Notes from the Clearwater - FioreWealthPlanningConsulting

STEP TRANSACTION/INDIRECT GIFT ATTACKS ON FLPs

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

HAS THE TAX COURT GONE TOO FAR? - JORGENSEN DECISION

...Estate Planning a Hot Topic in 2009!

...Congress and the Administration Consider an "Estate Tax Fix"

...Jorgensen v. Commissioner (3/26/09) - Another FLP case


I. Three Converging Reasons for Estate Planning Now!

These three (3) reasons supporting moving ahead now with new and updated estate planning (Family Wealth Planning, my preferred term) are (1) depressed asset values, especially securities portfolios and real estate (which indicates that intra-family transfers make sense), (2) quite low interest rates (and thus the AFR rates used for income and gift tax purposes as minimum rates - e.g. 2.05% per annum on a mid-term, 3-9 years, promissory note), and (3) possible adverse changes in law relating to valuation discounts (see my 2/10/09 newsletter discussion of H.R. 436, the Pomeroy bill).

In addition, with the 2009 $3.5 million per estate exemption from estate tax (note: lifetime gift tax exemption remains at $1 million), many formula type provisions in existing plans should be reconsidered. Flexibility in documentation of estate plans is the key issue.

II. Estate Planning is a Hot Topic - See below my upcoming CPE presentations:

    A. Western CPE Resort Conferences (www.westerncpe.com) - These conferences run usually 5-6 days and are held at various resort locations, often providing family-oriented activities and fun. Each presentation by the faculty runs from 7:30 am - 1:00 pm, leaving the afternoons for independent activities of participants.
       My two (2) courses this year, being presented at six (6) of the conferences, are (1) Hot Topics in Estate Planning (HTEP) and (2) Tax, Financial and Estate Planning for Family Business and Investment Entities (FB). Over the next several months, the presentations are as follows:

    1 - Jackson Hole, WY (Spring Creek Ranch), 5/25 - 5/29 - FB course on May 27th, and HTEP course on May 29th.
    2 - Whitefish, MT (Grouse Mtn Lodge, near Glacier National Park), 7/6 - 7/10 - FB course on July 8th, and HTEP course on July 9th.
    3 - SunRiver, OR (Sunriver Lodge), near Bend, OR, 7/13 - 7/17 - FB course on July 13th, and HTEP course on July 14th.
    4 - San Diego, CA (Hyatt Regency LaJolla), 7/13 - 7/18 - HTEP course on July 17th, and FB course on July 18th.

    If any of my readers has a question on these presentations or the resort conference format, email me at owen@owenfiore.com. In the Fall, I am at conferences being held in New Orleans and Las Vegas.

    Each course manual has about 100 pages of text materials, in addition to the power point slides used during the presentations, which are intended to be proactive and to involve the participants actively.

    B. CPELink (www.cpelink.com) - This cpe provider is experienced in interactive, live webcasting format for educational presentations, and has arrangements with some 15 state CPA societies across the country - in just a couple of years of operation! From my home office here in Idaho, upstairs in my barn and looking over the Middle Fork of the wild and scenic designated Clearwater River (Hwy 12, at Syringa, for GoogleEarth fans), I present 2 - 4 hour webcasts. The materials are all emailed to participants for downloading, as are the many power point slides used during my webcast. Both I and the participants can provide each other with input, make comments, ask questions.

    The CPELink website has a list of all the webcasts, self-study courses, etc. My upcoming presentations are as follows:

    1 - "CPA Practice Development Opportunities in Estate Planning" (2 hours) - 5/7/09

    2 - "Playing the Valuation Game: Family Wealth Planning and Valuation" (4 hours) - 6/18/09

    3 - "Hot Topics in Estate Planning" (4 hours) - 6/23/09

    4 - "Tax, Financial and Estate Planning for Family Business and Investment Entities" (4 hours) -
          6/30/09

    5 - "Efficient Uses of FLPs, LLCs and S Corporations to Preserve Family Business and Investment
          Wealth" (4 hours) - 8/6/09

Try out one of these webcasts, and you may find it enjoyable and worthwhile - as well as low cost!

III. The "Estate Tax Fix" - Uncertainty Reigns!

The Obama Administration proposed for the estate tax - to head off the 2001 Act 1-year repeal of the estate tax in 2010 with pre-2001 law to come back in 2011 - $1 million exemption, 55% top rate, etc. - making permanent the $3.5 million estate tax exemption and the 45% top rate which are in place for this year 2009.

Several bills have been introduced in Congress already, such as H.R. 498 and H.R. 436. I reviewed H.R. 436 in the last Newsletter -2/10/09. It repeals the upcoming carryover income tax basis rules, makes permanent the $3.5 million estate tax exemption, fixes a 45% top rate (but adds back the prior law 5% surtax on certain large estates), and then provides severe restrictions on valuation discounts on passive asset holding entities and limits on "minority discounts" using a broad attribution rule. These valuation changes, if enacted, would be effective as of date of enactment.

H.R. 498 goes somewhat further in estate tax relief - restoration of the unified credit against gift tax liability, gradually from 2010-2015 increases the exemption equivalent from $3.5 million to $5 million, and thereafter adjusts it for inflation, and also provides for a marital deduction "portability" provision between a married couple's estates.

In early April, as part of the Congressional budget deliberations, the Senate passed a couple of amendments to its budget resolution, perhaps only aspirational in nature - the thrust of these amendments was to propose an estate tax exemption of $5 million and a maximum estate tax rate of 35%; but also to somewhat tie this in with more relief for "Americans earning less than $100,000 per year in addition to amounts assumed in the budget resolution"! - how is this all possible?

So, on estate tax reform or relief, stay tuned! It seems highly unlikely that the estate tax exemption level will go above the $3.5 million or that the maximum rate will go below 45%. Nevertheless, very few estates will be subject to the tax in any event, as statistics have shown with the 2001 Act changes as they have cycled into effect.

Some of the best information on tax legislative developments can be obtained on the American College of Trust and Estate Counsel website, www.ACTEC.org, especially the "Capital Letters" authored by tax lawyer Ron Aucutt, Esq.

IV. Estate of Erma V. Jorgensen v. Commissioner of Internal Revenue, T.C. Memo. 2009-66

This decision was handed down by Tax Court Judge Haines on March 26, 2009, a case involving two (2) FLPs, each of which held substantial marketable securities. There were some "bad facts" involved, but also some good ones indicating the commitment to use of the FLPs for valid wealth management and preservation purposes and not just to claim valuation discounts. In fact, initially the family was not even interested in "discounts". There is some indication, after reviewing the case with estate litigation counsel and reading the trial transcript and the post-trial briefs, that the court in Jorgensen went overboard in its concentration on the FLP as merely a discounting device. See the following quote from the opinion, in which Judge Haines stated that it was "...especially significant that the transactions were not at arms-length and that the partnerships held a largely untraded portfolio of marketable securities."

On the passive asset issue, note that IRC Sec. 704(e), the income tax "safe harbor" for family partnerships, merely requires (1) capital to be a material income-producing factor in the entity, and (2) the donee partners be treated as "real partners". Further, the common and the Treasury Regulations definitions of a "partnership" relate to "business or financial assets".

Generally, it appears that the court in reality is taking IRC Sec. 2036(a) to the extreme, making it virtually impossible to have a passive investment asset holding FLP or LLC qualify as having the prerequisite real and significant non-tax purpose(s) to avoid treating transfer of assets into the entity followed by gifts, etc. as testamentary in nature and to be ignored for estate tax purposes! It will be interesting to see what other judges will say. In fact, in Estate of Anna Mirowski, T.C. Memo. 2008-74, Tax Court Judge Chiechi took a more fact-centered, complete approach, concluding the LLC there was valid for estate tax purposes and that the gifts of non-managing interests should be respected.

For a recent, detailed article on the past 12 years of litigation on FLPs/LLCs used in estate planning see my article in CCH Business Valuation Alert, April, 2009: The Good, the Bad, and the Ugly - FLP and FLLC Wealth Shifting Opportunities and Challenges." A reader wishing a copy of this article should email me with the request for same. Another case, with extremely poor facts and inept lawyering, is Estate of Thelma G. Hurford, T.C. Memo. 2008-378, reviewed in my December 18, 2009 Newsletter.

In the Jorgensen case, the husband, a lawyer and career Air Force pilot, directed the family's financial affairs, gradually and carefully building over a $2 million marketable securities portfolio. Gerald Jorgensen and his wife, Erma, were residents of Virginia and had two (2) children and six (6) grandchildren. The thrust of the first of two FLPs, established in 1995, was to develop a plan that would allow for gift transfers of interests in the portfolio to children and grandchildren (and in fact in the early years, "discounting" was not given a thought!). After Col. Jorgensen died in November, 1996, not one, but two, estate planning lawyers (one in Virginia, and the other in California) emphasized discounts - and their letters, which left much to be desired, were obtained through discovery. Judge Haines seemed to imput to the Jorgensen Family the suggestions of the lawyers, rather than to concentrate on facts involving the family members and their own actions.

Also, the court said that the second partnership, formed after the husband's death by Erma, his widow, was not needed as she could have used the living trust to manage the assets. Query - does not the taxpayer have the freedom to select among various, legal alternatives in managing his or her affairs? The two partnerships were considered needed to track income tax basis in an acceptable way for the securities.

