RECENT CASES AFFECTING FAMILY LIMITED PARTNERSHIPS AND LLCs Louis A. Mezzullo McGuireWoods LLP Richmond, Virginia lmezzullo@mcguirewoods.com (August 25, 2005) Copyright 2005 by Louis A. Mezzullo. All rights reserved.
TABLE OF CONTENTS 1. Turner v. Commissioner, 382 F. 3d 367 (3 rd Cir. 2004), aff g Estate of Thompson v. Commissioner, T.C. Memo 2002-246...1. 2. Estate of Bongard v. Commissioner, 124 T.C. No. 8 (March 15, 2005)...8. 3. Estate of Bigelow v. Commissioner, T.C. Memo 2005-65 (March 30, 2005)...14. 4. Estate of Edna Korby v. Commissioner, T.C. Memo. 2005-102 (May 10, 2005) and Estate of Austin Korby v. Commissioner, T.C. Memo. 2005-103 (May 10, 2005)...17. 5. Estate of Schutt v. Commissioner, T.C. Memo. 2005-126 (May 26, 2005)...22. 6. Estate of Ida Abraham v. Commissioner, 95 AFTR 2d 2005-2591 (lst Cir. May 25, 2005), aff g T.C. Memo 2004-39 (February 18, 2004)...27. 7. Estate of Strangi v. Commissioner, No. 03-60992 (5 th Cir. July 15, 2005), aff g T.C. Memo 2003-145 (Strangi II)...30. i
RECENT CASES AFFECTING FAMILY LIMITED PARTNERSHIPS AND LLCs Louis A. Mezzullo McGuireWoods LLP Richmond, Virginia lmezzullo@mcguirewoods.com (August 25, 2005) 1. Turner v. Commissioner, 382 F. 3d 367 (3 rd Cir. 2004), aff g Estate of Thompson v. Commissioner, T.C. Memo 2002-246 1 a. Introduction b. Facts The Third Circuit, in an opinion by Chief Judge Scirica, affirmed the Tax Court s decision in Thompson that assets transferred to two limited partnerships were includible in the decedent s estate under 2036(a)(1). Not surprisingly, because of the facts in the case, the Third Circuit agreed with the Tax Court that the decedent had retained an implied right to the income from assets he transferred to two limited partnerships and the transfers to the partnerships were not bona fide sales for an adequate and full consideration in money or money s worth. The transfers were made in 1993 pursuant to the Fortress Plan, which was also the plan used in Strangi v. Commissioner. 2 The Thompson Partnership involved the decedent s son and the Turner Partnership involved the decedent s daughter and her husband. The decedent owned 49% of the corporate general partner of each limited partnership. His son owned 49% of the corporate general partner of the Thompson Partnership and an unrelated party owned the remaining 2%. His daughter and son-in-law each owned 24.5% of the corporate general partner of the Turner Partnership and an unrelated charity owned the remaining 2%. The decedent transferred a combined total of approximately $2.4 million in marketable securities and $418,000 of notes receivable (95% of his assets) to both partnerships, taking back a 95.4% interest in the Turner Partnership and 62.27% interest in the Thompson Partnership. His children contributed cash, mutual funds and real property for their interests. At the time of the creation of the partnerships the decedent was 95. He retained enough assets to pay for his expenses for approximately 3.5 years, while his life expectancy was 4.1 years. 1 This discussion of Turner is taken from an article by Lou Mezzullo in the October 2004 issue of The Journal of Taxation. 2 Estate of Strangi v. Commissioner, No. 03-60992 (5 th Cir. July 15, 2005), aff g T.C. Memo 2003-145 (Strangi II).
