PROTECTING THE REALITY IN ENTITY-BASED TRANSFER
TAX VALUATION ADJUSTMENTS
OWEN G. FIORE
JOHN F. RAMSBACHER
Owen G. Fiore, JD, CPA, and John F. Ramsbacher, JD, are partners of The Fiore Law
Group LLP, San Jose, California, a firm focusing its practice on estate and financial planning,
entity and valuation strategies and tax litigation for high wealth individuals, closely-held family
businesses and technology founders and executives.
Mr. Fiore is a California State Bar Certified Specialist in Taxation, a Fellow of the
American College of Trust and Estate Counsel, past member and Chair of the Advisory Board
for the NYU Institute on Federal Taxation and currently serves on the Editorial Board for Trusts
and Estates. He also is an Advisory Board member for the CCH Estate and Financial Planning
Group and a regular columnist appearing in the CCH Journal of Practical Estate Planning. Mr.
Fiore is a frequent faculty member for regional and national tax and estate planning programs,
having spoken at conferences sponsored by the California State Bar Taxation Section, AICPA,
the Society of Financial Service Professionals and the California CPA Education Foundation.
Mr. Ramsbacher is a California lawyer who has extensive taxation experience, both in
planning (especially for clients with technology-based wealth) and litigation. He is an Adjunct
Faculty member at the Golden Gate University Masters in Taxation program, and is active in the
California State Bar Taxation Section (2000-2001 Chair, Estate & Gift Tax Committee). Mr.
Ramsbacher is a frequent faculty member for the California Continuing Education of the Bar and
the Taxation Section as well as for various regional and national tax and estate planning
§1.01 Overview and Focus
§1.02 Importance of Entity Reality
 Valuation and Entity Planning
 Tax Court Views
 Valuation Planning Strategies
§1.03 The Mystique of “Fair Market Value”
 Standard Of Value
 “Transferred Interest” Focus And Evidence Of Value
 Valuation Uncertainty
§1.04 IRS National Compliance Program
 IRS Legal Arguments
 Judicial Developments
 Exam and Litigation Issues
 The Harper case
 What’s the Score?
 Impact On Planning
§1.05 Selected Valuation Issues
 “Built-In Gains” Discount
 Valuation Non-Aggregation
 Co-Tenancy Discounts
 Deduction Level Discounts
 Buy-Sell Agreements
 What Is Economic Substance?
§1.06 Application Of Valuation Strategies
 Sales, Loans, Opportunity Shifting
 Sales To Intentionally Defective Grantor Trust.
 Tailoring Planning to Client Situations
 Traditional Client Situations
 Technology Planning: Start-Ups, Options and IPOs
§1.07 Valuation Action Plan
§1.01 OVERVIEW AND FOCUS
Recent enactment of major tax legislation, including changes in the transfer tax system of
gift, estate and generation-skipping transfer taxes1, has had a significant impact on estate and
financial planning at a time when advisor strategic alliances have become quite important in
delivering quality advisory services to clients. The transfer tax valuation area long has been an
issue for planners and in recent years valuation controversies have become common.2
Not only does the Internal Revenue Code3 not contain a definition of “fair market value”
(other than certain “special valuation rules” dealing with specific situations), but also the
applicable Treasury Regulations actually promote uncertainty in valuation by adopting a general
hypothetical willing buyer-willing seller standard of value for transfer tax purposes.4 The 2001
tax law changes as to transfer taxes contain no adverse provisions respecting valuation. In fact,
with the 2002 increases to $1 million in transfer tax exemption equivalents plus the 2001
adjustment to $11,000 for the annual present interest gift tax exclusion, and, as to estate and GST
H.R. 1836, enacted as P.L. 107-16 on June 7, 2001.
Note the early discussion of avoiding estate tax liabilities through valuation adjustments
and entity techniques found in Cooper, “A Voluntary Tax? New Perspectives on
Sophisticated Estate Tax Avoidance”, 77 Columbia Law Review 161 (1977). See an
example of the litigation developments grounded in valuation issues in Porter, “Defending
the Family Limited Partnership: Litigation Perspective”, 59 NYU Inst. On Fed. Tax. Ch 18
References to statutory provisions are to the Internal Revenue Code of 1986, as amended.
Treas. Regs. §25.2512- (gift tax) and §20.2031- (b) (estate tax). See, accepting the fair
market value standard, U.S. v. Cartwright, 411 US 546 (1973).
taxes substantial additional increases in later years, the use of valuation adjustments
(“discounts”) is more beneficial in wealth preservation. Considering and advising clients as to
multi-generation capital allocation is an important practice area for estate and financial planners.
While, as we will see, transfer tax avoidance is a central theme of valuation planning using
various entities, a number of other goals can be achieved, such as income shifting to younger
generation family members, asset protection from outside creditors and non-owner spouses
involved in marital dissolution proceedings, financial education of family members and insuring
“Playing the Valuation Game”, while perhaps inviting Internal Revenue Service (“IRS”)
scrutiny and challenge, seems well-accepted by most tax practitioners, and is seen as a combined
factual and legal challenge.5 In the recent case of J.L. Baird Estate6 , Tax Court Judge Gerber
stated the following:
“The parties in estate tax cases often play a ‘valuation game’ and
advocate high and low values to provide the finder of facts with
limits within which the parties may be satisfied with the final
While it may appear then that the issue is how best to play this valuation game to achieve
optimal results for taxpayers or the IRS, as the case may be, the courts have not been pleased in
many situations with such gamesmanship. In particular, the U.S. Tax Court has expressed serious
concern, such as was stated long ago in Buffalo Tool & Die Mfg. Co.7:
“We are convinced that the valuation issue is capable of resolution
by the parties themselves….The Court may find the evidence of
valuation by one of the parties sufficiently more convincing than
that of the other party, so that the final result will produce a
significant financial defeat for one or the other, rather than a
middle-of-the-road compromise which we suspect each of the
parties expects the Court to reach.”
In view of the current IRS national program focusing on entity-based transfer tax
valuation issues, as will be reviewed in this article, it is appropriate to consider (i) the various
factual and legal issues that are raised in planning situations, (ii) compliance via preparation and
filing of tax returns, and (iii) return examinations which can lead to unresolved disputes resulting
in Appeals consideration and eventually tax litigation. These examination issues range from
determining the specific property interest transferred that is subject to transfer taxation to the
Fiore, “Effective Entity-Based Valuation Discount Plans”, 50 USC Inst. On Fed Tax. Ch.
12 (1998); see also, Fiore, “Ownership Shifting to Realize Family Goals, Including Tax
Savings”, 37 NYU Inst. On Fed. Tax. Ch 38 (1979).
T.C. Memo. 2001-258
74 TC 441(1980); as applied in Wall v. Commissioner, T.C. Memo. 2001-75.
appropriate application of appraisal methodology in arriving at conclusions of value. Central to
current litigation over valuation adjustments are questions relating to the reality of entities,
whether by reason of application of the “special rules of valuation” of Chapter 148 or certain
other principles or arguments, such as “substance governs over form” (economic substance),
“single testamentary transaction” and the like.9
As will be seen from the following discussion, tax practitioners must recognize that
proper legal and tax assumptions must be developed during the planning stage of any entity-
based valuation strategy so as to provide the qualified business valuation appraiser with the
foundation upon which to build solid analysis and conclusions of value for transfer tax purposes
respecting the fractional entity equity interests transferred without adequate monetary
consideration. Therefore, tax practitioners and other advisers must partner with appraisers in
building a defensible valuation position for non-public securities that are transferred within the
family. Appraisal methodology always appears to be in a state of review and development. This
perhaps is due, in part, to the fictional party nature of the transfer tax valuation standard.
