Summer is nearly over, and life is good - but the tax litigation over FLPs and LLCs has continued the past few months, both in estate and gift tax cases. Of particular interest are the several cases involving IRS use of the step transaction and IRC Sec. 2511 "indirect gift" arguments to eliminate valuation discounts for gifts of FLP/LLC interests shortly following formation of the entity. In addition, following on the Jorgensen decision in the Tax Court (see my April 21st newsletter), we have new decisions dealing with the estate tax consequences of FLP/LLC plans.
As the year 2009 moves into its final several months, Congress still has not acted on so-called "estate tax reform". Especially with the proposed valuation discount restrictions contained in the Pomeroy Bill, HR 436, it is important to consider entity and discount planning now wherever appropriate. The continuing national recession and low interest rates makes now an especially good time for wealth shifting within families.
I. Upcoming CPE Presentations -
I have two more Westerncpe Resort Conferences this year, one in New Orleans where I teach 6-hour courses on November 18 and 20; the other in Las Vegas where my presentations are on December 2nd and 3rd. One course is "Hot Topics in Estate Planning" and the other is "Tax, Financial and Estate Planning for Family Business and Investment Entities." Readers of this newsletter interested in these courses can check them out at www.westerncpe.com.
In addition, my periodic webcasts, beamed from right here in Idaho on the Middle Fork of the Clearwater River, are scheduled once again for the Fall by CPELink (see www.cpelink.com). These 4 courses are being presented on September 25, October 13, November 6 and November 11 - each with 4 hours of CPE credit and loads of materials for participants in an interactive webcast format. The above two courses constitute two of the presentations, with the other two being on Valuation and on FLPs/LLCs specifically. The webcast format is a most convenient and economical way to get CPE.
II. The Step Transaction/Indirect Gift "Silver Bullet" -
In 2008, Judge Halpern of the Tax Court issued two opinions on FLP gift tax cases, one being Bianca Gross v. Commissioner, T.C. Memo. 2008-221, and the other was Holman v. Commissioner, 130 TC No. 12 (2008). I commented on these cases in earlier Newsletters, available in the Archive section of my website. Essentially, what Judge Halpern presented was a requirement for the senior persons who form the FLP or LLC, and then fund same with assets, to have for an indeterminate amount of time (dependent on volatility of the investment assets contributed to the entity) a risk of economic loss prior to gifting interests in the entity. This was perceived by the court to be necessary to avoid IRS success in raising the alternative arguments of Sec. 2511 "indirect gift" and the judicial argument of "step transaction". In one case, where Dell Computer stock was transferred to the entity, a 6 day delay was sufficient, and in the other, involving marketable securities, an 11 day period was acceptable to the court. But Judge Halpern warned in a footnote to each opinion that less volatile assets (e.g. real estate) might well require a longer period between formation/funding and gifting (or sale of interests to family members).
This development, even though only the views of a single Tax Court Judge, has caused a great deal of concern in the estate planning community. It is to be expected that IRS will push this "silver bullet" issue in gift tax cases, especially where there is a quick succession of events, from formation of the FLP or LLC to the gift or sale of entity interests. It would appear the court failed to consider the state law issues involving such entities or the federal law principle that gifts must be valued considering the specific property interest transferred without full consideration in money or money's worth.
And now we come to the three (3) very recent cases dealing with the same gift tax issue - i.e. is the gift (or sale) of an FLP or LLC interest or, in reality, is it a gift of the underlying assets owned by the entity! These cases are two (2) Washington U.S. District Court gift tax refund cases and the reviewed opinion of the Tax Court (albeit on a preliminary issue, whether a single member LLC can be successfully used). Following are brief summaries of these cases, all worthy of a read by practitioners:
1. William and Stacy Linton v. U.S. - Western District of WA, USDC, 7/1/09, No. 2:08-cv-00227.
This is a gift tax refund suit in which the court granted the Government's motion for summary judgment against donor plaintiffs. The basis for granting the motion first was the IRC Sec. 2511 "indirect gift" issue and second the "step transaction" argument raised by the Service. There were virtually simultaneous formation of the family LLC, the funding thereof with real estate an marketable securities, and finally gifts of LLC interests. Therefore, the gift values were based on asset values without any valuation discounts for the equity interests actually transferred!
In late 2002 Mr. Linton formed a single-member LLC under State of Washington law. Then, on January 22, 2003, lots happened, including: (1) funding the LLC with investment assets, (2) gifting Mr. Linton's wife a 50% interest in the LLC (thus, no longer a single-member LLC), (3) creation of irrevocable trusts for each of the four Linton children with William's brother as Trustee, (4) assignment of 22.5% in member interests to each trust (thus, the senior Lintons retained only 10% in member interests).
The District Court, after a thorough analysis of prior cases (including those referenced above), found there was no material fact in dispute, i.e. that it was rather clear (in spite of the plaintiffs' counsel attempting to convince the court the gifts really took place later that January 22nd) everything occurred on the same day, and it was uncertain in what order the transactions actually took place!
2. David and Susan Heckerman v. U.S. - Western District of WA, USDC, 7/27/09, No. 2:08-cv-00211.
With a different District Court Judge, this gift tax refund case ended up with the same result, the Government's motion for summary judgment in its favor was granted as to the simultaneous contribution of substantial cash (actually mutual fund account interests, deemed equivalent to cash) and gifts to children's trusts of LLC member interests, i.e. 2511 indirect gifts of the cash and thus no discounts for LLC interest gifts. Here, however, the contribution of substantial real estate to the same LLC 2 weeks prior to the mutual fund contributions and gifts was allowed to stand and result in discounts to that extent.