Trading in the marketable securities held by the partnerships was minimal and, for the most part, income from real estate investments was allocated to the contributing partner. The Turner Partnership did invest $186,000 in a modular home construction project, but the project was sold for a loss in 1995. The Turner Partnership made loans to various family members for which interest was formally charged, but interest payments were often late or not paid at all, and loans were frequently reamortized. The partnership never pursued enforcement against any of its debtors and never made loans to non-family members. Cash distributions were made to the decedent during his life to enable him to make annual exclusion gifts and to pay his expenses and after he died the partnerships sold assets to raise money to pay the decedent s bequests and estate taxes. The decedent died in 1995 at age 97. On the estate tax return the decedent s executors claimed a 40% lack of control and marketability discount for the limited partnership interests owned by the decedent at his death. The IRS filed a notice of deficiency in the amount of $707,054. In an amended answer to the petition for redetermination in the Tax Court, the IRS asserted that the family partnerships and corporations should be disregarded for tax purposes or, in the alternative, 2036(a) should apply. The Tax Court found that the partnerships were validly formed and should be recognized for federal estate tax purposes, but held that 2036(a)(1) applied because the decedent retained the right to the income from the assets he transferred to the partnerships and the bona fide sale exception did not apply. c. The Court s Opinion Among the factors the Third Circuit considered in agreeing with the Tax Court that there was an implied agreement were: (1) the decedent transferred 95% of his assets to the partnerships; (2) he was 95 years old; (3) he did not retain sufficient assets to support himself for the remainder of his life expectancy; (4) his children anticipated and prepared for the decedent s requests for money from the assets he contributed to the partnerships to enable him to make gifts and pay his living expenses; (5) both of his children testified and the estate conceded that they would not have refused the decedent s request for distributions from the partnerships; and (6) the practical effect of changes in the relationship of the decedent to the assets he contributed to the partnerships was minimal. In addition, the partners continued to receive income from the assets they each contributed to the partnerships. Finally, the Court noted that the general testamentary character of the partnership arrangements supported the inference of an implied agreement. Neither partnership engaged in business or loan transactions with anyone outside the family. Consequently, transferring this type and volume of assets to family partnerships under these circumstances was more consistent with an estate plan than with an investment in a legitimate business. The Court turned next to the bona fide sale exception to 2036(a). It noted that the Tax Court had concluded that there were no transfers for consideration in this case because the transactions were not motivated by legitimate business 2
concerns. The Tax Court had found that the family limited partnerships served as a vehicle for changing the form in which the decedent held his property a mere recycling of value. The recycling of value concept, first expressed in Harper, 3 was also followed in Strangi II. The Court saw no distinction between the scenario analyzed in Harper and the present case. It noted that the family limited partnerships patently failed to qualify as the sort of functioning business enterprise that could potentially inject intangibles that would lift the situation beyond mere recycling, citing Strangi II. The Court then discussed at length the lack of legitimate business operations. The Court did note that there was one investment, the modular home construction project, that seemed to qualify as a legitimate business transaction with a third party. However, the Court concluded any legitimizing effect of the Turner partnership s investment in the Lewisville properties is overwhelmed by the testamentary nature of the transfer and subsequent operation of the partnership. Nonetheless, the Turner Partnership did invest about 13.5% of its assets in the modular home construction project. In contrast, in Kimbell, 4 the Fifth Circuit, in finding that there was a business purpose for forming the limited partnership, stressed that 11% of the assets transferred to the limited partnership were working interests in oil and gas properties. The Court also noted that the form of the transferred assets, predominantly marketable securities, was significant in determining the bona fide sale exception did not apply. The Court found it difficult to surmise a benefit that could be derived from holding an untraded portfolio of securities in the family partnerships. The Court distinguished Church, 5 because in that case the partners consolidated undivided ownership interests and the administration of a family ranching business; Stone, 6 because assets transferred to the family partnerships were operated as going concern businesses in order to transfer the management of the businesses to children; and Kimbell, because working oil and gas interests were transferred to a family partnership to provide, among other things, centralized management and protection from personal and environmental liabilities. The Court then turned to the Wheeler 7 case, where the Fifth Circuit stated unless a transfer that depletes the transferor s estate is joined with a transfer that augments the estate by a commensurate (monetary) amount, there is no adequate and full consideration for the purposes of either the estate or gift tax. The Court noted that the Tax Court had previously held that the dissipation of value resulting from the transfer of marketable assets to a closely-held entity will not 3 Estate of Harper v. Commissioner, T.C. Memo 2002-121. 4 Kimbell v. United States, 93 AFTR 2d 2004-2400 (5 th Cir. 2004), vac g and rem g 244 F. Supp. 2d 700, 91 AFTR 2d 2003-585 (N.D. Tex. 2003). 5 Church v. United States, 2001-1 USTC 60,369 (W.D. Tex. 2000), aff d per curiam, 268 F.3d 1063 (5 th Cir. 2001). 6 Estate of Stone, T.C. Memo 2003-309. 7 Wheeler v. United States, 116 F.3d 749 (5 th Cir. 1997). 3
