Since family limited partnerships (or FLPs) became popular in 1994, we have valued hundreds such asset holding entities. Family limited partnerships are useful because one generation, owning a general partnership interest, can control the cash flow from gifted assets. FLPs can simplify estate planning, allowing for gifting of fractional interests, and helping consolidate family assets. Another advantage of FLPs is that they are often designed to protect family assets from failed marriages, “unworthy” heirs, creditors, and other family disputes.
The valuation of FLPs generally begins with an estimate of net asset value. Appraisers then consider the application of appropriate minority interest and marketability discounts based on the facts and circumstances of each case. The cumulative amount of discounting in FLP appraisals is important because, given a net asset value, it determines the fair market value at which interests are gifted, and thus the taxes which must be paid on the value of the gift.
Because the use of FLPs is relatively new to many attorneys and clients, we are often asked to answer questions about how we value them. Many attorneys have asked the following (or a similarly worded) question. Since we are dealing with limited partnership interests, and since what can be transferred in most instances is only an assignee interest, shouldn’t there be a further discount applicable to the assignee interest? Good question.
To answer it, we need some further background. It is helpful to think of ownership in a limited partnership as consisting of two components: 1) the economic interest, and 2) the rights attached to the interest. We believe it is important not to confuse the two.
The economic interest is the pro rata ownership of or claim to distributions and assets. In almost all cases, an ownership interest of, say, 1%, has a pro rata 1% claim on all distributions (whether interim or at dissolution), as well as indirect ownership of 1% of the assets underlying the Partnership. Thus, in almost all cases, if a distribution of, say, $100 thousand is declared, then a 1% general partnership interest receives $1,000, as does a 1% limited partnership interest, as does a 1% assignee/transferee interest.
The rights attached are the second component of value, and the differences in rights attached can be significant. General partners might collectively own only 1% to 10% of total interests in a given partnership, but typically have exclusive authority to manage the partnership, including its investment policy, distribution policy, and other aspects of management. Limited partners and assignees/transferees typically have no real aspects of control over the partnership, despite the fact that they might own a majority in interest of the outstanding partnership units. This relationship is achieved by the covenant that is the partnership agreement, and is akin to the difference between voting and non-voting stock in a corporation, with some differences. Assignee interests are in essence limited partnership interests with economic participation equal to that of limited partnership interests but typically without the same rights.
The difference in rights attached to limited partnership interests versus that of assignee or transferee interests can be significant. In most FLPs, limited partners typically have the right to call meetings of the partners, to vote on certain matters such as dissolution and successor general partners, to inspect the books of the partnership, to transfer their interests to other partners or to third parties (sometimes subject to restrictions), and other similar rights. Assignee or transferee interests, on the other hand, typically do not garner the right to vote, inspect the books of the partnership, or transfer their interests.
The problem in attaching specific value to the rights relating to a limited partnership interest versus that of an assignee/transferee interest (or, conversely, discounting an assignee interest from the value of a limited partnership interest), is that the rights attached to a limited partnership interest are typically not transferable. If a limited partner wants to assign, gift, or sell his or her interest to another person, the interest that is received by the acquirer is generally an assignee interest, not a limited partnership interest. The rights of a limited partner are not usually transferable, only the economic benefit. Typically, only after the acquirer has received or has purchased the economic interest in the partnership do the partners vote to admit or refuse the assignee as a limited partner.
There is good reason for this. Partnerships are contracts between persons designed for their mutual benefit. One protection that limited partners receive is that they cannot easily be forced to accept someone with whom they did not originally covenant as their partner. Thus, the assignee interest is a sort of in-between phase in which the acquirer of an economic interest in the partnership petitions to become a partner. In some cases, only the general partner must approve. In other cases, the process of becoming a full limited partner is more onerous.
Nonetheless, if the only value transferable is the economic benefit (and not the limited partner rights attached to it), then is not every (or nearly every) valuation of a limited partnership interest actually the valuation of an assignee interest? Again, it is important to remember that the heir, acquirer, or purchaser of a limited partnership interest actually receives an assignee interest, not a limited partnership interest. The Quantitative Marketability Discount Model used by Mercer Capital is designed to value the economic aspects attributes of a limited partnership interest, i.e., the assignee interest. Our reasoning is consistent with a recent ruling of the United States Court of appeals (Fifth Circuit) [See McLendon v. Commissioner, KTC 1995-624 (5th Cir. 1995), case no. 94-40584.], in which the Court agreed that limited partner interests should be valued as assignee interests.
In a United States Tax Court case, the Court saw no economic distinction between valuing a disputed gift as a limited partnership interest versus that of an assignee interest (but ultimately valued it as an LP interest) [See Kerr v. Commissioner, United States Tax Court 113 T.C. No. 30, docket no. 14449-98.]. Unfortunately, a third ruling, also by the United States Tax Court, clouds the issue by agreeing that certain limited partnership interests should be valued as assignees for transfer tax purposes (so far so good). In this case, however, the Court then valued certain general partnership interests as general partner interests rather than as assignee interests because they were received by an existing general partner, contrary to the valuation standard of “hypothetical” buyers and sellers [See Nowell v. Commissioner, United States Tax Court T.C. Memo 1999-15., docket no. 19056-96.].
At this time, we have determined no compelling reasons to value gifts of assignee interests at a lower level than limited partnership interests. If, under appropriate circumstances, we were to assign value to limited partner rights above and beyond that of their economic interest, the impact of this adjustment would likely not be large. Market evidence of the differential between voting and nonvoting common stock interests suggests a minor impact if translated to the relationship between assignee interests (nonvoting) and limited partnership interests (voting), perhaps on the order of five percent, plus or minus a bit. However, in the context of a fair market value appraisal, a rational acquirer of an assignee interest would likely attribute little (if any) value to “the vote” since there is a positive probability that they might never be obtained.
If you have questions about the valuation of family limited partnerships or other similar concerns, please contact us. We would be glad to help.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 12, No. 1, 2000.