Closely Held Entities, FLP Discounts & IRC §2701–2704 Rules

27.2 Closely Held Entities, FLP Discounts & IRC §2701–2704 Rules

In the realm of advanced estate and gift planning, closely held entities—particularly Family Limited Partnerships (FLPs)—have become central tools for transferring wealth efficiently while minimizing tax liability. However, legislative and judicial scrutiny, especially under IRC §§2701–2704, can disallow or reduce the discounts commonly associated with these transfers. This section delves into how FLPs and other closely held entities function in estate planning, highlights valuation discounts, and provides insights into when and how they might be disallowed or restricted. Real-world case studies and precedents illustrate the potential pitfalls and successes of these strategies.

Overview of Closely Held Entities in Estate Planning

A closely held entity is any partnership, corporation, or limited liability company in which a small group of individuals—usually family members—control the majority (if not all) of the ownership interests. These entities can serve several purposes in the context of estate or gift tax planning:

• Facilitating intergenerational wealth transfers.
• Achieving potential valuation discounts due to minority interests, lack of marketability, or restrictive provisions.
• Centralizing asset management and preserving family ownership structures.
• Allowing family members to share in profits while centralizing control in key individuals.

Family Limited Partnerships (FLPs) are particularly common. An FLP typically includes two classes of partners: general partners (with control and management authority) and limited partners (with few or no management rights). Because limited partnership interests often carry restrictions and limited transferability, they may qualify for discounts in the gift or estate tax valuation process.

Anatomy of a Family Limited Partnership (FLP)

At its core, an FLP involves senior family members transferring assets—such as real estate, marketable securities, or a closely held business—into a limited partnership. They then gift or sell limited partnership (LP) interests to junior family members. The general partner (often the contributing family member, a management company, or a trust in some structures) retains control over investment decisions and distributions.

Below is a simplified diagram illustrating a typical FLP structure:

    flowchart LR
	    A[Parent(s)] --> B[Form FLP]
	    B --> C[Hold Assets (Real Estate, Securities, etc.)]
	    A --> D{General Partner Interest}
	    A --> E{Limited Partner Interests}
	    E --> F[Children/Heirs (LP Holders)]

In many cases, the transfer of limited partnership interests to children or trusts is completed at a discounted value due to factors such as:

1. Lack of Control (Minority Interest Discount): A limited partner lacks a controlling vote or management authority.
2. Lack of Marketability Discount: Limited partnership interests are not freely tradeable on active markets.

Both of these discounts, however, come under scrutiny by the IRS and the courts to ensure that there is legitimate business purpose and that the structure is not solely designed to circumvent estate or gift tax.

The Significance of Valuation Discounts

Valuation discounts can significantly reduce the taxable value of transferred interests. Without these discounts, families might face substantially higher estate or gift taxes when transferring large estates.

Common Discounts

1. Minority Interest Discount: Reflects the fact that a non-controlling stake in a partnership is less attractive to potential buyers than a controlling stake.
2. Lack of Marketability Discount: Reflects limited liquidity and the absence of a readily accessible market for interests in a closely held entity.

Factors Influencing the Magnitude of Discounts

• The partnership agreement’s governance provisions (e.g., the extent of restrictions on transferability or redemption).
• The asset composition and how easily those assets can be converted to cash.
• The track record of formal partnership operations—are distributions and management decisions aligned with a bona fide business?
• Precedent set by prior judicial or administrative rulings in similar contexts.

IRC §§2701–2704: An Overview

Enacted as part of Chapter 14 of the Internal Revenue Code, §§2701–2704 were introduced to prevent the undervaluation of transferred interests in family-controlled entities. These provisions target specific valuation manipulations involving preferred stock, partnership interests, and other retained rights. They effectively “look through” certain provisions in family-controlled entities to calculate the fair value of interests transferred between family members.