Another disturbing issue is that refusal of the court to grant taxpayer estate's motion to shift the burden of proof on fact issues in the litigation to the IRS (respondent) under IRC Sec. 7491(c). While there are several requirements for shifting the burden of proof, the court merely discarded 7491(c), indicating that it would look at the burden of persuasion - - yet, it appears the court did not take into account evidence (including testimony) as to the bona fide nature of the FLPs, the emphasis on sharing within the family in the assets involved, and the lack of concern about "discounts" as to the first FLP.

Judge Haines went through the litany of non-tax reasons as suggested by the estate, but found none of then to be legitimate and significant under the bona fide sale exception to 2036(a). See my detailed commentary on Jorgensen appearing in Steve Leimberg's email newsletter service - www.leimbergservices.com - Archive Estate Planning Newsletter #1442 (4/8/09), as well as another article, Gassman/Hall, #1443.

What comes out of this latest case, where many of the facts were positively in the decedent's favor, is that there is an uphill battle, unfortunately, in obtaining the benefits for estate tax purposes of FLPs/FLLCs, where passive investment assets are involved,  even though there may be many good reasons for use of such an entity.

It seems that Judge Haines failed to apply the proper and traditional standard of value and somewhat second-guessed the family that owned the assets and appeared to be properly developing a partnership format for wealth management and transfer. That failure coupled with denying the 7491(c) motion by the estate may form the basis for appeal to the 9th Circuit Court of Appeals (which in several cases has reversed the Tax Court for failure to follow proper valuation standards and principles).

Enjoy the Spring and Summer of 2009 - here in Idaho the river is up, the birds are nesting, and finally warm weather has returned. Time to plant flowers, mow the lawn, and enjoy the beauty of nature!

Owen Fiore

2009 - An Important Year for Estate Owners and Estate Planners

...Best Time in Decades to Shift or Transfer Wealth within the Family

...Clouds on the "Valuation Discount" Horizon - H.R. 436

...Estate of Litchfield - Corporate Estate Tax Valuation Tax Court Opinion (1/29/09)


I. 2009 - The Year for Family Wealth Transfers and Updated Estate Planning.

Under current law, but for this year only, the estate tax-free exemption equivalent per estate is $3.5 million in taxable estate value, or $7.0 million per couple if proper marital deduction planning is utilized.Therefore, very few estates will result in Federal estate tax liability; however, this assumes proper Wills and trusts, taking advantage of marital deduction benefits and yet still meeting the clients' goals for ultimate estate distribution. As most planners are aware, the year 2010 is scheduled for a 1-year only repeal of the estate tax, and in 2011 it will come back to 2001 levels (a mere $1 million exemption equivalent and a 55% top rate). Wills and trusts must be flexible enough to take this into account, as well as the hoped for estate tax reform in the new Obama Administration. It appears that continuing, perhaps permanently, the $3.5 million per estate exemption, a 45% rate, and perhaps even "portability" of the exemption to insure $7.0 million in tax-free estate transfers by a married couple may well be legislated this year.

But there is more to planning opportunities this year, relating to intra-vivos or lifetime transfers. For example, the February, 2009 applicable federal rates (AFRs) are extremely low, one thing good about the recessionary economy. The short-term AFR (up to 3 year period in loan or sale) is only .60%, the mid-term (3-9 years) is 1.6+% and the long-term (9 and over years) AFR is but 2.9+%. Thus, an intra-family loan for 10 years can bear interest at only 2.96% per year with a balloon for principal at the end of the 10-year period, thus giving the borrowing younger generation family member (or trust for such person's benefit) 10 years within which to build capital at a much higher rate.

While the gift tax lifetime exemption (beyond annual exclusions of $13,000 per donor, per donee) remains frozen at $1 million ($2 million, married couple), a combination of gifts and loans or sales using the low AFR rates will result in shifting substantial wealth to the younger generations. This is especially valuable in this economy in which, in many cases, a family's wealth base has declined in value by 1/3 - 1/2 when compared to a couple of years ago. So, in addition to the tax-free gifts, loans and sales within the family, there is substantial hoped-for future appreciation that would accrue to the benefit of the younger generations through proper planning now. The low February, 2009 7520 rate likewise allows for effective use of other types of transfers, such as certain charitable trusts and grantor retained annuity trusts (GRATs). Therefore, the current down economy offers opportunities for intra-family transfers - transfer within the family in down economic times, and only sell to unrelated third parties when values are high!

II. Will "Valuation Discounts" be Cut Back by Congress and the Obama Administration?

Washington, D.C. tax lawyer Ron Aucutt's "Capital Letter" (1/20/09) reports on H.R. 436 as a development that has captured surprising attention. (see the ACTEC.org website) Rep. Earl Pomeroy, D. N.D., introduced on January 9th H.R. 436 titled "Certain Estate Tax Relief Act of 2009". This Bill, referred to the House Ways & Means Committee, makes permanent the $3.5 million exemption equivalent, freezes the maximum estate tax rate at 45% (but adds back the old 5% phase-out rate for estates between $10 million and $41.5 million), but does not include anything on marital deduction portability.

In spite of the title of this Bill, it is Section 4 that proposes special valuation rules for "certain transfers of nonbusiness assets", essentially removing them from the entity valuation (both as to minority and marketability discounts) and taxed without discounts as if they had been direct transfers of the nonbusiness assets to the transferee(s). There is no way of knowing what sort of traction H.R. 436 has at this time; however, given its attach on valuation discounts, many planners are rushing to complete gifts of entity interests where the entity owns nonbusiness or passive investment assets, since presently the effective date in the Bill is date of enactment of legislation. Given that prior efforts to cut back valuation discounts were unsuccessful, perhaps it is unlikely H.R. 436 will be enacted. But planners and their clients would do well to review the Bill and watch its progress carefully. This but reinforces the importance of inter-vivos transfers now within the family, as part of an overall update of the estate plan (Family Wealth Plan).

III. Lessons on Appraisals and Available Valuation Discounts - the Litchfield Case

On January 29, 2009, the Tax Court (Judge Stephen Swift) issued its memorandum opinion in the Estate of Marjorie deGreef Litchfield v. Commissioner, T.C. Memo. 2009-21. Note to my readers - a copy of the opinion can be obtained from the Tax Court's website, www.u.s.taxcourt.gov.

Having agreed and stipulated on net asset values of two (2) closely-held investment corporations owned by one family's members, the Estate and IRS litigated the valuation discount issues, including discounts for potential built-in capital gains taxes, lack of control and lack of marketability. Further, IRC Sec. 7491(a) (shifting burden of proof on fact issues to the Commissioner in litigation) was a factor here.

The sequentially applied three (3) valuation discounts involved the Estate's appraiser opining discounts about double that presented by the IRS appraiser. This opinion by Judge Swift sets out a thorough summary of how the "valuation game" is played and the primacy of the court's role as trier of fact. In summary, Judge Swift determined combined discounts that were over 85% of those sought by the Estate itself, the combination thereof ending up being over 40% off the net asset value of each of the corporation's as to the Estate's interests in same. Of course, the discount levels and results in any one case are not authority for discounts in any other case - but the court's analysis remains important.

Litchfield Realty Co. (LRC) and Litchfield Securities Co. (LSC) both were incorporated in the 1920s and had a long history over many decades. Mrs. Litchfield died in 2001, her husband having predeceased her in 1984 and then establishing a Qtip marital deduction qualifying trust. The assets of LRC consisted of crop share (active business) leased farmland plus securities, while the LSC assets were marketable securities. Both corporations were C corporations, until LRC elected Subchapter "S" status January 1, 2000 - with then the special 10-year period commencing for corporate level tax on sales of S corporation assets where the C corporation was converted to S status. LSC remained a C corporation.
The Estate elected the 2032 alternate valuation date, which was 10/17/01. While apparently not a major factor in the valuation here, LRC and its shareholders entered into a restrictive buy-sell agreement (partly to protect "S" corporation status) in 2000. The assets of both corporations, as of the alternate valuation date, were substantially appreciated in basis over cost or other adjusted basis - thus there were substantial unrealized capital gains tax liabilities.

Federal Estate Tax Return (Form 706) and IRS Audit - On the 706, the Estate claimed combined discounts totaling 54.9% of its 40+% minority interest in LRC and 52.7% for its 23% interest in LSC. After over two (2) years of IRS examination of the 706, a 90-Day Letter (statutory notice of deficiency) was issued to the Estate, valuing the LRC and LSC equity interests at over 50% higher than the reported values, for an estate tax deficiency of $6.2 million.

The "Bottom Line" Result - In summary, Judge Swift agreed, after a detailed discussion of Sec. 7491(a), that the burden of proof on the valuation fact issues was to be shifted to respondent IRS; the Estate's expert was correct in his opinions on the discounts both for potential capital gains tax liabilities and lack of control; and finally the court determined toward the midpoint lack of marketability discounts in this case.

The "Valuation Game" - The court pointed out, during its discussion in depth of valuation principles in estate tax cases, "...a court's valuation need not be tied to specific testimony or evidence if it is within the range of values supported by the evidence." And remember here the burden of proof had been shifted to IRS. The "net asset value" of each corporation had been stipulated by the parties; therefore, only the discounts were at issue.

