Five Recent Cases Reveal Continuing Uncertainties in the Treatment of Transfers of FLP and LLC Interests for Estate and Gift Tax Valuation Purposes
Federal courts recently issued five opinions concerning the federal estate and gift tax treatment of transfers of interests in family limited partnerships and limited liability companies (FLPs or LLCs) to family members. The first three cases deal with the issue of the lifetime gifts of interests in FLPs and LLCs, and whether these are gifts of FLP and LLC interests at a discounted basis or gifts of the underlying assets in the FLP or LLC without discounts.
- Linton v. United States, 2009 U.S. Dist. LEXIS 56604 (W.D. Wash. July 1, 2009) – The Western District of Washington found that taxpayer parents made indirect gifts of an LLC’s assets to their children’s trusts when the FLP was funded on the same day that the LLC interests were transferred to their children’s trusts. The step transaction doctrine also applied.
- Heckerman v. United States, 2009 U.S. Dist. LEXIS 65746 (W.D. Wash. July 27, 2009) – Another Western District of Washington trial court case with similar facts to Linton produced the same outcome as in Linton.
- Pierre v. Comm’r, 133 T.C. No. 2 (Aug. 24, 2009) – The Tax Court held that the check-the-box regulations did not cause a LLC to be disregarded for purposes of determining the value of the donor’s transferred LLC interests and the donor’s corresponding federal gift tax liability.
The last two cases deal with the valuation of FLP and LLC interests in a decedent’s estate.
- Keller v. United States, 2009 U.S. Dist. LEXIS 73789 (S.D. Tex. Aug. 20, 2009) – In a remarkable taxpayer victory, a Texas trial court allowed significant valuation discounts for FLP interests held by taxpayer’s estate where the taxpayer demonstrated a non-tax purpose for forming the FLP even though the FLP was formed shortly before the decedent’s death but not funded until more than a year after the decedent’s death.
- Malkin v. Comm’r, T.C. Memo 2009-212 (Sept. 16, 2009) – The taxpayer lost on most issues where the court determined that the taxpayer had retained beneficial enjoyment of stock used to fund two FLPs under section 2036(a). The taxpayer was also found to have made indirect gifts of LLC assets, cash, and a promissory note to his children.
In Linton, a husband and wife sought a partial refund of federal gift taxes paid on transfers of interests in their LLC to trusts created for the benefit of their children. In November 2002, Mr. Linton formed an LLC and was its only member. On Jan. 22, 2003, Mr. Linton gave a 50% interest in the LLC to Mrs. Linton.
On the same day, the Lintons executed the following documents to fund the LLC: (i) a quit claim deed for real property; (ii) letters of authorization for transfers of securities and cash; and (iii) an assignment of assets. Also on Jan. 22, 2003, the Lintons signed separate trust agreements establishing a trust for each of their four children. They also signed “gift of percentage interest” documents that transferred 22.5% of the Lintons’ interests in the LLC to each child’s trust. On their 2003 gift tax returns, the Lintons claimed a 47% discount on the value of the transferred interests attributable to a lack of marketability and control which rendered the LLC interests unmarketable.
On the Internal Revenue Service’s (Service) motion for summary judgment, the court considered testimony offered by the Lintons to establish a chronology of events favorable to the taxpayers. However, the court found that the evidence offered by the Lintons was insufficient to overcome the express language of the trust and transfer documents. Specifically, the court found that the express language of the children’s trust agreements and the LLC transfer documents established that the trusts were created and the gifts to the trusts were made on the same day.
The court further found that the Lintons failed to present evidence that would justify a reformation of the trust agreements and gift documents to a date nine days after the LLC was funded. The court concluded that the trusts were validly created on Jan. 22, 2003, and that the Lintons made gifts of LLC interests to the trusts on the same day. Therefore, the court, in comparing the facts in the Lintons’ case to those in Shepherd v. Comm’r, 115 T.C. 376 (2000) and Senda v. Comm’r, 433 F.3d 1044 (8th Cir. 2006), found that the Lintons had made pro rata indirect gifts of the LLC’s underlying assets to the children’s trusts and not gifts of percentage interests in the LLC itself.
