There's some good news in the ongoing war with the Internal Revenue Service over family limited partnership (FLP) discounts: IRS agents are settling practically all of the “good” cases — and even most of the “bad” ones. That means it pays to know how to negotiate during the estate and gift tax audit stage. It also means you have to understand what's happening on the ground. Audits have long been a good percentage of our practice, so we offer here the benefit of our perspective and experience.1
The IRS begins fighting discounts during the field audit. FLP cases are identified and submitted to the Office of Appeals for national coordination. There are monthly FLP conferences attended by appeals officers, FLP “specialists” and other IRS personnel. In January, IRS supervisors speaking at the Heckerling Institute of Estate Planning in Miami noted that, at that time, there were 206 active FLP cases on appeal and 74 cases docketed and scheduled for trial.2
Clearly, the IRS' decade-long national campaign against FLPs is hitting its stride. But things might change. On July 23, David Johnston reported in The New York Times that the Bush administration was planning to cut almost half of the IRS estate tax lawyers and support personnel.3 It's anyone's guess what impact this would have on the government's FLP examination and classification program — if indeed these cuts ever take place. On July 30, IRS Commissioner Mark Everson defended the proposed cuts,4 stating in a USA Today editorial that income tax audits of rich individuals were more lucrative than estate tax audits. Nevertheless, on Aug. 1, House Appropriations Committee member John Olver (D-Mass.) wrote to Everson, urging him to delay the staff reductions until the IRS can show definitively that the cuts will enhance and not weaken its current efforts to detect estate and gift tax avoidance. At presstime, it was still unclear what, if anything, would happen.
If the cuts in personnel are implemented, however, the IRS will have a hard time sustaining the momentum it built with the national FLP audit program; the agency already is short-staffed. But don't think this is a good thing for taxpayers and that more discounts will slip past the IRS. It could mean that the whole process will take longer. Already, resolving an audit or appeal can take upwards of three years. Our clients are usually asked to extend the limitations period on gift tax returns to accommodate the IRS' lengthy review period for an audit or appeal. Even in estate tax cases, when the limitations period cannot be extended, we have found the IRS delaying an appeals conference or settlement offer until six months before the period expires. And, inevitably, the Service will make additional, burdensome requests for documents from us and our clients as the clock ticks down to zero. Also, conventional wisdom tells us that taxpayers can get a better result with a seasoned appeals officer, since the appeals officer is more likely to look at the big picture and properly assess the risks of litigation. This has proven true in many of the FLP audits that we've seen. Naturally, then, we'd view any loss of senior appeals personnel as a negative.SECTION 2036(A)(1)
One caveat: It doesn't matter which appeals officer you're dealing with, if an examiner has done a good job developing a case based on Internal Revenue Code Section 2036(a)(1). As we are all painfully aware, that provision requires the inclusion in a decedent's estate of the undiscounted value of the partnership assets, not the discounted value of the decedent's partnership interests, if there was an implied agreement that the decedent could access the partnership's assets or income as needed.5 The IRS is instructing its agents not to settle 2036(a)(1) cases in the early stages. In 2006, at the Heckerling Institute, Mary Lou Edelstein, the FLP coordinator at the IRS' National Appeals Office, indicated that she will settle well-developed 2036(a)(1) cases at appeals for an overall discount of only 5 percent to 10 percent.
Before a case gets to that stage, however, there is the audit. We've found that most audits in the northeast United States involve relatively modest requests for information and documentation concerning FLP formation and operations. We understand, however, that our colleagues elsewhere have not been so lucky. In the 2036 battleground districts — most notably South Florida and Texas — taxpayers have been asked to provide an incredible level of detail if they fall victim to an auditor's Section 2036 fishing expedition.