No material issue of fact was found to exist regarding the sequence of events in this case either, there being determined no credible evidence was presented as to what took place first. In addition, the court accepted the Government's alternative "step transaction" argument, after analyzing the three separate theories for applying the step transaction principle, namely, the binding commitment test, the interdependence theory, and the end result theory. The court found the latter two tests or theories were applicable to the facts here, and the 2008 Tax Court opinions expressly were found to be distinguishable on their facts.
3. Pierre v. Commissioner, 133 TC No. 2 (8/24/09).
This case involves a donor mother wanting to provide financial security for her son and granddaughter, but in a manner that insures family wealth will be kept intact and safe from marital dissolution issues. Gifts and sales of interests in a single-member LLC formed under Texas law were made to two irrevocable trusts 12 days after the LLC was created and funded with over $4 million in cash and marketable securities. The specific issue covered in this opinion was whether valuation discounts were possible where a single-member LLC was involved. It would seem obvious that, on transferring interests to the trusts, the single-member LLC status was no longer existing. However, a split 10-6 opinion of the Tax Court in a reviewed opinion contained many views of the individual judges and combinations of judges as to whether the "check-the-box" Regulations, which treat the single-member LLC as a "disregarded entity for tax purposes" in effect meant that, for gift tax purposes, the underlying assets were transferred, not LLC member interests. Again, it would appear that Texas law should govern!
The majority opinion concluded that the "check-the-box" Regs did not prevent valuation discounts for gift tax purposes. In this case, the mother gave a 9.5% interest to each trust, and then sold to each trust a 40.5% interest for a secured promissory note, with a 30% valuation discount being claimed. Thus, 100% of the LLC equity was transferred to the trusts.
In footnote 3 to the court's opinion, other issues were left to another day! - "In this opinion, we decide only the legal issue set forth above (involving the single-member LLC). The following issues were argued by the parties but will be addressed in a separate opinion: (1) whether the step transaction doctrine applies to collapse the separate transfers to the trust an (2) the appropriate valuation discount, if any." So stay tuned for the "final score" in this case!
III. Two Recent FLP Estate Tax Cases -
1. Estate of Valeria M. Miller v. Commissioner, T.C. Memo. 2009-128 (5/27/09).
An interesting aspect of this estate tax case involving an FLP is that one set of transfers to the entity was accepted by the court, while the later, second set of transfers was not, i.e. for IRC Sec. 2036(a) purposes. So the stipulated 35% valuation discount for FLP interest transfers worked as to asset transfer #1, and did not as to asset transfer #2. The court details the facts involving each set of asset transfers, focusing on the "driving force" behind the FLP formation and separate asset transfers.
Judge Goeke considered the FLP to be an effective vehicle to continue the predeceased spouse's long-standing and detailed management program for marketable securities. This supported the decedent surviving spouse's FLP formation and the appointment of the parents' oldest son as the manager, continuing the father's securities portfolio management program and increasing the investment activity. The son testified he spent 40 hours per week in managing the portfolio, which was performed through his own management entity.
The first set of asset transfers were found valid by the court, with the statement that the "driving force" there was to continue the management of the family's securities under the father's management program. However, the second set of asset transfers, which took place after mother became very ill and just before her death, were found to have "driving forces" being the decline in decedent's health and the desire to reduce her taxable estate via discounts. Thus, 2036(a) was applied to this second set of transfers and no valuation discounts were allowed. One can only speculate as to why the family did not place all the securities into the FLP at the outset!
This opinion is helpful in that it indicates that a strong and evident purpose of active management of passive investment assets may well be a sufficient nontax purpose under Secs. 2036(a) and 2038 to support the entity's viability and thus those discounts supported by credible appraisal evidence.
2. Keller, et al. v. U.S., U.S. District Court, TX, No. V-02-62 (August 20, 2009).
Here we have an estate tax refund suit brought by the co-executors of the Estate of Maude O'Connor Williams to recover estate taxes, based primarily on claimed valuation discounts for limited partnership interests owned by two trusts includable in decedent's gross estate. The court states that "The formation of the limited partnership is at the center of this controversy." Certainly, this was the case, since partnership funding had not been completed at decedent's death and the executors assumed that the partnership plan was not effective - that is, until one of the co-executors attended a seminar on estate planning during which the taxpayer victory in Church v. U.S., 2000 WL 206374 (W.D. TX, 2000), with somewhat similar facts, was discussed.
The FLP was created (formed) just days prior to Maude's death (90 years of age), who signed the partnership documents while in the hospital, while the re-titling of the assets to the FLP was not done prior to her death. Over $250 million in cash and securities was involved here!
The co-executors went ahead, after Maude's death and the seminar attendance, and completed the funding of the FLP, filing the 706 with the partnership interest shown therein and claiming a 48% valuation discount. The District Court agreed with the plaintiffs - stating that it was clear from the facts that the decedent intended the investment assets in question to be partnership assets and that such intent is good enough in Texas!
Practitioners of course will want to avoid IRS attacks an ensuing litigation by making certain formation, funding and - likely after some delay - any gifting of entity interests, all are accomplished with supporting documentation and entity operation consistent with the plan.
Hope my readers learn from the discussion of the foregoing cases. Email me should there be any questions or comments.
Owen Fiore
