2036 & ECONOMIC SUBSTANCE IRS FLP CHALLENGES AND ADVISOR RESPONSES

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1 2003 ACTEC Annual Meeting Symposium I Thursday, March 6, :45 a.m.-10:15 a.m & ECONOMIC SUBSTANCE IRS FLP CHALLENGES AND ADVISOR RESPONSES Given the ongoing IRS national compliance program on pass-through entities which are utilized, in part, to develop transfer tax valuation adjustments ( discounts), estate planners must pay attention to the operation of such entities as well as to plan design, documentation and implementation. The Service continues to advance multiple attack theories including those based on Chapter 14, namely, IRC Sections 2703 and However, recent developments indicate that the retained life estate/power of control statutory provision, IRC Section 2036, and also perhaps the judicial doctrine of economic substance, provides IRS with opportunities for success in its estate tax compliance and litigation efforts. Further, the gift tax area cannot be overlooked, including IRS attack on 2503(b) annual exclusions and the continued raising of the gift on formation issue. Our panel presentation primarily will consider the 2036 and economic substance issues in a manner designed to assist estate planners in minimizing estate tax audit and litigation risks. The client s understanding of such risks is key to meeting our duty of assisting the client in giving informed consent to an FLP/FLLC-based valuation strategy to achieve maximum family wealth preservation. Owen G. Fiore San Jose, CA T. Randall Grove Vancouver, WA SI-OGF/TRG-1

2 Symposium I Focus Owen G. Fiore T. Randall Grove The Internal Revenue Service, with the apparent support of at least some Tax Court judges, appears to have found a potentially potent weapon resulting from in its over 5-year national compliance program challenging pass-through entity use to achieve transfer tax savings through entity-based valuation adjustments ( discounts ). This weapon is IRC Section 2036, a broad estate tax statutory provision. Although to date it is Section 2036(a)(1) that has been used by the Tax Court to disregard entities (as discussed in the panelists outline materials), both IRC Secs. 2036(a)(1) and 2036(a)(2) are in play in Service 2036 challenges to the viability of pass-through entities. These challenges are to the reality of the Family Limited Partnership ( FLP ), the Family Limited Liability Company ( FLLC ), and even as indicated in one FSA the S corporation. As to corporate entities, whether C or S in nature, IRC Section 2036(b) (the anti-byrum provision) also is relevant to our review. Further, the judicial doctrine of economic substance continues to be advanced by the Service in tandem with 2036; and, in addition, the Service has been attempting to increase its compliance efforts relating to gift tax returns. SI-OGF/TRG-2

3 Based on the above, the focus of our Symposium I panel will be as follows: (1) Review of pass-through entity planning, operation and IRS examination defense in light of Service success in application of IRC Section 2036 to disregard the entity for estate tax purposes. (2) Consideration of IRS related arguments, such as no economic substance, testamentary transaction, step transaction and IRC Section Some reference also will be made to what might be called a gift tax equivalent to 2036, namely, that contribution of assets to an entity in exchange for entity equity interests may be alleged to be a Section 2511 gift on formation. Also in the gift tax area, the availability of the 2503(b) present interest annual exclusions will be discussed in light of the Hackl Tax Court opinion. (3) Development of a practitioner-friendly matrix of negative factors to be avoided in planning and operation of pass-through entities as a defense against exam attack. (4) Presentation of a simplified checklist approach to considering with clients possible use of pass-through entities in valuation strategic planning, together with sample memos and letters communicating to clients and to the advisor team at various stages of the entity plan SI-OGF/TRG-3

4 We will discuss case studies relating to various size estates, including evaluating alternatives to pass-through entities (co-tenancy, trusts, etc.) and optimum entity structuring design. Further, tax counsel management of an IRS transfer tax examination of the entity plan will be considered, such as handling IDRs, IRC Section 7491 burden of proof shifting, and attorneyclient privilege. A listing of selected reference materials has been provided clearly evidencing the uncertainty of transfer tax valuation results where entity interests are the property interests transferred. Note that since application of 2036 often makes the valuation appraisal-based discounts irrelevant, the Symposium I will not deal in detail with valuation methodology itself or resulting hoped for discounts. The playing of the valuation game has received the attention of the Tax Court. See, for example, Judge Gerber s opinion in Estate of Baird v. Commissioner, T.C. Memo , as well as Judge Beghe s complaints in Wall v. Commissioner, T.C. Memo (citing and discussing Buffalo Tool & Die Mfg. Co. v. Comm r, 74 T.C. 441 (1980)). Tax Court Judge David Laro stated at a 2001 tax conference the following: Despite the subjectivity surrounding the issue of valuation, we continually strive to measure value precisely and objectively. (Also, see Judge Laro s opinion in Estate of Auker v. Comm r, T.C. Memo ). Clearly, the results of tax litigation on transfer tax valuation are quite uncertain. Now, the entity reality side of pass-though entity developed valuation discounts has taken center stage. In recent years ACTEC Fellows have been presenting pass-through entity and valuation entity reality issues at our meetings and in articles appearing in the ACTEC Journal (formerly SI-OGF/TRG-4