If you find yourself in this predicament, you must understand the nature and extent of the applicable privileges afforded to taxpayers — then weigh the costs and benefits of claiming them at the audit stage. For example, should you accede to an auditor's request to produce copies of privileged correspondence in which you extol the benefits of discounting or illustrate the potential estate tax savings of the FLP strategy being audited?6 Such a letter might become Exhibit A in the government's 2036(a)(1) case against your client. It can also open the door to a claim to waive the attorney's privileges regarding work product and client communications. If you have no experience with tax litigation, a litigator's assistance is indispensable to help you strategize around the privilege issue.7
By now, everyone is familiar with the laundry list of bad facts analyzed in many FLP cases,8 especially 2036(a)(1) implied agreement cases requiring the forfeiture of all of the discounting benefits and the inclusion of the undiscounted value of the FLP's assets in the decedent's estate.9 Fortunately, many of us will have clean records devoid of bad facts. We will continue to bargain from strength, conceding very little in the way of discounts. These are the “good” cases.
With bad cases, though, the IRS is in the catbird seat and will be inclined to cut our clients little slack, if any.
The cases falling into the gray area between these two extremes will, of course, be fact-sensitive. Your ability to salvage any discounts will depend on your negotiating skills and whether you draw a long or a short straw for an examiner or appeals officer.SECTION 2036(A)(2)
It's during the audit that the IRS is likely to deliver its first Section 2036(a)(2) salvo, seeking to include the undiscounted value of the FLP's underlying assets in the decedent's estate on the theory that the decedent retained the right to determine possession or enjoyment of the partnership property. Do you simply run up the white flag if your client had power to control FLP distributions as a general partner or could participate in a decision to liquidate the FLP as a voting limited partner? Our experience in defending such assertions in non-2036(a)(1) cases has been consistently positive.
The examiner will cite Judge Mary Ann Cohen's strained attempt to distinguish United States v. Byrum in Estate of Strangi v. Commissioner (Strangi III), and the district court's questionable analysis in Kimbell v. Comm'r, to support the conclusion that the decedent's control over or participation in distribution and liquidation decisions is a retained interest, despite the fiduciary constraints the Supreme Court found so compelling in Byrum.10 The IRS often raises this position early in the audit — but later drops it, particularly in the absence of other theories that the IRS might muster to disallow the discounts altogether. The government seems to understand that, standing alone, Section 2036(a)(2) will not carry the day.11SENDA: NOT SO SCARY
Still, IRS staffers are well aware of the negotiating leverage that the U.S. Court of Appeals for the Eighth Circuit unaccountably gave them in Senda v. Comm'r.12 This is one of the few gift tax cases involving FLPs. In Senda, the appeals court affirmed the Tax Court decision on the indirect gift issues, a straightforward application of prior Tax Court holdings in cases that focused on the sequence of capital contributions and gifts.13 Under these cases, a capital contribution made to a partnership after a transfer of partnership units is an indirect gift to the partners. Because the Senda taxpayers could not prove that they had funded the partnership with stock before they transferred partnership interests to their children, the Tax Court concluded that the taxpayers' capital contributions were indirect gifts of stock to the children.
On appeal, the government seized on some ambiguous language in the Tax Court decision and also argued that the step-transaction doctrine applied because the capital contribution and gift transactions were closely sequenced and prearranged. Therefore, the Service said, the separate steps should be collapsed and treated as a gift of the undiscounted contributed capital.14 Unfortunately, the Eighth Circuit took the bait, and interpreted the Tax Court's findings by stating: “Immediately after concluding that they did not meet their burden of proving that the stock transfers preceded the gifts, the [T]ax [C]ourt finds: ‘At best, the transactions were integrated (as asserted by respondent) and, in effect, simultaneous.’ The [T]ax [C]ourt recognizes that even if the Sendas' contribution would have first been credited to their accounts, this formal extra step does not matter.”
This has obvious implications for any audit involving gifts of FLP interests made close in time to the entity's formation. Before Senda, the courts were reluctant to apply the step-transaction doctrine, part of the common law of corporate reorganizations,15 in the estate and gift tax area. Because Senda establishes no bright-line test for determining how much time must elapse to avoid the integration of capital contribution and gift, the IRS can threaten to combine a capital contribution with any subsequent gift of a limited partner interest. As a result, Senda has quickly become one of the darlings in the auditor's nursery.16STRATEGIES
We have found, however, that the government's step-transaction bark is often worse than its bite. Several rejoinders are available if you must deal with Senda.