automatically constitute inadequate consideration for purposes of 2036(a), citing Harper and Stone. Nonetheless, the Court believed that the reduction in value because of the lack of control and marketability discounts should trigger heightened scrutiny into the actual substance of the transaction. Where, as in this case, the valuation discount provides the sole benefit for converting liquid, marketable securities into illiquid partnership interests, there is no transfer for consideration within the meaning of 2036(a). The Court then turned to the bona fide sale component of the exception. The Court noted that a bona fide sale is a transfer made in good faith and only requires a sale in which the decedent/transferor actually parted with her interest in the assets transferred and the partnership/transferee actually parted with the partnership interest issued in exchange, citing the Fifth Circuit s holding in Kimbell. The Court quoted Kimbell as follows: Just because a transaction takes place between family members does not impose an additional requirement not set forth in the statute to establish that it is bona fide. A transaction that is a bona fide sale between strangers must also be bona fide between members of the same family. In addition, the absence of negotiations between family members over price or terms is not a compelling factor in the determination particularly when the exchange value is set by objective factors. The Court then distinguished the present case from Harper and Strangi because the members of the decedent s family participated substantially in the formation and funding of the partnerships. However, a bona fide sale, while not requiring an arm s-length transaction, must still be made in good faith. According to the Court, a good faith transfer to a family limited partnership must provide the transferor some potential for benefit other than the potential estate tax advantages that might result from holding assets in the partnership form. Again citing Kimbell, the Court stated that objective indicia that the partnership operates a legitimate business may provide a sufficient factual basis for finding a good faith transfer. But if there is no discernible purpose or benefit for the transfer other than estate tax savings, the sale is not bona fide within the meaning of 2036(a). The Court concluded after a thorough review of the record, we agree with the Tax Court that the decedent s inter vivos transfers do not qualify for the 2036(a) exception because neither the Thompson partnership nor the Turner partnership conducted any legitimate business operations, nor provided the decedent with any potential nontax benefit from the transfers. There was a concurring opinion by Judge Greenberg, joined in by Judge Rosenn. To Judge Greenberg, nothing could be clearer than a conclusion that if the discount was justified in a valuation sense then the decedent could not have received an adequate and full consideration for his transfers in terms of money s worth. Therefore, he believed it clear that the Fortress Plan as applied in this case in which the decedent retained for his life the enjoyment in the transferred 4
property should be completely ineffective to create a tax benefit by reducing the value of the decedent s estate as the transferred property must be recaptured by the estate for estate tax purposes. Judge Greenberg made three additional points. First, he wanted to dispute the estate s argument that, because there was no gift on formation, the transfers must have been for an adequate and full consideration. He believed that there were no gifts made as a result of the transfers to the partnerships because there was merely a recycling of the assets and, as a result, nothing passed to anyone else and the decedent continued to enjoy the property he transferred until he died. The second point was to limit the reach of the holding. He noted that there were surely numerous partnerships in which a partner dies after contributing assets to the partnership and therefore has made a transfer that arguably could be said to be within 2036(a). However, the Court was not holding that in all such circumstances 2036(a) would be applicable. In the present case, he noted that we have a narrow situation in which the partnerships were created in furtherance of what the estate calls an estate plan with the primary purposes to provide a vehicle for gift giving, to preserve assets and ultimately to transfer the partnership s interests in an orderly and efficient fashion. He notes that, because the Commissioner emphasized that the estate had conceded that the partnerships never intended to carry on any sort of active trade or business and that the partnerships did not carry on any sort of common investment activity of any significance, the Commissioner implicitly recognized that there were limitations on the applicability of 2036. He made the second point because he did not want the Court s reasoning in the present case to be applied in routine commercial circumstances. In this regard, he states: This second point is important because courts should not apply 2036(a) in a way that will impede the socially important goal of encouraging accumulation of capital for commercial enterprises. Therefore in an ordinary commercial context there should not be a recapture under 2036(a) and thus the value of the estate s interest in the entity, though less than the value of the pro rata portion of the entity s assets, will be determinative for estate tax purposes. This case simply does not come within that category. Judge Greenberg s third point was a rejection of the Tax Court s statement in the Stone case that the Commissioner s argument reads the bona fide sale exception out of the Code. Although the Commissioner was applying the exception precisely as written, his position should not be applied in ordinary commercial circumstances even though one could argue that the decedent enjoyed the property until his death. In a footnote, Judge Greenberg also criticizes the failure of the 5
