Sunday, May 28, 2006

BUILT-IN GAINS VALUATION DISCOUNT AND PARTNERSHIPS

In valuing stock in a corporation for estate and gift tax purposes, if the corporation's assets are appreciated, some discount in value will usually be allowed. This is because there is a future tax liability that relates to the stock - when the corporation sells the appreciated asset income tax will be imposed on the gain. Remember that the test for value of the stock for estate and gift tax purposes is the price that a hypothetical willing buyer would sell the stock to a hypothetical willing seller, neither being under any compulsion to buy or sell. Clearly, a buyer would note the future tax and reduce the purchase price since that future tax would reduce the assets of the corporation and thus the value of the stock upon sale of the appreciated assets.

A recent tax case acknowledges that this concept probably does not apply to valuing partnership interests in a partnership that has appreciated assets. This is because of Section 754 of the Internal Revenue Code - a provision that applies only to partnerships and not corporations. A buyer of a partnership that has made a Section 754 election gets the benefit of an adjustment in tax basis to the assets of the partnership allocable to the purchased interest, based on the purchase price paid for the interest. The effect of this election is that a buyer of a partnership interest, in the hypothetical purchase and sale used for valuation, will NOT have to pay future tax when the appreciated property is sold by the partnership (to the extent of the purchase price paid). Therefore, such a hypothetical buyer would not be able to convince a hypothetical seller to reduce the purchase price for this tax liability, and no discount for the future tax liability obtains. See Temple v. U.S., 97 AFTR 2d 2006-1649 (DC TX 2006).

Is it fair to for the court to assume that a Section 754 election would be made by the partnership, as the court in Temple did? Perhaps when the interest at issue is a control interest that would allow the buyer to make the election in its discretion. However, if the interest is only a minority interest or a limited partner interest so that the Section 754 election is in the hands of someone other than the buyer, perhaps this assumption is inappropriate. Note that in that circumstance, another partnership provision may come into play to reduce or eliminate the built-in gains deduction. That provision is Section 704(c), which will tax a contributing partner when the partnership sells the property on the gain in partnership property that existed at the time that such contributing partner made its contribution. This provision can redirect some of the appreciation in partnership assets to a partner other than the buyer, and thus would also reduce the valuation reduction for future taxes. This is also mentioned in the Temple case.
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