1 / 11100%
Because Johns ultimate desire is to transfer a portion of his sole proprietorship to his two children
Cindy and Luke, for the purpose of keeping some if not all the business’ wealth within the family line
for more than just his generation, I would propose to John a plan for the restructuring of his estate
asset: the machine shop worth $10M to go from being solely owned to being a Family Limited
Partnership in Trust (even if only temporarily). This allows room for both John and his children to
experience the new ownership statuses without the full tax responsibilities being fully enacted all at
once.
And it gives room for the life of the new entity to grow with John’s descendants as needed. Starting
with a 60/40 split for its first year or two, with review and adjustment set by its third, for the life of the
Trust. Thus, reducing John’s yearly tax liabilities and if accepted, slowly introducing those liabilities
to his children based on their agreed allocations.
John, as a Priority Limited Partner, would be assigned 60% of the business interest carrying the
majority control and voting rights to start, with the agreement that upon his death the full 60% would
be transferred to the Trust in whole to be allocated equally between all his surviving decedents with
follow Priority Limited Partners receiving a greater %. John would also be designated as the General
Partner because he currently continues to handle and oversee the shops’ day-to-day operations (Fritz).
6 months after the Trust creation I would take the remaining 40% and proceed in transferring the
initial gifts towards Cindy and Luke with a 75/25 split between the Trust and them. Assigning both
Cindy and Luke as Limited Liability Partners in Interest with the value of $500,000 each, representing
just 10% of the total Trust, or 5% each. Working with the assumption that less than half of John’s
lifetime unified credits have been used thus far, allows the first year of ownership to have zero tax
liabilities on Cindy and Luke. By taking this time and having the yearly tax documents properly reflect
ownership changing hands, the associated valuation discounts will less likely be inaccurate and FMV
can easily be assessed and realized in all transfer agreement documentations (T&E Adm).
And in year two transferring another 5% each if both Cindy and Luke have agreed to the terms of the
Family Trust, redesignating them Priority Limited Partners as original members by the end of year
three, resulting in 15% each ownership, with the remaining 5% being allocating in year five (if not
sooner). I understand that during the first 2-3 years John may have to deal with an additional tax return
for the Trust itself as it owns partial interest not yet allocated. But through
By properly documenting the transfers, the dates of ownership and giving the new owners a chance to
see what best options may exist outside of the current plan, both the financial advisors and the John
family are given the opportunity they need to explore the estate’s asset transferring in all aspects.
Setting up a plan that does not give room for change or growth can be bound to fail without proper
review and thorough examinations before agreements/creation take place because depending on the
size, these decisions carry with them sizable tax liabilities. It’s during the creation period that all facets
of the transition can be explained and detailed.
For example, what if both Cindy and Luke enjoy the additional income from the shop but never want
to run its daily operations, this time allows them to explore all possibilities. Like what liabilities would
result from them debating for several years on whether they want to sell it off, especially if its value
drops by 15%. Or if several years after John’s passing and selling off about 35% of the shop, Luke’s
oldest son Jake decides that he wants to carry on in his grandfather’s footsteps. Having that remaining
65% interests carries with it the nepotistic ability to appoint Jake with a high controlling position
within the business. None of which would be possible if during the first few years the instant pressure
of an unfamiliar ownership caused both Cindy and Luke to turn down their respected interests in the
shop and choose to liquidate (most likely at an unvalued sales price) instead.
