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MONTH YEAR: Lead Article: 1 ¾ pages [2nd page about 45 lines]
Lead Article Title: Valuing Gifts of FLP Interests: Holman – Part ISummary: A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships (“FLPs”) and limited liability companies (“LLCs”). While it received much attention in the professional literature, most regular folk haven’t heard much. www.leimbergservices.com had no less than 4 articles covering this case! (If you’re an estate planner and haven’t subscribed, you’re missing great stuff). An overview analysis of the case will be presented. Next month, in Part II, planning lessons reviewed, and several important points that seem to have gotten short shrift in the professional literature will be discussed.
Dad worked at Dell Computer and received substantial Dell stock options which he exercised, and both Dad and Mom bought additional shares. Mom and Dad formed an FLP and contributed their Dell stock to it. Thereafter, Mom and Dad gave FLP interests to one child’s custodian account, and larger gifts to a trust for all four of their children. They claimed discounts aggregating nearly 50% on the value of these FLP interests (e.g., if the Dell stock was worth $2 million and they gave away 10% they did not value it at 10% x $ 2M = $200,000 but more like about $100,000. This reduction reflected discounts (i.e., reductions in value) for minority interests (the recipients of the FLP interests could not control the partnership since they owned small percentages), and discounts for lack of marketability (tough to sell interests in a family entity). There were both good and bad facts in the case. Bad Facts: ◙ Tax returns were never filed. ◙ Almost no income was earned. ◙ Only one asset was owned, Dell stock. ◙ No business plan. ◙ No employees. ◙ No letterhead or telephone listing. ◙ No accounting reports. Good Facts: ◙ FLP formalities were generally adhered to. ◙ The Dell stock was properly transferred to the FLP prior to gifts of FLP interests being made.
The IRS argued that the taxpayers made indirect gifts of Dell stock (i.e., no discounts) to their children’s trust. If the gifts are considered indirect gifts of Dell stock, instead of gifts of FLP interests, no discounts would apply. Just the market price of Dell stock would determine the value of the gifts. See Sheperd v. Commr., 115 TC 376 (2000), aff’d 283 F.3d 1258 (11th Cir. 2002) and Senda, TC Memo 2004-160. Point to the Taxpayer. Treas. Reg. Sec. 25.2511(a), (h)(1). A classic example of an indirect gift is illustrated if you make a gift to a corporation. This is treated as the equivalent of a gift indirectly from you, through the corporation, to each of the corporation’s shareholders. Holman won this issue by observing the appropriate steps of first properly transferring assets to the FLP, waiting a period of time, then making the gifts of FLP interests. The Court did not find that a gift occurred on the FLP formation and funding. Had the Holman’s transferred FLP interests to the trust on the same day, the court might well have held otherwise. Thus, Holman doesn’t represent the end of the IRS indirect gift argument, but it seems pretty clear that if you observe the formalities and independence of the partnership, assure that assets are properly transferred, and so on, that argument should be toothless. Mishandle the paperwork (like the Sheperd case) and the indirect gift argument will still bite.