First, if you are outside the Eighth Circuit, assert that Senda is not binding precedent.17 Also note that Senda is contrary to several cases in which courts have not found step transactions despite closely sequenced capital contributions and gifts of limited partner interests, even some made on the same day.18
Even if your Tax Court case can be appealed to the Eighth Circuit, assert that the Senda precedent is limited strictly to its facts, and that the government is interpreting the case more broadly than the Eighth Circuit intended.19 The court considered the attorneys' argument that even if Mark and Michele Senda had made the capital contributions after they transferred the partnerships interests, the capital contributions would have been allocable first to the capital accounts associated with the partnership interests the Sendas retained. A subsequent transfer of those capital accounts would constitute a transfer of the corresponding partnership interests. The Sendas' attorneys argued that this distinguished the case from Shepherd, in which the taxpayers' capital contributions were credited to their children's capital accounts.20 In Shepherd, the U.S. Court of Appeals for the Eleventh Circuit indicated that it would have allowed a partnership level discount if the taxpayers' contributions had been allocated to their own capital accounts and then followed by gifts of partnership interests to the children.
You also have a good argument if your client's gift was made 42 days or more after the partnership was funded. The taxpayers in Senda made their capital contributions on Dec. 20, 1999. The IRS conceded that transfers of limited partner interests on Jan. 31, 2000, were gifts of partnership interests and not gifts of the taxpayers' capital contributions.VALUATION
Section 2036(a)(1) and Senda are the auditors' low hanging fruit. They can easily recognize cases involving sloppy administration that might give the government a basis to disregard the entity and assess a gift or estate tax based on the entity's undiscounted net asset value.
IRS personnel get much less excited about parsing through governing documents and technical appraisal reports to find a taxpayer's Achilles heel. This is particularly true when confronted with the well-prepared report of a respected valuation professional with a track record of successful testimony before the Tax Court. A professional appraisal report gives you a big leg up in negotiations.
Reading appraisal reports and the myriad valuation decisions of the Tax Court is tough going. It requires some understanding of the capital markets and finance. You must have at least a passing familiarity with the concepts and methodology to negotiate effectively with the IRS. At a minimum, you should read the Tax Court's critiques of the government's and taxpayers' experts in cases like Mandelbaum, Lappo, Peracchio and McCord.21 Those with less time and patience should review Judge Juan Vasquez's excellent “short course” in valuing non-publicly traded entities in Estate of Kelley v. Comm'r.22 It provides a good overview of the Tax Court's valuation jurisprudence to date. (See “Court-Decided Discounts,” p. 25.)
Unfortunately, though, the IRS is likely to take issue with even the most impartial and thorough appraisal. Examiners and appeals officers have heartily assured us on several occasions that our clients' appraisals were not worthy of the bottom of a birdcage, and thus the clients were entitled to no discounts at all. Fortunately, such threats appear to be a scare tactic. We have yet to see any court deny all discounts based on a useless appraisal. So here are a few of the basic strategies that have helped us in addressing the IRS' criticisms of our clients' appraisals.MARKETABILITY
For FLPs that have primarily fungible investment assets (marketable securities and/or cash), the courts generally have preferred the “private placement approach” over the use of restricted stock studies that examine mostly operating companies. Be prepared for a challenge if your appraiser used restricted stock studies. Also, it helps to call the appraiser and ask whether changed circumstances (updates of studies, valuation jurisprudence) would influence your appraiser to revise the report's methodology or conclusions in any way.
