The year 2009 was less than two weeks old when Congressman Earl Pomeroy (D-N.D.) introduced a bill1 with the express purpose of legislatively prohibiting discounts for transfers of interests in family-owned holding companies when the underlying assets are passive investments.

The Pomeroy bill foreshadowed where the action would be in the courtroom in 2009, as critical cases focused on family limited partnerships (FLPs) and limited liability companies (LLCs). The Internal Revenue Service concentrated its efforts on those cases where the battleground was over conditions precedent — if the IRS was successful in its argument, a court could preclude any consideration of discounts or diminish their magnitude.

Discounts — All or Nothing

Cases decided in the valuation arena in 2009 came primarily in two flavors. Gift tax cases saw challenges related to Internal Revenue Code Section 25112 indirect gifts and/or step transactions. Estate tax cases were subjected to passing the IRC Section 2036 test.

Four cases3 in 2009 addressed the indirect gift/step-transaction issue; five4 weighed in on Section 2036 matters.

Both Sections 2511 and 2036 are tools the IRS uses to win a case before the size of a discount even becomes an issue. When the IRS won in 2009, it walked away with a zero discount victory. But when it lost, taxpayers ended up with substantial discounts — of 35 percent,5 47.5 percent,6 and 41 percent.7

The bad news is that the IRS won more than it lost.

Indirect Gifts

Linton v. United States and Heckerman v. U.S. were prominent Section 2511 indirect gift tax refund cases. Federal district courts agreed with the IRS' contention that transfers were indirect gifts of the undiscounted underlying assets, not interests in the partnership or LLC.

The indirect gift cases have had common attributes. The cases involve the transfer of assets into the entity and same-day gifts of entity interests that leave taxpayers unable to prove which happened first. Although the regulations under IRC Section 2511 do not expressly address partnerships or LLCs, the courts look closely to find whether the donating party's property contribution is apportioned among the other partners/members or is attributed only to the donor's capital account.

Same-day property contributions and interest transfers result in a taxpayer having the unenviable — and so far unwinnable — task of proving the sequence of what came first and trying to establish that contributions were first allocated to their capital account.

Step Transactions

As a companion argument in indirect cases, the IRS often also uses the step transaction. The step-transaction analysis examines a series of formally separate steps to determine if the steps are in substance integrated, interdependent and focused toward a particular result. The three separate tests applied in finding a step transaction are the:

  1. binding commitment test,
  2. end result test, and
  3. interdependence test.

Is there a binding commitment at step one to undertake the next step? Are the steps a pre-arranged sequence to achieve an end result? Are the steps so interdependent that the outcome of one step would be fruitless without the completion of the series of steps?

In 2008, taxpayers in two tax court cases, Holman v. Commissioner8 and Gross v. Comm'r,9 avoided step-transaction treatment by waiting six and 11 days, respectively, between funding and transferring interests in the FLP. In both cases, the court found there was a real economic risk of a change in value during the period between FLP funding and FLP interest gifts.

To avoid collapsing multiple steps into one, the type of assets involved plays a role in the length of delay required between funding and making a gift. Underlying assets comprised of heavily traded volatile securities may afford the taxpayer the opportunity to make gifts with a wait of approximately 10 days after funding. Low volatility assets (cash, real estate, municipal bonds) are likely to require more seasoning (real economic risk of a change in value) in the FLP before non-step transaction gifts are possible.

The year 2009 brought multiple cases in which the step-transaction doctrine backstopped the indirect gift analysis. Same-day funding of the entity and gifting of entity interests not only are susceptible to indirect gift results, but also, even if sequence evidence is in place, the prospect is remote for the taxpayer to successfully avoid the step-transaction test.

In both Linton and Heckerman, the decision in favor of the IRS was based on finding that indirect gifts occurred and alternatively, that the end result and interdependence legs of the step-transaction test applied.

Section 2036 Wins and Losses

In five cases in 2009, taxpayers won two,10 lost two,11 and had a split decision.12 The common attribute in taxpayer success has been meeting the bona fide sale exception to Section 2036. The legitimate non-tax purposes in 2009 to satisfy a bona fide sale varied and included continuation of a family investment strategy, protection of family assets from divorce, and active trading of securities inside the FLP.

