By Dennis I. Belcher and David T. Lewis
Mary Smith, a widow, is a beneficiary of a QTIP marital trust that her late husband created. The trustees of the QTIP marital trust transfer $1 million of marketable securities to a family limited partnership (FLP) that Mary Smith's two children created. The QTIP marital trust receives a limited partnership interest in exchange for its marketable securities. In addition, Mary Smith transfers $1 million of her own funds to the FLP and also receives a limited partnership interest. Mary's two children transfer $10,000 each and receive a 1% general partnership interest. Has Mary Smith made a gift of $400,000 to her children on the creation of the FLP? Also, has the QTIP marital trust triggered a tax on the disposition under Code § 2519? According to the IRS' analysis in TAM 9842003, the IRS believes that Mary Smith has made a gift on creation of the FLP, and, FSA 199920016 notwithstanding, the QTIP marital trust may have accelerated and triggered the tax.
It is impossible to discuss sophisticated estate planning techniques with any client without discussing valuation discounts. When a lawyer advises a client whose estate is in the maximum estate tax bracket, the client already has heard in social settings about FLPs and valuation discounts. Clients now tell their estate planning advisors about a friend of a friend who obtained a 45% discount on the transfer of a membership interest in an LLC owning 100% marketable securities.
Despite these exaggerations, the fact remains that using valuation discounts is one of the most popular techniques in estate planning to leverage annual exclusion and unified credit gifts to push wealth to lower generations. The overall increased wealth created by the long running bull market and the confiscatory nature of the transfer tax system only amplifies the willingness to use valuation discounts aggressively to transfer wealth.
For years, estate planning lawyers and their clients have taken advantage of valuation discounts in transferring common stock in operating corporations or interests in partnerships holding business assets. The recent focus on valuation discounts has shifted from interests in entities holding active business assets to using valuation discounts for transfers of interests in entities holding nonbusiness assets, such as marketable securities, vacation homes, unimproved real estate, artwork and other assets of significant value. The increased popularity of using interests in limited partnerships and LLCs to transfer nonbusiness assets to family members at significant discounts has caused the IRS to scrutinize these transactions closely.
In numerous TAMs released in 1997 and 1998, the IRS aggressively attacked valuation discounts applied to interests in limited partnerships and LLCs used primarily for estate planning purposes. See, e.g., TAM 9730004; TAM 9725002; TAM 9723009; TAM 9719006. In these TAMs, the IRS attacked valuation discounts on the following theories:
* The transfer of assets to the partnership should be regarded as a testamentary transaction occurring at the decedent's death;
* The value of the property subject to the partnership agreement should be determined without regard to the partnership agreement in accordance with Code § 2703(a)(2); and
* All restrictions on the decedent's ability to liquidate the partnership or LLC interest should be disregarded in valuing the interest under Code § 2704(b)(2).
In TAM 9842003, the IRS expanded its attacks to include an argument that the decedent's transfer of assets to an FLP or LLC was a gift by the decedent subject to gift tax on the creation of the entity. The IRS took the position that the amount of the gift was the fair market value of the assets transferred to the partnership or LLC less the fair market value of the partnership or membership interest that the decedent received in the transfer.
There are sufficient legal grounds, and often sufficient factual grounds, to challenge each of these IRS attacks on FLPs. This article, however, addresses only the IRS' position that a taxable gift results on the formation of an FLP or LLC.
The IRS Gift on Creation Argument
The IRS gift on creation argument is deceptively simple. A donor contributes assets to a limited partnership with other partners (family members) and receives a partnership interest in exchange for the donor's contribution. Because a hypothetical buyer would value the donor's partnership interest on a discounted basis, the donor must have made a taxable gift to the other partners equal to the difference in value.
The IRS first articulated this argument in TAM 9842003, issued on October 19, 1998. The IRS observed that Treas. Reg. § 25.2511-1(c)(1) provides that the gift tax applies to gifts made indirectly in any transaction in which an interest in property is gratuitously passed or conferred on another, regardless of the means or device employed. The IRS also noted that Treas. Reg. § 25.2511-2(a) provides that the gift tax is not imposed on the receipt of property by the donee, is not determined by the measure of enrichment resulting to the donee from the transfer and is not conditioned on the ability to identify the donee at the time of the transfer. The IRS asserted that the gift tax is an excise tax on the donor's act of making a transfer and is measured by the value of the property passing from the donor. The gift tax is imposed regardless of the fact that the identity of the donee may not be known or ascertainable at the time of the gift.
The IRS first successfully made such an argument in Estate of Trenchard v. Commissioner, 69 T.C.M. (CCH) 2732 (1995). In 1977, Mr. Trenchard and his wife, daughter and three grandchildren transferred property to a newly formed corporation in exchange for common stock, voting preferred stock and debentures. Mr. Trenchard died in 1985, and Mrs. Trenchard died in 1992. The IRS claimed that the voting preferred stock and debentures that Mr. Trenchard received were not equal in value to the real property he transferred to the corporation. Accordingly, the IRS assessed gift tax deficiencies for 1978 through 1985 along with a penalty for failure to file gift tax returns. Mr. Trenchard's estate, on the other hand, contended that Mr. and Mrs. Trenchard merely made a bad business decision and that the gift tax does not reach a transfer of property made in the ordinary course of business. The estate relied on Treas. Reg. § 25.2512-8.