Fifth Circuit in Kimbell to deal with the fact that the estate was not replenished by an asset of equal value, citing Estate of D Ambrosio v. Commissioner. 8 d. Analysis of the Court s Opinion The holding with regard to the implied agreement to enjoy the income from the property transferred adds little, if anything, to what most practitioners already knew. Many of the same bad factors present in earlier cases were also present in Turner. Added to those factors are testimony by the children that Thompson s requests for distributions would be satisfied and correspondence to and from the advisors assuring the family that nothing would really change. In addition, the loans to family members and special allocations of income from real estate investments to the contributing partner were not present in other cases dealing with 2036(a)(1). Furthermore, the case sheds no additional light on the 2036(a)(2) issue, the right alone or in conjunction with any other person to designate the persons to possess or enjoy the property or the income from the property. Although the IRS raised the issue in its reply brief, the Third Circuit, unlike Judge Cohen in Strangi II, declined to deal with that issue because it found 2036(a)(1) applied. However, did the extensive discussion of the bona fide sale exception, both by the deciding judge and the concurring judge, give practitioners any clear guidance on when the exception would apply? In what respects did the Third Circuit s analysis differ from the Fifth Circuit s analysis in Kimbell? It seems clear that Judge Scirica did not believe that the adequate and full consideration prong of the bona fide sale exception was satisfied simply because the contributing owners received a pro rata interest in the entity based upon the fair market value of the assets each contributed. This was the position taken by the Tax Court in Stone and the Fifth Circuit in Kimbell. He believed that the decedent had to have the potential of realizing some benefit from the creation of the entity besides tax savings in order to for the decedent to receive an adequate and full consideration when value of the entity interest received by the decedent was less than the value of the transferred assets as a result of the discounts for lack of control and marketability. Judge Greenberg went further in his concurring opinion. He would never find adequate and full consideration in such a case, but would not apply 2036(a) to routine commercial circumstances. He believed that the court s opinion here should not discourage transfers in ordinary commercial transactions, even within families. He goes on to make the statement quoted earlier about not impeding the socially important goal of accumulation of capital for commercial enterprises. Judge Scirica agrees with Stone and Kimbell that the bona fide sale prong of the exception does not require an arm s-length transaction, nor negotiations among the parties, especially when the value is objectively determined, such as by an 8 101 F.3d 309 (3 rd Cir. 1996). 6
independent appraisal. He believes that heightened scrutiny of intra-family transfers, rather than a uniform prohibition on transfers to family owned entities, will prevent the mischief that may arise in the family estate planning context. Nevertheless, he states that while a bona fide sale does not necessarily require an arm s-length transaction, it still must be made in good faith. To him good faith means that the transfer must provide the transferor some potential for benefit other than the potential estate tax advantages that might result from holding assets in an entity. While operating a legitimate business may provide a sufficient basis for finding a good faith transfer, if the only discernable benefit is tax savings, the sale is not bona fide. Consequently, Judge Scirica would require a business or nontax purpose in order to satisfy both the adequate and full consideration test and the bona fide sale test of the exception. Judge Greenberg, in his concurring opinion, does not offer additional guidance on the bona fide sale test, perhaps because he would never find adequate and full consideration when the entity interests received by the decedent are discounted, but would evidently exclude routine commercial transactions from the application of 2036(a). According to the Fifth Circuit in Kimbell, the bona fide sale test is satisfied as long as the transferor actually parted with her interest in the transferred assets and the partnership actually parted with the interest issued in exchange. It did, however, in holding that the transfers in that case were bona fide, list four facts that supported the taxpayer s position: There was no commingling of funds; formalities were followed; the assets included working interests in oil and gas properties; and there was credible testimony concerning the nontax business reasons for forming the partnership. The Tax Court in Stone, in finding the transfers were bona fide, also listed a number of favorable facts, including the active management of the assets after they were transferred. Note that the Fifth Circuit, in affirming the Tax Court s decision in Strangi II, refined the test as articulated in Kimbell by adding the requirement that there be a legitimate nontax reason for forming the entity. e. Effect on Planning The Third Circuit s opinion in Turner should give pause to those who believed that, based on the Kimbell decision, it would be easy to satisfy the bona fide sale exception. Even the Court in Kimbell emphasized the nontax reasons for Mrs. Kimbell s formation of the limited partnership. If the only reason that the business entity is created is to save estate taxes, the bona fide sale exception may not apply. The Court will then turn to whether the decedent retained a right to the income or, in conjunction with any other person, the right to control the enjoyment of the income. While a legitimate business purpose, such as the Court found in Church, should clearly go a long way to satisfy the bona fide sale exception, hopefully other legitimate nontax reasons that are supported by the facts in the case should also be sufficient to invoke the bona fide sale exception, provided the decedent received a pro rata partnership interest, as the decedent did in Church, Stone, and Kimbell. 7
2. Estate of Bongard v. Commissioner, 124 T.C. No. 8 (March 15, 2005) a. Facts In 1980, decedent incorporated Empak Inc. In 1984, decedent married Cynthia Bongard. He had four children by a prior marriage and she had one child by a prior marriage. In 1986, decedent formed the ISA Trust for the benefit of his children and his wife s child and funded the trust with shares of Empak stock. In 1991, Empak incorporated Empak International, Inc. as a wholly-owned subsidiary, and then, pursuant to a joint venture agreement, sold an interest to an unrelated foreign corporation. Between 1991 and 1994, ISA Trust made six distributions of shares of Empak stock to specific beneficiaries. After each distribution, Empak redeemed the shares from the distributee for cash. On January 30, 1996, WCB Holdings, an LLC, was established, but was not capitalized until December 28, 1996, when the decedent and ISA Trust transferred their respective shares of Empak stock to WBC Holdings in exchange for membership units, which were divided into Class A Governance, Class A Financial, Class B Governance, and Class B Financial units. Only