Tax Court Upholds Taxpayer's Use of Family LLC
In Estate of Mirowski,1 the Tax Court held that assets transferred to a limited liability company (“LLC”) were not includable in the decedent's gross estate under Section 2036(a) in spite of the fact that the decedent both formed the LLC and made gifts of interests in the LLC within 30 days of the decedent's death.
Mrs. Mirowski was a widow who in 1990 inherited from her husband, Dr. Mirowski, patent rights to an implantable defibrillator that monitors and controls abnormal heart rhythms. During Dr. Mirowski's lifetime, the patents generated modest royalties. After Dr. Mirowski's death, the royalties received from the patents increased significantly from several thousand dollars a year to millions of dollars a year.
In 1992, Mrs. Mirowski created three trusts—one for the benefit of each of her three daughters and their respective descendants. Mrs. Mirowski named all three daughters as co-trustees of each of the three trusts because she wanted her three daughters to work together and have a close working relationship. In 1992 and 1993, Mrs. Mirowski transferred interests in the patents to her daughters' trusts.
In 2000, Mrs. Mirowski's attorney prepared for her draft Articles of Organization and an Operating Agreement for an LLC to be know as Mirowski Family Ventures, LLC (“MFV”). In January 2001, Mrs. Mirowski developed a foot ulcer which was not life-threatening. On 8/27/01, Mrs. Mirowski executed the documents to form MFV. On 8/31/01, Mrs. Mirowski was admitted to a hospital for treatment of her foot ulcer. At that time, it was expected that Mrs. Mirowski would recover and that she would return to her home.
In early September 2001, Mrs. Mirowski transferred the bulk of her assets to MFV including her interests in the patents in exchange for 100% of the ownership interests in MFV. Mrs. Mirowski was the General Manager of MFV. On September 7, 2001, Mrs. Mirowski made gifts of 16% of MFV to each of her three daughters' trusts. After the gifts, Mrs. Mirowski owned a 52% interest in MFV. Mrs. Mirowski understood that her gifts to her daughters' trusts would generate a substantial gift tax liability. Although after the gifts Mrs. Mirowski retained enough assets to meet her living expenses, she did not retain sufficient assets to pay from those assets the substantial gift taxes resulting from her gifts of MFV to her daughters' trusts.
Mrs. Mirowski died unexpectedly on September 11, 2001 from complications from her foot ulcer. In 2002, MFV made distributions to the estate of Mrs. Mirowski to enable the estate to pay federal and state estate and gift taxes, legal fees, and other estate obligations. MFV did not make distributions to the daughters' trusts. After the estate filed the estate tax return, the IRS issued a notice of deficiency since the IRS determined that all the assets that Mrs. Mirowski transferred to MFV were includable in her estate pursuant to Section 2036(a).
The court began its analysis by considering whether the transfers by Mrs. Mirowski to MFV were subject to Section 2036(a). A transfer which is a bona fide sale for an adequate and full consideration in money or money's worth is exempt from Section 2036(a). The Tax Court in Estate of Bongard 2 stated that the bona fide sale exemption is satisfied if the taxpayer establishes: (1) the existence of a legitimate and significant nontax reason for creating the family limited partnership (the significant purpose must be an actual motivation, not a theoretical justification), and (2) the transferors received partnership interests proportionate to the value of the property transferred.
The IRS argued that there were no significant nontax reasons for Mrs. Mirowski forming MFV or for transferring assets to MFV. The court disagreed with the IRS and found that Mrs. Mirowski had the following three significant nontax reasons for forming MFV and transferring assets to it. First, the court found a legitimate and significant nontax purpose in the fact that Mrs. Mirowski wanted to ensure the joint management of the family's assets by her daughters and eventually her grandchildren. The record demonstrated that Mrs. Mirowski wanted her daughters, and eventually her grandchildren, to work together, remain closely knit, and be jointly involved in managing the investments derived from the royalties received from the patents and the business matters relating to the patents, including any litigation arising with respect to the patents.
