Financial valuation Applications and Models phần 6 pot

• To promote the efficient and economic management of the assets and propertiesunder one entity• To consolidate fractional interests in family assets • To increase family wealth • Whereb

Any documents showing any offers to buy or sell or indications ofinterest in buying or selling the restricted shares

Latest company prospectus

Three to five years of annual reports

Trading prices and trading volume and the related class of tradedsecurities one month preceding the valuation date

The relationship of the parties to the agreements concerning therestricted stocks, such as whether they are members of the immedi-ate family or whether they are officers or directors of the company Whether the interest being valued represents a majority or minorityownership

6 Weighing Facts and Circumstances Material to Restricted Stock Valuation

Depending on the circumstances of each case, certain factors may carry

more weight than others

Earnings, net assets, and net sales must be given primary consideration In some cases one element may be more important than others

For manufacturing, producing, or distributing companies, primary weight

must be accorded earnings and net sales

For investment or holding companies, primary weight must be given to the

net assets

Careful review of resale provisions found in restricted agreements

The two elements of time and expense should be reflected in a discount The longer the buyer of the shares must wait to liquidate the shares, the

greater the discount

If certain provisions make it necessary for the buyer to bear the expense of

registration, the discount is greater

If the provisions of the restricted stock agreement make it possible for the

buyer to “piggyback” shares of the next offering, the discount would besmaller

The relative negotiating strengths of the buyer and seller of restricted stock A tight money situation may cause a buyer to have more negotiating

strength

In some cases the relative strengths may tend to cancel each other

The market experience of freely tradable securities of the same class as

restricted securities is also significant

Whether the shares are privately held or publicly traded

Securities traded on a public market generally are worth more to investors

than those not traded on a public market

The type of public market in which the unrestricted securities are traded can

be given consideration

Revenue Ruling 93-12

The IRS revoked Revenue Ruling 81-253, which applied family attribution to mine control when valuing minority interests in closely held companies AfterRevenue Ruling 81-253 was issued, the IRS lost a majority of the court cases con-cerning family attribution

deter-Revenue Ruling 93-12 states that a minority discount on stock transferred to afamily member will not be challenged solely because the transferred interest, whenaggregated with interests held by other family members, will be a part of a control-ling interest This ruling arose from a gift tax case

Issue

If a donor transfers shares in a corporation to each of the donor’s children,

is the factor of corporate control in the family to be considered in valuingeach transferred interest?

Facts

Taxpayer owned all the shares of stock of a corporation

Taxpayer made simultaneous gifts of 20 percent blocks of stock to each of

five children

Law and Analysis

The value of the property at the date of the gift shall be considered the

amount of the gift

The value of the property is the price at which the property would change

hands between a willing buyer and a willing seller, neither being under anycompulsion to buy or to sell, and both having reasonable knowledge of rel-evant facts

Fair market value on the date of the gift

Among the factors to be considered is the degree of control of the business

being represented by the block of stock to be valued

Revenue Ruling 81-253, 1981-1 C.B 187 holds that, ordinarily, no

minor-ity shareholder discount is allowed with respect to transfers of shares ofstock between family members if, based on a composite of the family mem-bers’ interests at the time of the transfer, control (either majority voting con-trol or de facto control through family relationships) of the corporationexists in the family unit

Revenue Ruling 81-253 states that the Internal Revenue Service will not

fol-low the decision in the 1981 case Est of Bright v United States

In Bright the court allowed a 27.5 percent interest to be valued as a

minor-ity interest, even though the shares were to be held by the decedent’s viving spouse

sur- Propstra v United States (1982), Est of Andrews v Comm (1982) and Est.

of Lee v Comm (1978) These cases held that the corporations’ shares

owned by other family members cannot be attributed to an individual ily member for determining whether the individual family member’s shareshould be valued as a controlling interest of the corporation

fam- The IRS has concluded, in the case of a corporation with a single class of

stock, notwithstanding the family relationship of the donor, the donee, andother shareholders, the shares of other family members will not be aggre-gated with the transferred shares to determine whether the transferredshares should be valued as part of a controlling interest

The five 20 percent interests that were gifted should be valued without

regard to the family relationship of the parties

Holding

If a donor transfers shares in a corporation to each of the donor’s children,

the factor of corporate control in the family is not considered in valuingeach transferred interest

The IRS will follow Bright, Propstra, Andrews, and Lee in not assuming

that all voting power held by family members may be aggregated as part of

a controlling interest

A minority discount will not be disallowed solely because a transferred

interest, when aggregated with interests held by family members, will bepart of a controlling interest

This will be the case whether the donor held 100 percent or some lesser

per-centage of the stock immediately before the gift

Effect on Other Documents

Revenue Ruling 81-253 is revoked

Valuation of Family Limited Partnerships

The family limited partnership (FLP) is a sophisticated financial planning nique that, when implemented properly, enables a family to hold and manage itswealth, including the family business, within several generations of family members

tech-as partners Families with significant wealth incretech-asingly establish an FLP ratherthan a corporation because the FLP often is better suited to achieving certainobjectives

Some background on corporations and partnerships is helpful to ing the FLP The profits of a C corporation are taxed at a maximum rate of 35 per-cent (for federal tax purposes); when the after-tax profits of the C corporation aredistributed to the shareholders as dividends, those same profits are taxed a secondtime to the individual shareholders, up to the maximum federal statutory rate of38.6 percent The combined corporate and personal tax rate can easily exceed 60percent, even before state and local income taxes are taken into account

understand-Alternatively, the profits of a subchapter S corporation are, in general, taxed atthe shareholder level only—making the S corporation a more appealing structurethan the C corporation in many instances However, there are numerous restrictions

on the qualifications for functioning as an S corporation, even after the liberalizingamendments enacted in 1996

By comparison, a partnership is a pure “flow-through” entity, meaning that theincome realized by the entity flows through and in all cases is taxable to its individ-ual owners and not to the business per se As a result, the limited partnership hasbecome increasingly popular as a flexible and tax-efficient vehicle for conductingbusiness—particularly as compared to a corporation, which is more a formal andgenerally can be a tax-inefficient means for conducting business

Further enhancing the desirability of partnerships is the Uniform LimitedPartnership Act adopted by a large majority of the states This statute standardizesand simplifies the laws governing a limited partnership’s conduct of business in morethan one state

FAMILY LIMITED PARTNERSHIP USES

In addition, FLPs may be used by families as the means:

• To provide a resolution of any disputes that may arise among the family, preserveharmony, and avoid the expense and problems of litigation

• To maintain control of the family assets

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• To promote the efficient and economic management of the assets and propertiesunder one entity

• To consolidate fractional interests in family assets

• To increase family wealth

• Whereby annual gifts can be made without fractionalizing the underlying familyassets

• To restrict the right of nonfamily members to acquire interests in the familyassets

• To provide protection of the family assets from claims of future creditors

• Of preventing the transfer of a family member’s interests as a result of a failedmarriage

• To provide flexibility in business planning not available through trusts, tions, or other business entities

corpora-• To facilitate the administration and reduce the cost associated with the disability

or probate of the estate of family members

• To promote the family’s knowledge of and communication about the familyassets

These goals can be achieved as a result of the FLP’s ability to:

• Engage in the real estate business, i.e., to acquire, own, hold, develop, and ate real estate enterprises

oper-• Invest funds and to raise funds to be invested in furtherance of the underlyingpurposes

• Invest, manage, and operate various investments including but not limited tomarketable securities, stocks, bonds, gold, silver, grain, cotton, other commodi-ties, and debt instruments

TAX ADVANTAGES

This type of entity structure also provides a vehicle to maximize the profits and yield

to the family members due to three factors:

1 A partnership structure eliminates the possibility of double taxation (i.e., tion at the entity and the individual level) This will provide higher returns to thefamily members, by reducing their tax burden Unlike outright gifts, this struc-ture minimizes the possibility that any new partners could impair the value ofthe assets

taxa-2 Internal Revenue Code Section 754 permits a partnership to file an election uponthe death of a partner to adjust the basis under IRC Section 743(b) Again thisprovides additional value to the family members

3 Internal Revenue Code Section 2036(b) provides that the retention of the right

to vote (directly or indirectly) shares of stock of a controlled corporation is aretention of the enjoyment of transferred property Accordingly, the value ofsuch stock is still includable in the estate of the transferor However, IRC Section2036(b) does not apply to partnership interests