The split decision in Estate of Valeria M. Miller v. Comm'r illustrates the distinction between success and failure. The court found the bona fide sale exception applied to Valeria Miller's transfer of marketable securities to an FLP 13 months before her death. But her transfer of securities 13 days before dying of ongoing, serious health problems failed to have sufficient non-tax reasons to satisfy the Section 2036 exception.

The earliest transfers were found to have been made for the purpose of continuing management of securities under a program of the deceased husband's management program. The oldest son's appointment as FLP manager and his active trading of securities by the FLP confirmed the non-tax purpose.

The transfers within 13 days of death were found to have been motivated by a desire to reduce her taxable estate.

In the absence of the bona fide sale exception, the distribution to the decedent's estate to pay its taxes was sufficient to establish a retained interest, making Section 2036 applicable to eliminate any discount for the second round of transfers.

What Lies Ahead?

All eyes are on Congress in the early months of 2010, as legislation is more likely to have a greater impact on valuation issues than market conditions. An array of proposals are circulating on Capitol Hill to raise revenue by eliminating discounts, raising the marginal gift and estate tax rates, curtailing the effectiveness of grantor retained annuity trusts — to name a few.

Meanwhile, the healthcare debate has been consuming most, if not all, of the oxygen for legislative action and the 2010 election season is upon us. The 111th Congress keeps digging a deficit hole that gets deeper and deeper. As of this writing, it remains unknown what the specific estate and gift tax law will be for 2010. But the focus on valuation issues in general and on discounts in particular is certain to intensify. The objective of raising tax revenue through enforcement and compliance is a continuing trend, even if the legislative proposals against discounts lay dormant. Every legislative action in 2010 that is taxpayer friendly can be expected to be offset by an equal or greater action that raises taxes. Curtailing or eliminating discounts is a revenue raiser that is an attractive target, which may make for a short shelf life for discounts as we know them.

Endnotes

  1. H.R. 436.

  2. Treasury Regulations Section 25.2511-1(h)(1) applies the indirect gift approach for contributions to a corporation, resulting in an indirect gift of the property to each shareholder.

  3. Linton v. United States, No. 2:08-CV-00227 (W.D. Wash. July 1, 2009); Heckerman v. U.S., No. 2:08-CV-00211 (W.D. Wash. July 27, 2009); Suzanne J. Pierre v. Commissioner, U.S. Tax Court, 133 T.C. No. 2 (Aug. 24, 2009); Estate of Roger D. Malkin v. Comm'r, U.S. Tax Court, T.C. Memo 2009-212 (Sept. 16, 2009).

  4. Estate of Erma V. Jorgensen v. Comm'r, U.S. Tax Court, T.C. Memo 2009-66 (March 26, 2009); Estate of Valeria M. Miller v. Comm'r, U.S. Tax Court, T.C. Memo 2009-128 (May 27, 2009); Keller v. U.S., No. 6:02-CV-00062 (S.D. Texas Aug. 20, 2009); Malkin, ibid, at note 3; Estate of Murphy v. U.S., No. 07-CV-1013 (W.D. Ark. Oct. 2, 2009).

  5. Miller, ibid, at note 4.

  6. Keller, supra note 4.

  7. Murphy, supra note 4.

  8. Thomas H. Holman, Jr. and Kim D.L. Holman v. Comm'r, U.S. Tax Court, 130 T.C. No. 12 (May 27, 2008).

  9. Bianca Gross v. Comm'r, U.S. Tax Court, T.C. Memo 2008-221 (Sept. 29, 2008).

  10. Keller, supra note 4, and Murphy, supra note 4.

  11. Jorgensen supra note 4, and Malkin, supra note 4.

  12. Miller, supra note 4.


Radd L. Riebe is a managing director of the Valuation and Financial Opinions Group at Stout Risius Ross, Inc., in Cleveland

SPOT LIGHT

Sold in Dubai —An untitled oil painting by the Turkish artist Omer Ulec, measuring about 59 inches by 117 inches, sold Oct. 27, 2009, for U.S. $116,500, at Christie's “International Modern and Contemporary Art” sale in Dubai.