Florida Estate Planning Blog

Bergquist v. Commissioner: Not Quite What These Doctors Ordered

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Fri, 01 Aug 2008 09:55:59 -0500

In Bergquist v. Commissioner, the Tax Court came down hard on a group of doctors who attempted (quite unsuccessfully) to obtain significant charitable deductions on their income tax returns in connection with the consolidation of their medical practice group with a larger entity.

The Facts

The petitioners, a group of several anesthesiologists, practiced medicine as employees and as stockholders in University Anesthesiologists, P.C. ("UA"). Through UA, the petitioners provided medical services to patients of the Oregon Health & Science University Hospital ("OHSU"), a public teaching and research hospital. In 1998 OHSU decided to form the OHSU Medical Group ("OHSUMG") and register as a Section 501(c)(3) tax-exempt professional service corporation to serve as a single consolidated medical group into which thirty different medical practice specialty groups (including UA) would be consolidated. In early 1999 and in light of the pending consolidation of UA into OHSUMG, one of the petitioners attended a conference sponsored by the Medical Group Management Association during which he learned that some doctors throughout the country were claiming substantial charitable contribution deductions relating to donations to academic-affiliated institutions of stock in their medical groups. The conference attendee reported this information back to UA's attorney and accountant, and at the next UA shareholders' meeting the petitioners decided to adopt the following plan:

Because UA consisted only of voting stock, the first step was to issue a new class of nonvoting stock so that each shareholder could "donate" their nonvoting stock to OHSUMG prior to the consolidation (and thereafter claim substantial charitable deductions on their income tax returns), while at the same time making sure the doctor shareholders retained control of UA in compliance with the Oregon law that required a majority of the voting stock in a medical professional service corporation be held by licensed doctors. After the consolidation, the UA shareholders would "donate" all of their their voting stock to OHSUMG, and claim additional charitable deductions. Once the consolidation of UA into OHSUMG was complete, UA would cease to operate, would have no doctors and no patients, and would continue in existence just long enough to collect its accounts receivable. As a last step before proceeding with the "donation", UA retained the services of a valuation firm to determine the values of the nonvoting and voting stock.

With this plan in place, just prior to the consolidation of UA into OHSUMG, 24 of the 28 UA shareholders each donated all of their nonvoting stock, and just under half of their voting stock, to OHSUMG on September 14, 2001. Using the valuation figures reached by the valuation service hired by UA, the petitioners' deductions for the year 2001 ranged from $176,787 to $200,895. On January 1, 2002, the consolidation into OHSUMG was complete, and UA continued in existence only long enough to collect its accounts receivables. In auditing the petitioners' returns for 2001, the IRS completely disallowed the claimed charitable deductions.

The Holding

The Tax Court upheld the IRS' disallowance of the petitioners' 2001 charitable deductions, finding as follows:

The valuation of the UA stock by petitioners' experts was overinflated and in error, as the petitioners' experts incorrectly treated the UA stock as a "going concern". Section 170(a)(1) of the Internal Revenue Code allows for charitable deductions equal to the fair market value (FMV) of the contributed property on its date of contribution. The FMV of the property is defined as the price at which "the property wold change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." Sec. 1.170A-1(c)(2) Income Tax Regs. While the Tax Court will not generally look at subsequent events in determining whether a valuation was accurate, it may consider relevant subsequent events if they are reasonably foreseeable "because they would be foreseeable by a willing buyer and a willing seller, and they therefore would affect the valuation of the property." Estate of Gimbel v. Commissioner, T.C. Memo 2006-270. In the case at hand, the Tax Court found ample evidence that the petitioners were aware of the fact that UA would no longer be operative (and thus no longer a "going concern") shortly after the donation of the UA stock to OHSUMG. This evidence included the minutes from several shareholders' meetings describing the consolidation of UA with OHSUMG as a way to reap a potential "150k" windfall. While the petitioners' argued that the consolidation was uncertain (they cited uncertainty as to whether OHSUMG would adopt a governmental retirement plan that met the petitioners' approval), the Tax Court concluded otherwise, and found that petitioners certainly would not have donated their UA stock to OHSUMG if the consolidation were uncertain at that point.

