The most important element in determining gift and estate liability is the value of the asset being transferred. To reduce that value, estate planners create family limited partnerships (FLPs) and family limited liability companies (LLCs). The theory: Because the donee or legatee now has only a noncontrolling interest in the asset — a closely held, not readily marketable entity — his interest in it is worth less. Values have been discounted by up to 60 percent.
But FLPs and LLCs are labor-intensive and under attack by the Internal Revenue Service. Annual returns and forms must be filed with federal and state authorities, accurate books and records must be kept, and many tax rules followed. The Service also has successfully defeated FLPs when the transferor ignored the partnership and continued to use the transfered asset as if it was still his personal property. (See “The 2036 Threat,” March 2003.)
FLPs, including those funded entirely with marketable securities, usually are successful in obtaining valuation discounts. But the Service has indicated during the past few years that it is concerned about the substantial discounts claimed for limited partnership interests in FLPs whose underlying investments consist of cash, cash equivalents, marketable securities and similar liquid assets. Although the arguments asserted by the IRS appear to be largely surmountable, valuation battles continue. It may be only a matter of time before either the IRS successfully identifies a fatal weakness in the FLP structure or Congress simply legislates their demise.
Thus, a better asset for estate-planning purposes is one that inherently has a valuation discount applied to it, such as stock in a closely held corporation or interests in certain hedge funds that restrict withdrawals and transfers to third parties. Unfortunately, not all of our clients own these types of businesses or have access to such investments. For them, a restricted-management account (RMA) could be the answer.
We developed and implemented the RMA a few years ago. Other advisors have since run with the idea. Already, RMAs have attracted millions.
Simply put, the RMA is an account established with an investment manager under an agreement giving that manager the exclusive right to invest the assets (and the obligation to do so) for a fixed term (for example, five years). The investor cannot withdraw his funds or direct the investments during that term, giving the manager a free hand. These restrictions are designed to enable the investment manager to manage the account for greater long-term performance, rather than being forced to maintain short-term performance to retain the investor as a client.
Because the investment manager has the obligation to manage the funds for this fixed term , the RMA agreement typically says the account may only be transferred to family members during that time, unless the manager consents. This balances the manager's desire to control the identity of his clients and the investor's desire to have the power to make a transfer for the benefit of his family.
The lack of control and limits on transferability means a RMA should be subject to valuation discounts for federal-transfer-tax purposes, reducing the federal-transfer-tax value of the RMA below the aggregate fair market value of the assets it holds.1 There has not yet been a published case or revenue ruling on this particular strategy. But anecdotally, we have heard of them passing muster in audits.
Creation of the restrictions before transfer is key to obtaining discounts.2 And a donor can gain a tax advantage from acts that depress the value of his gift, according to the U.S. Court of Appeals for the Seventh Circuit back in 1988. For example, the court said, “If you own the Mona Lisa and paint (indelibly) a mustache on it before giving the painting to your child, with the result that its value is greatly reduced, still your gift tax will be computed on the reduced value.” The same result would follow, said the Seventh Circuit, if “owners had placed restrictions on their stock by agreement and the restrictions took effect before a transfer that was subject to gift or estate tax.”3, 4
The RMA, implicitly following the analysis in this case, Citizens Bank & Trust, takes the exact opposite approach by creating restrictions before and unrelated to the transfer. By agreement, the restrictions carry over to the donees. Other entities and structures have adopted this principle, but its simplest expression can be found in the RMA.
LIKE 144 STOCK?
