Tax Law Update 2011-10-01 (1)Tax Law Update 2011-10-01 (1)

U.S. Court of Appeals for the Ninth Circuit approves defined value formula — The Ninth Circuit upheld the Tax Court's decision approving a formula gift and sale in Estate of Anne Y. Petter v. Commissioner, — F.3d — (9th Cir. No. 10-71854, Aug. 4, 2011), affirming T.C. Memo. 2009-280 (Dec. 7, 2009).

Anne Petter inherited stock in United Parcel Service of America, Inc. (UPS), worth more than $20 million when UPS went public in 1999. After consulting with an estate-planning attorney, Anne decided to establish Petter Family LLC (PFLLC) to own the stock.

Anne created two grantor trusts in late 2001, one for her son Terry and the other for her daughter Donna. Anne then gifted limited liability company (LLC) units to the trusts. The assignment document for each trust provided that Anne intended to assign 940 units of PFLLC, in the aggregate, to the trusts and to two charities. Each trust was to receive a number of units equal in value to half of Anne's remaining gift tax exemption. The charities were to receive the difference between 940 units and the number of units assigned to the trusts. The assignment provided that if the value each trust received, as finally determined for gift tax purposes, is greater or less than the gift tax exemption, each of the trusts and the respective charities would reallocate the units among themselves to ensure that each trust received units equal in value to its share of Anne's gift tax exemption.

Anne also sold additional PFLLC units to the trusts. The sale documents were structured similarly to the assignment documents. In each sale document, Anne declared her intent to transfer 8,459 units, in total, to each trust and the respective charity. Each trust purchased a number of units that was equal in value to $4,085,190, in exchange for a promissory note that was secured by the shares. As a result, after the sale, each trust's debt-to-equity ratio was 9:1. The sale documents again used a formula to provide that the respective charities were to receive the difference between 8,459 units and the number of units purchased by each trust.

Anne's attorney drafted the gift and sale documents, revising them after Anne's daughter's attorney and the attorney for the two charities reviewed them. The assignment, purchase and gift agreements were signed by Anne, Donna (as trustee of her trust), Terry (as trustee of his trust) and the presidents of the charities. In addition, Anne, Donna and Terry signed consents as managers and members of PFLLC and the presidents of the two charities signed consents of the sale documents as members of PFLLC. Anne retained an appraiser to formally value the membership units of PFLLC. The appraiser applied significant lack of control and lack of marketability discounts (13.3 percent for lack of control and 46 percent for lack of marketability), leading to a value of $536.20 per unit. On audit, the Internal Revenue Service disagreed, asserting a value of $794.39 per unit. Anne and the IRS ultimately agreed on $744.74 as the value per unit. However, Anne argued that the formula clause was valid and that the charities received a greater number of units due to the revaluation. The IRS disallowed the charitable deduction for the additional amounts transferred to the charities by gift and argued that the units received by the trusts in the sale transaction were worth more than the promissory note paid, causing an extra gift.

The Tax Court agreed with Anne's estate (Anne died after trial), holding that the formula clause was valid, that Anne transferred a fixed amount to the trusts via both a gift and a sale and that the excess amount that passed to the charities was eligible for the charitable deduction. The Tax Court recounted the history of litigation regarding savings clauses and formula clauses, citing Comm'r v. Proctor, 142 F.2d 824 (4th Cir. 1944), McCord v. Comm'r, 120 T.C. 358 (2003), and Estate of Christiansen v. Comm'r, 586 F.3d 1061 (8th Cir. 2009). The court ultimately drew a distinction between a donor who gives away a fixed set of rights with uncertain value (as in Christiansen, which was fine in the court's view) and a donor who tries to take property back (as in Proctor, which the court found problematic).

The Ninth Circuit agreed with the Tax Court's holding. The question on appeal was whether the formula clause created a condition precedent for the gift, rendering it ineligible for the charitable gift tax deduction under Treasury Regulations Section 25.2522(c)-3(b)(1). The Ninth Circuit reasoned that the formula clauses didn't affect whether a transfer would take place, but only the value of the transfer, explaining that after execution of the assignment and sale documents “the only possible open question was the value of the units transferred, not the transfers themselves.” Furthermore, the court held that the reallocation clauses that provided for a transfer of units to correct for any value received in the event of a revaluation were merely a method to enforce the charity's rights to receive a preset number of units, but weren't a condition precedent.

On appeal, the IRS also argued that the phrase “value as finally determined for gift tax purposes” used in the assignment and sale documents means the value shown on the taxpayer's return. If so, this would cause the taxpayer to have transferred the particular number of units based on the value reported on the gift tax return (that is, the total value intended to be transferred divided by $536.20), resulting in a larger gift to the charities. The Ninth Circuit disagreed, noting that the transfer documents didn't specify the value of an individual LLC unit, but relied on the fair market value (FMV) of a unit.