The court also found persuasive the Service’s alternative argument that the Lintons made indirect gifts of LLC assets to the children’s trusts under the step transaction doctrine. After setting forth the three generally recognized step transaction tests (binding commitment, end result, and interdependence), the court found that each test was satisfied. The binding commitment test was satisfied when the Lintons executed the binding trust agreements and gift documents at the same time the LLC was funded. The end result test was met because the Lintons made prearrangements to maximize the value of the transfers to their children while minimizing their federal gift tax liability when Mr. Linton did not date the LLC gift documents in an attempt to ensure that the LLC was funded before the gifts to the children’s trusts were effective.
Likewise, the court found that the interdependence test was satisfied where the evidence showed that the Lintons would not have funded the LLC without the anticipated valuation discount for the transfers to the trusts for the children. The court further distinguished this case from the pro-taxpayer decisions in Holman v. Comm’r, 130 T.C. 170 (2008) and Gross v. Comm’r, T.C. Memo 2008-221 (2008), where the taxpayers delayed making gifts for several days (six days and eleven days respectively) after funding the underlying LLC.
Finding no genuine issue of material fact related to the Lintons’ transfers of LLC interests to their children’s trusts, the court granted the Service’s summary judgment motion, and held that the Lintons made an indirect gift of the underlying assets in the LLC to their children’s trusts.
In Heckerman, a different judge in the Western District of Washington, but on essentially the same theories advanced in Linton, accepted the Service’s assertion that parents were not entitled to a refund of federal gift tax where it was alleged that the parents had made indirect gifts to their two children.
On Nov. 28, 2001, Mr. and Mrs. Heckerman created trusts for their children. That same day, the Heckermans created three limited liability companies: an Investments LLC, a Real Estate LLC and a Family LLC (to serve as an umbrella for the Investments and Real Estate LLCs). On Dec. 28, 2001, the Heckermans funded the Real Estate LLC with a beach house located in Malibu, California. On Jan. 11, 2002, the Heckermans funded the Investments LLC with $2.85 million in mutual funds. Also on Jan. 11, 2002, the Heckermans transferred just under 50% interests in the Family LLC to each child’s trust. On Feb. 6, 2002, the Heckermans obtained an appraisal report that valued the gift transactions as of the date of transfer, Jan. 11, 2002. The Heckermans’ subsequent gift tax returns for the transfers to the trusts reflected a 58% discount for the lack of marketability of the LLC interests.
The Service asserted that the Heckermans’ contributions to Investments LLC should be treated as indirect gifts to the children’s trusts. Alternately, the Service argued that the step transaction doctrine should apply to the funding of the LLC and the corresponding gifts of LLC interests. Significantly, the Service did not argue that the Heckermans’ contribution of real estate to the LLC on Dec. 28, 2001, was an indirect gift to the children’s trusts, when gifts of LLC interests in the real estate were made fourteen days later.
The court rejected the Heckermans’ attempts to contradict the “overwhelming” express written evidence that showed that the gifts of LLC interests were made on the same day the LLC was funded. The court further disallowed the Heckermans’ attempt to argue that the gifts were not effective until the gifts were delivered to the trustees, because the Heckermans failed to raise this argument in their initial claim for refund. The court also found that the Heckermans could not establish that their capital accounts were increased by the amount of their contributions to Investments LLC that would entitle them to receive the amount of their contributions from the entity in the event of its liquidation.
Like the court in Linton, the court in this case also found the step transaction doctrine applicable to the transactions, since the funding of Investments LLC and subsequent gifts of Family LLC interests to the children’s trusts were “at best, integrated and, in effect, simultaneous.” The court found that two of the three alternative step transaction tests – the end result test and the interdependence test – were satisfied. Relying on Mr. Heckerman’s testimony and an e-mail between Mr. Heckerman and his financial advisor, the court found the end result test was met because the evidence showed Mr. Heckerman’s intent to fund the LLC in a way that would not incur a federal gift tax.