HOW FAMILY LIMITED PARTNERSHIPS ARE FORMED

The family limited partnership usually is formed by the senior generation by ferring assets in return for general and limited partnership interests These interestscarry certain rights as to distributions, cash flows, and/or access to assets based onthe state law provisions specific to the state of governance

trans-Assets are generally investment real estate, marketable securities, bonds, orother assets that are expected to appreciate General partner interests usually rangefrom 1 to 5 percent Alternatively, limited partner interests usually range from 95 to

99 percent Further, general partner interests usually are held by the senior tion or by a separate entity, whereby the senior generation retains control of theentity and the underlying assets

genera-Subsequently, gifts generally are made to the junior generation of limited nership interests as a highly efficient means of transferring value and assets out ofthe estate of the senior generation while maximizing the use of the federal and stateestate and gift tax structure Such efficiency and tax structure benefits are made pos-sible because federal and state laws and regulations treat an ownership interest in alimited partnership substantially differently from a direct ownership interest in par-ticular assets

part-For example, assume that a husband and his spouse own various marketablesecurities worth $1 million They both transfer these assets to an FLP Later, theytransfer a 10 percent interest to their child This transfer typically will be taxedfor gift tax purposes based on the value transferred If a 10 percent interest in theunderlying assets were directly transferred, the taxable value would be $100,000($1,000,000× 10 percent) However, through the use of the FLP, the taxpayers(husband and spouse) can leverage the amount of the gift The taxable value, due

to the nature of the interest transferred, would not be a pro rata interest in theunderlying assets Rather, it would be the amount that a “hypothetical buyer”would pay for a 10 percent interest in a limited partnership This interest wouldconsider the fact that a limited partner’s interest (or an assignee’s interest) can-not and does not have access to partnership assets and cannot force any distri-bution or effectively control the ability to receive a return on his or herinvestment

As a result, the transferred interest above would be discounted for these ership and marketability issues and might be valued as follows:

Discount for lack of control 25%* ⫺ 25,000

75,000Discount for lack of marketability 30%* ⫺ 22,500

Value of interest transferred $ 52,500

*Note: For illustrative purposes only

By utilizing this type of transfer structure, the taxpayers have effectivelyreduced their exposure to estate and/or gift taxes by $26,125 ($100,000 pro ratavalue – $52,500 discounted value = $47,500 × 55 percent marginal estate/gift taxrate = $26,125) or 26.0 percent.

This type of “wealth preservation planning” technique can accomplish ple goals with respect to an individual’s assets, wealth, and estate However, thesebenefits do not come without their share of issues

multi-OTHER CHARACTERISTICS OF FAMILY

STATE LAW, PROPERTY RIGHTS, AND THEIR IMPORTANCE TO

THE VALUATION PROCESS

To fully assess the magnitude and volatility of an investment’s risks and returns,the valuation analyst needs to begin with a precise definition of the specificinvestment or ownership interest to be valued The analyst’s function will then

be to quantify the value of the “bundle of rights” associated with the investment

or specific ownership interest The characteristics of this bundle of rights heavilyimpact the value of the investment and provide some indication of the risk andreturn associated with it In addition, the more rights associated with the invest-ment or ownership interest, the more valuable it is Consequently, the analystalso must precisely define the bundle of rights associated with the subject inter-est, or the resulting value (although mathematically correct) may be of the wronginvestment

Rights are granted to a specific ownership interest by the underlying statelaws that govern the investment to be valued For this reason, attorneys are bestqualified to opine on the characteristics of the bundle of rights associated with thesubject investment To assure accuracy of the legal assumptions on which thevalue opinion will be based, the analyst may want to include legal counsel in earlydiscussions of the property being valued and the state laws and property rightsassociated with it

For instance, the value on a per share basis of a 32.5 percent interest in a closelyheld California corporation and a 33.5 percent interest in the same California cor-

poration are not necessarily the same As discussed in Estate of Luton vs Commissioner, T.C Memo 1994-539, an interest in a California corporation of

one-third or greater has the ability to force liquidation under certain circumstances

Accordingly, the liquidation rights associated with the 33.5 percent interest increaseits value since an investor may be willing to pay more on a per-share basis for suchrights.

By way of another example, an assignee interest typically will have the lowestlevel of rights of any interest, which may include factors such as the following:

• A right to receive, to the extent assigned, nonliquidating distributions andliquidating distributions to which the assignor/partner would be entitled aswell as a right to receive, to the extent assigned, allocations of income, gain,loss, deduction, credit, or similar item to which assignor/partner would beentitled

• No right to require any information or account of the FLP transactions

• No right to inspect the FLP books

• No right to vote on any matters that a general or limited partner would be tled to vote

enti-• No right to call partnership meetings

• No voice in the management of the FLP

• No ability to maintain an action (lawsuit) against a general partner for breach offiduciary duty

• No right to withdraw from the FLP and receive fair value for its assignee

inter-est prior to the expiration of the term of the partnership

FLP property rights consist of either or both: (1) an ownership interest in thepartnership and (2) management rights Both general and limited partners, as well

as their assignees, have no interest in the underlying assets owned by the FLPbecause these assets are no longer owned directly by the contributing partners Theyare now owned by the FLP The contributing partners received interests in the part-nership in exchange for their contribution of assets and surrendered their ownershipinterest in the underlying partnership assets

Therefore, an interest in the partnership is considered intangible personal erty and consists of the partner’s share of FLP distributions and the allocation ofincome, gain, loss, deduction, credit, or similar items, irrespective of the actual phys-ical character of the underlying partnership assets

prop-Once a valuation analyst has a solid understanding of the bundle ofrights, he or she is better prepared to determine how to capture theiraddition to or detriment from value in the subject’s benefit stream,rate of return, discount applied to enterprise value, or a combination

of these Doing this will involve gaining a picture not only of therights that exist but, more important, of those rights that do notexist

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IMPROPER FORMATION CAN CREATE

PROBLEMS FOR PARTNERS

A variety of considerations regarding FLP formation have become the focus ofrecent Internal Revenue Service (IRS) attacks and litigation These considerationsinclude but are not limited to:

• Gifts on formation

• Indirect gifts

• Subsequent asset infusions

• Asset diversification

• Real property assessments

“Gift on Formation,” Indirect Gifts, and Subsequent Asset InfusionsGifts of assets on the formation of an FLP typically are transferred to the newlyformed entity in return for partnership interests (limited and general) As such, it isimportant that these initial contributions be transferred on the date the FLP isformed and that they have been appropriately valued to provide the desired basisfrom which to determine the percentage of ownership to attribute to each con-tributing partner The percent ownership interest received by each partner inexchange for contributed assets should be based on the relative value of those assetsand should be reflected in the individual partner’s capital account Last, the part-nership should be a “straight-up” pro rata partnership with respect to all alloca-tions Allocations of all items should be based on the partnership interest percent

If assets are not transferred upon formation in return for the same percentage

of partnership interest in relation to the assets, there can be an unintended gift ofthe value differential between the assets transferred and the interest received

“Indirect” gifts typically are created through non–pro rata allocations of income

or capital appreciation and/or the attribution of improper asset values to a lar partner’s capital account at formation When additional assets are transferred tothe FLP after formation and the value of the subsequent assets is not attributed to thedonor’s capital account, an indirect gift to the nondonating partners can also occur.Asset Diversification

particu-When publicly traded securities are contributed to an FLP, it is important to avoidtriggering the gain recognition rules under the “Investment Company” provisions ofInternal Revenue Code (IRC) § 351

IRC § 721(a) provides that, as a general rule, no gain or loss is recognized byany partner transferring property to a partnership in exchange for an interest in thepartnership However, IRC § 721(b) provides that the transfer of appreciated prop-erty to a partnership that would be treated as an investment company within themeaning of IRC § 351 (if it were incorporated) would not be a tax-free transferunder IRC § 721(a) The section further states that such a transfer would be con-sidered taxable if:

• The transfer results, directly or indirectly, in the diversification of the transferor’sinterests

• The transfer is to an entity holding more than 80.0 percent of the value of itsassets, excluding cash and nonconvertible debt instruments, for investment inreadily marketable stocks, securities, or interests in regulated investment compa-nies or real estate investment trusts