A family limited partnership (FLP) is a limited partnership where partners are primarily related. The
creator can name themselves as general partner and retain full control regardless of the number of
additional partners. If John wishes to transfer part ownership of his business to his two adult children,
Cindy, and Luke, an FLP will allow him to retain managerial control over the company while
distributing family assets and providing protection from creditors (Raub & Belveder, N.D.). CFR
§20.2031-1(b) assesses the valuation of property in general includible in a decedent’s gross estate as
the fair market value at the time of death or the alternate valuation method under IRC §2032. CFR
§20.2031-3 values interests held in a business as the net among a willing purchaser would pay to a
willing seller, determined based on all relevant factors including a fair appraisal and demonstrated
earning capacity. This section allows for partnerships and closely held corporations to take advantage
of valuation discounts as shares convey no control and are relatively illiquid. The lack of
marketability, lack of control, and lack of liquidity reduce the assets’ value for gift tax purposes during
the decedent’s life and estate taxes following death. In addition, John can begin gifting up to $17,000
(for 2023 under IRC §2503(b)) in limited partnership interest to Cindy and Luke through taking
advantage of the annual exclusion amount. Further gifting of interest would be valued at the
proportional FMV of the transfer less discounts attributed to lack of marketability, lack of control and
lack of interest.
Despite this, special valuation rules apply to transfers to members of family of certain interests in
corporations and partnerships under IRC §2701 and the use of discounts to the valuation of business
assets are susceptible to scrutiny. Any discounts applied to the valuation of an estate must be
supported through appraisals and may be subjective. As supported by IRS Revenue Ruling 59-60 the
valuator must consider all relevant facts, elements of common sense, informed judgement, and
applying reasonable weight to their significance (IRS, N.D.). Inaccurate valuations may be penalized
for a deficiency in taxes payable, and may trigger legal disputes with the IRS.
CFR §20.2031-1(b)
CFR §20.2031-3
IRC §2032
IRC §2503(b)
IRC §2701
IRS. (N.D.). IRS Revenue Ruling 59-60. Retrieved from
https://www.pvfllc.com/files/IRS_Revenue_Ruling_59-60.pdf
Raub, B., Belvedere, M. (N.D.). New Data on Family Limited Partnerships Reported on Estate Tax
Returns. Retrieved from https://www.irs.gov/pub/irs-soi/11pwcompench2cfam.pdf
The best partnership that John should convert his sole proprietorship into is a limited partnership. We
can even take it a step further and say that they create a family limited partnership (FLP). In this type
of partnerships, the general partner oversees the business and its operations. In our case, John would
be general partner. The other remaining partners are called limited partners which would be Cindy and
Luke and they would have little to no involvement in the management of the business. Since John is
the general partner, he would be liable for all the company's debts and financial obligations. Under US
code section 721 there would be no gain or loss on John's behalf since the transfer to his kids is in
exchange for interest in the partnership.
To structure the transfer of the business to Cindy and Luke, I would make sure that their interests are
non-controlling interests. IF this is put in place, any transfer would be given a discount. There is also a
second discount that could be given, and this is because "there is no ready market for the sale of FLP
limited interests." (Rubenstein, 2013) These discounts have been scrutinized by the IRS because they
can range between 25-40%. Any penalties for undervaluation will come from code section 6662(a).
This code section states that "there shall be added to the tax an amount equal to 20% or the portion of
the underpayment to which this section applies. (26 U.S. Code § 6662)
Transferring a portion of the partnership to Cindy and Luke by way of a gift is not ideal, due to the
value of the property would be the fair market value at the time the property is gifted. John may want
to consider limited partnership. e A company that is held by two or more family members is known as
a family limited partnership (FLP). FLP are created to safeguard a family's generational wealth by
permitting the transfer of assets, real estate, and other forms of wealth without paying taxes. With the
ability to transfer assets, real estate, and other types of wealth tax-free, FLPs are frequently created.
FLP can be general or limited and in this case the transfer of property from John to his children be
limited noncontrolling, to take advantage of minority interest discount.
When considering a partial transfer of ownership in a business, it's important to choose the
appropriate business structure. In my opinion, for this case a limited partnership would be a good
choice. A limited partnership consists of at least one general partner who has unlimited legal liability
and manages the business, and one or more limited partners who have limited liability but do not
participate in the day-to-day operations of the business. This structure allows for the transfer of
ownership while maintaining the current owner's control over the business. In this scenario, John can
remain as the general partner and transfer partial ownership to his two adult children, Cindy and Luke,
as limited partners. The value of the business is currently at $10,000,000, and each person's
proportionate share would be 1/3. However, to achieve a fair market value of the transfer that is less
than Cindy and Luke's proportionate share of the $10,000,000 value, valuation discounts can be
applied.