In most of the decided cases, the marketability discount provides the lion's share of the overall discount. Your appraisal is vulnerable if it is light on analysis and simply establishes a benchmark discount range that the courts have supported. In Peracchio,23 the taxpayer's appraiser reported that Mandelbaum24 established a benchmark of 35 percent to 45 percent as the “lack of marketability discount range.” The appraiser applied the Mandelbaum factors to the subject partnership to determine where the marketability discount should fall with respect to what the appraiser asserted was Mandelbaum's benchmark. The Tax Court dismissed this analysis, stating that “nothing in Mandelbaum suggests that we ascertained that range of discounts for any purpose other than the resolution of that case.”25MINORITY INTEREST
Beware of the appraisal that applies an across-the-board minority discount to all categories of assets in an FLP. The report should stratify the partnership by asset classes, applying an appropriate minority interest discount to each.26 Studies of closed-end funds have been favored for liquid assets such as publicly traded stocks, bonds and cash. Publicly traded real estate investment trusts (REITs) provide an appropriate starting point for determining the minority interest discount for real estate partnerships. If your valuation report does not properly stratify assets and apply the relevant studies to your facts, ask your appraiser to republish it. If the appraiser is not credible or cannot salvage the report, hire another valuation firm to redo the work.
Keep in mind that your first appraisal should be your best appraisal. (Obtaining an appraisal should be like taking the bar exam: Do it once, do it right, never do it again.) We tell our cost-conscious clients that a good appraisal is like insurance, and a lot less expensive than a trial on valuation issues. The values reported on a gift or estate tax return are admissions by the taxpayer; the court may reject lower values reported by the taxpayer on a subsequent or updated appraisal prepared for trial unless the taxpayer proves that the values reported on the return were erroneous.27
Also, remember that the auditor or appeals officer is not an appraiser, so when the valuation issue arises, you, with your qualified appraisal, have the advantage. If you cannot resolve the valuation issues, the IRS must hire its own appraiser, probably after the case is docketed, and will probably demand that your client get a new one. We usually tell the auditor that we're happy to obtain a new appraisal to confirm our existing one — as soon as we see the IRS' appraisal report; then if we cannot reach an accommodation, the government's appraiser and ours can fight it out in court. The court will not like either appraisal and likely will split things down the middle. You and the IRS must weigh the costs and pitfalls of this path of great resistance. In pure valuation cases — those involving little or no basis for the IRS' successful assertion of Section 2036(a)(1) or Senda arguments — we have found that such proposals often prompt a reasonable settlement offer from the auditor or appeals officer. (The archived version of this article available to Trusts & Estates subscribers includes an extensive listing of the results our clients have achieved in FLP discounting cases that have been audited or appealed. See the “Discounting Delights and Dilemmas,” chart at www.trustsandestates.com.28)OBSTINATE CRUSADERS
Sometimes, though, you will be stuck with an auditor or appeals officer whose supervisor insists on adherence to an unreasonable position that is unsupported by the law. In such instances, it sometimes helps to remind your adversary of recent cases involving discounting in which taxpayers have recovered litigation costs under IRC Section 7430(a).29 In 1996, Congress amended IRC Section 7430 to shift from the taxpayer to the IRS the burden of proving that the government's position taken in administrative proceedings and litigation was substantially justified; this increased the taxpayer's chances of prevailing. But remember: The government is the ultimate deep-pocketed litigant. A bureaucrat with no personal stake in the game might not be moved by the prospect of an award of costs. If you are forced to resort to litigation, be sure to build the best record to sustain a Section 7430 claim if you prevail.30
Despite some recent IRS court victories, using FLPs as part of a client's estate plan still can provide the client with legitimate and significant non-tax benefits, as well as transfer tax savings. The IRS and the courts have raised their suspicion level of FLPs to Code Red, and now you can't even bring toothpaste or liquids to your appeals conference.31 Practitioners therefore need to be aware of the risks associated with FLPs, and how to create, fund and manage these entities to avoid audits or achieve favorable settlements of the valuation issues without resorting to litigation.Endnotes
- Our purpose is not to provide prospective strategies for the formation and operation of family limited partnerships (FLPs) to avoid audit risks or to perform “triage” to lessen the risk before the client dies. Many helpful articles are available on these topics. See, for example, Michael Mulligan, “Current Status of Use of Limited Partnerships and Estate Planning,” 30 Tax Mgmt. Est. Gifts & Tr. J. 199 (July/August 2005); John Porter, “Bulletproofing the Family Limited Partnership-Current Issues,” 38 Univ. of Miami, Heckerling Institute of Estate Planning 6 (January 2004).