Additionally, in the court’s opinion, the interdependence test was satisfied because the court determined that the Heckermans would not have funded Investments LLC without the anticipated discount in valuation and corresponding federal gift tax on the transfers of the LLC interests.
The court further distinguished the Heckermans’ case from Holman and Gross, noting again that several days had passed in those cases between the funding of the FLPs and the gifting of the FLP interests. Furthermore, the court noted that unlike the taxpayers in Holman and Gross, the Heckermans did not bear any real economic risk that the LLC units would change value between the date of funding and the date of gifting. Accordingly, the court granted the Service’s motion for summary judgment and held that the Heckermans had made indirect gifts of the underlying assets in the LLC to their children’s trusts with respect to the LLC’s assets.
The Service assessed tax deficiencies on the taxpayer’s payment of federal gift tax and generation-skipping transfer tax. The sole issue before the court was whether interests transferred in a LLC that is a disregarded entity under the “check-the-box regulations” found in Regulations sections 301.7701-1 through 301.7701-3 are valued as a proportionate share of the LLC’s underlying assets, or are instead valued as transfers of LLC interests.
On July 13, 2003, Ms. Pierre created an LLC under New York law. She did not elect to treat the LLC as a corporation for federal income tax purposes. On July 24, 2000, she created separate trusts for her son and granddaughter. On Sept. 15, 2000, she funded the LLC with $4.25 million in cash and securities. Then on Sept. 27, 2000, through a combined gift and sale, Ms. Pierre transferred her entire interest in the LLC to the trusts created for her family members. She asserted a 36.55% valuation discount on the transfers for gift tax purposes.
The Service asserted that Ms. Pierre’s gifts of interests in the LLC were actually gifts of the LLC’s underlying assets, and were not gifts of interests in the entity itself. Likewise, the Service claimed that Ms. Pierre made gifts to the trusts to the extent that the value of the underlying assets of the LLC exceeded the amount of the promissory notes used to finance the sales from herself to the trusts.
The Service asserted that the check-the-box regulations should cause the transfers of interests in the LLC to be treated as transfers of the LLC’s underlying assets, and not transfers of interests in the LLC for purposes of valuing the transfers. Ms. Pierre contended that state law defines the nature of property interests transferred for federal gift tax valuation purposes. She further argued that under New York state law, a membership interest in a limited liability company is personal property, and that LLC members do not have specific interests in an LLC’s property.
The court considered whether the check-the-box regulations altered the federal gift tax valuation regime. The court found that the check-the-box regulations were used to classify an entity with a single owner disregarded “for federal tax purposes.” However, a majority of the court’s judges found that the check-the-box regulations did not require a single-member LLC to be disregarded for federal tax purposes when valuing and taxing Ms. Pierre’s transfers of ownership interests in the LLC.
The court determined that while the check-the-box regulations governed how a single-member LLC is taxed for federal income tax purposes, the regulations did not apply to disregard the LLC in determining how Ms. Pierre as donor of the transferred interests should be taxed for federal gift tax purposes. The court stated that if Congress intended for the check-the-box regulations to apply as the Service asserted, Congress would enact such a specific provision as it had elsewhere in the Code.
Accordingly, the court held that Ms. Pierre’s transfers of interests in the LLC should be valued for federal gift tax purposes as transfers of interests in the entity, and not as transfers of the entity’s underlying assets. The court reserved judgment on related valuation issues and application of the step transaction doctrine for a later opinion.
In Keller, the executors of the Estate of Maude O’Connor Williams sought a refund of estate taxes paid based on a claimed 47.5 % valuation discount of FLP interests held by the estate. In 1998, Mr. and Mrs. Williams created a family trust to hold a pool of investment assets. The record showed that Mrs. Williams was significantly concerned with protecting the family’s assets from the claims of a non-blood relative, in the event of the divorce of a family member. Following Mr. Williams’ death in 1999, Mrs. Williams began considering the use of a series of FLPs to hold each class of the family’s assets. The court found that the purpose of the FLPs was to consolidate and protect the assets for management purposes, and to facilitate the transfer of the assets to younger generations.