Real Property Reassessment

Property tax laws in the governing state are of crucial importance when valuing anFLP Certain transfers of real property into an FLP can give rise to a reassessment ofthe real property for real estate tax purposes In certain states, real property taxreassessment may not be triggered by the initial transfer of real property to the FLPbut may be triggered by the subsequent transfer of the FLP interests In many juris-dictions, the exclusions for reassessment that apply to the direct transfer of realproperty may not apply in the context of the transfer of FLP interests As a result,

in certain situations (usually upon the transfer of 50.0 percent or more of the FLPinterests on a cumulative basis) this may result in a reassessment In addition, somestates have a transfer tax on real property exchanges

VALUATION OF FAMILY LIMITED PARTNERSHIP INTERESTS

The valuation of an FLP interest involves a number of considerations and steps:

Preliminary Considerations

• Information required

• Analyzing the agreement

• IRC Chapter 14 considerations

The Valuation Process

• Understanding the assets, operations, and financial components of the ship

partner-• Data sources, comparative/benchmark information

• Valuation approaches

• Application of the data and multiples or adjustments

Each of these considerations is discussed in depth below

Preliminary Considerations

Information Required

As with all valuation engagements, the information required to prepare the tion of an FLP is dependent on the facts in the case However, where available, cer-tain information should be considered the minimum foundation to complete theassignment This information includes:

valua-• Final partnership agreement and all amendments and assignments associatedwith it

• Documentation of assets being contributed

• Appraisals of real estate and other partnership assets

• Other valuations as needed (in tiered entity structures)

• Balance sheet as of valuation date

• Income statement as of the valuation date

• Tax returns or prior filings

• Certificate of limited partnership

• Income and distribution history

• Prior valuations of the partnership

• Details of prior transfers (gift or otherwise) into the partnership

• Management structure and analysis of decision making rights

• Governing state partnership laws

Analyzing the Agreement

One of the key considerations to valuing an FLP interest is a thorough ing of the provisions of the partnership agreement to accurately reflect them in thevalue estimate Given the fact that the agreement is a legal document and most ana-lysts are not attorneys, the analyst will want to seek the guidance of legal counselfor this task

understand-The provisions of the agreement, as well as governing state partnership law,will define the interest and rights associated with the particular FLP A typical agree-ment will have provisions regarding capital contributions, distributions, allocations,liquidation, voting, term, withdrawal, death, transfer, and termination.Furthermore, the agreement will provide for certain rights and restrictions specific

to the general partner(s) and to the limited partners

Examples of 15 common provisions in family limited partnership agreementsare provided below, using typical terminology and language structure

lim-ited partnership in the office of the Secretary of State of Anystate and shall tinue for forty years from December 1, 2002, unless sooner dissolved pursuant

con-to the provisions of this Agreement or unless continued by unanimous consent

of the Partners.”

acquire, own, operate, and dispose of investment real estate property.Additional related business activities permitted by law may be engaged in bythe Partnership from time to time as determined by the General Partners.”

Term restriction is important from a valuation perspective because itdefines the inability of the limited partners to receive a return on theirinvestment prior to the completion of the partnership term

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3 Majority Vote “Majority vote shall mean the affirmative vote by the Limited

Partners of record which vote represents more than 50 percent of the aggregateInterests of the Limited Partners of record entitled to vote.”

a “The term ‘transfer,’ when used in this article with respect to a Partnershipinterest, shall include any sale, assignment, gift, pledge, hypothecation,mortgage, exchange, or other disposition of such Partnership interest.”

b “No Partnership interest shall be transferred, in whole or in part, except inaccordance with the terms and conditions set forth in this article.Notwithstanding the preceding sentence, if all of the Partners enter into anAgreement for the purchase of a Partner’s Partnership interest, suchAgreement shall be binding upon the Partners and the Partnership.”

This type of provision provides rights for limited partners in certain cumstances that may enable them to affect some operations of the part-nership As such, the impact of this type of provision is partiallydependent on the size of the limited partnership interest being valued.ValTip

cir-If the provisions in the agreement are anything other than fair marketvalue between family members, it may be disregarded under § 2703

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Most partnership agreements have a clearly stated restriction on ferability of partnership interests, primarily to protect all partners fromfinding themselves legally bound to partnership with individuals not oftheir choice From a valuation perspective, such restrictions on trans-ferability may have a material impact on the selection of the degree ofdiscount for lack of control and lack of marketability However, ifother provisions modify the transferability restrictions, they may pro-vide a mitigating effect on the depth of the discount for lack of controland lack of marketability

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5 Capital Contribution of General Partners “The General Partners shall be

cred-ited with the Gross Asset Value of the property contributed by them As of thedate of such contributions, the Capital Account balance of the General Partnersshall equal XX percent of the aggregate Capital Account balances of allPartners.”

Partners shall actively manage and conduct the business of the Partnershipdevoting such time to the management as the General Partners may deem nec-essary The General Partners shall have the full and complete power to do anyand all things necessary or incident to the management and conduct of thePartnership business The General Partners shall have full power and author-ity to take any action they deem necessary or advisable on behalf of thePartnership and shall make all decisions affecting the business, affairs andproperties of the Partnership No person dealing with the Partnership shall berequired to inquire into the authority of the General Partners to take anyaction or execute any document on behalf of the Partnership Specific pow-ers include:

a Conveyances “The General Partners shall have the authority to sell,

exchange, assign, or transfer any of the property or assets of the Partnership,

in furtherance of the business of the Partnership, and, in connection with, to execute, in the Partnership name, by agent or nominee, any and allassignments, documents, bills of sale, and other papers pertaining to thePartnership business

there-b Authorized Acts of the General Partners “Without limiting the generality

of the provisions of this Agreement concerning general authority and gations of the General Partners and conveyances and in furtherance of thepurposes of the Partnership, but subject to any specific limitations provided

obli-in the Act or obli-in this Agreement, the General Partners are hereby authorized

to do any and all of the following:

i Resolve claims of or demands against the Partnership;

ii Pay as a Partnership expense all costs associated with the operation ofthe Partnership;

iii Apply the Partnership’s funds in a manner consistent with thisAgreement;

iv Make tax elections;

v Require in Partnership contracts that no Limited Partner have anypersonal liability thereon;

All contributions are to be credited to the partners’ accounts to avoidthe “gift on formation” issues previously discussed

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vi Execute all documents or instruments of any kind which the GeneralPartners deem appropriate for carrying out the purposes of thePartnership, except as otherwise provided herein;

vii Acquire, hold, develop, improve, maintain, operate, lease, sell,exchange, and dispose of any real property and personal property thatmay be necessary to the accomplishment of the Partnership’s pur-poses;

viii Borrow money from banks or other lending institutions on behalf ofthe Partnership; and in connection therewith, mortgage, pledge, orcreate other security interests on any or all of the Partnership assetsand income therefrom and secure or provide for the repayment ofsuch borrowing or loans;

ix Deposit Partnership funds in bank certificates of deposit, bearing savings and checking accounts, prime commercial paper, orgovernment obligations;

interest-x Purchase insurance, or extend the General Partners’ insurance, at thePartnership’s expense, to protect Partnership properties and the busi-ness of the Partnership against loss and to protect the GeneralPartners against liability to third parties arising out of Partnershipactivities; and

xi Enter into any kind of activity and perform and carry out contracts ofany kind necessary to the accomplishment of the purposes of thePartnership, so long as said activities and contracts may be lawfullycarried on or performed by a partnership under the laws of the State

of XXXXXX.”

all or part of his partnership interest to a person or entity who is not a GeneralPartner, such transfer shall be permitted if, and only if, (i) the proposed trans-feree is to become a Limited Partner and shall be subject to the provisions ofthis Agreement having to do with the transfer of a Limited Partnership interest,

or if (ii) the proposed transferee is approved as an additional or successorGeneral Partner by unanimous consent of all partners.”

other-wise provided in the following section, the General Partners may, without theconsent of any Limited Partner, amend any provision of this Agreement, andexecute whatever documents may be required in connection therewith.”

thereby, no amendment to this Agreement shall be permitted if the effect ofsuch amendment would be to:

a Extend the term of the Partnership as set forth as provided in the provisions

of this Agreement having to do with the term of the Partnership;

b Amend this section;

c Convert the interest of a Limited Partner into the interest of a GeneralPartner;

d Alter the interest of a Limited Partner in the Profits, Losses, or Distributions

of the Partnership, except for a change which is necessary to cure any guity or correct or supplement any provision contained in this Agreement

ambi-which may be incomplete or inconsistent with any other provision tained herein;

con-e Increase the amount of Capital Contributions payable by any LimitedPartner;

f Modify the limited liability of a Limited Partner or reduce or modify the bility of any General Partner; or

lia-g Otherwise increase the duties or liabilities of the General Partners or of anyLimited Partner.”