- See Steve Akers, “Heckerling 2006 Institute Musings,” Leimberg's Estate Planning Newsletter #931, Feb. 22, 2006, at http://www.leimbergservices.com.
- David Johnston, “IRS to Cut Tax Lawyers Who Audit the Richest,” The New York Times, July 23, 2006, at http://select.nytimes.com/gst/abstract.html?res=F30A15FD3F5B0C708EDDAE0894DE404482.
- Mark Everson, “We're Targeting the Rich,” USA Today, July 30, 2006, at http://pqasb.pqarchiver.com/USAToday/access/1086291191.html?dids=1086291191:1086291191&FMT=ABS&FMTS=ABS:FT&date=Jul+31%2C+2006&author=Mark+Everson&pub=USA+TODAY&edition=&startpage=A.10&desc=We%27re+targeting+the+rich+.
- See, for example, Estate of Abraham v. Commissioner, 408 F.3d 26 (1st Cir. 2005), cert. denied, 126 S. Ct. 2351 (2006).
- Circular 230, which sets forth mandatory rules governing the form and content of many written communications with clients, probably put the kibosh on such letters. Circular 230 gives us a headache and, fortunately, is beyond the scope of this article.
- See Porter, supra, note 1, for a good primer on privileged communications.
- For an excellent discussion of what constitutes “bad facts,” see Byrle Abbin, “A Practical Checklist for Planning with Family Limited Partnerships,” 33 Est. Plan. 10 (October 2006).
- Estate of Bongard v. Comm'r, 124 T.C. 95 (2005), gives the Internal Revenue Service some glimmer of hope even in a clean Section 2036(a)(1) case. The Bongard court found the existence of an implied agreement even though the FLP made no distributions of assets during the decedent's life and the decedent did not need any of the assets in the FLP for his living expenses. The court found that the decedent's various controls over entities related to the partnership gave him practical control over the FLP's assets. In negotiations, we have found it best to assert that because it involved “tiered” entities and discounts, Bongard was highly fact-sensitive and irreconcilable with the other cases in which the Tax Court has refused to find an implied agreement in the absence of multiple bad facts.
- Estate of Strangi v. Comm'r, T.C. Memo 2003-145, aff'd, 417 F.3d 468 (5th Cir. 2005); Estate of Kimbell v. Comm'r, 244 F. Supp.2d 700 (N.D. Tex. 2003), vacated and remanded, 371 F.3d 257 (5th Cir. 2004); United States v. Byrum, 408 U.S. 125 (1972).
- In Strangi III, supra, note 10, and Bongard, supra, note 9, the IRS raised the Section 2036(a)(2) issue but the court did not rule on it, since in each case the partnership's assets were includible in the decedent's estate under Section 2036(a)(1).
- Senda v. Comm'r, 433 F.3d 1044 (8th Cir. 2006), reh'g denied, 2006 U.S. App. LEXIS 8153 (8th Cir. 2006). We say “unaccountably” because, as is discussed in endnotes 15 and 16 and the accompanying text, the U.S. Court of Appeals for the Eight Circuit could have affirmed Judge Mary Ann Cohen's Tax Court decision based on prior precedent alone without affirming an arguably illusory alternative basis for the holding that is completely unsupported.
- See Shepherd v. Comm'r, 283 F.3d 1258 (11th Cir. 2002); Jones v. Comm'r, 116 T.C. 121 (2001).
- If a taxpayer engages in a series of transactions that are in substance a single, unitary, or indivisible transaction, the courts may disregard the intermediate steps and, for tax purposes, consider only the completed transaction. See, for example, Palmer v. Comm'r, 62 T.C. 684 (1974). This is referred to as the step-transaction doctrine, an elastic common law theory that courts have applied liberally in corporate income tax matters but have shown very little enthusiasm for in gift and estate tax cases.