the Class A Governance units had voting rights. Earlier in the year, Empak had a stock split greatly increasing the number of shares held by the decedent and ISA Trust and Empak incorporated Emplast, Inc., capitalizing it with some of Empak s non-core assets. Later that year Empak distributed the Emplast shares to decedent in exchange for some of his Empak shares, which were cancelled. On December 29, 1996, decedent and ISA Trust created the Bongard Family Limited Partnership ( BFLP ). Decedent transferred all of his WCB Holdings Class B Membership units to BFLP in exchange for a 99% limited partnership interest and ISA Trust transferred a portion of its WCB Holdings Class B Membership units to BFLP in exchange for a 1% general partnership interest. The following year, in 1997, Empak International merged into Empak, which resulted in the foreign corporation s receiving an ownership interest in Empak and the cancellation of Empak s shares in Empak International. On March 15, 1997, decedent transferred WCB Holdings Class A Membership units to three trusts he had previously established, one for the benefit of his children, one for the benefit of his grandchildren, and a QTIP trust for the benefit of his wife. On December 10, 1997, decedent gave his wife a 7.72% limited partnership interest in BFLP and entered into a post-marital agreement with his wife. Decedent died unexpectedly on November 16, 1998 at the age of 58. Beginning in 1995, decedent and his advisors began planning for what was referred to as a corporate liquidity event, which would provide Empak with the necessary capital to remain competitive. A corporate liquidity event included either a public or private offering of Empak stock. The plan included the creation of a single holding company to hold all the Empak stock owned by the Bongard 8
family. Several years later, as indicated above, WCB Holdings was created for this purpose. Other events, some discussed above, including the incorporation and spin off of Emplast, were also part of the business plan. However, the creation of BFLP was apparently not part of the plan. After the decedent died, Empak and Fluoroware, decedent s former employer, were consolidated into Entegris, Inc. Entegris completed an initial public offering in July 2000, consummating the business plan. In a letter dated December 28, 1996, the decedent explained to his children that the formation of WCB Holdings and BFLP provided, among other things, a method for giving assets to the decedent s family members without deterring them from working hard and becoming educated, protection of his estate from frivolous lawsuits and creditors, greater flexibility than trusts, a means to limit expenses if any lawsuits should arise, tutelage with respect to managing the family s assets, and tax benefits with respect to transfer taxes. According to the facts as stated in the opinion, from its inception until decedent s death, BFLP did not perform any activities, never acted to diversity its assets, and never made any distributions. The WCB Holdings membership units in BFLP were non-voting, and decedent had the right to determine whether the Empak shares held by WCB Holdings would be redeemed. WCB Holdings did not redeem any of its Class B Membership units held by BFLP before decedent s death. The estate tax return for the decedent s estate showed the combined value of the decedent s WCB Holdings Class A Membership units and his 91.28% limited partnership interest in BFLP to be $45,523,338. The IRS issued a notice of deficiency that determined a federal estate tax deficiency of $52,878,785, based on its determination that shares of Empak stock transferred to WCB Holdings were includable in his gross estate because he had retained 2035(a) and 2036(a) and/or (b) rights and interests in the transferred property. The value of the Empak shares totaled $141,621,428, resulting in an increase in the value of the gross estate by $96,098,120. Prior to trial, the IRS amended its answer to seek an increased deficiency based upon an increase in the starting price of Empak shares, resulting in a revised increase in the value of the decedent s gross estate. b. The Court s Opinion The estate argued that the decedent s transfer of Empak stock to WCB Holdings and decedent s transfer of WCB Holdings Class B Membership units to BFLP: (1) did not constitute transfers under 2036, (2) satisfied the bona fide sale exemption, and (3) did not include the retention of a 2036 interest. The Tax Court concluded that the decedent s transfer of his Empak stock to WCB Holdings and the decedent s transfer of his WCB Holdings Class B Financial and Class B Governance units to BFLP, were included in a broad interpretation of the term transfer. The Tax Court then turned to the bona fide sale exception. It noted that in the context of family limited partnerships, the bona fide sale for adequate and full 9
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. The significant nontax purpose must be an actual motivation, not a theoretical justification. By contrast, the bona fide sale exception is not applicable where the facts fail to establish that the transaction was motivated by a legitimate and significant nontax purpose. The list of factors that support such a finding includes the taxpayer s standing on both sides of the transaction, the taxpayer s financial dependence on distributions from the partnership, the partners commingling of partnership funds with their own, and the taxpayer s actual failure to transfer the property to the partnership. The Tax Court also noted that the Fifth Circuit, in Kimbell v. United States, 371 F.3d 257 (5 th Cir. 2004), disagreed with the District Court s determination that a sale between members of the same family cannot be a bona fide one, although the transaction is subject to heightened scrutiny to ensure that it is not a sham or disguised gift. The Fifth Circuit also found that the decedent s transfer met the bona fide sale exception because the partnership was in actual possession of the assets transferred, partnership formalities were satisfied, the decedent retained sufficient assets outside of the partnership to meet her personal needs, some of the assets contributed were active business assets, and she had nontax business reasons for creating the partnership. The nontax business reasons included, among others, the protection of the taxpayer from personal liability with regard to the oil and gas properties contributed, the pooling of all the decedent s assets to provide greater financial growth than splitting the assets up, and the establishment of a centralized management