The following Tax Court summaries were written by John Gilbert of The Financial

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1 Financial Valuation: Applications and Models, Third Edition By James R. Hitchner Copyright 2011 by James R. Hitchner CHAPTER 15 ADDENDUM 1 Current Tax Court Cases of Interest The following Tax Court summaries were written by John Gilbert of The Financial Valuation Group in Montana or Chris Treharne, John Walker, and Fawntel Romero of Gibraltar Business Appraisals in Colorado. These are not all-inclusive, but do contain some of the most important Tax Court cases since the last edition of this book. FCG VALUATION CASE E-FLASH, PRICE v. COMMISSIONER, TCM Citation Walter M. Price, Petitioner v. Commissioner of Internal Revenue, Respondent, and Sandra K. Price, Petitioner v. Commissioner of Internal Revenue, Respondent, Docket Nos , Filed January 4, The Tax Court ruled whether gifts of limited partnership interests were properly characterized as present interests, thus qualifying for annual gift tax exclusions (not lifetime gift tax exclusions). Comments In Hackl v. Commissioner, 118 T.C. 279, 294 (2002), the court found that transfers of LLC interests were gifts of future interest, and the court ruled that the gifts did not qualify for the annual gift tax exclusion. According to Hackl, to prove gifts are present interests, it must be shown that: 1. The LLC would generate income at or near the time of the gifts 2. Some portion of that income would flow steadily to the donees 3. The portion of income flowing to the donees can be readily ascertained The Facts Walter M. Price and Sandra K. Price gifted minority limited partnership interests in Price Investments Limited Partnership (the Partnership ) to their children from 1997 through Gift tax deficiencies were asserted for 2001 and authored by Chris D. Treharne, ASA, MCBA, BVAL and Fawntel Romero, Gibraltar Business Appraisals, Inc., a member firm of the Financial Consulting Group, Issue 12:1. 1

2 2 FINANCIAL VALUATION Per the partnership agreement, the limited partners have no right to withdraw their capital accounts in the Partnership. Additionally, the partnership agreement prohibits partners from selling or transferring their interests to third parties without the unanimous consent of all other partners. Without the unanimous consent of the partners, a partnership interest can only be transferred to another partner or to a partner s trust. Furthermore, the sale or transfer to third parties is subject to the Partnership s and its partners right of first refusal to purchase the offered interest, which does not specify a time limit for fulfilling the partners obligation once the right is exercised. Section 11.2 of the partnership agreement provides, Any assignment made to anyone, not already a partner, shall be effective only to give the assignee the right to receive the share of profits to which his assignor would otherwise be entitled... and shall not give the assignee the right to become a substituted limited partner. The Partnership paid distributions in each year except 1997 and 2001 (interestingly, 1997 was not included in the deficiency notice, and 2002 was included even though distributions were made). The partnership agreement indicates distributions will be paid at the discretion of the general partner, and Section 7.3 indicates, Neither the Partnership nor the general partner shall have any obligation to distribute profits to enable the partners to pay taxes on the Partnership s profits. The IRS Positions The annual exclusion gifts made by Walter and Sandra Price to their children were gifts of future interests because the partnership agreement imposes transfer restrictions to third parties. The partnership agreement does not require distributions of Partnership income to its partners. Because the conditions to shift the burden of proof to the IRS had not been met, the taxpayers bear the burden of proof. The Taxpayer Positions Hackl was decided incorrectly. Even if the Hackl ruling was correct, it was dissimilar from the current case. The Partnership intends to pay distributions sufficient to cover the tax liability associated with the Partnership s pass-through income. Hence, these distributions represent a present interest. The general partner has a strict fiduciary duty to make distributions to the donees. Court Analysis The court followed the methodology in Hackl and concluded that the taxpayer failed to prove that the gifts provide the immediate use, possession, or enjoyment of either 1) the transferred property or 2) the income therefrom. The court disagreed that the partnership agreement allows the donees to access substantial economic benefit from the transferred interests. Specifically, the donees do not have the right to withdraw their capital accounts in the Partnership. Additionally, the partnership agreement indicates any transfer or sale of a partners interest to a third party requires the unanimous consent of the other partners. As stated in Hackl, transfers subject to the approval of the LLC s manager cannot support a present interest characterization, and the possibility of making sales in violation