Three (3) Discounts, Sequentially Appled - See my Leimberg Information Services, Inc. (LISI) commentary posted as Estate Planning Email Newsletter - Archive Message #1410 (plus the Paul Hood LISI commentary, Archive Message #1409, and a clarifying posting as #1411), www.leimbergservices.com. These newsletters go into depth on the court's analysis and conclusions.

   

(1) The built-in capital gains potential liability disount ("BIG" discount) - Here the courts have considered and adopted one of two choices - a present value computation of the BIG discount (such as in this case) and the "dollar-for-dollar" discount, such as in Dunn v. Commissioner,  301 F.3d 339 (5th Cir. 2002) and Jelke v. Commissioner, 507 F.3d 1317 (11th Cir. 2007, cert. den. U.S. Supreme Ct., 10/06/08). The present value computation, if credible evidence is available, appears to be a better approach, especially where the projected asset sales also have projected additional appreciation to dates of sale before the p.v. discount is computed. As the result of this approach, in Litchfield, a high percentage of the built-in gain potential liability at the alternate valuation date was allowed here. The court agreed with the Estate's proposed discounts of 17.4% for LRC and 23.6% for LSC.

   

(2) Lack of control discount - in addition - Again, the court agreed with the Estate's appraiser, who concluded this discount should be 14.8% for LRC and 11.9% for LSC. Judge Swift compared the methodology and valuation analysis of both appraisers, and found that the Estate's appraiser performed a more credible job.

   

(3) Lack of marketability discount - again, in addition - Here the court reviewed both appraisal reports and testimony at trial, and disagreed in part with each appraiser. Reviewing the opinion is worthwhile to learn how the court deals with opposing appraisals. In the end, the court concluded lack of marketability discounts of 25% for LRC and 20% for LSC as applied to the Estate's interests therein.

And so here we have one more corporate valuation case to consider in the valuation area. Likely, more will come down this year, and no doubt there will be more FLP/LLC valuation cases (note my archived newsletters of 9/14/08, 10/20/08 and 12/18/08 dealing with both gift and estate tax case opinions).

Proper valuation evidence, by competent appraisers providing credible appraisal reports and testimony, is important. Note that if the 3-year gift tax statute of limitations is to be available, the gift tax return (Form 709) must contain "adequate disclosure" of the gift(s) - meaning usually a credible appraisal report, etc.

As always, I hope that this newsletter provides my readers with worthwhile information. The next newsletter will deal with Buy-Sell Agreements and their impact on gift and estate tax valuation.

Regards to all,

Owen Fiore

ESTATE OF THELMA G. HURFORD - Two Estate Plans Destroyed!

Merry Christmas and Good Cheer for the Holidays - Let's hope that the year 2009 will see an improvement in the national economy, that peace efforts throughout the world will bear fruit!

Mary Ann and I have much to be thankful for - love and good health truly are important assets to be preserved and enjoyed. We enjoyed a summer small ship cruise in Southeastern Alaska, and of greatest enjoyment, we witnessed our son Mark's marriage to his love, Chelsea - on the beach at Stinson Beach just north of the SF Golden Gate Bridge. Also, my consulting and education activities in 2008 allowed me to apply my decades of experience in estate planning - more of the same is anticipated in 2009.

My next newsletter, in January of 2009, will focus appropriately on the impact on estate planning of the current recession involving much loss of wealth for many families. In addition, the incoming Obama Administration, while having many issues to consider, most probably will get into the tax arena big time -
even the gift and estate tax area(especially with the 2001 Act coming to the point of the 1-year repeal of the Federal estate tax in 2010). Watch for the January newsletter as it will provide suggestions for client communications with clients on estate plan review and update, new practitioner resources to do a better job in estate planning, and as always, recent developments.

In January, on January 13th and 14th specifically, I again am online in a live webcast sponsored by CPE Link - see www.cpelink.com for details of the Valuation and FLP courses to be offered online those days. These are interactive webcasts so lots of give and take is possible.

In 2009, my association with Western CPE continues, which this coming year includes my being a presenter for two (2) days at each of 7 "resort conferences"(35 such conferences are offered by Western CPE each year). My two (2) new courses are as follows: "Hot Topics in Estate Planning" and "Family Business and Investment Entity Planning and Preservation". My presentations will be in such places as Jackson Hole, WY (late May), Whitefish, MT, Sunriver, OR, San Diego, CA(all in July), and then later on in the year(see the schedule at www.westernCPE.com) I will be at resort conferences in Palm Springs, CA, New Orleans, LA, and Las Vegas, NV.

The Hurford Tax Court Opinion (12/11/08) - Hurford v. Commissioner, T.C. Memo. 2008-278, decided by Tax Court Judge Holmes - - FLPs and a Private Annuity Exchange of FLP Interests for an Annuity Disregarded Entirely!

Estate planners - and their clients - should be shocked by the Hurford opinion due principally to the overreaching, sloppy, manipulative advice and actions the estate planning attorney for Thelma Hurford. As we will see in this case discussion, the planner stretched to combine the FLP plan with a private annuity even while his client was suffering from cancer, he failed miserably in execution of his plan in many ways, he obviously disregarded or failed to appreciate the lessons learned over the past dozen years on how properly to use FLP/LLC planning. But Judge Holmes patiently went through some 45 pages of finding of facts and then in his final 40 pages of opinion in the 85 page decision set out a number of issues, finding against the estate in all of them(actually against the estate's attorney, but the estate paid the price!) except on the negligence penalty asserted by the Service. Along the way in this opinion, there are not only lessons to be learned, but also specific factors to consider in how to structure, document, implement and monitor a successful FLP plan - which might well in some fashion even be combined with a private annuity in some instances.

A key to what came after in the opinion is Judge Holmes' first statement therein: "It is a truth universally acknowledged, that a recently widowed woman in possession of a good fortune must be in want of an estate planner." As we will see, this perhaps "tongue in cheek" statement foretells the story of disaster that occurred by the Hurford case. So below, I will review the family and its wealth, the estate plans of husband Gary, who died in April, 1999, and his wife, Thelma, who died in February, 2001, and what went on in the estate planning area, while Thelma was bravely battling cancer. Then we will try and make some sense, in terms of positive planning lessons, out of this latest Tax Court opinion in the most litigious area of Federal transfer taxation.

I should mention that any day now we expect some commentary from Paul Hood and from John Porter on the Hurford case to appear in LISI - www.leimbergservices.com - the outstanding source for alert newsletters on estate planning and other subjects. In addition, FMV Opinions, Inc., www.fmv.com, just released an extensive analysis of the case. Finally, Business Valuation Resources, www.bvresources.com, in its BVWire publication, bvwire.com, alerted its appraiser and other subscribers to the case and its various implications.

In earlier newsletters of mine this past year, I discussed estate tax cases Rector v. Commissioner(1/3/08) and Estate of Mirowski(5/1/08), and more recently several gift tax FLP cases - see newsletters of 9/14/08 and 10/20/08 - - all available in my newsletter archives for your review. But really, in terms of "bad lawyering", Hurford wins the prize! So in the following discussion, keep thinking how you would do the planning differently than Mr. Garza, the hapless planner hit hard by Judge Holmes in his opinion. Judge Holmes criticized Mr. Garza for his "sloppiness", pointed to his having "mangled" the predeceased husband's estate plan(handled by former counsel, quite competent and well respected), and concluded that Garza had "conjured partnership discounts out of the air"! Further, the husband having died in April of 1999, and Garza having filed the 706 estate tax return for his estate, a year later - in spite of obviously substantial value changes in estate assets - Garza merely continued using the 706 values, i.e. without any new evaluations! This case is a must reading for tax professionals, although I warn you it is also sad to see a trusting, perhaps naively so, family served so poorly by a tax professional.

First Estate Tax Case to Refer to IRC Sec. 704(e) in the past 10 years!

In the early 1950s, after judicial confusion about the income tax reality of family partnerships, Congress took over and enacted IRC Sec. 704(e), the family partnership "safe harbor". Here the tests are first is capital a material income-producing factor for the partnership. Then, second, is the "donee partner" (younger generation family member usually, by gift or sale) of a partnership interest treated as a true partner.

At page 71 of an 85 page opinion, Judge Holmes points out that "For an FLP to work, the minority interest holders must at a minimum receive their interests either by gift or by contributing their own assets or services", citing Income Tax Regs. Sec. 1.704-1(e)(1)(iii) - which sets out a bona fide transaction test, i.e. "not a mere sham for tax avoidance or evasion purposes", i.e. that the donee partner must be a real owner of the interest in the entity. So here in Hurford, Judge Holmes points to the income tax area, and then of course continues thereafter by applying IRC Sec. 2036 and 2038 to the situation, as seen below. What he then says is significant: "We have found no legal authority for Garza's position that partners can have a partnership interest with nothing more than a shuffle of paper."(referring to Garza's having set up 3 FLPs with partners including children prior to any funding of the entities, and in fact the children never contributed anything and mother never reported gifts of interests to them!)

The Hurford Family, Its Wealth and the Deaths of Gary and Thelma.