The Penalty

Under Section 6662(h) of the Internal Revenue Code, a taxpayer can be liable for a 40% accuracy-related penalty on the portion of an underpayment of tax attributable to a gross valuation misstatement. A gross valuation misstatement exists if the value of the property as reported on the tax return is 400% or more of the amount finally determined to be the correct value; but a penalty is enforced only to the extent the misstatement exceeds $5,000. While Section 6664(c)(1) allows for an exception from the penalty in cases where the taxpayer (1) relied on a "qualified appraisal" made by a "qualified appraiser" AND (2) made a good faith investigation into the value of the contributed property, the Tax Court found that the petitioners in this case made no such good faith investigation. Relying blindly on advice from appraisers will not suffice as evidence of a good faith investigation. Further, there was evidence on the record that the petitioners were actually advised NOT to bring their own tax advisers to the UA shareholders' meeting where the stock donation plan was voted on, and were directed to actually withhold information from their own tax advisers. Thus, to the extent the petitioners' gross valuation misstatements exceeded $5,000, each was liable for a 40% accuracy penalty.

The Tax Court finally went on to hold that to the extent the Section 6662(h) 40% accuracy penalty was not applicable to petitioners, each would be liable for a 20% accuracy-related penalty under Section 6662(b)(1) for understatement of tax attributable to negligence or to disregard of rules or regulations.

Another FLP Fact Pattern: Holman v. Commissioner

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Thu, 31 Jul 2008 09:58:48 -0500

In Holman v. Commissioner, the latest family limited partnership (FLP) case to go before the Tax Court, victories were had on behalf of both the taxpayer and the IRS. After all was said and done, the Tax Court increased the value of the taxpayer's gifts of FLP units to his children because the FLP's restrictions on the transferability of the children's interests did not serve a "bona fide business purpose" (victory for the IRS), but at the same time the Tax Court rejected the IRS' argument that the lack of control and marketability discounts should not have applied to the gifts. This resulted in a substantially lower value for the gifts than the IRS had originally calculated (victory for the taxpayer).

The factual scenario of Holman is relatively straightforward. The taxpayer had acquired a significant amount of Dell stock throughout his term of employment with the company. After consulting with an estate planning attorney, the taxpayer created a FLP and immediately funded it with Dell stock. After just six days had elapsed since the date of the funding of the FLP, the taxpayer gifted units of the FLP to trusts for the benefit of his children. In valuing the gifts, the taxpayer utilized both the lack of control and lack of marketability discounts, in addition to claiming a discount based upon transfer restrictions found in the FLP agreement which, in essence, were aimed at preventing the sale or transfer of FLP interests by the taxpayer's children. The IRS challenged the values of the gifts reported on the Form 709 gift tax return, making a two-fold argument.

First, pursuant to Reg. Section 25.2511-1(h)(1) the IRS argued that the transfer of the Dell stock by the taxpayer to the FLP for less than adequate consideration constituted a gift by the taxpayer as a shareholder of the FLP to the other shareholders of the FLP, to the extent of each shareholder's individual interest.

The Tax Court rejected this argument, distinguishing past cases where the argument had been successfully applied (Shepherd v. Commissioner and Senda v. Commissioner) as having involved situations where the FLP's shareholders either acquired their interests in the FLP before the transfer of property to the FLP, or instantaneously with the transfer. In Holman, the transfer of property occurred before, not after, the taxpayer transferred interests in the FLP to his children.

Second, pursuant to the "step transaction doctrine" the IRS argued that because of the short period of time that had elapsed between funding the FLP and gifting the FLP units, the separate steps of creating the FLP, funding it, and gifting FLP units should have instead been deemed a single transaction. This meant, argued the IRS, that the FLP units should have been treated as indirect gifts of Dell stock, rather than as direct gifts of FLP units, resulting in a loss of the use of the lack of control and marketability discounts applied by the taxpayer in valuing the gifts of the FLP units.

The Tax Court rejected the IRS's "step transaction doctrine" argument, observing that the FLP was formed and funded almost one week before the gifts were made, and that because of the delay in time between funding the FLP and gifting the FLP units, the taxpayer bore a real economic risk that the value of the FLP interests could fluctuate during that time. The fact that the period of time was only six days was not dispositive in the opinion of the Tax Court; the six day period was enough of a delay in time to qualify each step as its own independent "transaction".

But the Tax Court did not stop there. It went on to hold that while the lack of control and marketability discounts would apply to the gifts of the FLP units (although at a lower discount rate than that originally applied by the taxpayer), the discount applied by the taxpayer because of the FLP agreement's stringent control on the transfer of FLP units by the shareholders could not stand. The restriction appeared to the Tax Court to solely be an attempt by the taxpayer to discourage his children from dissipating the wealth transferred to them. It did not serve a bona fide business purpose.