3 Current Tax Court Cases of Interest 3 thereof, to a transferee who would then have no right to become a member or to participate in the business, can hardly be seen as a sufficient source of substantial economic benefit. Furthermore, the donees were not partners when the gifts were made. Accordingly, the court ruled the donees were not substituted limited partners per Section 11.2 of the partnership agreement. Instead, the donees held assignee interests and lacked the ability presently to access any substantial economic or financial benefit that might be represented by the ownership units. The court also pointed out that even if the donees were substituted limited partners, any transfer or sale of the donees interest would be subject to the right of first refusal provision of the partnership agreement that does not specify a time limit. The absence of a time limit infers that the transfer does not represent a present interest. Further, the court ruled that distributions were discretionary, even those paid to cover the tax liability. Regarding the taxpayers position that the general partner had a fiduciary obligation to pay distributions, the court indicated that even if such duty exists, it does not establish a present interest in a partnership where the limited partners lack withdrawal rights. Furthermore, the donees were assignees rather than substituted limited partners. Under Nebraska state law, an assignee is not owed any duties other than loyalty and due care from the general partner. Finally, the argument that an interest in the Partnership enhances the donee s financial borrowing ability was regarded by the court as highly speculative. The court indicated there is no evidence to support this argument, and it does not represent a substantial economic benefit. Conclusion The court ruled that the gifts did not offer the donee an unrestricted and noncontingent right to immediately use, possess, or enjoy either the property itself or income from the property and therefore did not qualify for the annual gift tax exclusion. FCG VALUATION CASE E-FLASH, ESTATE OF BLACK 2 Citation Estate of Samuel P. Black, Jr., Deceased, Samuel P. Black, III, Executor, et al. v. Commissioner, 133 T.C. No. 15 Docket Nos , , , December 14, Comments While the ruling is lengthy, the following summary captures the salient points of the case. Further, a close reading indicates that effective estate planning significantly reduced the decedent s estate tax liability. 2 authored by Chris D. Treharne, ASA, MCBA, BVAL, and John Walker, of Gibraltar Business Appraisals, Inc., a member firm of FCG, Issue 11:6.

4 4 FINANCIAL VALUATION Key points in the ruling included: Transfers of closely held stock from the gross estate to a family limited partnership (FLP) were for full and adequate consideration and therefore not includable in the gross estate. Passive entities can be created for legitimate and significant nontax reasons (including preventing the sale of assets by grandsons who lacked ambition and preventing distribution to a spouse in an anticipated divorce proceeding). The date of death of the surviving spouse was a reasonable date for funding of the QTIP trust given that the death of husband and wife were close together and their estates were so intertwined. Interest on a loan to pay estate tax and associated fees was not deductible in this case. Significant portions of the estate s attorney and executor s fees were disallowed for one estate but includable in the other. Details Samuel P. Black, Jr. (the Decedent, or Mr. Black ), engaged in sophisticated estate planning between 1988 and his death in November The Decedent created an FLP (Black Interests Limited Partnership, BILP ) and several trusts as part of his estate planning. Upon creation of BILP on October 12, 1993, the Decedent, as trustee of two of the trusts ( Grandson Trusts ), contributed nonvoting Class A shares of stock in a closely held company ( Erie ) on behalf of the trusts in exchange for limited partnership interests. Mr. Black also contributed all of his Class A nonvoting shares and almost all of his Class B voting stock of Erie in exchange for a large limited partnership interest and a 1.0 percent general partnership interest in BILP. The Decedent s son ( Son ) also contributed most of his Class B nonvoting stock of Erie to the Partnership in exchange for a significant limited partnership and 0.5 percent general partnership interest. According to the partnership agreement, BILP was formed in part to consolidate assets owned by the family of Mr. Black, to avoid division of certain properties, and to prevent family members from transferring interests in BILP without first offering them to other family members. The partnership agreement required written consent of the Partnership and all of the other partners to transfer an interest to unrelated entities or people. Additionally, the partnership agreement granted rights of first refusal to BILP and its partners to purchase any interest subject to disposition, including via death of a partner or via divorce of a partner. Mr. Black served as managing partner (in whom management of the Partnership was vested) until October 1998, at which time he ceded his general partnership interest and responsibilities to Son (and only other general partner). Between the time of formation and his death, Mr. Black gifted almost 7 percent of the limited partnership interests to his family members (including the Grandson Trusts) and charities. In August 2001, the Decedent transferred his remaining percent limited partnership interest to a revocable trust. The revocable trust required the formation of a marital trust for the benefit of the Decedent s wife (Mrs. Black), should she survive him. The marital trust was to dissolve upon Mrs. Black s death. The fact that the Blacks died within six months of