10 Capital Contributions of the Limited Partners “The Limited Partners shall be

credited with the Gross Asset Value of the property contributed by them As ofthe date of such contribution, the Capital Account balance of the LimitedPartners shall equal XX percent of the aggregate Capital Account balances ofall Partners.”

11 Limitation of Liability “No Limited Partner shall be liable for any debts,

lia-bilities, contracts, or obligations of the Partnership; have any personal liabilityfor the repayment of the Capital Contribution of any other Partner; and berequired to lend any funds to the Partnership.”

The provisions concerning amendments to the partnership agreementprovide a substantial level of authority to the general partner withinput by the limited partners However, many partnership agreementsprovide for a “power of attorney” clause whereby the limited partnersspecifically provide the authority for the general partner to act on theirbehalf In addition, a restriction on transferability provides some level

of protection to the limited partners regarding possible changes inpartnership management of the partnership These restrictions as well

as the general partner(s)’ legally binding fiduciary responsibility towardthe limited partners may allow for some level of discount for lack ofcontrol when valuing a general partner interest

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Like the provision for the general partner capital accounts, this sion makes it clear that all contributions are to be credited to the part-ners’ account to avoid the “gift on formation” issues previouslydiscussed

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12 No Management Responsibility “No Limited Partner, when acting solely as

such, shall take part in the management of the Partnership or transact any ness for the Partnership All management responsibility is hereby vested in theGeneral Partners.”

busi-13 No Authority to Act “No Limited Partner, when acting solely as such, shall

have the power to sign for or bind the Partnership or transact business in thename of the Partnership All authority to act on behalf of the Partnership ishereby vested in the General Partners.”

14 Access to Information “Each Limited Partner shall have the right to obtain,

from time to time upon written request, for any purpose reasonably related tothe Limited Partner’s interest as a Limited Partner, any such requested infor-mation relating to the business of the Partnership and such other information

as a limited partner has a right to obtain under the Act, provided that thePartnership may require the Limited Partners to pay the costs incurred by thePartnership in responding to any such request for information.”

15 Transfer by a Limited Partner “A Limited Partner may assign and transfer all

or any part of such Limited Partner’s Partnership interest only with the writtenconsent of the General Partners

a Any successor or transferee of a Limited Partner hereunder shall be bound

by the provisions of this Agreement

b Any assignee who is not a Partner at the time of the assignment shall be tled to the allocations and distributions attributable to the interest assigned

enti-to it and enti-to transfer and assign such interest in accordance with the terms ofthis Agreement; provided, however, such assignee shall not be entitled to theother rights of a Limited Partner until it becomes a substitute LimitedPartner

c No assignee of a Limited Partner’s Partnership interest is entitled to become

a substitute Limited Partner until the following have occurred:

i The General Partners shall have given their prior written consent,which consent may be withheld in his absolute discretion;

ii The transferring Limited Partner and the transferee shall have cuted and acknowledged such other instrument or instruments as theGeneral Partners may deem necessary or desirable to effect suchadmission;

exe-iii The transferee shall have accepted, adopted, and approved in writingall of the terms and provisions of this Agreement as the same mayhave been amended; and

iv The transferee shall pay or obligate itself to pay, as the GeneralPartners may require, all reasonable expenses connected with its

One of the benefits to a limited partnership structure is the protectionafforded the limited partners from the debts and obligations of thepartnership or other partners

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admission as a substitute Limited Partner, including but not limited tothe cost of preparing appropriate amendments to this Agreement.”

Internal Revenue Code Chapter 14 Considerations

Chapter 14 (§§ 2701-2704 of the Internal Revenue Code [IRC]) was enacted by theOmnibus Budget Reconciliation Act of 1990 as a response to perceived “estatefreeze” abuses by estate planning professionals and their clients Chapter 14 focuses

on the taxation of certain transfers of corporate and partnership interests (§ 2701),the impact of buy-sell agreements on such transfers (§ 2703), the effect that certainlapsing rights have on the value of property subject to such transfers (§ 2704), andthe taxation of certain transfers in trust (§ 2702) Sections 2701, 2703, and 2704can significantly affect the value of an interest in a closely held corporation and afamily limited partnership Therefore, a detailed discussion of these code sections isprovided

Section 2701. Section 2701 addresses transfers of interests in controlled ties Subject to several definitions and qualifications, § 2701 applies to:

enti-• A transfer of an interest in a corporation or partnership

• To an applicable family member

• Where the transferor or an applicable family member retains an “applicableretained interest” after the transfer and

• The transferor and applicable family members control the corporation or nership following the transfer

part-If § 2701 applies, special valuation rules must be used in computing the value

of the interest in the corporation or partnership that is transferred to an applicablefamily member

The above provisions are the foundation for selecting appropriatediscounts for lack of control and lack of marketability for tworeasons:

1 A limited partner, by definition, does not have any right to manage

or control the partnership, thus eliminating his or her ability todetermine the amount and timing of any distributions or asset liq-uidations of the partnership This effectively eliminates some of thesources of return on the partner’s investment

2 In addition, the inability to readily transfer the interest or withdrawfrom the partnership eliminates the other avenue for a limited part-ner to receive a return on his or her investment

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These rules require that the value of the entire corporation or partnership must

be computed first That value will generally be attributed to the transferred interests

except to the extent that the retained interests have regular and fixed distributionrights that are cumulative; other rights generally will be ignored

Section 2701 normally would apply to the typical family limited partnershiparrangement but for the exception provided under § 2701(a)(2)(B) for transfers ofinterest that are the “same class” as the retained interest except for “nonlapsing dif-ferences with respect to management and limitations on liability.” In the standardFLP, general and limited partners do have the same interests in profits and losses ofthe partnership based on each partner’s proportionate interest in the partnership,with general partners having management rights and limited partners having limi-tations on liability pursuant to applicable state law Consequently, a transfer of alimited partnership interest should not be subject to the § 2701 valuation rules if theitems of income, gain, loss, deduction, and credit are allocated among all the part-ners, including limited partners, based on their capital accounts

By basing partnership allocations and distributions on the partners’ capitalaccount balances (i.e., pro rata allocations and distributions), the transfer of part-

nership interests should not be subject to § 2701 and the partnership agreement

does not need to contain the complex provisions of § 704(b) (dealing with the stantial economic effect test that applies to special allocations)

sub-Section 2703. Section 2703 provides that the value of property for estate,gift, and generation-skipping transfer tax purposes is determined without regard toany restrictions on the sale or use of the property unless:

• The restriction (e.g., a buy-sell agreement) is a bona fide business arrangement;

• The restriction is not a device to transfer property to family members for lessthan full and adequate consideration and

• The restriction must be comparable to similar arrangements entered into by sons in an arms’ length transaction

per-Section 2703 applies to a “right or restriction,” whether explicitly fashioned assuch, contained in the partnership agreement or similar document, or merelyimplicit in the capital structure of the entity

If § 2703 applies, key provisions commonly found in an FLP agreement, such

as restrictions against partners transferring interests in the partnership and the ners’ inability to liquidate their interest until the end of a specified term of years, can

part-be ignored

Thus, it is important to establish that the partnership agreement:

• is a bona fide business arrangement

• is not a device to transfer the property to members of the decedent’s family forless than full and adequate consideration in money or money’s worth

• is an arrangement the terms of which are comparable to similar arrangementsentered into by persons in arms’ length transactions

The IRS interpretation and application of § 2703 arguably is contrary to gressional intent Specifically, the legislative history pertaining to § 2703(a) indicates

con-that, in enacting § 2703, Congress was concerned with perceived abuses of buy-sell agreements and options For example, the Congressional Record states that:

[T]he committee is aware of the potential of buy-sell agreements for torting transfer tax value Therefore, the committee establishes rules thatattempt to distinguish between arrangements designed to avoid estate taxesand those with legitimate business agreements The rules generally disregard

dis-a buy-sell dis-agreement thdis-at would not hdis-ave been entered into by unreldis-atedparties acting at arm’s length 136 Cong Rec S15681 (10/18/90)

