Appeals Court Finds in Favor of Taxpayer With Regard to Valuation of Family Limited Partnership Interest
October 23, 2006
In a long-awaited decision, the Fifth Circuit Court of Appeals reversed the decision of the Tax Court and held in favor of the taxpayer with regard to the valuation of gifts of family limited partnership (FLP) interests to various exempt and nonexempt donees. McCord v. Commissioner, Docket No. 03-60700 (5th Cir. August 22, 2006). Notably, the Fifth Circuit agreed with the taxpayer’s expert regarding the valuation of the FLP interests, and upheld the taxpayer’s use of a “defined value” clause limiting the gifts of hard-to value FLP interests to a specified dollar amount.
The Pertinent Facts of the Case
In June 1995, Mr. and Mrs. McCord (who were in their 80s and resided in Louisiana) transferred a large portion of their assets consisting of cash, and other business and investment assets to a newly-formed Texas limited partnership in return for 100 percent of the Class-A limited partnership interests and a portion of the Class-B limited partnership interests representing just over 82 percent of the value of the partnership. In addition, their four children contributed cash to the partnership in return for all of the general partnership interests, and another partnership formed by the children contributed business and other investment assets in return for the remaining Class-B limited partnership interests. On formation, as well as on the date of the gifts in question, the assets of the partnership consisted primarily of marketable securities and interests in real estate partnerships.
Nearly six months after forming the partnership and having donated all of their Class-A limited partnership interests to charity, the McCords gifted all of their remaining Class-B limited partnership interests. Under the terms of the defined value formula clause contained in the Assignment Agreement, the children and the trusts were to receive portions of the gifted interest having an aggregate fair market value of $6,910,933; if the fair market value of the gifted interest exceeded $6,910,933, then the local symphony was to receive a portion of the gifted interest having a fair market value equal to such excess, up to $134,000; and, if any portion of the gifted interest remained after the allocations to the children, trusts and symphony, then a community foundation was to receive that remaining portion. The Assignment Agreement further specified that the value of limited partnership interests was to be based on the fair market value as of the date of assignment (i.e., under a willing buyer-willing seller test), and that any dispute with respect to the allocation of the assigned partnership interests would be resolved by binding arbitration. The Assignment Agreement also specified that the nonexempt donees (i.e., the children and the trusts) would be liable for all transfer taxes imposed on the McCords as a result of the gifted interest.
Approximately one month later, the McCord children obtained an appraisal of the transferred partnership interests as of the date of gift, which applied an overall combined minority interest and lack of marketability discount of 32 percent. Based on this valuation, the children and the charities (who were each represented by independent counsel) entered into a Confirmation Agreement, setting forth the respective ownership percentages of each donee based on the value of the gifted interests as determined by the appraisal. Three months later, the partnership exercised its call right under the partnership agreement to redeem the charities’ partnership interests based on an updated appraisal which reflected a slight increase in value.
The McCords timely filed a federal gift tax return, reporting the value of the gifted partnership interests based on the appraisal as of the date of gift. The reported value of the gifted interests was further reduced by the transfer taxes assumed by the nonexempt donees pursuant to the Assignment Agreement (i.e., gift taxes resulting from the transfer, as well as the actuarially determined present value of the additional estate taxes that could potentially be incurred if the McCords died within three years of making the gift, which would have caused the gift taxes paid to be added back into their estate). The IRS issued a deficiency notice, contending that the valuation discounts claimed by the taxpayers were excessive and that the value of the gifted interests was almost double the appraised value. In addition, the IRS argued that the gift could not be reduced by the present value of the additional estate taxes that potentially could be attributable to the transaction.
The McCords filed a petition in the Tax Court challenging the deficiency, contending that, in the event the value of the gifted partnership interest was redetermined, any increase in value shifted to the charitable donees by operation of the defined value formula clause in the Assignment Agreement, which would result in a corresponding increase in their charitable gift tax deduction and no additional gift tax due. The IRS claimed the formula clause was designed to neutralize the effect of any upward adjustment in value of the gifted interest and was therefore void as against public policy. Ultimately, the Tax Court split the difference between the McCords’ appraiser and the IRS valuation expert with regard to the value of the gifted partnership interest, but disregarded the defined value formula clause and held the donees to their respective ownership percentages as set forth in the post-gift Confirmation Agreement. The Court further determined that the contingent estate liability assumed by the donees was too speculative and could not be considered to reduce the value of the gifts.
On appeal, the Fifth Circuit reversed the Tax Court based on its finding that the wording of the Assignment Agreement was clear and that the Tax Court had erroneously allowed its “olfaction [i.e., smell test] to displace sound legal reasoning and adherence to the rule of law.” The Fifth Circuit upheld the taxpayer’s use of the defined value formula clause and agreed with the value of the gifted interest as reported on the gift tax return. The Court further determined that the present value of the obligation assumed by the donees to pay potential additional estate tax liability related to the transfer was not too speculative and properly reduced the value of the gifts as reported.
Interestingly, despite the fact that it took over two years for the Fifth Circuit to issue its opinion in this case, the Court did not rule on the public policy argument originally asserted by the IRS at trial due to the Court’s determination that the Commissioner did not assert this argument in its brief, and therefore waived the argument on appeal. Although the decision is a clear victory for the taxpayer in a family limited partnership case, many practitioners are disappointed that the Court did not address the public policy argument since this is typically what the IRS relies upon in challenging defined value formula clauses. Regardless, this is a seminal case in that it recognizes and upholds a defined value clause so as to limit the taxpayer’s additional gift tax exposure in the event that the value of the gift is redetermined. Although this type of clause has long been used by practitioners with regard to gifts of limited partnership interests and other hard-to-value assets, it has previously been viewed as abusive by the IRS and some courts.
In this case, the Fifth Circuit placed importance on the fact that an unrelated, third party (i.e., charity) was involved in the transaction, who was represented by independent counsel and could have challenged the value of the amounts passing to it under the Assignment Agreement (which was subsequently redeemed by the partnership pursuant to its call right). Another key feature of the defined value clause in this case was that the excess value did not revert back to the donor and instead passed to charity. Given the Fifth Circuit’s decision in McCord, it is likely that defined value formula clauses will be utilized more successfully by taxpayers in the future as a technique to limit their additional gift tax exposure when transferring limited partnership and other closely-held business interests, real estate and other hard-to-value assets.
For more information, e-mail Melinda Merk at melinda.merk@hklaw.com or call toll free, 1-888-688-8500.