Indirect gift turns on timing
Pursuant to IRC §2512, the IRS argued that the 1999 transfer of Dell stock to the HLP was an indirect gift to the limited partners, relying on two prior decisions: Shepherd v. Commissioner (11th Cir. 2002) and Senda v. Commissioner (8th Cir. 2006).The court distinguished the two cases on their facts. In particular, in Senda,the taxpayers transferred shares of stock to two FLPs on the same day they transferred LP interests to their children. Here, the Holmans didn’t gift the LP units to the children until six days later.
The IRS tried to argue that under the “step transaction” doctrine, the HLP formation and the LP gifts were so close in time, the court should treat them as a single transaction, resulting in an indirect gift. But the court would have had to find that “the legal relations created by one transaction would have been fruitless without a completion of the series,” it said. Given the six days between formation and funding, the court could not find that the HLP was of no legal consequence absent the 1999 gift. “Indeed, [the IRS] does not ask that we consider either the 2000 gift (made approximately 2 months after formation…) or the 2001 gift (made approximately 15 months [later]…) to be indirect gifts of Dell shares.”
Moreover, the taxpayers assumed the risk that stock values would change, even in the six intervening days. These facts gave “independent significance” to each step of the transaction, and while the court declined to draw any “bright line” concerning the amount of time necessary to deem a series of events independent for purposes of the step transaction doctrine, in this case, six days was sufficient.
Transfer restrictions must serve business purpose
Under IRC §2703(a), “the value of any property transferred by gift is determined without regard to any right or restriction relating to the property.” Under §2703(b), however, the value will include the restrictions if: 1) they comprise a bona fide business arrangement; 2) they are not devices to make transfers for less than full and adequate consideration; and 3) their terms are similar to those in arm’s-length transactions.
The HLP partnership agreement contained one particular restriction (paragraph 9.3) that, in the event of an unpermitted assignment of an LP interest, allowed the partnership to buy back the interest from the assignee at fair market value based on the assignee’s pro rata, distributional share. In attempting to disregard this restriction under §2703, the IRS argued that it could not be part of a bona fide business arrangement because the HLP’s primary goals were not business but personal—i.e., to preserve the taxpayers’ wealth and “disincentivize” their children from spending it.
The taxpayers argued that the creation of a mechanism—including a buy-sell agreement—to ensure family control of a family business satisfied the bona fide requirement. But the court disagreed, largely because in this case, “we do not have a closely held business.” From its formation, the HLP had simply held Dell stock, and its transfer restrictions served principally to discourage the LPs’ dissipation of assets.
Further, in the event of an unpermitted transfer, the restriction would prevent an assigning LP from realizing the difference in the fair market value of the LP units (which would include discounts) and the units’ proportional share of the undiscounted, net asset value (NAV). Under paragraph 9.3, the partnership could dissolve and redistribute that difference to the remaining partners, increasing their interests and effectively resulting in a transfer for less than adequate consideration. Thus, the transfer restrictions did not meet the first two requirements of §2703(b), obviating the court from ruling on the third.
Experts clash on discounts
Both the IRS and the taxpayers presented qualified business appraisers, who agreed that the NAV of the partnership on the date of the 1999 gift was $2.81 million, based on the number of Dell shares and their publicly traded values. The experts disputed NAV as of the two subsequent gifts. Relying on gift tax regulations, the IRS used averages of the high and low prices of Dell stock on the date of the gifts. Claiming that the rules didn’t apply to gifts of partnership interests, the taxpayers used closing values of Dell stock. But the taxpayers cited no authority for disregarding the rules, the court said. Because the partnership’s NAV turned “exclusively” on the values of the publicly traded Dell stock, it adopted the IRS’ values for the 2000 and 2001 gifts.
