United States: Letting Go: Common Gift & Estate Tax Triggers

It is the season of giving which ultimately fuels the season of estate and gift tax audits.

Many of the questions raised in an audit can be anticipated by prior cases, such as: review of the decedent's background, lifestyle, gifts and assets (Estate of Harper, TC Memo 2002-121); information about the donor's heath, intent and entity operation (Estate of Rosen, TC Memo 2006-115); the order in which transactions occurred (Estate of Shepard, 115 TC 376 (2000), aff'd 283 F3d 1258 (11th Cir. 2002)); and information about meetings with the client(s) and the reason for the entity, the manner in which business responsibilities were assumed, and the documentation of legitimate non-tax reasons (Estate of Rosen, TC Memo 2006-115). One of the common gift or estate tax audit triggers occurs when a family limited partnership (FLP) or a limited liability company (LLC) is involved. This is because these entities are utilized by donors who may not completely understand the risks associated with planning with these entities or who demand continued control. The result is that the Internal Revenue Service may claim the estate retained certain enumerated rights over the entity, and pursuant to §2036 of the Internal Revenue Code, the full value of the transferred asset should be included in the estate at the date of death value, not at a discounted value.

That is why Estate of Purdue v. Commissioner, TC Memo 2015- 249, stood out—because it bucked the typical scenario. In this case, the decedent and her husband in August 2000 formed a family limited liability partnership (PFLLC) to hold their marketable securities and their interests in a commercial building to centralize management and take advantage of valuation discounts. As set forth in the memorandum prepared by their attorney, the purposes of the FLP was (1) to consolidate their assets, (2) avoid fractionalization of their interests, (3) keep the ownership in the family, (4) protect assets, (5) provide flexibility and (6) promote education of and communication among the family with respect to financial matters.

The day after the FLP was formed, the family, including all five children received a draft Purdue Family Limited Liability Company operating agreement from this same attorney noting the tax savings the FLP could provide as well as four non-tax business reasons for the formation of the FLP. In November 2000 the FLP was funded. In the same month, the decedent and her husband also formed a family trust, the beneficiaries of which were their descendants and the spouses of their descendants. The trust provided for Crummey withdrawal rights and on Dec. 28, 2000, the decedent and her husband funded the trust with cash from two separate bank accounts, which was partially distributed to their children on Dec. 29, 2000 and completely distributed during 2001.

From 2001 until the death of the decedent, the children held annual meetings in their capacities as trustees and beneficiaries of the trusts, personal representatives and beneficiaries of their parents' estates, attorneys-in-fact for the parents and as members of the FLP. They discussed accounts and assets, heard presentations and received estate tax planning updates and advice. In addition, beginning in 2001, in order to address their concerns about the fractionalization of the investment structure, the family hired an investment firm who provided guidance regarding the FLP and their investments.

Also, prior to forming the FLP and the family trust, the decedent and her husband made annual gifts to their children and grandchildren. This pattern of gifting continued where from 2002 to 2007 the decedent made annual exclusion gifts of her FLP interests to the beneficiaries of the family trust with additional gifts at the end of the year if there were additional births or marriages. The value of the gifts was based on valuation summaries prepared by their attorney and each year waivers of their withdrawal rights were distributed and signed by the beneficiaries of the family trust.

During this period of planning, the decedent was in excellent health until her death in 2007, other than an injury sustained in 1984 from which she never fully recovered her ability to walk safely. Her husband, who died unexpectedly in 2001, was also considered to be in good health although later it was determined that he had Alzheimer's disease. Finally, because of family disputes and the structuring of the ownership of assets, one of the decedent's children was able to block the liquidation of assets/distributions so that the estate tax liability could be paid. Therefore, some of the beneficiaries loaned money to the estate to pay the estate tax liability and the estate in turn took any interest paid on the loan as a deduction on the estate tax return.

The issues highlighted in this case—§2036(a), annual exclusions and the deductibility of loan interest to pay estate tax—frequently arise in estate and gift tax audits although not usually in one single case. The first issue refuted was the IRS claim that the contributions of assets to the LLC was a transfer with a retained interest includible in the decedent's estate under §2036.