structure. Additionally, the Fifth Circuit rejected the Commissioner s argument that the LLC s interest was de minimus since it found no principle in partnership law that required partners to own a minimum percentage interest in the partnership for the entity to be legitimate. The Tax Court also referred to the Third Circuit s holding in Turner v. Commissioner, 382 F. 3d 367 (3 rd Cir. 2004), aff g Estate of Thompson v. Commissioner, T.C. Memo 2002-246, where it found that neither of the partnerships involved engaged in transactions rising to the level of legitimate business operations that provided the decedent with a substantive nontax benefit. Other than favorable estate tax treatment resulting from the change in form, the Third Circuit was unable to identify a legitimate and significant nontax reason for the transfer. In the case at hand, the Court stated that it had to separate the true nontax reasons for the entity s formation from those that merely clothed transfer tax savings motives. Legitimate nontax purposes are often inextricably interwoven with testamentary objectives. 10
The Court noted that in 1995, the decedent, while in good health, met with his advisors to discuss how Empak could remain successful and competitive. As a result, a memo was drafted and a checklist created detailing the specific steps of the plan to position Empak for a corporate liquidity event. Many of the steps in the checklist were completed, including the transfer of Empak stock held by the decedent and ISA Trust to WCB Holdings in exchange for membership interests proportionate to the number of Empak shares they had contributed. Because decedent was in good health until his sudden death in 1998, his health was not a reason to accelerate the completion of the steps. In addition, the positioning and structuring of Empak to facilitate a corporate liquidity event was also beneficial for decedent and ISA Trust, because the value of the shares was maximized by positioning Empak to attract potential investors and the potential market for Empak shares was increased. These facts together supported the fact that positioning Empak for a corporate liquidity event was a legitimate and significant nontax reason that motivated the Empak shareholders to create WCB Holdings. The Tax Court noted that the bona fide sale exception has not been limited to transactions involving unrelated parties as the IRS argument implied. The Tax Court stated: It is axiomatic that intrafamily transactions are subjected to a higher level of scrutiny, but this heightened scrutiny is not tantamount to an absolute bar. Based on the facts, the Tax Court could not hold that the terms of the transaction differed from those to unrelated parties negotiating at arm s length. The Tax Court also rejected the IRS argument that the formation of WCB Holdings was not a bona fide sale because there was not a true pooling of assets. The creation of WCB Holdings was part of a much grander plan to attract potential investors or to stimulate a corporate liquidity event to facilitate Empak s growth. The members capital accounts were properly credited and maintained, WCB Holding s funds were not commingled with the decedent s, and all distributions during the decedent s life were pro rata. The amalgamation of these facts demonstrated that creation of WCB Holdings resulted in a true pooling of assets. The Tax Court determined that the respective assets contributed by the members were properly credited to their respective capital accounts and distributions required a negative adjustment in the distributee member s capital account. Most importantly, the Tax Court found the presence of a legitimate and significant nontax business reason for engaging in the transaction. It rejected the IRS argument that the decedent did not receive full and adequate consideration, because it had contributed 86.31% of Empak s outstanding stock without receiving a control premium for his contribution. The rejection was based on the fact that the decedent, although not the manager of WCB Holdings, held an 86.31% interest in the Class A Governance units and had the power to remove the manager and appoint himself as the manager and to take any action the manager himself could take. Consequently, the Tax Court held that the decedent s transfer of Empak stock to WCB Holdings satisfied the bona fide sale exception of 2036(a). Therefore, it 11
was not necessary to determine whether the decedent retained a 2036(a) or (b) interest in the transferred property. The holding also precluded the application of 2035(a) to the decedent s gifts of WCB Holdings Class A Membership units to the three trusts as they were outright gifts, not gifts of retained 2036(a) interests. The Tax Court reached a different conclusion with regard to the BFLP. It noted that the BFLP agreement provided that the partnership was created to acquire, own and sell from time-to-time, stocks, including closely held stocks, bonds, options, mutual funds and other securities. The estate asserted that BFLP was established to provide another layer of credit protection for the decedent and to facilitate the decedent s post-marital agreement with his wife. The decedent s advisors also testified that the partnership was established, in part, to make gifts. However, the only gift that was made before the decedent died was a 7.72% interest in the BFLP to his wife. According to the Tax Court, the record did not support that nontax reasons for BFLP s existence were significant motivating factors. The formation of WCB Holdings had already eliminated direct stock ownership in Empak and allowed decedent to make gifts without diversifying the direct ownership of Empak. One of the alleged purposes for forming the BFLP was to continue the decedent s gift giving. Although the decedent, in fact, made numerous gifts after the formation of BFLP, all of the gifts were of WCB Holdings Class A Membership units, except for the one gift to his wife. Both at the time of BFLP s formation and at the time of his death, any additional gifts decedent had contemplated were speculative and indefinite at best. There was no immediate or definite plan for such gifts. Such intent is not sufficient to establish that the transfer of Membership units to BFLP was motivated by a significant nontax reason. Note that this indicates that the Tax Court might treat gift giving as a significant nontax reason. The estate s credit protection argument was also unpersuasive because WCB Holdings already served this function for the decedent. Any additional benefit provided by BFLP was not significant to the transfer to the BFLP because