Tax Law Update 2010-05-01 (1)Tax Law Update 2010-05-01 (1)

Holman rears its head again: Eighth Circuit holds that FLP transfer restrictions are disregarded under Internal Revenue Code Section 2703 — In 2008, the Tax Court held that gifts made by Thomas and Kim Holman would be respected as gifts of interests in their family limited partnership (FLP) rather than gifts of Dell stock transferred to the FLP. Holman v. Commissioner, 130 T.C. 170 (May 27, 2008). However, the Tax Court ultimately held that the transfer restrictions in the FLP agreement should be disregarded when valuing the gifted interests under IRC Section 2703, and the Holmans appealed. The majority of the U.S. Court of Appeals for the Eighth Circuit agreed with the Tax Court, holding that the transfer restrictions should not be considered when valuing the FLP interests for gift tax purposes. Holman v. Comm'r, No. 08-3774 (8th Cir. April 7, 2010).

The transfer restrictions in the FLP agreement provided that a partner could transfer interests to other family members or to trusts or custodians for their benefit. All other transfers were subject to the partnership's option to purchase the transferred interests at their appraised value (or the partnership could assign its right to purchase to any of the other partners). Assignees could only become partners with the consent of the other partners.

The Holmans had claimed discounts of just over 49 percent of the market prices for Dell stock owned by the FLP, based on lack of control and marketability. The Internal Revenue Service disregarded the transfer restrictions when valuing the FLP interests and allowed an overall discount of 28 percent.

IRC Section 2703 provides that the value of property shall be determined without regard to any option, agreement or other right to acquire or use the property at a price less than the fair market value unless the option, agreement or right (1) is a bona fide business arrangement, (2) is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration, and (3) has terms that are comparable to similar arm's length transactions. The court upheld the Tax Court's finding that the restriction was not a bona fide business arrangement because the FLP held only passive investments and had no planned investment strategy or other planned purpose. The Holmans' stated purposes of protecting assets from dissipation (through divorce, for example) and providing an opportunity to educate their children about financial responsibility were personal and testamentary purposes. The court didn't find any special context or particular investment philosophy as the Tax Court had found in other cases that justified finding a legitimate business purposes for a limited partnership established simply for investment purposes. The court distinguished the facts in Holman from prior cases such as Estate of Black v. Comm'r, 133 T.C. 15 (2009), Estate of Murphy v. United States, 2009 WL 3366099 or Estate of Schutt v. Comm'r, 89 T.C.M. 1353 (2005), in which the taxpayers had established legitimate business purposes for the partnerships sufficient to qualify for the “bona fide sale exception” of IRC Section 2036 (as interpreted by Estate of Bongard v. Comm'r, 124 T.C. 95, 111 (2005)). Instead, the Eighth Circuit held that the FLP was a “mere asset container” without any particular investment philosophy or goal. As a result, the transfer restrictions were not considered when valuing the FLP interests for gift tax purposes.

The Eighth Circuit upheld the Tax Court's approval of the IRS expert's discounts for lack of marketability. The IRS expert focused on the ability of the partners to dissolve the partnership and buy out an exiting partner and the ease of valuing the partnership assets (that is, publicly-traded Dell stock). He reasoned that third-party buyers would set their offer price by considering the potential for existing partners to buy an exiting partner's interests. The court agreed, dismissing the taxpayers' arguments that the expert's reasoning violated the hypothetical willing buyer/willing seller test. As a result, the IRS expert's suggested discount of 28 percent held the day.

Judge C. Arlen Beam wrote an extensive dissent arguing that: (1) the Tax Court's holdings should be subject to a stricter standard of review; (2) the FLP's transfer restrictions met the requirements of IRC Section 2703 (notably agreeing with the taxpayers that Treasury Regulations Section 25.2703-1(b)(1)(ii) was invalid because it was beyond the scope of IRC Section 2703); and (3) the IRS expert's methodology violated the hypothetical willing buyer/willing seller test.

IRS notice extends full deduction of bundled fiduciary fees pending IRS regulations — IRS Notice 2010-32 provides that bundled investment advisor fees do not need to be “unbundled” for deductions for tax year 2009. In Knight v. Comm'r, 552 U.S. 181 (2008), the Supreme Court held that fees paid to an investment advisor by a trust or estate are generally subject to the 2 percent floor for miscellaneous itemized deductions under IRC Section 67(a). The IRS has not yet issued regulations under IRC Section 67, which are expected to address how fiduciaries should treat bundled fees, only a portion of which may be subject to the 2 percent floor. In the meantime, previous IRS notices have allowed the full bundled fee to be deductible without regard to the 2 percent floor for years 2007 and 2008. IRS Notice 2010-32 extends this same treatment for the tax year 2009.

Hackl and Price continued: Gifts of LLC interests fail to qualify for annual gift exclusion — In Fisher v. U.S., 105 AFTR2d 2010-1347 (March 11, 2010), the District Court for the Southern District of Indiana ruled against a taxpayer on a motion for summary judgment regarding whether transfers of interests in a family's limited liability company (LLC) qualified as present interests for the gift tax annual exclusion. Following on the heels of Hackl, 118 T.C. 279 (2002) and Price, TC Memo 2010-2, the court ruled that the transfers did not so qualify.

