FLiP Flops - I Stepped on a Pop-top and Blew Out My Valuation Discount.

Transcription

1 FLiP Flops - I Stepped on a Pop-top and Blew Out My Valuation Discount. Cases, Trends, and Practical Approaches to Valuation Discounts with Family Limited Partnerships Presentation by: Scott K. Tippett Materials written by: Scott K. Tippett and J. Aaron Bennett Carruthers & Roth, P.A. 235 N. Edgeworth St. Greensboro, North Carolina (336) (336) (fax) skt@crlaw.com jab@crlaw.com

2 I. Family Limited Partnerships. a. In general. Families often use limited partnerships ( FLPs ) to transfer wealth to younger generations. Instead of transferring assets outright to a younger generation, which often results in a taxable gift, an individual may instead transfer assets to an entity, such as a FLP, in exchange for an ownership interest. Thereafter, the individual subsequently gifts small portions of his or her ownership interest to the younger generation. Because the holders of small ownership interests in an entity often lack the ability to control the entity or sell their interest, appraisers attribute a discount to the interest transferred, lowering the value of the gift for gift tax purposes. While FLPs are an attractive estate-planning tool, abuses have increasingly caught the attention of the IRS. As a result, those considering the use of FLPs to transfer wealth out of their estate should proceed with caution. The following is a discussion of the analysis being applied by reviewing courts and recent cases heard by the Federal Courts. b. Typical analysis prevents individuals from avoiding estate tax when they transfer property to testamentary substitutes and retain enjoyment over the property. In analyzing whether 2036 is applicable to a transfer, the court applies the following analysis: i. Whether the decedent made an inter vivos transfer of property; ii. Whether the decedent's transfer was a bona fide sale for adequate and full consideration; and iii. Whether the decedent retained an interest or right enumerated in 2036(a)(1) or (2) or (b) in the transferred property which the decedent did not relinquish before her death. 1 II. General rules within the typical analysis. a. Shifting the burden of proof. Under IRC 142 (a), the burden of proof in a deficiency action generally falls on the taxpayer and the Commissioner s determinations are presumptively correct. Under 7491, the burden shifts to the Commissioner where the taxpayer introduces credible evidence and establishes that he or she substantiated items, maintained records, and fully cooperated with the Commissioner s reasonable 2 requests. Credible evidence, in respect to 7491, is defined as the quality of evidence which, after critical analysis, [the court] would find sufficient upon which to base [the court s] decision. 3 1 Estate of Jorgensen v. Commissioner, TC Memo Kohler v. Commissioner, T.C. Memo , (2009); see I.R.C. 7491(a)(2)(A), (B) (referring to the amount of cooperation needed, 7491 (a)(2)(b) states the taxpayer has maintained all records required under this title and has cooperated with reasonable requests by the Secretary for witnesses, information, documents, meetings, and interviews ). 3 Estate of Erickson v. Commissioner, T.C. Memo , 761. Page -2-

3 Additionally, where the IRS s Notice of Deficiency does not adequately describe the basis on which the Commissioner relies to support a deficiency determination and the Commissioner seeks to establish the deficiency on a basis not described in the notice, the burden shifts to the Commissioner on the new basis. 4 To shift the burden, the taxpayer must bring the case in good faith and it must involve a factual dispute. In Erickson, the court denied an estate s motion to shift the burden where the court found the decedent s daughters testimony regarding the decedent s rationale forming the partnership 5 to be self-serving and not credible. On the other hand, in Kohler, discussed below, the court shifted the burden to the IRS because the estate introduced credible evidence including testimony of several factual witnesses, substantiated items, maintained records, and cooperated with respondent s reasonable requests. 6 The Kohler court did not state the extent of cooperation or the nature of the items and records maintained by the estate. The court did, however, address the IRS s argument that an estate s motion to quash a summons for documents constituted lack of cooperation. Where an taxpayer has a good faith belief that the documents being sought are irrelevant, sealed, or contain[] sensitive business information, a motion to quash the summons does not constitute lack of cooperation with respect 7 to The court emphasized that Kohler, where the IRS challenged a closely-held stock 8 valuation discount, did not involve a pattern of noncooperation. Cases involving patterns of noncooperation are tax protester cases, sham trust cases, and cases where taxpayers have failed to 9 file returns or have unreported income. The court has emphasized that if there is no dispute as to the underlying facts, there is no 0 reason for the court to shift the burden. 1 b. Was there a 2036 transfer of property? i. Transfer, defined. Transfer, as used in 2036, is broadly defined to include in the value of a decedent s 1 gross estate the values of all property she transferred but retained an interest in during her lifetime. 1 c. 2036(a) exception: Was the transfer a bona fide sale for adequate and full consideration? 4 st Estate of Abraham v. Commissioner, 408 F.3d 26 (1 Cir. 2005) (quoting Shea v. Commissioner, 112 T.C. 183, 197 (1999). 5 6 Kohler v. Commissioner, T.C. Memo , at ; see Estate of Jelke v. Commissioner, T.C. Memo (2005) (denying request to shift the burden of proof where there were no facts in dispute). 11 Estate of Jorgensen v. Commissioner, T.C. Memo , II.A. Page -3-

