This issue of my Newsletter series (past Newsletters are available in the archives on this website) covers a recent (March, 2016) Tax Court opinion on the estate tax challenges to pass-through entities via IRC Sec. 2036(a) and also provides information on my upcoming CPE webinars for CPE Solutions LLC (www.cpecredit.com) - 5 courses all on estate and succession planning issues.
Estate of Sarah D. Holliday v. Commissioner of Internal Revenue, T.C. Memo. 2016-51 (3/17/16) - IRS wins another one!
In my last Newsletter, I happily reported on a taxpayer estate victory, Estate of Purdue v. Commissioner, T.C. Memo. 2015-249 (12/28/15); but now the court has released the Holliday opinion, a clear taxpayer defeat! We now have seen about 40 trial court decisions on the estate tax section most dangerous for the viability of FLPs and FLLCs, namely, IRC Sec. 2036(a), described below. Of these, only about 15 decisions were for the taxpayers - not bad considering that it is the government that picks cases to attack partnerships and limited liability companies for estate tax purposes.
I can still recall the first of these 40 cases, namely, Estate of Dorothy Schauerhamer, T.C. Memo. 1997-242, because I was the tax litigation counsel for the estate - which I had early on advised in a confidential engagement letter likely would lose under Sec. 2036(a) of the Code! So this latest case, Holliday, allows us to remind taxpayers and practitioners alike of how important proper planning is in using the FLP or FLLC to spawn estate and gift tax valuation discounts in the high wealth estate. And since 2010, the Internal Revenue Code has included Section 7701(o), the "economic substance doctrine" - which simply makes clear that tax beneficial transactions, especially using entities, must have "significant and real non-tax purposes" if the transactions are to be respected for tax purposes.
First, let's summarize what 2036(a) is all about - it is an estate tax section that, if applicable to the facts, will disregard a lifetime transfer of property if the transferor retains income from or control over the property. At first blush, this would seem to prevent gifts or sales of wealth to family partnerships and limited liability companies; but it is more complicated than that. Plus, there is a major exception that, where applicable, prevents 2036(a) from even applying! The Tax Court in Holliday stated: "Section 2036 is intended to include in a decedent's gross estate inter vivos transfers that were testamentary in nature" (i.e. essentially not really effective until death of the transferor by virtue of retained interests). So two (2) things are necessary for 2036(a) to apply, namely, (i) a property transfer by the decedent during his or her lifetime, and (ii) retention by decedent, directly or indirectly (whether or not by an enforceable agreement), possession or enjoyment of, or the right to income from, the property for the decedent's remaining lifetime.
Second, what is the "exception" or, if you will "safe harbor", involved here? Best explained by the Tax Court in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005), and also discussed in depth in the above-cited Purdue case, 2036(a) does not apply at all if two (2) tests are satisfied by the entity-based transaction. These tests are, first, that there was a "bona fide sale" of the property, and second, that it was for "adequate and full consideration". What do these tests mean in the context of contributions of property to a partnership or limited liability company taxed as a partnership (followed later by gifts of fractional entity interests or transfers to heirs at death of the contributing individual(s)? Essentially, the most important factor is that, for the exception to apply, there must be a "legitimate and significant nontax reason for creating the family limited partnership and the transferors must have received partnership interests proportionate to the value of the property transferred." This is the formula for success identified in the Bongard opinion. Theoretical justifications, mere recitation of entity purposes or benefits other than tax benefits, are not enough. There must be "actual motivation" other than for gift or estate or other tax benefits.
So, in Holliday, where did decedent's two (2) sons go wrong (as did their legal counsel) in the plan? What happened was that the sons, holders of a durable power of attorney over assets of their mother, failed to meet the above tests for avoiding disaster under 2036(a). You may wish to view my complete commentary for Steve Leimberg in LISI Email Estate Planning Newsletter No. 2402 (March 28, 2016). In any event, in spite of all the court decisions on this issue from 1997 to date, the facts that could have saved the Holliday family were not present! There were quite doubtful nontax reasons for setting up an FLP with $5 million of marketable securities and an LLC owned by the sons as the tiny equity percentage general partner. Further, the mother was never involved in the planning and would just "do as the sons wished", as testified to in court(!). Finally, the partnership agreement was not followed - it actually stated (rather unusually) that there would be periodic mandatory distributions of net income not needed for entity expenses to the partners (and only one was made over the two years from entity formation until mother's death!).
So what can we say? - I believe it is that nearly 20 years of litigation should teach clients and their advisors how to avoid 2036(a), and if you can't do it, then don't use the pass-through entity at all!
Check Out www.cpecredit.com For My Upcoming Webinars - 5 courses, All On Estate & Succession Planning!
In May and June, under the sponsorship of CPE Solutions LLC (www.cpecredit.com), I will present live webinars (accompanied by detailed outlines, power point slides, and valuable appendices useful to tax practitioners and their clients) on the following subjects:
I. May 6th - "Trusts, Pass-Through Entities & Family Wealth Planning" (3 hours)
II. May 20th - "Family Wealth Valuation Issues" (2 hours)
III. May 27th - "Buy-Sell & Non-Qualified Deferred Compensation Agreements" (2 hours)
IV. June 10th - "Estate & Succession Planning for the 99%" (2 hours)
V. June 20th - "Family Succession Planning Developments - 2016" (2 hours
You can see the course description and learning objectives for each of these client-friendly courses at www.cpecredit.com!
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From the beautiful Central Panhandle of North Idaho! Owen Fiore