5 Current Tax Court Cases of Interest 5 each other prevented the calculation of Mr. Black s bequest to the marital trust, and the marital trust was not funded as of Mrs. Black s death. Son, as executor of both estates and trustee of the revocable trust, intended to fund the marital trust with the large limited partnership interest in BILP owned by the revocable trust. The Decedent s estate reported and paid a federal estate tax liability of $1.7 million during September 2002 out of the estate s liquid assets. Mrs. Black s estate lacked the liquidity to pay estimated taxes due to the transfer of the large block of illiquid BILP limited partnership interests. Son, as executor of Mrs. Black s estate, attempted to borrow money from several commercial lending institutions in order to satisfy the tax liability. However, the terms required were unacceptable to Son. Son then tried borrowing money from Erie but Erie refused. Son s legal and financial advisors then suggested Erie participate in a secondary offering of Erie stock from Black LP. Erie agreed as long as BILP agreed to pay Erie s expenses associated with the secondary offering. On January 29, 2003, BILP sold 3 million shares (just over one-third of the Erie shares owned by BILP). On February 25, 2003, BILP loaned $71 million total to Mrs. Black s estate and to the revocable trust, subject to an agreement signed by Son as representative for both entities. Terms of the note required 6 percent simple interest, with all principal and interest due and payable not before November 30, The note did not allow for prepayment of principal or interest. Calculated interest for the note was determined to be just over $20 million, which was deducted in full from Mrs. Black s estate tax return. Included in the $71 million disbursed by the estate were costs to reimburse Erie for its participation in the secondary offering, a $20 million bequest to a local college, $1,155,000 in legal fees, and the exact same amount in executor fees. Discussion Mr. Black s Estate IRC Section 2036(a) requires estates to include assets from the value of the gross estates except in certain instances ( except in the case of a bona fide sale for an adequate and full consideration in money or money s worth ). In particular, Section 2036(a)(1) includes in gross estates the possession or enjoyment of, or the right to the income from, the property that the decedent (in general) enjoyed even if a transfer of the property had taken place. The estate of Mr. Black argued that the formation of BILP was for legitimate nontax reasons, including, but not limited to: Long-term management and protection of the family s Erie stock holdings. Pooling the family s Erie stock holdings to allow the stock to vote as one block, thereby capitalizing on the block s swing vote characteristics. To protect the Erie stock from creditors and divorce. Further, the estate cited accomplishment of the goals of the Partnership in its argument. Additionally, the estate maintained the transfer was for full and adequate consideration. The IRS rejected the estate s arguments and asserted that the formation of BILP was not necessary to further the family s goals. The IRS did not believe full and adequate consideration was paid and that Mr. Black maintained an interest in the transferred Erie stock, thereby allowing it to be included in his gross estate.

6 6 FINANCIAL VALUATION Mrs. Black s Estate Although disadvantageous to the estate in terms of tax payments, Mrs. Black s son selected her date of death as the date of funding for the marital trust. In so arguing, the estate believed that was the earliest possible date at which the value of Mr. Black s estate value could be calculated and the amount passed to Mrs. Black could be determined. The IRS held no position on the estate s date determination, stating that Section (e) provides no clarity to the funding date of a QTIP trust when the surviving spouse dies before the trust is funded. The estate argued that the interest on the $71 million loan was tax deductible. The estate believed Son exercised reasonable business judgment in executing the loan rather than causing a distribution or forcing redemption from BILP. Additionally, the loan was bona fide because there was: A note Security Interest charges A repayment schedule Actual repayment of the loan Relationship between borrower and lender created a reasonable expectation or enforceable obligation to repay the note Additionally, the estate claimed deductions of almost $1 million to BILP to reimburse the Partnership for monies it paid to Erie for the secondary offering. The estate also claimed $1.155 million in legal fees and $1.155 million in executor fees. The IRS rejected the estate s arguments. The IRS s position on loan deductibility was: Repayment of the loan was created for the tax deductibility of the interest Son was in a position to distribute from BILP enough Erie stock to cover the liability Son was in a position to redeem at least a portion of Mrs. Black s BILP interest The only way for BILP to repay the loan was to redeem Erie stock, which made the loan pointless Further, the IRS sought to deny the full amount of reimbursement to BILP and any portion over $500,000 in legal and executor fees. Conclusion Mr. Black s Estate The court ruled that the formation of BILP was for legitimate nontax reasons. The Tax Court found Mr. Black had legitimate concerns about: His grandsons selling their Erie stock upon termination of their trusts and the resulting dilution of Erie stock His Son s marriage and dilution of Erie stock should the stock become marital property As a result of the preceding, the Court found that Mr. Black s transfer of Erie stock to the Partnership was a bona fide sale. Because the IRS acknowledged that the partners

7 Current Tax Court Cases of Interest 7 of BILP received partnership interests in proportion to the fair market value of the assets contributed, the full and adequate consideration prong of Estate Tax Regulation (a) definition of bona fide sale. Accordingly, only the fair market value of Mr. Black s limited partnership interests in BILP (not the value of the Erie stock the Decedent transferred to the Partnership) is includable in his estate under 2036(a). Significantly, the Tax Court found in this case as in Estate of Schutt v. Commissioner that a family limited partnership that does not conduct an active trade or business may nonetheless be formed for a legitimate and significant nontax reason. Mrs. Black s Estate The court found that the value of the marital trust likely could not have been knowable as of the date of Mr. Black s death in December 2001, as the trust would be funded with Partnership interests. As evidence, the court cited the date of valuation of the Decedent s interest in BILP (September 2002), more than three months after Mrs. Black s death in May Accordingly, her date of death was the latest reasonable date on which to consider the trust funded. Turning to the loan to pay Mrs. Black s estate taxes and administration fees, the court sided with IRS in ruling that the loan interest was not a deductible expense. The ruling was determined primarily because the Partnership lacked sufficient income and distributions to partners to repay the loan without the sale of Erie stock at the loan s maturity date. If the sale of Erie stock was necessary and enforceable at the maturity date, it was necessary and enforceable at the date of death, making the loan unnecessary. Finally, the court determined that only 49 percent of the secondary offering by BILP was used on behalf of Mrs. Black s estate. Accordingly, only 49 percent of the fee could be deducted. The court also held that because the executor for both Mr. and Mrs. Black was working on both estates simultaneously and because the estates were so intertwined, deductibility of executor fees should be split between the estates. Similarly, the court permitted deductibility of only one-half of the legal fees as only one-half of the work performed benefited Mrs. Black s estate. Comments In contrast to Estate of Malkin v. Commissioner, Estate of Black v. Commissioner shows that proper financial and legal estate tax planning can be invaluable to the taxpayer, particularly in Mr. Black s case. Because of proper planning and documentation, the court found that although BILP was a passive entity it was still created for legitimate and significant nontax reasons. The case is a clear victory for use of the FLP in estate tax planning. FCG VALUATION CASE E-FLASH, ESTATE OF MALKIN 3 Citation Estate of Roger D. Malkin, Deceased, Jonathan R. Malkin and Melissa Malkin, Executors, et al. v. Commissioner, TCM , Docket Nos , , , , September 16, authored by Chris D. Treharne, ASA, MCBA, BVAL and John Walker, of Gibraltar Business Appraisals, Inc., a member firm of FCG, Issue 11:5.