IRC §2701

• Focuses on transfers involving preferred and common equity in family corporations and partnerships.
• When a transferor (e.g., a parent) retains certain “extraordinary rights” or receives a “preferred interest,” the common stock or limited partnership interests given to children may be re-valued to include a proportionate share of the entire entity’s value.

IRC §2702

• Targets certain trust arrangements and retained interests like grantor retained annuity trusts (GRATs).
• Although less directly relevant to FLPs, it can still apply in scenarios where a senior family member retains certain annuity interests while transferring entity interests to a trust.

IRC §2703

• Applies to buy-sell agreements or other restrictions on property in intrafamily transactions that can artificially depress value.
• Provides that any agreement to acquire or restrict property at less than fair market value may be disregarded unless it meets specific safe harbor requirements.

IRC §2704

• Addresses the effect of lapsing voting or liquidation rights and certain restrictions on valuation.
• §2704(a) deals with lapsing rights in family-controlled entities, treating the lapse as a transfer.
• §2704(b) disregards certain restrictions on liquidation in determining the value of transferred interests if those restrictions can be removed by the controlling family or if the restriction does not exist under state law.

How §§2701–2704 Affect FLP Discounts

The overall intent of §§2701–2704 is to prevent the creation of artificial discounts that do not reflect genuine economic reductions in value. When FLPs are used purely as vehicles for valuation reduction—especially if there is little to no business purpose—the IRS may rely on these sections to negate or reduce claimed discounts.

1. Retained Senior Interests: If a parent retains a preferred interest or distribution right, it might trigger §2701’s revaluation rules.
2. Buy-Sell Agreement Restrictiveness: Under §2703, if a partnership or shareholder agreement artificially reduces the interest’s transfer value among family members, it can be disregarded.
3. Liquidation Restrictions: Under §2704(b), the IRS may ignore any “applicable restriction” that limits the ability of an entity to liquidate or redeem a family member’s interest if that restriction can be removed by the family.

Discount Disallowance or Restrictions: Key Considerations

Despite the theoretical benefits of FLPs, the IRS and courts often scrutinize the legitimacy of discounts. Here are critical considerations that may lead to discount disallowance or reduction:

1. Bona Fide Business Purpose

Courts have made it clear in cases like Estate of Strangi v. Commissioner and Estate of Stone v. Commissioner that structures lacking genuine non-tax reasons are at heightened risk. Indications that an FLP is purely a formal shell with little actual business activity can lead to valuation challenges.

2. Retention of Control

If the senior family member effectively continues to control the partnership assets—for example, using partnership funds for personal expenses—then the IRS may argue the structure is simply a disguised estate transfer. This scenario can lead to partial or full discount denials.

3. Timing of Formation

FLPs created or interests transferred close to the senior member’s death invite extra scrutiny. The IRS may argue the partnership is a testamentary device formed solely to reduce estate tax, disallowing the discount.

4. Adequate Capitalization and Formality

Maintaining partnership formalities—separate bank accounts, regular meetings, formal records, compliance with state partnership laws—is crucial. Failure to do so can undermine the entity’s legitimacy and thereby undermine any valuation discount.

5. Regulatory and Judicial Changes

Proposed regulations in recent years have targeted perceived abuses of valuation discounts. Although some regulations were withdrawn or delayed, the evolving legislative and judicial environment underscores the need to structure FLPs to withstand scrutiny under §§2701–2704.

Real-World Precedents and Examples

Estate of Strangi v. Commissioner

One of the most famous FLP cases, Estate of Strangi involved a family partnership where the deceased retained significant control over the assets. The Tax Court initially allowed discounts but, on a later appeal, parts of the overall structure were challenged. Ultimately, the court found that §§2701–2704 can override discounted valuations when the partnership is not operated with genuine independence or when the controlling individual continues to reap unfettered personal benefits.

Estate of Harper v. Commissioner

In Estate of Harper, the court examined whether the partnership interest provided legitimate discounts or was merely a tax-avoidance mechanism. While some discount was allowed, the IRS successfully challenged certain aspects, highlighting the importance of a legitimate business purpose and proper partnership governance.