Second, the court found the existence of another legitimate and significant nontax purpose from the fact that maintenance of the bulk of the family's assets in a single pool of assets made possible investment opportunities that would not be available if Mrs. Mirowski were to have made a separate gift of a portion of her assets to each of her daughters or to each of her daughters' trusts.
Third, the court found an additional legitimate and significant nontax purpose because the formation of MFV and Mrs. Mirowski's lifetime gift of an equal interest in MFV to each of her daughters' trusts enabled Mrs. Mirowski to ensure that her daughters and eventually her grandchildren would continue to hold respective interests of equal worth in the bulk of the family's assets.
In addition to the above-described legitimate and significant nontax purposes, the court recognized another legitimate, but not significant, nontax reason was the fact that Mrs. Mirowski formed MFV and transferred assets to MFV in order to provide additional protection from potential creditors. Although the daughters' trusts included provisions providing spendthrift protection from creditors, Mrs. Mirowski desired the additional creditor protection provided by an LLC, in particular the protection that an LLC would provide in the event of any negative developments in the respective marriages of her daughters. However, the court viewed these purposes as theoretical since at the time of trial, none of Mrs. Mirowski's daughters had been married more than once, nor had any of her daughters ever been separated from her spouse because of marital problems.
The court also found that Mrs. Mirowski received interests in MFV proportionate to the value of the property she transferred, that her capital account was properly credited, and that in the event of a liquidation and dissolution of MFV, Mrs. Mirowski had the right pursuant to the governing documents of MFV to a distribution of property from MFV in accordance with her capital account.
The IRS advanced the following six arguments to support its position that the bona fide sale exception did not apply to Mrs. Mirowski transfers to MFV: (1) Mrs. Mirowski failed to retain sufficient assets outside of MFV for her anticipated financial obligations; (2) MFV lacked any valid functioning business operation; (3) Mrs. Mirowski delayed forming and funding MFV until shortly before her death and her health had begun to fail; (4) Mrs. Mirowski sat on both sides of her transfers to MFV; (5) after Mrs. Mirowski died, MFV made distributions to Mrs. Mirowski's estate that the estate used to pay federal and state estate and gift taxes, legal fees, and other estate obligations; and (6) Mrs. Mirowski formed and funded MFV with the expectation of making gifts to her daughters' trusts. The court rejected each of the IRS's arguments.
The court rejected the IRS's argument that Mrs. Mirowski failed to retain sufficient assets outside of MFV for her anticipated financial obligations. The court found that the only significant financial obligation of Mrs. Mirowski was the substantial gift tax that resulted from her gifts of a 16% interest in MFV to each of her daughters' trusts. The court found that there was no express or unwritten agreement or understanding to distribute assets of MFV in order to pay that gift tax liability. The court found that in order to pay the anticipated gift tax liability, Mrs. Mirowski could have (1) used a portion of her personal assets that she retained, (2) used the distributions that she expected to receive as a 52% member in MFV, and (3) borrowed against her personal assets that she retained and her interest in MFV.
The court also rejected the IRS's argument that MFV lacked any valid functioning business operation. The court found that at all times, including after Mrs. Mirowski's death, MFV has been a valid functioning investment operation and had been managing the business matters relating to the patents, including related litigation. The court rejected the contention of the IRS that the activities of MFV had to rise to the level of a business under the federal income tax laws in order for the bona fide sale exception to apply.
The court rejected as well the IRS's argument that Mrs. Mirowski delayed forming and funding MFV until shortly before her death and her health had begun to fail. The court found that Mrs. Mirowski's death was unexpected.
The court also rejected the IRS's argument that Mrs. Mirowski sat on both sides of the transfers to MFV. The court stated that the IRS's interpretation of Section 2036(a) would read out of Section 2036(a) the bona fide sale exception for single member LLCs. The court further found that the IRS's position ignored the fact that Mrs. Mirowski fully funded MFV and that the daughters' trusts did not contribute any assets to MFV.