8 8 FINANCIAL VALUATION Comments While lengthy, the following summary captures the salient points of the case. A close reading of the case indicates that more attentive estate planning by the decedent and his advisors could have radically changed the outcome of the ruling. The petitioners failed to raise the issue of Section 7491(a), which could have shifted the burden of proof to the Commissioner. Transfers of publicly traded stock from the gross estate to FLPs were not for full and adequate consideration and therefore includable in the gross estate. Transferred property to FLPs and transferred interests in those FLPs to trusts were taxable gifts. Payments of LLC debts were gifts to the beneficial members of the LLCs. Cash loans to the decedent s children were gifts. Significant portions of the estate s accounting, attorney, and executor s fees were disallowed. Details In the findings of fact for the case, the petitioners failed to set forth objections to the Commissioner s findings of fact. In so doing, the petitioners effectively accepted the Commissioner s findings except for those that don t match the petitioner s facts or those already in evidence. Roger D. Malkin (the Decedent ) engaged in sophisticated estate planning between 1998 and his death from cancer in November The Decedent created two FLPs (MFLP and CRFLP) and four trusts as part of his estate planning. MFLP was formed on August 31, 1998, and capitalized with the Decedent s personally owned, publicly traded employer stock and cash from two trusts that had been created prior to the partnership s formation. The trustees also paid cash and executed self-canceling installment notes (SCINs) with the Decedent to purchase additional limited partnership interests he purchased as part of MFLP s original capitalization. On September 24, 1999, the Decedent pledged MFLP s assets as security against a personal bank loan with the trustees permission. The following April, he repledged the assets with a second bank. After being diagnosed with cancer during May 1999, the Decedent and two new trusts allegedly formed a second partnership, CRFLP, on February 29, Formation capital again included the Decedent s personally owned, publicly traded employer stock plus the Decedent s member interests in four LLCs that he owned with his son (as will be discussed later, the Decedent effectively attempted to create a partnership without any other partners). The same day, the Decedent allegedly transferred limited partnership interests to two new trusts. However, the trusts were not legally formed until the following day, March 1, As with MFLP and the two earlier trusts, the new trusts paid cash and executed SCINs with the Decedent for the purchase of additional CRFLP limited partnership interests. Immediately prior to his death on November 22, the Decedent then contributed additional shares of his publicly traded employer stock to CRFLP. As was the case with the shares owned by the other partnership, the shares had been pledged as collateral against personal debt. Unlike the other partnership, the pledge had been made before the stock was transferred to CRFLP. The Decedent died before the first payment came due on the CRFLP SCINs. Further, the estate never demanded payment.

9 Current Tax Court Cases of Interest 9 The Decedent was the general partner of each of the FLPs, while he and the two trusts were limited partners of each FLP. In addition to the preceding partnership transactions, the Decedent transferred cash to his children, purportedly as loans. However, promissory notes were executed for only two of the transfers, no interest was paid, and no demands for payment occurred. The Decedent also paid debts associated with two of the LLCs. During September 2000, the Decedent also paid money to one of the LLCs related to a capital call. However, in March 2000, he transferred his LLC interests to CRFLP. Discussion IRC Section 2036(a) requires estates to include assets from the value of the gross estates except in certain instances ( except in the case of a bona fide sale for an adequate and full consideration in money or money s worth ). In particular, Section 2036(a)(1) includes in gross estates the possession or enjoyment of, or the right to the income from, the property which the decedent (in general) enjoyed even if a transfer of the property had taken place. The IRS argued that the pledge of FLP assets to secure the Decedent s personal debt created an implied agreement that the Decedent would retain the right to use transferred stock. Estate Tax Regulation (b)(2) states that the discharge of a legal obligation of an individual falls under the use, possession, right to the income, or other enjoyment of the transferred property of IRC Section 2036(a)(1). The estate argued that the pledge of MFLP assets benefited MFLP and was an arm s-length investment decision guaranteed by the Decedent and approved by the trustees. Regarding the CRFLP assets, the estate noted that the assets had been pledged prior to their transfer to the partnership. In addition to the preceding issues, the IRS asserted there were no legitimate and significant nontax reasons for creating either of the FLPs that would qualify the transfers of the publicly traded stock for the bona fide sale exception of IRC Section 2036(a). The IRS position relied on the following: The estate provided no evidence that the FLPs were created for nontax purposes. The Decedent did not need the FLP structure to control the stock he contributed, because he already controlled the stock prior to contributing them to the partnerships. Use of the Decedent s (but not his children s) assets to capitalize both partnerships was evidence that there was no pooling of family assets, especially after recognizing that the children s personal net worths were more than adequate to provide personal asset contributions to the partnerships. In response, the estate argued that the partnerships were formed so that the Decedent could: Provide for his children. Control disposition of the public stock used to capitalize both partnerships so as to not undermine public investors confidence in his employer and to maintain the upside potential in stock value appreciation for the economic benefit of his children. Centralize family wealth management.