The practitioner’s fiduciary duties to his or her client require not only care in the
planning and implementation stages of an estate plan, but also in providing clear communication
to the client as to the risks of IRS audit and challenge. Only by doing this can the client be
expected to make an informed, reasonable risk/reward decision.
I.R.C. §§2701-2704, inclusive
TAM 9842003 (FLP); FSA 200049003 (LLC); FSA 200143004 (S corporation), all
illustrate the National Office-directed attack on pass-through entity use in supporting
transfer tax valuation discounts
Valuation issues in litigation before the Tax Court have become very significant in
number and the dollar amount of transfer tax, and often undervaluation penalty amounts are
involved. Tax Court Judge Laro emphasized this high level of valuation litigation in Estate of
Auker.10 This article focuses on transfer tax valuation issues and practice other than those
relating to I.R.C. §2702 (QPRTs and GRATs), with special emphasis on the IRS national
examination and litigation program on transfer tax valuation and pass-through entities.
§1.02 IMPORTANCE OF ENTITY REALITY
 Valuation and Entity Planning
T.C. Memo. 1998-185, a “market absorption” valuation discount case involving multiple
real estate holdings.
Tax practitioners and estate planners recognize that entity-based valuation
adjustments or “discounts” often are driven to a large extent by the perceived federal
transfer tax savings where multi-generational transfers are part of the plan.11 Also,
popularization of installment sale transactions, including sales to “defective grantor
trusts,” has underscored the interest of clients in valuation-based wealth preservation.
Recent developments in valuation strategic planning point out the mixed factual and legal
nature of the world of transfer tax valuation. The tax lawyer must provide legal and tax
assumptions of value to the qualified business valuation appraiser. Tax practitioners, often
the CPA, also must be sensitive to the importance of operation of the entity-based valuation
plan since both I.R.C. §2036 and economic substance issues on the entity itself deal with
relevant facts in plan operation.
By reason of selected developments reviewed in this article, we now can set forth
practitioner guidelines for action to provide our clients a planning and educational process
that maximizes the reality of the plan and availability of valuation discounts. At the same
time, this process minimizes the opportunity for IRS to successfully challenge entity-driven
valuation discounts, especially through as yet unsuccessful attacks on the legal and tax
viability of entities.
In recent years, the IRS has exhibited its frustration with transfer tax avoidance
using valuation discounts. This is especially evident with the family limited partnership
(“FLP”), which has been given much publicity in Technical Advice Memoranda and other
rulings, as well as in substantial and targeted litigation efforts of the Service to reduce
apparent advantages of the FLP (as well as the limited liability company) as a pass-through
entity with significant savings in federal transfer tax.12
 Tax Court Views
Fortunately, recent decisions of the U.S. Tax Court within the past year or so have
added to the belief of many advisors that IRS attacks on FLP viability will not be successful
in carefully documented, implemented and operated plans. The Tax Court, in a number of
reviewed and thus precedent-setting decisions, has provided guidance that generally is not
favorable to the IRS. For example, in the Strangi opinion,13 the Tax Court in late 2000
See, for example, Fiore, “Effective Entity-Based Valuation Strategies”, fn 5 supra;
also, Fiore & Lion, “Using Valuation Uncertainty in Estate Planning”, 36 USC
Institute on Federal Taxation Ch. 18 (1984).
See, for example, TAM 9842003 and FSA 200049003, as well as the Porter article on
FLP litigation at fn 2 supra.
Estate of Albert Strangi, 115 T.C. 478 (2000), in which the court found state law to be
determinative of FLP reality for tax law purposes, Strangi is on appeal to the 5th
made a strong statement that hopefully will be taken into account by the IRS in its future
audit and litigation initiatives:
“Mere suspicion and speculation about a decedent’s estate
planning and testamentary objectives are not sufficient to
disregard an agreement in the absence of persuasive evidence
that the agreement is not susceptible of enforcement or would
not be enforced by parties to the agreement. Cf. Estate of Hall
v. Commissioner, 92 T.C. 312, 325 (1989)”.14
Tax Court Judge Laro recently put the issue this way in considering the
fundamentally uncertain area of valuation, especially in reference to valuation
methodology, which is considered by the court to be a factual issue:
“Despite the subjectivity
surrounding the issue of valuation,
we continually strive to measure
value precisely and objectively.”15
 Valuation Planning Strategies
As will be obvious from the discussion in this article, transfer tax “fair market
value,” when applied to non-public equity interests in entities, is a mixed question of fact
and law. While the Tax Court has upheld the principle that state law establishes contract
and other property rights, the court has not been willing to accept questionable valuation
methodologies or unreasonable legal assumptions in determining value. Further, certain
legal issues continue to cause problems for taxpayers, as discussed below.
Thus, it appears that practitioners must continue to deal with the legal and tax
issues which have been raised as to the viability of entities and techniques for transfer tax
purposes, as well as with the evidence necessary to uphold asserted levels of valuation
adjustments or discounts. This article reviews selected recent developments and issues
relating to IRS challenges in the context of the use of the FLP and/or the LLC. Then
guidelines for action are suggested to assist practitioners to respond effectively to our
clients’ desires for maximum wealth preservation, minimum transfer taxation and
maximum retained control.
Even with major (perhaps short-lived) transfer tax reform, our family wealth
planning efforts should proceed for non-tax as well as tax reasons. Wealth preservation
and management is the key. There are multiple reasons for entity structures, a number of
which are non-tax in nature. So here we will consider tax issues and entity reality, all the
while recognizing the right of taxpayers to reduce tax liabilities within the existing transfer
Judge David Laro, “Valuation Issues: A Judicial Perspective”, presented on January
18, 2001, at the Advanced Estate Planning Institute sponsored by the Education
Foundation of the California Society of CPAs.
First, the article reviews briefly the essential transfer tax valuation principles that
should be taken into account in planning for a multi-purpose, tax effective entity program.
Next, a summary is presented of judicial responses to IRS legal arguments attacking entity
viability and transactional reality. Finally, given the generally favorable outlook for
FLP/LLC programs following a number of court decisions, we consider the remaining risk
factors and how tax practitioners can deal with them through a process requiring full
involvement, understanding and cooperation of our clients. The conclusion is obvious, in
the author’s view: Carefully designed, documented and implemented entity structures not
only are viable for transfer tax purposes, but also should be recommended proactively to
our clients as part of an Integrated Family Wealth Plan that considers multiple goals of
§1.03 THE MYSTIQUE OF “FAIR MARKET VALUE”
 Standard Of Value
Even though many provisions of the Code refer to or deal with “value” or “fair
market value,”17 no one statutory source provides taxpayers with the definition and scope
of these terms for federal estate and gift tax purposes.18 Our focus here, of course, is on
valuation of non-public securities, in particular, FLP and LLC equity interests, where
there are no truly comparable, arms-length sales at or near the valuation date.
Therefore, where equity interests in closely held corporations, non-public
partnerships or limited liability companies, or even co-tenancy interests in real property,
are involved, the primary authority on valuation of such interests are long-standing
Treasury Regulations together with a rather antiquated Revenue Ruling.19 Such IRS
authorities seek to set an objective, “hypothetical party” standard of value; however, over
the years, in practice this standard has become one of fiction, the “battle of the experts”
and clearly recognition of the practical reality of uncertainty.20
The author prefers “Family Wealth Planning” as being more inclusive and descriptive
of the process traditionally referred to as “estate planning.”
The previously cited Treas. Regs. define fair market value, and further guidance is found in
Rev. Ruls. 59-60, 1959-1 C.B. 237, and 93-12, 1993-1 C.B. 202.
See, for example, Judge Laro’s discussion in Estate of Auker, T.C. Memo. 1998-185,
which is a “market absorption” discount case involving real estate.