Personal Injury Settlement Proceeds: Special Concerns When Dealing with Special Needs Children

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Tue, 23 Oct 2007 17:51:40 -0500

In Estate of Hicks, the Tax Court permitted the estate of a special needs child to deduct a loan made by the child’s parent to a non-special needs trust established for the benefit of the child as part of a transaction intended to preserve the child’s future Medicaid eligibility. Here is how the case unfolded:

The child, Kimberly Hicks, along with her mother and sister, was involved in a horrific car accident when a train collided with the family’s car. Kimberly, who was only three years old at the time of the accident, sustained severe injuries that left her a quadriplegic, dependent on a respirator to breathe. A lawsuit brought by Kimberly’s parents against the train company resulted in a settlement for the family in the amount of $4,650,000. Pursuant to the proposed settlement plan, Kimberly was allocated $1,450,000 for her injuries, while her parents were allocated $1,415,000 for loss of consortium and services. The remainder went to attorneys’ fees and expenses.

Under Ohio law, where the Hicks personal injury case was filed, the probate court’s approval of the settlement plan was required. In addition to approving the proposed allocation of the settlement proceeds, the probate court also approved the following aspects of the plan:

1. The creation of the Kimberly Hicks Special Needs Trust. This trust was to be funded with $1,000,000 of Kimberly's settlement proceeds, and was designed to comply with Medicaid eligibility rules. Because of this, the assets of the trust would not need to be “spent down” to meet Medicaid eligibility requirements, but upon Kimberly’s death, the assets remaining in the trust would be required to be used to pay back the state for any medical expenses paid on Kimberly’s behalf.

2. The creation of the Kimberly Hicks Settlement Fund Management Trust. This trust was to be funded with $450,000 of Kimberly's settlement proceeds. The trust’s assets would be included in determining Kimberly’s eligibility for Medicaid. However, in what I think was a brilliant move, the attorney for the Hicks family proposed that in addition to $450,000 of Kimberly’s proceeds being placed in the trust, that Kimberly’s father loan the trust $1,000,000 of the settlement proceeds which were allocated to him. The loan was to be evidenced by a promissory note that required payment of interest, but not principal, and would be callable by Kimberly’s father on the occurrence of one of two events: Kimberly’s death, or, her inability to obtain medical insurance at a reasonable premium once she reached 18 years of age.

With the approval of the probate court, the two trusts were created and funded, but within four and a half years, Kimberly passed away. The estate tax return filed on behalf of Kimberly's estate included the assets in both trusts, but claimed a deduction under Code Section 2053(a)(3) and (4) for the $1,000,000 owed to Kimberly’s father under the promissory note. The IRS argued the loan was not bona fide, as Kimberly’s father never had control or possession over the $1,000,000. It argued the money was transferred directly from the court's guardianship account to the trust, and thus never really belonged to Kimberly's father. The Tax Court rejected this argument and allowed the deduction. In doing so, it made the following findings:

1. The probate court’s ruling as to the allocation of settlement proceeds, and thus to whom the proceeds belonged, was to be afforded great weight. The probate court had a great interest in seeing to it that Kimberly's interests, as a special needs child, were provided for, and the Tax Court should be very hesitant to interfere with the probate court’s approval of a settlement plan which did just that. Also, even though the probate court allocated $1,415,000 to Kimberly’s father, that large allocation was entirely reasonable in the eyes of the Tax Court, especially given the father’s duty under Ohio law to provide support for his minor child.

2. The loan made by Kimberly’s father was bona fide, and not without value. The interest payments required under the promissory note were concrete and capable of valuation. In short, there was true economic substance to the loan.

The Hicks case provides an example of just how crucial preventative estate planning is when it comes to personal injury or wrongful death cases where large settlements are likely. The importance of such preventative estate planning is heightened when there are children with special needs involved, and there are real concerns about preserving their Medicaid eligibility.

Estate Planning Considerations for Individuals with Special Needs

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Mon, 15 Oct 2007 13:37:33 -0500

As the population growth rate (both in North America and world-wide) continues to rise, so to does the number of individuals diagnosed every year with mental and/or physical disabilities. This makes it increasingly likely that, at some point in your estate planning practice, you will encounter a family in need of an estate plan addressing, and providing for, a family member with special needs. There are a multitude of tools available to these families which, when utilized, can serve not only to provide for the long-term care of the individual after the death of his or her caretaker, but also to provide tax benefits for expenses incurred in connection with the care of the special needs individual.