5 ACTEC Notes). The ACTEC Journal articles and ACTEC National Meeting outlines have included many choice of entity, valuation, FLP/FLLC planning, and similar categories showing that the College has been tracking entity and valuation developments rather well. Illustrative of ACTEC coverage of these topics are the following: (1) Choice of Business Entity Choice of Entity, Annual Meeting, 1994 (Fiore, Hall, McGaffey, Mezzullo) Choosing the Right Business Entity, Mezzullo, Fall/1994 Vol 20, No. 2 (2) Family Partnerships The Use of Discount Partnerships in Estate Planning, Eastland and McBryde, Fall Meeting, 1993 The Art of Making Uncle Sam Your Assignee Instead of Your Senior Partner: The Use of Family Partnerships in Estate Planning, Eastland, Summer Meeting, 1997 (3) Tax Audits & Appeals Estate & Gift Tax Audit Issues, Aucutt and Fiore, Annual Meeting, 1997 Business Valuations A View From the U.S. Tax Court, Judge Laro, Annual Meeting, 2000 SI-OGF/TRG-5

6 (4) Valuation Appraisers Role in Estate Planning, Christie and Kimball, Summer Meeting, 2000 Taking Advantage of Valuation Principles to Transfer Wealth, Belcher, 1996 Also, the ACTEC Journal has included two (2) articles authored by Owen Fiore on the FLP/FLLC issues and IRS entity attacks, namely, (i) Planning, Operating & Defending FLP/FLLC-Based Entities Spawning Valuation Discounts, 24 ACTEC Notes, 35 (Summer, 1998), and (ii) Coping with Continuing Uncertainty in FLP/LLC-Based Valuation Discount Strategies, 27 ACTEC Journal, 220 (Winter, 2001). These articles were an alert to practitioners on the IRS national compliance program on pass-through entity-based valuation discounts in estate planning. Also, generally on transfer tax valuation, see Zeydel and Benford, Valuation Principles and Recent Developments: Practical Guidelines for the Estate Planner, 25 ACTEC Journal 31 (Summer, 1999). SI-OGF/TRG-6

7 Outline Materials Index Panel Introductory Materials OGF-TRG-1-7 CCH Articles Re: Harper and Thompson H/T-1-7 Outline and Appendices of Owen G. Fiore (including OGF-1-55 as PART III selected reference materials) Outline and Appendices of T. Randall Grove TRG-1-17 (plus Exhibits) SI-OGF/TRG-7

8 2003 ACTEC Annual Meeting Symposium I March 6, & ECONOMIC SUBSTANCE IRS FLP CHALLENGES AND ADVISOR RESPONSES The following materials have been prepared by Owen Fiore in support of the Symposium I panel presentation by Owen Fiore and Randy Grove. These materials are for educational purposes only and use thereof in connection with any specific client matter or advice to a client is the sole responsibility of the user. Cartoons were provided courtesy of my son, Mark Fiore, an editorial cartoonist and animator in San Francisco. See Mark s website: I express appreciation to my partner, John Ramsbacher, recently elected as an ACTEC Fellow, and to John Prokey and Erin Wilms, firm associates, for their input and assistance with these materials. At the time of completion of our outlines the third week of January this year, as you will see from the panel presentation and the materials themselves, more 2036 developments emerged 2036(a)(1) and 2036 (a)(2) now are both in play! Owen G. Fiore, JD Fiore Ramsbacher LLP Attorneys at Law 125 South Market Street, Suite 1150 San Jose, California Telephone: (408) Fax: (408) ogf@fioreramsbacher.com SI-OGF-1

9 2036 A Challenge For All Of Us ACTEC Fellows have witnessed a number of years during which the use of entities has been recommended as at the core of effective transfer tax valuation strategies. We as estate planners know that typically there are non-tax reasons that are operative in such planning. The selected bibliography included in these symposium materials bears witness to advisor focus on entity structures and planning for multiple purposes, including tax savings. As the cartoon following this introductory statement evidences, IRC Section 2036, a broad statutory provision, poses a significant threat to realization of the planned for wealth preservation goals, especially in use of pass-through entities (FLPs, FLLCs and S corporations) that, in part, generate or spawn valuation adjustments ( discounts ). The IRS national compliance program in this area, having been built up for at least 5 years, in many respects has failed to bear fruit, as detailed in my outline materials. However, the Tax Court cases of Schauerhamer, Reichardt, Harper, and most recently, Thompson, have been hailed by the Service as heralding in effect a transfer tax version of the economic substance doctrine using its IRS-perceived statutory form, i.e. IRC Sec. 2036(a)(1). The Service examination program, quite invasive in many cases, prevents tax advisors from merely dismissing the 2036 Tax Court opinions on the basis of bad facts. Also, the th Circuit reversal in part of Strangi, remanding the case for 2036 consideration has intensified consideration of 2036 pitfalls, including both 2036(a)(1) and (a)(2). In spite of the solely corporate facts application of IRC Sec. 2036(b) (the anti-byrum rule), questions have been raised as to the applicability of the 1972 U.S. Supreme Court case of U.S. v. Byrum, 408 U.S. 125 (1972), to protect or shelter partnership pass-through entities from 2036(a)(2). Finally, the Tax Court case of Hackl, reviewed in this outline, raises the issue of availability of the IRC Section 2503(b) present interest annual exclusion (now $11,000 per donor, per donee, per year). See ACTEC Fellow Jerry Deener s article in 28 ACTEC Journal 83 (2002), Hackl Debacle: Are the Annual Exclusions and Discounts Mutually Exclusive for Gifts of Closely Held Business Interests? SI-OGF-2

