IRS to Disallow Valuation Discounts for Restricted Management Accounts

July 21, 2008

In Revenue Ruling 2008-35, 2008-29 I.R.B. 116 (July 18, 2008), the Internal Revenue Service for the first time addresses the availability of discounts for interests held in a Restricted Management Account or “RMA” and rules that discounts will not be allowed for estate and gift tax purposes.

An RMA is an agreement between a depositor and an investment manager (often a bank or a brokerage firm). Pursuant to the terms of the RMA agreement, the depositor agrees to relinquish control of the assets placed in the account for a selected term of years and gives the investment manager the sole and absolute right to manage the account during that the term. The term usually can be extended by the depositor. During the term of the RMA, the depositor cannot make withdrawals from the RMA. Instead, any income earned during the term is retained and reinvested. The RMA agreement usually limits the permissible recipients of interests in the RMA to family members of the depositor or related entities such as revocable trusts for the benefit of family members.

Proponents of RMAs believe that the restrictions on the access of the depositor to the assets in the RMA entitle the depositor to valuation discounts on both gifts of RMA interests during life and in the depositor’s estate at death. The longer the term and the greater the restrictions, the larger the discounts that proponents believe should be available.

Because of their simpler structure, RMAs have been promoted as cost-effective and more easily understood and managed alternatives to family limited partnerships and limited liability companies when individuals are seeking techniques to obtain valuation discounts. Proponents also have asserted that RMAs are less susceptible to challenges by the IRS. Because an RMA is not a corporation or partnership, proponents argue that sections 2701 (stock and partnership freezes), 2702 (gifts of interests in trusts in which the grantor retains certain interests and gives away other interests), and 2704 (ignoring certain restrictions in a corporation or partnership when valuing interests in the corporation or partnership) are inapplicable. Proponents also contend that section 2703 (disregarding certain rights and restrictions in intra family transactions such as buy-sell agreements) will not apply because an RMA is an agreement between the depositor and a third party and the RMA has significant non-tax benefits and thus cannot be considered a device the primary purpose of which is to transfer assets to others for less than full and adequate consideration.

The Service in Revenue Ruling 2008-35 completely disagrees with the positions taken by the proponents of RMAs and essentially treats an RMA like any other bank or brokerage account in which the value for transfer tax purposes is the value of the underlying assets. It notes in the ruling that the “interposition of the RMA agreement to manage [the depositor’s] assets, reduces neither the fair market value of the transferred property for gift tax purposes nor the fair market value of the property included in [the depositor’s] gross estate for estate tax purposes.” The Service appears to distinguish interests in RMAs from family limited partnership interests or limited liability company interests by noting that under state property laws, the depositor is the sole and outright owner of the assets in the RMA and the income from the assets. This is different from a family limited partnership or limited liability company in which the partner or member owns only partnership or member interests and has no direct ownership of the underlying assets.

The Service analogizes the RMA to a management contract between the owner of property and a property manager. Any restrictions in the Service’s view relate to performance of the duties of the manager under the contract and are not substantive restrictions on the underlying assets held in the RMA. The Service also analogizes the valuation of RMAs to the valuation of retirement accounts citing Smith ex. rel. Estate of Smith v. United States, 391 F.3d 621 (5th Cir. 2004), and Estate of Kahn v. Commissioner, 125 T.C. 227 (2005), for the long held policy of valuing retirement accounts, despite the restrictions on them, at the fair market value of the assets held in the retirement accounts. The Service, without any analysis or discussion, states that section 2036 will apply to a depositor’s retained interest in an RMA at death and section 2703 will apply to disregard transfer restrictions in an RMA for valuation purposes. As a last shot, the Service notes that to the extent that a depositor has the ability to terminate the RMA under state agency law principles, no discounts will be allowed.

Whether one agrees or disagrees with Service, this Revenue Ruling makes the use of RMAs as a substitute for family limited partnerships or limited liability companies far less attractive to customers and clients because of the Service’s repudiation of RMAs as a technique to obtain valuation discounts. Individuals who have been considering RMAs will now want to consider family limited partnerships and limited liability companies. Despite the attacks made by the Service on family limited partnerships and limited liability companies in the last several years, many family limited partnerships and limited liability companies have withstood attacks by the Service. Thus, family limited partnerships and limited liability companies continue to be viable techniques for obtaining valuation discounts if they are established and managed appropriately. Individuals currently holding RMAs will now want to pursue other techniques. Of course, if the term of the RMA cannot be shortened, using the assets in the RMA in other techniques may be impossible before the end of the term.

Banks and other investment managers that have existing RMA relationships should review each relationship to see what steps, if any, can and should be taken in light of this Revenue Ruling and be ready to discuss the possible steps with the clients and customers who have RMAs.

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