Special Needs Trusts

A. Purpose

Special Needs Trusts (also called “Supplemental Needs Trusts”) enable the caretaker of an individual with special needs to provide for the individual long after the caretaker’s death. The typical plan provides for a testamentary trust whereby, upon the death of the caretaker, a trustee is appointed to hold the assets of the trust for the benefit of the special needs individual, paying special attention not to make available to the beneficiary any assets which could be deemed to disqualify the beneficiary from being eligible to receive certain benefits under governmental programs such as Social Security and Medicaid.

B. Critical Provisions

The terms of the Special Needs Trust should provide the trustee with discretion to make distributions from income or principal that are deemed necessary or advisable for the satisfaction of the beneficiary’s “special non-support needs.” Special non-support needs should be specifically defined as those necessary to sustain the beneficiary’s good health, safety, and welfare when, in the discretion of the trustee, those requisites are not being provided by any public agency, office, or department, or are not otherwise being provided by other sources of income available to the beneficiary. It is advisable to include a non-exclusive list of what special non-support needs may consist of, such as: sophisticated medical or dental or diagnostic work or treatment for which funds are otherwise unavailable, including plastic surgery or other non-necessary medical procedures; private rehabilitative training; dental care; and recreation and transportation. It is imperative, however, to specify that payment for such special non-support needs can only supplement governmental or private assistance or benefits programs and cannot replace them. This is key to ensuring the assets of the Special Needs Trust never serve to disqualify the beneficiary’s eligibility for the governmental assistance he or she may be receiving.

Other crucial language in a Special Needs Trust includes empowering the trustee to take whatever administrative or judicial steps may be necessary to continue the public assistance program eligibility of the beneficiary (including terminating the trust), as well as specifying that the beneficiary may not appoint or assign the trust’s assets away, and that the assets are not available to the beneficiary except in the trustee’s discretion.

C. Selecting a Trustee

As for who should be appointed trustee of the Special Needs Trust, there are several possibilities, with the appropriate choice depending upon the particular family’s situation:

- a trusted family member or friend
- a bank or other corporate trustee
- a committee of individuals
- a pooled account trust administrator

For a brief but helpful outline of the planning considerations to be taken into account when drafting a Special Needs Trust, see this Martindale-Hubbell article.

Tax Benefits for Families with Special Needs Children

Thomas J. Brinker, a CPA and professor of accounting at Arcadia University in Pennsylvania, recently prepared an income tax benefit checklist for Steve Leimberg’s Estate Planning Newsletter, outlining the numerous potential tax benefits for families caring for special needs children. Some of the more notable benefits include:

- Deductions for expenses associated with sending a special needs child to a school or institution with a special curriculum for mentally disabled individuals. Deductible expenses include: lodging, meals, transportation, incidental education costs provided by the institution, costs of supervision, care, treatment, and training.

- Deductions for expenses associated with tutoring by a specially trained teacher, such as for therapeutic and behavioral support services.

- Deductions for medical conferences and seminars, including both transportation and conference fees.

- Deductions for medical travel and transportation.

- Deductions for unreimbursed medical expenses, to the extent the taxpayer itemizes the deductions and expenses exceed 7.5% of the taxpayer’s AGI.

Last Point of Consideration

In preparing for the possibility that a caretaker predeceases a special needs individual, drafting a letter of intent to accompany the estate plan is highly recommended. The letter should be delivered to the trustee upon the caretaker’s death and should summarize the individual’s needs: medical and otherwise. It can include information such as the individual’s medical history, required medications, medical service providers, social contacts, skills and hobbies.

The Blame Game

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Fri, 24 Aug 2007 09:08:39 -0500

In Estate of Zlotowski v. Commissioner, the U.S. Tax Court held the estate's two executors liable for the untimely filing of the estate's 706 return. While an individual may escape liability if it is shown he or she reasonably relied on the legal advice of counsel, the Tax Court found no such reasonable reliance in Zlotowski. While the estate argued its attorney had failed to advise the executors of the return's due date, the IRS responded by arguing that, first, a taxpayer's reliance on the advice of its attorney with respect to matters such as meeting filing deadlines generally does not constitute reasonable reliance, and, secondly, the executors' reliance on the attorney to file the estate tax return was an impermissible delegation of their responsibility as executors. The IRS further pointed out that, in this case, there was no evidence the executors even discussed with their attorney whether, as a matter of law, it was not necessary to timely file a return. Therefore, the IRS concluded, there was no actual legal advice given that the executors could even argue they reasonably relied upon.

