Significant Recent Developments in Estate Planning (Part I)

EXECUTIVE SUMMARY

The HIRE Act contained several provisions that have estate planning effects, including new withholding and reporting requirements affecting individuals who have offshore accounts, investments, or interests in foreign trusts. The Patient Protection and Affordable Care Act included a new 3.8% Medicare tax on certain unearned income for high-income taxpayers. The status of the estate tax for 2010 remains uncertain, with a retroactive reinstatement of the tax for 2010 a possibility. The details of the estate tax when it returns in 2011 are also uncertain; the president’s budget and a bill passed in the House have proposed a reinstatement of the 45% rate and the $3.5 million exemption amount that was effective in 2009. The Tax Court held for the IRS in two cases on the issue of whether the transfer of an interest in a family limited partnership is a gift of a present interest where there are significant restrictions on the further transfer of the FLP interest. Several courts also addressed the issue of whether a gift of an LLC interest should be treated as an indirect gift of a share of the assets of the LLC. In two cases, the courts approved the use of a formula clause to avoid increases in estate and gift tax.

---

This two-part article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2009 and May 2010. Part I discusses legislative developments, an outlook on estate tax reform, and gift tax cases and rulings. Part II, in the October issue, will cover the estate tax, generation-skipping transfers, trusts, changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001, and the annual inflation adjustments for 2010 relevant to estate and gift tax.

Legislative Developments

Two major pieces of legislation were passed by Congress and signed by President Obama over the past year that affect the practice of estate planning.

On March 18, 2010, the president signed the Hiring Incentives to Restore Employment (HIRE) Act 1 into law. It provides tax breaks for businesses to encourage the hiring of unemployed workers. The act also includes as revenue raisers the following international reporting requirements affecting individuals who have offshore accounts, investments, or interests in foreign trusts:

• It imposes a 30% withholding tax on income from U.S. financial assets held by foreign financial institutions unless the institutions enter into an agreement to disclose certain U.S. account holders, annually report the account balance, gross receipts, and gross withdrawals, and comply with certain other requirements; 2
• It imposes a 30% withholding tax on any withholdable payment (generally, certain passive-type income and proceeds from the disposition of such assets) to a foreign entity that is not a financial institution if that foreign entity, or another nonfinancial foreign entity, is the beneficial owner of the payment, unless the beneficial owner or the payee provides the withholding agent with either a certification that the beneficial owner does not have any substantial U.S. owners or the name, address, and taxpayer identification number of each such substantial U.S. owner of that beneficial owner; 3
• It requires individuals to report offshore accounts or assets worth over $50,000 on their tax returns; 4
• It imposes a 40% penalty for understatements attributable to an undisclosed foreign financial asset;
• It increases the statute of limitation for omissions on a tax return of items over $5,000 that are attributable to one or more reportable foreign assets; 5
• It expands the definition of a U.S. beneficiary relating to foreign grantor trusts, makes certain agreements between a U.S. transferor of property to a foreign trust and foreign persons part of the trust agreement, 6 requires a U.S. person to comply with certain information requests by the IRS regarding foreign trusts, 7 and increases the minimum penalty for failure to file certain informational returns to $10,000; 8 and
• It treats as a distribution from a nongrantor foreign trust for income tax purposes the uncompensated use of foreign trust property by a U.S. grantor, a U.S. beneficiary, or a related U.S. person. 9

On March 23, 2010, the president signed the Patient Protection and Affordable Care Act 10 into law. It contains the following two provisions that will affect wealthy individuals starting in 2013:

• It increases the employee portion of the FICA health insurance tax by 0.9% on wages in excess of $200,000 ($250,000 if married filing jointly); 11 and
• It imposes a new 3.8% Medicare tax on unearned income, such as capital gains, dividends, and interest, to the extent that modified adjusted gross income exceeds $200,000 ($250,000 if married filing jointly). 12

Outlook on Estate Tax Reform

At the time of this writing, there is no clear indication as to whether Congress will enact legislation on estate tax reform in 2010. Currently, there is no estate tax and no generation-skipping transfer (GST) tax. The step-up in basis for inherited assets has been replaced by modified carryover basis. However, there continues to be a gift tax.

On December 2, 2009, the U.S. House of Representatives passed H.R. 4154, which would make permanent the 2009 levels with a top marginal rate of 45% and an estate and GST exemption amount of $3.5 million. However, the Senate has failed to act on the legislation. Prior to the end of 2009, Senate Finance Committee chair Max Baucus (D-MT) attempted to extend to 2010 the 2009 rates and exemption amounts by unanimous consent in the Senate, but that attempt failed.

There are many possibilities as to what Congress may or may not do in 2010. Among the most commonly discussed are that it could:

• Enact legislation that retroactively reinstates the estate and GST taxes to January 1, 2010;
• Enact estate and GST taxes effective prospectively but leave a gap in time when neither of these taxes apply; or
• Do nothing and allow the estate and GST taxes to disappear in 2010 and be reinstated in 2011.