The IRS also argued that the taxpayers made indirect gifts of Dell stock under the step transaction doctrine. This doctrine provides that if a series of steps in a transaction are so integrated and interdependent, economic reality may be better reflected by collapsing the various steps into a single step. Thus, the IRS view of Holman under the step transaction doctrine was that the transfer of stock to the FLP and the gift of FLP interests to the children’s trust would be more realistically viewed as a mere gift of the Dell stock direct to the trust (i.e., the formation of the FLP was really just part of making stock gifts to the trust). The doctrine might be applied if there is a binding commitment to consummate all of the steps involved. The taxpayer’s in Holman, however, were not under any obligation to make gifts to their children’s trust. The doctrine may be applied if the various steps involved are interdependent steps. This means that the legal implications of one step would be fruitless if the other step wasn’t also completed. This was not the case in Holman. Mom and Dad could have stopped once the FLP was formed, that step would not have been irrelevant if the gifts were not made. Finally the step transaction doctrine might be applied by applying an “end result” test. This, however, was not discussed by the Holman Court. Point to the Taxpayer. The court reasoned that during the six day time period that the FLP held the Dell stock from the time stock was contributed to the FLP, until the date the gifts were made, created a “real economic risk of change in the value”. The Court believed this risk occurred because the FLP was holding a highly volatile, heavily traded, stock. The court indicated that it might view the time period differently (i.e., six days would not be enough time for a real economic risk) if the FLP held a preferred stock or long term government bond. The court apparently viewed these as stable assets that would not have the likelihood of a “real economic risk of change in value” over a period as short as a week. Huh? So let’s say that you contributed a 30-year Treasury to your FLP. But two weeks later, before you could make gifts of FLP interests to the kiddies, Bernanke decided to ratchet up interest rates to stave off inflation. That supposedly secure long term government bond that the Holman court presumes has a stable value, would look like the economic equivalent of a bowling ball heading down a ski slope. Now what about real estate? Yeah, real estate always holds its value over the short term (don’t they get CNN in the Judges chambers?). If you have a power shopping center with long term AAA tenant leases, that might not change much in the short term. But what if a key tenant goes bankrupt? What if you have a single use commercial property used as a back office for a residential mortgage processing company? That’s about as stable as Sybil. Should either of these types of properties be evaluated differently then a strip mall with a bunch of mom and pop tenants? Should you analyze the credit worthiness of commercial tenants to determine how long real estate should be held in an FLP before gifts can safely be made? How much analysis is necessary to determine the requisite holding period? The Holman holding period is not practical, simple, clear or reasonable. But hey, if it was cookbook simple think of all the unemployed tax attorneys.
Courts are often sticklers to find real non-tax business purposes for FLP and similar transactions. Yet, the concept of needing a time period between funding of the FLP and the gift is inconsistent with business reality. In real business deals, entities often have essential documents executed, then assets transferred to them, at the same meeting at which that same entity is then sold. If the Courts want to apply a business standard, they should do so consistently. If the Courts and the IRS don’t like discounts on FLP transactions then they should encourage Congress to change the law. Instead, and Holman is yet another example, the IRS and the Courts continue the confusing fact based interpretations to attack FLPs, but whose reasoning often doesn’t comport with business reality.
The Holman FLP agreement, similar to most partnership agreements for close or family entities, contained significant restrictions and limitations on transfers. The court held that these restrictions were to be disregarded in determining the value of the FLP interests given away because the restrictions did not past muster under the requirements of Code Section 2703(a)(2). Under this provision, restrictions will not be respected unless they are: 1) Bona fide business arrangements. The Holman FLP had no real business. Holding one stock, Dell, didn’t suffice (how many stocks must you hold?). While an FLP doesn’t have to involve an actively managed business to have a business purpose for the Code Section 2703(a)(2) rules, there must be an adequate bona fide business purpose. Educating the kiddies and preserving assets by preventing the kids from dissipating them, were close, but this wasn’t horseshoes. 2) The restrictions aren’t a device to transfer value to the taxpayer’s family. Holman used the FLP to transfer Dell stock to his heirs. 3) The terms are comparable to similar arrangements made by unrelated people. They were, but the Court never got passed the first two tests. Point to the IRS. Some commentators describe this as match point in the FLP volley. While it’s a biggie, that’s might not really be the right characterization. The taxpayers still achieved a 16% – 22.4% discounts from the underlying value of a publicly traded stock with lots of bad facts. So to say that this was a major taxpayer defeat isn’t right. For Holman, unfortunately, it was probably a Pyrrhic victory. Appraisal and legal fees might have devoured all tax bennies. That’s called “hazards of litigation”, something that needs to be carefully evaluated when planning your strategy for any tax audit.
Next month’s newsletter will conclude the analysis of the Holman case and present specific planning recommendations, and a review of several important issues that were overlooked in some of the professional literature.
HOLMAN Part II
Summary: A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships (“FLPs”) and limited liability companies (“LLCs”), especially for gifts. Last month’s lead article provided an overview and analysis of the case in Part I. This month’s article, in Part II, reviews planning lessons, and several important points that seem to have gotten short shrift in the professional literature.
