Discussion:

A general partner in a partnership has unlimited legal liability but also has managerial control over the partnership. A limited partner has limited liability but does not exercise control over the day-to-day operations. John, your client, owns a machine shop operated as a sole proprietorship. The business is worth $10,000,000. He would like to transfer a portion of ownership to his two adult children, Cindy and Luke, by converting the business into a partnership. How would you structure a partial transfer of ownership in the business to Cindy and Luke to achieve a fair market value of the transfer that is less than Cindy and Lukes proportionate share of the $10,000,000 value? Are there any penalty concerns associated with the valuation discounts that your proposed transfer takes advantage of, especially if the valuation is found to be inaccurate?

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For John, the best course of action to transfer ownership to Cindy and Luke, would be to establish a limited partnership. The partnership would name John as a 1% general partner, and Cindy and Luke as 49.5%, each, limited partners. John would then contribute the machine shop, in return for Cindy and Lukes limited partnership interests. This is beneficial for a few reasons: John will continue to hold the general partnership interest, leaving him in control of the business; and Section 721 states there is no gain or loss recognized on contribution, if the contribution is in exchange for interest in the partnership (26 U.S. Code 721). This would be considered a family limited partnership, and John would be able to gift Cindy and Luke limited partnership interests. He can do so by gift, which should fall in value under the annual gift tax exclusion amount defined in Section 2503; or he can gift them each a lump sum in interest, using the lifetime estate and gift tax credit, however, would have to pay the necessary gift tax above the credit amount. If John wanted to gift Cindy and Luke the limited partnership interest without paying gift tax, it could take quite a long time, leaving a large amount at risk of estate tax upon his death. Therefore, I would advise John to gift Cindy and Luke large interest at once.

Under Section 2512, the value of gifts of property are valued at fair market value at the date of the gift (26 U.S. Code 2512). However, due to lack of control and lack of marketability of limited partnership interests, John can apply valuation discounts to the amount given. If the machine shop has a value of $10 million, gifting Cindy and Luke 49.5% each would value the gifts at $4,950,000. John should then obtain an appraisal of the limited partnership interest to define a valuation discount. In the case Grieve v. Commissioner of Internal Revenue, Mr. Grieve was able maintain a 35% valuation discount on gifts made to his children. With appropriate appraisal, John could report taxable gifts to Cindy and Luke at $3,217,500 a piece, with a FMV in the interest of $4.95 million. This would also allow a large reduction in Johns estate, including only $100,000 of partnership interest in his gross estate.

John should be aware of penalty under Section 6662, which could cause a 20% addition of tax on the original underpayment. Valuation discounts can be red flags to the IRS, and Family Limited Partnerships are watched closely. Without the proper appraisal, such as in the court case mentioned above, John, Cindy, and Luke could lose the valuation discount, and John could pay a substantial amount in additional gift taxes (26 U.S. Code 6662).

ANSWER THIS: In responding to classmates, comment on how the Andrews, Curry, Cook, andOKeefee cases covered in the required reading support or undermine the structuring of the ownership transfer to attain valuation discounts that your peers have proposed.