Section 2036(a) generally provides that if there is an inter vivos transfer made for something other than a bona fide sale for adequate and full consideration and the decedent retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property is included in the value of the decedent's gross estate.1 A bona fide sale requires a legitimate and significant nontax reason for creating the entity. The estate, who had the burden of proof and never argued that the burden shifted to the government, stressed the seven non-tax motives for the transfer outlined in the decedent's attorney's memorandum the day after the formation of the FLP (TC Memo 2015-249 at p. 15-17). The court in Purdue, however, focused on the change in management of the assets after the FLP was formed, specifically that there was a single advisor involved in the management, that the children made the decisions jointly and that the decedent and her husband were not involved once the transfer occurred. To the court, this was a legitimate non-tax motive for the transfer of property. And although, as the IRS argued, the decedent and her husband stood on both sides of the transaction, the court reasoned that "an arm's length transaction occurs when mutual legitimate and significant non-tax reasons exist for the transaction and the transaction is carried out in a way in which unrelated parties to a business transaction would deal with each other." (Id. at 20 (citing Estate of Bongard v. Commissioner, 124 TC 95 at 123)). The court was clear that this was not a mere change in form, as argued by the IRS, because if "a decedent employ[s] his capital to achieve a legitimate non-tax purpose, the court cannot conclude that he merely recycled his shareholdings." (Id. at 22 (citing Estate of Schutt v. Commissioner, TC Memo. 2005-126). The remaining factors (the financial independence of the transferors, the lack of commingling, timely transfers, the entity maintained annual records and the transferors were in good health) all were decided in favor of the Estate.

The next issue refuted was the IRS claim that the annual gifts were not present interest gifts that qualified for the annual exclusion. To qualify as a present interest gift, a gift must give the donee "[a]n unrestricted right to the immediate use, possession or enjoyment of property or of income from the property." When the gift is of LLC or limited partnership interests, as in Purdue, the donees must "obtain use, possession or enjoyment (1) of the limited partnership interests or (2) of the income from those interests within the meaning of Section 2503(b)." The difficulty that the estate had in Purdue was that the donees membership interests in the LLC were limited because no one interest could be transferred without unanimous consent of the other members and so there was not the receipt of "unrestricted and noncontingent rights to the immediate use, possession or enjoyment of the PFLLC interests themselves." However, utilizing the three prong test set out in Calder v. Commissioner, 85 TC 713, 727-28 (1985), the court reasoned that the present interest requirement was met (TC Memo 2015-249 at pg. 26-27) since the LLC held income-producing real estate and dividend-paying marketable securities, the LLC made distributions to the trust and the trust made distributions to the beneficiaries over eight years of approximately $2 million, and the rent was readily ascertainable.

The third issue refuted was the claim by the IRS that the interest expense deducted as an administration expense under §2053 was not actually and necessarily incurred in the administration of the estate. For interest to be deductible, "the loan obligation must be bona fide and actually and necessarily incurred in the administration of the decedent's estate and essential to the proper settlement of the estate." Since one of the decedent's daughters created a deadlock by not voting for the liquidation of assets/distributions so that the estate tax liability could be paid, the loan was necessary. Therefore, the deduction of the interest expense on the loan was permitted.

Purdue provides a clear roadmap of how to successfully divest oneself of the risks associated with key audit triggers. Careful planning, working with trusted advisors whose advice is followed, and having the ability to cede control to the successor generation ensured that the issues raised by the auditors were resolved in favor of the Estate. The Purdue family began their estate plan almost 12 years prior to the audit and five years prior to the actual creation of the family LLC or family trust. Yet it was not the facts alone that made their plan a success but rather the years of administration that followed. Succession planning is difficult for myriad reasons but those difficulties can be minimized when a plan is instituted based on a knowledge of known audit triggers and an ability to let go.

Footnotes

1. Section 2036(a) is applicable when (1) an inter vivos transfer was made, (2) that was not a bone fide sale for full and adequate consideration, (3) decedent retained an interested or right enumerated under Section 2036(a)(1) or (2) or (b) in the transferred property that was not relinquished prior to death.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Moira A. Jabir
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.