Family Limited Partnerships – A Valuation Overview

Family limited partnerships have become an increasingly popular estate planning tool. The partnership structure allows the donor to consolidate a portion of his or her assets into a single portfolio, manage the assets in an orderly fashion, and gift interests in the portfolio as whole (rather than gift individual assets on a piecemeal basis). The limited partnership structure allows the donor to retain significant control over the contributed assets if he or she wishes to act as general partner while providing limited liability to the transferees via the gifted limited partnership interests. This structure also provides estate and gift tax advantages versus the direct transfer of individual assets, and the gifted limited partnership interests may be subject to appropriate valuation discounts, such as a minority interest discount or a marketability discount for minority interest and lack of marketability.

In forming a family limited partnership, it is important that the triggering of investment company status be avoided. Otherwise, the donor will be forced to recognize and pay taxes on any capital gains embedded in the contributed assets. For a single donor, the primary means of not being construed to be an investment company is for less than 80% of the value of the contributed assets to consist of cash and marketable securities.

One common use of the family limited partnership is as a structure for holding and managing real estate assets. Such assets can range from a single vacation property used primarily by the family itself to multiple commercial income properties. The limited partnership agreement sets out the terms for the management of the property(ies) and the conditions under which the partnership may be dissolved. It also provides for the distribution of any excess cash flow among the various partners. The alternative would be to grant undivided interests in parcels of real estate. This approach, however, does not provide for an orderly management structure and allows the transferee the option of seeking judicial partition of the subject parcel.

As mentioned previously, valuations of the limited partnership interests may be subject to minority interest discounts and marketability discounts. In developing minority interest discounts, appraisers frequently refer to the current and historical relationship between the quoted market values versus their stated net asset values for shares of publicly traded closed-end investment companies and real estate investment trusts (REITs), or other public companies with asset structures similar to the subject. Net asset values in such cases refer to management’s estimates of the fair market values of the underlying assets, less any liabilities. Typically, shares in closed-end mutual funds and REITs trade at some discount to net asset value. The discounts incorporate, among other factors, the market’s collective assessment of built-in capital gains, capitalized operating expenses and management fees. This is the starting point for imputing an appropriate minority interest discount.

The final estimation of the discount follows from the appraiser’s evaluation of the consequences of the lack of control for the limited partner relative to the current condition and outlook for the assets in the partnership. Such control issues may include the size of the vote needed to liquidate the partnership or amend the agreement, whether or not the agreement requires the general partner to distribute excess cash, and how much discretion the general partners have in making new investments.

The size of the marketability discount for limited partnership interests is primarily a function of four factors:

• Dividend capacity and dividend policy. These factors determine the extent to which the investor’s return is dependent on the exit value, that is the future sales price or value realized upon the liquidation of the partnership, a highly uncertain number. The prospect of significant dividends above any income tax liability generated for the partners tends to mitigate the marketability discount, since much of the investor’s return will be in current dollars. On the other hand, if dividends are expected to fall short of partners’ tax liabilities, a high marketability discount will be required due to the implied negative after tax cash flows.
• Quality and liquidity of the underlying assets. The marketability discount tends to be mitigated if there is a strong demand for the underlying assets. Such a condition may imply greater dividend capacity, greater ease of liquidation, and greater potential for appreciation. If the underlying assets are highly liquid, the partnership may be dissolved via a distribution of assets to partners or dividends may be made via distributions in kind rather than in cash.
• Restrictions in the partnership agreement. Family limited partnership agreements generally restrict gifts and bequests to lineal descendants of any partner. The agreements also typically grant rights of first refusal to the partnership and the remaining partners on any sale. The rights of first refusal often include the right to pay the purchase price in installments at an interest rate favorable to the partnership or remaining partners. Generally, the greater the restrictions on resale, the higher the marketability discount.
• Potential liquidity of the partnership interests. As noted above, the partnership agreement may restrict the marketability of partnership interests. There is generally no established market for partnership interests. Given the particular facts related to the partnership agreement, the control of the general partnership, past or prospective policies toward providing liquidity, rational, hypothetical (or real) investors may consider that the prospective holding period for the subject interest may be quite long or even indefinite.

Guidance as to the appropriate level of discounts is limited. It is interesting to note that recently in LeFrak v. Commissioner, T.C. Memo 1993-526, the Tax Court recently allowed a combined minority interest/marketability discount of 30% on interests in 22 apartment buildings and office buildings located in the New York City area. The interests were originally gifted as undivided interests in the various parcels of real estate but were later converted to limited partnerships. The Tax Court ruled that the gifts must be evaluated on the ownership structure in place at the time of the gift. The Tax Court implied in its opinion that had the gifts actually been valid limited partnership interests, a combined discount in excess of 30% could have been in order.

Reprinted from Mercer Capital’s Value Added^TM newsletter – Vol. 6, No. 3, 1994.