The Tax Court agreed with the IRS. In his opinion, Judge Laro stated: "We closely scrutinize a transfer involving related parties, such as family members and their closely-held corporation, to determine whether the transfer is a gift. We presume that such a transfer is a gift." Estate of Trenchard, 69 T.C.M. (CCH) 2732. Although the court allowed a 40% control premium in valuing Mr. Trenchard's voting preferred stock, the court held that the value of the property that Mr. and Mrs. Trenchard received in forming the corporation was less than the value of the contributed property. The court held that the excess value flowed to the common shareholders and constituted gifts by Mr. and Mrs. Trenchard subject to gift tax. In addition to the deficiency, the court upheld the addition to tax under Code § 6651(a) for failure to file gift tax returns on a timely basis.
Mr. Trenchard's estate argued that Mr. and Mrs. Trenchard could liquidate the corporation and receive back their corporate contributions in their discretion. Not persuaded, the court noted that such a liquidation would violate their fiduciary obligations to the other shareholders. Thus, the power to liquidate did not prevent a gift on the creation of the corporation. Significantly, Mr. and Mrs. Trenchard did not obtain an appraisal of the stock and debt instruments that they received from the corporation when they transferred the real estate to it.
The IRS also successfully used the gift on creation argument in Estate of Bosca v. Commissioner, 76 T.C.M. (CCH) 62 (1998). There, the court held that Mr. Bosca made a gift when exchanging shares of voting common stock for nonvoting common stock of a closely held corporation. One of the important aspects of Bosca is the manner in which the court determined the amount of the gift. According to Judge Whalen, the amount of the gift was the difference between what Mr. Bosca transferred and what he received.
Bosca is a classic case of bad facts resulting in bad law. The valuation issue in Bosca involved the recapitalization of closely held stock owned by Mr. Bosca before his death. Under the recapitalization plan, Mr. Bosca exchanged voting stock for nonvoting stock on a one-for-one basis, taking the position that there was no difference between the voting and nonvoting shares. After the recapitalization, Mr. Bosca's sons owned all shares of voting stock. In determining the amount of the gift, the court did not address the corresponding increase in the value of the stock owned by the sons, but focused on the diminution of value of Mr. Bosca's interest in the company.
Analysis of the IRS Position
The Trenchard and Bosca decisions represent fairly limited opinions on uncommon factual situations. TAM 9842003, on the other hand, was an attempt by the IRS to apply the Trenchard holding to a more common estate planning scenario. Because of their factual limitations, the Trenchard and Bosca opinions should not be read broadly. Every entity created with multiple owners results in the contributors' receiving an interest in the entity not equal to the value of the underlying assets contributed. That fact is the basis for discounts for lack of marketability and lack of control. What the family and the IRS should consider are the intangibles received by the contributors, many of which are not taxable and are difficult to measure, such as centralized management, protection from creditors and administrative savings. Treas. Reg. § 25.2512-8 recognizes this in explaining, ". . . a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm's length, and free from any donative intent), will be considered as made for an adequate consideration in money or money's worth."
Trenchard and Bosca must be reconciled with the fact that every contributor to an entity will lose value on the formation of the entity. Under the IRS' expansive reading of Trenchard and Bosca, two unrelated individuals may be subject to gift taxes if they contribute assets to a partnership or LLC in a pure business setting. Certainly there is no donative intent in the situation in which a landowner contributes real estate and a developer contributes cash to an LLC for the purpose of developing the real estate, although each receives LLC membership interest in exchange for his or her contribution.
Avoiding a Gift on Creation
There are several methods to avoid a gift on the formation of an entity. First, the lawyer and the family could ensure that the formation of the entity is done for a valid business purpose, with bona fide, arm's length transactions. If so, the Treasury Regulations protect the transaction from the imposition of gift taxes. Treas. Reg. § 25.2512-8 provides that a transaction entered into for a valid business purpose, ". . . will be considered as made for an adequate consideration in money or money's worth." Independent appraisals can help support the bona fide, arm's length nature of the transaction.
The lawyer could structure the arrangement so that the donor can liquidate the entity following the transfer of property by the donor to it. Thus, the donor receives an interest in the new entity with a fair market value equal to the property contributed. This can be accomplished in one of several ways. If the donor is the general partner, the general partner could have the power to liquidate the entity, thereby returning to the donor the property that the donor transferred to the entity. Another approach is to use a corporation or an LLC as the general partner and give the donor control of the general partner. In addition, if the donor receives a sufficient interest in the entity as a limited partner or an LLC member, the donor may have the power to liquidate the entity. Unfortunately, some of these solu-tions may create problems under the Code § 2704(a) rules for lapsing liquidation rights.