General Planning Considerations of the Holman Case.
◙ The IRS has had a lot of success attacking FLPs and LLCs for estate tax purposes under Code Section 2036. The Section 2703 attack may become the IRS’ new weapon of choice on gifts of FLP and LLC interests. Expect repeat performances. ◙ Evaluate the magnitude of discount that may be achievable. ◙ Weigh the potential estate tax benefit versus the income tax detriment (no step up in basis, and the possibility of higher capital gains rates under the next administration). ◙ Weigh the discount benefits of an FLP (or LLC) versus mere tenants in common ownership which is cheaper and simpler (but it doesn’t provide control, asset protection and other FLP non-tax benefits). ◙ Compare the hoped for tax benefits of each possible approach against the real non-tax benefits each provides.
◙ Document real non-tax business reasons for the FLP and the transactions. These should be reflected in the partnership agreement. ◙ Observe all formalities that an independent real business would (well, at least as the Tax Court defines “real”). ◙ File tax returns. ◙ Have a CPA prepare a statement (or at least have annual Quicken, or Quickbooks or equivalent reports). ◙ Be sure all appraisal assumptions are subjected to sensitivity analysis. What happens if a fact or assumption changes? What are the consequences if an assumption or calculation is carried through or projected forward? Do the results remain reasonable? ◙ All positions and arguments should be consistent. The Holman court was clearly disturbed by inconsistent assumptions and positions in the taxpayer’s appraiser. ◙ Appraisals shouldn’t use guesstimates. But, in many situations it’s impractical or impossible not to do so. If it is essential at least discuss the rationale and implications of the guesstimates so that they are supported as reasonable, and determine the consequences of changing the guesstimates (sensitivity analysis). ◙ Use letterhead. ◙ Have partners other than parents contribute assets to the FLP on formation (but something more than the .14% contributed by the Trust in Holman would probably be a good thing). ◙ Have a written business plan (or an investment policy statement, or both). ◙ Execute governing documents (e.g. partnership agreement) for each phase and transfer to corroborate that each step of the transaction (e.g., after each gift) is a complete and meaningful step. This should help demonstrate that each step is independent and legally sufficient. ◙ File gift tax returns. ◙ Obtain an FLP telephone listing. ◙ Every document should be dated the date it is signed (regardless of whether it has a different effective date). ◙ Clients should understand the partnership agreement or other governing documents. The Holman Court said “Tom impressed us with his intelligence and understanding of the partnership agreement…” Taxpayers should make changes to conform them to their wishes. Corroborate this development trail (e.g., save track change documents, etc.). ◙ Hold non-marketable assets. The Holman Court accepted the use of general equity funds for the evaluation for the evaluation of discounts of the Holman FLP holding only Dell stock. Introduce non-marketable assets and your discount may differ favorably from those found by the Holman Court and some of the analysis of the Holman court that was detrimental to the taxpayer may take a different spin for your case. ◙ If later contributions are made to the FLP formally treat them as being made for additional FLP interests of the appropriate value, and document the change in ownership interests in an amended and restated partnership agreement.
◙ How long do assets have to age in an FLP before you can make gifts? How long must they age to face a “real economic risk of change in value”? The Court said “We draw no bright lines.” Thanks, you could have at least left a light on! ◙ If you’ll only make annual gifts how can you cost effectively comply with the Holman standards? It’s not reasonable to obtain the level and quality of appraisals and analysis the Holman court seeks if you’re merely giving a couple of kids $12,000 gifts. ◙ The Holman Court considered a private market for limited partnership interests among the FLP’s partners. This completely violates the tax law prescription for determining “fair market value” for a gift based on a hypothetical willing buyer and willing seller. There are lots of definitions of “fair value”. The highest value for many assets is “strategic value”, when the asset or business involved fulfills a unique need of the buyer so that the buyer is willing to pay far more than going rate because of the unique value of the asset to them. The Holman Court took a dangerous mis-step in this direction. What happens to the definition of value next?