Gary and Thelma Hurford had three children, Michael(a psychiatrist), David(having ongoing problems, and working on family ranches), and Michelle(involved in parents' finances and bookkeeping). The Hurfords were domiciled in Texas, where Gary eventually became the first non-family President of Hunt Oil Co. In fact the largest single asset in the Senior Hurfords' estate(Texas community property) was Hunt Oil Co. "phantom stock" - i.e. a nonqualified deferred compensation program tied to the value of Hunt Oil shares.

Gary died in April, 1999, and at that time the community estate was in excess of $14 million in value, with farms and ranches of over $2 million, over $2 million in marketable securities, $5.5 million in the referenced Hunt Oil phantom stock, plus life insurance and other property.

A highly respected estate planner, Sandy Bisignano, planned the Hurfords' estates in 1993 using a conservative approach as Gary's choice (even though Sandy had discussed FLPs, GRATs, and irrevocable life insurance trusts). So Gary's estate plan at his death involved dividing most of his community half of the total estate of the Hurfords into a $650,000 bypass "Family Trust" and the QTIP Marital Trust, with Thelma as the successor trustee upon Gary's death. Following Gary's death, Thelma had to get into the financial picture, something new for her, and professional advice was sought - including Chase Bank of Texas for investment advice, first Mr. Bisignano as counsel - including on Thelma's own estate plan. First of all, Sandy suggested and Thelman agreed to make $675,000 in gifts to the 3 children, which was done in February of 2000 - totaling the gift-tax exemption amount at the time. The Bisignano recommendations included partnership planning, but no action then was taken. In August, 2000, Gary's retirement a/c was rolled into an IRA in his wife's name. Then the farm and ranch properties all were leased out, as Thelma did not want to be involved in them.

Unfortunately, in early 2000 Thelma was diagnosed with stage 3 cancer, and she began fighting the disease during this period of having to be involved more in the financial aspects of family wealth than ever before. There were family concerns about understanding Mr. Bisignano's recommendations, as well as the timeliness of his planning for Thelma - who knows the reality involved here? In any event, Michael searched for a new attorney, one was found and retained, Joe B. Garza, and Bisignano was terminated - obviously this was not a wise choice for the family as it turned out. Judge Holmes, in introducing his discussion of the "Garza Plan" stated that, according to Garza, a "brilliant estate-planning strategy" is one "that saves estate tax". Who could quarrel with that - if that is NOT the sole purpose of the estate plan!

So, as reviewed below, Mr. Garza began his program of setting up three (3) FLPs, and then having Thelma enter into a private annuity transaction with her transfer in exchange for an annuity of all her interests (over 96%) in the FLPs - if it had worked great result, as she died within a year of setting this all up and the concept in a private annuity is that there is no estate tax includability of the exchanged assets upon the annuitant's death. Sham transactions, Secs. 2036, 2038 and 2035 applicability, and strong criticism of the failures of Garza were the opinions of Judge Holmes in his analysis of what had been done. Mr. Garza had even had Thelma pull out the assets from the bypass and marital trusts to put into the FLPs, thus, as the Judge noted, "mangling" the husband's estate plan.

The Garza Plan - Planning Without Care and without Careful Implementation.

Much detail on the facts and the failings of Mr. Garza is included in Judge Holmes' opinion. The formalities of the FLPs were not followed, the handling of formation and funding was amazingly fouled up, the values used were out-of-date at time of formation and the private annuity exchange(Garza using lower Gary estate tax return values from the year before), moneys to pay the private annuity payments of $80,000 per month came from the partnership assets just previously contributed to the FLPs. In fact, one of the FLPs held only the Hunt Oil Co. phantom stock - note that this was a Sec. 691 asset in the estate without step-up in basis, and clearly as time went on there would be an "anticipatory assignment of income" (Sec. 61) issue for income tax purposes!

The "first obstacle" facing an aggressive planner, per Judge Holmes, is the necessity of using "fair market value" in valuing gifts or estate transfers. Then the Court considers how private annuities work, being able (absent an issue, which really appeared to be present here, of not having a reasonable life expectancy of beyond at least a year) to using mortality tables in structuring the private annuity.

The Court delved in depth into the "execution" of Garza's Plan - first, "Phase I" the three (3) FLPs - and here in all the documents, the Court noted an "unsteady drafting ability" pointing out many errors in the documents, the setup, the funding, etc. The Garza Plan went forward without completion in proper manner of the FLP funding! Then, second, "Phase II" was the private annuity transaction between Thelman and only 2 of her children, Michael and Michelle - even though the evidence showed the intention was that David was a 1/3 owner/beneficiary - Query? - was the lawyer just avoiding working out a carefully drafted trust to protect David from his problems?

In valuing the FLP property, as stated above, Garza just utterly failed to use current values, instead using the 706 values in Gary's estate. Further, he obtained valuation discount information informally from appraisers, and then "out of the air" set his own numbers - how bad is that?

Thelma died in February, 2001, not even 2 years after her husband's death, possibly believing she had preserved her estate for her children - nothing was further from the truth,sadly.

Tax Returns, Audit, Deficiencies Proposed and the Court's Determinations.

The opinion of Judge Holmes goes into detail on the many tax returns involved in the Garza Plan, including that Garza prepared and filed the 706 in Gary's Estate as well as the 706 for Thelma's estate. In Thelma's 706, Garza failed to answer the pointed questions on the 706 Form as to whether decedent owned an interest in a partnership, whether 2035, 2036, 2037, 2038 transfers were involved, and on and on - so the Court roundly criticized Garza on his return preparation. Thelma's estate tax return reported only $847,000 in assets - this could have been the proper reporting, in my view, if the facts were better, Thelma lived a number of years, the documents and their handling in fact had been handled properly - but with "Garza at the switch", that was not going to happen!

The 90-Day Letter Notices of Deficiency following audit included estate tax deficiency in Thelma's estate of $9.8 million, plus the proposed $1.9 million negligence penalty. A companion and alternative deficiency notice for gift taxes, $8.3 million, was issued - but eliminated by the Court, which went with the estate tax deficiency approach. Right out of the box, the estate conceded an estate increase in value of $3.4 million as Garza failed to report certain items, including money Thelma received when she liquidated her IRA(!).

So the Court, in introducing the Opinion section to its decision. stated the main issue to be decided is "what else should have been included - - specifically, whether Thelma's transfers to the FLPs and the subsequent private annuity transaction were valid under sections 2035, 2036 and 2038", plus several other issues. Essentially, without belaboring the facts and failings of the attorney, the Court concluded the private annuity was a sham and the partnerships should be disregarded(including all claimed "discounts") under sections 2036 and 2038 - lots of detail in the opinion to analyze on these points.

This appears to be the ultimate "house of cards" situation, i.e. the private annuity disregarded, the partnerships disregarded, and the above-referenced "mangling" of the predeceased husband's estate resulting in the maximum possible value in Thelma's estate subject to estate tax. The only issue won by the estate related to the negligence penalty, perhaps due to the obvious trusting nature of the family and its having been open with the Service throughout the process of the case.

A reading of this case provides insights into the Tax Court's perceived factors both as to the "bona fide sale" exception to Secs. 2036 and 2038 and as to the issues under Secs. 2036(a)(1) and (a)(2) designed to bring back into the estate assets transferred in essentially testamentary fashion. I recommend that tax practitioners review the factors presented by the Court in these areas, considering them in future planning.

I sincerely hope this review of Hurford is helpful to my readers - no doubt more cases will come down on FLPs, hopefully some will confirm the propriety of this approach to wealth preservation. However, the advisors and the client must be in sync with the plan and not try and, especially with someone suffering from severe illness, eliminate virtually all estate tax.

Again, regards and enjoy the Holiday Season!

Owen Fiore

BIANCA GROSS - Another FLP Gift Tax Case & Taxpayer Wins!

This is a great month for the Fiore Family - son Mark and Chelsea Donovan will be married October 25th - on the beach at Stinson Beach, CA, just north of the SF Golden Gate Bridge! Mary Ann and I look forward to a Fiore reunion, including all 6 children and spouses, 12 grandchildren, and my brothers Mike and Kevin and their ladies. No doubt the wedding weekend will be a great time.

Just a couple of weeks ago, the Tax Court, for now the third time this year, issued an opinion on a Family Limited Partnership gift tax case. Once again the FLP as an entity was respected for tax purposes and valuation discounts were allowed - more on this case later in the Newsletter.

Continuing Education Activities.

Fall is a busy time in the cpe area. I recently returned from attending the 28th Annual Southern California Tax & Estate Planning Forum. There were outstanding speakers such as Professors Jeff Pennell, Stan Johanson and Sam Donaldson, as well as practitioners Jonathan Blattmachr, Diana Zeydel, and many others. The uncertainty of the future of the Federal estate tax was covered by several speakers, focusing on the need for planning flexibility and the liklihood that some form of the estate tax will endure. Also, much consideration was given to the Grantor Trust area, with its benefits of no adverse income tax consequences while at the same time providing an estate tax "freeze".

Also, last month I attended a valuation conference, the Summit on the Discount for Lack of Marketability, at USD Law School in San Diego - the result was confirming that appraisers differ among themselves just as do lawyers, CPAs and other planners. But it was clear that "discounts" are real, but require careful work on the valuation assumptions, methodology and application of studies supporting value conclusions.