Valuation discounts are used to adjust the value of an ownership interest in a business to reflect the
fact that the interest is not easily marketable or lacks control. Two common types of valuation
discounts are minority interest discounts and lack of marketability discounts. A minority interest
discount is applied when a person owns less than 50% of the business. The rationale is that the person
does not have control over the business, which makes their ownership interest less valuable. A
minority interest discount can range from 10% to 50%, depending on the circumstances of the
business. A lack of marketability discount is applied when an ownership interest is in a non-publicly
traded business. This type of discount reflects the fact that the ownership interest cannot be easily sold
or transferred like a publicly traded stock. A lack of marketability discount can range from 20% to
50%, depending on the business.
It is important to note that the use of valuation discounts can be controversial and can raise concerns
about accuracy. The IRS has challenged the use of valuation discounts in the past and has issued
regulations and rulings to limit their use. One example of this is Treasury Regulations section 25.2704-
1, which provides that certain restrictions on the ability to liquidate an ownership interest may be
disregarded for valuation purposes if the restriction will lapse after the transfer or if the transferor or
family members retain certain control rights.
Another example that I was able to find is the Revenue Ruling 93-12, which provides guidance on the
use of discounts for lack of marketability and minority interest in the context of intra-family transfers.
This ruling specifies that discounts may be appropriate for lack of marketability and minority interest,
but only if they are supported by a qualified appraisal and are not artificially created through
restrictions that are not bona fide business arrangements. To sum it up, in order to structure a partial
transfer of ownership in a business, a limited partnership may be a good choice. To achieve a fair
market value of the transfer that is less than the proportionate share of the business's value, valuation
discounts can be applied, such as minority interest discounts and lack of marketability discounts.
However, it's important to be aware of the IRS regulations and rulings regarding the use of these
discounts to ensure compliance and accuracy.
Hope your weeks are going well, moving right along into the first third done. If Cindy and Luke do
not have time to be part of the day-to-day workings of the company, then a limited partnership sounds
like a good way to make them part of the company without them having to make decisions while John
is still running the business. In a Limited partnership, John would remain as the general partner with
unlimited personal liability like he did before in the sole proprietorship (Shweta, 2022). But Cindy and
Luke would be limited and have limited liability also known as silent partners (Shweta, 2022). When
it comes to the taxes a Schedule K-1 would be filed and passed through the losses, deductions, credits
and earnings to the general partner, John (Shweta, 2022). “Limited partners do not have to pay self-
employment taxes; only general partners have to do so” and the earnings are considered passive
earnings or losses (Shweta, 2022).
To maximize the benefits of a FLP (family limited partnership would be to make both Cindy and Luke
0.17% partners and increase this each year following the gift tax yearly limit (Kennon, 2023). This
would take advantage of the yearly gift tax without cutting into the estate tax exclusion limit (Kennon,
2023). And as their percentages increased the profits from the company would continue to pass to
them (Kennon, 2023). Because of the current laws the estate tax will be dropping back down to ~6
million by 2026. Because of this by giving both Cindy and Luke 30% will keep them below the Estate
tax, John could keep giving shares to them each year staying within the yearly gift tax limit (Kennon,
2023).
Valuation Discounts could be used to adjust the value of the owners interest. There are minority
discounts and lack of marketability discount and future interest discounts (Rutan & Cfp, 2021). Lack
of marketability is when “refers to calculating the value of closely held businesses or restricted shares
of public companies” (Rutan & Cfp, 2021). This can range from 20 to 50% (Rutan & Cfp, 2021).