The bill does not affect minority discounts or other discounts able under present law

avail-In the Conference Report under the heading “Buy-Sell Agreements andOptions,” it is stated:

[T]he conferees do not intend the provision governing buy-sell ments to disregard such an agreement merely because its terms differfrom those used by another similarly situated [entity] H.R Rep 964,101st Cong., 2d Sess 1137 (1990)

agree-The Senate Report statement reads that, apart from the restrictions concerningacquisition or use of the property addressed in the bill, the bill does not otherwisealter the requirements for giving weight to a buy-sell agreement For example, it leavesintact present law rules requiring that an agreement have lifetime restrictions in order

to be binding on death

These sources of legislative history demonstrate that Congress’s intent in

enact-ing IRC § 2703 was not to deny the existence of valid partnerships but rather to

combat potential abuses associated with certain buy-sell agreements Thus, the IRSinterpretation of the statute, as set forth in the Technical Advice Memorandums(TAMS), is contrary to Congress’s intent

The IRS interpretation of IRC § 2703(a) also is inconsistent with the Code’sstatutory construction The IRS view of § 2703(a) supersedes the need for § 2704which covers restrictions in an agreement with respect to liquidation UnderTreasury Regulation § 25.2704-2(b), any option, right to use property, or agreementcovered by § 2703(a) is not covered by § 2704(b) Thus, to the extent that § 2703(a)applies to a restriction, § 2704(b) is ignored

If the IRS interpretation of § 2703(a) is adopted and the existence of a partnershipcan be ignored, all restrictions affecting the rights of partners are covered by § 2703(a)and nothing remains to be addressed by § 2704(b) Taken to its logical conclusion, theIRS view assumes that Congress passed a meaningless statute in the form of § 2704(b).The IRS interpretation also is contrary to the Treasury Department’s intent andthe construction of regulations under § 2703 It does not appear that Treasuryintended that § 2703 could be applied to disregard a partnership when valuingproperty for federal transfer tax purposes This is evident in Treasury Regulation §25.2703-1, which states that “a right or restriction may be contained in a partner-ship agreement, articles of incorporation, corporate bylaws, a shareholder’s agree-ment, or any other agreement.” This language is different from “a right or

restriction may be a partnership or a partnership agreement,” which would be theappropriate language if Treasury had believed that legal entities established understate law should be ignored.

Additionally, if a partnership or corporation could be disregarded under

§ 2703, Treasury would not have stated in paragraph (b)(5) of Treasury Regulation

§ 25.2703-1 that:

[I]f property is subject to more than one right or restriction described in[section 2703(a)], the failure of a right or restriction to satisfy therequirements of [section 2703(b)] does not cause any other right orrestriction to fail to satisfy those requirements if the right or restrictionotherwise meets those requirements Whether separate provisions areseparate rights or restrictions, or are integral parts of a single right orrestriction, depends on all the facts or circumstances

Logically, if a partnership can be disregarded under § 2703 as a “restriction,”there is no need to elaborate on the subject of multiple restrictions If the IRS view

of § 2703 is adopted, paragraph (b)(5) is void of meaning This could not have beenTreasury’s intent

Since the IRS interpretation of IRC Code § 2703(a) is contrary to Congress’sand Treasury’s intent and to the statutory construction of the Code and regulations,

it should be rejected, and § 2703(a) should not be applied in a manner that gards the creation of a partnership Nonetheless, the broad manner in which thestatue and regulations are written, and the lack of substantial legislative history,enable the IRS to credibly argue that § 2703 can be applied to disregard a partner-ship for federal transfer tax valuation purposes

disre-Section 2704. Section 2704 is intended to accomplish two purposes:

1 Section 2704(a) treats the lapse of certain rights as a gift by, or as includible inthe estate of, the owner of the lapsed right

2 Section 2704(b) disregards certain restrictions on the ability of an entity to uidate when determining the estate or gift tax value of the interest to which therestriction applies

exist, a lapse of any voting, liquidation, or similar right in a partnership will betreated as a transfer for gift tax purposes by, or, if applicable, will be included inthe estate of, the individual who held the right immediately before the lapse

Section 2704(a) applies only if, both before and after the lapse, the individualholding the lapsed right immediately before the lapse and members of such indi-vidual’s family control the partnership (§ 2704(a)(1)(B))

The definition of control for partnerships is different for a general partnershipthan for a limited partnership For a general partnership, control means “the hold-ing of at least 50 percent of the capital or profit interests in the partnership”(§§2704[c][1] and 2701[b][2][B][i]) For a limited partnership, control means “theholding of any interest as a general partner” (§§2704[c][1] and 2701 [b][2][B][ii]).Most family limited partnership agreements contain provisions that cause ageneral partnership interest to convert to a limited partnership interest upon the

occurrence of certain triggering events (e.g., transfer, death, bankruptcy, etc.) Theconversion of a general partnership interest to a limited partnership interest doesconstitute a lapse of voting and liquidation rights and thus will be subject to §2704(a) As a result, the general partnership interest must be valued as if there hadbeen no lapse in the general partner’s voting and liquidation rights This means thatany lapsed rights will be assumed to have not lapsed, thus increasing the value.

part-nership to (or for the benefit of) a family member and the transferor and members

of the transferor’s family control the entity immediately before the transfer, then

the transferred interest will be valued without considering any “applicable tion.”

restric-An “applicable restriction” means any restriction that limits the ability of apartnership to liquidate if:

• The restriction lapses, in whole or in part, after a transfer of an interest in thepartnership to (or for the benefit of) a member of the transferor’s family; or

• After the transfer, the transferor or any member of the transferor’s family (eitheralone or collectively) has the right to remove the restriction in whole or in part(§ 2704[b][2])

Section 2704(b)(3) provides two exceptions to the definition of an applicablerestriction:

1 An applicable restriction does not include a commercially reasonable restrictionwhich arises as part of any corporate or partnership financing with a person who

is not related to the transferor, the transferee, or a family member of either

2 An applicable restriction does not include any restriction imposed, or required

to be imposed, by federal or state law

Thus, despite the enactment of § 2704, the exceptions to § 2704 provide atleast three situations where an FLP can be used to reduce the estate or gift tax value

of a limited partnership interest An FLP arrangement may generate estate and gifttax valuation discounts when:

• One or more of the general partners are not family members

To avoid the negative impact § 2704(a) can have on the estate tax value

of a limited partnership interest, it is better if the limited partner does not

own a general interest in the partnership at death Alternatively, the ited partner can gift all of his or her limited interest before he or she dies.ValTip

lim-• A liquidation restriction is imposed as part of a financing arrangement with anunrelated party

• A liquidation restriction is imposed under federal or state law

A restriction that requires the unanimous consent of all of the partners to beremoved should be respected notwithstanding § 2704(b), provided there is at leastone unrelated general partner in the partnership and, under state law, the familymembers by themselves cannot have the restriction removed

If one or more of the general partners are not family members and the tion restriction does not lapse in whole or in part after the transfer, the restrictionshould be respected because it cannot be removed by the transferor or members ofhis or her family either alone or collectively However, the ability to remove therestriction is determined by reference to the state law that would apply but for amore restrictive rule in the governing instrument of the partnership

liquida-If a general partnership interest is given to a charitable organization, for ple, and the organization’s consent is required, under the partnership agreement andapplicable state law, to liquidate the partnership or an interest therein, arguably theprovisions of § 2704(b) should not apply and the value of a limited interest in thepartnership may be determined by applying valuation discounts thereto This tech-nique also could be used by giving a general partnership interest to a nonfamilymember rather than to a charitable organization

exam-In summary, if an FLP violates any of the provisions of Chapter 14 (IRC §§

2701, 2703 or 2704), it can be detrimental to the valuation of the FLP It is best toavoid the application of Chapter 14

For instance, under § 2701, if the only differences between the senior and ior equity instrument is that of management, voting, or liability, then the complexand negative impact of the code section will not apply

jun-Under IRC § 2703, it is important to make sure that all provisions under thethree-part test are satisfied:

1 Bona fide business purpose

2 Not a device to transfer

3 Similar to other arm’s-length transactions

Under IRC § 2704, it is important to make sure that none of rights in the FLPlapse upon death or transfer The liquidation restrictions should be no more restric-tive than the governing state law

Accordingly, the underlying provisions of Chapter 14 add a substantial level ofcomplexity and possible detrimental impact on the valuation If these provisions aretriggered, a qualified professional with a good grasp of these provisions should beconsulted

• The approach that is given the most weight is dependent on the interest beingvalued as well as the facts and circumstances in a given case.