In September 1999, Mrs. Williams reviewed a spreadsheet identifying which assets would fund the FLP. The general partner of the FLP was to be a newly created LLC that would be initially funded with $300,000 and wholly owned by Mrs. Williams. Mrs. Williams was diagnosed with cancer in March 2000. Following months of drafting and revisions to the partnership agreement forming the FLP, Mrs. Williams signed the agreement on May 9, 2000, and the documents to fund the FLP.
The schedule of capital accounts on the FLP agreement were intentionally left blank in order to later determine the accurate market value of the assets used to fund the entity. On May 10, 2000, the FLP’s agent applied for a tax identification number for the entity, began the process for establishing a new account to hold the FLP’s assets, and wrote a $300,000 check to fund the FLP’s new LLC general partner. Mrs. Williams died on May 15, 2000, before signing the check.
Initially, all activity ceased on formalizing and funding the FLP after Mrs. Williams’ death. Approximately twelve months later, one of the estate’s executors heard about the decision in Church v. United States, 2000 U.S. Dist. LEXIS 714 (W.D. Tex. 2000), and he believed that Mrs. Williams had successfully formed and begun the process of funding the FLP prior to her death. Moreover, the estate had paid estimated federal estate tax of $147 million, nine months after the date of death. In Church, the formation of the FLP was completed after the death of the donor, but the donor’s intent to create the FLP was found to control the creation and funding of the FLP under Texas law. The executors resumed their efforts to formally establish the FLP, and sought an estate tax refund in excess of $40 million.
The court found that at the time of her death, Mrs. Williams intended certain bonds to be FLP property. Likewise, the court determined that Mrs. Williams intended that the LLC general partner of the FLP was to be capitalized with $300,000. Under Texas law, the court found that the executors had a duty to complete the transaction to form the LLC. The court concluded that the FLP was fully formed and funded prior to Mrs. Williams’ death. The court heard testimony from both the estate’s and Service’s valuation experts on the availability of discounts for marketability and lack of control. The court found the estate’s expert to be more credible, in part to due to errors in the Service’s expert’s application of the willing buyer and seller standard, and accepted a 47.5% discount.
The court stated that Texas law provides that the intent of an owner to transfer assets to a partnership will cause assets to be considered partnership property, regardless of whether title to the property has been transferred. Therefore, the court found that Mrs. Williams was obligated to fund the LLC general partner. Finding that Mrs. Williams intended to fund the FLP at the time she signed the partnership agreement, the court determined that the FLP was a valid Texas limited partnership before her death. Accordingly, since the assets were considered FLP property before her death, the FLP interests were eligible for a valuation discount, and the estate could claim an estate tax refund based on the discounted value.
The court held that Mrs. Williams’ transfer met the definition of a “bona fide sale” under sections 2036(a) and 2038(a), and was not otherwise a sham transaction. There was a transfer for adequate consideration and a significant non-tax reason for creating the partnership. The court found that the primary purpose of creating the FLP was to protect the family’s assets from ex-spouses’ claims in divorce proceedings. Additionally, it was significant that Mrs. Williams retained substantial assets outside of the FLP on which to live, and upon liquidation of the FLP, each partner was to receive the value of his or her capital account that corresponded to the interests in the FLP.
The court found that the estate had met its burden of proof and was entitled to a refund of estate taxes which amounted to a nearly 50% valuation discount of the FLP interests. This case required a four-day trial, and the judge took almost two and one-half years to issue his opinion. The Service may appeal this case to the Fifth Circuit in the hope of getting a more favorable result at the appellate level.
The Service asserted deficiencies in excess of $11 million in federal gift tax and $6 million in federal estate tax against the Estate of Rodger Malkin. During his life, Mr. Malkin created two FLPs and four trusts to benefit his two children. One FLP (MFLP) was funded with Mr. Malkin’s company stock, while the other FLP (CRFLP) was funded with company stock and interests in four LLCs that he owned with his son.