10 Another troubling problem for consideration in this ACTEC Symposium I relates to attorney and other advisor standards of tax practice, important ethical issues, and the creation of exposure to malpractice claims by clients for recommending, not recommending, monitoring, or not monitoring an FLP/FLLC-based valuation plan. Randy Grove and I, with assistance, advice and insight of a number of ACTEC Fellows, plan to review in Symposium I what we perceive to be the current state of the law relating to 2036, a matrix of negative 2036 factors, points to consider in qualifying a client for embarking on a pass-through entity/valuation discount program, and how to evaluate various typical situations. We also will raise the new spector of 2036(a)(2). In view of concentration by IRS on entity operational facts in applying 2036 to disregard the entity, our panel will develop a chronological analysis - entity design, documentation, formation, funding, day-today operation, compliance (tax returns), and audit management. Note that while we will not focus in detail on FLP/FLLC equity valuations, that always remains an important consideration. It appears IRS is using the 2036 threat to secure agreement of taxpayers to lower entity interest valuation discounts regardless of the valuation evidence! ACTEC Fellows therefore need to be proactive in working with business valuation appraisers, including by providing guidance on legal and tax assumptions. Comparison of Tax Court opinions in Strangi, Knight, Jones and Dailey, all cited and discussed below, are helpful in this regard. As speakers at the 2003 Puerto Rico ACTEC Annual Meeting, Randy Grove and I appreciate this opportunity and welcome the challenge to present Symposium I 2036 & Economic Substance IRS FLP Challenges and Advisor Responses. We sincerely hope our oral presentation and these symposium materials provided in support thereof will assist Fellows to help their clients achieve a maximum level of wealth preservation. Owen G. Fiore San Jose, CA January 24, 2003 SI-OGF-3

11 When the Symposium I panel presentation concludes, perhaps Fellows present will subscribe to this cartoon at least as to the FLP/FLLC entity reality/valuation discount area. See my Appendix C for what Petitioner s counsel in Strangi thinks of Service efforts. [ Kinder gentler IRS ] SI-OGF-4

12 This cartoon perhaps says it all the fortress (with no credit given Texas-based The Fortress Plan product) is pretty tough and real, and should stand up to IRS attack. Yet 2036 has become a major problem, especially where the cumulative negative factors are such that the entity may be disregarded in litigation. [ Hole in wall cartoon SI-OGF-5

13 Fiore Outline Table of Contents PART I KEY POINTS & OVERVIEW SI-OGF-8 I. KEYNOTE STATEMENT: VALUATION MEETS SI-OGF-8 ENTITY REALITY II. VALUATION STRATEGY SPECTRUM SI-OGF-9 III. AREAS OF RECENT VALUATION DEVELOPMENTS SI-OGF-10 IV. OUR CHALLENGE SI-OGF-11 V. IRS COMPLIANCE PROGRAM SI-OGF-12 VI. IRS ON THE ATTACK SI-OGF-15 A. The Bills Cases. SI-OGF-16 B. The Box Score on IRS Attacks. SI-OGF-17 C. How The Battle Begins The IDR. SI-OGF-19 PART II - ENTITES, VALUATION & PLANNING SI-OGF-24 I. VALUATION PRINCIPLES AND APPLICATION TO SI-OGF-24 ENTITIES A. Transfer Tax Valuation. SI-OGF-24 B. The Property Interest Transferred. SI-OGF-25 C. IRS Challenges. SI-OGF-25 II. NON-PASS THROUGH ENTITY VALUATION ISSUES SI-OGF-29 A. Seven (7) Areas Other Than FLPs/LLCs and Valuation SI-OGF-29 Methodology. 1. What About Built-In Capital Gains - And How Is It SI-OGF-29 Computed As A Discount? 2. Non-Aggregation Confirmed - Can It Be Expanded? SI-OGF-30 SI-OGF-6

14 Fiore Outline Table of Contents (Continued) 3. CA And Other Co-tenancy Discount Cases, Plus Can A SI-OGF-31 Co-Tenancy Be a Partnership? 4. The Deduction Level Discount - A Pitfall? SI-OGF Buy-Sell Agreements & IRC Section SI-OGF Substance Versus Form. SI-OGF Value Definition Clauses. SI-OGF-34 B. The 5 th And 9 th Circuit Valuation Reversals of the SI-OGF-34 Tax Court. III AND OTHER PITFALLS PLUS IMPACT ON SI-OGF-37 PLANNING A Principles and Planning. SI-OGF-37 B. Significant Recent Judicial Decisions. SI-OGF-37 C. Planning and Operating FLP/FLLC To Minimize IRS SI-OGF-42 Attack. D. Final Thoughts and Conclusions. SI-OGF-49 PART III - SELECTED REFERENCE MATERIALS SI-OGF-53 APPENDICES Appendix A Sample FWP Memo Appendix B Excerpt, Advisor Memo on 2036 Appendix C Estate of Strangi Brief OGF-A-1-22 OGF-B-1-6 OGF-C-1-3 SI-OGF-7

15 PART I KEY POINTS & OVERVIEW I. KEYNOTE STATEMENT: VALUATION MEETS ENTITY REALITY The presumed reality of entities and the taxpayer s established freedom to choose among available entities per state law is at the heart of transfer tax valuation adjustment ( discount ) strategies. Yet IRS, through its national, multi-level compliance program on pass-through entities used in part to create valuation discounts, has developed a set of alternative arguments to destroy FLPs, LLCs and even S corporations for transfer tax (gift, estate and GST) purposes. If unsuccessful in that effort, IRS then pursues its traditional challenge of the appropriate level of valuation discounts. Our task here is to evaluate the IRS arguments and challenges as part of required tax advisor due diligence and service to our clients. We must remember that the client must make the ultimate risk/reward decisions; therefore, client communication is critically important throughout the valuation strategy spectrum. For a recent discussion exploring and evaluating this keynote statement, see the following Fiore & Ramsbacher article published in 2002 based on a presentation made at the 2001 NYU Institute on Federal Taxation: Protecting The Reality in Entity-Based Transfer Tax Valuation Adjustments, 60 NYU Inst. On Fed. Tax. Ch 30 (2002). SI-OGF-8