The Tax Court sided with the IRS, holding that there was no way the estate could possibly stand upon its argument of reasonable reliance on the advice of counsel: there was no evidence the executors had even asked their attorney for advice as to whether the return was due on time, let alone that they had received such advice. In its analysis, the court also pointed to testimony given by one of the executors that further demonstrated the executors' complete disengagement from the estate administration process, including the preparation of the estate tax return. In the end, the estate was held liable for the additional tax generated as a result of the late filing.

The moral of the story: An executor's complete disengagement from the estate administration process will not suffice as support for the argument of reasonable reliance on the legal advice of counsel. The executor of an estate, in accepting the position, takes on certain obligations and responsibilities that cannot be ignored or placed solely upon an attorney. For this reason, the position of executor is not one to be accepted without giving consideration to the duties involved.

How Many Trustees Do You Need?

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Tue, 31 Jul 2007 11:21:07 -0500

In this recent Wall Street Journal article, the pros and cons of the increasing trend toward employing multiple trust advisors to manage a single trust are explored. The article points out that in the past, when it came time to appoint a trustee, most families opted to appoint a single trustee (such as a family member, trust company, or trusted advisor) to perform trustee duties such as investing and monitoring trust funds, ensuring tax returns and related paperwork get filed, and making distributions to beneficiaries. When families did choose to appoint multiple trustees, it was typically under a scheme where all the trustees shared the same responsibilities. Nowadays, however, more and more individuals are invoking a more complicated regime when it comes to who manages their trusts:

"...families are 'slicing and dicing' trust duties, says Dennis Belcher, a trust lawyer with McGuire Woods LLP in Richmond, Va. Families are specifying that one trustee, typically an institutional trust company, hold custody of the assets and handle the administrative trustee duties. Meanwhile, another fiduciary -- often a family investment committee -- has the authority to direct investments. Trust creators are also naming separate trustees to handle distributions to beneficiaries. "

In order to manage the increasing number of trustees per trust, some individuals are even opting to designate "trust protectors," who are given the power to hire and fire trustees. Additionally, a growing number of states have enacted laws that specifically allow trust documents to name separate trustees for administration and for trust investments; trusts that utilize this approach are termed "directed trusts" and can be especially useful for families who may be uncomfortable handing family businesses or real estate over to trust companies for management.

Despite the benefits these "directed trusts" can provide, there are several cons to keep in mind, namely: cost and complexity. Dividing trustee duties between multiple institutions or individuals can clearly lead to an increase in trustees' fees. Additionally, appointing multiple trustees can make it difficult to determine which trustee is responsible for what, and hence which trustees bear fiduciary responsibility if things go wrong.

IRS Releases CLAT Sample Language and Annotations

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Wed, 11 Jul 2007 09:43:08 -0500

In Revenue Procedures 2007-45 and 2007-46, the IRS released sample language to be utilized in drafting both inter vivos (Rev. Proc. 2007-45) and testamentary (Rev. Proc. 2007-46) charitable lead annuity trusts (CLATs).

A CLAT is an irrevocable split-interest trust which provides that during the term of the trust, a specified amount be paid to one or more charitable beneficiaries, and that at the end of the term of the trust, the principal remaining be paid over to (or held in trust for) a noncharitable beneficiary named in the CLAT. An inter vivos CLAT conforming with applicable statutory requirements qualifies the gift of an interest in the CLAT for the gift tax charitable deduction and/or the estate tax charitable deduction, while a testamentary CLAT results in the value of the charitable lead annuity interest being deductible by the decedent’s estate. Given the obvious benefits that a CLAT can provide, any estate planner drafting one should ensure full compliance with the IRC by paying close attention to the new sample drafting language (with accompanying annotations) published in Rev. Procs. 2007-45 and 46.