Finally, the 4th Annual Jerry A. Kasner Estate Planning Institute, sponsored by the Santa Clara University School of Law, was held September 19th in San Jose, CA. This was a wonderful day-long institute concentrating on estate planning with outstanding speakers, including - again on Grantor Trusts - Dick Oshins of Las Vegas, NV, a close friend of Professor Kasner, who passed away nearly 5 years ago. He was a good friend to many tax practitioners and a true leader in the field of estate planning.

Next month I will be a presenter for CPAs and others in Maui at the WesternCPE Resort Conference being held at the Ritz Carlton Kapalua Resort November 10-15. My subjects include FLP/LLC Planning and Defending Such Entities, and also "Hot Topics in Estate Planning." See www.westerncpe.com for more information. Then beginning in January, 2009 I will again present several live webcasts for CPELink, see www.cpelink.com, and from May to November, 2009, I am scheduled to present courses at 7 WesternCPE Resort Conferences.

And Now to the New FLP Gift Tax Opinion of the Tax Court

In prior Newsletters I have discussed the first two (2) 2008 FLP gift tax cases, namely, Jane Astleford v. Comm'r, T.C. Memo. 2008-128, and Holman v. Comm'r, 130 TC ___(2008). Each of these cases adds to the lessons that can be learned from review of judicial opinions in the FLP/LLC area. Now we have the newest Tax Court opinion, issued September 29, 2008, namely, Bianca Gross v. Commissioner, T.C. Memo. 2008-221 - a marketable securities FLP in which the "bottom line" result for gifts of partnership interests to family members was a 35% combined valuation discount!

Both the Holman and the Gross cases were decided by Tax Court Judge Halpern, and as will be seen below, footnotes to the opinion are most illuminating here on the IRS argument of "gift on formation" either via an indirect gift under IRC Sec. 2511 or by means of application of the "step transaction" judicial doctrine. While in both cases, IRS lost on this issue, the fight is by no means over. So let's review the Gross opinion.

1. Findings of Fact. A widow, Mrs. Gross had two adult daughters, and she was a well-organized, savvy investor. Her goal was to "...encourage her daughters to work together and to learn from her experience while preserving her control(as sole general partner) over the partnership's assets."
    Dimar Holdings L.P. was formed, albeit with some problems as raised by the Service, and Dimar became the vehicle for holding over $2 million in value of marketable securities, mostly common stocks, so as to facilitate gifting of partnership interests to the daughters. By July 15, 1998, Mrs. Gross and her daughters had agreed orally on the partnership specifics - including that mother would have full control, i.e. "exclusive discretion concerning the timing and the amounts of distributions to partners."
The required Certificate of Limited Partnership for Dimar was filed in the State of New York and publication thereof was made. However, the actual Agreement of Limited Partnership was not signed by the partners until the same day (12/15/98) that the gifts of partnership interests were made!
    Minor cash contributions by the daughters were made the end of July and by mother in mid-November, and from October through December 4th, mother transferred the securities to the partnership entity. Then in addition to signing the partnership agreement on December 15th, Mrs. Gross on that day transferred, by "deeds of gift", a 22.25% limited partnership interest in Dimar to each daughter. Capital accounts of the FLP apparently were handled properly to reflect the capital contributions and the gifts. The Service issued its deficiency notice claiming that Mrs. Gross "had made indirect gifts to each of her daughters of securities when she contributed the Dimar securities to Dimar rather than direct gifts of 22.25% interests in Dimar." Note that this was essentially one of the same arguments made by IRS in Holman where only 6 days separated Dell Computer stock capital contributions from the later gifts of limited partnership interests. Here, you will note, 11 days separated the last of the capital contributions of securities to Dimar from the gifts of interests.

2. So the Tax Court, with the background of Holman recently decided, weighed in! The Service believed New York law was not followed properly for there to be a partnership at all, until the agreement was signed in December. The petitioner/donor claimed the limited partnership was formed July 15th even though the written agreement was not signed until December 15th - - note how easy it should have been to avoid this problem: Sign the agreement first, promptly file and publish the Certificate of Limited Partnership, and then contribute the capital, and finally make the gifts!
    The Tax Court felt neither litigating party made a good case for its position; however, the court agreed that, if not a limited partnership, at least the evidence at trial showed there was a general partnership properly formed July 15th - that spelled the end of the IRS chances for success.
    So, there being a general partnership, and the securities having been contributed and accounted for properly over several months, the remaining issue was whether the "step transaction" doctrine applied since the last capital contribution was made only 11 days before the gifts of partnership interests. No problem here, said Judge Halpern, but as in Holman, he warned in a footnote that where there was less volatility in the capital contributed perhaps more time would be required to have the capital contributions be deemed "separate" from the gifts by reason of the contributing partner's risk-taking. This seems to be a peculiar test, and note that Judge Swift, in Astleford,was not bothered by real estate contributed the same day as the gifts being made! Likely, that was due to there not having been raised the "indirect gift" issue.

3. Lessons here to be learned, from all three (3) of these 2008 Tax Court gift tax cases are to form, fund and operate the entity in the proper ordering of its steps, and perhaps to separate the funding from the gifting by some reasonable period of time, perhaps even months. No doubt in the gift tax area, the Service will continue to use the indirect gift argument where it can, and in addition, as seen in Holman, IRS will go to Sec. 2703 to cut down at least some of the partnership agreement's restrictive provisions.

I hope you enjoyed this Newsletter, and, as always, I welcome your comments.

Owen Fiore
Syringa, ID

GOOD NEWS, BAD NEWS FOR FLPs AND LLCs!

For nearly a dozen years, the IRS, the courts and taxpayers have been sparring over the validity and use of Family Limited Partnerships(FLPs) and Limited Liability Companies(LLCs) as pass-through entity vehicles for income tax purposes that also are expected to have estate planning advantages - including valuation discounts for entity equity interest transfers. Decades ago, in the 1950s, IRC Sec. 704(e) was enacted by Congress as an income tax "safe harbor" for family partnerships. Here treating the "donee" partners as real partners and having capital as a material income-producing factor allows the FLP(and its modern counterpart, the LLC) to be recognized for income tax purposes.

However, in the Federal transfer tax area, especially as to the estate tax, the Service has challenged FLPs and LLCs, often with considerable success. Heavily redacted IRS Appeals Guidelines issued in October, 2006, identify the issues involved - both as to FLP/LLC reality on various issues, especially estate tax provision IRC Sec. 2036(a), and as to valuation methodology.

Over the past year, there have been a number of judicial opinions on FLP/LLC plans that are worthy of review, some of which already have been the subject of prior newsletters here. These decisions cover several specific areas, namely, (1) Section 2036(a) application and availability of its exception for a "bona fide sale for full and adequate consideration", (2) the use of "fixed dollar value" formula gifts and estate transfers to backstop valuation appraisals obtained by taxpayers, and (3) developments in appropriate valuation methodologies for appraisers to use in valuing equity interests in an FLP or LLC. First, this newsletter outlines these developments, and second, I present a summary of "Factors for Success" in the use of FLP/LLC planning as part of an overall integrated Family Wealth Plan.

I. The 2036(a) Estate Tax Trap and How to Avoid It!

    There are several court decisions here that provide taxpayers, their tax counel and appraisers with guidance in having a successful FLP/LLC plan for estate tax purposes. However, the first and second of these cases are taxpayer defeats, namely the Bigelow and Rector cases. I have commented in previous newsletters on cases such as Erickson, another taxpayer defeat. The first of the modern day 2036(a) cases was one I handled in Tax Court, namely, Estate of Dorothy Schauerhamer v. Comm'r, T.C. Memo. 1997-242 -  which illustrated the importance of clearly following the partnership plan, including as to bank accounts and deposits of partnership income into same.

    (1) Estate of Virginia Bigelow v. Comm'r, 2007 U.S. App. LEXIS 22030, 9th Circuit Court of Appeals(September, 2007) - The appellate court affirmed the Tax Court's decision that there was an implied agreement for Mrs. Bigelow to enjoy FLP income and benefits beyond her pro rata share based on capital interest in the FLP. Thus, the claimed 37% estate tax valuation discount was lost by the estate in a poorly designed and improperly operated FLP. Mrs. Bigelow remained personally liable on liabilities encumbering assets transferred to the entity, the FLP failed to observe partnership formalities, there was no real shield from personal liability, and, most important of all, Mrs. Bigelow was left "impoverished" after the FLP was set up, but for receiving partnership distributions. No clear non-tax purposes were served here, which spelled disaster for the estate!

    (2) Estate of Concetta Rector v. Comm'r, T.C. Memo. 2007-367(January, 2008) - Under 2036(a), Judge Laro appeared to set an extremely high standard for success in using an FLP or LLC. The court applied 2036(a)(1), the "implied agreement" provision, and thus ignored the entity, resulting in loss of valuation discounts all around. The key here was that the decedent had transferred most of her assets to the entity and was left with insufficient personal assets to support herself. No partnership formalities were followed, cash distributions to decedent were made without equalizing distributions to other family members who were partners, etc. Judge Laro stated that the 2036(a) "bona fide sale" exception could only be applicable if there was a significant non-tax business purpose for the entity, and that "gift-giving" was not a business purpose(disputed in Morowski, discussed below).