4 Under 2036(a), an estate may avoid the inclusion of property transferred to a FLP if it demonstrates that the transfer was part of a bona fide sale for adequate and full consideration. The following is a general discussion of the elements required to establish the exception: i. Bona fide sale overview. Whether a transfer is bona fide depends on whether credible evidence establishes that formation of the FLP and the subsequent property transfers to the FLP were motivated by nontax reasons. The rule applied in recent cases involving the transfer of securities to FLPs is found in Estate of Bongard. There, the Tax Court stated: In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership, and the transferors received partnership interests proportionate to the value of the property transferred. [... ] The objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership s creation. [... ] A 2 significant purpose must be an actual motivation, not a theoretical justification Whether a transaction constitutes a bona fide sale is a question of motive. A reviewing court looks at the circumstances surrounding the transaction to determine whether the transferor had a 4 legitimate and significant nontax reason, established by the record, for transferring her property. 1 If the primary motive behind a transaction is the potential tax advantages, the transaction will not 15 constitute a bona fide sale. Several factors are considered when determining whether transfer to a FLP was motivated by a legitimate and significant nontax reason, these factors include: Operational concerns: o The taxpayer s financial dependence on distributions from the partnership; o Whether the taxpayer commingled her own funds with partnership funds; and o Whether the FLP functioned as a business enterprise or otherwise engaged in any meaningful economic activity (note: this phrase is undefined, but suggests the FLP does not have to be a functioning business). Organizational: o The taxpayer s delay or failure to transfer the property to the partnership; and 12 Estate of Bongard v. Commissioner, 124 T.C. 95, 118 (2002). 13 Estate of Jorgensen v. Commissioner, T.C. Memo , II.B Keller v. United States, 2009 WL (S.D. Tex. 2009). Page -4-

5 6 o The taxpayer s old age or poor health when the FLP was formed Recognized nontax reasons. a. Management succession. Management succession is an accepted legitimate nontax business purpose. In Mirowski, discussed below, transfers of patent licenses for a medical device to a family partnership were bona fide where the transferor required his children to maintain joint management of business matters 17 and related litigation. In Keller, the court held favorably where the purported purpose of a series of family partnerships was to consolidate and protect family assets for management purposes and 8 to make it easier for [such] assets to transfer from generation to generation. 1 b. Centralized management of family wealth. Centralized management of family wealth may be a legitimate nontax reason for creating an FLP. Malkin, where the court found the transferor s son and daughter had significant personal resources available to add to the FLP, requires a pooling of family assets into the FLPs for 19 centralized management to be considered legitimate. Therefore, contributions need to be from more than one transferor to support this as a nontax reason. In Malkin, the fact that there was no pooling of family wealth weighed heavily against the argument that the FLPs were created to 20 centralize management of the family wealth. c. Protect family assets from depletion. Protecting family assets from depletion by ex-spouses through divorce proceedings was held 21 to be a legitimate purpose in Keller. There, this purpose was supported by evidence that the transferor s daughter endured a long and expensive divorce, placing the family s assets at risk. However, where depletion of family assets is tied to the need to protect assets from eventual sale, 22 to justify such a purpose the family must ensure that the FLP actually serves that end. Malkin is an example of a case where a FLP s purported purpose was to protect the value of its underlying assets (a large interest in a corporation) by preventing their sale. The court rejected this as a legitimate purpose because not all of the family s stock was transferred to the FLP and the transferor 23 had just as much ability to protect the shares from sale without the FLP as he did with the FLP. 16 Estate of Hurford v. Commissioner, T.C. Memo , (citations omitted) (emphasis and alterations added). 17 Estate of Mirowski v. Commissioner, T.C. Memo Keller v. United States, 2009 WL , 4 (S.D. Tex. 2009). 19 Estate of Malkin, T.C. Memo (2009). 20 Estate of Malkin, T.C. Memo (2009). 21 Keller v. United States, at Estate of Malkin, T.C. Memo (2009). 23 Page -5-

6 d. Continuing an investment philosophy. In Miller, discussed below, the court held the continuation of the family s investment 24 strategy as a legitimate and significant nontax purpose. The court emphasized, however, that the investment philosophy the partnership perpetuated involved active charting and trading stocks, a process that consumed nearly forty hours of the general partner s week. 2. Purported nontax reasons not endorsed by the court. a Passive partnership activities. While efficient management may count as a credible non-tax purpose where there is active management, the fact that a partnership is solely used as a passive investment vehicle weighs heavily 25 against finding a non-tax purpose. The court has noted, however, that the passive nature of 6 transferred assets is generally not determinative in 2036 analysis b. Facilitating a gift-giving plan. In Erickson, the court held that the decedent s purported purpose of facilitating a gift-giving 27 plan was not a significant nontax purpose. ii. Adequate and full consideration. The second prong of the bona fide sale exception requires that the transferor receive adequate and full consideration for his or her transfer. Adequate and full consideration requires consideration of the following: (1) [W]hether the interests credited to each of the partners was proportionate to the fair market value of the assets each partner contributed to the partnership, (2) whether the assets contributed by each partner to the partnership were properly credited to the respective capital accounts of the partners, and (3) whether on termination or dissolution of the partnership the partners were entitled to distributions from the 8 partnership in amounts equal to their respective capital accounts. 2 Courts summarize this test by stating [w]e look to see if [a]ll partners in each partnership received interests proportion-ate [sic] to the fair market value of the assets they each transferred, and 9 partnership legal formalities were respected Estate of Miller, T.C. Memo , III.A. (2009). 25 Estate of Jorgensen v. Commissioner, TC Memo (2009). 26 Estate of Korby v. Commissioner, T.C. Memo Estate of Erickson v. Commissioner, T.C. Memo , 764; see also Estate of Rosen v. Commissioner, T.C. Memo Keller v. United States, at Estate of Hurford v. Commissioner, T.C. Memo , 1530 (quoting Estate of Bongard, 124 T.C. at 117). Page -6-