Minority share is when “a partial ownership interest may be worth less than its pro rata (proportional)
share of the total business” (Rutan & Cfp, 2021). This discount can range from 10 to 50% (Rutan &
Cfp, 2021
When there is a substantial understatement of value of 65% or 35% wrong then under section 6662
this could cause an additional 20% tax of the original underpayment. This could also cause a red flag
and make the IRS more likely to watch your partnership. This is also the reason that the IRS currently
watches family partnerships very closely.
John has a sole proprietorship business which is worth $ 10,000,000, and he intends to transfer the
portion of its ownership to his adult children Cindy and Luke. For dividing the business between his
children, limited partnership is an appropriate structure. It will ensure that both the children are
partners have limited liability (Chen, 2022). Moreover, it will also enable John to have a control over
the day-to-day operations of the business and ensure that it runs smoothly. In order to structure the
ownership transfer so that a fair market value of the transfer can be achieved that is less than Cindy
and Luke's proportionate share of the $10,000,000 value, the viable option is utilizing valuation
discounts. Valuation discounts serve as useful instruments that can help to minimize the value of an
asset for the purpose of taxation. However, while adopting the method it is instrumental to adhere to
AICPA Code of Professional Conduct. The structure change must be done in a competent and honest
manner so that the process will be legal and ethical in nature (Professional responsibilities. AICPA.).
According to the American Bar Association (ABA), emphasis must be laid on due diligence,
truthfulness of statements with others, etc. (Americanbar.org). In the specific scenario, there is an
opportunity for John to create a family limited partnership so that he could transfer his proprietorship
business to it. By taking such a step it will be possible for both of his adult children to have limited
control over the assets that are under the family limited partnership. It has been identified as a suitable
step since it will enable John to lower the fair market value of his machine shop business.
However, while adopting the valuation discount option, it is essential for John to ensure that the
valuation is done in a fair and accurate manner. According to Koste (2009), the Internal Revenue
Service (IRS) can minimize the valuation discounts that is afforded to family limited partnerships.
Hence John must ensure that the strategy that is adopted by him meets all the necessary legal
requirements.
In case the valuation that is made by John is found to be inaccurate, it can give rise to penalty issues
relating to the valuation discounts of the proposed transfer. Some of the main forms of penalties that
may arise in case inaccuracies or mistakes are identified in valuation discounts include fines, as well
as criminal charges.
"Section 25.2512-1 of the Gift Tax Regulations provides that, if a gift is made in property, its value 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 any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts."
(Revenue Ruling, N.d) In this case, John should set up a partnership and be the general manager
transfer partial ownership to his daughter and son as the limited partners. His initial contribution of the
property to the partnership would not be subject to income tax because the transfer of property to a
partnership in exchange for a partnership interest is generally tax-free under Section 721 of the
Internal Revenue Code. Unless in the future the partnership decided to sell then the partners could be
subject to tax on their share of the gain. The current valuation of the business is at 10,000,000, this
business could be separated any way but the easiest is to separate 3 ways, with each party getting 33%.
To achieve the a FMV that is lower than the share valuation discounts must be applied. Valuation
discounts are the difference in value between a company's peers in the same industry to that a buyer
assesses. Some examples that may help in this case are minority interest discounts and lack of
marketability discounts which can be applied with or without controlling interest. A minority interest
discount is applied when a person owns less than 50% of the business. The discount can range from
20% to 50% it is entirely dependent on the type of business. Lack of marketability discounts discount
is for cases where the ownership interest cannot be easily sold or transferred like a publicly traded
stock. We see through cases like Andrews vs United States where "Although appealing because of the
simplicity, we must reject respondent's methodology in valuing the contract right of the decedent."
Estate of Curry v. Commissioner, 74 T.C. 540, 548, 1980 U.S. Tax Ct. LEXIS 118, *20 (T.C. June 9,
1980) We can also see that the IRS in the past has challenged the use of valuation discounts and has
issued regulations and rulings to limit their use. The concerns would be if the IRS found the valuation
to be different and the clients had to pay increased tax.