The following are some of the key factors and definitions controlling FLPvaluations

Lack of an Available Public Market

Many partnerships are nontraded investment vehicles designed to be held by inal family members until such time as the partnership sponsor elects to sell theunderlying assets and make liquidating distributions to the partners Unlikesecurities traded in the public markets, there is not a readily available referencesource to assist in establishing these partnerships’ fair market values Althoughthere exists a “secondary market” in which publicly held partnership interests are thinly traded, the transaction volume for them is insufficient to constitute atrue market

orig-Net Asset Value

Due to the highly restricted nature of limited partnership interests in FLPs, the right

to receive distributions represents the most significant economic benefit due to thelimited partners Net asset value represents the theoretical cash distribution (net ofcosts) that would be available to the partners in the event of an immediate, all-cashsale of the partnership’s underlying assets

Liquidation Rights of General and Limited Partners

While the value of liquidation rights is important to family members and should beconsidered in the valuation of any FLP interests, the significance of these rights isreduced in instances where liquidations are neither imminent nor certain

Individually and collectively, partners may not be able to determine the timing

or amount of distributions, control the purchase or sale of assets, or set ment policies Therefore, the complete lack of liquidation rights of the limited part-ners may add significantly to the discount for lack of control

manage-Fair Market Value

The appropriate measure of value for FLP limited partnership interests is fair ket value Long-standing regulations and rulings, such as Treasury Regulation20.2031-1(b) and Revenue Ruling 59-60, 1959-1 C.B 237, have provided defini-tions for fair market value and guidelines for estate and gift tax valuations for morethan 40 years and have been referenced in numerous legal cases

mar-If fair market value is the appropriate standard of value, factors encing the pricing of partnership interests in secondary transactionsmay be considered

influ-ValTip

Investment Factors Considered by Limited Partnership Investors

Typical considerations of investors in partnership investments where a marketexists, provide some foundation for understanding how an investor may look at aninterest in an FLP However, FLPs may have characteristics similar in nature butoften inferior to those with some market in which to transact

Buyers and sellers of securities (including partnership interests) express theirpreferences with respect to a number of investment characteristics when they eval-uate buy and sell decisions Buy/sell preferences for partnership interests are princi-pally driven by these factors:

• Secondary market liquidity and investment control

• Cash flow and distributions

• Asset type and quality

• Management capabilities and fee structure

• Market capitalization

• Portfolio diversification

• Capital structure (debt versus equity)

• Liquidation time horizon

The market normally applies an adjustment for absence of control This ment is often smaller for partnership interests that actively transact on the second-ary market (exhibit liquidity) and larger for partnership interests that seldom ornever change hands in secondary transactions (are virtually illiquid) The premiseunderlying these adjustments is that the negative consequences associated with lack

adjust-of control are decreased in instances where a relatively liquid secondary marketexists and are increased when liquidation through sale of the partnership interest in

a secondary transaction is not possible or is severely limited

Cash Flow and Distributions. Partnership interest investors can receive nomic benefits through distributions of current cash flow and/or the cash resultingfrom the sale or financing of assets However, since individual investors in limitedpartnership interests have limited control over partnership distribution policies andthe timing of asset sales/financings or resulting distributions, they place heavyemphasis on current cash flow distributions when making investment decisions.Since secondary market investors express a strong preference for current distri-butions, partnerships which distribute amounts in excess of existing current cashflow from existing cash balances usually carry larger discounts or lower value Somepartnerships historically accumulated cash and distribute it years after it was gener-ated This is an indication the current distribution level cannot be sustained

eco-Alternatively, partnerships that have strong current cash flows and distribution thatare supported by current partnership operations usually will carry smallerdiscounts.

Asset Type and Quality. The economic benefits investors in partnership ests receive will depend on the performance of the existing partnership asset poolover the expected remaining investment-holding period Unlike operating compa-nies, partnerships generally do not sell or finance assets and reinvest the resultingproceeds in new assets As a consequence, partnership investors are highly con-cerned with the type and quality of assets held in a partnership portfolio at the time

inter-of investment Accordingly, adjustments to net asset value will be made for nerships that own assets of inferior quality and/or that are out of favor withinvestors

part-Management Capabilities and Fee Structure. For a partnership expected tooperate indefinitely, an evaluation of management capabilities, fee structure, andfinancial incentives is critical in an investor’s decision to buy or sell a partnershipinterest

The market can reflect premiums for partnerships operated by respected agement companies, which charge reasonable fees and have adequate incentives and

man-a demonstrman-ated cman-apman-ability to creman-ate vman-alue The mman-arket usuman-ally penman-alizes mman-anman-age-ment that has a poor reputation

manage-Market Capitalization. In the markets for publicly traded securities, a rity’s market capitalization influences the amount of attention it receives frominvestors This principle also holds true in the secondary market for partnershipsecurities Larger issues with significant equity receive more attention from the bro-kerage community and from secondary market firms than smaller partnerships withless current equity This increase in buy-side interest increases demand for the part-nership interests and results in higher prices paid by secondary market buyers.The market usually applies a larger adjustment to net asset value to reflect thenegative influence of small market capitalization on the partnership’s unit price

secu-Portfolio Diversification. Partnerships with concentrated ownership in a gle asset or in a pool of assets with very similar investment characteristics are inher-ently more risky than partnerships that are broadly diversified As such, the marketusually adjusts the net asset value to account for the impact of such risks on thepartnership’s unit price

sin-Capital Structure (Debt versus Equity). Financial leverage increases risk.Accordingly, larger adjustments may be appropriate in partnerships with high debtlevels

Liquidation Time Horizon. For partnerships with extended liquidationtime horizons, net asset value becomes a factor of diminishing importance andoperating risks become a more significant consideration The opposite is true forpartnerships expected to liquidate in the near term The market usually applieslarger adjustments to net asset value for partnerships not expected to liquidate inthe near term

Goodwill. In a few instances, investors demonstrate strong favor for certainpartnership investments due to name recognition or other “intangibles.” In suchinstances, the market applies premiums to net asset value to account for the influ-ence of these factors on the price of the partnership interest.

Recent Historical Performance. Partnership family members are stronglyinfluenced by recent performance trends Recent and significant changes in partner-ship’s distributions/cash flow or reported changes in the performance of a partner-ship’s underlying assets will impact the pricing of a partnership interest

Analytical Complexity. Numerous factors can complicate the analysis of apartnership investment Such factors may include complex financial reporting, con-voluted joint venture structures, inadequate disclosure by management, and owner-ship of difficult-to-value assets

Partnership family members favor simplicity Accordingly, the market usuallyapplies larger adjustments to net asset value for partnerships that are difficult toevaluate

Other Factors That Affect Value and Need to Be Considered

• Provisions in the partnership agreement or in the certificate of limited ship that the partnership shall continue to exist for a definite term of years, unlessdissolved or liquidated prior thereto

partner-• The reputation, integrity and perceived competence of the partnership ment/general partner

manage-• Lack of guarantees by general partner(s) regarding the return of partner capitalcontributions, allocations of profits or losses or cash distributions, includingamounts to cover the tax burden

• Exclusion of limited partners from participation in management and approvalrights of limited partners required for certain major decisions

• The means by which new managing general partners are elected

• The number of investors in the partnership

• Type and diversification of assets owned by the partnership

• Amount of debt in the partnership’s capital structure

• Degree and reliability of the information flow to the limited partners

• General partner rights to determine distributable cash

• Current and historical amount of cash actually distributed to partners andassignees

• Underlying cash flow coverage of yearly distributions made to partners andassignees

• Capital call provisions obligating limited partners and assignees to contributemore capital

• Limitations on the voluntary and involuntary transferability of general partnerlimited partner, and assignee interests

• Presence of rights of first refusal for transfers

• Size of the partnership interest

• Universe of interested buyers

• Limitations such as:

• A transferee or assignee of an interest in the partnership will not become asubstituted limited partner unless approved by the consent of all partners.