7 The IRS asserts that a transferor of property to a FLP cannot receive adequate and full consideration due to the commensurate reduction in value of the property from lack of control and marketability. Courts, however, have not adopted the IRS s view. Instead, they have stated: [a]n inter vivos transfer of real property to a family limited partnership, which inherently reduces the fair market price of the resultant partnership interests, does not per se disqualify the transfer from falling 32 under 2036(a) s [bona fide sale] exception. Whether a transferor receives full and adequate consideration cannot be gauged independently of the non-tax related-business purposes involved 33 in making a bona fide transfer inquiry. As a result, courts consider the bona fide sale and 34 adequate and full consideration elements as interrelated criteria. Thus, whether there is adequate and full consideration is related to the existence of a legitimate non-tax business purpose, discussed in II.c.i. above. c. Did the transferor retain an interest or right enumerated in 2036(a)(1) or (2) or (b) in the transferred property? i. assets. There must not be an express or implied right to access partnership Where the transferor maintains the same control over assets before and after their transfer 35 to an FLP, the transfer falls within 2036(a)(1). Factors cited in assessing whether an implied right to possession exists include: [C]ommingling of funds, a history of disproportionate distributions, testamentary characteristics of the arrangement, the extent to which the decedent transferred nearly all of his or her assets, the unilateral formation of the partnership, the type of assets 6 transferred, and the personal situation [... ]. 3 Where an elderly and wealthy individual transfers the bulk of his or her assets into a partnership controlled by herself or her family, and continues to use the assets, 2036 returns the assets to 37 the transferor s estate. In Miller, the court held transfers made during the decline of the transferor s life that completely depleted her resources showed the transferor retained the 8 economic benefit of the securities transferred th Estate of Bigelow, 503 F.3d 955, 968 (9 Cir. 2007) at Estate of Malkin, T.C. Memo (2009). 36 Estate of Erickson v. Commissioner, T.C. Memo , 763 (holding a delay in transferring assets until death was imminent showed an implied agreement that the decedent-transferor retained the right to enjoy the assets she transferred to the family partnership shortly before her death). 37 Estate of Thompson v. Commissioner, T.C. Memo , Estate of Miller, T.C. Memo , III.A. (2009). Page -7-

8 III. Review of Recent FLP Cases A. Estate of Murphy Transfer to the FLP satisfied the bona fide sale exception to The value of the limited partnership interest was calculated by first determining the net asset value of the stock in the three companies owned by the FLP, taking into consideration Rule 144 and blockage discounts (applying the taxpayer's expert's discounts of 5%, 10.6%, and 1.3% for the three corporations) and of a timber and farm plantation. The value of the % limited partnership interest was determined by applying a 12.5% lack of control and 32.5% lack of marketability discount, for an overall combined discount of about 41% of the net asset value. The value of decedent's 49% interest in the LLC, which is the general partner of the FLP, was determined by applying two levels of discounts; (i) the LLC's % general partner interest was valued with a 20% lack of control/lack of marketability discount, and (ii) the estate's 49% interest in the LLC was valued with a lack of control discount of 11.1% and a lack of marketability discount of 32.5%. The overall discount of the tiered entity was 52% of the net asset value. Purposes of the FLP included pooling "the family's Legacy Assets into one entity to be centrally managed in a manner that was consistent with Mr. Murphy's long-term business/investment philosophy." (The IRS argued that holding assets long term without active management is not a legitimate non-tax purpose. The court responded that the Estate of Schutt case held that implementing a buy and hold investment strategy is a legitimate non-tax purpose, and that the youngest son was actively involved in management of the three Legacy Asset companies.) The estate was allowed an estate tax deduction for all of the interest on a 9-year Graegin note for amounts borrowed from the FLP and for the interest actually paid on another note. The proceeds of the loans were used to pay federal and state estate taxes. B. Estate of Keller In this estate tax refund case, published about 2 ½ years after a four-day trial, the decedent signed a partnership agreement and expressed the intent to fund the partnership with a specifically identified bond portfolio and cash, but the funding did not formally occur before her death. The decedent died unexpectedly, so the planner put the funding on hold for about a year until one of the planners heard about the Church case, which had recognized a partnership that similarly had not been formally funded at the decedent's death. The planners completed the formal funding transfers and the estate filed an estate tax return reporting the partnership interests (without a discount) and reporting about $143 million of estate tax. Page -8-