16 II. VALUATION STRATEGY SPECTRUM No longer can estate planners walk away from clients once the plan has been initially implemented. The client should give informed consent for implementation of any estate plan, particularly where IRS can be expected to challenge the plan (as in FLP/LLC-based valuation discount planning). See the recently updated ABA Model Rules of Professional Conduct, Sec. 1.0(e) thereof, defining informed consent. Compliance and operation per plan are important elements for the advisor acting as a gatekeeper for the plan in action. We will evaluate the 2036 Tax Court decisions in light of factual circumstances apparently giving rise to the court s conclusion of existence of a 2036(a)(1) implied agreement or understanding ; plus, we will consider 2036(a)(2) as well. Consider the following areas involved in the Valuation Strategy Spectrum: Scope of representation, dealing with conflicts of interest, clear involvement by client(s) and education of the client(s). Goals, tax and financial analysis; advisor recommendations, communication. Plan design and organization, with real-world assumptions the risk/reward issues. Client decision-making process and written confirmation thereof. Integrated plan documentation, consistent with goals and the agreed plan, plus proper and timely funding and implementation steps. Clear, documented and consistent plan operation - absolutely necessary if the plan is to succeed tax-wise; plus periodic plan check and making of necessary adjustments. Dealing effectively with compliance issues (tax returns, adequate disclosure of gifts, etc.), plus taking advantage of the audit lottery. Tax controversy management - from audit to Appeals and, if required, to Tax Court. SI-OGF-9

17 III. AREAS OF RECENT VALUATION DEVELOPMENTS The following areas encompass many of the recent developments that specifically relate to valuation discount strategies: The expanding Spectrum of Family Wealth Planning Status of IRS Reorganization and Impact on Field Audits in the Transfer Tax Area IRS Audit Initiatives - What Are They? Dealing with the 1998 Act, in particular IRC Section 7491 (Shifting of Burden of Proof) and other aspects of the Taxpayer Bill of Rights 3 Choices and Documentation relating to the Adequate Disclosure statutory and regulations requirements for running of the Gift Tax Statute of Limitations (gifts after 12/31/96) The Reality of Entities and Transactions for Transfer Tax Purposes, including FLPs and FLLCs in light of Shepherd, Strangi, Knight, and Jones The question of availability of 2503(b) present interest annual exclusions, as considered in Hackl IRS Use of IRC Section Schauerhamer, Reichardt, Wineman, Harper and Thompson Substance Over Form - What Does It Mean, and can this doctrine trump IRC Section 704(e)? IRC Sec issue of gift on formation valid or not? Consideration of special valuation issues, such as post-transfer events, selection of valuation methodology, credibility of appraisers, the Mellinger non-aggregation rule (and the recent Fontana case, 118 T.C. 318 (March 28, 2002), layered discounts, built-in gains (Davis, Eisenberg, Jameson and Dunn), premium on voting stock (Simplot), Chapter 14 (IRC Secs and 2704) Valuation Evidence - Audit, Appeals and Tax Court Levels of Evidence Audit and Controversy Management Suggestions for Practitioners SI-OGF-10

18 IV. OUR CHALLENGE You Must Remember This the title of Fellow Roy Adams column in Trusts & Estates, September, 2002 (p.56) - reminds all tax and financial service professionals of the importance of giving complete advice to our clients. It is not enough to be technically competent in the areas of tax and estate planning advice, its documentation and implementation. Rather, we should insure prudent decision-making by the client (as set forth in the recently added ABA MRPC 1.0) by insuring a client s informed consent i.e. a client s agreement after the lawyer has communicated adequate information and explanation about the material risks of, and reasonably available alternatives to, the proposed course of conduct. (MRPC 1.0(e)) It is suggested this definition should be considered by all tax professionals. Family wealth preservation on a multi-generation basis necessarily must consider the Federal transfer tax especially due to the uncertainty of permanent estate tax repeal and the continuance of the gift tax (after capped exemption equivalent of $1 million). Thus, life insurance, charitable giving and valuation discount strategies continue to be key areas (together with retirement plan alternatives) for maximizing wealth preservation net of taxes. Special opportunities for success in family wealth preservation, transfer and management, if properly planned, can be provided through effective use of pass-through entities. Our challenge is to educate the client so he or she can make informed decisions; and then we must work diligently in all phases of the Valuation Strategic Plan. SI-OGF-11

19 V. IRS COMPLIANCE PROGRAM Would that estate planners and tax litigators could concentrate on playing the valuation game, with its uncertain methodology, the battle of the appraisers, and the regular ability of taxpayers to structure transactions and entities in advance and then to retain credible experts to support enterprise values and fractionalized entity equity discounts! See Tax Court Judge Gerber s comment in Baird v. Commissioner, T.C. Memo : The parties in estate tax cases often play a valuation game and advocate high and low values to provide the trier of fact with limits within which the parties may be satisfied with the final decision. Note also my comments, and reference to playing the valuation game in the following article: Effective Entity-Based Valuation Discount Plans, 50 USC Inst. On Fed. Tax. Ch 12 (1998). However, in view of the now fully in place IRS national compliance program seeking to eliminate or at least to reduce the discounts by vigorously attacking the entity used to create them, we have a more difficult task in planning, implementation, compliance, entity operation and eventually, in many cases, tax controversy resolution. I believe we must revisit our standards of tax practice and communications with clients who, after all, must make prudent risk/reward decisions based on our advice. See in the detailed outline recent evidence of implementation of the IRS compliance program. Several articles of mine have reviewed the IRS compliance program and how practitioners might react to it. See, for e.g., Fiore & Ramsbacher, Protecting the Reality in Entity-Based SI-OGF-12

