The Tax Court held that, based on the facts, a transfer by a couple to their daughters of interests in a family limited partnership (FLP) that held only stock in one corporation was a transfer of the partnership interests, not an indirect transfer of stock held by the partnership.
Thomas Holman Jr. worked for Dell Computers (Dell) from October 1988 to November 2001. During this time, Holman received stock options from Dell, some of which he exercised to receive Dell stock. Holman and his wife, Kim, also purchased additional shares of Dell stock outright. As the Dell stock’s value grew, the Holmans became concerned about managing their wealth (which consisted primarily of the Dell stock) and how the stock might eventually be transferred to their four daughters.
After discussing the issue with an estate planning attorney, the Holmans determined that the best way to transfer the stock was through an FLP. The Holmans first set up a trust naming themselves as grantors, Thomas’s mother as trustee, and their daughters as beneficiaries and transferred Dell stock to the trust. The Holmans then set up an FLP with Thomas and Kim as general and limited partners and Thomas’s mother as trustee of the trust and as custodian, separately, for each of their daughters, as a limited partner. In return for their partnership units, Thomas’s mother transferred the Dell stock held by the trust, and Thomas and Kim transferred additional Dell stock they owned to the partnership.
A week later, the Holmans transferred the bulk of their limited partnership (LP) units to the trust and to their youngest daughter. Later in 1999, the Holmans’ other three daughters transferred shares that were held for their benefit in a separate trust to the partnership in return for LP units. The Holmans transferred part of their remaining LP units in the partnership to their daughters in 2000. In January 2001, the Holmans transferred more Dell stock they owned personally to the partnership in return for additional LP units, and in February they transferred more LP units to their daughters.
The Holmans reported the transfers of the LP units to the trust and to their daughters in 1999–2001 as gifts and elected to split the gifts. The value reported by each spouse for their respective gifts was $601,827 in 1999 and $40,000 in both 2000 and 2001. The value the Holmans reported for the gifts was based on independent appraisals of the LP units, which applied a 49.25% discount for lack of marketability or minority interest to the units.
The IRS disagreed with the values reported for the gifts by the Holmans and issued notices of deficiency for additional gift tax. The Service based its deficiency amounts on values of $1,184,684 for the 1999 gifts, $78,912 for the 2000 gifts, and $78,760 for the 2001 gifts. The Holmans challenged the IRS’s deficiency determinations in the Tax Court.
The IRS’s Arguments
With respect to the 1999 transfer, but not the 2000 and 2001 transfers, the IRS argued that the property that passed from the donors was Dell stock, not the LP units. It first argued that the transfer was subject to Regs. Sec. 25.2511-1(h)(1), which states that a shareholder’s property transfer to a corporation for less than adequate consideration is a gift to the other shareholders in the corporation to the extent of their proportionate interest in the corporation.
The Service had previously successfully argued that this regulation applied in the case of a transfer by a partner to a partnership in Shepherd, 115 TC 376 (2000), aff’d 283 F3d 1258 (11th Cir. 2002), and Senda, TC Memo 2004-160, aff’d 433 F3d 1044 (8th Cir. 2006). In Shepherd, a taxpayer transferred property to an FLP, and part of the property’s value was credited to the accounts of his two sons, who were also partners in the FLP. In Senda, the taxpayers transferred property to an FLP and on the same day transferred interests in the FLP to their children.
Alternatively, the IRS argued that the formation and funding of the partnership and the gifts of the LP units in 1999 were steps of an integrated donative transaction and that once the intermediate steps were collapsed, the gifts were gifts of Dell stock in the form of partnership units. Again, the Service relied on the Tax Court’s ruling in Senda as support for its argument.
The Tax Court’s Decision
The Tax Court held that the Holmans’ 1999 transfers of the LP units to their children were gifts of partnership interests, not indirect gifts of the stock held by the partnership. In response to the IRS’s first argument, the Tax Court determined that its holdings in Shepherd and Senda on the application of Regs. Sec. 25.2511-1(h)(1) did not apply in the Holmans’ case because the timing of the transfers of stock to the FLP and the partnership interests to the children was different.
In Shepherd, the taxpayer transferred the stock to the FLP after his sons had already received their FLP interests. In Senda, the transfer of stock to the FLP and the transfer of partnership interests to the children occurred on the same day. In the Holmans’ case, the transfer of stock to the FLP occurred six days before the transfer of the partnership interests to the children. According to the Tax Court, the facts in Shepherd and Senda were materially different than those in the Holmans’ case, and therefore the holdings in Shepherd and Senda did not apply to it.
To analyze the Service’s step-transaction argument, the Tax Court used the interdependence test, under which a series of transactions will be treated as one transaction if the separate steps have no independent significance or are significant only as part of a larger transaction. The Tax Court found that although it had no doubt that the Holmans’ intent was to make a gift of the Dell stock to their daughters, it could not say that the FLP’s formation and funding would have had no significance had the Holmans not also made the gift of the LP units.
The Tax Court once again distinguished the Senda case from the Holmans’ case based on the difference in timing of the formation and funding of the partnership and the transfer of the partnership interests. While the Tax Court stated that it had not held in Senda that an indirect gift could occur only if a partnership was formed and partnership interests were transferred on the same day, it noted that the passage of time between the two events might indicate a change in circumstances that gives the two steps independent significance.
The Tax Court further found that the IRS had essentially conceded that a separation in time between the funding of an FLP and the transfer of interests in the partnership could prevent the application of the step-transaction doctrine because the Ser-vice had not challenged the Hol-mans’ 2000 and 2001 transfers of LP units, which occurred 2 months and 15 months, respectively, after the FLP’s formation. According to the Tax Court, the IRS presumably did not challenge the 2000 and 2001 transfers because the Holmans bore a significant risk of economic loss with respect to the Dell stock during the time between the formation of the FLP and the transfer of the LP units.
However, the Tax Court found that the Holmans also bore a real (if smaller) risk of loss during the six-day period between the FLP’s formation and the transfers of the LP interests in 1999. Therefore, the Tax Court held that it must treat the 1999 transfers in the same manner as the Service conceded it must treat the 2000 and 2001 transfers. Thus, the Tax Court could not disregard the passage of time and apply the step-transaction doctrine to treat the transfers as if they had occurred simultaneously.
ReflectionsAlthough the Tax Court confirmed that the strategy of transferring investment property through a family limited partnership can work, it consciously refused to articulate any bright-line standards to use as guidelines for planning. In a footnote, the Tax Court explained that while it held that the six-day period between the formation of the partnership and the transfer of LP units in the Holmans’ case was acceptable based on the fact that the Dell stock was a publicly traded (and at that time, a relatively volatile) stock, the same period would not necessarily suffice in another case where a different type of investment property (e.g., preferred stock or a long-term government bond) was contributed to an FLP.
Holman, 130 TC No. 12 (2008)