For a decedent who died on January 1, 2010, the federal estate tax return would be due without extensions on October 1, 2010. Conceivably, Congress could wait until then and reinstate the estate and GST taxes retroactively to January 1, 2010. It is likely that the estate of a significantly wealthy decedent who dies in 2010 prior to the enactment of such legislation will have incentive to challenge the constitutionality of such a change. Whether the retroactive provision in any reform legislation would withstand a constitutional challenge remains to be seen. However, there is precedent that such a provision might withstand such a challenge. 13

Congress could allow a gap period where no estate tax applies to decedents who die in that period. Whether the gap period would also cover GSTs is another question. Allowing a few estates of people who happen to die in the gap period to escape estate tax is entirely different from allowing taxpayers to intentionally make inter vivos multigenerational transfers and avoid the GST tax. Nonetheless, it could happen.

If Congress allows a gap period, it also remains to be seen whether it will leave carryover basis in place or repeal it retroactively. Some members of Congress have suggested that if there were a gap period, the estates of decedents dying during that period would be able to choose carryover basis or the regime enacted by estate tax reform legislation (which would presumably allow a step-up in basis). This election would benefit those smaller estates that would otherwise be affected by the modified carryover basis rules but would not be subject to estate tax due to the estate tax exemption amount.

Congress could do nothing and allow the estate and GST taxes to be repealed in 2010 and then reinstated in 2011 at rates and exemption amounts reverting to the levels set forth in the Economic Growth and Tax Relief Reconciliation Act of 2001 14 (EGTRRA) for 2011 and beyond. This would mean going back to top marginal rates of 55%, with the exemption amount reverting to $1 million and only the GST exemption amount being indexed for inflation.

In February 2010, the president released his 2011 fiscal-year budget. The budget contains the following proposals related to estate tax reform (much the same as contained in his 2010 fiscal-year budget):

• Retroactive and permanent extension of the estate, gift, and GST tax rules applicable in 2009, including the tax rates (45%) and exemption amounts ($3.5 million for estates).
• Creation of an additional category of disregarded restrictions under Sec. 2704 that would be ignored in valuing an interest in a family limited partnership (FLP). In certain circumstances, this would curb the discounts taxpayers can achieve for transfer tax purposes by putting assets in an FLP. The IRS would be granted broad regulatory authority to determine which restrictions should be disregarded and to create safe harbors to permit taxpayers to avoid these restrictions.
• Imposition of a minimum annuity term of 10 years and a remainder interest valued at an amount other than zero for grantor retained annuity trusts (GRATs). The minimum term increases the risk that the grantor might die during the annuity term, requiring all or part of the GRAT’s assets to be included in the annuitant’s estate for estate tax purposes. The “amount other than zero” would require that the transfer to a GRAT be disclosed on a gift tax return. This provision has already made it into recent legislation. 15
• Limitation of the basis of inherited property to the value the property is assigned for estate tax purposes (subject to subsequent adjustments). The executor of an estate would be required to report the valuations used in filing the estate tax return.

Gift Tax

Gift Tax Annual Exclusion

Sec. 2503(b) excludes from gift tax the first $13,000 16 of present interest gifts a donor makes to any person or persons during a calendar year. Regs. Sec. 25.2503-3(b) defines the term “present interest” as the unrestricted right to the immediate use, possession, or enjoyment of property or the income from property. In contrast, Regs. Sec. 25.2503-3(a) provides that a future interest in property, for which the annual exclusion is not available, includes reversions, remainders, and other interests or estates, whether vested or contingent and whether supported by a particular interest or estate, that are limited to commence in use, possession, or enjoyment at some future date or time.

Since the explosion of the use of FLPs in estate planning in the late 1990s, the IRS has taken the position that, due to the restrictions on distributions from and transferability of FLP interests generally contained in FLP agreements, the donees of FLP interests derived no present economic benefit from the transfer. As a result, it concludes that transfers of FLP interests are gifts of a future interest and are thus not eligible for the gift tax annual exclusion. In Hackl, 17 the Tax Court agreed with the IRS that the restrictive FLP agreement that was the subject of the case made gifts of the FLP interests ineligible for the gift tax annual exclusion.

In Hackl, the Tax Court ruled that in order for a taxpayer to satisfy the requirement that a transfer of property be a gift of a present interest, at least one of the following requirements must be satisfied:

• The donee is able to dispose of his or her interest in the business and obtain a substantial present economic benefit; and/or
• The donee is entitled to the income from the underlying property.

In order to satisfy the first requirement, the taxpayer must prove that the facts and circumstances establish that possession of the interest renders an economic benefit reachable by the donee (via sale, acquisition, or otherwise). In order to satisfy the second requirement, the taxpayer must prove that: (1) the property in fact will produce income; (2) some portion of that income will flow steadily to the beneficiary; and (3) the portion of income flowing out to the beneficiary can be ascertained.