decedent s Class A Governance Membership units, with their voting power, remained in WCB Holdings with only the protection provided by that entity. The Tax Court also gave no credence to the estate s argument that the decedent wanted to create BFLP because of the greater flexibility it would provide him as compared to the trusts he had previously created. The decedent created three trusts within days of BFLP s creation, which were funded just months after BFLP was created with very large gifts. Clearly, the decedent was not adverse to establishing trusts, nor was there evidence that would establish how a limited partnership interest in BFLP provided decedent with greater flexibility than he already possessed by holding WCB Holdings Membership units outright. Finally, BFLP did not perform a management function for the assets it received. It never engaged in any business-like transactions, its only ownership interest was in WCB Holdings, and 99% of that interest was contributed by the decedent. 12
BFLP never attempted to invest or diversify its assets. As a practical matter, the decedent did not receive any benefit beyond transfer tax savings from placing his WCB Holdings Class B Membership units in BFLP. Consequently, the decedent recycled the value of his WCB Holdings Class B Membership units by contributing them to BFLP. Under these facts, the decedent s transfer of WCB Holdings Class B Membership units to BFLP did not satisfy the bona fide sale exception. Note that there is no separate discussion of the full and adequate consideration in money or money s worth prong of the bona fide sale exception. The Tax Court then turned to whether the decedent retained a 2036(a) interest in BFLP. Decedent s control over whether BFLP could transform its sole asset, the Class B WBC Holding s Membership units, into a liquid asset, demonstrated the understanding of the parties involved that the decedent retained the right to control the units transferred to BFLP. The Tax Court dismissed the estate s argument that the general partner s fiduciary duties prevented a finding of an implied agreement because it was overcome by the lack of activity following BFLP s formation and BFLP s failure to perform any meaningful functions as an entity. Consequently, an implied agreement existed that allowed decedent to retain enjoyment of the property held by BFLP and therefore the decedent s gross estate included a value of the WCB Holdings Class B Membership units held by BFLP on decedent s death that was proportionate to the decedent s 91.28% limited partnership interest. In addition, because the value of the limited partnership interests given to his wife would have been included in his estate under 2036(a), they are included in his estate under 2035(a) because he died within three years of the transfer. In valuing the WCB Holdings Membership units owned by the decedent and included in the decedent s estate under 2036(a) and 2035(a), the Tax Court adopted the parties stipulated discounts, which included a 13% lack of control discount, and a 17.5% lack of marketability discount for both the Class A Membership units and the Class B Membership units, and an additional 5% lack of voting rights discount for the Class B Membership units. The opinion, written by Judge Goeke, was joined by Judges Gerber, Swift, Colvin, Vasquez, Thornton, Haines, Wherry, Kroupa, and Holmes. Judge Gale concurred in the result only. Judge Laro wrote a concurring opinion, which was agreed to by Judge Marvel. Judge Laro believed that, in order to satisfy the adequate and full consideration prong of the bona-fide sale exception, unless the transfer was an ordinary commercial transaction, the value of the partnership interest received must equal the value of the property transferred. Judge Halpern concurred in part and dissented in part. He also believed that the value of the partnership interest received should equal the value of the transferred property and there could be a gift on formation if this was not the case. Finally, Judge Chiechi concurred in part and dissented in part and was joined by Judges Wells and Foley. She believed that the majority erred in finding an implied agreement that the decedent would continue to enjoy the property transferred to the BFLP, citing extensively the Byrum case. 13
c. Analysis of the Court s Opinion This case presents a good example of when the use of an entity for achieving estate planning objectives will and will not be respected by the courts. Although the Tax Court s reasoning concerning the inclusion of the BFLP assets in the decedent s estate seems weak, particularly because it focuses on the decedent s retention of control in applying 2036(a)(1) rather than on an implied agreement to enjoy the income from the transferred assets, nonetheless, the nontax reasons for forming BFLP were substantially less persuasive than those for forming WCB Holdings. As the following cases demonstrate, the lack of a substantial nontax reason for forming the entity will make it impossible to satisfy the bona fide sale exception, leaving the taxpayer to prove the lack of an implied agreement to enjoy the income from the transferred assets or the lack of the retention of control over the enjoyment of the income from the transferred assets. 3. Estate of Bigelow v. Commissioner, T.C. Memo 2005-65 (March 30, 2005) a. Facts Mrs. Bigelow died August 8, 1997, at the age of 88. At the time of her death, she owned through a revocable trust and in her own name a 45% interest in a limited partnership that owned rental residential real estate. The partnership was formed in December 1994, when the decedent s trust transferred property, worth $1,450,000 at the time, to the partnership in exchange for 14,500 B limited partnership units. The decedent also had previously contributed $500 to the partnership in exchange for a 1% interest as a general partner, and her trust and her three children each contributed $100 in exchange for one A limited partnership unit. The only apparent difference between A units and B units was that the A units were issued for cash and the B units were issued for property. At the time the partnership was formed, the decedent s total annual income was $9,300 and total annual expenses $8,350. After the transfer of the property to the partnership, her income was reduced to $5,800 and her expenses were reduced to $7,000, creating a deficiency of $1,200 ($7,000 - $5,800). In the following year, her income was further reduced by $1,500, and the year after that by another $2,100, creating a shortfall of $4,800. At the time the decedent transferred the property to the partnership, it was subject to two loans, one for $350,000 and the other for $100,000. Although the property remained subject to the loans, the decedent remained personally liable on the loans. After the transfers to the partnership, 40 transactions occurred between the partnership and the decedent s trust for the purpose of providing decedent s living expenses and other reasons. Although the partnership had not assumed the debts, it paid $2,000 a month on the $350,000 loan. After the partnership was formed, the decedent made a series of gifts to her children and grandchildren of interests in the partnership, reducing her interest to 45%. The gifts were valued taking into account a 31% discount for lack of marketability. The 45% limited partnership interest included in the 14