The court noted that its holding was consistent with the Eighth Circuit's decision in Christiansen, in which a decedent's will provided that 25 percent of the amounts disclaimed by her daughter were to pass to a foundation. The Eighth Circuit held that the property transferred to the foundation was eligible for the charitable deduction because, even though the value of the charitable donation was uncertain, the foundation's right to receive the property wasn't.

Lastly, the Ninth Circuit didn't address the IRS' public policy arguments that formula clauses reduce the IRS' incentive to audit, explaining that public policy can't override interpretation of the Treasury regulations.

Petter certainly weakens IRS arguments against formula clauses that result in excess gifts to charities. However, it remains to be seen whether formula clauses without charitable beneficiaries will withstand IRS attack.

Family limited partnership (FLP) interests included in taxpayer's gross estate; indirect gifts qualify for annual exclusion — In Estate of Clyde W. Turner Sr. v. Comm'r, T.C. Memo. 2011-209 (Aug. 30, 2011), the Tax Court held against the taxpayer and included the value of partnership assets in his gross estate.

Clyde Sr. and Jewell Turner resided in Georgia. They had four children and a large extended family. Clyde Sr. owned a significant number of shares of Regions Bank stock due to family ties to the bank. He and Jewell also owned several bank and investment accounts and invested in real estate occasionally with their son-in-law. Clyde Sr. also established an irrevocable life insurance trust for the benefit of his children and grandchildren, which owned various insurance policies on his life.

In the mid-1990s, Clyde Sr.'s grandson, Marc, began helping Clyde Sr. and Jewell manage their assets. In 2002, after discussing their finances, Clyde Sr., Jewell and Marc spoke to an estate-planning attorney who suggested forming an FLP to manage Clyde Sr.'s and Jewell's assets. In April 2002, Clyde Sr. and Jewell formed Turner & Co. as a Georgia limited liability partnership and signed a limited partnership (LP) agreement. Clyde Sr. and Jewell each had a .5 percent general partnership interest and a 49.5 percent LP interest. The partnership agreement provided that the general partners were entitled to a reasonable management fee, that net cash flow would be distributed to each partner pro rata to the extent of the partner's federal and state income tax liability and that the balance of the net cash flow, if any, could be distributed to the partners pro rata at the general partners' discretion. In addition, the general partner could amend the partnership agreement without the consent or approval of the limited partners.

The partnership was funded in December 2002 with cash, shares of Regions Banks stock, various certificates of deposit and assets held in various investment/brokerage accounts. That same month, Clyde Sr. and Jewell gave LP interests to their three children and several of their grandchildren. They also gave LP interests to a trust for the benefit of one of their grandchildren, Rory, who was using illegal drugs. The partnership interests were appraised and the gifts were declared on gift tax returns.

The partnership assets continued to be managed as before — by Clyde Sr.'s grandsons on his behalf. The partnership made several payments to a law firm for Clyde Sr. and Jewell's estate planning. The partnership invested in several parcels of real estate, but Clyde Sr. wrote personal checks on behalf of the partnership's investment to repay the partnership's debt. In 2002 and 2003, the partnership made frequent distributions to Clyde Sr. and Jewell, but not to any of the limited partners. Clyde used some of these distributions to pay insurance premiums for the policies owned by the life insurance trust.

At the end of 2003, Clyde Sr. became ill and he died in February 2004. On the estate tax return, the estate reported general and LP interests valued at over $1.8 million. However, the IRS determined that the assets of the partnership were includible in Clyde Sr.'s estate and issued a notice of deficiency based on including half of the net asset value (which was almost $10 million) of the partnership in the estate.

Internal Revenue Code Section 2036 includes the value of property transferred by a decedent if he has retained the possession or enjoyment of the property or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property. However, IRC Section 2036 won't include the value of transferred property in a gross estate if the transfer was a bona fide sale for adequate and full consideration.

The IRS argued that the assets transferred to the partnership in exchange for a .5 percent general partnership interest and a 49.5 percent LP interest were includible in Clyde Sr.'s estate under IRC Section 2036. The estate argued that the assets shouldn't be includible because the exception for a bona fide sale for adequate and full consideration applied.

A bona fide sale requires that the taxpayer: (1) have a legitimate and significant non-tax reason for creating the FLP, and (2) receive partnership interests proportionate to the value of the property transferred. The parties stipulated that the partnership interests Clyde Sr. received were proportionate to the FMVs of the assets he contributed to Turner & Co. and that the assets Clyde Sr. contributed to Turner & Co. were properly credited to his capital accounts. The question that remained was whether there were legitimate and significant non-tax reasons for forming Turner & Co.

