Assignor Beware: Partnership Interest Held to be Limited Partner Interest Rather than Assignee Interest
The Tax Court recently held that a partnership interest assigned to a revocable trust was not an assignee interest but rather was a limited partnership interest, and as result, the discounts for lack or marketability and lack of control were reduced and eliminated respectively.1 The Estate of Frank D. Streightoff (the “Estate”) argued that an 88.99% interest held in a revocable trust, includable in the Estate under IRC §2038, was owned by the trust as an assignee interest, and that the trust had not been admitted to the partnership as a partner. The Tax Court however concluded otherwise.
On October 1, 2008, Frank D. Streightoff (the “Decedent”), acting through his daughter, Elizabeth, who held a power of attorney for the Decedent (the “POA”), formed Streightoff Investments, LP, a Texas limited partnership (the “Partnership”). The Decedent held an 88.99% limited partnership interest upon formation. The general partner of the Partnership was Streightoff Management, LLC, of which Elizabeth was the manager.
Also on October 1, 2008, the Decedent established the Frank D. Streightoff Revocable Living Trust (the “Trust”). Upon formation, the Decedent transferred his 88.99% interest to the Trust. Both actions were executed by Elizabeth, acting as the Decedent’s agent under the POA.
The document which assigned Decedent’s partnership interest to the Trust was titled “Assignment of Interest” (the “Assignment”). Decedent was the assignor and the Trust was the assignee. The Assignment transferred the Decedent’s 88.99% interest “together with all and singular the rights and appurtenances thereto in anywise belonging, unto the said Assignee, its beneficiaries and assigns forever.” Decedent also agreed to provide any further documentation or sign any additional instruments necessary to provide such rights to the Assignee as well as to be bound by the terms of the partnership agreement. Further, the Assignment was signed by Elizabeth in her capacities as the Decedent’s agent under the POA, as trustee of the Trust, and as manager of Streightoff Management, LLC, the general partner of the Partnership.
The partnership agreement provided that limited partners owning 75% or more of the partnership interests could remove the general partner resulting in a termination of the Partnership. Thus, owning 75% of the limited partner interests was enough to force the Partnership to dissolve and distribute out its assets to its partners.
As far as transfer restrictions, the partnership agreement provided that a limited partner could not sell or assign an interest in the Partnership without the written approval of the general partner. Additionally, a limited partner could only transfer its interest in a permitted transfer, but the parties stipulated the transfer at issue was a permitted transfer. Nevertheless, even in the case of a permitted transfer, the recipient of the interest was treated as an unadmitted assignee with rights only to allocations and distributions until being admitted as substitute limited partner. Unadmitted assignees had no right to any information or accountings of the Partnership nor rights to inspect the books and records of the Partnership, among other restriction. In order for an unadmitted assignee to be admitted as a substitute limited partner, the following three conditions must be satisfied: 1) each general partner must consent; 2) the interest must have been transferred in a permitted transfer under the partnership agreement; and 3) transferee must become a party to the partnership agreement as a limited partner and execute any documents and instruments requested by the general partner to confirm that the transferee is bound by the terms and conditions of the partnership agreement.
On the Estate’s Form 706 Estate Tax Return, the Estate included the 88.99% limited partnership interest on Schedule G as includable under IRC §2038. The interest was listed as an assignee interest rather than as a limited partnership interest. The total valuation discount taken amounted to 37.2% which included a 13.4% discount for lack of control and a 27.5% discount for lack of marketability as well as a discount for lack of liquidity which was not discussed. The Internal Revenue Service (the “IRS”) issued a notice of deficiency increasing the value of the interest from $4,588,000 to $5,993,000. The IRS expert who valued the interest concluded that the interest was not an assignee interest but rather was a limited partnership interest.
In its opinion, the Court addressed several issues including the validity of the notice of deficiency as well as the burden of proof. But the opinion centers on determining the type of interest, whether an assignee interest or a limited partnership interest, and the subsequent fair market value based on the determination of the appropriate type of interest.