Among one of the more important annotations found in Rev. Procs. 2007-45 and 46 is the annotation regarding guaranteed annuity amounts. For one thing, in order to qualify for an estate tax charitable deduction, a CLAT must provide for the payment of a guaranteed annuity amount at least annually to a qualified charitable organization for each year during the annuity period. To qualify as “guaranteed,” the annuity amount must be determinable. It is “determinable” if the exact amount that must be paid under the conditions specified in the instrument may be ascertained as of the appropriate valuation date. A charitable interest expressed as the right to receive an annual payment from a trust equal to the lesser of a sum certain or a fixed percentage of the trust assets (determined annually) is not a guaranteed annuity interest. An annuity interest is also not guaranteed if the trustee has the discretion to commute and prepay the charitable interest prior to the termination of the annuity period.

For other drafting considerations and useful annotations see Rev. Proc. 2007-45 and 46.

Congress to Tighten Kiddie Tax Loophole

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Thu, 21 Jun 2007 09:38:21 -0500

Beginning in 2008, Congress will ratchet up the restrictions imposed by the so called "kiddie tax " by increasing the age under which children are taxed at their parents' marginal rate for unearned income. The new cut off age will be age 18 and younger, or age 23 and younger for "children" who are full-time students.

In this recent article on Investors.com authored by Donald Jay Korn for Investors Business Daily, Korn discusses the new law, which targets upper-income families, and is designed to prevent such families from shielding income on dividends and long term gains by shifting such income to their children.

"A partial remedy for parents in higher brackets was to give appreciated assets they wanted to sell to their kids. That was especially attractive if the kids were in the two lowest tax brackets [which owe 0% on most dividends and long term gains]. They could sell the assets and owe no tax."

While the increased restrictions do exclude married children who file joint returns, as well as children whose own earned income constitutes more than one-half of their support, it would seem these exceptions will be applicable in only a small percentage of cases.

Finally, although the new law does impose increased restrictions, parents can still always save in gains taxes by transferring assets to their children to hold until after the child graduates college, and then having the child sell at his own (and most likely much lower) tax rate.

Claims Against Estates: Proposed Amendments to the Regulations Under Section 2053

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Wed, 20 Jun 2007 13:35:38 -0500

In the April 23, 2007 publication of the Federal Register, the U.S. Treasury proposed several amendments to the regulations on claims against estates governed by Section 2053 of the Internal Revenue Code. The most notable proposed changes include:

1. Events occurring after a decedent's death will be considered when determining the amount deductible under all provisions of Section 2053;

2. Deductions under Section 2053 will be limited to amounts actually paid by the estate in satisfaction of deduct able expenses and claims;

3. A protective claim for refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund if the amount of a liability will not be ascertainable by the time of the expiration of the period of limitations for claims of refund; and

4. No deduction may be taken on an estate tax return for a claim that is potential, unmatured, or contested at the time the return is filed.

The proposed regulations serve as a reaction to a history of inconsistent case law regarding whether post-death events should be taken into account in valuing claims against an estate. Unlike Section 2031, Section 2053 does not contain a specific directive to value a deductible claim at its date of death value. As a result of this vagueness, courts have gone both ways, resulting in the inconsistent treatment of estates for estate tax purposes. The Treasury hopes that by adopting the proposed regulations, Section 2053 will be construed and applied the same way in all jurisdictions.

Another One Bites the Dust...

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Thu, 31 May 2007 16:26:39 -0500

In Estate of Erickson, the U.S. Tax Court finds the assets of yet another family limited partnership includable in the decedent's gross estate for estate tax purposes.

With a fact pattern strikingly similar to that of Estate of Korby, (a case I previously wrote about here) it is no wonder the U.S. Tax Court came out the same way in Estate of Erickson. In Estate of Erickson, the court recounted yet another case where the suspicious fact pattern and timing of events surrounding the creation, funding, and management of a family limited partnership led the court to conclude that the property transferred to the partnership were includable in the decedent's gross estate.

Just as in Estate of Korby, the court invoked the following three prong test to determine whether the property was properly includable in the decedent's gross estate:

1. Did the decedent make an inter vivos transfer of the property?

2. Did the decedent retain a right or interest in the transferred property that he or she did not relinquish until death?

3. Was there an absence of a bona fide sale for adequate and full consideration?

The court answered each of these three questions in the affirmative, and in doing so looked to the following factual circumstances present in the case:

1. The delay in transferring the assets to the partnership (it was not fully funded until just days before the decedent died);

2. The partnership made funds readily available to the decedent (or the decedent's estate) whenever needed;

3. The partnership had little practical effect during the decedent's life;

4. The partnership did not have any relevant nontax purpose, in that it appeared to be a mere collection of passive assets intended to assist the decedent's tax planning; and

5. The partnership was formed near the end of the decedent's life (she was 88 years old), when she was suffering from Alzheimer's disease.