Treas. Regs. 25.25 12- (gift tax): Treas. Regs. 20.2031 (estate tax); Rev. Rul. 59-60, 59-1
Representative of the uncertainty in the factual determination of value when
considered by the Tax Court, as the trier of fact at trial, is the 1997 FLP case of Estate
of Lehmann, T.C. Memo. 1997-392; also, as the article discusses, recent cases, such as
 “Transferred Interest” Focus And Evidence Of Value
Shepherd, Strangi, Knight and Jones, clearly evidence uncertainty both on factual
issues and legal assumptions of value. IRS recently issued (September, 2001) Business
Valuation Guidelines, including a valuation report checklist, that evidence a
concentrated effort to upgrade Service use of appraisers in countering valuation
discount evidence provided by taxpayer appraisers. See also the Engineering Program
Handbook (IRM 4.3.16).
The nature of the federal transfer tax system (gift, estate and GST taxes) is that, as
an excise tax, it is triggered by the transfer of property without adequate consideration.21
Both “transfer” and “property” are significant terms here, and we can appreciate that
readily marketable property (e.g. cash, marketable securities, and fee interests in real
estate), contributed on a tax-deferred basis to an entity,22 sets the stage for valuation
adjustments (or so-called “discounts”) where there are gratuitous or testamentary
transfers of the fractionalized entity equity or real estate interests.
Key to valuation strategic planning is the absence of “family attribution.” Thus, as
was finally confirmed by the Internal Revenue Service (after numerous defeats in court),23
the family relationship among donors and donees in and of itself will not prevent valuation
discounts for fractional, minority or non-controlling equity interests. Nevertheless, as we’ll
see in our discussion here, the Service, since issuance of Rev. Rul 93-12, has advanced
through audit and litigation initiatives a number of arguments challenging allegedly
abusive transfer tax valuation discounts. Of course, we all recognize that valuation experts
will differ, and the Tax Court regularly points out that it is the court’s role as trier of fact
to make the ultimate factual determination of value.24 Beyond the evidence of value, given
taxpayers’ usual ability to fund support of adequate valuation reports, the Service
U.S. v. Land, 303 F.2d 170 (5th Cir. 1962); McLendon v. Comm’r, 77 F.3d 447 (5th Cir.
1996); Estate of McClatchy, 106 T.C. 206 (1996), reversed, 147 F.3d 1098 (9th Cir. 1998)
and most recently, Estate of Strangi, 115 T.C. 478 (2000).
See, Code § 721(b), as to partnerships and LLCs taxed as partnerships.
Rev. Rul 93-12, 93-1 C.B. 202; TAM 9432001.
See, for example, Lehmann, supra, at fn 20.
(especially in the FLP area) in recent years has promoted a number of legal issues in an
obvious effort to thwart use of FLPs and other “pass-through” entities (LLCs and S
corporations included) as a “wrapper” for the purpose of creating a valuation discount
plan.25 In the context of the FLP and LLC program, we’ll now review the IRS arguments
and relevant judicial decisions, to catalog how the IRS has fared in its litigation efforts to
 Valuation Uncertainty.
TAM 9842003; see Fiore, “Planning, Operating & Defending FLP/FLLC-Based
Entities Spawning Valuation Discounts”, 24 ACTEC Notes, 35 (1998); and Fiore,
“Coping with Continuing Uncertainty in FLP/LLC-Based Valuation Discount
Strategies”, 27 ACTEC Journal 220 (2001).
Much of the uncertainty over transfer tax valuation arises out of the fictitious “fair market
value” standard of value. The Tax Court, while stating in its Standing Pretrial Order that
valuation cases are especially susceptible of settlement before trial, nevertheless often is willing
to substitute its own judgment, as trier of fact, for the opinions of valuation appraisers for the
The 9th Circuit and 5th Circuit Courts of Appeals, however, recently have reversed the
Tax Court on transfer tax valuation.27 Perhaps this sends a signal to the Tax Court that more
care is required on the part of the trial court in developing its own valuation conclusions,
especially as to application of the hypothetical party standard of value.
Over the years, the Tax Court has developed its approach to expert testimony of
valuation appraisers that, while suggesting guidelines for taxpayers and IRS, actually appeared
Wall v. Commissioner, fn 7, supra.
Morrissey et al v. Commissioner, 243 F.3d 1145 (9th Cir. 2001), Estate of Mitchell v.
Commissioner, 250 F.3d 696 (9th Cir. May 2, 2001), and Estate of Simplot v.
Commissioner, 249 F.3d 1191 (9th Cir. May 14, 2001).
to add to the uncertainty of result in valuation cases.28 Perhaps this is due to the factually nature
of specific valuation cases. Three recent 9th Circuit reversals of the Tax Court remind
practitioners of the inherent complexities of the fictional transfer tax standard of value. First, the
Tax Court’s rejection in Kaufman of actual sales of the stock being valued 29 was criticized in
Morrissey where the 9th Circuit ruled that the Tax Court failed to follow the hypothetical party
standard of value and erroneously rejected the actual sales evidence.
Buffalo Tool & Die Mfg. Co., 74 T.C. 441 (1980), Mandelbaum v. Comm’r, T.C. Memo.
1995-255, Lehmann, supra at fn 20, Borgatello, T.C. Memo. 2002-262.
T.C. Memo. 1999-119.
Next, in Mitchell, the 9th Circuit reversed the Tax Court on the basis of the trial court’s
failure to explain in detail how its concluded valuation discount was determined.30 Then in
Simplot, again reversing the Tax Court,31 the appellate court pointed to three errors of law,
namely, (1) departing from the “objective value standard” of the hypothetical willing buyer-
seller transaction involved in the transfer tax, (2) proportionately applying a control premium to
the estate’s minority interest in voting stock based upon a premium applied to all the voting
stock, and (3) failing to show that a purchaser even of all the voting stock would be able to use
control to increased economic advantage.
The Jameson case,32 decided by the 5th Circuit, once again reversed the Tax Court,
essentially for failing to apply the hypothetical party transfer tax valuation standard. The
appellate court determined that the Tax Court (1) erroneously assumed the existence of a
strategic buyer, (2) erred in its preemptory denial of a full discount for built-in, unrealized capital
gains tax liability and (3) also may have erred in disregarding an actual negotiated value sale
between siblings who owned beneficially the stock of the corporation being valued in the estate.
It will be interesting to see if these four valuation case reversals bring about any change
in the Tax Court approach to valuation determinations. Practitioners may be well advised to
have actual sales of equity occur, especially, for example, to key employees having separate
legal representation, to provide a basis for gift or other intra-family transfers. Also, note the
discussion in several of the cases to the effect that the burden of proof on valuation shifts to the
Service if at trial the valuation position is substantially below that set forth in the statutory notice
§ 1.04 IRS NATIONAL COMPLIANCE PROGRAM
Transfer tax valuation deals with the “fair market value” of the specific property interest
transferred, net of any monetary consideration received, as already stated.33 If, therefore,
investment assets, such as cash, marketable securities, and real estate, can be contributed to an
entity valid under state law (usually without triggering income tax on unrealized appreciation), it
has been assumed that entity equity interests thereafter gifted or transferred at death should be
valued as such. The result, based upon accepted valuation methodology applied by a qualified
appraiser, is that the transferred equity interests are valued net of substantial downward
Estate of Paul Mitchell, T.C. Memo. 1997-461. See Also Leonard Pipeline Contractors
v. Comm’r, 142 F.3d 1133 (9th Cir. 1998).
Estate of Richard Simplot v. Comm’r, 112 T.C. 130 (1999).
Jameson v. Commissioner, 267 F.3d 366 (5th Cir. 2001).