9 The estate later filed a claim for refund for about $40 million of estate tax. The court concluded that the decedent had expressed the clear intent to fund the partnership with the identified assets, and under Texas law that caused the assets to become partnership assets. The bona fide sale exception to 2036 and 2038 applied because the partnership was genuine, there was a legitimate business purpose for the partnership (protecting family assets from divorce proceedings and facilitating the administration of family assets) and because she retained significant assets outside the partnership. The taxpayer's valuation expert's value was accepted, representing a 47.5% discount. The IRS's expert's opinion was rejected because it violated several of the tenets of the hypothetical willing buyer-willing seller valuation principle, including considering the true identities of the buyer and seller, speculating as to future events, and aggregating the interests of the various owners. The estate borrowed $114 million from the partnership to pay estate taxes and other debts. The interest on the 9-year loan was deductible for estate tax purposes because the interest expense was actually and necessarily incurred in the administration of the estate. C. Estate of Maulkin In Malkin, the IRS sought to include property transferred by the decedent to two FLPs 39 in the decedent s estate. The court held there was no legitimate nontax reason for the FLPs. In Malkin, the decedent was the former Chairman and CEO of Delta & Pine Land Co. ( D&PL) and held substantial stock and options in the company. The decedent created two FLPs and two sets of trusts for his son and daughter to transfer the stock to his two children. In 1998, The decedent formed the first FLP ( MFLP ), and two trusts ( JRM I and MM I ). MFLP had 1,000 limited partnership units and 99,000 general partnership units. On August 31, 1998, the decedent transferred about $16.8 million worth of D&PL stock to MFLP for a 1-percent general partnership and a percent limited partnership interest. The same day, the trustees of JRM I and MM I each transferred $25,000 to MFLP for a percent limited partnership interest. Then, the decedent sold an percent limited partnership interest to JRM I and MM I in exchange for 40 $884,848 in cash and $7.96 million in self-canceling installment notes. For the next two years, the trusts paid the interest on the notes by borrowing money from the children, who received the money from the decedent as gifts. In May of 1999, nearly one year after funding the trusts, the decedent was diagnosed with pancreatic cancer. On September 24 th of that year, the decedent, with authorization from the limited partner trustees, pledged nearly all of MFLP s D&PL stock to secure his personal debt to Bank of America. Two months after pledging the stock, the decedent personally guarantied the debt and paid MFLP a fee equivalent to percent of the value of the DP&L stock. Five months later, the decedent refinanced his personal debt 39 Estate of Malkin, T.C. Memo (2009). 40 The terms of the self-canceling note were 9 years at 7.14-percent. Page -9-

10 and repledged MFLP s D&PL stock to Morgan Guaranty Trust Co. Again, the decedent personally guarantied the debt and paid MFLP a fee for pledging its assets. Within a year of being diagnosed with cancer, the decedent established a second FLP ( CRFLP ) and two additional trusts ( JRM II and MM II ). Before the decedent signed the documents creating JRM II and MM II, the decedent transferred all of his interests in the four LLCs he controlled with his son to CRFLP in exchange for all 100,000 CRFLP partnership units (1,000 general partner units and 99,000 limited partner units). That same day, the decedent assigned 44,500 limited partnership units to JRM II and MM II. The trusts contracted to pay the decedent a combined $801,000, with ten-percent down and a nine year promissory note at 6.8-percent. Thereafter, the decedent signed the documents creating JRM II and MM II and personally transferred $81,000 to the trusts, which the trusts paid back to the decedent two days later as the cash down payment. In November 2000, the decedent transferred 80,000 D&PL shares to CRFLP. The decedent pledged the shares as collateral for a personal debt before transferring them to CRFLP, and the shares remained encumbered after their transfer. The decedent s estate was insolvent at the decedent s death. First, the IRS argued an implied agreement existed between the decedent and the 41 limited partner trustees that the decedent retain use over the transferred property. For instance, the decedent, with the consent of the trustees of the two trusts, pledged MFLP s D&PL stock to secure substantial personal loans. In addition, CRFLP s D&PL stock was encumbered by the decedent s personal debt before he transferred the shares to CRFLP. The estate counter-argued that pledging 42 MFLP s shares was an arm s length investment decision. The court, however, was not satisfied 43 that such transactions served a legitimate business purpose. The estate did not explain what business purpose was served by the pledge. Furthermore, the estate failed to offer evidence that the percent fee the decedent paid to MFLP for pledging the assets was reasonable. As to CRFLP, there was no distinction between the partnership pledging assets itself and receiving previously 45 pledged assets. Based on this evidence, the court held the decedent retained the same control over 46 the assets as he did before the transfer to the FLPs. The decedent used the D&PL shares as he pleased and the trustees rubber stamped his decisions. Next, the court looked at the transfers in the context of whether they were part of a bona fide sale for adequate consideration. The decedent s purported legitimate and significant nontax reasons for creating the FLPs included: (1) providing for his children; (2) preventing the sale of the underlying stock; and (3) centralizing management of the family s wealth. The court was particularly amused by the argument that the transfers were made to prevent the sale of the stock, given the decedent did not demand his son contribute his shares to the FLP, and the shares that were 47 transferred were controlled by the decedent anyway. Both the son and daughter had considerable 41 at II.C at II.C at II.C at II.C Page -10-

