amount to purchase the FLP interest, even though the underlying stock is worth more. Therefore, if you gave away the FLP interest instead of the stock, the gift would be substantially smaller because the fair market value of the FLP interest is smaller. Assuming that the FLP interest has a fair market value of $60,000, subtracting the the annual $12,000 exclusion would mean that the taxable base is now $48,000 instead of $88,000 if you just gave away the stock.

That's pretty cute, isn't it? But as you can imagine the IRS doesn't think so, and has been fighting this technique "tooth and nail" in the Tax Court,seeking to keep the money in the donor's estate as a retained interest. I will address how they are fighting this in the Tax Court in a later post. Their weapon: IRC §2036(a).

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