Supra, fn 21.
adjustments (“discounts”) from underlying asset value.34 The same “two-step” analysis applies
in valuing equity interests in entities conducting active business operations, with the active
business first valued using one or more of several relevant methodologies.35
For a good general discussion, review Zeydel and Benford “Valuation Principles and Recent
Developments: Practical Guidelines for the Estate Planner”, 25 ACTEC Notes 31 (1999).
Well-respected appraiser Shannon P. Pratt, ASA Accredited Senior Appraiser, authored an
interesting article discussing appraisal methodology issues: “Valuation: an Appraiser’s
Perspective”, 58 NYU Inst. on Fed. Tax. Ch 19 (2000)
The Internal Revenue Service has developed over the past several years a national
compliance program specifically directed toward challenging at audit and through litigation
perceived abuses in use of FLPs, LLCs and even S corporations, all of which are pass-through
entities for income tax purposes. This program, still not published after several years of
implementation and still actively being used, is designed to develop through concentrated
examination effort legal arguments for disregard of entity reality as well as greater use of I.R.C.
§ 203636 the latter attack being one used in estate tax cases. Further, the considerable
uncertainty in the level of valuation discounts, leading to taxpayers and IRS alike “playing the
valuation game”, as described earlier herein, has resulted in greater IRS focus on valuation
 IRS Legal Arguments
Given substantial uncertainty as to acceptance of evidence presented through
business valuation appraiser expert testimony, as well as the greater role of federal courts
as “gatekeepers” in evaluating appraisal evidence,38 it is not surprising that the IRS turned
to “substance over form,” Chapter 14 (Code §§ 2701-2704) and other legal arguments in its
nationally organized campaign against FLP/LLC discounts
Essentially, there have been four IRS attack categories, namely:
Under §2036, an estate tax includibility section, the courts have broad discretion in
determining whether there was an “implied agreement” that a donor would remain in
control, directly or indirectly, of gifted assets until the donor’s death. See Estate of
Reichardt v. Commissioner, 114 T.C. 116 (2000).
See the IRS Business Valuation Standards, including a valuation report checklist, finalized
September, 2001, based upon IRM 4.3.16.
Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 US 579 (1993) and Kumho Tire Co.
v. Carmichael, 526 US 137 (1999).
(i) Constructive gift on entity formation, a step transaction concept merging the
entity’s formation with subsequent equity interest transfers; this approach is
often used when the formalities of entity formation have not been followed or
when there has not been proper funding.
(ii) Lack of reality of the entity based on alleged lack of “business purpose” or
application of a doctrine that “substance governs over form.”
(iii) Defects in operation of the entity, raising the claim that the donor by implied agreem
(iv) Broad application of Chapter 14, specifically Code §§ 2703 and 2704(b),
Through an audit program directed by the National Office, many FLP cases were
subjected to in-depth examination, with those perceived to be most abusive being targeted
for litigation. Since the always present valuation uncertainty also is an issue, some
examiners used the purported legal arguments to develop audit level settlements at lower
valuation discount levels.
Clearly Congress has been reluctant to restrict valuation discount planning.
Therefore, the IRS has turned to the courts for guidance, i.e., support for IRS positions,
and during the past couple of years judicial decisions have finally now been issued,
including several significant reviewed opinions of the Tax Court that together provide
substantial precedent and guidance generally favoring FLPs and similar pass-through
 Judicial Developments
During the recent period of litigation focus on valuation, the always present
arguments over valuation methodologies and expert testimony often to have been pushed
aside in favor of a multi-phased legal attack on FLP viability. So, what is the state of this
IRS attack now in light of recent developments? Fortunately, we can say that, with certain
major exceptions quite susceptible of avoidance through careful planning, the IRS attack
has been rejected by the courts.
First, generally, it appears that IRS excitement and litigation generated over Chapter 14
was unfounded. The Tax Court recently rather clearly rejected the Service’s §2703 and 2704(b)
arguments in several opinions, including Kerr v. Commissioner,39 Knight v. Commissioner,40
113 T.C. 449 (1999), on appeal to 5th Circuit. See also Estate of Harper v. Comm’r, T.C.
115 T.C. 506 (2000).
and Estate of Strangi v. Commissioner.41 Essentially, the special valuation rules of Chapter
14 have been narrowly construed, as they should be, and should not pose any problem to
careful practitioners in planning. The entity formed, funded and operated properly under
state law will be respected for federal transfer tax purposes.
In addition, in both the Strangi and Knight cases, the court underscored that the
hypothetical third party purchaser would not disregard the existence of a valid entity (and
consequently equity transfer restrictions, non-marketability and lack of control of interests
therein). And, after all, that is the standard of value for transfer tax purposes.
See fn 13, above.
Finally, certain other IRS arguments, including that “substance governs over form”
and that the mere formation and funding of an FLP constitutes a taxable gift (so-called
“gift on formation”), have been rejected by these and other recent cases.42 In March 2001,
Judge Cohen, who wrote the Tax Court majority opinion in Strangi, issued a reviewed Tax
Court opinion in Jones v. Commissioner,43 another FLP case. This opinion reiterates the
Tax Court position that there is no gift involved on formation of an FLP, at least where pro
rata capital contributions are involved and are properly documented. However, the
taxpayer did not fare so well on the valuation determination.
It appears therefore that tax practitioners, private and government alike, now
should refocus their efforts on valuation evidence. In the recent Dailey case,44 involving a
marketable securities holding FLP, the Tax Court, not considering either party’s appraiser to be
“extraordinary”, nevertheless accepted the taxpayer’s appraisal evidence supporting a 40%
discount. This case, citing Strangi,45 found that the FLP was validly formed under state law and
thus would not be disregarded for transfer tax purposes. The court also accepted the parties’
stipulation that, under IRC § 7491(a), petitioner had introduced credible evidence on valuation,
and, therefore, respondent IRS had the burden of proof at trial. The testimony of the appraiser
for respondent IRS was dismissed as being “contradictory, unsupported by the data and
inapplicable to the facts” - especially in view of his admission that he “could not recall reviewing
the Partnership Agreement”.
Nevertheless, although many IRS arguments and theories are in a shambles, the IRS still
See discussion in articles cited in fn 2 and 5; also, note Sloan, “Family Business
Succession Planning: Minimizing the Wealth Transfer Tax Through Enhanced and
Leveraged Giving”, 59 NYU Inst. on Fed. Tax. Ch 15 (2001).
116 T.C. No. 121 (2001)
E.M. Dailey Estate, T.C. Memo. 2001-263
See fn 13, above
has valid positions that can be advanced in cases where practitioners and/or their clients have not
followed the proper steps for valid entity creation, funding timing and integrity, or operational
respect for the entity.
This is where we must sound the alarm based upon the cases of Schauerhamer,46
Reichardt,47 and Shepherd.48 The first two of these cases deal with Code § 2036, the Tax Court
finding in both Schauerhamer and Reichardt that there was an “implied agreement” among the
donor and donees that the donor would retain control over and benefits from the transferred
partnership interests (and underlying assets) for the donor’s lifetime. These cases raise a
question about a donor acting as the general partner in a family partnership, even though the tax
law recognizes this is permissible, at least for income tax purposes.49 In Reichardt, Tax Court
Judge Colvin stated, “Decedent’s fiduciary duties [as a general partner and trustee] did not deter
him from continuing to possess and enjoy the house in which he lived or the other assets he
conveyed to the partnership.”50 Therefore, we must educate clients involved in partnerships and
Estate of D. Schauerhamer, T.C. Memo. 1997-242 (the author was taxpayer’s counsel
in the Tax Court proceeding).
C. Reichardt, 114 T.C. 144 (2000).
J. Shephard, 115 T.C. 376 (2000).
Code § 704(e), the family partnership “safe harbor” rule, applied in a gift tax case,
Winkler v. Commissioner, T.C. Memo. 1997-4.
