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Contents
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Valuation in the Current Environment The current economic environment has challenged the valuation community in determining the value of most businesses. Valuators not only have to deal with the subjectivity of valuation overall, but are now struggling to support some of the most basic valuation issues such as cost of capital and marketability discounts in quickly changing economic times. The need for increased self-review, research and support for valuation methods utilized has never been greater. Methods to develop the costs of capital and marketability discounts should look familiar but also include an element to account for the current economic environment. Additional thought and support should be given to the following areas:
These are just some of the factors that should be noted when reviewing valuations in the later part of 2008 and early 2009. Our valuation experts are available to discuss these issues with you and are capable to address the current economic conditions in a supportable manner. For more information about our Business Valuation practice, email BVLS@SCandH.com or call (410) 403-1500 | (800) 832-3008.
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Valuations Insights, Second Quarter, 2009 Case Includes a List of Facts By Which to Assess a FLP's Non-Tax Business Purpose Estate of Hurford v. Comm'r, 2008 WL 5203652 (U.S. Tax Ct.) December 11, 2008 "It is a truth universally acknowledged that a recently widowed woman in possession of a good fortune must be in want of an estate planner." So begins Judge Holmes’ latest Tax Court opinion considering the formation and funding of family limited partnerships (FLPs). This case, however, was further complicated when the widow was stricken with cancer. "She lost her life to the cancer," the court said. "We must now decide how much of her estate will be lost to taxes." While she was still alive, the widow's estate was worth over $14.2 million, consisting primarily of deferred compensation in the form of phantom stock ($5.5 million) plus real property, life insurance, and stocks and bonds. Her attorney recommended that she create three FLPs for the various assets and take a 96% limited partner (LP) in each. Her three children would hold 1% LP interests and an LLC would serve as the 1% general partner. In addition, the widow would sell her 96% interest to the children via a private annuity transaction. Sloppy legal work. Unfortunately, the attorney was "sloppy" and "unsteady" in drafting the controlling agreements. To avoid gift taxes, he also created the children's LP interests before funding the FLPs. Last but hardly least, the attorney failed to get current, independent appraisals of the assets that funded the FLPs. Instead, he used the values listed on the husband's estate tax return, without any effort to consider changes in their values. Similarly, he failed to obtain independent appraisals of the appropriate discounts to the interests. After bragging to the children that he had obtained discounts from the IRS as high as 50%, he picked discounts ranging from 25% to 42%, with no clear basis for the percentages. His values for the private annuity transaction were similarly unsupported and his drafting accomplished the sale of Mrs. Hurford's 96% interest to only two of her three children. After Mrs. Hurford died less than a year later, her attorney prepared her estate and gift tax returns. The returns reported that each of the children's interests in the FLPs increased from 1% to 33%, based on substantial capital contributions, while Mrs. Hurford's 96% LP interest dwindled to 0%.In addition, the attorney denied that the decedent held any partnership interests at the time of her death or made any qualified transfers under IRC Sections 2035, 2036, 2037, or 2038. Finally, her returns reported no taxable gifts and requested a refund of over $238,000. The IRS assessed substantial deficiencies for both Mrs. Hurford's estate tax return ($9.8 million) and her gift tax return ($8.3 million), plus over $3.5 million in combined penalties. At trial, the Tax Court's main consideration was what assets to pull back into the estate; in particular, whether Mrs. Hurford's transfers to the FLPs and the subsequent private annuity transaction were valid under Sections 2035, 2036, and 2038. Apart from some minor concessions, the estate argued that the decedent’s tax returns were correct. It acknowledged her attorney's "sloppiness," but claimed that all the transfers were bona fide sales for adequate consideration; and that the decedent had not retained any rights to the transferred property. By contrast, the IRS attacked the entire estate plan as "nothing more than a transparently thin substitute for a will." The decedent kept control over all the assets, it claimed, and the exchange of her LP interest for the private annuity was not a bona fide transaction. The estate retained two independent appraisers to try and "clean up some of the problems" caused by the attorney. They testified that his discount percentages were within acceptable limits, and that even if his FLPs values were incorrect, the private annuity payments ($80,000 per month) exceeded what they would have been if the attorney had valued the FLPs correctly. The court was not persuaded, and held that both the decedent's transfer of property to the FLPs and their subsequent exchange by the private annuity arrangement with her children were void for lack of fair and adequate consideration. The private annuity, in particular, was "a sham" and a substitute testamentary device. The decedent commingled her own funds with the partnership funds until shortly before she died—and long after she supposedly traded her FLP interests for the private annuity. Further, the attorney "conjured the partnership discounts out of the air," the court said, and "put the same lack of effort" into valuing the FLP assets and the interest sold by private annuity. He should have retained independent appraisals to determine the fair market value of the properties at the time of the transfer, "so that the value of the annuity received would be roughly equal to that of the property sold." He also disregarded partnership formalities by delaying the funding of the FLPs for several months after they were formed. The FLPs provided no legitimate, non-tax business purpose other than serving as a 'holding pen' to fund the monthly annuity payments, the court said. Finally, the attorney made "egregious" errors on the decedents' tax returns. The amounts claimed as capital contributions appeared to be "complete fictions," according to the court; the children received their LPs interest gratis. Based on all the evidence, the court ignored the private annuity and pulled all of the FLP assets back into the decedent’s estate. A laundry list of FLP factors. In compiling these findings and reviewing prior case law, the Tax Court also culled a comprehensive list of facts by which to assess a FLP's non-tax business purpose, including whether:
Considering the entities in this case, the court found that they existed only to satisfy the Hurfords' "drive for a discount." In deciding the final question—whether to apply a discount for lack of marketability and lack of control to the FLP assets in the estate—the court looked to whether the decedent and her children had an implied agreement that she would retain control over the property for her lifetime. Prior cases have found implied agreements when the decedent: 1) transferred nearly all of her assets to the FLP, but 2) her relationship to the assets remained largely the same; and 3) she continued to use FLP assets to pay personal expenses. The attorney's plan "plunges this case right into these precedent," the court held. The FLPs were "shuttled right into the private annuity just weeks after they were created and before they were fully funded" with nearly all of the decedent’s assets—and then she received these assets back in the form of private annuity payments, which she used to pay her living expenses. Accordingly, under IRC Sections 2035(a) and 2036(a)(1), the court disallowed any discounts for the FLPs. |
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