10 10 FINANCIAL VALUATION Turning to the issue of gifts, the facts associated with the formation of CRFLP and its two trusts undermined the legitimacy of the Decedent s limited partnership transfers. First, the partnership was allegedly formed with the trusts as limited partners even though the trusts were not formed until the next day (the court particularly noted that Mississippi law does not recognize one-person partnerships). Second, the alleged limited partnership interests were transferred to trusts that didn t exist on the transfer date (they were created the next day). Accordingly, CRFLP did not validly exist until the day of formation of the trusts, and the date-of-formation transfers were of the father s LLL member interests, not CRFLP limited partnership interests. Regarding the loans to the Decedent s children, they did not recall signing promissory notes for some of the loans, did not recall getting at least one of them, and did not pay interest on them; and repayment was never demanded. As a result, the IRS asserted the loans were gifts. In May 2000, the Decedent transferred to one LLC a promissory note worth approximately $1 million. In September of the same year, the Decedent paid a capital call of the LLC. However, as of March 1, 2000, the Decedent had transferred his interest in the LLC to CRFLP. Under Delaware law (the state of registration for both LLCs), no member is obligated to pay the debts of an LLC. In response, the estate argued that the LLC operating agreements extended personal liability for LLC debts to their members. Finally, the Tax Court had to determine which Form 706 estate tax deductions were appropriate. The Commissioner asserted that the estate attempted to claim deductions that exceeded the value of the gross estate, including: The value of debt in excess of the collateral securing it. LLC debt for which the Decedent was no longer personally liable. Executor s commissions, legal fees, and accounting fees. Conclusion The court ruled that the transfer of the LLCs to CRFLP did not imply that the Decedent retained the right to present economic benefit of the LLCs. However, the court agreed with and accepted the IRS argument that the Decedent had retained the right to use the publicly traded employer stock transferred to both FLPs. Further, the court held that the estate failed to show that the pledge of publicly traded employer shares to secure the Decedent s personal debt was an arm s-length business decision even though the trusts charged the Decedent a fee for doing so (timely payment of the fee to MFLP might have strengthened the estate s argument). Further, the timing of the pledging of the CRFLP shares (i.e., prior to the contribution to the partnership) was not relevant to the court. The estate failed to prove that there were significant nontax reasons for the transfer of the Decedent s publicly traded employer stock into the FLPs. The court also ruled that the SCIN sales of CRFLP limited partnership interests by the Decedent were a sham because: At the time the SCINs were executed, the Decedent was terminally ill. The Decedent provided the cash down payment for the purchases even though both children had the financial ability to do so. The estate provided no evidence that the transaction was an arm s-length sale. The estate could not explain its failure to demand payment on the promissory notes.

11 Current Tax Court Cases of Interest 11 Because the preceding transfers were not bona fide sales for full and adequate consideration, the value of the stock was includable in the Decedent s gross estate. To bolster its conclusion, the Tax Court cited both Estate of Bigelow and Strangi Circuit Court rulings (which, in both cases, affirmed the Tax Court). Further, the transferred stock was includable in the estate because the Decedent retained possession and enjoyment of the stock within the meaning of IRC Section 2036(a)(1). Turning to another disputed matter, the loans from the Decedent to his children were treated as gifts by the court. The Tax Court determined that the Decedent s payment of debts owed by LLCs represented indirect gifts. Because the Decedent had transferred his interest in an LLC to CRFLP, he was no longer a member of the LLC, and his transfers to the LLC (the promissory note and capital call) should be treated as indirect gifts to the beneficial owners (his children) of the LLC. Regarding the Form 706 deductions, the Tax Court: Accepted a deduction for the value of the secured debt as an estate tax deduction but disallowed that portion of debt exceeding the value of the collateral. Disallowed deductions for LLC debt for which the estate claimed the Decedent was personally liable because the Decedent was no longer a member (having transferred his interest to CRFLP). Disallowed more than $500,000 of executors commissions, legal fees, and accounting fees as the estate offered no evidence the fees were actually paid. Although the Decedent engaged in sophisticated estate planning (establishment of FLPs, family trusts, promissory notes, etc.), the estate s lack of attention to detail in the execution doomed the estate in Tax Court. Had the estate and its advisors executed the estate planning properly (e.g., establishing trusts before making them limited partnerships in a partnership, understanding that the Decedent was no longer a member of an LLC), the Court s ruling likely would have been much more favorable to the estate. FCG VALUATION CASE E-FLASH, PIERRE v. COMMISSIONER 4 Citation Pierre v. Commissioner, 133 T.C. No. 2, August 24, 2009 Comments The Tax Court was asked to determine whether transfers of interests in a singlemember LLC should be valued as direct transfers valued as an undiscounted, proportionate share of the LLC s assets or as transfers of interests in the LLC, thus being subject to valuation discounts. 4 authored by Fawntel Romero and Chris D. Treharne, ASA, MCBA, of Gibraltar Business Appraisals, Inc., a member firm of FCG, Issue 11:4.