- Generally, the IRS has succeeded in applying these doctrines only in cases such as Estate of Murphy v. Comm'r, 60 T.C.M. (CCH) 645 (1996). In that case, the IRS successfully argued that a transfer of a 1.76 percent block of the decedent's closely held stock 18 days before the decedent's death, which reduced the decedent's holding to below 50 percent, should be collapsed with the decedent's testamentary transfer of her remaining shares as a single integrated testamentary transfer. The court reasoned that the only motivation for the gift was estate tax reduction. Generally, the courts will refuse to find step transactions or apply the “substance over form” doctrines in wealth transfer tax cases in which the taxpayer was not solely motivated by tax avoidance, recognizing, as the Tax Court has, that “taxpayers generally are free to structure a business transaction as they please, even if motivated (in part) by tax avoidance considerations.” Kerr v Comm'r, 113 T.C. 449, 464 (1999).
- We had a case on appeal in which the paper trail was confusing concerning whether the capital contributions antedated the gifts of limited liability company (LLC) member interests. After an exchange of legal memoranda, we were able to convince the appeals officer that, as a matter of state law, the capital contributions became irrevocable before the gifts were made even though the formal documentation was incomplete. We had agreed to a settlement and were waiting for it to be documented when the appeals officer informed us that his supervisor had rejected the settlement because the government had just argued the appeal in Senda and expected to prevail on the step-transaction argument. We reviewed the Tax Court opinion and the government's and taxpayer's briefs. We were optimistic that the compromise would be resurrected after the court of appeals issued its opinion. We took comfort in the Fifth Circuit's refusal in Strangi IV to reach Judge Cohen's alterative holding under Section 2036(a)(2) because it was not necessary to the outcome. (See Strangi v. Comm'r, 417 F.3d 468 (5th Cir. 2005)). We were amazed when the Eighth Circuit went out of its way not only to reach the step-transaction issue, but also to establish such an open-ended precedent. Our unhappy saga ended with a negotiated settlement of a sharply reduced discount after the case was docketed in Tax Court.
- The Tax Court isn't bound by or compelled to follow the holdings of a court of appeals to which the Tax Court's decision isn't appealable. Estate of Jelke v. Comm'r, T.C. Memo 2005-131, citing Golsen v. Comm'r, 54 T.C. 742 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971).
- See Jones, supra, note 13; Knight v. Comm'r, 115 T.C. 506 (2000).
- For an excellent discussion of this issue, see Mitchell Gans and Jonathan Blattmachr, “Re: Senda,” Leimberg's Estate Planning Newsletter #911 (Jan. 9, 2006), at www.leimbergservices.com.
- Shepherd, supra, note 13.
- Mandelbaum v. Comm'r, T.C. Memo 1995-255, aff'd without publ'd op., 91 F.3d 124 (3d Cir. 1996); Lappo v. Comm'r, T.C. Memo 2003-258; Peracchio v. Comm'r, T.C. Memo 2003-280; McCord v. Comm'r, 120 T.C. 358 (2003), rev'd and remanded, 2006 U.S. App. LEXIS 21473 (5th Cir. Aug. 22, 2006).
- T.C. Memo. 2005-235.
- Peracchio, supra, note 21.
- Mandelbaum, supra, note 21.
- Peracchio, supra, note 21, at 284.
- See McCord, Lappo, and Peracchio, supra, note 21. McCord started the trend of stratifying minority-interest valuation discounts by composition of assets. Peracchio took the asset-by-asset classification approach to its extreme by establishing six asset classes (one of which comprised less than one percent of the assets). In all three cases, the Tax Court rejected the conclusions the experts reached from the empirical data and used the data to draw its own conclusions. Some appraisers are skeptical of the stratified valuation approach, because it assumes that a limited partner has greater access to the partnership's cash than to its less liquid assets. The IRS may criticize a pre-McCord appraisal for failing to stratify the discounts; after pointing out that your appraiser, while peerless, is not clairvoyant, it may be a good idea to provide the government with a stratified analysis that shows a minority interest discount consistent with the one in your appraisal.