• Whether the managing general partners or general partners are required tomake an IRC § 754 election to set up the basis in the assets at the date oftransfer This would eliminate exposure to capital gains and increase depreci-ation on certain assets

• The right of the general partner to withdraw from the partnership prior to theexpiration of its stated term

• The right of a limited partner or assignee to withdraw from the partnershipprior to the expiration of its stated term

• Provisions for dissolution of the partnership that do or do not mirror the sions of state law

provi-• The “Default Rules” under state law All states have partnership acts However,not all states have the same provision language

Evaluating and Understanding the Financial Components

The analyst needs to evaluate and understand the following financial components of

com-Assets. The analyst needs to understand the underlying risk associated with

an FLP’s assets, incuding their liquidity, their ability to appreciate and generate cashflows, and their respective lives Assets are usually some combination of closely heldbusiness interests, real estate, or marketable securities and cash, and possibly otherassets, such as art collections or other valuable personal property and patents, copy-rights or other intangibles Generally, the less risky the underlying partnershipassets, the higher the value of the FLP

Assets within a particular category may produce different impacts onvalue For instance, if an FLP is holding undeveloped land instead of anincome-producing property, its value will be influenced by the inability

of the undeveloped land to generate a return to partners other thanthrough ongoing appreciation and possible liquidation of the asset

ValTip

Another reason for understanding the asset base of an FLP is that it can have

an impact on the sources of data to be used in the context of the valuation Suchdata sources will be discussed in another section

Liabilities. Liabilities are also important in the context of the valuation due

to the impact they may have on the equity of the asset base as well as the cash flowsgenerated from the underlying assets and operations High levels of debt increasethe exposure of the asset base and related cash flows to instability and other risks.The existence of debt allows fluctuations in asset value to impact and erode part-nership ownership values In addition, the existence of a debt service obligationcreates a fixed cost component that can substantially impair the FLP’s ability tocover other expenses or make distributions Other similarly value-eroding factorsare future obligations, such as balloon payments on loans, deferred maintenancecosts, or development costs associated with real estate assets All of these factorsnegatively impact the FLP’s ability to provide a return to the partners and, thus,negatively impact value

Income, Expenses, and Distributions. An FLP’s ability to generate an incomestream and provide distributions to partners is important In some cases, the onlydistribution to partners comes upon liquidation of partnership assets and/or termi-nation of the partnership Potential investors seek ongoing liquidity and returns.Thus, FLP values are often heavily discounted due to lack of liquidity and lack ofreturns

The analyst needs to understand the subject FLP’s ability to generate income aswell as its expense structure (including debt service) to fully assess their impact ondistributions and value

Investment Yield. All of the above factors directly influence FLP investmentyield as does the general investment rule that high-yield assets typically carry higherlevels of associated risk

In FLPs, there are two types of yields to consider:

1 Yield within the partnership (i.e., net cash flow plus appreciation generated bythe partnership)

2 Distribution yield to the partners (based on actual distributions made)

These yields may be different percentages because most partnerships do not tribute 100 percent of the cash flow generated, plus the first kind of yield includescapital appreciation on assets, if any

dis-Sources of Information to Assist in FLP Valuation

Numerous sources of information can assist in the valuation of FLPs Some provideempirical data as a basis to understand the difference in value from the underlyingassets or cash flow to the interest to be valued These sources include the traditional

initial public offering (IPO) and restricted stock studies and the QuantitativeMarketability Discount Model (QMDM) for quantifying a marketability discount,all of which have been discussed elsewhere in the book.

However, other available data sources are specific to the valuation of an FLP.The specific data source used will be dictated by the underlying asset breakdown ofthe FLP and the facts in a given case Next we will focus on several of the more com-monly used of such data sources

Data Sources for Family Limited Partnerships Holding Marketable Securities.

An FLP holding marketable securities has many characteristics in common with aclosed-end fund Accordingly, most practitioners utilize an analysis of closed-endmutual funds as a foundation for determining either a discount or a multiple to beapplied to the net asset value of the FLP

Some of the reasons that closed-end funds are useful sources of empirical data

by which to value FLP interests follow

1 Breadth of asset mix and size of universe There are literally hundreds of

closed-end funds available, all offering numerous specialized investment options

2 Fund unit prices represent minority interests The prices paid for publicly traded

closed-end fund units represent minority interests that are otherwise fully ketable Therefore, if the net asset values of a closed-end fund can be found andcompared with the freely traded price of the fund units, it can be determinedwhen and under what conditions the market applies an adjustment (positive ornegative) to the net asset value of a minority interest

mar-3 Ownership restrictions A closed-end fund issues a fixed number of shares that

does not change over the life of the fund Investors desiring to own shares in thefund must purchase the shares from other closed-end fund shareholders, notfrom the fund itself When the demand for units in a closed-end fund increases,the unit price of the fund increases This is more consistent with an FLP with aspecified number of units issued

The closed-end funds to be used should match as closely as possiblethe specific portfolio structure of the FLP For instance, if the FLP isholding only technology stock and some blue chips, the closed-endfunds selected should have a similar asset mix so that they will appro-priately reflect the market perception of risk for the type of portfoliobeing held by the FLP

ValTip

4 Similar base for net asset values The net asset value of a closed-end fund is the

aggregate value of the stocks and bonds owned by the fund, and the transactions

in a closed-end fund take place at the current trading unit price of the fund Thistrading unit price may be equal to, more than, or less than the net asset valueper unit

5 Similar investor lack-of-control issues An investor in a closed-end fund does not

have any ability to control, manage, or otherwise determine the nature of theinvestments made by the fund manager, although he or she has some assurance thatthe fund will continue to invest in certain types of investments based on its statedinvestment objectives The investor’s only choice is whether to continue as aninvestor in the fund or to liquidate the investment and invest in a different fund.Accordingly, ownership interests in closed-end mutual funds have many of the samelack of control characteristics and restrictions as FLP ownership interests have

6 Abundance of data sources Since closed-end funds are publicly traded,

numer-ous sources of data regarding them are available In fact, any service that vides public market data typically can provide information related to closed-endfunds

pro-One such source is Morningstar—Principia Pro.1This subscription serviceallows the analyst to sort over 600 closed-end funds using various search crite-ria including fund type, performance, risk, portfolio, and operations Eachsearch criteria provides a wealth of subcategories to enable the analyst to nar-

As a point of reference, publicly traded open-end mutual funds issueand redeem shares directly to and from the fund itself Consequently, ifthe demand for an open-end fund increases, the fund issues moreshares An open-end mutual fund normally prices unit purchases andredemptions at the transaction cost adjusted net asset value Therefore,these types of funds will continually dilute and grow with purchasesand shrink with sales Typically, they do not experience the relativeprice fluctuations that closed end funds do

ValTip

For this reason, analysis of closed-end funds with similar investmentcharacteristics to the subject FLP can provide an indication of theadjustment to net asset value that the market would require

ValTip

1Morningstar Principia Pro for Closed-End Funds, Morningstar © 1996–2001, www morningstar.com.

row the scope of the search A sample of search results from Morningstar isincluded as Exhibit 12.6 later in this chapter Morningstar provides historicaland current statistics on a fund-by-fund basis as well as the trading price per unitand net asset value per unit The analyst can evaluate such data based uponindustry sectors, portfolio profile, investment objectives, investment duration,and performance to more readily determine the differences between the selectedfunds and the subject FLP interest.

Data Sources for Family Limited Partnerships Holding Real Estate. Two mary sources of information typically are utilized for valuing an FLP holding realestate: (1) data regarding transactions in real estate investment trusts (REITs), and(2) data regarding transactions in publicly held syndicated real estate limited part-nerships (RELPs) Information on REITs is available through brokers who promotesuch investments or through the National Association of Real Estate InvestmentTrusts (NAREIT) Data on RELPs are available through Partnership Profiles, Inc.2The data from these sources need to be selected carefully to get a meaningful com-parison to the subject FLP

pri-Ownership interests in REITs and publicly held real estate LPs are consideredcomparable to FLP interests because they have no:

• Control over the distribution of cash flows

• Control over the reinvestment of the cash flows

• Control over the liquidation of the assets

• Management control or voice

However, unlike most FLPs, REITs have required distribution of substantiallyall income on an annual basis This means that they often are not considered asapplicable as a source of data for FLP valuation purposes

1 REIT Data: Shows various statistics and historical yields or returns for several

types of REITs These REITs are usually broken down into property type as well

as REIT type REIT data also includes:

2 Annual Partnership Re-Sale Discount Study, Published by Partnership Profiles Inc., Also,

Annual Partnership Profiles Minority Interest Discount Database, www.PartnershipProfiles com.