The Estate of Erickson is thus another reminder to make sure that when forming a family limited partnership, steps are taken to avoid certain "red flags" that could lead to the partnership's inclusion in the decedent's gross estate. First and foremost would be establishing a justifiable nontax purpose for the partnership.

Estate of Gimbel: The Cloud of Confusion Created in Valuing Large Blocks of Unregistered Stock

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Fri, 13 Apr 2007 16:41:11 -0500

In reading the United States Tax Court's memorandum regarding the Estate of Gimbel, I could not help but be reminded of just how important it is to have a thorough estate plan in place. By thorough, I mean that aside from having all the appropriate estate planning documents in order, the estate's assets are arranged so that they systematically and as effortlessly as possible follow the scheme laid out in the estate planning documents.

Georgina Gimbel died owning 3,601,267 shares in Reliance Steel and Aluminum Company, a publicly traded company that had been founded by the uncle of her predeceased husband. Of those shares (which represented approximately 13% of the company's outstanding stock), approximately 3,548,450 were unregistered. This, along with the fact that the decedent held such a large number of shares so as to qualify her as an "affiliated person" under federal securities law, meant that the shares could be sold on the public market only under extremely limited conditions. Taking this into account, the estate argued for a 17% valuation discount, while the IRS was only willing to allow a 9% discount. Inevitably, valuation experts were hired, disagreements as to the proper method for valuing the stock ensued, and the case wound up before the U.S. Tax Court.

In its memorandum, the Tax Court addressed four different methods for valuing the unregistered stock:

A secondary public offering;
A private placement;
a repurchase by Reliance Steel; and
Selling the shares on the open market over time (the "dribble-out" method)

The court quickly ruled out the first two methods as non-viable options. A secondary public offering was impossible, given the fact that as of the valuation date, Reliance was considering purchasing another company. In order to conduct a secondary public offering, Reliance would have had to disclose that fact; a disclosure that would have been in clear violation of a related confidentiality agreement. A private placement was likewise unfeasible. First, the shares owned by the estate represented only a minority interest in Reliance, and the evidence presented showed market disinterest in acquiring anything other than an entire company. As a further deterrent, the SEC Rule 144 restrictions on the restricted shares would have been applicable to any entity which purchased the shares.

In the end, the court decided upon a complex hybrid method of valuation in which it utilized both the repruchase and dribble-out methods. The court held that, as of the valuation date, it was forseeable that Reliance would have agreed to repurchase 20% of the shares. It went on to calculate the value of the remaining 80% if they were "dribbled-out" onto the open market, over a span of time. For a detailed explanation of the hybrid valuation method adopted by the Tax Court, see its memorandum here, starting at page 19.

In summary, the process of valuing large blocks of unregistered and restricted shares can be a very complicated one that unquestioningly results in a sizeable portion of an estate's resources being utilized for experts' fees. When advising clients concerning their ownership in marketable securties, it is important to keep the Estate of Gimbel in mind, and take preventative steps to ensure the least amount of confusion over valuation.

For additional explanation of the Tax Court's reasoning in Estate of Gimbel, see this article by John A. Bogdanski.

Eighth Circuit to Estate of Korby: "Not So Fast."

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Fri, 06 Apr 2007 10:28:48 -0500

Why, when certain circumstances are present, the assets in a family limited partnership can be included in the decedent's gross estate.

Section 2036 of the Internal Revenue Code provides:

"The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer…by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death…the possession or enjoyment of, or the right to the income from, the property."

In Estate of Korby v. Commissioner of Internal Revenue, the Eighth Circuit Court of Appeals held that this provision can, in certain circumstances, also apply to family-created limited partnerships.

In Korby, a married couple created a limited partnership and funded it with a total of $1,888,704.00 worth of assets. The couple’s living trust obtained a 2% general partnership interest, while the couple itself obtained a 98% limited partnership interest. The couple proceeded to gift their 98% limited partnership interest to four irrevocable trusts created for their sons. When both husband and wife passed away, neither estate tax return included the value of the estate assets that had been transferred to the partnership, and the IRS issued notices of deficiency as to both of the estates. The IRS argued that the full value of the partnership assets was includable in the gross estate because the couple had retained "for their lives ‘the possession or enjoyment of, or the right to the income from, the property." The Eighth Circuit Court of appeals agreed with the IRS’s position.