- See Estate of Leichter v. Comm'r, T.C. Memo 2003-66; Estate of Hall v. Comm'r, 92 T.C. 312 (1989).
- All subscribers to Trusts & Estates can access the magazine's archives. There are instructions on the website how to create your user name and password.
- See Cervin v. Comm'r, 111 F.3d 1252 (5th Cir. 1997) (IRS relied upon discredited unity-of-ownership valuation theory); Dailey v. Comm'r, T.C. Memo 2002-301 (IRS conceded lack of substantial justification for maintaining position that FLP should be disregarded for tax purposes, and court awarded litigation costs in the amount of $42,700); Estates of John L. and Sarah W. Baird v. Comm'r, 416 F.3d 442 (5th Cir. 2005) (The Tax Court abused its discretion in finding that the IRS met its burden of proving substantial justification for asserting that fractional interest discounts for minority interests in realty trust were limited to costs of partitioning trust's underlying real estate).
- Baird, supra, note 29, provides an excellent road map for building such a record. See also Larry Gibbs, “What You Can Do if the Government Uses Rambo Tactics,” Trusts & Estates (July 1994), at p. 57.
- In August 2006, in response to terrorist threats, the U.S. federal government banned passengers from bringing liquids, including toiletries, onto airplanes. Apparently this lessened the risk of terrorist activities on board aircrafts. In September 2006, in response to pressure from the airlines and passenger groups, the government refined its security measures to allow passengers to bring on board containers holding no more than three ounces of toiletries.
The average combined discount in these famous family limited partnership cases was 34.66 percent — significantly higher than the discounts the Internal Revenue Service argued for at trial
|Case||Assets||Total Combined Discount From Net Asset Value|
|Knight||Securities and Real Estate||15.0|
|McCord||Securities and Real Estate||49.3|
|Lappo||Securities and Real Estate||35.4|
|Source: Joseph F. McDonald, III and Amy K. Kanyuk|
In “good facts” cases, the Internal Revenue Service tends to offer reasonable settlements for family limited partnership discounts. Ten examples from our practice
|Year Plan Implemented, Gifts Made, Client's Status||Strategy||Underlying Assets Contributed to Entity||Discount Reported on Return/Appraisal||Audit?||Has Limitations Period Expired on Return?||Discount Determined After Audit or Appeals||Other Comments|
| Client #1 |
Two LLCs formed in 2004; client living
|LLC member units gifted to irrevocable grantor trusts and individual donees||Commercial rental real estate||1.25% combined (35% marketability, 25% minority interest)||Yes. Gift tax settled at audit||No||35% combined discount||Return also reported gifts of minority interests Gifts in the stock of closely-held automobile dealership (corporation) and auditor accepted reported discounts of 51%.|
| Client #2 |
Entity formed in 2003; gifts and sales made in 2003; client died in 2004
|LLC common member interests gifted and sold to irrevocable grantor trust in exchange for promissory note||Cash and marketable securities||40% combined (25% marketability, 20% minority interest)||Yes. Gift and estate tax-both settled at audit||No||33% combined discount (No adjustments made to 706, other than to adjusted taxable gifts)|
| Client #3 |
Entity formed in 2002; gifts and sales made in 2002; client living
|LLC common member units gifted and sold to an irrevocable grantor trust in exchange for promissory note. fractional interest||Cash, marketable securities and life insurance policies||40% combined (25% marketability, 20% minority interest)||Yes. Gift and estate tax-both settled at audit||No||34% combined discount for LLC units, and 20% for fractional interest in real property||LLC units sold to irrevocable grantor trust in exchange for promissory notes with principal adjustment clause. IRS argues that difference between appraised fair market value and fair market determined for gift tax purposes is a gift, not an increase of the purchase price of the units sold.|
| Client #4 |
Entity formed in 2001; gifts and sales made in 2001; client died in 2003
