TAX COURT FURTHER LOOSENS THE STRINGS ON FORMULA GIFTS

The Internal Revenue Code provides for a tax on gifts. However, annual exclusion gifts of $13,000 per recipient and gifts that do not exhaust a donor’s available unified credit will not generate a current gift tax. Thus, donors often seek to make gifts that come within, but that do not exceed, the above exemptions and credits.

This can be difficult if the gift is of property and not cash, since the precise value of the gift may not be known. Therefore, donors will want to include terms to their gift that if the value, as determined by the IRS, exceeds what was expected, the amount gifted will be scaled back to come within the exemption or credit amounts. However, at least since the case of Commissioner v. Procter, 142 F.2d 824, 827-828 [32 AFTR 750] (4th Cir. 1944), donors have run a significant risk that the IRS and courts would not respect such arrangements.

In recent years, several favorable taxpayer cases have upheld somewhat complex arrangements that seek to accomplish such adjustments, such as Estate of Petter v. Commissioner, T.C. Memo. 2009-280 [TC Memo 2009-280], aff'd, 653 F.3d 1012 [108 AFTR 2d 2011-5593] (9th Cir. 2011) and Estate of Christiansen v. Commissioner, 130 , T.C. 1 (2008). The taxpayers in the favorable cases have melded the gift-giving with either gifts to charities or disclaimers. These elements were added in large part because established gift tax law for charitable gifts and disclaimers allows for the use of “formulas” to define the amount of a gift, and also to bring in third parties that will purportedly enforce the clause or that have favorable public policy elements (such as enhancing charitable gifting).

The Tax Court has now ruled in favor of a donor that used a formula gift, but did not include any charitable gifts or disclaimers. Such an arrangement is of course much easier to implement in a usual gift-giving scenario, and thus substantially lowers the bar for taxpayers who want to use formula gifts to avoid inadvertent gifts.

The case largely turns on the formula which defines the gift as a given dollar amount of property. Thus, while an initial property transfer based on the taxpayer’s estimation of value will be undertaken, the amount of property transferred will be readjusted if the subsequent appraisal, the IRS or the courts determine a different value. This is to be distinguished from a gift of a fixed amount of property, that will later involve additional transfers of property back or forth based on IRS valuations. Is there really a difference between the two? It is hard to say. What is clear is how to draw a qualifying transfer that the Tax Court likes: express the amount of property transferred as a formula, as a stated dollar value to be transferred. The only variable should be the finally determined value for the property that is to be transferred. The court found the following language from Petter to be central to this issue:

Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer's transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive.

Some additional important points and observations from this case include:

     a. The donees were family members of the donor. Thus, the court did not believe the family relationship alone would void the effective operation of the formula clause although this was not expressly discussed.

     b. While Petter included language regarding the policy of encouraging gifts to charitable organizations, that factor was not determinative to the acceptance of a formula clause. Here, there was no charity involved and the court expressly noted that this element of Petter was not a requirement to an effective formula gift.

     c. In drafting a formula and transfer arrangement, it should be clear that the donor’s intent was to transfer only a certain fixed dollar amount of property, and not to transfer a fixed amount of property that would be later readjusted.

     d. The properties transferred here were interests in a partnership. The IRS argued that since the capital accounts were adjusted to provide for the initial number of units transferred, that fixed the amount of the gift by state law and a later revaluation could not undo the gift. The court rejected this, both on legal grounds, and on the factual that it was not clear that the capital accounts had been adjusted for the gifts based on the initial transfer amount. What happens in a case when the capital accounts are formally adjusted based on the initially determined transfer amount so that the factual argument is not available to a taxpayer? Based on the language of the court, even in that situation it would appear that this would not create a basis for a taxable gift because of the legal argument that the capital accounts do not control.

Does this case mean that formula gifts can be undertaken now without charitable or disclaimer elements? Perhaps yes, but more conservative planners may still want to include the charitable or disclaimer elements for more certainty, at least until additional favorable precedent arises.

Joanne M. Wandry, et al. v. Commissioner, TC Memo 2012-88

AN EXECUTOR'S JOB IS NOT ALL FUN AND FEES

A recent District Court case reminds co-executors that if they do not do their job right, they can incur personal liability for the income taxes of the decedent whose estate they are administering. In the case, the decedent had a substantial unpaid income tax liability at the time of her death. Notwithstanding the liability, the executors, with knowledge of the income tax liability, conveyed real property of the estate to the son of the decedent (who was also one of the executors) for one dollar. The son eventually sold the real property, and later claimed that he lost the proceeds in the stock market.

Presumably because they could not collect against the son or other assets of the estate, the IRS sought to impose liability on the executors for disposing of the real estate without first satisfying the income tax liabilities of the decedent. The District Court found for the IRS and imposed liability for the taxes on the executors.

The executors got caught under the federal priority statute (also known as the federal claims statute) under 31 USC 3713(b). This provision is not under the Internal Revenue Code, but is referenced in Code §6901(a)(1)(B).  This provision is an exception to the normal rule that executors will not have personal liability for the debts and obligations of a decedent. Under the statute, a fiduciary that disposes of assets of an estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government if three elements are met:

(1) the fiduciary distributed assets of the estate;

(2) the distribution rendered the estate insolvent; and

(3) the distribution took place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes. 