11 resources which they could have transferred to the FLP. The daughter had a net worth of $ million and the son was worth $22 million. The lack of any pooling of family wealth weighed heavily against the argument that the FLPs were created to centralize management of the family 49 wealth. These findings along with evidence that the FLPs consisted of an untraded portfolio of marketable securities led the court to hold the transfers did not qualify for the bona fide sale 50 exception. As a result, the court held all of the D&PL stock the decedent contributed to MFLP and 1 CRFLP was includable in the decedent s estate under 2036(a)(1). 5 D. Pierre v. Comm. In Pierre, the issue was how a transfer of an ownership interest in a single member LLC, taxed as a disregarded entity for federal income tax purposes, should be valued under 52 Federal gift tax regulations. The Tax Court held there was no indirect gift of the underlying assets. Consequently, the gift tax on the transfer was to be imposed on the LLC membership interest transferred, not the underlying assets held by the LLC. The taxpayer organized a single-member limited liability company on July, 13, About two months later, she transferred $4.25 million in cash and marketable securities to 53 the LLC in exchange for a 100% interest. The taxpayer did not elect to treat the LLC as 54 corporation for federal tax purposes, so by default it was treated as a disregarded entity. Twelve days later, she transferred a 9.5-percent interest to each of two trusts established for the benefit of her son and granddaughter. She also sold a 40.5-percent interest in the LLC to each trust in exchange for a total of $2,184,266 in secured promissory notes. The opinion does not indicate the collateral securing the note. In valuing the notes, she applied lack of marketability and lack of control discounts. Because of an appraisal error in valuing the underlying assets, the values 55 reflected a percent discount. She only meant to apply a 30-percent discount. The taxpayer filed a gift tax return reporting the 9.5-percent interest transfers. The IRS argued the taxpayer should be treated as having transferred cash and marketable securities, not LLC interests because the LLC elected to be treated as a disregarded entity for federal income tax purposes. On the other hand, the taxpayer argued that, under New York law, a membership interest in an LLC is personal property and a member has no interest in 56 the underlying assets of the LLC. The court held the check-the-box regulations do not require that the singlemember LLC be disregarded in determining the value of a donor s transfer of an ownership at II.D.4. FN at II.D at II.E. Pierre v. Commissioner, 133 T.C. No. 2 (2009) at at I. Page -11-

12 57 interest in the LLC. The court reasoned that the federal check-the-box regulations do not apply in defining the property interests and rights being transferred for federal gift tax purposes. The definition of property rights and interests is determined according to state law. Under New York law, the taxpayer s LLC is treated separate from its members. As a result, the taxpayer did not have an interest in the LLC s underlying assets. Thus, the taxpayer s transfers were transfers of interests in the LLC, not transfers of the underlying assets. The court limited its analysis to whether the check-the-box regulations govern how a single-member LLC is taxed. It did not address the accuracy of the valuation discounts. E. Heckerman Parents transferred liquid assets in the form of mutual funds to an LLC and made gifts of LLC interests to trusts for their children on the same day. The IRS argued that the transfer of cash constituted an indirect gift to the trusts, and alternatively that the step transaction doctrine applied to eliminate discounts as to the cash transfers. The IRS did not make the indirect gift or step transaction arguments as to a similar transfer of real estate made fifteen days before the assignment of LLC interests to the trusts The court concluded that the transfer of cash was an indirect gift because the taxpayer could not establish that the transfer of the mutual funds occurred before the assignment of LLC interests to the trusts. The court also concluded that the step transaction doctrine applied, using very broad reasoning, like the Linton case. The court distinguished Holman and Gross because those cases involved some delay (6 days and 11 days, respectively) between the date of funding of volatile stocks to the entities and the date of the gifts and because of the nature of the property transferred, cash rather than volatile stocks. F. Linton The court found factually that undeveloped real property, cash, and municipal bonds were contributed to an LLC on the same day that gifts of LLC interests were made to a trust, also created on that same day for the donor's children. Despite factual testimony as to the intended dates of the gifts, the trust agreement itself stated that the gifts of LLC interests to the trust were made "[a]t the time of signing of this Agreement" and the trust agreement was signed on the same date as the date of the contributions. In a gift tax refund action, the court upheld the government's motion for summary judgment, finding that no discount should be allowed with respect to the LLC interests. The gifts constituted indirect gifts of the underlying assets; the facts are particularly similar to those in Senda where the contribution and gift occurred on the same day and the facts did not make clear which occurred first. "Because the Trusts were created, and gifts of LLC interests were made to the Trusts, on January 22, 2003, either before or simultaneously with the contribution of property to WFLB, LLC, the Court holds that this case is analogous to both Shepherd and Senda, and that the Lintons' transfers of real estate, cash, and securities enhanced the LLC interests held by the 57 at IV. Page -12-