The estate argued that the non-tax reasons for establishing the partnership were: “(1) To consolidate their assets for management purposes and allow someone other than themselves or their children to maintain and manage the family's assets for future growth pursuant to a more active and formal investment management strategy; (2) to facilitate resolution of family disputes through equal sharing of information; and (3) to protect the family assets and Jewell from Rory, and protect Rory from himself.”

However, the court found that the evidence didn't establish that any of these reasons actually motivated the formation of Turner & Co. It noted that the assets weren't actively managed, nor managed according to any particular philosophy. There was no meaningful change in the portfolio of securities transferred to the partnership or the method of management. The court also wasn't convinced that funding the partnership was intended to resolve discord among Clyde Sr. and Jewell's children. And, since Jewell continued to give Rory funds after the partnership was funded and there was already a protective trust established for Rory, the partnership didn't serve any additional protective purpose.

Lastly, Clyde Sr. stood on both sides of the transaction, creating Turner & Co. without any meaningful bargaining or negotiation with Jewell or other limited partners. The court also noted that assets weren't transferred to Turner & Co. for at least eight months after it was formed. In addition, Clyde Sr. used partnership assets for his personal use. The court emphasized the testamentary nature of forming the partnership as part of Clyde Sr.'s estate plan. These factors also indicated that the transfer to the partnership wasn't a bona fide sale.

Since the bona fide sale exception didn't apply, the court next assessed whether Clyde Sr. had retained the possession or enjoyment of the property transferred under IRC Section 2036(a)(1). The court found that he did, due to: (1) the receipt of a $2,000 monthly management fee, which the court found unreasonable because there was no evidence that Clyde Sr. participated in managing the partnership, (2) the fact that the Regions Bank stock wasn't sold due to Clyde Sr.'s personal attachment to the bank, (3) distributions that were made to Clyde Sr. at will and disproportionately to make personal gifts to his grandsons, pay life insurance premiums and legal fees, (4) personal and partnership assets that were commingled when he purchased property on behalf of the partnership, and (5) the fact that Clyde Sr., as general partner, retained the right to amend the partnership agreement without the consent of the limited partners.

Interestingly, the court also addressed whether IRC Section 2036(a)(2) would apply. Property is included in a decedent's gross estate under Section 2036(a)(2) if a decedent retained “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.” The court acknowledged that retaining the right to manage transferred assets doesn't necessarily require inclusion under Section 2036(a)(2). However, the court found that Clyde Sr. was essentially the sole general partner of Turner & Co. despite Jewell owning 50 percent of the general partnership interests, presumably because she was generally uninvolved in management. As such, he had broad authority to manage partnership property, amend the partnership agreement at any time without the consent of the limited partners, make pro rata distributions of partnership income (in addition to distributions to pay federal and state tax liabilities) and make distributions in kind. The court noted that even if Jewell were treated as an equal general partner, Section 2036(a)(2) still applies if powers are held “alone or in conjunction with any person.” Finally, the court noted that even after the gifts to their children and grandchildren, Clyde Sr. and Jewell together owned more than 50 percent of the LP interests in Turner & Co. and could make any decision requiring a majority vote of the limited partners.

Lastly, the court assessed whether Clyde Sr.'s payments for life insurance premiums qualified as annual exclusion gifts to the beneficiaries of the life insurance trust. Clyde Sr. paid the premiums directly, rather than transferring funds to the trust for the trustee to make the premium payment. The life insurance trust agreement gave each of the trust beneficiaries the absolute right and power to demand withdrawals from the trust after each direct or indirect transfer to it. The court held that even though Clyde didn't transfer funds to the trust and the beneficiaries may not have known they had the right to demand withdrawals from the trust, the beneficiaries still had a legal right to demand funds and, as a result, the premium payments Clyde Sr. made as indirect gifts to the trust were gifts of present interests and qualified for the annual exclusion.

This holding is somewhat at odds with Revenue Ruling 81-7, which held that if a donor doesn't inform a beneficiary of a demand right before it lapses, such that the beneficiary doesn't have a reasonable opportunity to learn of and exercise the right, the donor's conduct makes the demand right illusory and therefore deprives the beneficiary of the power. Rev. Rul. 81-7 holds that if, due to the donor's conduct, a beneficiary doesn't know of a demand right with enough time to exercise it, a gift may not qualify for the annual exclusion. The Tax Court doesn't generally treat revenue rulings as binding and it's not clear if it was Clyde Sr. (as opposed to the trustee's) responsibility to notify the beneficiaries of their withdrawal right. Regardless, the court's decision on the annual exclusion issue seems to take a black-line approach that's taxpayer friendly.