IRS crackdown looms on valuation discounts for FLPs

In recent months, one persistent rumor has circulated in the blogosphere dedicated to estate and gift tax issues. It’s that the IRS is about to eliminate or at least limit the application of discounts related to family limited partnerships and similar structures. Also, BVWire cites a recent article in The New York Times discusses the impending crackdown.

Popular tool: FLPs and their variants are a popular tool to shift significant family wealth from one generation to the next at greatly discounted value. Under a common scenario, the transferor contributes assets to an FLP and then assigns fractional limited partnership interests to the transferees. Provisions in the partnership agreement or the organizational structure may place restrictions on the fractional ownership interest, as far as concerns control, marketability and liquidity, and transferability. If the restrictions stand up to scrutiny, they can translate into significant discounts and gift and estate tax savings.

The IRS has long been concerned over depressed valuations but has had limited success litigating the issue. Recently, representatives from the IRS and the U.S. Treasury said that new regulations limiting the use of valuation discounts would be forthcoming. It’s not clear when this will be or how the language will read. But business valuators fear the worst.

Relevant law: In 1990, Congress enacted Chapter 14 of the Internal Revenue Code, particularly sections 2703 and 2704, to prevent perceived abuses of the system. Section 2704(b), which deals with restrictions affecting the ability of a partnership or corporation to liquidate, is likely to be the focal point of the threatened regulations. It says that, if there is a transfer of an interest in a corporation or partnership to a member of the transferor’s family, and immediately before the transfer the transferor and his family have control of the entity, any “applicable restrictions” are disregarded when determining the value of the transferred interest.

In a 2001 technical advice memorandum (FSA 200143004), which discusses sections 2703 and 2704, the IRS's office of chief counsel explains how the agency may deploy the provisions in a gift tax matter. A digest of FSA 200143004 and the full text of the TAM are available at BVLaw. More on this issue is sure to follow.