Case Study: Real Estate FLP

Imagine a family capitalizing a new FLP with several parcels of real estate. All partnership formalities are followed—lease agreements, insurance, a separate bank account, property management decisions. If the senior member sells or gifts LP interests to children, there may be a legitimate minority discount due to the non-controlling nature of the LP interests and a lack of marketability discount due to private entity status. However, if the senior member continues to pay personal expenses out of the partnership account or fails to document transactions properly, the IRS could invoke §2701 or §2704 to disallow or reduce the claimed discount.

Practical Considerations for Avoiding Disallowed Discounts

1. Establish Clear Non-Tax Motives: Emphasize management consolidation, creditor protection, or other legitimate purposes.
2. Adhere to Formalities: Maintain separate financial records, file annual reports, hold regular partnership meetings, and document decisions thoroughly.
3. Limit the Senior Generation’s Control: Transfer actual authority to successors, and avoid commingling partnership assets with personal expenses.
4. Avoid Last-Minute Planning: Form the entity and complete transfers well ahead of potential health declines or death.
5. Seek Professional Valuations: Use qualified appraisers experienced in family entity valuations to substantiate the discount.

Diagram: Key Steps for Implementing and Supporting FLP Discounts

    flowchart TB
	    A[Form FLP] --> B[Draft Operating Partnership Agreement with Arm's-Length Terms]
	    B --> C[Fund FLP with Assets (Real Property, Securities, etc.)]
	    C --> D[Identify & Document Valid Business Reasons]
	    D --> E[Retain Qualified Appraiser for Value Analysis]
	    E --> F[Gifting or Selling Limited Partnership Interests]
	    F --> G[Maintain Ongoing Formalities & Proper Records]
	    G --> H[Scrutiny Under IRC §§2701–2704]

Common Pitfalls and Strategies to Overcome Them

• Pitfall: Failing to demonstrate a bona fide business purpose.
• Strategy: Use the FLP for real operations—collect rents, manage investments—demonstrating legitimate activity.

• Pitfall: Retaining excessive control.
• Strategy: Transfer meaningful authority to a successor or co-general partner, ensuring operational independence.

• Pitfall: Neglecting formalities.
• Strategy: Keep partnership funds in separate accounts, record all transactions, hold annual or quarterly meetings.

• Pitfall: Inadequate or too-aggressive discount claims.
• Strategy: Consult qualified valuation experts, maintain robust documentation of discount factors, and be prepared to justify positions to the IRS.

• Pitfall: Ignoring external changes in the law or IRS guidance.
• Strategy: Regularly review entity structures and partnership agreements with tax professionals to stay compliant with new regulations or case law.

Conclusion and Future Outlook

Closely held entities, particularly FLPs, can offer substantial tax advantages in estate and gift planning. However, §§2701–2704 of the Internal Revenue Code substantially limit the potential for manipulative or artificial discounting. Planners must balance the legitimate uses of FLPs (e.g., asset protection, centralized family governance) with the strict compliance requirements necessary to avoid discount disallowance. By observing formalities, articulating non-tax motives, and staying abreast of the newest rulings or regulatory changes, families and practitioners can successfully harness these techniques without running afoul of the IRS or the courts.

For those preparing for the TCP portion of the CPA exam, understanding the interplay between FLPs, applicable valuation discounts, and §§2701–2704 is critical. Mastery of these concepts will not only enhance exam performance but also lay the groundwork for providing nuanced, value-added guidance to future clients.

References and Further Exploration

• Internal Revenue Code §§2701–2704.
• IRS Publication 559 (Survivors, Executors, and Administrators) and related instructions on estate transfers.
• Estate of Strangi v. Commissioner, 115 T.C. 478 (2000).
• Estate of Harper v. Commissioner, T.C. Memo 2002-121.
• Estate of Powell v. Commissioner, 148 T.C. No. 18 (2017).
• State-specific partnership or LLC statutes for formalities and liability protections.

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