The RMA should be treated at least as favorably as stock subject to trading limitations under Securities and Exchange Commission Rule 144 (restricted stock), which has enjoyed valuation discounts ranging from 20 to 60 percent. SEC Rule 144 restricts the sale of stock in a publicly traded company that is unregistered for public sale or owned by a company insider (for example, an officer, director or shareholder owning 10 percent or more of the outstanding stock), also known as an “affiliate.”5 As a general rule, restricted stock may not be sold on an exchange for one year after its acquisition and continues to be subject to certain sales-volume restrictions until it has been held for two years and as long as the holder is an affiliate.6
Because stock burdened with securities-law restrictions is not freely transferable on the open market, the courts and the IRS have recognized that a discount in valuing such stock is appropriate.7 For example, in Estate of Sullivan v. Commissioner,8 the U.S. Tax Court allowed a 15 percent discount from the market price in valuing stock on the basis of the size of the block of stock and the applicable resale restrictions imposed by SEC Rule 144. Such a discount was allowed even though the taxpayer was part of a control group that collectively owned 56 percent of the outstanding stock and even though merger negotiations with another corporation were taking place when the taxpayer died. Likewise, in Trust Services of America and Estate of Gilford v. Commissioner,9 the tax court held that a 25 percent discount and a 33 percent discount, respectively, were warranted on the taxpayers' blocks of stock on the rationale that such blocks were subject to SEC Rule 144.
COMPARED TO FLPs
The RMA should be treated at least as favorably as an FLP, which also has enjoyed valuation discounts ranging from 20 to 60 percent. Although the FLP agreement typically contains restrictions on liquidations and transfers, its family members have the ability to remove such restrictions by amendment to the partnership agreement. With an RMA, any amendment of the investment-management agreement requires the consent of an unrelated third party.
FLPs usually are discounted. In Moore v. Commissioner,10 for example, the court acknowledged the similarities between minority shareholders of a closely held corporation and the limited partners of a partnership and the minority-interest discount that should apply.
Moore said: “Courts have long recognized that the shares of stock of a corporation which represent a minority interest are usually worth less than a proportionate share of the value of the assets of the corporation. The minority discount is recognized because the holder of a minority interest lacks control over corporate policy, cannot direct the payment of dividends, and cannot compel a liquidation of corporate assets. Although these cases deal with minority interest in closely held corporations, we see no reason for a different rule for valuing partnership interests in this case. The critical factor is lack of control, be it as a minority partner or as a minority shareholder.”11
In applying a 35 percent minority-interest discount, the Moore court also noted the following factors that the taxpayers' valuation expert had considered:
Minority partners could not select the managers of the business, control management policies, control the salaries of the managers or determine asset acquisitions or dispositions;
There was no established market for the partnership interests;
There was no expectation that partners representing a controlling interest would consent to a liquidation of some or all the partnership assets;
There was an abundance of partnership properties (that is to say, farm properties) on the market and thus little likelihood the remaining partners would repurchase an interest without demanding a discount.12
Minority-interest and marketability discounts also were applied to FLP interests in Estate of Hoover v. Commissioner.13 In Hoover, the IRS challenged a valuation discount the estate had applied to the decedent's minority interest in an FLP. Rejecting the IRS challenge, the Tenth Circuit stated that a “proper determination of fair market value necessarily must consider the decedent's minority interest and discount for it….Without applying the minority interest discount, the ‘value’ of the decedent's [minority] interest is not its fair market value at all.”14
Restrictions in the FLP agreement itself, as well as state law restrictions, also have been considered when valuing FLP interests. For example, in Kerr v. Commissioner,15 the tax court held that restrictions on liquidation in the partnership agreement should be taken into account in valuing the FLP interests. In Estate of McLendon v. Commissioner,16 the tax court held that because state law required the express consent of all the partners to transfer a partnership interest, the decedent transferred an assignee interest (rather than a partnership interest) to the transferee, which must be valued in light of the limitations applicable to such an interest.
Chapter 14 of the Internal Revenue Code (Sections 2701 through 2704) is frequently the IRS's weapon of choice in attacking FLPs. We therefore examine how the discounts applicable to the value of an RMA would hold up under that chapter.