Important Points Overlooked in Some Articles Examining Holman.
◙ Formalities: The kids trust to which the Holman’s made gifts was signed by the parents on 11/2, the trustee on 11/4 and made effective 9/10. This is reasonable and realistic, but looser then the ǘber perfection some courts have demanded of FLPs. ◙ The partnership agreement was signed 11/2 but the FLP was formed 11/3. The court and most commentators were silent on this snafu. ◙ The 11/8/99 gift was made by a document saying it was effective 11/8/99 but which itself was undated. When was it signed? It’s one thing to forgo a witness or notary, but a date? ◙ Count the dating goof-ups – at least three! Yet the Court felt that the formalities in the case sufficed! Commentators noted that the appropriate steps were taken in proper order. But were they? Was the Holman case a new version of the Dating Game? While Holman will undoubtedly be cited by taxpayers that have a dating error if challenged, more care is certainly advisable.
◙ Fiduciary Obligations: The general partner of a limited partnership is held, vis-à-vis the limited partners to a fiduciary standard. Could the general partner of the Holman FLP have generally adhered to such a standard if he didn’t diversify the Dell holdings as generally required under the Prudent Investor Act (PIA)? Might the IRS argue that a failure to follow the PIA indicates a failure to respect fiduciary obligations? This is no small issue. Central to the Court’s analysis was a discussion of a case, the Estate of Amlie v. Commr., TC Memo. 2006-76 which involved a conservator entering into a series of agreements while “…seeking to exercise prudent management of decedent’s assets…consistent with the conservator’s fiduciary obligations to decedent.” The Court noted that a fiduciary’s efforts to hedge the risk of a ward’s holdings and plan for estate liquidity may serve a business purpose under IRC 2703(b)(1). Would the result have differed had Holman had a wealth manager create an IPS and implemented an asset allocation model to hedge the risks of the limited partners to whom the GP owes a fiduciary duty? The Holman Court was not convinced by the taxpayer’s appraisal expert that a lack of portfolio diversity and professional management should justify an increased discount. So you get no discount benefit (not to mention investment return) from lousy investing, and you undermine your business purpose as a fiduciary. Should all FLPs have IPS’s? Yes, Jane, they should.
◙ Fair Market Value: The Holman court found a low discount because it was swayed by the argument that there was no economic reason why the FLP would not be willing to let somebody be bought out because the remaining partners would be left holding the same portion of assets and the same types of asset after the buyout. If the FLP held real estate or business interests this might not be true. Creditworthiness of the FLP to obtain credit for new real estate or business interests could be adversely impacted. But the Holman Court’s conclusions may not even apply to an FLP holding marketable securities. If the FLP assets are reduced below the minimum accounts size for the asset manager the FLP had used, a change might be mandated. That could be very significant. If FLP assets drop below a certain threshold certain types of investment products may no longer be available. So the Holman conclusion may be distinguishable in other marketable securities FLPs.
Another fact specific FLP case, full of good facts, bad facts, new theories that don’t fully make sense. Planning with FLPs (and LLCs), as before, remains complex and uncertain. Yet, as before, when business and personal reasons, independent of any sought after tax benefits, are served by and FLP structure, they can and should be used. Planning, especially for gifts of FLP interests, should proceed with consideration to the new lessons gleaned from Holman.
Checklist: Second Article 2 lines less than One Page [about 54 lines]:
Checklist Article Title: Rich Kid; Poor Kid
Summary: Estate planning when you have heirs of significantly different means can be quite a challenge. When your kids are the financial version of Danny DeVito and Arnold Schwarznegger in the movie Twins do you bequeath assets equally? If equal is not equitable, do you use a different non-equal approach?
* Rich Kid; Poor Kid: What to do when your children have very different situations? Most parents still leave everything equally. “They’re both our children”, “We love them the same”…. Are all common refrains. So perhaps the most common approach is the disparities between the children are simply ignored. This ostrich approach to a tough issue has one major benefit, it is simple.
