Tax Law | Expert Legal Commentary

July 13, 2010

Holman v. CIR: Valuation of Gifted LLP Shares

Holman v. Commissioner of Internal Revenue

By H. Jacob Lager of Zuber Lawler & Del Duca

Holman v. CIR: Valuation of Gifted LLP Shares

Email Print

The Eighth Circuit U.S. Court of Appeals recently ordered that I.R.C. section 2703 could be applied to disregard transfer restrictions for valuations of gifts of shares in a family limited partnership (“FLP”). In Holman v. Commissioner of Internal Revenue, 601 F.3d 763 (8th Cir., 2010), the 8th Circuit also agreed with the tax commissioner that, while lack of control and marketability discounts would apply to the gifts of the FLP units, the discounts should be lower than those proposed by the donors.

BACKGROUND

Thomas H. Holman, Jr. and Kim D.L. Holman (the “donors”) are the parents of four daughters. During the 1990s, Mr. Holman worked as an employee of Dell Computer Corporation and amassed a significant number of Dell shares (and commensurate wealth) during his tenure at Dell.

The Holmans sought to preserve wealth within the family, pass it on to their children, prevent their children from dissipating assets, etc., so in 1999 they set up the Holman Family Limited Partnership (“FLP”), transferring 70,000 shares of Dell stock into the FLP. Five days later, the donors transferred limited partnership interests in the FLP into trusts for each of their five daughters. The FLP had four stated goals: long-term growth, asset preservation, asset protection, and education.

The Holmans filed a Gift Tax Return, claiming discounts of about 49% on the valuation of the gifts due to lack of marketability and minority interest, and taking into account the transfer restrictions in the FLP agreement.

The IRS Commissioner contested the valuation discounts, making four arguments: 1) that the gift was not really a gift of FLP interests at all, but a direct gift of Dell shares under the theory articulated in Senda v. Commissioner; 2) that the FLP’s transfer restrictions should be disregarded for valuation purposes pursuant to I.R.C. section 2703; 3) that even if lack-of-marketability and minority-interest discounts apply, they should be smaller than the combined 49% claimed by the donors.

The Tax Court held that the gifts were gifts of limited partnership shares, not direct gifts of stock, due to the time lag between the creation and funding of the FLP and the gifting of the shares. The Tax Court agreed with the Commissioner, however, that the transfer restrictions in the FLP agreement should be disregarded pursuant to I.R.C. section 2703. The Tax Court also agreed with the Commissioner that lower lack-of-marketability and minority-interest discounts should apply.

The donors appealed, challenging the Tax Court’s application of section 2703, its determination of the discounts, and the overall valuation, which was higher than the donors claimed. The Commissioner did not challenge the Tax Court’s determination that the gifts were gifts of FLP shares, not direct gifts of Dell stock, so that issue was not before the court on appeal.

Proper application of I.R.C. section 2703 disregards the transfer restrictions for valuation purposes

Generally, transfer restrictions on any property tend to reduce that property’s value. Often those restrictions are placed for legitimate business purposes, but sometimes they are used to minimize tax consequences of gifts or transfers. In order to distinguish between the two, Congress passed I.R.C. section 2703, which enables taxpayers to have a transfer restriction considered for valuation purposes if certain conditions are met: 1) the restriction must be “a bona fide business arrangement;” 2) the restriction must not be “a device to transfer such property to members of the decedent’s family for less than full and adequate consideration;” and 3) the terms of the restriction must be “comparable to similar arrangements entered into by persons in an arms’ length transaction.” Holman v. Commissioner of Internal Revenue, 601 F.3d 763 (8th Cir., 2010) (citing Section 2703(b)).

Both the Tax Court and the Eighth Circuit agreed that the transfer restrictions in the FLP at issue were not a “bona fide business arrangement” in accordance with section 2703(b)(1). Because the primary purpose of the FLP was to hold “passive investments without a clearly articulated investment strategy,” there was no business purpose. 601 F.3d at 769.

The donors challenged the Tax Court decision, claiming that the Tax Court interpretation was too restrictive, imposing an “operating business nexus” on the restriction in order to consider it for valuation purposes. But the Circuit Court said, “[T]he Tax Court correctly assessed the personal and testamentary nature of the transfer restrictions. Simply put, there was and is no ‘business,’ active or otherwise.” Id. at 770. While the Court left open the possibility that the transfer restrictions in some FLPs may present a more challenging case, where the restrictions “apply to a partnership that holds only an insignificant fraction of stock in a highly liquid and easily valued company with no stated intention to retain that stock or invest according to any particular strategy, we do not view this determination as difficult.” Id.

The Highly Liquid Nature of the Shares Called for Lower Discounts

Both the donors and the IRS presented appraisers to support their respective claims of the appropriate discounts to apply. On appeal, the donors only challenged the Tax Court’s determination of a marketability discount.

The donors’ appraiser argued for a marketability discount of 35% “without additional quantitative explanation.” Id. at 773. The IRS appraiser seemed to sway the court by examining the issue “with greater detail,” even though the two appraisers used similar methods. Id. at 774. After in-depth analysis, the IRS appraiser determined “that the 12% lack-of-market or liquidity discount was similar to what private buyers of the limited-partnership shares would demand.” Id. That 12% discount would adequately account for a lack of a secondary market; discounts above that would only be related to holding-period restrictions not applicable to the FLP at issue. The FLP was relatively easy to dissolve, and partners were able to buy out one another – if financial circumstances warranted it, one or more of the members could cash out with relative ease. The Court determined that the partners had to be treated like rational economic actors who would not voluntarily subject themselves to unreasonable restrictions. Id. at 775. The valuation should take this into account.