13 children's Trusts, thereby constituting indirect gifts to the Trusts of pro rata shares of the assets conveyed to the LLC." The court distinguished Holman and Gross because those cases involved some delay (6 days and 11 days, respectively) between the date of funding of volatile stocks to the entities and the date of the gifts. The court specifically observed that the assets involved in this case (real property, cash, and municipal bonds) were not as volatile as the assets involved in Holman and Gross. G. Miller The court held bona fide sale for full and adequate consideration exception to 2036 applied to transfers of marketable securities to an FLP made about 13 months prior to the decedent's death. The court concluded that there were legitimate and significant non-tax reasons for the contributions to the partnership, finding credible the witnesses' testimony "that the driving force behind decedent's desire to form [the FLP] was to continue the management of family assets in accordance with Mr. Miller's investment strategy." The court emphasized that 1) there was active management of the partnership's assets by the decedent's son as general partner, 2) there was a change in the investment activity after formation of the FLP and 3) the decedent retained sufficient living expenses. The court refused to apply the bona fide sale exception to additional contributions to the FLP made only 13 days before the decedent's death following very serious health problems, finding that the decline in her health and the decision to reduce her taxable estate were clearly the driving forces behind the subsequent contribution of assets to the FLP. As to those assets, the court held 2036(a)(1) applied, primarily pointing to pro rata postdeath distributions from the partnership 8 months after the date of death, where the estate used its 92% pro rata portion of the distributions to pay estate taxes. H. Jorgensen In Jorgensen, the Tax Court held that marketable securities transferred to two FLPs 58 were includable in the transferor s estate under 2036(a). The court held such transfers were not made for legitimate and significant non-tax reasons. Furthermore, the transferor s use of the assets post-transfer indicated she retained an interest in the property. In Jorgensen, a retired Colonel and his wife accumulated over $2 million in marketable 59 securities. In 1995, Colonel Jorgensen ( Colonel ), who was diagnosed with cancer in 1993, met with an estate-planning attorney and decided he and his wife would form a FLP. Ms. Jorgensen and her children were not involved in the discussions between Colonel and the attorney. On May 15, 1995, Colonel, Ms. Jorgensen, and their two children formed the first FLP ( JMA-I ). On June 30, 58 Estate of Jorgensen v. Commissioner, T.C. Memo at Page -13-

14 1995, Colonel and Ms. Jorgensen each contributed $227,644 to JMA-I for 50-percent limited partnership interests. Colonel and his two children were named general partners. Colonel and Ms. Jorgensen s two children and six grandchildren were listed as limited partners. The children and grandchildren did not make contributions to JMA-I in exchange for their interests. Colonel used a buy-and-hold strategy in managing JMA-I s assets and made all partnership decisions until his death on November 12, After Colonel s death, his interest in JMA-I passed to a family trust. Colonel s estate claimed a 35-percent valuation discount on its interest in JMA-I. The estate-planning attorney wrote Ms. Jorgensen recommending she transfer her personal brokerage accounts and the remainder of Colonel s estate to JMA-I to qualify for a 35-percent discount. The end result would potentially save Ms. Jorgensen $338, Thereafter, the attorney met with the Jorgensen s children and son-in law about forming a second FLP ( JMA-II ). Ms. Jorgensen did not participate in the discussions. In July 1997, Ms. Jorgensen contributed about $2.1 million of her marketable securities and $528,276 of Colonel s estate to the newly formed JMA-II. Ms. Jorgensen received an 80-percent interest and Colonel s estate received a 20-percent interest. Again, the children and grandchildren did not make contributions but were listed as general and/or limited partners in the partnership agreement. Ms. Jorgensen gifted about 30.6-percent of JMA-I among her two children and six grandchildren between 1995 and With respect to JMA-II, Ms. Jorgensen gifted about percent among her children and grandchildren in 1997 and Gifts made between 1999 and 2001 were valued using a 50-percent discount, while the 2002 gifts were valued using a 42-percent discount. Gift tax returns were only filed for years 1999 and later. Ms. Jorgensen died in JMA-II funds were used to pay estate administration fees. In applying 2036 to the facts, the court separated the bona fide sale exception into two prongs: (1) whether the transaction was a bona fide sale, and (2) whether the decedent received full and adequate consideration. As to the first prong, the court emphasized the importance of the 60 transferor s motive in forming the partnerships. The estate argued the partnerships were formed to (1) provide efficient management succession, (2) promote the financial education of the family and family unity, (3) perpetuate Colonel s capital preservation and buy and hold investment philosophies, and (4) achieve economies of scale through the pooling of assets, and address 61 spendthrift concerns. The court held that these motivations represented more theoretical purposes 62 rather than the actual purpose, which was tax savings. While efficient management may count as a credible non-tax purpose where there is active management, the partnership s sole use as a passive 63 investment vehicle weighed heavily against finding a non-tax benefit for the transfers. The court cited (1) minimal securities trading; (2) lack of investment research and records; and (3) failure to consult often with investment advisors, in support of its finding that JMA-I and JMA-II were passive 64 investment vehicles. In addition, correspondence between the Jorgensens and their attorney about 65 the formation of both FLPs showed tax savings was the primary factor in forming the entities. The 60 at at at at 482. Page -14-