After the Tax Court’s ruling in Hackl, the issue was not raised again until this year. In two separate cases, the courts ruled that Hackl was applicable and denied the donors gift tax annual exclusions for transfers of interests in an FLP and a limited liability company (LLC).

In Price, 18 the taxpayers created an FLP by transferring stock and real estate to it in return for a 1% general interest and a 99% limited interest. The FLP agreement generally prevented any partner from withdrawing their capital contributions. It also restricted the transfer of FLP interests to anyone other than a current partner of the FLP, and any assignment of FLP interests granted the assignee only the right to share in the FLP’s profits. If an assignment did occur, the FLP and/or its partners had the option to purchase the FLP interest from the assignee for its fair market value. Finally, the FLP agreement provided that FLP profits were to be distributed to its partners at the sole discretion of the general partner, except as otherwise directed by a majority of interests of all the FLP’s partners. Over the course of six years, the taxpayers made annual transfers of limited interests in the FLP to their three children.

Following its test in Hackl, the Tax Court first determined that the donees received no substantial present economic benefit from the transfer of the FLP interests because, under the FLP agreement, the donees: (1) had no unilateral right to withdraw their capital accounts; (2) were prohibited from selling, assigning, or transferring their FLP interests or otherwise encumbering or disposing of such interests without the consent of all partners; and (3) were considered assignees of the FLP. The court then determined that the donees were not entitled to income from the FLP because, under the FLP agreement, distributions were at the general partner’s discretion.

In Fisher, 19 over a three-year period that was the subject of an audit, the taxpayers transferred interests in an LLC to each of their seven children. From the date of the LLC formation to the date of the transfers, the LLC’s principal asset was a parcel of undeveloped land. The LLC’s operating agreement provided that the LLC’s powers were to be exercised by or under the authority of the management committee and that the exercise of such powers was binding on the LLC and on each member. The operating agreement also provided for a general manager who was to supervise the LLC’s day-to-day operations. The general manager further had the power to determine the timing and amount of distributions from the LLC.

If a member wanted to transfer an interest in the LLC, the LLC’s operating agreement gave the LLC a right of first refusal to purchase such interest within 30 days from the date it received notice of the member’s intent to sell his or her interest at an amount equal to the prospective transferee’s offer. Under the operating agreement, the LLC would purchase a transferring member’s interest with a nonnegotiable promissory note that would be payable over a period of time not to exceed 15 years in equal installments of principal and interest, the first of which would be due and payable one year after the closing date.

In applying the test in Hackl, the district court determined that:

• The donees’ rights to income were at the exclusive discretion of the LLC’s general manager (the donee’s parents);
• There was nothing in the LLC agreement that gave the donees the right to use the LLC’s property (the undeveloped property); and
• The donees’ right to transfer their LLC interests was too restrictive.

Thus, the court ruled that the donees received no substantial economic benefit from the transfer of the LLC interests.

While a right of first refusal to purchase a transferring member’s interest within 30 days from the date it received notice of the member’s intent to sell his or her interest at an amount equal to the prospective transferee’s offer would seem to create the right to realize a substantial present economic benefit from a transferred interest, it was the additional terms of the right of first refusal that probably doomed the transfer. The fact that the first payment was not due until one year after the closing date was sufficient to render the transfer as the gift of a future interest. In order to avoid this fatal flaw, the LLC should not exercise the right of first refusal by giving the transferor a note. If a note is required because the LLC does not have the funds to completely purchase the interest, a sizable payment should be made with a demand note for the remaining amount. The LLC should pay the demand note as soon as it has the funds to do so.

Practice tip: In response to Hackl, many estate planners altered FLP agreements so they did not run afoul of the Tax Court’s ruling. To increase the likelihood that the transfer of an FLP interest will qualify for the gift tax annual exclusion, the authors suggest that the FLP agreement include provisions that allow a person who receives an interest in the FLP by “gift” to presently transfer or otherwise receive fair market value for his or her FLP interest. The following alternatives are ways to potentially accomplish this goal:

• The FLP agreement could omit transfer or withdrawal restrictions contained in the FLP agreement.
• The FLP agreement could allow transfers of FLP interests subject to the FLP’s right of first refusal (avoiding the payment structure in Fisher).
• The FLP agreement or the instrument transferring the FLP interest could include a provision that gives the transferee the equivalent of a “put” right.

The “put” right would allow the transferee of an FLP interest by gift the right (for a reasonable period of time after receiving the FLP interest) to require the FLP or the transferor of the FLP interest to buy back the transferred FLP interest at a price equal to the fair market value of the FLP interest. In Price, the Tax Court took issue with the third alternative; however, the court noted that although the partner had a right to put the interest to the FLP, the FLP was not otherwise required to purchase it.

Indirect Gift

Under Regs. Sec. 25.2511-1(h)(1), an indirect gift occurs upon the transfer of assets to an entity wherein the transferor does not receive a proportionate interest in the entity in return for the transfer. The difference between the value of the assets transferred and the value of the interest received results in a gift to the other members of the entity.

