Multilevel valuation discounts: Handle with care

Estate planners often use family limited partnerships (FLPs) and family limited liability companies (FLLCs) to consolidate a family’s wealth management, protect assets against creditors, and reduce gift and estate taxes. FLPs and FLLCs reduce taxes via valuation discounts for lack of control and marketability that are subtracted from the net asset value of the entity’s holdings.

In some cases, multilevel discounts are available for tiered entities, which usually take the form of a holding company that owns an interest in another company.

Levels of discounts

For example, suppose Bob gives limited partnership interests in an FLP to his children. The FLP has several real estate holdings. Among those holdings is a 50 percent interest in a general partnership that owns and manages farmland.

In valuing the FLP interests for gift tax purposes, Bob applies two levels of discounts. First, in determining the FLP’s net asset value, he applies a combined 30 percent discount for lack of control and marketability to the general partnership interest (the lower tier). Next, in valuing the FLP interests (the upper tier), he applies a combined 35 percent discount for lack of control and marketability. The cumulative effect of these two discount layers is to reduce the net asset value of Bob’s underlying interest in the general partnership’s farmland by nearly 55 percent.

Tax Court views

In Estate of Astleford v. Commissioner, the U.S. Tax Court allowed similar discounts under circumstances much like those in the example. But in reaching this conclusion, the court emphasized that the general partnership interest accounted for less than 16 percent of the FLP’s net asset value and was one of 15 real estate investments held by the FLP. Multilevel discounts might not be available, the court warned, when the lower-tier interest constitutes a significant portion of the upper-tier entity’s assets.

This was the case in Estate of O’Connell v. Commissioner. The Tax Court disallowed multilevel discounts when the upper tier consisted of a 95.3 percent common stock interest in a holding company. The court allowed a 30 percent discount for lack of marketability for the lower tier (a majority interest in a closely held company) but denied a marketability discount for the upper tier because the discounted lower-tier assets represented a significant portion of the upper tier’s assets.

The court suggested that an upper-tier discount might have been appropriate if the upper-tier entity had held a minority stock interest, rather than a majority interest — even though the discounted lower-tier assets constituted a significant portion of the upper-tier entity’s assets.

It’s all about risk

There are no bright-line rules for determining when multilevel discounts are appropriate or how to quantify discounts at each level. Rather than focus on percentages, the best way to support these discounts is to have a financial expert analyze the business purposes and relative risks associated with each tier. Reasonable, well-documented tiered discounts will more likely stand up under scrutiny.

If additional tiers serve no bona fide business purposes — such as investment consolidation or asset protection — then additional discounts might not be warranted.

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