20 Transfer Tax Valuation Adjustments, cited supra; Fiore & Wilms, Pass-Through Entities and Valuation Discounts, Trusts & Estates, May, 2002; and the two articles of mine in the ACTEC Journal (formerly ACTEC Notes), cited in Part III hereof. The comments in these articles generally point to the necessary higher level of due diligence in entity-based valuation discount plan implementation and operation. Therefore, this outline includes planning suggestions for effective entity and valuation planning. While details and guidelines of the IRS compliance program remain in draft form thus, are not publicly available; as set out infra in these materials, IDRs issued by E&G examiners, statutory notices (90-Day Letters) and Tax Court pleadings and briefs make clear the nature and scope of Service compliance and litigation efforts. I believe that Tax Court Judge Mary Ann Cohen made an especially significant statement in the Strangi opinion: Mere suspicion and speculation about a decedent s estate planning and testamentary objectives are not sufficient to disregard an agreement in the absence of persuasive evidence that the agreement is not susceptible of enforcement or would not be enforced by parties to the agreement. Cf. Estate of Hall v. Commissioner, 92 T.C. 312,325 (1989). Judge Mary Ann Cohen, in Estate of Strangi v. Commissioner, 115 T.C. 478 (2000) (aff d in part, 5 th Cir., reversal and remand on 2036 issue) However, IRS counsel Donna Herbert, in her opening statement before Judge Nims at trial of the Harper case, Morton B. Harper, T.C. Memo stated: Your Honor [Ms. Donna Herbert, IRS counsel], this case concerns what s perceived by respondent as a transfer tax shelter, that is, the family limited partnership... But regardless of whose idea it was, the formation of this partnership enabled the decedent and his children to claim large discounts on SI-OGF-13

21 the value of this portfolio for both gift and estate tax purposes... It is undisputed that the decedent transferred virtually all of his assets into the partnership... [H]ow was he going to live?...[i]t is the government s position that the partnership lacked economic substance in that it had no business purpose, and because if was created solely for the purpose of reducing estate and gift taxes... [T]he formation of the partnership was tax avoidance... Your Honor [in response to Judge Nims question about Strangi], while we are aware that this division of the Court is bound by Strangi, we wish to preserve the issue for appeal. And we believe that essentially the same record is needed to support the economic substance argument as the 2036 argument in most respects. The foregoing quotes can be seen as a reminder that facts as established by credible evidence are what should determine the outcome in most contested tax cases. The Raptor Cartoon Who Pays for All This!? [ Raptor cartoon] SI-OGF-14

22 VI. IRS ON THE ATTACK To provide a backdrop of sorts for a discussion of entity reality, especially as involved in 2036, consider a common fact pattern of elderly clients with passive real estate holdings and/or a portfolio of marketable securities. What are the IRS alternative arguments that might be advanced? Assume a husband and wife with passive real estate and marketable securities having an aggregate or combined value of $10 million. The parents have several adult children, one of whom manages the real estate. Further, assume one or both of the parents have a serious and perhaps even life threatening illness. A revocable trust is in existence and the children are the sole outright beneficiaries thereof following the parents deaths. So then enters the estate planner, and an FLP/LLC plan ultimately is proposed. Questions arise at the outset, including (i) Who is the client?, (ii) What are the non-tax purposes of the entity plan?, (iii) Who is the manager and why?, (iv) Why is a pass-through entity to be used, and not merely the revocable trust operating now and becoming irrevocable at the deaths of the parents? Then, as may be expected, shortly after the FLP/LLC plan (with resulting valuation discounts) is put in place, one or both parents dies. What are the IRS alternative arguments against such an entity plan? SI-OGF-15

23 A. The Bills Cases. Look at the laundry list of arguments set forth by the Service in its stat notices in the now Tax Court docketed cases of Walter L. and Ida Belle Bills (TC Docket Nos.: , , , , ), in which I am co-counsel for the Bills Estates. In Bills, a multiple LLC plan was implemented by husband and wife, and LLC interest gifts made, then the wife died within days, and thereafter the husband died within a few months. Adverse facts that could lead to 2036 application generally are not present in these cases. However, the stat notices tell all as to the Service attack plan; and Bills appears representative of estate tax cases in litigation. Following are the IRS alternative arguments in the Bills cases, which by the way, appear sometimes to have been advanced without regard to case facts: It is determined that the decedent retained, for a period that did not in fact end before death, the possession, enjoyment or right to the income from the assets transferred to the WIB Holdings, LLC, ( WIB ) and WIR Holdings, LLC, ( WIR ) within the meaning of 26 United States Code section It is determined that the decedent retained at the date of death the power to alter, amend, revoke or terminate the transfer of the assets to WIB and WIR within the meaning of 26 United States Code section It is determined that the existence of WIB and WIR should be disregarded for federal transfer tax purposes and that the transfers of the assets to the LLCs should be regarded as testamentary transactions occurring at the decedent s death. It is determined that the merger doctrine applies, resulting in the trusteebeneficiary becoming the absolute owner of the trust assets and causing the trust to terminate. SI-OGF-16