References:
Anderson, Kenneth and Hulse, David and Rupert, Timothy Pearson (2023) Taxation 2023
Corporations, Partnerships, Estates; Trusts Retrieved on:
https://plus.pearson.com/courses/c5bbf0f3f5514da496e7aa394b970921_d2l_snhumlp/products/17354
2/pages/589?locale=&isTpi=Y&redirectURL=https://plus.pearson.com/bookshelf&use
rPreferredType=read
Fritz, Farrell (October 30, 2018) Family Limited Partnerships They’re Still Out There (?)
Revenue ruling 93-12. (n.d.). Retrieved May 2, 2023, from http://s-corp.org/wp-
content/uploads/2016/08/IRS-Revenue-Ruling-93-12.pdf
Americanbar.org. (n.d.). Retrieved May 4, 2023, from
https://www.americanbar.org/groups/professional_responsibility/publications/model_rules_of_profess
ional_conduct/model_rules_of_professional_conduct_table_of_contents/
Chen, F. (2022). Comparison Between Companies and Partnerships. In Essential Knowledge and
Legal Practices for Establishing and Operating Companies in China (pp. 15-19). Singapore: Springer
Nature Singapore.
Koste, A. (2009). The IRS Fished Its Wish: The Ability of Section 2703 to Minimize Valuation
Discounts Afforded to Family Limited Partnership Interests in Holman v. Commissioner. Cath. UL
Rev., 59, 289.
Professional responsibilities. AICPA. (n.d.). Retrieved May 4, 2023, from
https://us.aicpa.org/interestareas/personalfinancialplanning/resources/practicecenter/professionalrespo
nsibilities#:~:text=Additionally%2C%20all%20AICPA%20members%20are,client%20confidentiality
%2C%20disclose%20to%20the
Kennon, J. (2023, January 17). How Family Limited Partnerships Can Lower Gift and Estate Taxes.
The Balance. Retrieved May 4, 2023, from https://www.thebalancemoney.com/family-limited-
partnership-gifts-358121
Rutan, C., & Cfp, V. K. (2021, October 12). Valuation Discounts for Gift and Estate Tax Savings.
CAPTRUST. Retrieved May 5, 2023, from https://www.captrust.com/valuation-discounts-for-gift-and-
estate-tax-savings/
Shweta. (2022, September 28). What Is A Limited Partnership? Definition, Pros And Cons. Forbes
Advisor. Retrieved May 4, 2023, from https://www.forbes.com/advisor/business/what-is-limited-
partnership/
Legal Information Institute. (n.d.). 26 CFR § 25.2704-1 - lapse of certain rights. Legal Information
Institute. Retrieved May 1, 2023, from https://www.law.cornell.edu/cfr/text/26/25.2704-1
Revenue ruling 93-12. (n.d.). Retrieved May 1, 2023, from http://s-corp.org/wp-
content/uploads/2016/08/IRS-Revenue-Ruling-93-12.pdf
https://www.assetlawyer.com/family-limited-partnerships-
discounting/#:~:text=Family%20limited%20partnerships%20(FLPs)%20reduce,in%20the%20FLP%2
0is%20discounted.
26 U.S. Code § 6662
Code Section 721
https://www.investopedia.com/terms/l/limitedpartnership.asp
Anderson, K.E., Pope, T.R. & Rupert, T.J. (2023) Taxation 2023 Corporations, Partnerships, Estates &
Trusts Pearson. (Chptr 2 Limited Partnerships)
Fritz, F.P.C. (2018) Family Limited Partnerships They’re Still Out There?
https://www.taxlawforchb.com/2018/10/family-limited-partnerships-theyre-still-out-there/
T&M Admin (2023) Understanding Serious Mistakes and Planning Implications in the Smaldino Tax
Court Case https://actecfoundation.org/podcasts/smaldino-tax-court-case/
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