The enormous tax dollars at stake in connection with valuation discounts for estate and gift tax purposes is evidenced by the never ending stream of family limited partnership cases. The cases we report on here all came out since our last edition was published in May.

Taxpayers lost two cases in the United States District Court in Washington State that, frankly, they should have lost. They simply tried to do everything too quickly. In both Linton v. United States (July 1, 2009) and Heckerman v. United States (July 27, 2009), the taxpayers transferred assets to family limited partnerships and then made gifts of interests in the partnerships on the same day. Under these circumstances, the taxpayers were unable to conclusively prove that what they had given away was a partnership interest rather than the underlying assets themselves. You simply must allow some time to pass between the transfer of assets to the partnership and the gift of partnership assets. The cases have taught us that more time is required for assets whose value is not very volatile than it is for assets whose value is highly volatile.

In Estate of Miller v. Commissioner (May 27, 2009), the taxpayer got a mixed result in the Tax Court. The case did not involve the valuation of a gift but instead the value of a retained partnership interest in a decedent’s estate. The estate claimed a 35% discount for the value of the partnership interest. The IRS did not challenge the amount of the discount but instead argued that the underlying assets the decedent had transferred to the partnership should be brought back into the decedent’s estate pursuant to IRC Section 2036(a). This section requires a decedent’s estate to include for estate tax purposes the value of any asset the decedent had transferred during his lifetime but retained: i) the right to receive income from the property; ii) the right to possession or enjoyment of the property; or iii) the right to designate the persons who will have the right to receive income from or possess or enjoy the property. There is an exception for transfers that constitute bona fide sales for adequate and full consideration. In order for a transfer to a partnership to qualify for the bona fide sale exception, the courts require the existence of a legitimate and significant non-tax reason for the creation of the partnership. Much of the recent litigation has focused on this very issue.

In this case, the transfers at issue were made by the decedent at two different times. The first transfers were made in April of 2002 when the decedent was in good health for her age. The second transfers were made in May of 2003 when the decedent was hospitalized for congestive heart failure. She died on May 28, 2003. The Tax Court found that the April 2002 transfers qualified for the bona fide sale exception to IRC Section 2036(a) because at that point the purpose of the partnership and the purpose of her transfer of additional assets to the partnership was to provide for a continuation of her late husband’s investment approach and philosophy. However, the court found that the May 2003 transfers were simply an acknowledgement of her rapidly declining health and a desire to try to capture an estate tax discount with respect to the assets transferred. As with the cases discussed above, it mostly came down to a question of timing.

More recently, in Pierre v. Commissioner (August 24, 2009), the Tax Court addressed for the first time the question of how to treat the gift of an interest in a single member limited liability company. For income tax purposes, a limited liability company with only one member is disregarded as an entity separate from its owner. Its owner is treated as the tax owner of any assets that are actually owned by the limited liability company. Does the same rule apply for estate and gift tax purposes? If it does, then no fractional interest discount would be available where the decedent or the donor owned or transferred an interest in a limited liability company.

In this case of first impression, the Tax Court held that for gift tax purposes, the asset to be valued was the interest in the limited liability company rather than the underlying assets. The court based its decision on the 1940 decision by the United States Supreme Court in Morgan v. Commissioner, where the Court held that you look to state law to determine the nature of the underlying property rights and then you apply principles of federal tax law to determine the consequences of transactions involving such property rights. Under state law, the taxpayer owned an interest in a limited liability company; she did not own the underlying assets after they were transferred to the limited liability company.

The taxpayer is not yet home free, however. The Tax Court left an important timing question for a separate, yet to be issued opinion. The taxpayer transferred cash and marketable securities to the single member limited liability company on September 15, 2000. Twelve days later on September 27, 2000, she made gifts of interests in the company to trusts for her children and sold additional interests to the trusts. She claimed, based upon an appraisal, a 30% valuation discount for both the gifts and sales. The IRS claims that the step transaction doctrine should be applied to essentially ignore the transfer of the cash and securities to the limited liability company and simply treat the gift as being of those assets. The second opinion will also address the propriety of the 30% discount.

This case establishes an important concept. That is, although the entity classification rules apply for all federal tax purposes, they do not determine the nature of the property rights that are subject to estate and/or gift taxes. You must still look to state law to identify the underlying property rights. This case was considered by the full court and it was a split decision. A total of ten judges voted for the result but the other six, including the current chief judge, thought that the single member limited liability company should also be disregarded for purposes of identifying the assets that were transferred.

State law also loomed large in the final case on which we report. In Keller v. United States (August 20, 2009), the United States District Court for the Southern District of Texas handed a Texas taxpayer a huge victory. The case deals with the substantial estate of Mrs. Maude O’Connor Williams. Mrs. Williams had signed a limited partnership agreement in her hospital room shortly prior to her death. She had not signed any document or other writing that transferred any assets into the partnership. A corporation was the general partner of which she was the initial sole shareholder. She also signed the organization documents for this corporation in her hospital room. The two limited partners were trusts of which she was the trustee. In other words, Mrs. Williams was the only party who signed the limited partnership agreement.

Upon Mrs. Williams’ death, her advisors initially believed that the partnership had not been funded and that no discount could be claimed on her estate tax return attributable to the partnership. Her accountant later changed his mind about this when he attended an estate planning seminar. Although no discount was claimed on the original estate tax return, the estate subsequently filed an amended return and claimed a refund of estate tax based upon taking a valuation discount for the partnership interests. The estate filed suit when the IRS refused to grant the refund. The estate probably adopted the strategy of claiming the discount by way of a refund claim to avoid the imposition of penalties if it lost the case.

The court found that the bona fide sale exception was applicable as the partnership was formed for significant non-tax purposes, the principal one of which was to protect the family assets from spouses in the case of divorce proceedings. This, however, was not the most significant holding of the case. The court also held that the record in the case clearly established that Mrs. Williams intended to transfer a bond portfolio to the partnership, even though she never signed anything to do so. Under Texas law, the court said that if someone intended an asset to be owned by a partnership, it was then owned by the partnership. The court cited several Texas court decisions but did not cite any statutory authority for this proposition. Then, the court found that Mrs. Williams had a contractual obligation (apparently oral) to transfer the stock of the corporate general partner to certain of her children and grandchildren. The fact that she was not treated as owning or controlling the general partner no doubt resulted in a larger discount.

In a further victory for the taxpayer, the court also allowed a deduction from the gross estate for all of the interest that would become due on a loan the partnership made to the estate to enable it to pay its estate taxes. This type of loan is commonly called a Graegin loan, after the first case that approved the estate tax deduction for the interest.

It is hard to even imagine the creative (abusive?) uses tax advisors may try to make of a holding like this. It took the judge two and one-half years to come out with his decision after the trial concluded, so maybe he struggled with the result. The IRS can appeal this decision to the United States Court of Appeals for the Fifth Circuit. It remains to be seen whether this happens and whether the District Court’s holding stands up. It is also not clear how many states other than Texas have a law that permits a partner to “will” property to be owned by the partnership.