- Sections 2701 and 2704
Section 2701 contains special valuation rules applicable to transfers of certain interests in corporations and partnerships. This section disregards certain voting and liquidation restrictions in valuing partnership and corporate interests and treats as a gift certain lapses of rights and restrictions with respect to corporate and partnership interests. FLPs, as partnerships, are subject to the provisions of these sections. Accordingly, FLP agreements must be structured carefully to avoid falling into the traps set by Sections 2701 and 2704, as these sections have been the principal basis for IRS attacks on FLPs.
The provisions of these sections apply only to corporations and partnerships. The RMA is not a corporation and, with only one owner, cannot be considered a partnership. Accordingly, Sections 2701 and 2704 do not apply, and neither do the relevant IRS attacks.
- Section 2703
This section provides that for gift- and estate-tax purposes, the value of any property is determined without regard to: 1) any option, agreement or other right to acquire or use the property at a price less than its fair market value (without regard to such option, agreement or right), or 2) any restriction on the right to sell or use such property.
Like an FLP agreement, an RMA agreement falls within the scope of Section 2703(a) because such an agreement restricts the owner's right to sell or use the assets in the account. However, Section 2703(b) sets forth certain exceptions to Section 2703(a). In particular, it provides that Section 2703(a) does not apply to an option, agreement, right or restriction:
that is a bona fide business arrangement,
that is not a device to transfer property to family members for less than full and adequate consideration in money or money's worth, and
the terms of which are comparable to similar arrangements entered into by persons in an arm's length transaction.
Each of these three requirements must be independently satisfied for a right or restriction to qualify for this exception.17 In several private-letter rulings, the IRS has employed Section 2703 as a principal weapon in its attack on FLPs, asserting that one or more of its requirements has not been met. But an RMA should satisfy each of the requirements necessary to fall within the exception provided by Section 2703(b), for the following reasons:
- Bona Fide/Comparable Business Arrangement
Reg. Section 25.2703-1(b)(4) provides that a right or restriction is treated as comparable to similar arrangements entered into by persons in an arm's length transaction if the right or restriction is one that could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm's length. A right or restriction is considered a fair bargain if it conforms with the general practice of unrelated parties under negotiated agreements in the same business.
Because an intra-family arrangement is subject to “special scrutiny” under Section 2703, FLPs are particularly susceptible to attack for not being bona fide business arrangements that are comparable to similar arrangements entered into by persons in an arm's length transaction. It generally is difficult to establish a business purpose for an FLP, particularly those funded entirely with cash or marketable securities. Those business purposes most often asserted by taxpayers (for example, diversification of investments and pooling of family assets), generally can be accomplished by simpler means. In addition, the facts often do not support the purposes asserted.
The RMA, however, is in fact a bona fide business arrangement entered into between unrelated parties in an arm's length transaction. Thus, it is not only comparable to similar arrangements entered into by persons in an arm's length transaction, but is such an arrangement. The purpose of an RMA is to maximize the value of the assets held in the account by freeing the investment manager of short-term pressures in order to attain greater long-term investment results. At the termination of the agreement, the owner intends to reacquire investments having a greater value than those he transferred to the account. The restrictions on transferability of the RMA are a necessary protection for the investment manager because, unlike conventional investment management accounts, the manager cannot terminate the account at will upon its transfer to another individual.
- Not a “Device.”
The RMA also is not a “device” to transfer the property of the account to members of the decedent's family for less than full and adequate consideration in money or money's worth. In Technical Advice Memorandum 9842003, issued Oct. 16, 1998, and addressing FLPs, the IRS stated, “[W]e believe that a ‘device’ under Section 2703(b)(2) is reasonably viewed as including any restriction that has the effect of artificially reducing the value of the transferred interest for transfer tax purposes without ultimately reducing the value of the interest in the hands of the transferee-family member.”18
By contrast, with the RMA, neither the investor nor any member of the investor's family has control over the account or has the right to receive the RMA assets until the termination of the agreement. Thus, the restrictions that reduce the value of the account in the investor's hands also reduce the value of the account in the hands of a transferee-family member. Accordingly, an RMA does not artificially reduce the value for transfer tax purposes without reducing the value in the hands of a transferee, and therefore is not a device under the test set forth in TAM 9842003.