12 12 FINANCIAL VALUATION Details Suzanne J. Pierre formed the single-member Pierre Family, LLC ( Pierre LLC ), a New York limited liability company, on July 31, Both parties agreed Pierre LLC was validly formed under New York state law, which recognizes the entity as being separate and apart from its members. Pierre LLC was treated as a disregarded entity under the check-the-box regulations for federal income tax purposes. On September 15, 2000, Ms. Pierre transferred cash and marketable securities to the entity. To use her available generation-skipping transfer tax exemption, 9.5 percent interests were transferred to two trusts 12 days after the LLC was capitalized. Ms. Pierre then sold 40.5 percent interests to each trust in exchange for promissory notes. The IRS Because Pierre LLC is a single-member LLC and a disregarded entity under the check-the-box regulations, the IRS argued the gifts should be treated as direct, undiscounted transfers of cash and securities rather than discounted transfers of LLC member interests. As a result, lack of control and marketability discounts were not appropriate. The Taxpayer The taxpayer argued that state law rather than federal tax law determines the nature of a taxpayer s transferred ownership. More explicitly, because New York state law recognizes the entity as being separate and apart from its owner, the subject LLC ownership interests were subject to discounts for lack of control and lack of marketability. Court Analysis The court s majority ruled that the check-the-box regulations do not apply to transferred property ownership interests for federal gift tax purposes, but rather govern how the entity will be taxed for federal income tax purposes. The court s minority argued that Pierre LLC and Ms. Pierre constitute only one actor for federal tax purposes, which includes federal gift tax purposes as well. As a result, the gift of an interest in Pierre LLC should be treated as a direct gift of cash and securities. More explicitly, the court s minority indicated that the taxpayer should bear the burden as well as the benefits of the check-the-box regulations. Conclusion Neither the regulations nor previous court rulings cited by the IRS or the court s minority provided the court s majority with evidence that the existence of the entity (validly formed under state law) should be ignored for federal gift tax purposes. If the check-the-box regulations apply, federal law rather than state law would define property rights and interests transferred for federal gift tax purposes. Accordingly, the court allowed the valuation discounts.

13 Current Tax Court Cases of Interest 13 FCG ESTATE AND GIFT VALUATION E-FLASH 5 Citation Paul D. Garnett and Alicia Garnett v. Commissioner, 132 T.C. No. 19, Docket No , June 30, 2009 Comments The IRS asserted that interests in LLCs, LLPs, and tenancies-in-common were limited partnership interests, thereby disallowing losses generated by passive investments. However, the Tax Court determined that the ownership interests were not limited partners and not subject to IRC Section 469(h)(2). The Facts Paul and Alicia Garnett (the Garnetts or Petitioners ) were general partners in seven limited liability partnerships and nonmanaging members of two limited liability companies, all of which were engaged in some form of farming or ranching. They also owned interests in two other businesses, which they claimed were tenancies-incommon. Although the Petitioners tax return listed only Mr. Garnett as a partner or member, neither the court nor the IRS challenged the Petitioners contention that the interests were owned jointly. Petitioners primarily owned interests in the LLPs indirectly through holding company LLCs and directly owned only one LLP interest. Each Form 1065 Schedule K-1 listed the relevant interest holder as limited partner. The LLP agreements generally reduced the partners liability for partnership debts and stated that each partner would actively participate in the management and direction of the partnerships business activities. The Garnetts also owned interests in two LLCs, one directly and one through a holding company. Each Schedule K-1 listed the relevant interest holder as a limited liability company member. The business of the two LLCs was to be conducted exclusively by a managing member, selected by majority vote of the LLC s members. The Petitioners were not managers in either of the LLCs in which they owned interests. Finally, the Garnetts indirectly owned interests (through a holding company) in two other businesses (tenancies-in-common), which operated as de facto partnerships and owned rental real estate. During 2000, 2001, and 2002, the Petitioners claimed losses attributable to the various business entities mentioned. Discussion IRC Section 469 defines and sets forth the terms for the tax treatment of passive entities. In particular, Section 469(b) generally defines a passive entity as one in which the taxpayer does not materially participate. Section 469(c)(1) defines material participation as regular, continuous, and substantial involvement in the business operations. 5 authored by John Walker and Chris D. Treharne, ASA, MCBA, of Gibraltar Business Appraisals, Inc., a member firm of FCG, Issue 11:3.