Supra, fn 47.
other entities to maintain complete records, to keep investment assets separate and distinct from
personal assets, and to fully carry out management and other fiduciary duties. Conservative
planning may well call for the donor not to be the sole manager of an entity which holds his or
her contributed assets.
In Shepherd, a general partnership gift tax case, we have an example of defective timing
in the funding of a general partnership. Here the Tax Court majority, with a number of
concurring and dissenting opinions filed, found that the donor made indirect gifts of asset
interests, not gifts of partnership interests. The donor had made the initial asset transfers
concurrently with his execution of a partnership agreement which the children (donees) did not
execute until the following day. The court found that there could be no completed gift on the
first date, that is, on the day only the donor signed the agreement, as there was no donee, and
state law required two or more partners for there to be a valid partnership. Citing the gift tax
Treasury Regulations,51 the court found in substance the donor’s transfers of property to the
entity should be characterized as indirect gifts of undivided property interests (not partnership
interests) to the donee children, citing cases such as Kincaid v. U.S.52 and Estate of Bosca v.
Commissioner.53 Also, note the earlier case of LeFrak v. Commissioner,54 which determined the
gift value of co-tenancy interest transfers even though the plan involved immediate contribution
of the gifted real property interests to a partnership.
Having seen the courts’ rejection of various IRS legal arguments against FLPs,
practitioners and their clients now should concentrate on developing the best possible
evidence of value. This will give us maximum opportunity for avoidance of valuation
disputes altogether or, at a minimum, likely dispute resolution in the taxpayer’s favor at
the examination level, in Appeals or even in U.S. Tax Court.
In recent years, the Tax Court, through its opinions in valuation cases, has provided
basic guidelines for tax advisors and business valuation appraisers on appropriate
valuation methodologies, the evidentiary standards for expert witness opinions and reports,
and the importance of critical analysis of all relevant facts. Tax practitioners must become
fully involved in the valuation process, working cooperatively with valuation professionals.
 Exam and Litigation Issues
The author recently had the opportunity to discuss FLP/LLC and other transfer tax
valuation issues with Chuck Morris, IRS Supervisory Attorney and Territory 5 Estate &
Gift Tax Manager, IRS Small Business & Self-Employed (SBSE) Division. Mr. Morris
provided input on the current status of IRS restructuring as applied to transfer taxes and
Treas. Reg. Sec. 25.2511-1(h)(1).
682 F.2d 1220 (5th Cir. 1982).
T.C. Memo 1998-251.
T.C. Memo 1993-526.
details of the IRS national examination program respecting entity-based valuation
discounts, especially as related to the use of pass-through entities such as family limited
partnerships (FLPs) and limited liability companies (LLCs).
Under the IRS restructuring program, there are 5 estate and gift tax group
territories nationwide, with Territory 5 covering generally the Western United States. As
Territory 5 Manager, Chuck Morris intends to bring focus and consistency of examination
procedures to the various groups within his Territory 5. Presumably, this mission extends
to the other four (4) transfer tax Territories as well.
The national examination, appeals and litigation programs of the Service relating to
FLP/LLC-based valuation discount plans continues in spite of Tax Court decisions such as
Strangi, Knight, and Jones, all discussed in this article. Clearly, the IRS has not given up
on its legal arguments against FLPs and similar entities in those cases where the Service
believes (i) there is no true economic substance,(ii) IRC§2036 may be applicable, or (iii)
there are defects in funding and/or operation of the entity. In the litigation arena, Kerr,55 is
on appeal to the 5th Circuit and briefs have been filed relating to the IRC Sec. 2704(b) and
assignee interest transfer issues. The Service also has appealed Strangi,56 and perhaps will
appeal other cases as well. And, the taxpayer has appealed Estate of Shepherd. 57
Therefore, practitioners cannot expect final judicial resolution of the various issues for
 The Harper case
Then, as further evidence of continuing litigation, note the Estate of Morton Harper
Tax Court trial opening statement of IRS counsel presented at trial on March 23, 2001.
“Your Honor [Ms. Donna Herbert, IRS counsel],
this case concerns what’s perceived by
respondent as a transfer tax shelter, that is, the
family limited partnership .... But regardless of
whose idea it was, the formation of this
partnership enabled the decedent and his
children to claim large discounts on the value of
this portfolio for both gift and estate tax
purposes .... It is undisputed that the decedent
transferred virtually all of his assets into the
partnership .... [H]ow was he going to live? ...[I]t
is the government’s position that the partnership
lacked economic substance in that it had no
113 T.C. 30 (1999)
115 T.C. 478 (2000)
115 T.C. 376 (2000)
business purpose, and because it was created
solely for the purpose of reducing estate and gift
taxes .... [T]he formation of the partnership was
tax avoidance.... Your Honor [in response to
Judge Nims’ question about Strangi], while we
are aware that this division of the Court is bound
by Strangi, we wish to preserve the issue for
appeal. And we believe that essentially the same
record is needed to support the economic
substance argument as the 2036 argument in
The reported case of Estate of Morton Harper,58 was a hearing on taxpayer’s motion
for summary judgment relating to the § 2704(b) issue, which the petitioner-taxpayer won.
The Harper case59 then was tried on 2036, and substance over form issues in March, 2001.
Therefore, it is clear that, even in the new era of H.R. 1836, the IRS will continue its active
and targeted program of FLP/LLC examinations, at least where there are present any or
all of the following: (i) “deathbed” FLP, (ii) entities formed (and transactions, including
gifts and sales occurring) through use of a durable power of attorney, (iii) donor/decedent
retained control, ala 2036 (“implied agreement”), (iv) passive investment entity especially
involving marketable securities, (v) asset transfer, non pro rata cash distributions, (vi)
valuation methodology issues.
 What’s The Score?
Based on the author’s recent examination and litigation experiences, plus
consultations with other tax counsel, what are the issues and who is “winning”? In terms
of indicated IRS litigation initiatives, there appear to be eight (8) areas of dispute at audit,
Appeals and in litigation:
1. “single testamentary transaction”
2. “the partnership wrapper” and application of IRC § 2703
3. “substance over form” or absence of any business purpose
4. disregarding 2704(b) liquidation restrictions
5. set-up and entity funding problems
6. “gift on formation”, IRC § 2511
T.C. Memo. 2000-202
T.C. Docket No. 19336-98
7. the “implied agreement” IRC § 2036 attack in estate tax cases
8. valuation methodology and application disputes
Considering the cases during the period 1999-2001, including Tax Court cases, U.S.
District Court and 5th Circuit Court of Appeals decision and the four recent valuation cases
(not FLP cases) in the 9th and 5th Circuits, all of which are reviewed herein, it appears that -
subject to further developments - the “box score” on the foregoing 8 issues is Taxpayers-5,
IRS-O, “All Depends On The Facts”-3. The technical 2703 and 2704 arguments, as well as
“gift on formation”, “single testamentary transaction” and even “substance over form” or
economic substance probably will not be accepted as of now by the Tax Court and at least some
Where the IRS has had some success is both (i) where there are defects in funding, setup
or operation of the entity (especially as relates to Section 2036), and (ii) in dealing with the
overall uncertainty of valuation evidence either due to legal assumption issues or by reason of
appraiser weaknesses, such as appraiser taking advocacy positions. However, a careful reading
of the earlier referenced Field Service Advice60 proves that IRS intends to present the economic
substance argument with even more force than previously. Thus, practitioners need to consider
the elements of entity and transactional substance or reality necessary to thwart such efforts.
Of interest is a Florida State Bar (Taxation Section) conference, held April 27, 2001,
titled “The Birth and Life After Death of the Family Limited Partnership” 61 The
conference speakers included the IRS Appeals national coordinator on FLP case appeals,
IRS counsel who tried Strangi, Knight and Reichardt, IRS Estate Tax Attorneys active in
developing and implementing the ongoing FLP examination program, and several private
practitioners (including taxpayer’s counsel in Strangi).