In other rulings, the Service has held that an arrangement constitutes a “device” if the “sole” or “primary” reason for the arrangement is the avoidance of federal taxes. For example, in TAM 9736004 (issued Sept. 6, 1997), the Service held that the transfer of the decedent's assets to limited liability companies two months prior to her death was primarily for the purpose of artificially reducing the value of her assets for a brief period before they passed through her estate to her children. With an RMA, however, the nontax benefits of the arrangement to the investor are real and substantial: professional investment management and greater long-term investment performance.
The factual contexts (so far) in which an FLP has been found by the IRS to constitute a device are those in which the decedent transferred property to an FLP shortly before his death (which was imminent at the time of the transfer) and his descendants controlled the FLP. Thus, if an FLP, being subject to “special scrutiny” as an intra-family agreement, is not created when death is imminent and generally passes the device test, then the RMA, which should not be subject to such special scrutiny, should have even less difficulty passing the test.
ESTABLISHING THE RMA
SEC rules preclude registered investment advisors from entering into an RMA agreement. The SEC has taken the position that a registered investment advisor may not restrict an investor's ability to withdraw his funds from the investment advisor. But nonregistered investment advisors, banks and trust companies, which are not subject to this SEC restriction, can enter into such arrangements. Any bank or trust company with which an RMA is being considered must verify with its counsel that applicable state and federal banking and trust company regulations do not prohibit it from entering into the arrangement.
To establish a RMA, the investor simply transfers funds to the investment manager and signs the RMA agreement. Prior to implementation, the manager will obtain information about the investor, such as his financial objectives and risk profile, to determine the appropriate investment strategy for the RMA. The RMA agreement may contain statements of the investment objectives, which, in turn, determine the allocation of assets into equities, fixed income, cash or alternative investments. Once executed, the investor has no further control over the assets until he receives them upon termination of the agreement. The investor may transfer the RMA to members of the class specified in the agreement, such as his spouse or children or trusts for their benefit. Transfers to anyone else would require the manager's consent.
The RMA agreement may authorize the manager to pay from the account certain expenses and taxes generated by the assets. Under certain circumstances, the manager also may be given the power to delegate investment authority to outside advisors.
SURE TO GROW
Because the RMA contains many of the same restrictions and limitations on control and marketability that courts have used to justify minority interest and marketability discounts for interests in closely held business entities, FLPs and restricted stock, they should be subject to similar valuation discounts. Increasing attacks on FLPs by the IRS and the simplicity of the RMA are factors likely to lead to their increased use over time.
- Where the form, nature or characteristics of property limit the owner's ability to control the investment or business interest represented by the property or to sell or liquidate the property, valuation adjustments (for example, discounts) may be appropriate in determining fair market value for transfer tax purposes. See “IRS Valuation Training for Appeals Officers,” Department of the Treasury, Internal Revenue Service (CCH) (1998), confirming the appropriateness of reducing the value of property that is not readily marketable or that represents a minority interest.
- Citizens Bank & Trust v. Commissioner, 839 F.2d 1249 (7th Cir., 1988). Instruments that impose restrictions in the transfer document will most likely fail to achieve any discount. See Ahmanson v. United States, 674 F.2d 761 (9th Cir. 1981).
- 839 F. 2d at 1249.
- 839 F. 2d at 1255.
- Some examples of restricted stock include: 1) stock acquired in a private placement; 2) stock acquired from someone who directly or indirectly controls the management of the issuer; 3) securities acquired through employee stock options without registration; and 4) securities obtained through employee stock-purchase plans without registration. “IRS Valuation Training for Appeals Officers,” Department of the Treasury, Internal Revenue Service (CCH) 11-4 (1998).