    (3) And now we come to the taxpayer victory, a significant one applying the "bona fide sale" exception to application of 2036(a)(and 2038 as well) so that the entity is respected and the discounts have an opportunity to work! This case is Estate of Anna Morowski v. Comm'r,  T.C. Memo. 2008-74, in which Tax Court Judge Chiechi delivered a welcome boost to tax advisors and appraisers who try and establish workable FLP/LLC plans. The court was very impressed with the Morowski Family values, close personal relationships and the desire of the mother Anna to keep the family together through common investment pool arrangements, including trusts and the LLC established in August 2001 after a year or so of consideration of the plan. The LLC was set up in late August, 2001, a few days later it was funded and then almost immediately gifts of 16% of LLC member interests were made to trusts for the three (3) Morowski daughters - Just 4 days later, on the infamous date of 9/11/01, Mrs. Morowski suddenly died, losing her long fight with diabetes.For the gifts, in a pre-trial settlement with IRS, it was agreed that the gifts were to be valued net of over 40% in discounts! See my earlier newsletter on this important case which shows, as does the case of Stone v. Comm'r, T.C. Memo. 2003-309, that FLP/LLC plans can work with good facts.

    (4) How to win FLP/LLC cases, in addition to utilizing the services of a qualified, experienced business valuation appraiser? Here are some "factors for success":

       a. Design an effective plan at the outset, especially developing realistic, well-support non-tax purposes for using the entity.
       b. Avoid senior generation impoverishment, i.e. by keeping out of the entity assets sufficient to continue to support the founding partner(s).
       c. Transfer assets with their related liabilities.
       d. Consider using a non-transferor general partner or managing partner.
       e. Maintain proper capital accounts, proportionately credited or charged with contributions and distributions.
       f. Always follow entity formalities and provisions of the entity agreements.
       g. Avoid non-pro rata distributions.
       h. Consider changing the entity's direction and set up a "business plan" for the future.
       i. Show the entity to be a true educational experience for younger generation family members, a "training ground" for the future.
       j. Use an LLC as the general partner of the FLP to be able to evidence "asset protection".

II. "Fixed Dollar Value" Formula Clauses - McCord and Christiansen.

    As a protective backstop for appraisals, the concept here is to state that the gifted or estate transfer value is that number of shares or units in the entity that equals X dollars, "as finally determined for gift(or estate) tax purposes." There must be a clear and understandable adjustment clause, rather than any elimination of the transfer.

    In McCord v. Comm'r, 120 TC 358(2002), a gift tax case, such a formula clause was used by the taxpayer, but the Tax Court went off on its own - which resulted in a stinging reversal by the 5th Circuit. Then in 2008, an estate tax case with a charitable disclaimer provision based on a formula clause determination, was issued, namely, Estate of Helen Christiansen v. Comm'r, 130 TC No. 1(January, 2008). The Service challenged the formula clause as a "condition subsequent" and as "against public policy" - but lost on both grounds!  At least where charitable giving is involved, it appears the Tax Court would find now that there is no public policy argument supporting the IRS attack. While there is continuing uncertainty here, no doubt formula clauses will be used more often now.

III. Astleford and Holman - Instructive Gift Tax Decisions.

    These two (2) gift tax cases provide interesting legal and fact issues for review. Both cases are Tax Court opinions, with different judges and they deserve careful study and consideration by tax advisors and business valuation appraisers alike.

    (1) First, Astleford v. Comm'r, T.C. Memo. 2008-128, involved a real estate investment FLP and various gifts of partnership interests therein. Among the assets contributed to the partnership was a 50% interest in a real estate venture, a general partnership, in which the donor mother was a venture partner. Therefore, the issue of "layered" or "tiered" discounts was present, and Judge Swift found here that such a tiered discount was available, giving footnote guidance to standards for same. The court determined that a partnership interest was transferred to the FLP, not merely an assignee interest, and finally, but see Holman below, the court was not bothered on a "step transaction" principle by the virtually simultaneous transfer of assets to the FLP and gifts of FLP interests. In the valuation methodology area, the court exercised its long stated prerogative of "mixing and matching" appraisers' opinions and methodology to arrive at its own value conclusions. There were a total of 6 appraisers involved in the case!

    (2) Second, we have another gift tax case, i.e. Holman v. Comm'r, 130 T.C. No. 12(5/27/08), in which the FLP had as its sole asset, contributed by the parents, shares of Dell Computer stock. Dell, a public company, has a volatile stock price history, which was important here in avoiding a "step transaction" disaster - as only 6 days separated the contribution of Dell shares to the entity from the gifts of entity interests to children of the founders of the FLP. Also here there was a detailed discussion of IRC Sec. 2703 which, unless a "safe harbor" applies, disregards transfer restrictions in a family-controlled entity. But even though the court determined the safe harbor was inapplicable and the restrictions should be disregarded, the entity was allowed to be recognized and substantial discounts still present. On appraisals, the court stated it "lacked confidence" in the taxpayer's appraiser, and so the case is worth reading to see how the court deals with discount methodology and the strengths and weaknesses of individual appraisers.

Upcoming education events -

    First of all, for CPELink(www.cpelink.com) I have two (2) four-hour webcast courses, the first on Valuation(9/25/08) and the second on FLP/LLC planning(10/7/08) - check out the course descriptions, how to sign up, etc. on the CPELink website. These courses are interactive, with email questions and answers involved, with each course also having downloadable course materials - over 100 pages for each one!

And then I present both "Hot Topics in Estate Planning" and "FLP/LLC Planning", each course a 6-hour live presentation, at the Ritz-Carlton Kapalua on Maui in Hawaii November 13 and 14, respectively - check out the WesternCPE website for these courses - see www.westerncpe.com.

Later this week I attend a special "Summit on the Discount for Lack of Marketability" in San Diego, sponsored by USD School of Law, Business Valuation Resources and the ASA(Thursday), and then the 4th Annual Jerry A. Kasner Estate Planning Institute on Friday in San Jose. As most know, Professor Jerry Kasner was a giant in the tax and estate planning field, and such a good friend to so many of us, including me.

Hope you enjoy this newsletter - more coming soon!

Education Events and New Developments

Summer continues here in Idaho, with high temperatures, cool water in the Clearwater River, and planning for the Fall. Mary Ann and I had a wonderful experience on the small ship Alaska Cruise last month. We were on a Lindblad Expedititions/National Geographic cruise in Southeastern Alaska - great scenery, lots of whales, bear, sea lions, many eagles - plus good company and food. See the Lindblad website at www.expeditions.com.

Education Events

I will be attending a couple of tax seminars in September. First, in San Diego on September 18th there is the "Summit on the Discount for Lack of Marketability" at the USD School of Law with Tax Court Judge David Laro and CPA Mel Abraham as co-chairs - speakers include tax litigator John Porter, Chuck Rettig, Esq., and a number of appraisers. The next day, September 19th, I attend the 4th Annual Jerry A. Kasner Estate Planning Institute at the University of Santa Clara in the San Jose area. Jerry Kasner was an outstanding law professor and advisor to many tax professionals for nearly 50 years until his death about 5 years ago.   

As mentioned in my last newsletter, dated July 17th, I am participating as an author/instructor for CPELink in several webcasts - from my home office in Idaho thanks to the technology available. You can check out the topics and dates on the website: www.CPELink.com. My first presentation, 2 hours in length, is on August 26th, 9-11 am PDT - "CPA Practice Development Opportunities in Estate Planning". Then on September 25th I present a Valuation Planning 4-hour course and finally on October 7th my 4-hour course is on Effective Uses of Pass-Through Entities, Including FLPs, LLCs and S Corporations. See the details of these courses on the CPELink website.

I am also in the process of working out my course and presentation schedule with WesternCPE - see the website for this CPE provider, including its many Resort Conferences, at www.westerncpe.com. In 2009 I will be a presenter at 6 or 7 Resort Conferences, with likely my courses being "Hot Topics in Estate Planning" and "Tax Planning for the Family Business" at each location. The WesternCPE approach is to have a course or courses each day over 5-6 days at a great resort location running from 7:30 am to 1:00 pm - leaving the rest of the day for resort activities. My remaining course for 2008 is at the Ritz-Carlton Hotel and Resort at Kapalua, Maui, HI in mid-November - incl presentation of my "Hot Topics in Estate Planning" and "Pass-Through Entities" courses - each with over 100 pages of course materials, plus power point slides.

New Developments

 
My May 1, 2008 newsletter reported on the LLC case in which the taxpayer won hands down - namely,    Estate of Anna Morowski, T.C.Memo. 2008-74, the Tax Court opinion having been issued March 26, 2008. The court in this case found substantial non-tax purpose for the LLC entity, and thus determined that the "bona fide sale for full and adequate consideration" exception to application of the IRC Sec. 2036(a) attack on the entity was available and proper to use in this case. See my report on the case in the archived May 1st newsletter for the details.

Then we have seen two (2) gift tax FLP/LLC cases which provide insights into a number of issues including "layered discounts", "step transaction" and the valuation methodology issues. I will report in the near future in detail on these cases, which are Holman v. Comm'r, 130 TC No. 12(2008), and Astleford v. Comm'r, T.C. Memo. 2008-128(2008).