24 It is determined that there is no economic substance to the formation or operation of WIB and WIR, or that they had no valid business purpose, or that they were substitutes for a testamentary disposition, or that the step transaction doctrine treats the formation of the LLCs and the series of formally separate steps (e.g., the series of gifts made) as a single transaction, and that in substance the LLCs cannot be recognized for federal transfer tax purposes. It is determined that in substance and effect the decedent s interest in WIB and WIR is more analogous to an interest in a trust than to an interest in an operating business and should be valued as such for federal transfer tax purposes. It is determined that the underlying property of WIB and WIR and/or the decedent s interest in the LLCs should be valued without regard to any restriction on the right to use or sell such property pursuant to 26 United States Code section It is determined that any lapse of voting or liquidation rights in WIB or WIR should be treated as a transfer by the decedent which is includible in the gross estate pursuant to 26 United States Code section 2704(a). It is determined that certain restrictions on the liquidation of WIB and WIR interests contained their operating agreements should be disregarded for valuation purposes pursuant to 26 United States Code section 2704(b). It is determined pursuant to the lack of substantial evidence of gifts (26 U.S.C. 7491; Tax Ct. R. 142(a) (interim amendment, 1999)); the purported transfer of property to the purported LLCs, and purported transfers of interests therein, are disregarded for tax purposes and the full fair market value of the property is included in the gross estate. It is determined that any reduction of value of the decedent s interest in property contributed to WIB and WIR was a gift made on the formation of WIB and WIR which constitutes an adjusted taxable gift within the meaning of 26 United States Code section 2001(b). If the value of the decedent s interest in WIB and WIR is other than that determined above, then it is determined that the gross estate includes the gift tax on the gift that was made on the formation of WIB and WIR as per to 26 United States Code section 2035(c). In the Estate of Sam Gordon, a case in which gift and estate tax stat notices were issued December 3, 2002 (the last day under the applicable statute of limitations), the SI-OGF-17

25 Service narrowed its array of arguments challenging an FLP established by a 90-year old widower owning substantial values in real estate and marketable securities Gift tax alternate position is that gifts were undervalued (note no gift on formation argument advanced); no gifts if Service 2036/2038 arguments ( primary position ) upheld. Estate tax primary position, involving $8.1 million in estate tax deficiency and and IRC Sec penalty, plus interest is that the assets transferred to the FLP at date of death values are subject to estate tax, (i) decedent retained, for a period that did not in fact end before his death, the possession, enjoyment or the right to the income from the assets that he transferred to the FLP and his two children under Section 2036, (ii) alternatively, decedent retained at the date of his death the power to alter amend, revoke or terminate the transfer of assets to the FLP under Section 2038, or (iii) alternatively, if neither Section 2036(a) nor Section 2038(a) are found to apply the decedent s 96% interest in the FLP should be valued without regard to any valuation discounts Other adjustments included increases in underlying FLP asset values and elimination of discounts claimed for decedent s 90% equity in an S corporation as well as adjustment to the entity s underlying investment assets. Our firm is litigation counsel to the Estate of Gordon and Petitions in Tax Court will have been filed just prior to the 2003 ACTEC Annual Meeting. B. The Box Score on IRS Attacks. I contend that the litigation box score thus far clearly favors the taxpayer (see the analysis of cases in Part II hereof), with the notable exception in estate tax cases involving IRC Sec (Schauerhamer, Reichardt, Harper, Thompson), and also Hackl, a gift tax case on 2503(b) annual exclusions. Yet many issues remain. As Yogi Berra once said (or more than once said), It s Not Over Til It s Over (does this mean an ultimate judicial decision by SI-OGF-18

26 the Supremes! Certainly, Congress will not be of help). Is this the way to administer the transfer tax law? who knows, but we and our clients must take these developments into account. My estate planning background teaches the importance of client education. Also, my litigation experience especially since the Cristofani case in 1991 suggests that we try and hold the Service to the statute, or at least to a reasonable interpretation thereof. The real question here is what is the reasonable interpretation of the transfer tax law as applied to pass-through entity/valuation discount areas of dispute? Also, we need to ask: what do our clients want or expect? Chuck Morris, a Territory 5 Manager in Southern California, oversees over 150 IRS Estate Tax Attorneys in the Western U.S. as Territory 5 Manager. What does his client (IRS) want or expect? I discussed this with Mr. Morris recently. He advises that a significant goal of the Service is fair and consistent treatment of similarly situated taxpayers. Unfortunately, he refers to taxpayers who do no planning as compared to those who develop entity structures! C. How The Battle Begins The IDR. A type of roadmap of planning, implementation, operation and compliance success for the FLP/LLC valuation discount strategy can be developed by review of the following recent sample of an IRS examiner s lists of questions SI-OGF-19

27 presented in an Information Document Request ( IDR ) in an ongoing estate tax audit (name changed for confidentiality purposes): OGF Family Limited Partnership Please supply the following documents for my review. Please mail me all items, except number (3) have available for inspection. (1) All documents that were prepared to meet state law requirements on the formation and operation of the partnership (i.e., Certificate of limited partnership which has the filing date stamp on it and all amendments thereto; stamped copies of annual reports; supplemental affidavits on capital contributions, etc.) (2) All partnership financial statements and tax returns prepared and/or filed since inception. (3) All of the partnership s bank and other records (i.e., general ledger, cash receipts and disbursements journals, check registers, etc.) which reflect the amount and nature of all deposits and distributions, including distributions to partners, for the period since the partnership was formed to the date of death/current date. (4) Minutes of all partnership meetings; if none, indicate the dates of all meetings and the business discussed. (5) Evidence showing how the value of each partnership asset was arrived at as of the date: a. it was contributed to the partnership; b. of each gift of a partnership interest; and c. of the death of the donor; provide all appraisals and supporting workpapers obtained of the partnership s assets, including partnership interests and any discounts. (6) Evidence to substantiate all initial and subsequent capital contributions and the source of all contributions of partners other than the donor/decedent. (7) For each partnership asset, explain/provide: a. evidence that the partnership owns the asset (i.e., deeds, bills of sale, other title changes, account statements, the date the transfer of the asset to the partnership was complete); b. when the donor/decedent acquired the asset; c. how the asset was used by the donor/decedent since its acquisition and how the partnership has used the asset since (i.e., held for rent; personal residence, investment, etc.); and SI-OGF-20