In recent years the IRS has increasingly challenged the value of transfers to FLPs, arguing that an indirect gift has occurred when the formation of, transfer of property to, and transfers of interests in an FLP have occurred out of sequence or when the sequence cannot be determined. The proper sequence of events is for the taxpayer to create the FLP, then contribute property to the FLP and credit it to the taxpayer’s own capital account, and finally make a gift of FLP interests. Taxpayers need to establish this chronology of events in order to be treated as making a gift of the FLP interests.

In Estate of Malkin, 20 the Tax Court considered whether the decedent had made an indirect gift of the LLC interests rather than a gift or perhaps sale of the interests in an FLP. On February 29, 2000, the FLP was purportedly created, and the LLC interests were purportedly transferred to it. Trusts that were the decedent’s partners in the FLP were not created until the next day. The Tax Court determined that a one-person partnership is not recognized under Mississippi law, so the FLP was valid only after the trusts were formed on March 1, 2000, and the decedent could transfer his interests in the LLCs only after the FLP was validly formed. The fact pattern is similar to the one in Shepherd, 21 where the taxpayer was held to have made indirect gifts of the underlying assets rather than gifts of partnership interests.

The estate argued that Shepherd does not apply because the trusts purchased the partnership interests from the decedent. The Tax Court dismissed this argument and concluded that the purported sale of these interests was a sham. About a week after signing the sales agreement, the decedent transferred cash to the trusts, which the trusts used two days later to pay the required down payment to the decedent. The trusts never paid any interest on the notes, the decedent died before the first payment became due, and the estate never made a demand for payments. Thus, the Tax Court was not convinced that the decedent expected the trusts or his children to pay off the notes for the purchase of the interests in the FLP. The court concluded that because the purported sale of the FLP interests to the trusts was a sham and Shepherd controlled, the decedent made gifts of the LLC interests, not interests in the FLP.

Even when the transfers have occurred in the proper sequence, the IRS has raised the step-transaction doctrine to collapse all the events into one and assert that an indirect gift has occurred. The Tax Court considered the step-transaction doctrine in two recent cases, Holman 22 and Gross, 23 but did not apply it. In Holman, Dell stock was transferred to the partnership six days before partnership interests were gifted. The value of the stock fluctuated during the six-day interval, so the court concluded that the taxpayers bore a real economic risk that the value of the partnership interests could change during that time and refused to apply the step-transaction doctrine. The Tax Court reached a similar conclusion in Gross, in which common shares in well-known companies were transferred to the partnership over a three-month period, and the last assets were transferred 11 days before the partnership interests were gifted. In both cases, the court dropped footnotes in the opinion indicating that if the assets had been of some other nature (citing, for example, preferred stock or long-term government bonds), it might have ruled that the step-transaction doctrine was applicable.

The step-transaction doctrine treats a series of formally separate steps as a single transaction if the steps are in substance integrated, interdependent, and focused toward a particular result. The courts have generally followed one of three alternative tests in determining whether a series of transactions should be stepped together: the binding commitment test, the end result test, and the interdependence test.

The binding commitment test collapses a series of steps if, at the time the first step was entered into, there was a binding commitment to undertake a later step. The end result test looks to whether a series of formally separate steps are prearranged parts of a single transaction intended from the outset to reach the ultimate result. The interdependence test considers whether, based on a reasonable interpretation of the objective facts, the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series of transactions.

In a pair of cases from the same district court in Washington, a court for the first time ruled that the step-transaction doctrine applied and that transfers to LLCs were indirect gifts. It should be noted, however, that neither of the rulings on the step-transaction doctrine was necessary because the court had already determined that the transfers of the interests in the LLCs occurred either before or simultaneously with the transfer of assets to the LLCs.

In Linton, 24 the district court ruled that the transfers of the LLC interests were indirect gifts of the actual assets of the LLC. The trust agreements for the benefit of the taxpayers’ children stated that they are effective upon contribution of property to the trusts and that at the time of signing, the LLC interests were being transferred to the trustee and the trustee acknowledged receipt of the property. Thus, based on the express language of the documents, the trusts were created and gifts of the LLC interests were made on the date of signing the trust agreement. Because the trusts were created and gifts of the LLC interests were made either before or simultaneously with the contribution of property to the LLC, the court concluded that the transfer of assets to the LLC enhanced the LLC interests held by the children’s trusts and were therefore indirect gifts of those assets to the trusts.

While the district court could have concluded its ruling based solely on the bad sequencing of events, the court also addressed whether the step-transaction doctrine rendered the transfers to the children indirect gifts. The court determined that the taxpayers failed all three tests regarding the doctrine. The binding commitment test was satisfied because the taxpayers signed the trust agreements and the gift documents at the same time that they took the first steps to contribute assets to the LLC. The end result test was satisfied because the taxpayers admittedly were seeking to minimize their gift tax liability by utilizing the discounts available from transferring assets to the LLC and subsequently gifting the LLC interests. The interdependence test was satisfied because the taxpayers supposedly would not have contributed assets to the LLC without the ability to claim the discounts for gift tax purposes.