The court considered whether Mr. Malkin retained possession and enjoyment of the stock transferred to the FLPs under section 2036(a), thereby causing the value of the stock to be included in his gross estate. Additionally, the court considered whether he made indirect lifetime gifts to his children of the FLPs’ underlying assets. The court also considered whether he made various other direct and indirect gifts to his children during the last three years of his life.
In 1998, Mr. Malkin created two trusts, one to benefit each of his children. Each trust was funded with cash. Following the registration of MFLP in Mississippi on Aug. 31, 1998, Mr. Malkin funded it with nearly $17 million in stock in one company called Delta & Pine Land of which Mr. Malkin was the CEO and chairman for twenty years. The trustees of the children’s trusts entered into contracts to purchase certain units of MFLP for each trust with a combination of a cash down payment and a nine-year self-canceling installment note. Over a year after MFLP was created and the trusts were funded, the trustees of the children’s trusts authorized Mr. Malkin to pledge MFLP’s assets in order to secure two of Mr. Malkin’s personal debt obligations. The collateral used to secure each debt obligation was equal to nearly all of MFLP’s underlying assets.
In May 1999, Mr. Malkin was diagnosed with pancreatic cancer. Several months later he organized the second FLP, CRFLP. On Feb. 29, 2000, CRFLP was funded with Mr. Malkin’s interests in four LLCs. The next day Mr. Malkin executed documents to establish two additional trusts, one for each of his children, to hold interests in CRFLP. The trustees of these trusts entered into contracts to purchase interests in CRFLP through a combination of a cash down payment and a nine-year promissory note. Additionally, in November 2000, Mr. Malkin funded CRFLP with certain shares of stock that he had previously used as collateral for another personal debt obligation. The stock remained collateral for the debt following the transfer to CRFLP. The trustees never made interest payments on the promissory notes to CRFLP before or after Mr. Malkin’s death on Nov. 22, 2000.
Prior to his death, from 1998-2000, Mr. Malkin also: (i) made direct transfers of several hundred thousand dollars to his children; (ii) paid several million dollars of the outstanding debts of the LLCs he co-owned with his son; and (iii) assigned a $1 million promissory note to one of the LLCs.
In considering whether Mr. Malkin retained the use and enjoyment of the property transferred to the FLPs, the Service asserted that both an express and implied agreement existed between Mr. Malkin and the trustees of the children’s trusts to permit him to retain the present economic benefits of the stock that he used to fund the two FLPs. The executors of Mr. Malkin’s estate contended that no agreement existed to permit Mr. Malkin to retain the economic benefits of the property used to fund the FLPs. Additionally, the executors argued that the trustees’ ratification of Mr. Malkin’s pledge of the FLP shares for his personal debt obligations was an investment decision that was made at arm’s length and was otherwise in the best interests of MFLP.
Although the court found that Mr. Malkin did not retain the economic benefit of the LLC interests used to fund CRFLP, the court agreed with the Service as to Mr. Malkin’s retained benefit and use of the stock used to fund both FLPs. Citing section 20.2036-1(b)(2) of the Estate Tax Regulations, the court stated that the retained use and enjoyment of transferred property includes property used to discharge a legal obligation. Accordingly, the court found that the stock Mr. Malkin used to fund the FLPs was applied toward discharging his debt obligations.
The court further found insufficient evidence to support the executors’ argument that the trustees’ approval of Mr. Malkin’s pledge of the FLP’s underlying assets was in fact a business decision made at arm’s length, or that it was otherwise in the best interests of MFLP. Likewise, the court found no business reason for CRFLP to hold shares pledged to secure Mr. Malkin’s personal debt. The court determined that Mr. Malkin’s unrestricted use of the shares used to fund the FLPs suggested an implied agreement that the shares were available for his use and enjoyment. Therefore, Mr. Malkin retained the possession and enjoyment of the shares within the meaning of section 2036(a)(1).