 Impact On Planning
We cannot take much comfort in taxpayer victories (or worry about defeats) in
expensive, time-consuming tax litigation. This is especially the case where, as special tax
litigation counsel, the author finds that often the estate planner setting up the FLP/LLC
valuation program has not “followed the rules” and perhaps has not even clearly
communicated with the client the necessary attention to operational details. Also, clients
FSA 200143004, supra at fn 20
This conference was titled “Forming and Funding a FLP”. (Course #4908R, outline
book and audio tapes available: The Florida Bar, 650 Apalachee Parkway,
Tallahassee, FL 32399-2300, telephone: (850) 561-5831). See the proceedings of the
2001 Heckerling Institute on Estate Planning, specifically the Chapter 3 article by
Milford B. Hatcher, Jr., “Planning for Existing FLPs”, identifying important
FLP/LLC operational pitfalls to be avoided. Also, review the previously referenced
excellent analysis by John W. Porter, “Defending the Family Limited Partnership: Litigation
Perspectives”, 59 NYU Inst. on Fed. Tax, Ch. 18 (2001).
and their advisors must evaluate the risks and expenses involved in being subjected to an
in-depth examination of the FLP plan and the valuation discounts spawned by such a plan.
Yet, clearly, there is an “audit lottery” factor to be considered - the IRS cannot audit all
transfer tax returns with FLP/LLC issues, nor does the IRS have the resources to litigate
even all cases considered abusive. Both exam and Appeals regularly settles FLP cases - so
our question is how is our planning affected in entity-based valuation plans?
The client, who is the “CEO” of the estate planning team (or should be), must be
made aware of the standards of design, documentation and operation of the entity in order
to maximize the opportunities with minimum risk. Since as of January 1, 2002, the
applicable exclusion amount for transfer tax purposes rises from $675,000 to $1 million per
person, clearly leveraged gift, sale and other “estate freezing” transactions will be quite
popular, regardless of whether or not the estate and GST taxes reach repeal in 2010 (for 1
year only in any event, unless Congress acts favorably again).
§1.05 SELECTED VALUATION ISSUES
Obviously, FLP/LLC valuation issues are not the only areas of transfer tax
valuation controversy. Therefore, it is important to identify selectively either valuation
issues that are the subject of controversy with IRS, such as “built-in capital gains” impact
on valuation conclusions. The following certainly is not an exhaustive list of valuation
dispute areas; however, this selective review again, as with the FLP/LLC area of
controversy, proves the importance of valuation to tax practitioners and their clients. Also,
this discussion ends with consideration of the economic substance principle as might be
applied to transfer tax cases.
 “Built-In Gains” Discount
If asset value is not important in the determination of fair market value, then the
“built-in gain” discount is not important. However, in the Simplot case,62 the parties
agreed that a substantial block of publicly traded company stock held as an
“nonoperating” asset should be valued net of 100% of the unrealized capital gains tax.
Where an investment holding company is being valued, the built-in gains issues is
quite important. The Service failed in its attack on this discount in Davis,63 and thus
taxpayers can be confident that at least the marketability discount should take into account
built-in, unrealized gains.
However, that does not end the discussion. For example, in Jones,64 as to the §754
election issue and impact on valuation, the Tax Court believed the built-in gains (absent a
754 election) was not worthy of consideration.
112 T.C. 130 (1999), reversed 249 F.3d 1191 (9th Cir. 2001)
110 T.C. 530 (1998), see alsi Eisenberg, 155 F.3d 50 (2nd Cir. 1998), Jameson, T.C. Memo.
1999-43, reversed, 267 F.3d 366 (5th Cir. 2001)
116 T.C. 121 (2001)
The bottom line appears to be that, considering the hypothetical buyer’s
opportunity to purchase assets at full basis, discounts for “inside” or built-in capital gain
are reasonably available.
 Valuation Non-Aggregation
Mellinger65 decided the non-aggregation issue for QTIP trusts and surviving spouse
interests in entities and real Estate. Essentially, since Congress had not determined
aggregation was appropriate for valuation purposes, the includibility result was not
The authors’ firm represents the Estate of Aldo Fontana66 in an effort to apply the
Mellinger rule to a general power of appointment trust situation, arguing the same
principle applies here.
Practitioners need to take into account Mellinger in planning. For example, it
would appear estate planners should at least draft trusts with a contingent disclaimer trust
opportunity for the surviving spouse to take advantage of Mellinger.
 Co-Tenancy Discounts
A most interesting area in valuation is that of co-tenancy property ownership.
While generally a right of partition exists, the impact of such right, and the legal and
practical limitations thereon, on valuation for transfer tax purposes, has been the subject
of much litigation. The hypothetical buyer certainly will take into account time delays,
costs and other issues in acquiring hypothetically a co-tenancy interest.67
Also, the debt issue can be significant. At least for estate tax purposes, where debt
obligations are reported on the 706, Schedule K, per I.R.C. §2053, it seems clear that any
co-tenancy discount is applied to gross asset value, and the debt, without discount, is
reported on Schedule K of the 706, in accordance with, at least as to recourse liability, the
706 instructions and Treasury Regulations.68
112 TC 26 (1999), A.O.D. 1999-006; Nowell, T.C. Memo. 1999-15; Lopes, T.C. Memo.
T.C. Docket No. 6635-00, full stipulated decision, except as to non-aggregation issue
Brocato, T.C. Memo. 1999-424; Stevens, T.C. Memo. 2000-53; Wineman, T.C. Memo.
2000-193; Baird, T.C. Memo. 2001-258
Treas. Regs. §20.2053-7
 Deduction Level Discounts
The Estate of Frank DiSanto69 opnion has reminded practitioners that valuation at
the estate tax deduction level is different from the gross estate level of value.
Planners need to keep in mind the opportunities and pitfalls involved in valuation
strategies where gross estate and deduction values may vary; and planners should consider
the DiSanto pitfall in structuring the plan.
Among the references for this issue are Chenoweth,70 and appellate court
 Buy-Sell Agreements
As included in the FLP developments below, the Church72 case dismissed the
Government’s 2703 argument that 2703(a) could be so broadly interpreted so as to eliminate the
partnership entity. It appears that the Service has lost its “partnership wrapper” argument.
However, both pre-2703 and under 2703 itself (eff. for restrictive arrangements after
October 8, 1990), common sense applies to the issue of “testamentary substitute”, as considered
in the Godley73 and Lauder74 cases. Here again we are reminded of the importance of qualified,
credible appraisal work, with the tax advisor’s involvement in the assumptions of value.
T.C. Memo. 1999-421
88 T.C. 1577 (1987)
Ahmanson Foundation v. U.S., 674 F.2d 761 (9th Cir. 1981), Provident Bank v. U.S., 581
F.2d 1081 (3rd Cir. 1978); also see TAMS 9403002 and 9403005.
2000 U.S. Dist. LEXIS 714; 2000 - 1 U.S. Tax Cas. (CCH) P 60, 369; 85 A.F.T.R. 2d (RIA)
804); affd. 268 F.3d 1063 (5th Cir. 2001)
T.C. Memo. 2000-242
 What Is Economic Substance?