In Heckerman, 25 the taxpayers established two trusts for the benefit of their minor children on July 28, 2001. On the same day, they also formed three LLCs—Investments LLC, Real Estate LLC, and Family LLC, which was an umbrella LLC that solely owned Investments LLC and Real Estate LLC. On December 28, 2001, they transferred a house first to Family LLC and then from there to Real Estate LLC. On January 11, 2002, they transferred cash to Investments LLC and also transferred units from Family LLC to each of their children’s trusts. The taxpayers claimed a 58% discount for minority interest and lack of marketability when the gifts were valued on their gift tax returns.

The taxpayers could not establish the proper chronology of events. The transfer of cash to the Investment LLC took place on January 11, 2002, the same day that all the paperwork surrounding the gift of the LLC interests to the two trusts was dated. The taxpayers argued that they probably did not sign the documents assigning the LLC interests to the trusts until after January 11, 2002 (or at least later in the day on January 11 after the cash had been transferred) and that the gifts to the trusts were not actually complete when the assignments were signed but rather were complete only when they were delivered to the trustees (who were not the grantors) at some later date.

The district court concluded that there was no genuine issue of fact that would require a trial. Even if the taxpayers actually signed the assignment documents after January 11, 2002, they expressly made them effective as of January 11, 2002, and consistently treated them as gifts on that date. In their claim for refund, the taxpayers had not argued that the assignments were not effective until they were delivered to the trustees, so it was too late to make this argument to the court.

While the district court again could have concluded its holding based solely on the bad sequencing of events, it also addressed the step-transaction doctrine. The court examined all three tests and determined that the end result test and the interdependence test had been met but the binding commitment test had not. The LLCs and the trusts were created several weeks before the transfer of cash to the LLC and the gifts of the LLC interests, so the court concluded that there was no evidence that the taxpayers had a legal commitment to either transfer the cash or carry out the gifting of the LLC units. Nevertheless, it stated that the Ninth Circuit does not require that the binding commitment test be met before applying the step-transaction doctrine. The court concluded that based on the fact that the end result test and the interdependence test were met, the general characterization of the transaction as stepped together is correct as a matter of law.

Valuation Clauses

Taxpayers use formula clauses to avoid unintended gift, estate, and GST tax consequences when transferring property. There are two general types of formula clauses. A “definition clause” defines a transfer by reference to the value of a possibly larger, identified property interest. An “adjustment clause” retroactively adjusts the value of a transfer due to a subsequent valuation determination. The IRS has been successful in having savings clauses disregarded for gift, estate, and GST tax purposes as against public policy because they prevent the IRS from properly administering the Code. The definition clause is a relatively new clause in estate planning; as in the following cases, the courts that have addressed these types of formula clauses have generally
respected them for gift, estate, and GST tax purposes.

In Estate of Christiansen, 26 the decedent left the residue of her estate (which included interests in FLPs) to her daughter. The daughter disclaimed the bequest to the extent that the value of the residue exceeded a formula amount determined by reference to a fraction, the numerator of which was the fair market value (FMV) of the gift (before the payment of debts, expenses, and taxes) on the date of the decedent’s death, less $6,350,000, and the denominator of which was the gift’s FMV (before the payment of debts, expenses, and taxes) on the date of the decedent’s death “as such value is finally determined for federal estate tax purposes.”

The decedent’s will provided that if the daughter disclaimed any portion of the bequest, 75% of the disclaimed portion would go to a charitable lead annuity trust (CLAT) (the annuity interest passes to the family foundation and the remainder interest passes to the daughter if she is living at the end of the annuity term) and 25% would go to the family foundation outright.

One of the issues addressed by the Tax Court and the subject of appeal was whether the defined value clause (a type of definition clause that defines a gift or sale in terms of the value of property intended to be transferred) should be given effect. The IRS raised its long-argued position that such clauses are against public policy for the reasons set forth in Procter 27 and its progeny, and therefore the estate tax charitable deduction for the property passing to the family foundation outright could not be increased due to a revaluation of the property on audit.

The Tax Court discounted the IRS’s public policy concerns because the defined value clause would not “undo” the transfer, it would only reallocate the value transferred among the daughter, the CLAT, and the family foundation. The court noted that the IRS’s incentive to audit returns affected by such a clause would marginally decrease if the court allowed the increased estate tax charitable deduction, and this would encourage similarly situated taxpayers to lowball the value of the estate to cheat charities. However, the court noted that executors and foundation managers are bound by fiduciary duties that have punitive consequences under state and federal tax law if those duties are violated.

