Corporate Law: IRS targets discounts in pass-through entities

Stephen F. Aton is a Springfield attorney practicing in the areas of corporate law and taxation, and estate planning.

In the past few years, attorneys and other tax practitioners have been utilizing various corporate entities as a vehicle for gift and estate-tax planning purposes.

The attorney may organize a limited liability company, or set up a limited partnership to assist in passing assets to younger generations at a lowered gift or estate-tax cost. While the entity formation strategy has yielded significant tax savings for many wealthy individuals, recent challenges to the structure by the Internal Revenue Service are attempting to erode its effectiveness as a tax savings method.

The typical scenario as an estate-planning vehicle is to set up a limited partnership, sometimes called a "family limited partnership." The parents usually are trying to pass assets to their children at a reduced tax cost. The parents are each made general partners in the amount of 1 percent to 2 percent each, and are made limited partners with the rest of the assets. It is from the limited partnership interests of the parents that the gifts are made to the children, who then become limited partners, as well.

The general partner in a limited partnership runs the business. The limited partner, by state law, has very little power to act. Since the interests being gifted are limited partnership interests, the children lack ability to control the business and a valuation discount is thus applied to the gift for their "lack of control."

An additional discount commonly applied to the value of the gift for tax purposes is for "lack of marketability." The pool of investors willing to buy limited partnership interests in such a business is very small. Investors generally desire the ability to control their financial undertakings, and would thus pay significantly less for a business interest that barred their participation in all but minor ways.

The bottom line is that gifts that would, except for the transfer through the entity, have been valued at 100 percent of fair market value, might after application of various discounts, be valued at only 60 percent or less of that amount, thus reducing the amount of tax collected by the government. It is this reduction in tax income liability that the IRS is now challenging.

There are four primary arguments being advanced by the government in challenging such valuation discounts. The IRS is now asserting that: 1) the donee receives no present interest and the $11,000 annual gift exclusion should not apply; 2) there is a gift on formation of the entity, since the value of the interest received is lower than what was initially contributed; 3) the structure lacks economic substance and is a method designed solely to reduce tax liability; and 4) the valuation methods employed are inappropriate or overstated.

While these arguments have been helpful to the IRS position, such entities can still be structured to minimize the chance that valuation discounts will be reduced or overturned by the courts. Careful planning with your tax adviser should be employed to minimize and manage the risk.