15 court gave little weight to a letter sent by the attorney to Ms. Jorgensen after JMA-II s formation and funding that identified several nontax reasons for creating JMA-II. Furthermore, JMA-I and JMA-II disregarded partnership formalities. (1) Neither maintained formal books or records; (2) Ms. Jorgensen, who was not a general partner, wrote checks on JMA-II to make personal cash gifts; (3) Ms. Jorgensen s son borrowed $125,000 from JMA-II to purchase a home but did not make loan payments for two years; and (4) Ms. Jorgensen paid her personal income tax, attorney fees and Colonel s estate administration with FLP money. To show the family s lack of understanding about how the partnerships were suppose to operate, the court noted Ms. Jorgensen s son wanted to know whether there was a way to access some of this money that s mine, and was perplexed by the fact he would owe interest on money he borrowed from the 66 partnership. Ms. Jorgensen retained assets outside of those she transferred to the partnerships and was not financially dependent on the FLPs. However, her use of partnership funds after their transfer supported the court s holding that the partnership was not motivated by legitimate and significant 7 nontax reasons. 6 The court emphasized the transfers to JMA-I and JMA-II were not made at arm s length. Ms. Jorgensen s lack of involvement in the formation stages of JMA-I (where only Colonel was involved in formation discussions) and JMA-II (where only Ms. Jorgensen s children and son-in-law were involved in formation discussions) showed her transfers to the FLPs were not at arm s length. As to the second prong, the adequate and full consideration test requires measur[ing] the value received in the form of a partnership interest to see whether it is approximately equal to the 68 property given up. Here, the parties stipulated the transfers were made for full and adequate 9 consideration. 6 The IRS also argued the totality of the circumstances showed Ms. Jorgensen retained an 70 interest in the transferred property. While no express agreement existed that Ms. Jorgensen retain economic use of the transferred assets, an implied agreement did. Implied agreements have been found where (1) the partnership assets are used to pay personal expenses, (2) the transferor transferred nearly all of his assets to the FLP, or (3) the transferor s relationship to the assets remains 71 the same before and after the transfer. Here, Ms. Jorgensen, while not a general partner, had the ability to write checks on the FLP. She used FLP assets to continue making significant cash gifts to her family post-transfer. When Ms. Jorgensen attempted to pay back JMA-I for a 1999 gift to her daughter, she deposited the funds in JMA-II s account and never fixed her error. Furthermore, her children used JMA-II funds to discharge the obligations of her estate. The court found the actual use of a substantial amount of partnership assets to pay Ms. Jorgensen s predeath and postdeath obligations undermine[d] the claim 66 at at at at at 484. Page -15-

16 [that there was no understanding Ms. Jorgensen would retain economic use of the assets transferred]. As a result, the Tax Court held the property transferred to the FLPs was fully includable in 2 the transferor s estate under 2036(a). 7 I. Mirowski In Mirowski, the IRS sought to include LLC assets in the decedent-transferor s estate where the transferor died within fifteen days of creating the entity and a significant amount of the 73 entity s assets were used to pay gift and estate taxes owed by the decedent. After closely analyzing the unique facts of the case, the court held the transactions were part of a bona fide sale for full and adequate consideration. In Mirowski, the decedent inherited her husband s 73-percent interest in the license to an implantable defibrillator device that her husband developed in the 1970 s and 1980 s. In 1992, the decedent transferred a total of percent of the patent rights among her three daughters. Over the years, the royalties paid on the patent dramatically increased to millions of dollars per year. The decedent began investing, initially in U.S. Treasury securities, and later in a more diversified portfolio with the help of Goldman Sachs. In 2000, the decedent met with representatives of U.S. Trust who introduced her to the concept of forming an LLC to provide for her three daughters and grandchildren on an equal basis. In January 2001, the decedent, a diabetic, developed a foot injury that putting her health at risk. Over the next few months, the decedent purchased interests in two retirement communities, one to serve as her primary residence, the other to get her on a waiting list for a larger unit when it became available. In August 2001, at an annual family meeting in which the decedent did not attend, the decedent s daughters invited the decedent s attorney to discuss the formation of a family LLC. On August 27, 2001, the decedent executed LLC documents as sole general manager, forming the Mirowski Family Ventures, L.L.C. ( MFV ). Four days later, the decedent was admitted to the hospital for foot treatment and her health rapidly deteriorated. The next day, on September 1, the decedent funded MFV with patents th th and her percent interest in the patent license. Between September 5 and 7, the decedent transferred $62 million in securities and cash from her personal Goldman Sachs brokerage account th to a Goldman Sachs account in the name of MFV. On September 7, the decedent gifted 48-percent of her interest in MFV equally among her three daughters. The decedent retained about $3.3 million in cash and about $4.3 million in real and personal property after the transfers. As the decedent s condition worsened, she refused amputation and died from an infection on September 11, In 2002, MFV distributed $36.4 million to the decedent s estate to pay gift and estate taxes, legal fees, and other estate obligations. The three daughters elected not to receive corresponding pro-rata distributions. 72 at Estate of M irowski v. Commissioner, T.C. Memo (2008). Page -16-

17 Despite the close proximity between the contributions and the decedent s death, and the decedent s transfer of 87-percent of her assets, the court held that the transfers were part of a bona fide sale for full and adequate consideration. Applying Bongard s legitimate and significant 74 nontax reason test, the court held the following to be legitimate and significant nontax reasons based on the testimony of two of the decedent s three daughters: (1) Joint management of the family s assets by [the decedent s] daughters and eventually her grandchildren; (2) maintenance of the bulk of the family s assets in a single pool of assets in order to allow for investment opportunities that would not be available if [the decedent] were to make a separate gift of a portion of her assets to each of her daughters... or to each of her daughters trusts; and (3) providing for each of her daughters and eventually each of her 5 grandchildren on an equal basis. 7 While the daughters testimony was self-serving, the court found the daughters completely candid, 76 sincere, and credible and their respective testimonies... reasonable. The IRS presented several arguments to the court challenging the bona sale test. First, the IRS argued the decedent failed to retain sufficient assets outside of the LLC by not reserving 77 sufficient assets to pay gift taxes with respect to her LLC transfers. The court noted the decedent had real and personal property plus anticipated royalty payments under her interest in MFV s patent 78 license agreement to pay her gift tax liability. Furthermore, the decedent s death was unexpected at the time of the transfers and once death appeared imminent, there was no time for the family to make an agreement that MFV would cover the decedent s estate obligations Second, the IRS argued MFV lacked a valid functioning business operation. The court, however, dismissed this contention finding that managing the business matters relating to the ICD patents and the ICD patents license agreement, including related litigation was a valid 9 functioning investment operation. 7 Third, the IRS argued the decedent timed the formation and funding of MFV to occur 80 as her health began to fail. Again, the unexpected nature of the decedent s health complications persuaded the court that the timing of MFV s formation and funding was not driven by an expectation that the decedent would die shortly thereafter. 74 at at at at at Page -17-