|LLC common member interests gifted and sold to an irrevocable grantor trust in exchange. for promissory note||Cash, undeveloped real property and marketable securities||43.75% combined (25% marketability, 25% minority interest)||Yes. Gift and estate tax-both settled at appeals||No||32.5% combined discount||LLC units sold to irrevocable grantor trust in exchange for promissory noteS with principal for promissory note adjustment clause. IRS argues that the difference between appraised fair market value and fair market value as finally determined for gift is a gift, not an increase of the purchase price of the units sold. Trust agreement provides that if gift tax value of gifted units is greater than donor's remaining gift tax exemption, 1% of taxable amount will pass to generation skipping transfer exempt trust and remaining excess will pass to charity. IRS is claiming that this provision is void under Procter analysis.|
| Client #5 |
Entity formed in 2000; gifts and sales made in 2001; additional gifts in 2002; client living
|LLC common member units gifted and sold to an irrevocable trust in exchange for a private annuity||Winnings from “Powerball” lottery ticket||40% combined (25% marketability, 20% minority interest)||Yes. Gift tax settled at audit||Yes||30% combined discount||Lottery winnings valued by determining the net present value of remaining lottery payments, after 27% income tax withholding (on the theory that a hypothetical buyer would take into account the effect of the “step in the shoes” rule of IRC Section 704(c) when determining purchase price of LLC common member units (for instance, hypothetical buyer would recognize that portion of income from lottery payments would be allocated to him each year, and he would be liable for income taxes due on those payments.)|
| Client #6 |
Entity formed in 2001; gift and sales made in 2001; client died in 2002
|LLC member interests gifted and sold to irrevocable grantor trusts in exchange for promissory notes||Marketable securities and unimproved real property||43.75% combined (25% marketability, 25% minority interest)||Yes. Gift and estate tax-both settled at appeals||No||21.5% combined discount||Case was settled while docketed in Tax Court. Main issue: Senda step-transaction challenge — proximity of sequential capitalization of LLC and gifts of member interests.|
| Client #7 |
Entity formed in 2000; gifts and sales made in 2000; client died in 2004
|FLP interests gifted and sold to irrevocable grantor trust in exchange for promissory note||Commercial rental real estate||43.75% combined (25% marketability, 25% minority interest)||No||Yes||N/A||No estate tax returns required to be filed, because discounts reduced value of gross estate below remaining exemption amount.|
| Client #8 |
Entity formed in 2000; gift and sale made in 2000; Decedent died in 2002
|LLC member interests gifted and sold to irrevocable grantor trusts in exchange for private annuity. Client's son and daughter-in-law made significant capital contributions to LLC, and were represented by separate counsel||Cash, marketable securities. and residential rental real estate. (Decedent contributed only cash and marketable securities)||44.75% combined (35% marketability, 15% minority interest)||Yes. Gift and estate tax — docketed in Tax Court.||No||N/A|
| Client #9 |
Entity formed in 2000; gifts and sales made in 2000; clients are living
|LLC member interests gifted and sold to irrevocable grantor trusts in exchange for promissory notes||Cash, marketable securities and real estate||44.75% combined (35% marketability, 15% minority interest)||No||Yes||N/A|
| Client #10 |
Entity formed and gifts made in 1999; client died in 2000
|LLC common member interests gifted to an irrevocable grantor trust and three common law GRITs established for nephew and issue||Marketable securities||42.80% combined (35% marketability, 12% minority interest)||Yes. Gift and estate tax-both settled at appeals||Yes||36.25% combined discount||Gift to irrevocable grantor trust subject to net gift agreement. Trustee of the irrevocable trust agreed to pay the gift taxes on the transfer and any estate tax attributable to the gift tax paid by trust on the transfer if donor died within three years of making gift and gift to to irrevocable trust to account for net gift agreement.|
|Source: Joseph F. McDonald, III and Amy K. Kanyuk|