Gift, Estate, & Income Tax Compliance

March 1, 2022

Mercer Capital’s Value Matters® 2022-03

All in the Family Limited Partnership

Reprinted from Mercer Capital’s Family Business Director Blog

Many enterprising families have January 1, 2026, circled on their calendars. Why? Because the individual estate tax exemption reverts to $6 million (give or take, depending on inflation) in 2026 from its current level of $12 million. As a result, many estates that are not currently large enough to be taxable will become so, and the effective tax rate for all estates will increase.

A recent Wall Street Journal article highlighted the benefits, and potential downsides, of family limited partnerships, or FLPs (and their close cousin, the family limited liability company).

The “magic” of the FLP is the ability to transfer assets to heirs, and out of taxable estates, at discounted values. The WSJ article points out that the IRS is skeptical of many FLP planning strategies, noting that audit challenges may become more frequent as the IRS puts its new $80 billion enforcement budget to work.

While the valuation discounts applicable to FLPs may seem like estate planning magic, there really is no sleight-of-hand involved. Instead, valuation discounts reflect economic reality.

Fair Market Value Is an Arm’s-Length Standard

Estate planning transfers must be accounted for using the “fair market value” of the subject interest. Revenue Ruling 59-60 offers the following definition for fair market value: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

There’s a lot there, but for this post, we will simply highlight that fair market value is not determined with respect to a specific buyer or seller and therefore does not consider any familial relationship between the transferor and transferee in an exchange. Rather, fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts.

Under this standard of value, business appraisers typically value interests in FLPs using a three-step approach.

The Market Value Balance Sheet

The first step is to compile a listing of all assets owned by the FLP, reduced by any liabilities.  FLPs hold all kinds of assets, some of which have more readily ascertainable values than others. So, for some FLPs, the market value balance sheet can be constructed simply by referring to a brokerage statement, while other assets, like shares in a family business, will require a separate valuation process. Once the market values of the assets and liabilities have been determined, the difference between the two, referred to as “net asset value” or “NAV,” provides the starting point of the valuation analysis.

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