 Very recently, the Tax Court(Judge Swift) issued an opinion in 6 consolidated docketed cases with 20 other cases riding also on the result per stipulation, that dealt with the stock value of a professional service corporation the stock of which was donated to a tax-exempt organization. Claimed charitable deductions at over $400 per share were determined as being properly valued at only $35 per share. This of course was quite a defeat for the 26 out of 28 medical doctors in the professional corporation who claimed the charitable deductions!  See Bergquist and Kendrick, et al v. Comm'r, 131 TC No. 2(7/22/08).

    (1) Various medical practice specialty groups practiced through their professional service corporations and provided services to patients of the Oregon Health & Science University Hospital(OHSU). The specific provider reviewed in the Tax Court case reported on was University Anesthesiologists, P.C.(UA) which had 5 Oregon doctors practicing anesthesiology.

    (2) OHSU however decided that all the specialty practices should consolidate into a single practice group(OHSU Medical Group), which was a newly formed 501(c)(3) organization. A CPA who was a shareholder of UA and its CEO learned that doctors around the country in similar situations were claiming charitable income tax deductions for donating their private personal service corporation stock to academically affiliated health care institutions.

    (3) Timing is everything! There were many issues involved in the consolidation and it was not completed until shortly after the 9/14/2001 date of contributions of stock to OHSU Medical Group. So the most significant issue was whether the completion of the consolidation was reasonably foreseeable at the valuation date since otherwise post-valuation date events cannot be taken into account.

    (4) Judge Swift believed that it was incorrect for the taxpayer appraisers to use a "going concern value" for the UA entity, which was most likely to go out of existence shortly, and did in fact. One of taxpayer's appraisers stated that if the consolidation were a "done deal", the going concern value approach would not have been used, so obviously many fact details may not be contained in the opinion.

    (5) The IRS appraiser used the net worth method and then opined on discounts approaching 65% on a combined basis! It appeared that going with the IRS appraiser on such high discounts indirectly was a penalty against the taxpayers for claiming the charitable deductions. Plus, the court imposed accuracy-related and negligence penalties on the taxpayers!

    (6) Lots of bad facts - other practice groups did not donate their corporation stock to the tax-exempt entity, only UA; the management of OHSU Medical Group notified UA in writing shortly after the "gifts" that it would enter the stock on its books at zero value as it did not expect any cash distributions or other financial benefits from the UA stock.

    (7) Footnote 6 on the Tax Court's opinion seems to say it all! - "In their expert reports neither of petitioners' experts explain how or why they selected a going concern premise of value, and they conveniently and incredibly make no mention of the scheduled Jan. 1 2002 consolidation."

Summer Time - Reflection, Outdoor Fun and Planning

Summer has arrived in Idaho - hot and dry, finally, after a wet winter, both in snow and rain. Mary Ann and I are traveling this weekend to Alaska to enjoy a small ship(60 passengers) cruise in the fjords of southeastern Alaska. I reflect upon the year 2008 now over half gone, and appreciate all the opportunities for client consulting and for being involved in tax education activities.

On the education side, I have thoroughly enjoyed participating as an author and presenter for WesternCPE in its "resort conferences". Mary Ann and I both look forward to being in Maui in mid-November for WesternCPE, where I will present two (2) courses: (1) Family Wealth Preservation Through FLPs, LLCs, S Corporations and Valuation Discounts, and (2) Hot Topics in Estate Planning. Check out the conference details at the website: www.westerncpe.com.

In addition, I am participating in several webcast programs presented by CPElink, and this group's website is www.cpelink.com. These webcasts seem to be an excellent way for CPAs and other tax advisors to keep up-to-date in a cost efficient and low impact way. The CPElink programs are interactive and qualify for the CPA continuing education requirements. My initial course, 2 hours in length, is "CPA Practice Development Opportunities in Estate Planning." Here I will focus on the CPA as the "trusted advisor" who is well suited to working closely with clients and their families on estate planning. In an uncertain and down economy and with confusion continuing over the future of the Federal estate tax, existing plans should be reviewed and updated with new plans being most important for wealth preservation. I will cover a number of actual case studies and review the top 12 estate and wealth planning issues involved in estate planning. My webcast presentation is set for August 26th, from 9:00 - 11:00 am(PDT). Visit the website - www.cpelink.com - for more information! Also, on September 25th and October 7th I will be webcasting two (2) more courses, one on Valuation Planning and the other on the Effective Uses of Pass-Through Entities - both these courses are 4 credit hours, and the details again are on the website.

Well, now we are off to Alaska, returning July 27th. Then I will develop another newsletter, this one discussing two (2) significant FLP gift tax cases decided in the Tax Court recently, namely, Astleford and Holman. I hope each of my readers enjoys his or her summer!

Owen Fiore

IRS 'ATTACKS' ITS OWN VALUATION STANDARD!

Hello to all! it is interesting that, in the gift and estate tax valuation area, the Service has evidenced its disagreement with its own valuation standard - i.e. the "hypothetical willing buyer, willing buyer standard". This standard, per Code sections and Treasury Regutions, was designed to have an "objective standard of value" - but, of course, that opened up the issue of the non-marketability and lack of control of fractional interests in real estate and in companies of various types. Sol the result has been the "valuation discount game"!

In 2007, the Service proposed changes in Treasury Regulations to IRC Sec. 2053, with regard to contingent and as yet unsettled claims of liability - see my earlier newsletters on this subject. Now, as the result of the total taxpayer victory in the valuation case of Kohler v. Comm'r, T.C. Memo. 2006-152, the Service has proposed changes in Treas. Regs. Sec. 20.2032-1 to state that, where the alternate valuation date is selected by the estate(6 months after death value), only changes in value due to "market conditions" may be taken into account.

In the Kohler case, the privately-held company, after decedent's death owning 12.5% of the outstanding stock, approved a reorganization plan that involved teh opportunity to elect to have restricted stock - thus at least great discounts than would have been the case at the date of death. The plan was approved and the estate elected to take the restricted stock, obviously due to overall advantages to the estate. This was a key issue in the estate tax case, and the estate's appraiser was successful in arguing that, at the 6-month alternate valuation date, the now restricted stock was subject to deeper discounts - and the taxpayer estate prevailed.

Note that the estate could not, in and of itself, insure the reorg would take place, but in fact, the estate took advantage of the plan within the 6 month period. One of the Prop. Regs. examples deals with a family that sets up an FLP or LLC after date of decedent's death but prior to the alternate valuation date - presumably to take greater discounts. This too would not be allowed under the new Prop. Regs., which are subject to comment within the next couple of months.

Only "market conditions" can be taken into account, says the IRS. What are "market conditions" - as defined by the Service, these are "events outside of the control of the decedent(or decedent's executor or trustee) or other person whose property is being valued that affect the fair market value of the property being valued. Changes in value due to mere lapse of time or to other post-death events other than market conditions will be ignored in determining the value of decedent's gross estate under the alternate valuation method."  Interestingly, in many cases, "lapse of time" is what the market determines lowers the value of assets, e.g. real estate in the recent economic downturn - but maybe that is not "mere" lapse of time!

So it appears this Service initiative is limited to situations in which the estate in some sense is pro-active in trying to (1) change downward the value of its assets, and (2) then elect the AVD, i.e. 6 months after decedent's death. In this limited sense, perhaps the proposal makes sense, but one wonders whether the Service really is trying to nit-pick its own traditional "fair market value" standard.

Regard to all. 

Owen Fiore
email: owen@owenfiore.com

GREAT NEW TAX CASE ON LLC-TAXPAYER WINS!GREAT NEW TAX CASE ON LLC-TAXPAYER WINS!

May Seminars Coming Up

My May seminars for Western CPE(see www.westerncpe.com) are just around the corner - Napa, May 9th and 10th, Las Vegas, May 23rd, and Jackson Hole, WY, May 20th and 30th. My March 9, 2008 Newsletter has all the information on these courses, one being on Estate and Gift Tax Valuation Planning and the other involving Strategic Planning Using FLPs, LLCs and S Corporations. Check out the Western CPE website for the details!


Estate Planning More Important Than Ever

With the 2008 political uncertainty about the national elections, the current economic downturn, and continuing uncertainty about the future of the Federal Estate Tax, more than ever families and their advisors need to focus on a review of current planning, improvement of plans for wealth preservation and succession, and a commitment to the steps necessary to design, document and implement an effective Family Wealth Plan.

In my experience, the concept of "Fair Market Value" is at the core of Family Wealth Planning with entities and techniques combined in the best possible way. Therefore, a team concept is essential, which must include qualified appraisal advice as well as the traditional planners such as lawyers, accountants and life insurance advisors. Of course, I am available as a consultant to families and their advisors.