28 d. who managed the asset prior to and after its contribution; explain in detail what the management consisted of and how it changed after the partnership was formed. (8) For each gift or transfer of a partnership interest, provide: a. evidence that the partnership interest was legally transferred under state law and under the partnership agreement; b. any assignment of partnership interest prepared; c. the terms of the assignment, if not indicated in a written assignment; d. the amount and source of any consideration paid; e. an explanation of how the amount of the consideration was arrived at. (9) Provide the following with respect to the donor/decedent, all other original partners and any recipients of gifts or transfers of partnership interests: a. date of birth; b. education, occupation, and their residence address; c. experience and expertise in dealing with partnerships, real estate, financial affairs and investments; provide tangible evidence thereof; d. any personal financial statements and credit applications which were prepared in connection with loan applications after the partnership was created. (10) Indicate whether the partnership is currently in existence, and, if so, provide the current ownership interests. (11) Provide a summary of any other transfers of partnership interests not reflected in the gift tax returns filed. (12) A statement describing the donor s/decedent s state of health at the time of the formation of the partnership and for the six month period prior thereto, including a description of any serious illness. Information, including a copy of the medical records, if necessary. (13) A statement including the identity of the parties recommending the use of the partnership, when the recommendations were made, and the reasons set forth in support of the partnership. OGF Family Limited Partnership Please answer the following questions: A. Creation of the FLP 1. Was the FLP created in conjunction with other estate planning? If so, what was it? SI-OGF-21

29 2. Was the creation of the FLP a matter of negotiation? If so, explain what negotiations took place. 3. At whose suggestion was the FLP created? 4. Why was the FLP created at this time? 5. What kind of advice did the Donor/Decedent seek? 6. What are the qualifications of the advisor? 7. What advice were the parties given on the formation of the FLP, and by whom? 8. What notes were kept of the advice received? 9. What benefits was the Donor/Decedent advised of? 10. What was the amount and source of the other partners contributions to the FLP? 11. Why could the Donor s/decedent s assets no longer be managed as before the creation of the FLP? 12. Explain how the partnership assets were managed before their contribution to the FLP. 13. Describe the business purpose(s) for establishing the FLP. B. Operation of the FLP 14. Explain how the partnership assets were managed after their contribution to the FLP, including all individuals involved and the amount of time devoted. 15. If the FLP consists of marketable securities held in brokerage accounts, explain whether the investment decisions are made by the general partner or by an investment advisor or manager who is responsible for the account and whether this has changed since the creation of the FLP. 16. Describe the qualifications and expertise of the general partners of the FLP and explain the specific duties actually performed by him or her in connection with managing the assets both before and after they were contributed to the FLP. 17. Was there a joining in the common conduct of a business by the family members? If so, explain how. 18. What was the business? SI-OGF-22

30 19. Explain where the fees were deducted for creating the FLP. Now, I ask you what is your response as a practitioner to the foregoing initial questions? Is the client prepared to pay all the fees necessary to fully respond? Are the questions reasonable? When you recommended the plan, did your client know this might happen? Note attorney-client privilege, burden of proof (7491) and other issues involved in management of such an exam. These and other questions actually should be considered in the planning and implementation process, rather than be left until after the fact! Also, see the second Dailey opinion, awarding 7430-based litigation costs due to IRS attack deemed and conceded as unreasonable! on the partnership entity! Estate of E.M. Dailey, T.C. Memo (12/9/02). SI-OGF-23

31 PART II - ENTITES, VALUATION & PLANNING I. VALUATION PRINCIPLES AND APPLICATION TO ENTITIES A. Transfer Tax Valuation. 1. Entity-based valuation strategies are perceived by the Service to be solely or at least primarily driven by the client s goal of transfer tax (gift, estate and GST) reduction. While this usually is an incorrect perception, estate planners must deal with it in a proactive manner. a. Yet as Tax Court Judge Cohen made clear in Strangi, referred to above, entities formed and operated in accordance with state law generally should be respected for tax purposes. SFLP was validly formed under State law. The formalities were followed, and the proverbial i. s were dotted and t s were crossed. The partnership, as a legal matter, changed the relationships between the decedent and his heirs and decedent and actual and potential creditors. Estate of Strangi, 115 T.C. 478 (2000). b. While the Service often points to Estate of Murphy, T.C. Memo , in support of its challenges to entity viability, it is clear that tax motives, where not the sole motives, are not dispositive of entity reality. See, for example, the Estate of Frank, T.C. Memo , for acceptance of Petitioner s witnesses (family members of decedent) that tax avoidance was not the sole or even a primary motive. 2. For transfer tax purposes, the standard of value is that of fair market value of the property transferred to which the Federal transfer tax is applicable, based upon a hypothetical willing buyer-willing seller analysis without family attribution. Treas. Regs (gift tax) and (b) (estate tax), Estate of Cartwright, 411 US 546 (1973); Estate of Bright v. U.S., 658 F.2d 999 (5 th Cir. 1981); Rev. Rul 93-12, 93-1 C.B. 202, TAM Where non-public securities are involved and there are no actual sales of the entity equity at issue at or near the valuation date, then expert witness evidence is looked to by the courts to determine value. This is where much of the valuation game takes place. Estate of Andrews, 79 T.C. 938 (1982) SI-OGF-24