The Eighth Circuit agreed with Tax Court, noting that: (1) the IRS’s role is not merely to maximize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection; (2) there is no clear congressional intent suggesting a policy to maximize incentives for the IRS to challenge or audit returns; and (3) even if the court were to assume such congressional intent, no corresponding rule of construction would be necessary in the present case to promote accurate reporting of estate values. This case is significant because it is the first time the Tax Court (in a fully reviewed opinion) and now the Eighth Circuit have specifically addressed the validity of a defined value clause (although the Fifth Circuit tacitly approved (without addressing) a similar clause in McCord). 28

In Estate of Petter, 29 the Tax Court addressed a defined value clause intended to determine the amount of property transferred to the grantor’s heirs and the amount transferred to charity with respect to the total property interests transferred from the grantor.

The taxpayer transferred stock she had inherited to a family-owned LLC. She then made gifts of LLC units to two intentionally defective grantor trusts for the benefit of her children and grandchildren. The taxpayer intended the gifts to make up 10% of each trust’s assets. At the same time, she also gave LLC units to two public charities. She transferred a specific number of LLC units in two transactions. Each transaction was for one trust and one charity. The amount allocated to each trust for gifted units was the amount of units equal to one-half the maximum amount that could pass free of gift tax by use of what was left of the taxpayer’s $1 million gift tax applicable exclusion amount. The rest of the LLC units for each transfer passed to the charity.

The gift documents also provided that if the value of the LLC units that each trust initially received exceeded the amount each was to receive when the value of the units was finally determined for federal gift tax purposes, the trustee would transfer the excess units to the charity. Each charity also agreed to transfer units to the trust if the gift tax value of the units was determined to be less than originally thought.

Shortly after the gift transactions, the taxpayer sold the two trusts LLC units intended to make up 90% of each trust’s assets in return for promissory notes from the trusts. Language similar to that used in the gift transactions was included in the sales agreements so that the trusts were required to transfer any units valued in excess of the stated sale price to the charity.

The taxpayer disclosed all the transactions on her gift tax return. The IRS audited the return, and the parties agreed on an increased value for the LLC units. Under the formula clause, additional units would be reallocated from the trusts to charity based on the agreed-upon value of the LLC units. The IRS argued, however, that the formula clauses were void because they are contrary to public policy for the reasons set forth in Procter, so the taxpayer’s taxable gift to the trusts should be increased.

The Tax Court noted that the documents’ plain language provides that the taxpayer was giving a specific dollar amount to the trusts, not a specific number of LLC units, so the gift is more like Christiansen than Procter. The court also concluded that the defined value clause was not contrary to public policy because the gift was not as susceptible to abuse. In this case, the charities were part of the negotiations, retained their own counsel, and won changes to the transfer documents to protect their interests. In addition, the Tax Court recited numerous situations in which the IRS had approved the validity of formula clauses in the context of charitable remainder trusts, marital deductions, GST taxes, and gift tax disclaimers.

The Tax Court’s blessing of the defined value gift clause in this context is an important victory for taxpayers who frequently employ this type of clause when the gifted property is not readily marketable. It follows Christiansen, which approved a formula clause for an estate tax disclaimer, and McCord, which tacitly approved without addressing a similar clause in the gift tax context.

Valuation

In Pierre, 30 the Tax Court concluded in a 10–6 decision that gifts of interests in an LLC, which under the check-the-box regulations was a disregarded entity for federal tax purposes, were not gifts of interests in the LLC’s underlying assets.

Upon receiving a $10 million gift from a wealthy friend in 2000, the taxpayer wanted to provide for her son and granddaughter while preserving the family’s wealth. She organized a single-member LLC, validly created under New York law, and did not elect to treat the LLC as a corporation for federal tax purposes. Twelve days after funding the LLC with cash and marketable securities, she gave interests in the LLC to trusts for the benefit of her son and granddaughter and sold the rest of her interests in the LLC to the trusts. In valuing the gifted LLC interests on her gift tax return, the taxpayer claimed a 36.55% discount for minority interest and for lack of marketability. The IRS disregarded the discounts. The issue before the Tax Court was whether the LLC that is a disregarded entity separate from its owner for federal tax purposes under the check-the-box regulations is also disregarded for federal gift tax valuation purposes.

The majority opinion examined the historical background of gift tax valuation and concluded that state law historically determines the nature of property rights, and federal law determines the appropriate tax treatment of those rights. Under New York law, the LLC was an entity separate and apart from its members, and the taxpayer had no property interest in the underlying assets of the LLC. As a result, under the historical gift tax valuation regime, the interests to be valued were the gifted interests in the LLC, not in the LLC’s underlying assets.

The majority then examined whether the check-the-box regulations change that result for single-member LLCs. The IRS issued the regulations in 1996 to simplify the classification of entities for federal tax purposes. Under those regulations, a domestic business entity that has a single owner may elect to be a corporation or, in default of making an election, is disregarded as an entity separate from its owner. The majority opined that the regulations do not apply to define the property interest that is transferred for federal gift tax purposes and that to conclude that the regulations overrule the gift tax valuation regime would be “manifestly incompatible” with the estate and gift tax statutes. The majority noted that Congress has not acted specifically to eliminate entity-related discounts for entities in general or for single-member LLCs. In the absence of congressional action, the majority stated that the IRS cannot by regulations overrule the historical federal gift tax regime.

