Several of my recent articles have focused on qualifying your estate for valuation discounts, usually by using limited liability companies (LLCs) and family limited partnerships (FLPs). I have mentioned several times, however, that the IRS doesn’t look on these discounts with favor and has often challenged them in the United States Tax Court.

In a recent Tax Court case involving Mr. and Mrs. Peracchio, the IRS lost again giving credence to the techniques I’ve been discussing.

In November, 1997, Mr. and Mrs. Peracchio created a Delaware FLP and a Family Trust. They transferred over $2 million in cash and securities to the FLP in return for a 0.5% general partnership interest and a 99.4% limited partnership interest. The securities were in over 40 different companies and in many different industries. At the same time, Mr. Peracchio’s son contributed $1,000 to the FLP in return for a 0.05% general partnership interest equivalent to one partnership unit. Finally, the Peracchio Family Trust paid $1,000 to the FLP in return for a 0.05% limited partnership interest.

Shortly after these initial transfers were completed, Mr. Perachhio gifted a 0.045% general partnership interest to his son. He also gifted a 45.47% limited partnership interest to his Family Trust and transferred an additional 53.48% limited partnership interest to the Family Trust in exchange for a promissory note in the amount of $646,764. By the time he completed all of his gifts and transfers, the Perachhio Family Trust owned 99% of the limited partnership interest.

I apologize for burdening you with all these percentages, but it is important to outline the events as they occurred.

After Mr. Perachhio completed his gifting, he filed a Form 709 Federal Gift Tax Return listing the gifts. He valued the gift to his son at $9,070 and the gift to the Family Trust at $550,000, claiming a 40% discount on the value of the gift to the Family Trust because of lack of marketability and lack of control.

When the IRS reviewed Mr. Perachhio’s Gift Tax Return, it disallowed the 40% valuation discount and substituted an 18.74% net discount. As a result of the IRS disapproving the larger discount, the value of the gift to the trust went from $550,000 to $916,667. Mr. Perachhio was ordered to pay gift tax of $328,317. He appealed.

Before the Tax Court, the Taxpayer and the IRS agreed that the total value of all assets contributed to the FLP was $2,010,370 and that there should be some discount in value because of lack of marketability and lack of control. The disagreement was over the size of the discount.

One thing to come out of this case is the importance of having a qualified, reputable appraiser determine your discount and testify to the reasonable value of the discount and how it was determined. This factual analysis must withstand court scrutiny. Both the Taxpayer and the IRS used reputable appraisers in court to support their respective positions. As you would expect, the expert for the Taxpayer testified to a much higher discount than the expert who testified for the IRS. Mr. Perachhio called two separate experts who testified that the gifts should qualify for discounts of between 42.7% and 45%, while the IRS expert testified the discount should only be 18.74%.

Mr. Perachhio did everything right. He documented his transfers. He hired qualified, competent appraisers to do a full-blown appraisal and calculate the appropriate discounts. The discount claimed was actually less than that arrived at by either of his appraisers. He justified the discount on his Federal Gift Tax Return and attached documentation establishing the value of the underlying assets and the justification for the discount. Finally, once he gifted or transferred the FLP interests to his son and the Family Trust, he kept "hands off" and did not give the IRS any reason to argue he had retained control of these assets.

The Tax Court reviewed the testimony of all three experts and made some adjustments of its own. It said the value of the minority interest discount should be 6% and the lack of marketability discount should be 25%. The IRS expert had argued for a range of marketability discount between 5%-25%, and the court used his highest number in setting the lack of marketability discount. The final value placed on the gift to the Family Trust by the Tax Court was $644,446.00, more than $270,000 less than the value assigned to the gift by the IRS, thereby saving the Taxpayer over $130,000 in additional taxes. This ruling was a complete victory for the Peracchios because the gifted assets were cash and marketable securities, both of which could readily have been converted into cash at full face value. If there ever was a case in which the IRS expected to triumph, this was it. It was black and white, cut and dry, and clear as the morning sun. Despite this, the Tax Court essentially split the difference between the discount values claimed by the Taxpayer and the IRS.

This decision is being appealed by the IRS, so nothing is conclusive yet. If this Tax court ruling is upheld on appeal, it will cause an increase in the use of FLPs and LLCs funded solely by cash and marketable securities and will probably result in more aggressive discounts being sought by taxpayers. Stay tuned as this case makes its way through the appellate process.

If you have a large taxable estate in excess of the present exempt amount of $1.5 million, using lack of marketability and lack of control discounts in conjunction with limited liability companies or family limited partnerships could save you significant estate or gift tax. Be sure to consult with an estate planning attorney knowledgeable of the tax rules who can guide you through the sometimes