14 14 FINANCIAL VALUATION Section 469(h)(1) lists seven exclusive tests for determining material participation. Section 469(h)(2) states: Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which the taxpayer materially participates. The IRS argued that the Petitioners interests in the various companies should be considered as limited partners in limited partnerships, which then presupposes that the subject interests income is generated from passive activities. Underlying the IRS position was inability of the subject interests to control the parent entities, and the limited liability the interests received in exchange for the lack of control. [Note: The holding companies were disregarded by the IRS in this matter and the Garnetts did not dispute the IRS s position.] The Petitioners argued that Section 469(h)(2) was not applicable because none of the companies in which they owned interests were limited partnerships and because the subject interests were general partner interests rather than limited partner interests. The court disagreed with the IRS position and cited the legislative history of the regulations in finding that that although Congress considered limited liability in its passing of Section 469(h)(2), limited liability was neither the only nor the determinative factor. Further, Congress believed that statutory restriction on a limited partner s ability to manage the business meant the limited partner did not materially participate. The Tax Court believed such logic did not apply to the subject interests, as the subject interests were not restricted statutorily from participation in company management. Accordingly, the Tax Court ruled that subject interests were all general partners within the meaning of the regulations. Conclusion Although the characteristics of the subject interests differed in many respects from general partnerships general partners, their status differed more from limited partnerships limited partners. As a result, the subject interests were not subject to Section 469(h)(2), and losses generated by the interests were allowed by the Tax Court. FCG VALUATION CASE E-FLASH, MILLER v. COMMISSIONER 6 Citation Miller v. Commissioner, TCM , May 27, The Tax Court determined whether a discount was appropriate to apply to cash and securities transferred to a family limited partnership. Comments In an unrelated recent case (Estate of Jorgensen v. Commissioner, TCM , March 26, 2009), the Tax Court found that transfers made by Mrs. Jorgensen to 6 authored by Fawntel Romero and Chris D. Treharne, ASA, MCBA, of Gibraltar Business Appraisals, Inc., a member firm of FCG, Issue 11:2.

15 Current Tax Court Cases of Interest 15 FLPs were not bona fide sales for full and adequate consideration. The court ruled that the partnership assets were commingled with personal funds and there were no nontax purposes for the formation of the partnerships. However, in Estate of Miller v. Commissioner, the court found that the Miller FLP s assets were not commingled with personal funds, there were valid reasons for the formation of the partnership, and the partnership was formed for legitimate, nontax purposes. Unlike Miller, family members in the Jorgensen case did not treat the FLPs as independent partnership entities. Accordingly, the court ruled in favor of the IRS and did not allow the discounts for the Jorgensen FLPs. The Facts Mr. Miller spent a significant amount of his time during retirement charting and managing his family s investment securities. He kept handwritten records of his investment activity. Mr. Miller passed away during After his death, the family formed V/V Miller Family Limited Partnership ( MFLP, the Partnership ) during Later in 2002, a portion of the family s investments was transferred to the Partnership. Valeria M. Miller, the widow, was 86 years old upon the formation of MFLP and owned 920 of the 1,000 partnership units issued. The Millers son, Virgil, managed the assets of the partnership based on his father s investment strategy of charting stocks. He also subscribed to several trade publications and purchased computer software for trading purposes. Mrs. Miller (the Decedent ) was diagnosed with congestive heart failure and suffered a traumatic brain injury during May During the same month, several transfers were made from her trust s investment account to MFLP. Mrs. Miller died on May 28, Securities Transferred during 2002 The IRS The IRS argued that MFLP did not function as a business operation and a valid reason for the formation of the Partnership did not exist. Further, the IRS argued that the Decedent stood on both sides of the transaction and retained rights in the property that were not relinquished until death. Additionally, the commissioner asserted that Virgil s desire to reduce estate tax liability seemed to be the driving force for the 2002 transfer. The Estate The estate argued that there were legitimate and nontax purposes for the formation of MFLP. Supporting its arguments, the estate indicated that the Partnership was formed to continue Mr. Miller s investment philosophy, and its assets were actively managed by Virgil. The estate also pointed out that the Decedent seemed to be in relatively good health during the 2002 transfer and did retain sufficient funds for living expenses outside of the Partnership. Court Analysis The court agreed that the Partnership was formed for legitimate nontax purposes and the 2002 transfer constituted a bona fide sale for adequate consideration.

