Court Rejects IRS Transfer Tax Attack on Family Partnership
In Estate of Purdue, 1 the Tax Court held that a decedent's transfer of assets to a family limited liability company (LLC) was a bona fide transfer for full and adequate consideration and, therefore, the LLC assets were not includable in the decedent's gross estate, and that the decedent's lifetime gifts of LLC interests to a trust qualified for the gift tax annual exclusion.
In 2000, the decedent and her husband formed an LLC. In that same year, the decedent and her husband transferred to the LLC a portfolio of marketable securities with a value of $22 million, their entire 1/6 interest in a commercial building valued at approximately $900,000 that was subject to a long-term triple net lease and that was managed by a real estate management firm, a certificate of deposit with a value of approximately $865,000, and a promissory note from one of their children with a face amount of $375,000.
Also in 2000, the decedent and her husband established the Purdue Family Trust (PFT). The beneficiaries of the PFT were the descendants of the decedent and her husband and the spouses of the descendants. The trust agreement provided the beneficiaries with Crummey withdrawal rights. From 2000 to 2007, the decedent made annual exclusion gifts of LLC interests to the PFT.
The decedent's husband died unexpectedly in August 2001, but at the time of the formation and funding of the LLC, he appeared to be in good health and enjoyed an active lifestyle. The decedent died in 2007. The decedent's estate timely filed a federal estate tax return. The IRS issued notices of deficiency for both estate taxes and gift taxes. In the notices the IRS contended that:
(1) The value of the assets transferred by the decedent to the PFT were includable in her gross estate under Section 2036.
(2) The decedent's gifts to the PFT were not gifts of a present interest and therefore did not qualify for the gift tax annual exclusion.
Section 2036 generally provides that an inter vivos transfer by a taxpayer, other than a bona fide transfer for adequate and full consideration, are included in his or her estate if he or she retains certain enumerated rights or interests in the property transferred. In the context of family limited partnerships, the bona fide transfer for adequate and full consideration exception is met where the record establishes that a two-prong test has been satisfied by establishing:
(1) The existence of a legitimate and significant nontax reason for creating the family limited partnership.
(2) The transferors received partnership interests proportional to the value of the property transferred. 2
A significant purpose must be an actual motivation, not a theoretical justification. A list of factors to be considered when deciding whether a nontax reason existed includes:
- The taxpayer's standing on both sides of the transaction.
- The taxpayer's financial dependence on distributions from the partnership.
- The taxpayer's commingling of partnership funds with the taxpayer's own.
- The taxpayer's actual failure to transfer the property to the partnership.
- Discounting the value of the partnership interests relative to the value of the property contributed.
- The taxpayer's old age or poor health when the partnership was formed. 3
The court quickly concluded that the second prong of the test was satisfied because the court found that the decedent received interests in the LLC proportional to the property she contributed. With respect to the first prong (i.e., the bona fide transfer test), the court noted that the decedent transferred property to the LLC to simplify the gift-giving process and to assure transfer tax savings through the use of discounts. The court found, however, that gift giving was not the decedent's only motive in transferring property to the LLC. Rather, the court found that a significant purpose of the decedent's transfer of property to the LLC was to consolidate investments into a family asset managed by a single advisor.
In addition, before the formation of the LLC, Mr. Purdue handled all of the financial decisions regarding the marketable securities. After the formation of the LLC, the Purdue children made the LLC investment decisions jointly. The court concluded that the decedent's desire to have the marketable securities and the building held and managed as a family asset was a legitimate nontax motive for her transfer of property to the LLC.
The court also found that other factors supported the estate's argument that a bona fide transfer occurred. First, the decedent and her husband were not financially dependent on distributions from the LLC because the decedent retained substantial assets outside of the LLC to pay her living expenses. Second, there was no commingling of the decedent's funds with the LLC's funds. Third, the formalities of the LLC were respected because the LLC maintained its own bank accounts and held meetings at least annually with written agendas, minutes, and summaries. Fourth, the evidence showed that the decedent and her husband were in good health at the time the transfer was made to the LLC.
Therefore, the court concluded that the bona fide transfer prong was satisfied because the decedent had legitimate and actual nontax motives in transferring the property to the LLC. Since both prongs of the bona fide transfer test were satisfied, the court held that Section 2036(a) was inapplicable to the transfer and did not operate to include the value of the property in the value of decedent's gross estate.
Next the court considered the issue of whether the decedent's gifts of LLC interests were present interests and therefore qualified for the gift tax annual exclusion under Section 2503(b) . Reg. 25.2503(b) provides that a present interest is an unrestricted right to the immediate use, possession, or enjoyment of (1) property, or (2) the income from property.
The property in this case was an ownership interest in an LLC. The court recognized that a gift in the form of an outright transfer of an equity interest in a business, such as limited partnership interests, is not necessarily a present interest gift. The court stated that the estate must show that in receiving the LLC interests, the donees thereby obtained use, possession, or enjoyment of: (1) the limited partnership interests, or (2) of income from those interests.
With respect to the LLC interests themselves, the primary source of the donees' rights and restrictions to the use, possession, or enjoyment of the property was the LLC operating agreement. The donees' rights, however, were limited. The members of the LLC could not transfer their interests without unanimous consent by the other members. Therefore, the donees did not receive unrestricted and noncontingent rights to the immediate use, possession, or enjoyment of the LLC interests themselves. Therefore, the court considered whether the donees received such rights in the income of the LLC.
To ascertain whether rights to income satisfied the criteria for a present interest, the estate had to prove that:
(1) The LLC would generate income.
(2) Some portion of that income would flow steadily to the donees.
(3) That portion of income could be readily ascertained. 4
The court found that these three requirements were satisfied. First, the LLC owned the building that generated rental income as well as dividend-paying stocks. Second, the LLC made annual distributions to the members. Third the rental income and the dividend income was readily ascertainable. Therefore, the court held that the gifts qualified for the gift tax annual exclusion.
This case is clearly a victory for the use of family limited partnerships in estate planning. The case lays out a roadmap for practitioners to follow when incorporating a family limited partnership into an estate plan. The importance of [pg. 46] following all formalities in the formation and operation of the partnership is imperative in order to defend against an audit by the IRS. Unlike many other recent reported cases, the decedent, her family, and her advisors followed the required rules and formalities in establishing and operating the family partnership. Therefore, unlike those other taxpayers, the estate prevailed against the challenge by the IRS.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets his clients have accumulated and minimizing federal and state tax liability. These clients range from homeowners whose property has appreciated to people with significant investment, retirement, business, and real estate holdings. For more on charlitable deductions, contact Frank at (301) 657-0175 or email@example.com.
This article originally appeared in the April 2016 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.