In a recent Tax Management publication, T.M.'s Estates, Gifts and Trusts Journal(2008), there was an excellent article, co-authored by two Michigan attorneys, Julius H. Giarmarco and Sebastian V. Grassi, Jr. This is a most worthwhile article for reading by both advisors and their clients. It is entitled "The Ten Levels of Estate Planning", and is set up in terms of specific action plans. After the obvious discussion of the importance of a married couple fully using their respective applicable exclusion amounts(now $2 million for estate tax purposes), the ten item "to do" list goes on into gifts without paying gift tax or using up the $1 million gift tax exemption amount, leveraging gifts through life insurance trusts, reducing or shifting value of assets(especially appreciating assets), using Chapter 14's 2702 trusts, etc.
I am using a summary of this article, together with my own additions thereto, for my Western CPE courses. If any reader of this Newsletter wishes a copy of this 7-page memo, just email me with your request and I am happy to email a copy back pronto.

My March 9th Newsletter identified several topics for future newsletters, and I will get back to these soon. However, below I provide a summary and discussion of a most exciting case that recently came down from the Tax Court, namely, the Mirowski case - a breath of welcome fresh air in the FLP/LLC planning area.

Estate of Anna Morowski, T.C. Memo. 2008-74(March 26, 2008)

In some of my recent Newsletters, I have reported on significant taxpayer defeats in the FLP/LLC area involving such entities being disregarded entirely for estate tax purposes. Such cases included Estate of Bigelow v. Comm'r, 9th Cir. No. 05-75957, affirming the Tax Court, 9/14/07, and Estate of Rector v. Comm'r, T.C. Memo. 2007-367, 12/13/07. True, there were "bad facts" in these cases; however, these decisions provide encouragement to IRS ongoing attacks on pass-through entities, even though in many situations they should and have been respected for transfer tax purposes.

So now in Morowski, we have a total taxpayer victory, even on valuation discounts! The Service tried to destroy the LLC involved using IRC Secs. 2036, 2038 and even 2035, but to no avail due to the very strong non-tax purposes for the entity and a judge, Judge Chiechi, who believed the estate's witnesses and was most impressed with the history of the Morowski Family, as we will see below. Here is a case where the LLC was formed and received from the decedent mother, Anna Morowski, just a few days before her unexpected death many millions of dollars in value, including patent rights and licensing agreements producing significant annual royalties and mardetable securities. In addition, just 3 days before death, Anna successfully gifted substantial LLC member interests to irrevocable trusts for her three daughters.

So let us look at the 85 page Tax Court Memo Opinion authored by Judge Chiechi and learn of her extensive Findings of Fact and her Opinion in this remarkable case. I have authored a couple of articles already on Morowski, one for Steve Leimberg's great LISI series of Email Newsletters(see www.LeimbergServices.com - Estate Planning Email Newsletter #1268, 3/31/08) and an article soon to be published in BV Update, the Business Valuation Resources monthly publication for professional appraisers and other advisors.

   

1. Overview of Facts.

Of particular importance and typical of the strong language favoring the taxpayer in this opinion was the statement of Judge Chiechi at page 50, footnote 44: "On the record before us, we find that Ms. Morowski's significant and legitimate nontax purpose in forming and funding MFV(Morowski Family Ventures, LLC) of insuring joint management of the family's assets by her daughters(all 3of which were co-trustees of each daughter's truss) and eventually her grandchildren, standing alone, is sufficient to satisfy the requirement that, in order to qualify for the exception in Sec. 2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth, there must be a legitimate and significant nontax reason for creating the entity in question." This brings to mind another "great facts" case, namely, Estates of Stone v. Commissioner, T.C. Memo. 2003-309, which likewise was a taxpayer victory on the facts.

Decedent and her husband, who died in 1990, had a long history of having and encouraging a close knit family, taking annual family vacations with the three (3) daughters and later their children and families, and at such times discussing family business and investment issues often with lawyers and accountants as guests at the meetings. As stated in Forbes, May 5, 2008(Informer feature), Dr. M. Mirowski was the principal developed of the initially scorned but now popular implantable cardioverter defibrillator - which became, especially after his death, the principal source of the Mirowski Family's wealth. As Forbes writer Janet Novack stated(I was one of her confirming sources for the article) in the headline: "More History Made". Truly here was an LLC formed just prior to death of the decedent, gifts also being made just before death, and the parties' stipulated valuation discounts were successful both for gift and estate tax purposes - due to teh Tax Court's upholding of the validity of the LLC!

Dr. Morowski spent many years developing the heart implant device and also many years obtaining financing for such development and eventually marketing through licensing agreements. He owned a 73% interest in the patents involved. Following his death in 1990, at which time his ICD patents and licensing agreement shares went to his wife, Anna, there was a long history of family and charitable gifts by Anna and it was important to her that the family remained close in every way. Anna created and funded with interests in the ICD and its rolalties an irrevocable trust for each daughter in 1992, and named all 3 daughters as co-trustees. The royalties increased dramatically and eventually amounted by the time of Anna's death to millions of dollars per year. By the formation of the LLC(MFV), Anna still owned 51.09% ot the ICD patents and licensing agreements.

In the year 2000, the idea of an LLC for the family investments was presented by U.S. Trust, and Anna's long-time attorney prepared draft articles of organization, operating agreement, etc. However, as family decisions usually were made at the annual family vacation/meeting, nearly a year went by until the August, 2001 meeting took place at which the family decision was made - form and fund the LLC, with the understanding Anna was going to make significant gifts of LLC interests to the daughters' trusts. At this point the recurring foot ulcer problem for Anna, a diabetic, became more of a problem.

The timing of formation, funding, gifting as to the LLC and its interests was rapid, closely-timed and barely completed before Anna's death: August 14 - family meeting and decision to go with the LLC plan, August 22-final LLC documents sent Anna for signature, August 27-LLC documents executed, August 30-appropriate State of Maryland filing of MFV Articles of Organization, September 1-7-transfers of assets of Anna, sole member of the LLC, to MFV(all her interest in ICD patents and royalty agreements, securities valued at over $60 million and  cash of $1.5 million - quite a push for action! Then also on September 7th, Anna made gifts to the daughters' trusts of 16% member interests to each one, a total of 48% in member interests. Anna, the sole managing member of the LLC, took a sudden turn for the worse in her treatment of the foot ulcer on September 10th, and died on 9/11/01 - the day of the infamous terrorist attacks on the U.S.! The facts were absolutely clear and the testimony unshakable that Anna was not expected to die from her condition until the sudden change in circumstances on September 10th, only 3 days after these gifts.

These facts, set forth in great detail in the Tax Court's Findings of Fact, including a number of telling footnotes, set the stage for Judge Chiechi's analysis, followed by her conclusions fully supporting the Mirowski Family's position before the court. Here we clearly had "great facts", "excellent lawyering", and a "thoughtful judge" who was well aware the the hurdles of supporting an LLC formed just prior to a person's death.

   

2. Valuation Conclusions and Court's Opinions

        a. Valuation Discounts.

In this case we had both gifts(3 days prior to death) and a 52% interest of decedent in MFV at date of death to be valued. Since the Petitioner, Estate of Morowski, and the Commissioner of Internal Revenue(Respondent) were focusing most on the issue of whether the LLC should be respected for gift and estate tax purposes, the parties stipulated the valuation discounts from asset values as agreed. According to Curt Kimball, of Willamette Management Associates(who was the expert prepared to testify on valuation at trial), the taxpayer and IRS appraisers were fairly close on their valuation conclusions. Ultimately, in the stipulated values there were used the following approximate combined discounts - (1) over 40% for the gifted interests, and over 20% for the 52% interest of the decedent at death. That amounted to many millions of dollars of transfer tax savings once the court determined that MFV must be respected for gift and estate tax purposes.

       

b. Judge Chiechi's Opinion.

Now as to the legal issues, based on factual analysis and findings per the court, Judge Chiechi knocked down strongly each and every argument made by Respondent IRS. The details of the 2036, 2038 and 2035 arguments, and their rejection by the Tax Court, are contained in my cited detailed articles and, of course, in a number of other articles on this case.

Essentially, as to the transfers of assets to the LLC,  and whether the "bona fide sale" exception to Secs. 2036(a) and 2038(a) applied, the Judge found that the strong and legitimate nontax purposes of the LLC and the care in forming and funding the LLC were sufficient to support this particular entity. As to the gifts, a careful analysis of IRC Secs. 2036(a)(1) and 2036(a)(2) found on the facts that there was no prohibited retention of income, economic enjoyment, etc. from the gifted interests. And, finally, given that the court concluded that 2036(a) and 2038(a) did not apply here, the closeness in time of the gifts to Anna's death was not a factor - i.e. the prohibited 3-year rule of 2035 only applies to life insurance and to gifts that are subject to 2036, 2038, etc.

Interestingly enough, the Respondent's citing of all its judicial victories against FLP/LLC plans merely was dismissed by Judge Chiechi as involving cases distinguishable from Morowski on their respective facts.

However, are we "out of the woods" now on FLP/LLC plans - No Way! To develop facts such as involved in cases like Stone and Morowski takes work, and often just cannot be done. It is possible, of course, the Service may appeal the Tax Court's decision here. In any event, the importance of a total, realistic, and legitimate planning effort, insuring that there are true and significant nontax purposes for an entity, cannot be stressed too much. Planners will be discussing this case with their clients for many months to come. As Janet Novack said - More History Has Been Made!

I hope you have enjoyed this Newsletter, and I welcome comments and suggestions from readers.

Owen G. Fiore
FioreWealthPlanningConsulting
Kooskia, ID

www.owenfiore.com