Because Mr. Malkin had retained the use and the enjoyment of the transferred property, the court next considered whether his transfer of stock to the FLPs fell within the section 2036(a) exception for “bona fide sales” for “adequate and full consideration in money or money’s worth.” The court held that the exception did not apply because Mr. Malkin had no legitimate and significant non-tax reason for creating the FLPs. It specifically rejected the three non-tax reasons offered by the estate: (i) providing for children by having the appreciation pass to the children and not to the decedent; (ii) protecting the Delta Pine & Land stock from a sale; and (iii) centralizing management of the family’s wealth. Since Mr. Malkin’s transfers did not qualify for the bona fide sales exception under section 2036(a), the value of the stock held by the FLPs was includable in his gross estate.
The court next considered whether Mr. Malkin made indirect gifts to his children when he funded CRFLP with his LLC interests, then made gifts of interests in CRFLP to his children’s trusts. The court found that the transfers were analogous to the transfers in Shepherd, finding that Mr. Malkin created CRFLP, funded it with LLC interests, and then assigned CRFLP interests to each child’s trust the next day. The court rejected the executors’ reliance on the purported sale of CRFLP interests to the trusts, finding it to be a sham. The court noted that Mr. Malkin was terminally ill at the time the trusts were alleged to have purchased the interests from CRFLP.
Additionally, the court found that Mr. Malkin provided the cash for the down payments, even though each child individually had millions of dollars of assets to make the payments. The court found that the promissory notes were the only consideration the trusts gave to Mr. Malkin, but that there was no evidence to support the conclusion that either Mr. Malkin or his children expected the notes would be paid. Holding that the purported sale by CRFLP to the trusts was a sham, the court determined that Mr. Malkin made indirect gifts to his children of his interests in the LLCs.
With respect to certain cash transfers Mr. Malkin made to his children from 1998-2000, the court found that the promissory notes which attempted to disguise the direct gifts as loans were not assets of the gross estate. The court determined that Mr. Malkin made direct cash gifts to his children, and that the transfers should be reported on Mr. Malkin’s gift tax returns. The court further concluded that Mr. Malkin made additional indirect gifts to his children when he paid the debts of the LLCs used to fund the FLPs. He also made indirect gifts to his children when he transferred cash and a promissory note to one of the LLCs.
Lastly, the court rejected a deduction claimed by the estate for non-recourse debt of Mr. Malkin’s to the extent that the estate’s claimed deduction exceeded the value of the property securing the debt. The court disallowed an additional $2 million deduction the estate claimed as Mr. Malkin’s debt. With respect to this debt, the court determined that Mr. Malkin did not have a contractual obligation to purchase units in an LLC of which he was not a member at the time of his death. The court further disallowed deductions for executors’ commissions, attorneys’ fees, and accounting fees as the executors presented no evidence that the amounts were paid and that the estate was otherwise entitled to claim the deductions.
In light of the court decisions above, individuals, trusts, and other entities considering FLPs or LLCs should consider the following steps, among others:
- Identifying legitimate business and/or investment reasons for the FLP or LLC.
- If possible, including assets that require active management in the FLP or LLC, such as real estate.
- Keeping sufficient assets outside of the FLP or LLC to provide for the donor’s support, so that he or she does not have to rely on FLP or LLC distributions.
- Administering an FLP or LLC in accordance with its terms, and not treating the FLP or LLC as a personal checking account for the partners or members.
- Avoiding creating the FLP or LLC for an elderly individual who may die shortly thereafter.
- Having as long a period of time as possible between the contribution of assets to an FLP or LLC and the subsequent gifts of those FLP or LLC interests to family members or others.
- Avoiding status as a “disregarded entity” because there is a single member of an LLC by transferring a small interest in the LLC initially to family members or others to avoid having a court in the future apply the disregarded entity regulations to the transfers of the LLC interests as the Service asserted in Pierre.
The Service is continuing to aggressively challenge FLPs and LLCs, and only those that are formed and operated correctly will survive the scrutiny of the Service and the courts and provide the desired non-tax and tax benefits.
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Fiduciary Advisory Services assists financial institutions in a wide array of areas in which questions or concerns may arise. This includes advising corporate trustees on how to avoid litigation before it arises, and how to address litigation when it does arise. For further information on the recent cases cited above or McGuireWoods Fiduciary Advisory Services, please contact the authors.