16 16 FINANCIAL VALUATION Securities Transferred during 2003 The IRS The IRS argued that the Decedent stood on both sides of the 2003 transfer and did not retain sufficient assets outside of the Partnership for living expenses. Also, the IRS argued that if it were the Decedent s desire to have the assets managed in accordance with Mr. Miller s investment methodology, she would not have waited until the last weeks of her life to make the transfer. The decline in Mrs. Miller s health and the attempt to reduce estate tax liability seemed to be the reasons for the 2003 transfer. The Estate The estate indicated that the Decedent transferred her remaining assets during 2003 because she wanted them to be managed in accordance with her husband s investment methodology. Court Analysis The court agreed with the IRS finding that the Decedent did not have legitimate nontax purposes for the 2003 transfer of her remaining assets to MFLP. Conclusion The court allowed the application of a discount to the assets transferred during 2002 (i.e., before the Decedent knew she had major medical problems). However, the court did not allow the discount to the assets transferred shortly prior to the Decedent s passing because it found no nontax reason for the transfer. Additionally, in the first transfer, the Decedent retained sufficient assets outside of the Partnership to pay for living expenses but failed to do so in the second transfer. FCG VALUATION CASE E-FLASH, LITCHFIELD v. COMMISSIONER 7 Citation Litchfield v. Commissioner, TCM , January 29, The Tax Court calculated the discount for built-in capital gains taxes in a recently converted C to S corporation, along with discounts for lack of control and lack of marketability. Comments Regarding the capital gains tax issue, the court s ruling in Litchfield appears to be consistent with its ruling in Estate of Jelke v. Commissioner, TCM , but 7 authored by Fawntel Romero and Chris D. Treharne, ASA, MCBA, of Gibraltar Business Appraisals, Inc., a member firm of FCG, Issue 11:1.

17 Current Tax Court Cases of Interest 17 contrary to the 11th Circuit s reversal of Jelke in Estate of Jelke III v. Commissioner, 507 F.3d 1317 (11th Cir. 2007), and the Fifth Circuit s ruling in Estate of Dunn v. Comm r, 301 F.3d 339 (5th Cir. 2002). As a result, advisors and analysts should carefully review and understand the issues associated with C corporations built-in capital gains taxes. The estate s expert was criticized for relying on out-of-date restricted stock studies. Analysts should consider including an explanation stating that the regulatory rights afforded shareholders in the more recent studies differ from those in the earlier studies. When one considers the differences in those rights, the newer studies do not differ significantly from the earlier studies. Furthermore, the rights associated with closely held business interests often are more similar to the stocks included in the older studies. The Facts Marjorie degreeff Litchfield died in 2001, owning minority 43.1 and percent interests in Litchfield Realty Co. (LRC) and Litchfield Securities Co. (LSC), respectively. LRC converted to an S corporation on January 1, It owned appreciated assets, including farmland, marketable securities, and a closely held subsidiary. LRC occasionally sold farmland to raise capital. LSC was a C corporation that owned blue-chip marketable securities and other equity investments. It focused on maximizing cash dividends, and dividends increased consistently over time. Built-in capital gains represented 86.7 and 73.8 percent of LRC s and LSC s net asset values, respectively. Discount for Built-In Capital Gains Taxes The Estate Based on the estate s expert s analysis, average holding periods for LRC s and LSC s assets were calculated and present values of the estimated future capital gains tax liabilities were deducted from net asset value. The IRS The IRS expert calculated different holding periods, multiplied the tax rate at the end of each period by the capital gains, discounted the conclusions back to present values, and recognized the liabilities. For LRC, however, no capital gains taxes were recognized beyond 2009 because of its recent S election. Court Analysis The IRS expert did not account for appreciation during the holding period. Additionally, the estate s assumptions regarding asset turnover estimates were based on more accurate data, including management interviews. The court accepted the estate s built-in capital gains tax discounts.

18 18 FINANCIAL VALUATION Discount for Lack of Control The Estate To calculate an appropriate discount for lack of control (DLOC), the estate s expert compared both companies securities business segments to closed-end funds. Additionally, LRC s farmland and other assets were compared to real estate investment trusts (REITs) and real estate limited partnerships (RELPs). The IRS The IRS expert also selected closed-end fund data for LRC s and LSC s marketable securities business segments. LRC s farmland segment analysis was based on a variety of published data, including Mergerstat Review. Court Analysis The court acknowledged that both experts averaged their discounts for the farmland and securities business segments. However, the estate s expert used a weighted average to account for the proportionately greater value in LRC s farmland segment, while the IRS expert used a simple average. Regarding the LSC stock interest, the IRS expert used the same DLOC for both businesses security segments even though the estate s ownership interest in LSC was much smaller than its stock interest in LRC. In contrast, the estate s expert relied on a larger DLOC for LSC. The court concluded that the estate s DLOCs were appropriate. Discounts for Lack of Marketability The Estate To calculate an appropriate discount for lack of marketability (DLOM), the estate s expert compared the stock of LRC and LSC to restricted stock transactions using five criteria. The IRS Using a nine-point analysis, the IRS expert also compared both companies ownership interests to restricted stock sales (including three studies of restricted stock sales from the late 1990s that the estate s expert did not review). Additionally, the expert reviewed private placement data. Court Analysis The court concluded that the estate s selections of DLOMs were high, in part because the estate s expert relied on allegedly outdated data. The court also recognized that the estate s expert concluded that a much smaller DLOM was appropriate in a March 2000 gift tax appraisal for the same LSC minority stock interest. As a result, the court chose DLOMs of 25 percent and 20 percent for LRC and LSC, respectively. Conclusion A summary of the parties conclusions is shown in the following table.