Many recent court decisions concerning family limited partnerships or limited liability companies (“LLCs”) have involved “bad facts making bad law.” The “bad facts” include commingling of partnership and personal assets, deathbed formations, non–pro rata distributions, and paying estate taxes out of partnership funds. The “bad law” results in inclusion of the partnership assets in the decedent’s estate for estate tax purposes. In recent months, several “better” or even "good” facts cases have been decided in favor of the taxpayers. The most important of these is Estate of Anna Mirowski, T.C. Memo 2008-74 (March 26, 2008).
Anna Mirowski’s deceased husband was credited with developing the implantable cardioverter defibrillator (“ICD”) to monitor and correct abnormal heart rhythms. When her husband died in 1990, Ms. Mirowski received the ICD patents and Dr. Mirowski’s interests under the license agreements for the patents. For various reasons, after Dr. Mirowski’s death, the royalties received from the ICD patents increased dramatically. Ms. Mirowski conservatively invested the proceeds at various financial institutions. By 2000, Ms. Mirowski’s assets totaled millions of dollars, and she was introduced to the concept of consolidating the assets into fewer accounts and contributing those assets to an LLC for estate planning purposes. After discussing the matter with her attorney, Ms. Mirowski waited for the next annual family meeting with her three daughters in 2001 to present the matter and move forward with the plan. Although she understood that certain tax benefits could result from forming the LLC, those potential tax benefits were not the driving factor in her decision to form the LLC.
Her primary nontax reasons were:
- joint management of the family assets by her daughters and eventually her grandchildren,
- maintenance of the bulk of the family’s assets in a single pool in order to allow for investment opportunities that would otherwise not be available,
- providing for each of her daughters and eventually each of her grandchildren on an equal basis, and
- providing additional protection from potential creditors for the interests in the family’s assets not provided by the existing trusts.
In August 2001, Ms. Mirowski formed the LLC and over the next few weeks funded the LLC with the ICD patents, her interests under the license agreements, and securities totaling more than $70 million. In exchange, she received a 100% membership interest in the LLC. She was the sole general manager of the LLC. Shortly after forming and funding the LLC, Ms. Mirowski made gifts of 16% membership interests to three trusts for the benefit of her three daughters.
Ms. Mirowski suffered from diabetes but was generally in good health. Around the same time as the formation and funding of the LLC and the gifts to the daughters, Ms. Mirowski’s health deteriorated quickly as a result of a foot ulcer that had caused an infection of her bloodstream. In September 2001, three days after completing the gifts, Ms. Mirowski passed away. Ms. Mirowski may have anticipated receiving substantial distributions from the LLC’s cash flow to pay the anticipated gift taxes resulting from the gifts (she retained $7.5 million of assets outside of the LLC, including her personal residence and $3 million in cash and cash equivalents, but the gift taxes were more than $10 million). In the year after Ms. Mirowski’s death, the LLC distributed $36.4 million just to the estate (not pro rata to the other LLC members) to pay transfer taxes and estate obligations.
The IRS contended that the assets owned by the LLC were includible in Ms. Mirowski’s gross estate. The IRS argued that there was no legitimate, significant nontax reason for Ms. Mirowski’s forming and transferring assets to the LLC. The court disagreed, instead believing the testimony of the decedent’s daughters (with apparently little documentary evidence) about the significant nontax reasons for creating the LLC. The court analyzed the IRS’s contentions that the LLC lacked legitimacy because (1) Ms. Mirowski failed to retain sufficient assets outside of the LLC, (2) the LLC lacked any valid functioning business operation, (3) Ms. Mirowski delayed forming and funding the LLC, (4) Ms. Mirowski sat on both sides of the transaction, and (5) the LLC made a large non–pro rata distribution to pay the transfer taxes and estate obligations.
The court concluded that the IRS’s contentions were not supported by the facts and that the transfers to the LLC were bona fide transfers for adequate and full consideration. The court noted some assets had been kept outside of the LLC (even though not enough to pay the gift and estate taxes), the activities of the LLC did not need to rise to those of a “business” under federal tax laws, there were no express or implied agreements between members to distribute LLC assets to pay Ms. Mirowski’s tax liabilities, there was no commingling of personal and partnership assets, and Ms. Mirowski’s death was very unexpected. In addition to the detailed analysis of the various contentions, the court gave significant consideration to the family history of financial planning involving the junior generation, having annual family meetings with professionals present, and running the LLC as a real business.
The second transfer in question was the gift of the LLC interests to trusts for the benefit of the three daughters. The IRS argued that the gifts should be includible in Ms. Mirowski’s estate because she retained the possession or enjoyment of, or the right to, income from the property transferred. Such an interest or a right is treated as having been retained if, at the time of the transfer of property, there was an express or implied agreement or understanding that the interest or right would later be available to the transferor. The IRS’s primary argument hinged on the fact that Ms. Mirowski was the sole general manager of the LLC and, as such, had the right (along with other rights) to decide over the distribution policy of the LLC and thereby control the use and enjoyment of the LLC’s income. Moreover, because she retained a majority membership interest, she could not be removed and replaced as general manager by the other members without her consent. The court concluded that Ms. Mirowski did not retain the possession or enjoyment of, or the right to, income from the transferred LLC interests. Although the LLC agreement gave significant powers to the general manager, Ms. Mirowski’s authority to determine the timing and the amount of distributions was limited by the fiduciary duties imposed on her by state law and provisions in the LLC agreement requiring distributions of cash flow after ithholding required reserves for specified reasons.
The Mirowski decision is noteworthy for its systematic dismissal of IRS arguments in a case that included an LLC holding primarily marketable securities, the retention of a majority managing interest by the decedent, and non-pro rata distributions to pay transfer tax and estate obligations. It emphasizes the importance of having legitimate, significant nontax reasons for forming and operating a family limited partnership or LLC and a history of family involvement in business affairs. Overall, the case presents a good road map for families in setting up these kinds of vehicles.
In Astleford v. Commissioner, T.C. Memo 2008-128 (May 5, 2008), the taxpayer benefited from several discounts. The taxpayer’s family limited partnership owned a 50% interest in a general partnership that owned a 1,187 acre tract of land. First, the court allowed an “absorption discount” of 20% with respect to the land, because a sale of the entire tract would flood the market and depress prices. Next, the court allowed a 30% combined discount for lack of marketability and control with respect to the family limited partnership’s ownership of the 50% general partnership interest. Finally, the court allowed a combined discount of about 35% with respect to the actual interests in the family limited partnership. If you do all the math, each $100 of value of the land was treated for gift tax purposes as being worth only $36.
This case certainly suggests that further benefits can be created by setting up family entities through multiple tiers of ownership. Caution and restraint must be exercised, however, to be certain that a business purpose can be established for each tier of entities.
In Holman v. Commissioner, 130 T.C. No. 12 (May 27, 2008), the taxpayer transferred shares of Dell Computer Corp. to a family limited partnership and then made gifts of partnership interests to his children. The IRS raised an old argument that the gift should be treated as being of Dell shares, effectively ignoring the existence of the partnership. That would have eliminated the discounts that the taxpayers were claiming for minority interest and lack of control. In finding for the taxpayer on this issue, the court attached considerable significance to the fact that the partnership was formed and the gift of interests did not occur until one week later. It even contrasted this with another case where all these events had occurred on the same day.
The IRS did prevail on one issue. The partnership agreement imposed onerous transfer restrictions. The IRS convinced the court that these should be ignored for valuation purposes under the authority of IRC Section 2703, which generally provides that any restrictions more onerous than those imposed by state law are to be ignored in valuing interests for transfer tax purposes.