Illustrative of Service interest in the economic substance argument against pass-through
entity reality for transfer tax purposes are two recent Field Service Advises.75 First of All FSA
200031663 dealt with a family-owned LLC, releasing the FSA prior to the late 2000 Strangi and
Knight cases76 which were decided by the Tax Court November 30, 2000. Since, however, the
taxpayer victory in Strangi is on appeal by the Service to the 5th Circuit and, in any event, both
taxpayer favorable opinions were at the trial court level, consideration of this FSA’s arguments
Of special import here is the economic substance argument, even though the usual litany
of IRS attack theories also was set forth, including, I.R.C. §§2703 and2704(b), I.R.C. §2036, gift
on formation (not recommended in the FSA) and ultimately attacking the valuation discount
level. Further, the FSA suggests that the LLC and FLP are more like trusts than corporations, so,
according to IRS, the document (entity) restrictions should not reduce value of assets transferred
thereto. Also, the Service alleges that the interests of the willing seller must be taken into
account, i.e. the hypothetical willing seller would not transfer assets to an entity in exchange for
an entity interest worth substantially less. Of course, FLPs, LLCs, S corporations are not trusts
and the gift or estate transfer is of entity equity. As to the willing seller issue, it is common
knowledge that investors regularly contribute cash to investment vehicles (e.g. venture capital
partnerships) to leverage their ability to participate in investment opportunities and to obtain
high level management expertise.
Now, as to the economic substance argument itself, in both the referenced FSAs,77 ACM
Partnership v. Commissioner is discussed in some detail.78 The “objective economic substance”
of the transaction and the “subjective business motivation” should be the subject of inquiry,
according to the Service which believes these are “distinct aspects of the economic sham
FSAs 200031663 and 200143004
See supra, fns 13 and 40
Supra, at fn 75
T.C. Memo. 1997-115
inquiry”.79 The result of the inquiry is to determine “whether the transaction had sufficient
substance, apart from its tax consequences, to be respected for tax purposes”.80
What should tax practitioners take from the FSAs and the generally favorable Tax Court
opinions? First, it is clear the Service will continue to pursue its litigation objectives. Second,
the plan structure and its implementation in all events should take into account the economic
substance argument. Here careful planning will result in a taxpayer victory.
§1.06 APPLICATION OF VALUATION STRATEGIES
Valuation adjustment or “discount” strategies usually combine one or more entities with
a “transfer vehicle” (gift, sale, etc.). Choosing among techniques should involve careful analysis
of all business and personal issues, open client communication and complete documentation of
There are many strategies to be considered, and it is clear that the “risk/reward” decision
is to be made by the clients. Following are some thoughts for consideration, as to techniques and
types of clients.
 Sales, Loans, Opportunity Shifting
“Opportunity shifting”, where unsupported by contractual or other property rights, is not
subject to transfer tax. With the new “adequate disclosure” rules for running the gift tax statute
of limitations, “non-gifts” often will be reported.
Loans, using the §7872 “safe harbor” AFR provision for gift and income tax purposes,
allows for investment opportunities to be shifted within the family. And note that at the lender’s
death, a promissory note with the AFR rate must be valued for estate tax purposes under the
hypothetical party FMV standard.
For decades, the intra-family installment sale has been viewed as an effective estate
freezing technique. However, where a gain realizing §453 sale is involved, there are special
issues to be considered.
(i) Marketable securities cannot be the subject of a gain recognition deferral
(ii) And, even though FLP interests may be sold under §453 where the FLP assets are
solely marketable securities, there remain ordinary income traps for the unwary if
FLP assets include “hot assets” (receivables, inventory, etc.) subject to IRC §751,
or the seller of partnership interests has a deficit balance in his or her capital
(iii) Other intrafamily relationships with entities can be helpful in allocating or
shifting value, such as leases, joint ventures, royalty or commission arrangements,
and compensation (which always should be distinguished from capital transfers).
 Sales To Intentionally Defective Grantor Trust.
Increasingly popular in recent years (but not as certain in result as the straight installment
sale) is the combination of creation of a funded intentionally defective grantor irrevocable trust
(“IDGT”) with an installment sale. Certain of a straight installment sale’s disadvantages are
avoided since the sale to an IDGT is not recognized as such for income tax purposes since the
trust is a grantor trust; yet, at the same time, an estate freeze is accomplished for transfer tax
Advantages of the sale to an IDGT:
(i) Removal of assets from grantor-seller’s estate; although the installment note
(usually a long-term, interest only note with a balloon payment) will be an estate
(ii) No gain realized on sale of property, e.g. FLP units, to the IDGT.
(iii) Upside appreciation in assets sold (e.g. start-up founder’s stock, FLP interests in
non-qualified stock option owning FLP, etc.) flows to the younger beneficiaries of
the IDGT, i.e. the children.
(iv) Grantor liable for income tax on subsequent sales of IDGT assets, yet children
receive the gains without gift tax incurred by grantor.
(v) Grantor receives income stream from the installment note.
(vi) Grantor trust status can be relinquished in the future.
Whether using marketable securities, “concentrated stock positions” (e.g. pre-IPO
situation), real estate, or even non-qualified stock options, structuring an FLP (or LLC) makes
sense in combination with the IDGT sale transaction.
Of course, adequate coverage of the installment note requires that the IDGT have
sufficient assets on its own (10%?) to avoid, if possible, an IRS argument that the installment
note is merely a retained interest (not qualifying under IRC Sec. 2702) rather than debt.
A number of issues remain unresolved in the IDGT technique, such as the results of
termination of grantor trust status upon the grantor’s death where the note is still in existence.
 Tailoring Planning to Client Situations
Tax practitioners involved in client estate planning know well the personal issues that are
involved. The Service analysis of planning efforts, that is, that estate tax avoidance is the only
purpose involved, is not realistic. Identifying the client types for consideration, we can list real
estate based clients, closely-held family business owners, clients that own portfolios of
marketable securities, and, last but certainly not least, the technology equity-based client. Each
type of clients have special needs and tax issues to be evaluated.
 Traditional Client Situations
The traditional clients include those real estate, clients owning closely-held family
operating businesses, and clients with marketable securities. Obviously, there are combinations
of these situations, and actually a challenge for advisors is to be considerate of such
combinations and how that affects planning.
In the real estate area, advisors must consider issues such as, in some states, property tax
adjustments, debt in excess of basic considerations, and the pass-through entity’s tension
between income and distributions. Family-owned businesses, usually operated in C or S
corporation form (although LLCs recently have been used), necessarily must deal with a more
complicated valuation scenario, due to the operating business being valued.
In the marketable securities portfolio situation, after avoiding the I.R.C. §721(b) pitfall,
clearly the Service does not believe that non-public entity interests in entities owning marketable
securities justify valuation discounts for transfer tax purposes. However, as discussed above, the
courts properly have applied the tax law - entities properly formed and funded under state law
are to be respected. Our experience is that such entities can realize valuation discounts in the
25%-40% range (the latter for non-diversified portfolio holdings) with proper planning,
documentation and entity operation.
 Technology Planning: Start-Ups, Options and IPOs
The emergence of the new economy has created a new type of client. The
entrepreneur-type client ranges from the first time executive/entrepreneur with a
concentration of wealth in one privately-held company with his or her equity in the form of
founder’s stock and/or stock options, either incentive stock options (ISOs) or nonqualifed
stock options (NQSOs), to the serial entrepreneur involved in a promising new venture but
with significant assets from prior successful ventures. Planning for this type of client has
it’s own unique issues and challenges.
The most difficult challenge is getting the client to divert his or her attention away
from the business and to focus on his or her own personal planning. If the client, especially
the first time entrepreneur, does focus his or her attention on personal planning, many
times it will be limited in scope to the more straight forward or core planning needs. This
is usually a result of the client typically being illiquid, strapped for cash and cost conscious
and, especially in the post-high technology boom days, the client being painfully aware of
the failure rate of start-up companies. However, even straight forward and relatively
inexpensive planning such as irrevocable gift trusts funded with low value stock can be
extraordinarily effective at the early stage prior to any liquidation event, i.e. initial public
offering (IPO) or acquisition, if the company is ultimately successful. In many situations,
with the low value of stock and the client’s reluctance to gift a significant percentage of his
or her stock ownership, the use of annual exclusions is sufficient without the use of other
planning options which may leverage the value of the stock any further.