In determining the applicable discount for lack of control, both experts relied on data from closed-end investment funds, and each used three samples—one for each gift—of similar size. (In fact, they used many of the same samples.) But although the IRS relied solely on general equity funds, finding them most comparable to the HLP, the taxpayers’ expert used seven specialized funds. The IRS calculated median, mean, and interquartile mean discounts for each of his samples; the taxpayers’ expert computed only the median, adjusting them an additional 10% upward to account for the HLP’s qualitative factors (lack of diversification, etc.). Their conclusions for the discount for lack of control were:
|
1999 gift |
2000 gift |
2001 gift |
Taxpayer expert |
14.4% |
16.3% |
10.0% |
IRS expert |
11.2% |
13.4% |
5.0% |
At trial, the taxpayers’ expert admitted that the specialized funds resembled HLP only in their singular focus, and he agreed there was no correlation between the funds’ quantitative factors and the discounts at which they traded. He further admitted that his report failed to explain why he included the specialized funds in his samples.
The court calculated the median discounts from this subset of specialized samples (17.1% and 17.8%) and compared them to the medians from the full sample (12% and 13%). It found the differences “significant,” enough to disregard the data and adopt the more reliable general equity fund data. It constructed samples from the data common to both experts, resolving outliers by “following…the lead” of the IRS expert and using the interquartile mean. Overall, the court applied minority interest discounts of 11.32%, 14.34%, and 4.63% to the three respective gifts.
Holding period—little or no influence?
Both experts used restricted stock studies to calculate the discount for lack of marketability (DLOM). From his samples, the taxpayers’ expert calculated median and mean discounts of 24.8% and 27.4%, respectively. Because the LP units had “virtually no ready market” and a willing buyer would have “no real prospects” of publicly selling those interests for full value, he concluded that the DLOM should be “at least” 35%.
The IRS expert examined restricted stock studies for three distinct periods and calculated the average discounts for each:
- Before the SEC adopted Rule 144A (pre-1990), when there was no resale market for restricted stock, the average discounts were 34%.
- The seven years after 144A, which permitted limited access to a resale market, the average discounts were 22%.
- The two years following the 1997 amendment of 144A, which reduced the required holding period from two to one year, the average discounts were 13%.
Based on this evolution, he isolated two components that influenced investors in restricted stocks: limited liquidity and the holding period. In particular, he concluded that the 12% decline in discounts between pre- and post-144A was due to the opening of a limited resale market, and it represented the “charge” or incremental level of discounts that investors demanded before 1990, when the market became more liquid [this part unclear: the market didn’t become more liquid until after 1990]. The other 22% (of the 34%) was attributable to holding period restrictions and other factors. For private holding companies such as the HLP, which are not subject to legally imposed holding periods or the risks attendant to restricted stock, he said, the discount for lack of marketability was closer to 12%.
Adopting this baseline, the IRS expert analyzed HLP’s specific factors: its failure to make distributions and diversify from Dell stock, and its transfer restrictions. The last two factors increased marketability, he said—specifically because Dell is freely tradable and the buy-back provision permitted the partnership to dissolve and redistribute the assets to the remaining partners. The withdrawing LP would benefit because, in the event of an impermissible assignment, given the minority and marketability discounts that would apply to the proportional share of NAV, it would be in the LP’s economic interest (as well as the partnership’s) to negotiate some price between the discounted value of the units and the dollar value of the units’ proportional NAV share.
A reasonable buyer would request (and likely receive) a discount ranging from 10% to 15%, the IRS expert concluded. Given his baseline of 12%, he applied an overall DLOM of 12.5% for the LP interests. He made little, if any, adjustment for the holding period, believing that in this case, it had “little, if any, influence.”
More credible expert
Once again, the court lacked confidence in the taxpayers’ expert and found the IRS expert’s approach more persuasive. Observing that if the LP units lacked any available market, the resulting DLOM could conceivably reach 100%, and the gifts would then have zero value. At any rate, the taxpayers’ expert failed to persuade the court that his “stopping point” at 35% was “anything but a guess.”
The court also believed that the IRS expert correctly considered the partnership buy-back scenario; even if it ran counter to the HLP’s stated purpose—to preserve family assets—the purpose might well yield to the partners’ economic self-interest. Finally, the court agreed that the holding period, in this case, carried little weight, and it adopted the 12.5% as the appropriate marketability discount.
Holman v. Commissioner, 130 T.C. No. 12 (May 27, 2008)