32 a. Assuming the viability of the entity and the reality of the actual property interest transfer, application of accepted valuation methodology is required. Estate of Lehmann, T.C. Memo , is illustrative of many Tax Court opinions on the use, or disregard, as the case may be, of appraisal evidence. b. The Baird co-tenancy case, cited supra, and the Estate of Dailey, T.C. Memo , a partnership case, teach us that valuation is more art than science. No wonder the Service has turned to attacking entity reality or viability using various theories. B. The Property Interest Transferred. 1. The specific property interest transferred under the Federal transfer tax is the property to be valued and taxed. U.S. v. Land, 303 F.2d 170 (5 th Cir. 1962), McLendon v. Commissioner, 77 F.3d 447 (5 th Cir. 1996), Estate of McClatchy, 106 T.C. 206 (1996), reversed, 174 F.3d 1098 (9 th Cir. 1998). 2. We have seen that the IRS national compliance program focus, perhaps in part to attain leverage in litigation settlement negotiations for lower discounts, has been to challenge the entity, especially in the case of pass-through entities having certain characteristics, as discussed below. 3. Therefore, it is obvious that estate planners, who should take Service compliance issues into account, must do their best to insure entity reality, operational integrity and compliance adequacy. The latter can be especially important where adequate disclosure on gift tax returns is a goal in order to insure running of the gift tax statute of limitations. See Treas. Reg. Section (c)- 1(f)(2) 4. Issues can arise even as to the transfer tax subject matter, i.e. property interest transferred. See, for e.g., LeFrak v. Commissioner, T.C. Memo , and Shepherd v. Commissioner, 115 T.C. 376 (2000), affirmed, 283 F.3d 1258 (11 th Cir. 2002). C. IRS Challenges. 1. While, as reviewed below, there are numerous alternative arguments that have been advanced by the Service in its national compliance program, which began in earnest in the mid-1990s, the three(3) attacks that today appear to be those receiving the most exam and litigation attention are the following: SI-OGF-25

33 a. Disallowance of the IRC Section 2503(b) present interest annual exclusion. Hackl, 118 T.C. 279 (2002) the substantial present economic benefit issue. b. Alleged lack of economic substance of the entity, with IRS seeking to establish and apply this income tax judicial doctrine to FLP/FLLC plans. Thus far, this Service argument has not been accepted. See Strangi, supra, Knight, 115 T.C. 506 (2000), Dailey, supra, and Thompson, T.C. Memo c. The third attack or argument by IRS on entity reality, which is the concentration of our ACTEC Symposium I panel, is IRC Sec both 2036(a)(1) and 2036(a)(2). Several IRS victories in Tax Court, and the pending Tax Court consideration of 2036 in Strangi by reason of the th Circuit reversal and remand, have been hailed by Service representatives as the longer hoped for taxpayer smoking gun in estate tax cases. Later in this outline, the Tax Court decisions are reviewed and suggestions provided for avoiding, or at least minimizing, the 2036 issue. 2. Alternative theories advanced by the Service can be seen by review of exam IDRs and the contents of stat notices, as presented earlier in these materials (Bills and Gordon cases, IDR sample). a. Also, IRS rulings, which date back to 1997, set out the Service anti-entity theories. See the cited Fiore ACTEC Journal articles published in 1998 and b. In the CCH publication, Estate Planning Review, Vol. 27, No. 12 (12/19/01), I reviewed several IRS rulings, namely, TAM (FLP), FSA (FLLC) and FSA (S corporation). (1) As could be expected, the rulings generally set out and apply to specific facts involved quite similar arguments. These arguments or issues can be classified as either (i) broadly based, judicially supported issues, or (ii) statute based issues. (2) The broad attacks include (I) single testamentary transaction, (ii) solely tax motivated, thus no economic substance, (iii) step transaction theory. SI-OGF-26

34 (3) The statute based attacks include (i) IRC Sec. 2036, and often also Section 2038, (ii) IRC Sec gift on formation and/or indirect gifts of entity-owned assets, (iii) Chapter 14 arguments, namely, IRC Sections 2703 and (4) In the above-cited S corporation ruling, FSA , it is interesting to note the following introductory statement by the Office of Chief Counsel: Use of family limited partnerships, family limited liability corporations (sic), and closely-held corporations as legitimate planning devices has been recognized for several decades. On the other hand, the potential for abusing these entities, i.e., use of these entities merely as devices to escape federal transfer taxes, also has long been recognized. c. This statement is consistent with the Code, Regulations, and judicial decisions on the tax recognition of entities. We need to start with the statute. As to pass-through entity recognition for income tax purposes, IRC Sec. 704(e), enacted in 1951, and the Regulations relating thereto, provide a safe harbor for family partnerships. (1) The existence or absence of a tax avoidance motive is but one factor in determining entity reality. (2) Further, in Emerson Winkler v. Commissioner, T.C. Memo , the Tax Court utilized the 704(e) safe harbor to find there was no gift. And what was this judicially-determined partnership? - an oral partnership of family members as to lottery tickets! (3) Certainly, estate planners operating with competence and due diligence can develop documentation and operating procedures that avoid at least the broadly based judicial arguments, and, based upon recent cases (see the cited Fiore ACTEC Journal articles), the Chapter 14 issues as well. (4) As to the 2036/2038, 2503(b) and 2511 issues we need to analyze them here in more detail. 2036, as we ll see, now is a twin-headed monster both 2036(a)(1) and 2036(a)(2) are being raised by the Service. SI-OGF-27