Far more sophisticated planning may be warranted with the veteran entrepreneur
who has significant assets since the veteran entrepreneur will be more willing to consider
gifting a more significant percentage of his stock ownership which will not be covered by
the annual exclusion. In addition, due to the uncertain success of the company, planning
should be implemented which would minimize utilization of the applicable exclusion
The valuation of non-public stock creates a whole other issue whether the stock is
gifted outright or contributed to an FLP. Typically, the company has also made ISO
grants which require the company to determine an exercise price equal to fair market
value as determined in “good faith” by the company’s directors.81 Rarely will the
entrepreneur be willing to expend the additional funds to have an outside appraiser
determine the fair market value of the stock nor will the company be receptive to providing
an outside appraiser, not within their control, the information necessary for them to
perform a meaningful valuation. Nonetheless, the entrepreneur must understand that
valuations based on company determinations made in good faith, but not always with
extensive supporting valuation data and analysis, are susceptible to challenge by the IRS.
This is particularly true if, in hindsight, the company shortly thereafter has a successful
public offering and the value of the stock increases exponentially. For this reason, it is
optimal, although very difficult for the entrepreneur, to focus on having the planning
completed as early as possible before the public offering.
Once the value of the stock is determined, the entrepreneur must decide how he or
she wants to make the gifts, weighing the various tax advantages against non-tax practical
concerns such as control and complexity. Of course, the easiest method of making gifts is
outright to individuals or to irrevocable trusts created for the benefit of family members.
Many times, the entrepreneur is also at the stage in life where he or she may have
additional children after the gifts are made. Thus, in forming any trust for his or her
children, care should be given to allow the class of beneficiaries to expand to include
afterborn children. Because of the uncertain outcome related to the potential value of the
stock gift, the trust should be drafted with sufficient flexibility to allow the trustee to make
discretionary, rather than mandatory, distributions. Further, the trust should allow the
trustee to contribute the trust assets to an FLP in exchange for limited partnership
interests to limit access to the beneficiary.
I.R.C. § 422(c)(1)
The value of the gift can be further reduced by first contributing the stock to an
FLP (or limited liability company). Typically, as important as any tax advantages, an FLP
offers the entrepreneur a means of maintaining control of the equity position, while at the
same time sharing ownership with children and other family members. In addition,
restrictions on limited partners, such as lack of management rights and restrictions on
transfer of their interest, entitle the client to downward valuation adjustments for lack of
control and lack of marketability as discussed earlier in this paper. Thus, the FLP offers
clients a means of maintaining control of the equity position while receiving substantial
valuation reductions for transfer tax purposes. Furthermore, the benefits of various other
leveraging strategies such as the Grantor Retained Annuity Trust (“GRAT”) or
Installment Sale to an Intentionally Defective Grantor Trust are even further enhanced
when combined with the FLP.82
Careful consideration must be given to the likely small business stock (“QSB
Stock”) status83 of founder’s stock when undertaking any planning on behalf of the
entrepreneur. QSB status can provide the entrepreneur with an opportunity to rollover
gains to another QSB qualified investment. Contribution of QSB Stock to a partnership
will terminate the QSB Stock status because it will not meet the “direct issue” requirement
for qualification as QSB Stock.84 However, an exception to the “direct issue” requirement
is if QSB Stock is directly transferred by gift.85
In the situation where the entrepreneur is gifting “unvested” NQO stock options
rather than stock, the IRS ruled in Rev. Rul. 98-21 that such gift is not complete for gift tax
purposes until exercise of the option is no longer conditioned on the performance of
services by the employee.86 The alternative to the Service’s position in Rev. Rul. 98-21 is to
consider the transfer of enforceable economic rights under an unvested stock option as a
completed gift, and to factor any vesting requirement into the valuation of the option
transferred.87 In valuing gifts of NQO stock options, the IRS issued Rev. Proc. 98-3488
which provides a “safe harbor” for properly valuing NQO stock options by using a
recognized option pricing model (Black-Scholes or a binomial model). Rev. Proc. 98-34
does not preclude the use of other reasonable valuation methodologies and only applies to
See S. Stacey Eastland, “Transfer and Income Tax Planning with Stock Options”, 60 NYU Inst. On Fed.
Tax. Ch. # (2001).
See I.R.C. §§ 1202 and 1045
I.R.C. §1202 (h)
1998-18 IRB 1 (1998). But see Rothstein v. U.S., 735 F.2d 704 (2d Cir. 1984).
See, Bittker and Lokken, Federal Taxation of Income, Estates and Gifts, ¶122.3.5 at 122-11.
1998-18 IRB 15 (1998)
options granted with respect to publicly traded securities and not to options granted on
private company stock. However, for a number of reasons, many taxpayers will choose to
not utilize this safe harbor since the value determined will be significantly higher than the
actual fair market value of the option.89
§1.07 VALUATION ACTION PLAN
Based upon the foregoing discussion, what guidelines for action can be provided
practitioners and their clients who are considering FLP or LLC-based transfer tax
valuation strategies? The cases reviewed above, coupled with the income tax “safe harbor”
for family partnerships under Code §704(e), provide a “road map” of sorts to follow in
developing, documenting and implementing an effective FLP/LLC program. The Tax
Court’s clear confirmation that (i) the “fair market value” determination is applied to the
specific property interest transferred, and (ii) meeting state law requirements will insure
respect for the entity and equity interests therein, should be the guiding force for such
Kochis, Transferable Stock Options, 453 CCH Financial and Estate Planning 80 (October 21, 1998).
Thereafter, the major task in fractionalized equity interest valuation, which is an
integral part of any valuation strategy, is obtaining a valuation report from a qualified,
credible and reliable business valuation appraiser. Where lifetime transfers are involved,
such a report has the added advantage of meeting the Treasury Regulations “adequate
disclosure” requirements in order to start the applicable gift tax statute of limitations.90
The major pitfalls that appear from the discussion in this article relate to
funding and ongoing operation of the pass-through entity, whether an FLP or a
LLC. As we’ve seen, the Tax Court (and therefore examiners in the field) will look
carefully at the evidence presented concerning the nature and timing of the property
interest transferred both at the time of contribution to the pass-through entity and
when entity interests are transferred by gift, at death or otherwise, such as via an
Preservation of assignee interest characterization, especially where control is
at issue, appears necessary to insure substantial downward valuation adjustments.
In addition, in most cases, care should be taken to preserve the prorata nature of
distributions, except as to appropriate guaranteed payments (such as, for
management services). Throughout operation of the entity, the donor partner’s
control as a general partner of the FLP or manager of the LLC should be in
accordance with contractual and fiduciary standards, thus minimizing the problems
of retained enjoyment or control under Code § 2036. Often the best insulation on
this pitfall is use of a second entity as the manager, such as an LLC as the 1%
general partner of the FLP. Complete accounting records should be maintained for
the entity or entities with the new recommended standard of practice to be written
memorialization through minutes or manager action notices of the management
Treas. Reg. §301.6501(c)-1
activities relating to each entity.
At this time, it remains uncertain what direction the Service will take in view
of the recent Tax Court decisions. As a minimum, even if one or more appeals are
not filed, we can expect IRS to carefully examine FLP/LLC programs in terms of
§ 2036 exposure, funding and transfer defects and operational deficiencies. This
author believes careful practitioners and educated cooperative clients can and
should move forward with FLP/LLC-based valuation discount planning. Finally, as
to existing situations, it is suggested that the entity documents and operations be
reviewed carefully in light of all the recent developments. Curative action taken
now may well save an otherwise high risk situation.