Cash Held in Partnerships May be Subject to Significant Discounts

Often, cash and cash equivalents held by partnerships are considered by the IRS to be subject to no discounts or to only minimal discounts, because of the obvious liquidity. However, let’s take a look at the recently decided Tax Court case, Estate of Kelley v. Commissioner, T.C. Memo 2005-235, which considers the question of discounts applied to the interests of a family limited partnership held by the Estate. The partnership’s assets consisted solely of cash and certificates of deposit. In this case the overall discount allowed by the court was an amazing 32%! Why?

Discounts for lack of control and marketability

A typical limited partnership valuation relies on the application of discounts to the partnership’s net asset value (NAV). These discounts have traditionally been divided into two categories—a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). The first discount, the DLOC, is applicable because a minority limited partner is generally unable to control the cash flow, investment of assets, or liquidation of the partnership. The second discount, the DLOM, is applicable because the partnership interest is not readily marketable, as a publicly traded security would be.

Limited partnership comparable to closed-end investment fund

The methodology employed for determining the DLOC is fairly well settled in the valuation community—the partnership’s assets are analyzed and discounts are applied by looking to the public markets for investment vehicles holding similar assets. In the case of partnerships that hold securities and cash, closed-end investment funds are generally considered to be the most comparable publicly traded investment vehicle. From a control perspective, limited partners of the family limited partnership are positioned very similarly to investors in closed-end funds. Most closed-end funds sell in the marketplace for something less than the net asset value of the funds. Therefore, this discount is the best proxy for the discount that would be required by a new investor in the limited partnership to compensate for his lack of control over the underlying assets.

DLOM determination not as straight-forward

The methodology to determine the discount associated with the inability to easily sell the interests into a pre-established public marketplace (DLOM) is not as well settled. Let’s assume, however, that the discount is something an investor would apply to compensate for the absence of a ready market (all things being equal, investors prefer liquidity to illiquidity).

When a partnership holds cash as part of its portfolio of assets, we have seen the IRS argue that the cash portion of the assets is not subject to any discount for lack of control. Our response has generally been that cash held by a partnership is just as locked-up, from a control standpoint as any other asset held, and that all of the comparable closed-end funds to which the partnerships are compared (and which trade at discounts from NAV) hold some percentage of their assets as cash. Thus, cash is discounted in the public marketplace. At least that portion of cash held by the partnership that represents a percentage of the portfolio in proportion to the comparable closed-end funds’ percentage of cash ought to be discountable at whatever rate is applied to the rest of the partnership’s assets.

What discount is applicable to the “excess” cash held?

The frequent response we hear is that only a 2% discount should be applied because only 2% was allowed in Peracchio v. Commissioner, TCM 2003-280. Does this mean that going forward the IRS’ response when considering cash held by partnerships will be that the DLOC should be 12% because 12% was allowed in Estate of Kelley? Probably not. However, the underlying reasons for applying discounts to a limited partner’s interest support the application of significant discounts to whatever assets are held by a limited partnership.

DLOC for all underlying assets

Although in our recent experience, the IRS has become more aggressive in challenging discounts applied to limited partnership interests that hold only securities and cash, Estate of Kelley should at least provide some additional support for what we, as appraisers, know—in a valuation based on discounts from NAV, all underlying assets should be subject to significant DLOC because of the lack of control represented by the limited partner interest. While it is true that “cash is king,” cash held by a limited partnership is like a “king without a country.”

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Robert Buchanan

Valuation | ESOP
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