The court also rejected the IRS's argument that the bona fide sale exception did not apply because after Mrs. Mirowski died, MFV made distributions to Mrs. Mirowski's estate (and not the daughters' trusts) in order for the estate to pay federal and state estate and gift taxes, legal fees, and other estate obligations. The court found that because Mrs. Mirowski's death was unexpected, she and her daughters could not have anticipated that the estate taxes and the other estate obligations would arise so soon after the formation of MFV. Moreover, the court stated that the IRS's argument was not relevant to the issue of whether Mrs. Mirowski's transfers to MFV qualified for the bona fide sale exception, but the transfers were to be considered when the court examined the IRS's argument under Section 2036(a)(1).
The court refused the IRS's attempt to apply the step-transaction doctrine to Mrs. Mirowski's transfer of assets to MFV and her gifts of interests in MFV to her daughters' trusts. The IRS sought to re-characterize the two transfers as a single transfer in which Mrs. Mirowski received a 52% interest in MFV in exchange for her transfer of assets and therefore Mrs. Mirowski would not have received adequate and full consideration for her transfer to MFV. The court concluded that Mrs. Mirowski made two separate, albeit integrally related, transfers of property.
The court next turned its analysis to the gifts Mrs. Mirowski made to the daughters' trusts. The IRS argued that the gifts made by Mrs. Mirowski to her daughters' trusts were includable in her estate under Section 2036(a)(1) because at the time Mrs. Mirowski made those gifts and at the time of her death, an agreement—both express and implied—existed that Mrs. Mirowski retained the possession or the enjoyment of, or the right to the income from, the respective 16%interests in MFV that she gave to her daughters' trusts. The IRS based its argument on the contention that MFV made distributions to Mrs. Mirowski's estate that were used to pay federal and state estate and gift taxes, legal fees, and other estate obligations. This argument was similar to one of the arguments that the IRS raised with respect to whether Mrs. Mirowski's transfers to MFV qualified for the bona fide sale exemption.
The court again rejected this argument of the IRS for the same reasons it rejected the IRS's argument earlier. The court concluded that at the time of the gifts to her daughters' trusts, Mrs. Mirowski did not believe her death was imminent and therefore did not believe these obligations would become due so soon. With respect to the gift taxes that became due as a result of Mrs. Mirowski's gifts, the court found as it stated earlier in its opinion that Mrs. Mirowski had other sources available to her to pay those taxes other than distributions from MFV.
The IRS also contended that the gifts by Mrs. Mirowski to her daughters' trusts were includable in her estate under Section 2036(a)(2) because Mrs. Mirowski held the power as General Manager and majority owner to determine the timing of the distributions from MFV. The court examined in detail the provisions of the Operating Agreement of MFV and concluded that the Operating Agreement did not give Mrs. Mirowski as the majority owner or as the General Manager the authority to determine the timing or the amount of the cash flow, capital proceeds, and liquidation or dissolution distributions of MFV.
It appears from a reading of this case that the court had a favorable view of the facts. A reading of the findings of facts of the opinion indicates that the lawyers for the estate used a very professional approach in developing the testimony of the witnesses and the other evidence presented at trial.
This case is interesting for several reasons. First, the IRS was not successful in having the court apply the step-transaction doctrine to the gifts made by Mrs. Mirowski even though she anticipated making gifts at the time MFV was formed. Second, the court was willing to ignore the post-death distributions from MFV to Mrs. Mirowski's estate used to pay estate taxes and other estate obligations. In addition, the court did not require that MFV be engaged in active business operations, but rather accepted investment operations as sufficient. It is likely that the IRS will appeal this case, so stay tuned for further developments.
1 TC Memo 2008-74, RIA TC Memo ¶2008-074, 95 CCH TCM 1277
2 124 TC 95 (2005).
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.