How did the court reach this conclusion?

The answer lies in whether the transfer of assets to the partnership constituted a "bonafide sale for an adequate and full consideration in money or money’s worth." If it did, it would have been excluded from the gross value of the estate. However, the Eighth Circuit found that in the case of Korby, there was no such bonafide sale, because even after transferring the assets to the partnership, and then gifting 98% of the interest in the partnership to irrevocable trusts for their sons, the partnership continued to make distributions, whenever the couple requested, to the couple’s living trust.

In reaching its conclusion, the court noted the lack of a written management contract between the living trust and the partnership, the couple’s failure to keep track of the time they spent managing the partnership, and the couple’s failure to report the payments they received from the partnership as self-employment income. In fact, the Eighth Circuit agreed with the finding of the lower tax court that an implied agreement existed between the couple and their four sons that after the assets were transferred to the partnership, income from the assets would continue to be available to the couple for as long as they needed income. Especially important to the tax court, and to the Eighth Circuit, was the fact that the partnership made payments to the couple whenever they requested, rather than according to any sort of set schedule. An additional red flag identified by the court was the fact that the couple, who were both in poor health and could have expected to incur significant living expenses beyond what their Social Security would cover, retained less than $10,000.00 in assets in their living trust, which was their only source of income.

All of these factual considerations, when taken as a whole, led the Eighth Circuit to uphold the tax court’s opinion that the transfer of assets to the partnership was not a bonafide sale for adequate consideration under 26 U.S.C. § 2036(a), but rather, that the couple had essentially stood on all sides of the partnership’s formation.

For an excellent discussion of other recent cases dealing with family limited partnerships, see this Florida Bar Journal article by David Pratt, Trent S. Kiziah, and John F. Pokorny.

Speak Now, Or Forever Hold Your NIMCRUT

kmartinez-lejarza@smpalaw.com (Kimberly Martinez-Lejarza) — Fri, 06 Apr 2007 09:43:28 -0500

In a Private Letter Ruling issued December 8, 2006, the IRS had this to say in response to a taxpayer's inquiry as to whether a net income makeup charitable remainder trust (NIMCRUT) that had been judicially reformed would still qualify as a charitable remainder trust:

"Section 1.664-3(a)(4) of the Income Tax Regulations provides in part that [a charitable remainder trust] may not [emphasis added] be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in Section 170(c). "

The PLR went on to state that while "[a] modification or reformation of a charitable remainder trust does not violate Section 644 [of the Income Tax Regulations] if the modification or reformation corrects a scrivener's error," the judicial reformation of the Trust in question "was not due to a scrivener's error and would violate Section 664." Such a trust, the IRS concluded, "will not be treated as a charitable remainder trust."

In sum, reforming a NIMCRUT for reasons other than correcting a scrivener's error will destroy its status as a charitable remainder trust. But why were the settlors of the NIMCRUT in this case so interested in reforming it in the first place?

The answer lies in the difference between a NIMCRUT and a CRUT (charitable remainder unitrust). While a CRUT requires a fixed percentage of the annual value of the trust assets (which is no less than 5% nor more than 50%) be paid out to the beneficiary not less often than annually, a NIMCRUT adds a sort of "twist" in that it requires either a fixed percentage of the value of the trust assets (again no less than 5% nor more than 50%) or the net income of the trust for that year, whichever is lesser, be paid out to the beneficiary. In other words, should a NIMCRUT earn zero income in any given year, there will be no distribution whatsoever made to the beneficiary.

Coming back to the trust that was the subject of this PLR, the settlors argued that, first, the failure of their attorney to discuss with them the option of a traditional CRUT as opposed to a NIMCRUT, and second, changes in the current investment climate, had combined to frustrate the trust's purpose of providing them with a suitable annual income stream. This argument did not sway the IRS. Frustration of a NIMCRUT's purpose is just not enough to warrant judicial reformation.

In conclusion, because there is always the risk that the trust assets could earn little or even no income in any given year, a NIMCRUT is not a good option for individuals who are counting on receiving immediate income. For a more detailed explanation of the intricacies of a NIMCRUT, see this article from Charitable Remainder Trust.com and this one by Vaughn W. Henry found on gift-estate.com.