decedent s estate was valued for estate tax purposes by taking into account a 37% discount for lack of marketability. The partnership did not properly maintain records of partnership capital or the partners capital accounts. The balance sheets incorrectly showed the $350,000 loan as a liability of the partnership. None of the partners Schedules K-1 accurately reflected the partners capital account, e.g., decedent s capital account reported on the Schedule K-1 never reflected the decedent s trust s contribution of the property to the partnership. The partners did not comply with all the terms of the partnership agreement. The IRS contended that the value of the property transferred to the partnership should be included in the decedent s estate under 2036(a)(1), 2036(a)(2) and 2038. Because the Court held that the property was included in the decedent s estate under 2036(a)(1), it did not deal with the application of either 2036(a)(2) or 2038. b. The Court s Opinion The Court found that there was implied agreement that the decedent would retain the right to income from the property transferred to the partnership during her lifetime, based on the fact that after the transfer the decedent required distributions from the partnership in order to continue to pay her expenses and the partnership continued to make the monthly payments on the loan that the decedent was personally liable for. In addition, there were no distributions to any of the other partners during her lifetime. Finally, both the $350,000 loan and the $100,000 loan remained secured by the property that the decedent had transferred to the partnership. The Court also found that the transfer of the property in exchange for 14,500 B units in the partnership was not a bona fide sale for adequate and full consideration. To constitute a bona fide sale for adequate and full consideration, the transfer of the property must be made in good faith. Transactions between family members are subject to heightened scrutiny to ensure that the transaction is not a disguised gift. First, the Court noted that the transfer of the property impoverished the decedent. Second, the parties failed to respect the partnership formalities. Finally, there was no potential nontax benefit to the decedent. The estate argued that there were three nontax purposes for creating the partnership. First, the estate maintained that the partnership was formed to provide legal protection from creditors. However, since the decedent s revocable trust was the general partner of the limited partnership, and therefore was personally liable for the liabilities of the partnership, limiting the liability of the decedent s trust was not a purpose for forming the partnership and transferring the property to it. 15
Second, the estate contended that the partnership provided continuity of management for the property. The Court disagreed because there was no change in the continuity of management after the transfer of the property to the partnership because the partnership would terminate when the decedent s trust terminated. Because the decedent s trust was the general partner, the transfer achieved no additional continuity. Third, the estate contended that it was more efficient for the decedent to give her children and grandchildren interests in the partnership than to withdraw small undivided interests in the property from her trust and give them to her children and grandchildren by deed. However, the Court held that a transfer made solely to reduce taxes and to facilitate gift giving is not considered in this context to be made in good faith or for a bona fide purpose, citing Turner v. Commissioner, 382 F. 3d 367 (3 rd Cir. 2004), aff g Estate of Thompson v. Commissioner, T.C. Memo 2002-246. The Court also rejected the estate s contention that the transfer was a bona fide sale for adequate and full consideration under the analysis in Kimbell v. United States, 371 F.3d 257, 265 (5th Cir. 2004). The Court cited five differences between the facts in Kimbell and the facts in the case at hand. First, the decedent s trust did not part with all of its interest in the property because it continued to secure the obligations of the decedent and the trust to repay the bank loans. Second, because there was no potential benefit for the decedent or her trust stemming from the transfer of the property to the partnership, the value of the partnership interest received by the decedent s trust was not equivalent to the value of the property transferred. Third, because the general partner in Kimbell was a limited liability company, the transfer of the property did provide a shield from liability, while the trust, as general partner, remained personally liable. Fourth, Mrs. Kimbell retained more than $450,000 in assets outside of the partnership for her support, whereas in the present case the decedent did not retain enough assets to support herself. Fifth, Mrs. Kimbell did not make continuous transfers between her personal assets and the partnership, while there were 40 transactions between the partnership and the decedent s trust between the time the partnership was created and decedent died. The Court concluded that the decedent and her children had an implied agreement that the decedent could continue during her lifetime to enjoy the economic benefits of, and retain the right to the income from, the property after she conveyed the property to the partnership, and that the transfer was not a bona fide sale for adequate and full consideration. Consequently, the full value of the property was included in the decedent s gross estate. c. Analysis of the Court s Opinion This case fits in the pattern of earlier cases where the formalities were not followed and the decedent clearly could not survive without disproportionate distributions from the partnership. Somewhat disconcerting is the Court s 16