A final approach would be for the donor to make the contribution to a limited partnership or LLC and initially take back the entire ownership interest in the entity. In this situation, it would be difficult, if not impossible, for the IRS to argue that a gift has occurred, even if the donor later transfers partnership or membership interests to family members.
For example, assume that, in 1999, D transfers to an LLC investment real estate with a fair market value of $750,000 and marketable securities with a fair market value of $250,000. D receives ten class A voting membership units and 90 class B nonvoting membership units (collectively, all of the membership units of the LLC). Immediately after the transfer, the fair market value of all of D's membership units in the LLC is $1 million because D can liquidate the LLC and receive 100% of the underlying assets without any fiduciary obligation to other members.
In 2000, D transfers 1.6 class B units to each of his three children. D timely files a gift tax return reporting the gifts and attaches to the return an appraisal establishing the fair market value of 1.6 class B units at $9,600 (using a 40% discount). Rightfully so, neither the appraisal nor the gift tax return addresses the diminution in value of D's membership interest.
In 2001, D transfers two class A units to each of his three children. Again, D timely files a gift tax return reporting the gifts and attaches to the return an appraisal establishing the fair market value of two class. A units at $23,000 (using a 15% voting premium).
D dies in 2002 and his executors timely file an estate tax return, attaching to the return an appraisal establishing the fair market value of D's four class A units at $46,000 (using a 15% voting premium) and D's 85.2 class B units at $511,200 (using a 40% discount).
This example assumes that the LLC operating agreement and state law require a majority of voting membership interests to liquidate the LLC. If so, D's transfer of two class A units to each of his children is not a lapse of a liquidation right under Code § 2704(a). This is true notwithstanding the fact that D could liquidate the LLC immediately before the transfer and that D could not liquidate the LLC immediately after the transfer. See Treas. Reg. § 25.2704-1(c)(1), 1(f), Examples 4 and 7. The same analysis applies in the limited partnership setting where the donor is the sole shareholder of the corporate general partner as well as the sole limited partner. There is no lapse on the transfer of controlling shares in the corporate general partner.
Perhaps the greatest exposure to an IRS attack on a gift on the creation of an entity is when the donor contributes assets to a limited partner-ship and takes back a 99% limited partnership interest and the donor's descendants or trusts receive a 1% general partnership interest. The exposure here is not as a result of the IRS' position in TAM 9842003, Trenchard or Bosca, but rather that the value of the 99% limited partnership interest received by the donor will be under-valued for transfer tax purposes. In this regard, the lawyer and the appraiser must consider the Tax Court's recent decision in Estate of Simplot v. Commissioner, 112 T.C. No. 13 (1999), which involved the determination for estate tax purposes of the fair market value of voting and nonvoting shares of stock held by a decedent's estate in a family owned corporation.
In Simplot, the decedent owned 18 of the outstanding 76.445 shares of the voting stock and 3,942.048 of the outstanding 141,288.584 shares of the nonvoting stock of J.R. Simplot Co. The decedent's three siblings owned the remaining shares of outstanding stock. The ratio of nonvoting shares to voting shares was 1,848.24 to one. Mr. Simplot's estate plan made a specific gift of the voting stock in a disposition that would not qualify for an estate tax deduction. Mr. Simplot gave the balance of his estate in a manner that qualified for the estate tax marital deduction.
On the federal estate tax return, Mr. Simplot's personal representative reported the fair market value for both classes of stock as $2,650 per share. In the notice of deficiency, the IRS determined the fair market value of the voting stock to be $801,994.83 per share and the fair market value of the nonvoting stock to be $3,585.50 per share. The disparate valuations were attributable primarily to the valuation methodologies that the parties employed.
Judge Jacobs held that a premium for voting privileges was appropriate and should be determined in relation to the equity value of the corporation (enterprise value plus cash minus liabilities). The court applied a swing vote premium of 3% of the corporation's total equity to the voting stock, allocated proportionately to the voting shares. Although the reasoning of Simplot is arguably flawed, the IRS may apply this case to the valuation of partnership interests. Far better reasoning is the Simplot does not apply to a limited partnership or an LLC. Unlike a corporation, a general partnership interest is personal to the general partner, and the voting rights cannot be sold or assigned.
Like all other attacks on valuation discounts, the gift on creation attack by the IRS is best addressed by obtaining independent appraisals at the time of the transfer. If the IRS attempts to use Simplot as a sword, general partnership interests could have a control premium equal to a percentage (the experts in Simplot applied a control premium from 3-10%) of the equity of the enterprise. Because most appraisers and lawyers do not factor this premium into valuations, there could be significant unexpected adverse consequences in many estate plans.
Dennis I. Belcher is a partner with McGuire, Woods, Battle & Booth, LLP in Richmond, Virginia, and is Vice Chair of the Probate and Trust Division. David T. Lewis is an associate with McGuire, Woods, Battle & Booth, LLP in Charlotte, North Carolina, and is Vice Chair of the Probate Division's Marital Deduction (B-2) Committee.Probate & Property Magazine is published six times annually and is included in section members' annual dues.