* Leave the child in greater financial a larger bequest in your will. For example, bequeath 40% to the rich kid and 60% to the poor kid. A problem with this approach is that if there is a major change in the size of your estate the percentages may be more or less of a differential then you intend. Alternative approach: Make a fixed dollar bequest to poor kid, then leave the remainder of the estate in equal (or other percentages). Depending on the circumstances, you might feel this approach takes the sting out of the difference because the residuary (what is left after the dollar bequest) is divided equally between the children.
* Use Bactine! Remember, unlike hydrogen peroxide it doesn’t sting. Add a statement to the will to the effect that: “I have made a larger bequest to my son Sam, out of consideration for his greater financial needs, and not in any way to indicate greater lover or affection for him then for my other children.” May sound corny but the reality is most heirs equate love and money, and saying it “ain’t so”, even if you think it is obvious, can take the sting out of unequal bequests. Just be careful how you word such “fuzzy” provisions, you don’t want to create a condition that could affect the distribution, or raise the likelihood of one of the children challenging the will.
Leave the child in greater financial need more assets, but endeavor to minimize offending the wealthy child by making the disparate transfers less obvious. Avoid an “in your face” bigger bequest in your will.
* Set up 529 plans for the poor child’s children to alleviate the college cost burden. These gifts are made outside your will, and if under the annual exclusion amount ($12,000 in 2008), they won’t appear on a gift tax return. You might wish to avoid the front loading of 529 plan gifts (you’re allowed to make 5 years gifts at once) to avoid a gift tax return that would advertise it. Another plus is that if the child in greater need has more children there is a sense of fairness to defraying college costs. These gifts, while they directly benefit the grandchildren, can defray substantial costs for the child/parent. Importantly, if the financial tides shift, you can reclaim some or all of the 529 plan funds as the account owner for the plan. This is a key point many people planning for heirs of disparate wealth overlook, financial tides can be fickle. The kid worth mega-bucks today could be holding a pay telephone empire, or a patent for rotary dial phones. They might not be Richie Rich tomorrow.
* Buy a life insurance naming the poor child as the owner and beneficiary. This can minimize the tax costs of disparate gifts, avoid an obvious affront to the wealthy child, and accomplish your goals.
* Buy an annuity in the name of the poor kid using annual exclusion gifts. This can be a way to assure a cash flow overtime. If the poor kid is irresponsible use a trust or a non-cancellable annuity.
* Set up a joint bank or brokerage account with the poor kid that transfers on death automatically and leave everything under the will equally. You can always change the account if circumstances change. But if your estate is over the state or federal estate tax filing threshold this asset, and its disposition will appear on an estate tax return.
* Use a “pot” or “sprinkle” trust to distribute based on need. If the “rich” kid stays rich an independent trustee can distribute more to the poor kid. If the rich kid develops a health problem or business set back, the independent trustee can easily modify the distributions. A variant of this is to say leave 40% to rich kid, 40% to poor kid, and 20% to a trust for all heirs with an independent trustee able to address circumstances over time.
Recent Developments Article 1/3 Page [about 18 lines]:
Tax Authorities Weren’t Chicken: The widow of Colonel Sanders estate left charitable bequests to two colleges. The will was silent as to which beneficiaries should pay estate taxes. Kentucky law doesn’t exempt charitable beneficiaries from sharing in their allocable share of estate taxes. So, since the will was silent, the charities had to kick in their share. This is generally not the intended result because there is a “spoiler” effect when a charity has to pay tax. The bequests to the charity are tax deductible, but these deductions are reduced if dollars are allocated to the tax man. Without a clear direction in the will, the estate was left to whatever the state law default rules were. Since the tax authorities aren’t chicken, you should crow until your lawyer drafts it right. Taxpayers frequently don’t want to bother with many of the administrative details (“boilerplate”) of their estate plans and documents, but ignoring details is not what gets the result you want. Hael v. Moore, Nos. 2005-CA-001895-MR & 2006-CA-000662-DG, 2008 (Ky. Ct. App. 1/4/08).
