Originally Published on September 19, 2003

The United States Tax Court has issued a decision that discusses the use of minority and marketability discounts in Family Limited Partnerships.  The decision reaffirms the use of this planning tool to achieve significant tax savings.

Family Limited Partnerships are a sophisticated planning tool that, in the right circumstances, can help clients achieve their estate planning goals.  Limiting death tax costs is frequently an important client goal.  One of the key ways to achieve tax savings is for a client to give away assets during his or her lifetime to ensure they will not be included in the client's estate at death.  However, there are tax limitations on how much a parent or other individual can give to children or others and the donor generally loses control over donated property once a gift is made.  The Family Limited Partnership helps solve these problems by providing a way for a senior family member to make completed gifts to children or grandchildren at reduced values, while retaining operating control over the donated assets. 

A Family Limited Partnership is a limited partnership where all of the partners are family members or family trusts.  With a limited partnership, the "general partner(s)" have pretty much complete control over the management of the partnership and its assets.  The "limited partners" are basically passive investors who have no say over the day-to-day management of the affairs of the partnership.  This means that a family limited partnership with a parent as a 1% general partner and children as the 99% limited partners effectively gives the parent complete control of the partnership and its assets, even though the parent owns only 1% of the partnership. 

The partnership form also helps protect the gifted assets from a child's bad marriage or other creditor or liability problems.  And, as a big bonus, Family Limited Partnerships can also be used to achieve significant gift tax and/or death tax savings.  The recently reported Tax Court case of Lappo v. Commissioner of Internal Revenue (decided on September 3, 2003 ) shows how this device is used to save gift and estate taxes.

Clarrisa Lappo owned over $1.3 million in marketable securities in addition to real estate worth over $1.8 million.  She wanted to remove these assets from her taxable estate.  To do so, Clarissa and her daughter Clarajane formed the Lappo Family Limited Partnership.  Initially, Clarissa owned 99.7% of the partnership interests.  She then transferred ownership of her marketable securities and real estate to the partnership.  Then Clarissa gave almost all of her interests in the partnership away to Clarajane and her children; but Clarissa kept a 1% general partnership interest for herself so that she remained the controlling general partner.

Although the assets which Clarissa conveyed to the partnership were worth over $3.1 million, and Clarissa gave 99% of the partnership interests away, she filed a gift tax return that claimed that the value of her gifts of partnership interests to her daughter and grandchildren was only $1.5 million.  Clarissa claimed that this reduction in value was appropriate because of minority interest and marketability discounts that apply to limited partnerships.

Clarissa was claiming that the value of her interest in the partnership was worth a lot less than the real estate and securities were worth when she owned them outright the day before.  This "discount" was a result of the fact that her interests in the partnership were not readily transferable ("marketable") and were classified as a "minority" interest.  In effect, Clarissa was arguing that a reasonable buyer would not be willing to pay full value (based on the value of the assets owned by the partnership) for a non-controlling interest in a business entity that carries a number of restrictions, and that cannot be readily re-sold.

The IRS frequently contests cases involving what it perceives as overly aggressive discounting of limited partnership interests.  But, the Tax Court has upheld the concept of discounts and as a result, the IRS has been forced to accept it.  Recently, the IRS has been accepting 25% discounts as being reasonable where marketable securities or cash are involved, 25-40% discounts with real estate, and even higher discounts where an active business is involved.  In Clarissa's case, it agreed that minority and marketability discounts should be applied to her interests in the Lappo Family Limited Partnership, but it disputed the amount of Clarissa's claimed discount of approximately 50%. 

After hearing the testimony of various experts, the court concluded that the value of Clarissa's interest in the partnership was worth less than the value of her interest in the assets when she owned them outright, but not by 50%.  It applied a combination of minority and marketability discounts that totaled approximately 35.4% in determining the value of the gifts of the partnership interests she made.  Although the 35.4% was somewhat less than the discount Clarissa had originally claimed, it still provided her with significant tax savings.  Clarissa was able to reduce the taxable value of her gifts by 35.4% (over a million dollar reduction) by using the family limited partnership.  And, she retained control. 

Of course, Family Limited Partnerships involve some disadvantages as well as benefits.  The disadvantages include the cost of establishing and maintaining the entity. This is complicated work, and legal fees can be expensive.  There may also be appraisal costs involved in establishing the values of the assets and costs for preparing the annual income tax returns that will be required for the partnership. Pennsylvania also levies a realty transfer tax that can apply to real estate placed in a Family Limited Partnership, although there are exceptions to this tax, including one for family farms.  

Like most estate planning tools, this planning vehicle may make a lot of sense depending upon the particular situation.  This recent case, Lappo v. Commissioner of Internal Revenue, T.C. Memo 2003-258, is just further evidence of how effective it can be.  The case is available on the internet at http://www.ustaxcourt.gov/InOpHistoric/Lappo2.TCM.WPD.pdf