Assignee vs. Limited Partnership Interest
Generally, state law will control in determining what property interest has been transferred.2 According to The Texas Revised Limited Partnership Act (the “TRLPA”), as in effect at the time of the transfer in 2008, an assignee of a limited partnership interest was entitled to allocations of income and loss as well as distributions, but an assignment did not entitle the assignee to become or exercise the rights of a partner.3 An assignee may be admitted as a partner in the manner provided by the partnership agreement or if all partners consent.4
While state law generally controls, the Court noted that it is not bound by state law but rather the federal tax effect of a particular transaction is governed by the substance of the transaction rather than its form.5 This doctrine, referred to as the substance over form doctrine, is commonly used by the IRS to attack various transactions including those viewed to be abusive or to be entered into solely for tax reasons. The Court noted that the substance over form doctrine has been applied in Federal estate and gift tax cases and have been willing to look beyond the formalities of intrafamily partnerships to determine the substance of what was transferred.6
The Court made quick work of its analysis on the type of interest issue. First, the Court concluded that all three requirements of the partnership agreement for an assignee to be admitted as a limited partner in the Partnership had been met. First, Elizabeth signed the Assignment consenting the transfer in her capacity as manager of Streightoff Management, LLC, the general partner. Thus, all the general partners had consented. Second, the parties stipulated that the transfer was a permitted transfer. Third, the Assignment provided that the Trust agreed to be abide by and be bound by the terms of the partnership agreement. Accordingly, all three requirements were met for the Trust to be admitted as a limited partner and the IRS correctly concluded that the interest was a limited partnership interest rather than an assignee interest based on the form of the transaction.
While the Court concluded the form of the transaction resulted in the Trust being treated as a limited partner, the Court went on to state that the “economic realities underlying the transfer of Decedent’s interest also support [their] conclusion that the transferred interest should be treated as a limited partnership interest…because we conclude that regardless of whether an assignee or a limited partnership interest had been transferred, there would have been no substantial difference before and after the transfer to the [Trust].” The Court noted that no votes had been taken in the interim, the Trust was revocable, and Streightoff Management, LLC could have admitted the Trust as a substitute limited partner. So, in the opinion of the Court, the interest should be treated as a limited partnership interest due to the form as well as the substance of the transaction.
Fair Market Value
Having determined that the interest being valued was indeed a limited partnership interest rather than an assignee interest, the Court next turned to the valuation of the interest. Since a 75% limited partnership interest was enough to effectively terminate the Partnership, the Court concluded that there was no discount for lack of control.
In determining the discount for lack of marketability, the Court analyzed both the taxpayer’s expert report as well as that of the IRS. The taxpayer’s expert testified that it had valued the interest as an assignee interest in concluding a 27.5% discount for lack of marketability was warranted, and that this analysis would have included different considerations were the interest valued as a limited partnership interest instead. The IRS export report valued the interest as a limited partnership interest and concluded that there was an 18% discount for lack of marketability. The Court agreed with the IRS export report and held that the 18% discount for lack of marketability was appropriate.
As this case illustrates, having an interest treated as an assignee interest rather than as a limited partnership interest can have some significant benefits where larger discounts are helpful. But this case is one of bad facts. The fact that all the transactions were undertaken on the same day, that all transactions were undertaken by Elizabeth in one capacity or another, and that the Assignment was drafted in such a way that it satisfied the requirements for admission as a partner lead one to conclude that the transaction doesn’t pass the smell test. While the Court did not go into depth in its substance over form analysis, the opinion makes it clear that the transaction would not pass muster based on its substance. Taxpayers who might benefit from having an interest treated as an assignee interest might be wise to avoid the mistakes made by the taxpayer in this case.
- Estate of Streightoff, TC Memo 2018-178.
- McCord v. Commissioner, 120 T.C. 358 (2003), rev’d and remanded on other grounds, 461 F.3d 614 (5th Cir. 2006).
- Tex. Rev. Civ. Stat. Ann. Art. 6132a-1, secs. 7.01 and 7.02 (West).
- Id. Sec. 7.04(a) and (b).
- Frank Lyon Co. v. U.S., 425 U.S. 561 (1978).
- Heyen v. U.S., 945 F.2d 359 (10th Cir. 1991); Estate of Murphy v. Commissioner, T.C. Memo 1990-472; Kerr v. Commissioner, 113 T.C. 449 (1999), aff’d 292 F.3d 490 (5th Cir. 2002).