- Several exceptions apply to SEC Rule 144, including the following: 1) non-affiliates can sell restricted securities provided the securities have been fully paid for and the seller has beneficially owned the securities for at least two years; 2) under certain circumstances, a non-affiliate donee is not subject to volume limitations; and 3) a former affiliate may sell restricted securities that have been held for two years without regard to volume limitations when three months have elapsed since termination of the affiliate status. “IRS Valuation Training for Appeals Officers,” Department of the Treasury, Internal Revenue Service (CCH) 11-7 (1998).
- Trust Services of America, Inc. v. Commissioner, 88-1 USTC 13,767, at 84,162 (C.D. Cal. 1988), aff'd in part, rem'd in part and rev'd in part, 885 F.2d 561 (9th Cir. 1989).
- 45 T.C.M. (CCH) 1199 (1983).
- 88 T.C. 38, 51 (1987).
- 62 T.C.M. (CCH) 1128 (1991).
- Moore, 62 T.C.M. at 1133 (citations omitted).
- Id. at 1131-32.
- 69 F.3d 1044 (10th Cir. 1995).
- Id. at 1047.
- 113 T.C. 449 (1999) aff'd 2002 WL 1472762 (5th Cir., 2002).
- 66 T.C.M. (CCH) 946 (1993) rev'd , 77 F.3d 477 (5th Cir. 1995), rem'd on other grounds, 72 T.C.M. (CCH) 42 (1996), rev'd, 135 F.3d 1017 (5th Cir., 1998).
- See Reg. Section 25.2703-1(b)(2).
- Although Technical Advice Memoranda (TAMs) generally may not be used or cited as precedent to bind the Service (see IRC Section 6110(k)(3)), the TAMs we discuss provide an indication of the Service's position concerning the meaning of “device” and how it may be applied to the RMA.
USE THE RMA WITH AN IRA
The restricted-management account may be used in conjunction with an individual retirement account. Investing for the long term with an independent manager provides justification for possibly obtaining discounts on an IRA's fair market value, which the trustee must determine annually. A reduced fair market value would, in turn, decrease any required minimum distributions if the owner were older than 70. It would also reduce the value of the IRA for estate-tax valuation purposes.
The central concern with the RMA/IRA: If the IRA owner commits a prohibited transaction under the Internal Revenue Code, the result would be a loss of the IRA's tax-exempt status and a deemed distribution of all the assets, resulting in immediate income tax.
IRC Section 4975(c)(1) details the categories of prohibited transactions between the IRA and a disqualified person. These transactions include exchanging, selling or leasing property between the plan and a disqualified person, or if the disqualified person transfers or uses plan assets primarily for his/her benefit. An IRA owner is a disqualified person.
Advisory Opinion 2000-10A, issued September 2000, found that the funding of a limited partnership with IRA assets would not violate the prohibition on exchanging, selling or leasing assets between the plan and the disqualified person. The opinion expressly refused to rule on whether the transaction would be prohibited under the other categories comprising Section 4975(c)(1). The ruling specifically mentioned the categories in subparts “(D) and “(E),” both of which relate to agreements, understandings or arrangements in which a disqualified person uses plan assets primarily to benefit himself. This determination is a factual matter and not appropriate for an advisory ruling.
The Department of Labor ruling did, however, state that one factor mitigating the possibility of such a prohibited transaction was the presence of an investment manager unrelated to the disqualified person. The RMA investment manager, the bank, is clearly unrelated to the disqualified person and has no beneficial interest in the RMA. The RMA's terms preclude the IRA owner from directing, managing or withdrawing the assets after entering into the RMA. The only exception is that the owner may withdraw the required minimum distribution from the IRA subject to an RMA.
The RMA's investment-driven approach and its independent investment manager create the possibility of relegating any tax saving to an incidental benefit. If so, the DOL ruling implies that the IRA owner would avoid committing a prohibited transaction.
— David A. Handler and David Sennett