Divorce Digs New Depths: Ugly divorces seem to know no bounds, a recent case, however, plumbs new depths with a vain attempt at creative legal maneuvering. Here’s the play by play. 3rd period, a minute to play. Mom was about to die. Son was so behind on child support and alimony only a miracle kept him out of the penalty box. Mom revised her will leaving Son’s inheritance to Daughter so that Son’s ex-wife (no longer in the running for family MVP) wouldn’t be able to use his inheritance to pay arrearages in child support and alimony (OK, so Son wasn’t an angel either!). Not to worry, Daughter promised Son (her brother) she’d give him all his inheritance when the divorce issues disappeared (some gift tax issues on that one). Son’s ex-wife had a creative attorney who argued that Mom’s changing her will was a fraudulent conveyance. The judge declared no goal because Son had no right to Mom’s estate, so Mom could do as she pleased. But this game may go into overtime. The court suggested that Ex-Wife allege a constructive trust based on the Daughter’s promise to transfer assets to Son. Cabral v. Soares, 69 Cal. Rptr. 3d 242 (Ct. App. 2007). Go Red Wings!
Potpourri ½ Page:
Prudent Executors: Most executors make one of two (or sometimes a combination of both) errors:  Liquidate most estate assets leaving the proceeds in a checking and/or money market account;  Hold onto securities under the mistaken belief that they can do so without exposure since the decedent died holding them. While liquidity is important in many estates, and some heirs want distributions in kind (or the securities the decedent owned actually constitute a reasonable portfolio for the estate to continue to hold), the recommended approach is for the executor to hire an investment adviser evaluate the relevant factors affecting the estate and beneficiaries, develop a written investment policy statement (IPS) and act in accordance with the Prudent Investor Act. Thanks Gary.
Graegin Loans can Sell Life Insurance: So many readers loved the recent checklist column on reasons to buy life insurance, here’s an encore (yeah, they were probably all insurance agents, but so what!). Here’s a creative technique that can be used for estate planning with insurance. It can help advisers that sell insurance close a transaction. Most large life insurance policies are structured to be owned by insurance trusts (ILITs) to avoid taxation in the decedent’s estate. When the insured dies the ILIT cannot pay estate taxes directly so the ILIT can loan funds to the estate, or buy assets from the estate. Either approach provides the estate with the use of the cash received from the insurance proceeds. If the ILIT loans the estate the money, and the note mandates that the loan cannot be repaid or accelerated, so that the estate must in all events pay all the interest required under the note, the estate may qualify to deduct as an expense all of the interest to be paid back to the ILIT as an administrative expense. This special type of loan is called a “Graegin Loan” after the court case that first sanctioned it. So not only can the insurance proceeds be used to pay estate tax on the family business (don’t try this with a securities FLP), it may also generate a huge estate tax deduction thereby reducing the estate tax it is helping to pay! This can be a grand-slam in planning and close and insurance sale (if you’re an agent you should ). Planning pointers: ◙ Read the footnotes to the Graegin case when planning the transaction, the forms used by some planners are dangerously deficient. ◙ Carefully craft default provisions to simultaneously provide protection, yet not void the mandate that the interest be paid. ◙ Consider usury issues in the event of a default.
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Freebies: Take a look at the www.laweasy.com website. We’ve added scores of new planning articles, videos and audios. Over the next month scores of new forms will be added and searchable files will be added to help you identify audio and video clips relevant to you.
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Valuing Gifts of FLP Interests: Holman – Part I
HOLMAN Part II
Rich Kid; Poor Kid
Tax Authorities Weren’t Chicken
Divorce Digs New Depths
Valuing Gifts of FLP Interests: Holman - Part I
- A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships (“FLPs”) and limited liability companies (“LLCs”). While it received much attention in the professional literature, most regular folk haven’t heard much. www.leimbergservices.com had no less than 4 articles covering this case! (If you’re an estate planner and haven’t subscribed, you’re missing great stuff). An overview analysis of the case will be presented. Next month, in Part II, planning lessons reviewed, and several important points that seem to have gotten short shrift in the professional literature will be discussed.