18 Fourth, the IRS argued the decedent stood on both sides of the transaction as the sole 81 member of and contributor to MFV. The court quickly dismissed the argument stating accepting the IRS s contention would eliminate any single-member LLC from falling within the 2036(a) s bona fide sale for adequate and full consideration exception. Thus, the court did not sense congress intended to exclude single member LLCs from the 2036 exception. Fifth, the IRS argued MFV s $36.4 million post-death distribution to pay the decedent s transfer taxes and estate obligations supported a finding that the transfers were not bona fide. Again, the court emphasized the unexpected decline in the decedent s health and lack of 82 evidence of an agreement that MFV would pay the decedent s obligations. As a result, the decedent s transfer of approximately 87-percent of her assets within a week of her death was bona fide despite MFV having to distribute about 56-percent of her transferred assets back to the decedent s estate to cover estate obligations. As to the adequate and full consideration requirement, the IRS argued the decedent s transfers to MFV with the intention of gifting 48-percent of her acquired interest to her daughters showed the decedent in substance only received a 52-percent interest in MFV in 83 exchange for contributing 100-percent of MFV s assets. In other words, because of the integrated nature of the transfers, the decedent did not receive full consideration. The court rejected the IRS s argument. While the decedent s funding of MFV and subsequent 16-percent gifts of MFV units to each of her daughters occurred over the course of six days, each was a separate transaction in which 84 the decedent s capital account was properly credited or debited. Furthermore, the MFV s operating agreement provided that in the event of a liquidation and dissolution of MFV, the decedent had the 85 right to a distribution of property from MFV in accordance with her capital account. Next, the court addressed the question of whether the decedent retained a right of 86 enjoyment or possession over the transferred property under The IRS argued the decedent s authority as general manager and 52-percent interest holder gave her the right of possession of the assets. The operating agreement conferred on the general manager the discretion, power, and authority to manage the affairs of the company. Furthermore, the general manager, who could only be removed and replaced by a vote of a majority, had sole authority to determine the timing and amount of MFV s distributions. Despite the distribution authority conferred on the decedent, the court held such power did not amount to an express agreement that the decedent retain an interest in the transferred 87 property. The court noted the decedent, in her capacity as general manager and majority interest holder, owed a fiduciary duty to the other members in making distributions. As to the IRS s argument that the general manager had sole authority to determine the timing and amount of at at 402. Page -18-

19 distributions, the court pointed to the operating agreement s provision stating except as otherwise provided [in the operating agreement] the timing and the amount of all distributions shall be 88 determined by the Members holding a majority of the Percentages then outstanding. The agreement s provisions otherwise provided with respect to several potential distributions. For instance, the operating agreement required capital transaction proceeds, cash flow, and profit and 89 loss be distributed to interest holders pro-rata. Therefore, the court held the power conferred on the decedent as general manager and majority interest holder of MFV did not constitute retention of enjoyment over the property given the restrictions imposed by the operating agreement. As a result, the court held the decedent-transferor s estate did not include MFV s underlying assets. J. Gross In Gross, the IRS argued that the taxpayer s transfer of her interests in her FLP to her 90 daughters should be treated as indirect gifts of the assets contributed. The Tax Court rejected the IRS s argument and held the eleven days between the taxpayer s contributions of publicly traded stock before gifting interests to her daughters were sufficient to reflect real economic risk of a change in value. On July 15, 1998, the taxpayer and her two daughters formed an FLP to hold the taxpayer s portfolio of publicly traded securities. The FLP agreement provided the taxpayer, as general partner and majority owner, would manage and have sole authority to buy and sell FLP assets. Furthermore, the daughters agreed to be bound to certain restrictions: the daughters (1) could not transfer their interest without the taxpayer s approval; (2) had no withdraw rights and were not 91 entitled to their capital contributions; and (3) could not force dissolution. On July 31, 1998, each daughter contributed $10 to the FLP and on November 16, 1998, the taxpayer contributed $100. From October 1998 to December 4, 1998, the taxpayer transferred her stock portfolio to the FLP and her capital account was credited with $2,158,766. Eleven days after completing the transfers, the 92 taxpayer gifted 22.5-percent interests in the FLP to each daughter. The taxpayer s capital account increased on account of her contributions to the partnership and then decreased upon her gifts of her interest to her daughters. The taxpayer s gift tax return for the 2008 tax year reflected a 35-percent discount. The IRS challenged the discount claiming the transfers were indirect gifts of the FLP s underlying securities. The IRS first argued the taxpayer transferred securities to an entity that did not exist under New York law because the limited partnership agreement was not signed until December 15, The court held that the partnership was validly formed under New York law on July 15, because the parties had agreed to all essential terms and conditions of the partnership. As a result, the taxpayer s contributions between October and December 2008 were made to a valid FLP at at Gross v. Commissioner, T.C. Memo at at at Page -19-