The IRS attempted to include assets transferred during the decedent’s life to a family LLC in her estate in the case of the Estate of Barbara M. Purdue, TC Memo 2015-249 as well as claim that gifts of interests in the LLC did not qualify as gifts of a present interest. 

For purposes of including the assets in the Purdue Estate the IRS turned to its trusty favorite section for including assets, IRC §2036(a).  That section provides:

(a) General rule

The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death--

(1) the possession or enjoyment of, or the right to the income from, the property, or

(2) 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

In the case in question the taxpayer and her spouse had transferred stock holdings and their interest in a building to a family LLC.  During the formation of the family LLC the children had been involved. 

As the Tax Court opinion summarized:

The parents requested that the Purdue children receive copies of most or all of the MPBA [1] correspondence commencing in early 2000.  On January 20, 2000, Mr. Montgomery [2] recommended various estate planning strategies, including the creation of an irrevocable family gift trust, qualified personal residence trusts, and a member-managed Washington family limited liability company.  Mr. Montgomery noted that it was not necessary for Mr. Purdue or decedent to absorb all of the information but strongly recommended that the Purdue children do so. 

… On August 2, 2000, the parents formed the PFLLC and the Purdue Family Residence Trusts (PFRTs).  Decedent retained the right to income and distributions from the property she transferred to the PFLLC in proportion to her PFLLC ownership percentage.  The following day MPBA sent the parents and the Purdue children a memorandum, again recommending that the Purdue children study the information.

The children also attended annual meetings with regard to this entity.  As the Tax Court noted:

On June 14, 2001, the Purdue children held a combined meeting of the PFLLC and the PFT in their capacities as cotrustees of the PFT, coattorneys in fact for the parents, and members of the PFLLC on behalf of the PFT and the parents. The parents never attended any of these meetings.  The Purdue children met withMr. Montgomery and representatives from the Rainier Group, Inc. (Rainier Group), a professional management advisory firm, and agreed that an annual meeting would be held and that minutes and materials would be filed.

Since 2001 the Purdue children have held annual meetings in their capacities as trustees and beneficiaries of the PFT and the Purdue Testamentary Trusts, personal representatives and beneficiaries of the parents’ estates, attorneys in fact for the parents, and individual members of the PFLLC.  They discussed the Purdue family’s accounts and assets, ratified prior PFLLC distributions, approved annual cash distributions, heard presentations from the Rainier Group investment manager, and received estate tax planning updates and advice from Mr. Montgomery.

The interests gifted to the children were held in the Purdue Family Trust (PFT) in which each child had an interest.  Gifts to the trusts were subject to a Crummey right of withdrawal. 

The children received significant cash distributions from the trust with much of it funded by the LLC’s cash flow from the stocks, as the Court noted:

From 2001 to 2007 the Purdue children received, in approximately equal shares, cash distributions totaling $1,997,304 in their capacities as PFT beneficiaries.  Of the $1,997,304 of PFT cash distributions, $51,920 was net rent paid to the PFT for its 50% interest in the Purdue residence and $1,945,384 was its share of net cash loans and dividends from the PFLLC.

The Court pointed out that three conditions must be met in order for a transfer of assets to be “yanked back” into a decedent’s estate under the retained life estate rules of IRC §2036(a). 

They are:

…(1) the decedent made an inter vivos transfer of property; (2) the decedent’s transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he or she did not relinquish before death.

There is no question that a transfer was made during life, so the first condition was met. But the IRS and the estate disagreed on whether the latter two conditions had been met.

The key issue would be whether there had been a “bona fide sale for full and adequate consideration” for the transfer.  Generally the Courts have found that such a sale is deemed to have taken place if there were significant, legitimate nontax considerations for the transfer. 

However it takes more than a mere recitation of non-tax reasons to meet this test—the estate needs to show that those reasons were more than boilerplate pasted into the document but which did not reflect reality.  As the Court noted “[w]e must separate the true nontax reasons for the PFLLC’s formation from those that merely clothe transfer tax savings motives.”

In this case the Court found that there were actual non-tax reasons that were significant.

The Court notes the following nonexclusive list of criteria are generally applied to determine if there was, in fact, true non-tax reasons for the transfer:

A list of factors to be considered when deciding whether a nontax reason existed includes:  (1) the taxpayer’s standing on both sides of the transaction; (2) the taxpayer’s financial dependence on distributions from the partnership; (3) the taxpayer’s commingling of partnership funds with the taxpayer’s own; (4) the taxpayer’s actual failure to transfer the property to the partnership; (5) discounting the value of the partnership interests relative to the value of the property contributed; and (6) the taxpayer’s old age or poor health when the partnership was formed.

The Court notes that transfer tax savings were clearly one motive for the transaction, but that is not fatal to the taxpayer’s case so long as significant nontax reasons also exist for the transaction.

