Stock is discounted by the full amount of a company's unrealized gains. In Estate of Jelke III (2007-2 USTC para. 60,552), the U.S. Court of Appeals for the Eleventh Circuit held that the estate tax value of a decedent's stock in a closely held investment company should be discounted for the company's built-in capital gains tax liability, vacating and remanding a decision by the U.S. Tax Court (T.C. Memo. 2005-131). The company involved held and managed investments for its shareholders. At the time of the decedent's death, it had a $51 million potential tax liability.

The Eleventh Circuit followed the Fifth Circuit's decision in Estate of Dunn v. Commissioner, 301 F.3d 339 (2002), rev'g and rem'g 79 T.C.M. 1337 (2000), which allowed a dollar-for-dollar reduction for the entire builtin capital gains tax liability rather than only the present value of the future tax liability spread over 16 years, based on the company's average annual turnover of its holdings. In Dunn, the Fifth Circuit held that a hypothetical buyer must be assumed to liquidate the corporation it purchases immediately. Therefore, the price the buyer paid would take into account the full amount of any built-in tax liability. This company's stock also received a 10 percent discount for lack of control and a 15 percent discount for lack of marketability.

  • Revenue Ruling 2007-72 fine tunes medical expense deductibles. Internal Revenue Code Section 213(a) allows a taxpayer to take a deduction for medical care expenses for himself, his spouse or a dependent if the expenses are paid but not compensated by insurance or other sources, and to the extent that the expenses exceed 7.5 percent of adjusted gross income. Medical care includes amounts paid for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body.

    In Revenue Ruling 2007-72, I.R.B. 2007-50, 1154 (issued Dec. 7, 2007), the Internal Revenue Service issued guidance regarding the deductibility of amounts paid for diagnostic and similar procedures, and for certain devices that are not compensated by insurance or otherwise, as medical care expenses under IRC Section 213(a). The ruling clarifies that:

    1. the deduction is not limited to the least expensive form of medical care available (citing Ferris v. Comm'r, 582 F.2d 1112 (7th Cir. 1978)); and
    2. a physician's recommendation, while often important for determining whether certain expenses are for medical or personal reasons, is unnecessary when expenditures are for items wholly medical in nature that serve no other function in everyday life, citing Stringham v. Comm'r, 12 T.C. 580 (1949).

    Specifically, the ruling states that amounts paid for an annual physical examination is for diagnosis and qualifies as an expense for medical care, even though the taxpayer is not experiencing any symptoms of illness.

    In addition, amounts paid for a full-body scan are for diagnosis and qualifies as an expense for medical care, even though the taxpayer is not experiencing symptoms of illness and has not obtained a physician's recommendation before undergoing the procedure. The procedure serves no non-medical function, and the expense is not disallowed because of the high cost or possible existence of less expensive alternatives.

    Finally, amounts paid for a pregnancy test qualify as an expense for medical care, even though its purpose is to test the healthy functioning of the body rather than to detect disease.

    IRC Section 2503(e) also excludes from the gift tax any amount paid on behalf of an individual to any person who provides medical care as defined in IRC Section 213(d)). Therefore, the guidance provided by the revenue ruling clarifies what qualifies for the gift tax exclusion as well as the income tax deduction.

  • New twist on a case disallowing a discount for FLP assets. At this point, given the history of cases that have come to similar decisions based on similar facts, the result in Estate of Rector v. Comm'r, T.C. Memo. 2007-367 (issued Dec. 13, 2007), is not surprising — but the direction of this case is.

First, it's surprising that any discount was claimed for the partnership in this case, given that the decedent, Concetta Rector, died with control over the partnership as the owner (through her revocable trust) of the general partnership (GP) interests.

Second, it's interesting that the IRS argued that the partnership's assets should be included in her estate under IRC Section 2036(a)(1) — and not 2036(a)(2). Subsection 2 includes assets in the estate if the decedent died with the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. As the owner of the GP interests, Section 2036(a)(2) seems like the easier basis for inclusion.

In 1998, when Concetta was 92-years-old and moving into a convalescent home, she followed the suggestion of an attorney and, under the leadership of her sons John and Fred, she formed a family limited partnership (FLP) called the Rector Limited Partnership (RLP). Concetta and her revocable trust contributed all of the FLP's assets. In return, the revocable trust received a 98 percent limited partnership (LP) interest and she received a 2 percent GP interest. Concetta and John were co-trustees of the revocable trust.

Virtually all of Concetta's assets were contributed to the FLP. Her only other source of income was from Trust B, which was created under her husband's will. The partnership paid most of her living expenses directly, and in some cases distributed money to her revocable trust to pay Concetta's taxes. The income from Trust B was insufficient to cover those expenses.