Planners have avoided the potential problem raised by this case in the past by ensuring that in the case of married individuals, both parties established the LLC so the entity would be treated as a partnership for federal tax purposes. This case alleviates the concern about creating single-member LLCs for estate planning purposes.

In its second decision in the case (Pierre II), 31 the Tax Court applied the step-transaction doctrine to treat the gifts and the sale of the LLC interests as an integrated transaction, thereby affecting the amount of the discount available in valuing the interests. The Tax Court determined that it is appropriate to use the step-transaction doctrine where the only reason that a single transaction was split into two or more separate transactions was to avoid gift tax. In this situation, the court concluded that the donor intended to make gifts of 50% of the LLC to each trust and had primarily tax-motivated reasons for structuring the transactions as gifts and sales. The court found that nothing of tax-independent significance occurred in the moments between the gift transactions and the sale transactions and that the gift and sale transactions were planned as a single transaction with multiple steps used solely for tax purposes. The Tax Court held that the donor made a gift to each trust of a 50% interest in the LLC to the extent the interest exceeded the value of the promissory note executed by the trust. The court then valued the gifts of the 50% interests in the LLC, reduced the allowable discount to 8% for minority interest, and accepted the 30% for lack of marketability.

Even though the Tax Court applied the step-transaction doctrine in the gift tax context, it did not apply the doctrine to collapse the transaction all the way back to the transfer of the cash and marketable securities to the LLC. The IRS had argued that the gift was of the underlying assets and not the LLC interests. The Tax Court treated the gift as gifts of the LLC interests and just collapsed the gifts and sales of the LLC interests that were made on the same day, thereby affecting only the amount of the available discounts, not the existence of any discounts.

In Holman, 32 the Eighth Circuit affirmed the Tax Court’s ruling that the restrictions in the partnership agreement on transfers of interests in an FLP were subject to Sec. 2703 and should not be considered in determining the value of FLP interests transferred by the taxpayers to their children for gift tax purposes. Sec. 2703 was enacted to prevent the valuation of property for transfer tax purposes under agreements that artificially determined the value of property at less than its fair market value. Sec. 2703(a) provides that the value of property for transfer tax purposes is determined without regard to: (1) any option, agreement, or other right to acquire or use property for a price less than its fair market value; or (2) any restrictions on the sale or use of the property. Under Sec. 2703(b), however, this section does not apply to such an option, agreement, right, or restriction if: (1) the restriction is a bona fide business arrangement; (2) the restriction is not a device to transfer property to family members for less than full and adequate consideration; and (3) the restriction is comparable to similar arrangements entered into by persons in an arm’s-length transaction.

A couple transferred stock in a publicly traded company to an FLP in return for general and limited interests. The FLP agreement provided that the limited partners could not withdraw from the FLP or involuntarily or voluntarily assign or encumber their interests except as permitted by the FLP agreement. The FLP agreement further provided that if limited partners did assign their interests in the FLP, the FLP had the option to purchase those interests. The right was assignable to other partners if the FLP did not exercise the right. If the right was not exercised or the partners did not elect the person to whom the limited interest was assigned into the FLP, that person had only the rights of an assignee (i.e., only the right to receive distributions from the FLP). The couple gifted limited interests in the FLP to their children and trusts for their benefit over a three-year period. The IRS challenged the value of the limited interests reflected on the couple’s gift tax returns, arguing indirect gift and the application of Sec. 2703.

The Tax Court determined that the transfer restrictions in the FLP agreement should be disregarding for gift tax purposes because they failed to satisfy the first two requirements of Sec. 2703(b) (the bona fide business arrangement and the restriction is not a testamentary device). The Eighth Circuit agreed. Citing evidence that the FLP conducted no business, it determined that the restrictions could not satisfy the bona fide business arrangement requirement. The court stopped short of stating that restrictions in an FLP agreement that conducts only investment-related activities could never satisfy the bona fide business arrangement requirement. However, it noted that when the restrictions at issue in the case apply to a partnership that holds only an insignificant fraction of stock in a highly liquid and easily valued company (the FLP held Dell stock) with no stated intention to retain that stock or invest according to any particular strategy, the determination regarding whether the restrictions satisfy the bona fide business arrangement requirement was not difficult. Having made such a conclusion, the court determined that the restrictions were a testamentary device, thus failing the second requirement in Sec. 2703(b). Therefore, it ruled that the restrictions on transfers in the FLP agreement could not be considered in determining the value of the FLP’s limited interests for gift tax purposes.