2 RELP Data: The Partnership Spectrum (a publication of Partnership Profiles,

Inc.)3 conducts an annual study of secondary market transactions of publiclyheld real estate limited partnerships to determine the difference between thepartnership trading value and the net asset value These studies primarily sort theinformation by partnership type and debt structure However, they also provideinformation such as distribution yield and trading price per unit versus net assetvalue per unit In addition, the analyst can access a specific partnership’s finan-cial data filed with the Securities and Exchange Commission for purposes of bet-ter analyzing the fit with the subject FLP interest The chart in Exhibit 12.1illustrates the differences in discounts for a group of partnerships over the years.4

Exhibit 12.1 Discount Variation

Valuation Approaches

The valuation of an FLP interest utilizes the same approaches that are used in thevaluation of business interests The asset, income, and market approaches can all beapplicable to FLP interests The degree of applicability is dependent on the analyst’sjudgment coupled with the facts and circumstances in the case

Price to NAV for 13 Selected Partnerships

Minimum price to net asset value

Average price to net asset value

Maximum price to net asset value

bi-monthly by Partnership Profiles, Inc., P.O Box 7938 Dallas, Texas 75209,

www.PartnershipProfiles.com.

4 Partnership Profiles Minority Interest Database, Partnership Profiles, Inc © 2000–2002,

www.PartnershipProfiles.com.

For many analysts, FLP valuations are not based on an income approach fortwo reasons:

1 Many FLPs hold assets that do not generate an ongoing income stream, makingthe only applicable benefit stream the cash from liquidation at some undefinedtime in the future

2 The individual asset valuations used in the cost or market approaches may havealready incorporated the FLP’s benefits streams, and valuing them using theincome approach may count them twice

Double counting typically can happen when an FLP holds income-producingreal estate In this case, the underlying real estate appraisal is based on an income

or market approach that includes valuing the anticipated benefits from the realestate To use the same benefit streams again in an income approach could be a mis-take Accordingly, many FLP valuations are based on an asset and/or market approach.Generally, the analyst will do an analysis of the assets, liabilities, income,expenses, and distributions as discussed above He or she will do data searches toextract comparable market data from the various data sources The resulting infor-mation will be the foundation for the discount from net asset value of the partner-ship using the asset approach

Alternatively, this discount can be applied as a market multiple to net assetvalue in the context of a market approach For example, if the closed-end fundanalysis provided a discount from net asset value of 10.0 percent, this would imply

a market multiple of 90.0 percent The value estimate would be the same; the onlydifference would be in the means of presentation

Some cases have successfully used a combination of a cost approach and anincome approach However, these cases typically involve FLP interests in which theFLP had the characteristic of a holding entity with regard to real estate and the

The derived discount from Net Asset Value (NAV) can be viewed intwo ways The first is as a discount as follows:

NAV ⫻ (1 ⫺ D) ⫽ Value Where: D ⫽ Discount

$1,000,000⫻ (1 – 20) ⫽ $800,000

Or it can be viewed as a market multiple as follows:

NAV ⫻ Multiple ⫽ Value

$1,000,000⫻ 80 ⫽ $800,000ValTip

characteristics of an operating entity because the real estate was a working ranch orfarm It may be less meaningful to use a combination method such as this for an FLPinterest holding marketable securities.

ILLUSTRATIVE CASE STUDY

Assume that Chance Family FLP held certain assets as shown in Exhibit 12.2

Exhibit 12.2 Asset Portfolio

Other Assets: Chance Family FLP held other assets in the form of $10,000 in

cash in the bank at the date of valuation Accordingly, the total assets held byChance Family FLP is shown in Exhibit 12.3

Exhibit 12.3 Total Assets

unencumbered, income-producing real estate Additionally, the expenses associatedwith the partnership are low in relation to the total income generated However, theyields on the investments are low on a cash flow basis, resulting in a total yield ofless than 6 percent The distribution yield (amount paid to partners) is even lowerand is below 2 percent.

The analysis incorporated a search of the Partnership Profiles database as well

as the Morningstar database to find a portfolio of securities and real estate that iscomparable to the holdings of Chance Family FLP Our search of the PartnershipProfiles data was based on finding commercial properties with no debt and that aredistributing partnerships Additionally, the search was for those properties that hadless than 10 properties owned (See Exhibit 12.5.)5

With respect to the marketable security portfolio, the Morningstar database wassearched for the funds that were considered “blue chip” and had fundamental objec-tives first of growth and secondarily of income We wanted a diversified mix acrossvarious sectors but invested primarily in domestic equities due to the holdings ofChance Family FLP These funds can be summarized as shown in Exhibit 12.6.6Chance Family FLP’s expected yield is much lower than the average yield fordistributing partnerships and the funds analyzed above The Chance Family FLPholdings are much smaller than those of the funds and partnerships This smallersize typically provides for less diversification as well as more exposure to risk.Accordingly, an investor typically requires a higher return from this type of invest-ment compared to the marketplace, given the additional elements of risk inherent inthe nature of this investment Typically these partnerships are more marketable anddesirable than Chance Family FLP

Based on the above information, we then apply the various discount factors tothe net asset value of Chance Family FLP in the context of an asset approach asshown in Exhibit 12.7

For illustrative purposes, we have used the average from the various studies.Some analysts compare specific partnerships and put more weight on certain onesdepending on the similarities Due to the higher risk in Chance than in the real estatepartnerships and the closed-end funds, we could have increased the weighted dis-count from 18.2 percent to somewhere above that amount, say 22 percent This issubjective but still is warranted since Chance is smaller and enjoys a lower yield,among other risks

This calculation is representative of the discount for lack of control as it relates

to the net asset value in an asset approach Alternatively, the discount can be verted to a multiple of 78 to be applied to the net asset value in the context of amarket approach After this discount is applied, the resulting value is of a minority,marketable interest in Chance Family FLP

con-Accordingly, the analyst needs to apply a marketability discount to obtain avalue of the Chance Family FLP interest on a minority, nonmarketable basis Forillustration purposes we have applied a marketability adjustment of 30 percent, asshown in Exhibit 12.8 The analyst would have to support the use of this adjust-ment based on the analysis and comparisons to various marketability benchmarkstudies Marketability discounts are discussed in Chapter 8 of this book

5Ibid.

6Morningstar Principia Pro for Closed-End Funds, Morningstar © 1996–2001, www morningstar.com Used with permission.

Exhibit 12.5 Partnership Profiles

_ _ Units Outstanding 14,555 19,635,965 1,322,909 1,556,416 2,188,724

Annualized Distribution $ 20.00 $0.07 $0.64 $0.62 $ 0.83 Revenue $908,000 $1,137,000 $684,000 $706,000 $1,057,000 Operating Surplus $331,000 $1,653,000 $1,049,000 $1,192,000 $1,789,000

Many of the marketability discount studies show discounts in the range of 30percent to 45 percent We selected 30 percent to reflect the lower discount attribut-able to the real estate portion (Equity/Net Assets) of the analysis There is some lim-ited liquidity in sales of interests of partnerships from Partnership Profiles whereasthere is practically instant marketability for sales of interests in the publicly tradedclosed-end funds Some analysts will separate the two components (real estate and

Exhibit 12.7 Discount Factors

Average Discount Weighted

Totals $5,175,688 100.0% Weighted Avg ⫽> 18.2%

Exhibit 12.8 Fair Market Value of a 10 percent L.P Interest (Illustration Only)

Valuation Adjustments (22%—Lack of control) _113,865

Adjusted Net Assets (noncontrolling, marketable basis) $ 403,704

Valuation Adjustments (30.0%—Lack of marketability) _121,111

Fair Market Value of a Ten Percent (10.0%) Limited Partnership

Interest (on a noncontrolling, nonmarketable basis) $ 282,593

Fair Market Value of a Ten Percent (10.0%) Limited Partnership

Interest (on a noncontrolling, nonmarketable basis)—rounded $ 283,000