In 1999, Concetta gave an 11 percent LP interest to each son. In 2001, she transferred the GP interest to her revocable trust. And in 2002, she gave each son a 2.7 percent LP interest. Upon her death in 2002, her revocable trust owned the 2 percent GP interest and a 70.272 percent LP interest. On the estate tax return, a 19 percent valuation discount was claimed for the LP interests.

The IRS argued, and the Tax Court agreed, that the FLP assets should be included in Concetta's estate under IRC Section 2036(a)(1) so that no discount would apply.

Under Section 2036(a)(1), a decedent's gross estate includes the fair market value (FMV) of transferred assets to the extent that she retained possession or enjoyment of, or the right to income from, the assets for her life or for any other period that does not end before her death. In order not to have a retained interest as described in Section 2036(a)(1), a decedent must have “absolutely, unequivocally, irrevocably, and without possible reservations,” parted with all of her title, possession, and enjoyment of the transferred assets. The decedent has retained such an interest if there was an express or implied agreement among the parties to the transfer at the time of transfer that the transferor would retain the possession or enjoyment of, or the right to the income from, the transferred property. Whether there was such an understanding or agreement is determined from all of the facts and circumstances surrounding both the transfer itself and the assets' subsequent use.

The court held that the RLP agreement reflects an understanding among Concetta and her sons that she would retain her interest in the transferred assets by virtue of her ability to control those assets, including their management and disposition. Key facts leading to this conclusion included that:

  1. Concetta could control the FLP as the GP directly or through her revocable trust;
  2. the RLP operated without a business plan or an investment strategy and did not trade or acquire investments;
  3. the RLP issued no balance sheets, income statements or other financial statements;
  4. the RLP's partners did not hold formal meetings;
  5. the agreement said net cash flow could be distributed to the partners, but it distributed more than that to pay Concetta's living expenses; and
  6. the transfer of practically all of her wealth to the RLP left her with insufficient liquid assets to pay her living expenses.

The estate argued that the bona fide sale exception to Section 2036 should apply, but the court roundly rejected that claim.

The court said: “First, the formation of RLP entailed no change in the underlying pool of assets or the likelihood of profit. Without such a change or a potential for profit, decedent's receipt of the partnership interests does not constitute the receipt of full and adequate consideration. See Estate of Bongard v. Commissioner, 124 T.C. 95, 128-129 (2005); see also Estate of Bigelow v. Commissioner, 503 F.3d 955 (9th Cir. 2007).

“Second, to constitute a bona fide sale for adequate and full consideration, the decedent's transfer of the assets to RLP must have been made in good faith. See sec. 20.2043-1(a), Estate Tax Regs. For this purpose, good faith requires that the transfer be made for a legitimate and significant nontax business purpose. See Estate of Bongard v. Commissioner, supra at 118; Estate of Rosen v. Commissioner, T.C. Memo. 2006-115. A transaction between family members is subject to heightened scrutiny to ensure that the transaction is not a disguised gift. See Estate of Bigelow v. Commissioner, supra at 969; Harwood v. Commissioner, 82 T.C. 239, 258 (1984), affd. without published opinion 786 F.2d 1174 (9th Cir. 1986).”

The court also addressed and rejected each purported non-tax business purpose, based on prior cases: “The estate's stated goal of gift-giving is a testamentary purpose and is not a significant nontax business purpose. See Estate of Bigelow v. Commissioner, supra; see also Estate of Schauerhamer v. Commissioner, T.C. Memo. 1997-242. Nor is the estate's stated goal of efficiently managing assets such a purpose, given the lack of evidence that RLP required any special kind of active management. See Estate of Bigelow v. Commissioner, supra. The protection of assets against creditors also is not such a purpose in that the record does not establish any legitimate concern about the liabilities of decedent, nor did decedent's transfer of her assets to RLP actually protect the assets from her creditors in that she or her trust was at all times an RLP general partner. See id. The estate's stated claim to a diversification of assets also is not such a purpose in that RLP's ownership and management of the transferred assets was essentially identical to the 1991 revocable trust's pretransfer ownership and management of those assets. We also note that RLP had no investment strategy or business plan of providing added diversification of investments; rather, RLP held the securities transferred by decedent without any substantial change in investment strategy and did not engage in business transactions with anyone outside of the family. See Estate of Thompson v. Commissioner, 382 F.3d at 378 (partnership lacked substantial nontax purpose under similar facts).”

All of this led the court to conclude: “The formation of RLP was more consistent with an estate plan than an investment in a legitimate business. Id. at 377; see also Estate of Rosen v. Commissioner, supra.”