Final Regs. on Disputing Gift Tax Valuation Determinations in Tax Court

The Taxpayer Relief Act of 1997 33 enacted Sec. 7477 to provide a declaratory judgment procedure under which taxpayers may contest in Tax Court an IRS determination regarding the value of a gift. In the absence of Sec. 7477, without an actual gift tax deficiency, a taxpayer would be unable to petition the Tax Court to contest the determination or, without an overpayment of tax, file a claim for refund or bring suit for refund in federal court. This might occur, for example, if an increase in gift tax were offset by the taxpayer’s “applicable credit amount” (as defined in Sec. 2505(a)), so no additional tax would be assessed as a result of the valuation increase. Thus, without Sec. 7477 such a taxpayer would be left without any way to challenge the IRS determination, even though, upon the expiration of the statute of limitation, that determination would become binding for purposes of calculating the cumulative gift tax on all future gifts of that taxpayer, as well as the taxpayer’s estate tax liability.

On June 9, 2008, the IRS issued proposed regulations 34 that provided a procedure for pursuing a declaratory judgment in Tax Court under Sec. 7477. The proposed regulations set forth the following requirements that must be met in order to seek a declaratory judgment:

• The transfer must be shown or disclosed on a gift tax return;
• There must be an actual controversy with respect to a determination by the IRS;
• The pleading seeking a declaratory judgment under Sec. 7477 must be filed with the Tax Court before the 91st day after the mailing of the notice of determination of value (referred to in the proposed regulations as a “Letter 3569”); and
• The taxpayer must exhaust all administrative remedies available within the IRS with respect to the controversy.

On September 8, 2009, the IRS issued final regulations 35 that adopt the proposed regulations with a few clarifications. In particular, the final regulations explain when a taxpayer will have met the fourth requirement. The proposed regulations provided that the IRS would consider a taxpayer to have exhausted all administrative remedies if the taxpayer timely requested an Appeals conference and fully participated in the Appeals process. The final regulations specify that full participation requires timely submission of requested information and disclosure of all relevant information regarding the controversy. In addition, the final regulations provide that if Appeals does not grant the donor’s request for a conference, the donor will be treated as having exhausted all administrative remedies if, after filing a Tax Court petition for a declaratory judgment, the taxpayer participates fully in the Appeals office consideration when offered by the IRS while the case is in docketed status.

Footnotes

¹ Hiring Incentives to Restore Employment, P.L. 111-147.

² Sec. 1471.

³ Sec. 1472.

⁴ Sec. 6038D.

⁵ Sec. 6662(j)(3).

⁶ Sec. 679(c).

⁷ Sec. 1471.

⁸ Sec. 6038D(d).

⁹ Sec. 643(i).

¹⁰ Patient Protection and Affordable Care Act, P.L. 111-148.

¹¹ Sec. 3101(b)(2).

¹² Sec. 1411.

¹³ See Carlton, 512 U.S. 26 (1994); Nationsbank of Texas, 269 F.3d 1332 (Fed. Cir. 2001); Kane, 942 F. Supp. 233 (E.D. Penn. 1996), aff’d without opinion, 118 F.3d 1576 (3d Cir. 1997); and Estate of Cherne, 170 F.3d 961 (9th Cir. 1999).

¹⁴ Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

¹⁵ See Section 532 of the Small Business Jobs Tax Relief Act of 2010 (H.R. 5486), passed by the U.S. House of Representatives on June 15, 2010.

¹⁶ Adjusted for inflation by Rev. Proc. 2009-50, 2009-45 I.R.B. 617.

¹⁷ Hackl, 118 T.C. 279 (2002).

¹⁸ Price, T.C. Memo. 2010-2.

¹⁹ Fisher, No. 1:08-cv-0908-LJM-TAB (S.D. Ind. 3/11/10).

²⁰ Estate of Malkin, T.C. Memo. 2009-212.

²¹ Shepherd, 115 T.C. 376 (2000), aff’d, 283 F.3d 1258 (11th Cir. 2002).

²² Holman, 130 T.C. 170 (2008).

²³ Gross, T.C. Memo. 2008-221.

²⁴ Linton, 638 F. Supp. 2d 1277 (W.D. Wash. 2009).

²⁵ Heckerman, No. 2:08-cv-0211 (W.D. Wash. 2009).

²⁶ Estate of Christiansen, 586 F.3d 1061 (8th Cir. 2009), aff’g 130 T.C. 1 (2008).

²⁷ Procter, 142 F.2d 824 (4th Cir. 1944).

²⁸ McCord, 461 F.3d 614 (5th Cir. 2006).

²⁹ Estate of Petter, T.C. Memo. 2009-280.

³⁰ Pierre, 133 T.C. No. 2 (2009).

³¹ Pierre, T.C. Memo. 2010-106 (Pierre II).

³² Holman, 601 F.3d 763 (8th Cir. 2010), aff’g 130 T.C. 170 (2008).

³³ Taxpayer Relief Act of 1997, P.L. 105-34.

³⁴ REG-143716-04.

³⁵ T.D. 9460.

EditorNotes

Justin Ransome is a partner and Frances Schafer is executive director in the National Tax Office of Grant Thornton LLP in Washington, DC. For more information about this article, contact Mr. Ransome at justin.ransome@gt.com