In 2000, 2001 and 2002, the Fishers transferred a 4.762 percent interest in Good Harbor Partners LLC (the LLC) to each of their seven children. The LLC owned undeveloped land on Lake Michigan. The LLC operating agreement provided for a management committee, which appointed a general manager to handle day-to-day operations and determine the timing and amount of distributions. Under the operating agreement, a child could transfer his interest (such interest was defined to be each child's “share of the Profits and Losses of, and the right to receive distributions from, the Company”) with notice to the LLC. But, if the proposed transfer was to a third party other than the Fishers or their descendants, the LLC would have the right to purchase the interest at the offer price within 30 days of the notice. If the LLC elected to exercise its right, it had to purchase the interest within 90 days of receiving the notice.

The same issue raised in Hackl and Price was raised in Fisher: Is the transfer of an LLC interest, subject to restrictions in the LLC agreement, a present interest that will qualify for the gift tax annual exclusion? Under IRC Section 2503(b), the gift tax annual exclusion applies only to gifts of “present interests.” Treas. Regs. Section 25.2503-3(a) defines a present interest as an unrestricted right to the immediate use, possession or enjoyment of either the property or its income. Contingencies that could prevent the donee from enjoying the property may cause the gift to be considered a future interest.

The Fishers argued that the children who received the LLC interests: (1) had an unrestricted right to receive distributions from proceeds of the sale of a capital asset; (2) had an unrestricted right to enjoy the land that the LLC owned; and (3) could unilaterally transfer their LLC interests. The court disagreed. It held that the right to receive distributions upon a sale of a capital asset was contingent upon several factors, one of which was the general manager's determination, in his discretion, to make a distribution. The court held that the right to use the land was a possessory benefit but not a substantial present economic benefit (presumably a substantial present economic benefit requires an ability to convert the interest into cash). Lastly, the court held that the right of first refusal was another contingency hindering the children from realizing a substantial economic benefit. Therefore, the court held that the transfers of LLC interests were not gifts of “present interests” and granted the IRS' motion for partial summary judgment.

Sixth Circuit upholds “constructive addition” GST regulations — In Estate of Timken v. U.S., 2009-1 USTC para. 60,574 (April 2, 2010), the U.S. Court of Appeals for the Sixth Circuit upheld the “constructive addition” regulations under IRC Section 2601 and held that the lapse of a general power of appointment (GPA) over a trust that was grandfathered from generation-skipping transfer (GST) tax constituted a constructive addition to the trust.

A trust created under the estate of Henry Timken became irrevocable in 1968. Henry had granted his surviving wife, Louise, a GPA over the trust but Louise didn't exercise the power. On Louise's death, in default of her exercising her power, the trustee was directed to pay taxes due to the inclusion of the trust property in Louise's taxable estate. Then, the remaining trust property was to be divided and retained in trusts for the benefit of Henry's nieces and nephews. Some of Henry's nieces and nephews disclaimed their interests in the trust property, causing their share to be divided among Henry's grandnieces and grandnephews. Louise's estate took the position that the trust was grandfathered for GST tax purposes and the transfers to trusts for Henry's grandnieces and grandnephews were not subject to GST tax. The IRS disagreed and issued a notice of deficiency to Louise's estate of over $4 million in GST taxes, which the estate paid before suing for a refund.

IRC Section 2601 does not impose GST tax on a GST under a trust which was irrevocable on Sept. 25, 1985, as long as the transfer is not made from corpus “added” to the trust after that date. The statute alone does not define what constitutes an “addition” to a trust. Therefore, the statute doesn't directly address whether the release, exercise or lapse of a GPA is an addition to the trust. However, Treas. Regs. Section 26.2601-1(b) directly addresses this point and provides that if a person releases, exercises or allows the lapse of a power of appointment after Sept. 25, 1985 and such release, exercise or lapse is a taxable transfer under Chapters 11 or 12 of the IRC, such person is treated as having withdrawn the trust property and retransferred it to the trust. As a result, such a release, exercise or lapse of a GPA after Sept. 25, 1985 over a trust that is otherwise grandfathered from the GST tax will subject the trust property to the current GST tax rules.

The estate argued that the regulations' concept of a “constructive addition” was outside the scope of IRC Section 2601 and that the statute's use of the term “added” was intended to apply only to transfers to a trust from an outside source. However, the Sixth Circuit disagreed and held that Congress' intent in enacting the grandfathering exemption was to exempt trust property only if the future GST could not be avoided (that is, where no power of appointment was granted and the trust property was required to pass to skip persons pursuant to the terms of the trust). The Sixth Circuit also found the constructive addition concept fair and consistent with the treatment of a GPA as outright ownership in other sections of the IRC. As a result, the regulations were a reasonable construction of the statute, applied to Louise's lapse of her GPA and subjected the transfers to Henry's grandnieces and nephews to GST tax.

Tax Court denies charitable deduction for non-cash charitable contributions — In Friedman v. Comm'r, T.C. Memo 2010-45 (March 11, 2010), the Tax Court held that the taxpayers had not substantially complied with the regulations under IRC Section 170(c) that set out the reporting and substantiation requirements to qualify non-cash charitable contributions valued at more than $5,000 for the charitable deduction.