The Court found the actions of the parties following formation supported the assertion of the estate that consolidating management of assets into a single family pool was a true nontax reason.  As the Court noted:

Following the formation of the PFLLC and formulation of an investment plan with the Rainier Group, the parents’ assets were consolidated into PFLLC accounts with the Rainier Group subject to an overall, well-coordinated professional investment strategy applied to all of the investments.  Before the formation of the PFLLC, Mr. Purdue handled all of the financial decisions regarding the marketable securities.  After the formation of the PFLLC, the Purdue children made the PFLLC investment decisions jointly.

The Court also found that a number of other factors suggested this was not purely a tax motivated transaction.  As the Court notes:

Other factors, however, support the estate’s argument that a bona fide sale occurred.  First, decedent and Mr. Purdue were not financially dependent on distributions from the PFLLC.  Decedent retained substantial assets outside of the PFLLC to pay her living expenses.  Second, aside from a minimal dollar amount across three deposits to the PFLLC account, there was no commingling of decedent’s funds with the PFLLC’s funds.  Further, the formalities of the PFLLC were respected.  The PFLLC maintained its own bank accounts and held meetings at least annually with written agendas, minutes, and summaries.  Third, Mr. Purdue and decedent transferred the property to the PFLLC.  Lastly, the evidence shows that decedent and Mr. Purdue were in good health at the time the transfer was made to the PFLLC.  Although decedent was 88 at the time of transfer in 2000, she lived until 2007.  Aside from the accident in 1984 and the incident in 2000, decedent never experienced any mental illness or life-threatening illnesses. Mr. Purdue was 83 at the time of the transfer and experienced symptoms of Alzheimer’s disease.  Otherwise, Mr. Purdue lived an active lifestyle until his death in 2001.

Thus the Court rejected the IRS’s attempt to include the entire value of the assets in the LLC in Purdue Estate.

With regard to the question of whether the annual gifts of the interests represented a present interest, the IRS was raising an issue that they had carried in the Hackl case.  As the Court noted:

A gift in the form of an outright transfer of an equity interest in a business or property, such as limited partnership interests, is not necessarily a present interest gift.  See id. at 292; see also Price v. Commissioner, T.C. Memo. 2010-2.  Rather, we must inquire, among other things, “whether the donees in fact received rights differing in any meaningful way from those that would have flowed from a traditional trust arrangement.”  Hackl v. Commissioner, 118 T.C. at 292.

Looking at the interests transferred, the Court found the following criteria is useful in determining if the gift was truly one of a present interest:

To ascertain whether rights to income satisfy the criteria for a present interest under section 2503(b), the estate must prove, on the basis of the surrounding circumstances, that:  (1) the PFLLC would generate income, (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.  See Calder v. Commissioner, 85 T.C. 713, 727-728 (1985); see also Hackl v. Commissioner, 118 T.C. at 298; Price v. Commissioner, T.C. Memo. 2010-2.

In this case the Court concluded these criteria were met and the transfers were present interest gifts. 

As the Court noted:

First, the PFLLC held an interest in the Hocking Building, subject to a 55year lease, expected to generate rent income, as well as dividend paying marketable securities.  Second, the PFT made annual distributions from 2000 through 2008, totaling $1,997,304.  Further, the PFLLC operating agreement and applicable State law impose a fiduciary duty on the PFLLC to make proportionate cash distributions sufficient for the QTIP Trust and the Bypass Trust to pay their income tax liabilities.  See Wash. Rev. Code sec. 25.05.165 (West 2005) (specifying that partners are subject to the duty of loyalty, the duty of care, and the duty of good faith and dealing); Estate of Wimmer, T.C. Memo. 2012-157; Estate of Petter v. Commissioner, T.C. Memo. 2009-280, aff’d, 653 F.3d 1012 (9th Cir. 2011).  Lastly, as previously stated, the property of the PFLLC consisted of marketable securities and the interest in the Hocking Building.  The rent amount for the Hocking Building was readily ascertainable from the lease and the marketable securities were publicly traded.  Therefore, the partners could estimate the expected dividends.  See, e.g., Estate of Wimmer v. Commissioner, T.C. Memo. 2012-157.

CPAs involved with taxpayers like the Purdues should note that the Court spent little time on the documents in this case, but rather concentrated on the detailed facts, including what the taxpayers did and, for purposes of the present interest test, the nature of the assets in the entity.

While poorly drafted documents certainly can eliminate estate and gift tax benefits, the reverse is not true.  Even the highest quality estate planning documents drafted by the most skilled attorney will not save the tax benefits if the facts don’t support the benefits.  Key facts include how the family actually treats the entity in question and, for purposes of present interest gift exclusions, whether there is an actual realistic expectation of a current cash flow from the entity.

The CPA is generally going to be in the best position to determine whether the reality of the facts are going to pose a major risk to the expected tax benefits.  Thus, the CPA will have the responsibility of “raising the red flag” if the facts are bad, either at formation or, more problematical, as the entity continues in operation.

 

[1] The law firm involved in structuring the transaction.

[2] The attorney involved in the formation of the entit