Usually, executors will be protected by (3). Most executors, at least those that are properly represented, will know to first pay obligations of the federal government before using assets needed to pay those obligations to make distributions to beneficiaries. Thus, if the executors do not know of the unpaid tax liability, this third element will protect them from liability in many circumstances.

Surely to the dismay of the executor in this case who was not the son, if there is more than one executor all executors are jointly and severally liable for this liability. This means that if the son has insufficient assets to cover the liability, the executor who did not benefit at all from this transaction may be forced to pay the IRS 100% of the liability.

U.S. v. David A. Tyler and Louis J. Ruch, all 109 AFTR 2d ¶2012-583 (DC PA 03/13/2012) 

IC-DISC’S CAN EXPECT A RIGOROUS AUDIT

IC-DISCs are the last surviving major export incentive in the Internal Revenue Code. When combined with the current low rates applicable to qualified dividends, exporters can exclude a significant part of their export income from U.S. income tax. These savings have led to a substantial expansion in regard to their use.

There are a number of technical rules relating to the qualification and operation of IC-DISCs. Given their technical nature and the limited number of IC-DISCs, some taxpayers may expect that if audited, a rigorous examination is unlikely given the limited knowledge of IC-DISCs among most examiners.

However, the IRS has now issued fifty pages of explanation and audit guidelines for IC-DISC examinations. Therefore, taxpayers should expect that international examiners that audit IC-DISCs will be well educated on these special type of entities and how to examine them.

This is not all bad news. The existence of such guidelines allows taxpayers and their advisors to review IC-DISCs before an audit arises, and discover (and remedy) any potential problem areas.

Audit Guidelines for IC-DISCs

APPLICABLE FEDERAL RATES–APRIL 2012

THE LOTTERY WINNINGS EXCEPTION TO FEDERAL GIFT TAXES

An interesting circumstance often shows up with lottery winners. After they have won, it seems that a very high percent of them had arrangements in place before they bought their lottery tickets to share their winnings with family members. Due to this arrangement, when the proceeds are paid, they are paid into an entity owned by multiple family members. This allows those family members to share directly in the lottery winnings.

This is all fine if there was in fact a bona fide and binding arrangement to share the proceeds. However, if there was not, this arrangement should result in a gift as to the value of the lottery proceeds that are effectively transferred to the family members. Given the high multi-state Powerball and other payouts that occur these days, these transfers can be significant.

Some have wondered whether many of these pre-existing arrangements really exist, or are only a product of post-lottery planning. Seeing the number of these arrangements, one gets the feeling that many believe there is a "lottery winnings" exception to federal gift taxes that gives a free pass to the sharing of the winnings among family members.

A recent Tax Court case warns that there is no such lottery exception, and that the IRS will scrutinize the bona fides of such lottery sharing arrangements and assert gift taxes when appropriate.

In this case, the winner created a corporation after the win, which corporation claimed the lottery proceeds. The winner and her spouse owned 49% of the stock, and the remaining 51% were other family members. The IRS asserted a gift as to 51% of the proceeds. The winner claimed there was a binding contract to share the proceeds and thus no gift.

The court had a number of problems with finding an enforceable contract. There was no written agreement. There was no obligation by any family member to buy a certain number of tickets.The tickets were not kept in a place where all family members had access to the tickets. Each family member did not know if another had bought a ticket.  There was no fixed sharing percentage for winnings established before the win. It was unclear how much of the proceeds would be retained by the winner. It was unclear how many family members were a party to the agreement. In the end, the Tax Court found that while perhaps an informal family agreement existed, it was too indefinite, uncertain, and incomplete for enforcement.

The court noted that in the appropriate circumstances an enforceable lottery sharing agreement can exist. For example, it cited Pearsall v. Alexander, 572 A.2d 113 (DC 1990) when two men who worked together would go to a liquor store twice a week after work and purchase a package of vodka, orange juice, two cups and two lottery tickets. They would then use any winnings to buy additional tickets. The court there found an enforceable sharing agreement.

The taxpayers alternately asserted a “partnership” among the family members to avoid a gift. They cited Estate of Winkler v. Comm., T.C. Memo. 1997-4. In that case, the court found a valid lottery partnership when a family regularly purchased tickets and placed them into a special “family ticket” bowl. When a large ticket hit for them, a family meeting was called and sharing percentages were agreed upon (so apparently the failure to have an agreement in advance on sharing percentages will not by itself be fatal to a partnership arrangement). The partnership was respected for gift tax purposes.

The Tax Court distinguished Winkler from the current facts because the lottery tickets were purchased on a regular and consistent basis in Winkler. Also, all family members met with the accountant and lawyer after the win. In the current case the taxpayer made all the decisions on what happened to the proceeds – there was no joint effort.

Thus, there can be valid arrangements that allow for sharing of proceeds that will not give rise to a gift. However, they need to have elements of regular and consistent purchases, a clear agreement to share winnings, common knowledge of all participants of purchases, and joint decision making as to winnings. Absent such elements, a gift will result if sharing occurs – there is no lottery winnings exception to gift taxes.

Dickerson v. Comm., TC Memo 2012-60

CLAWBACK–MYTH OR MONSTER? (OR, “CLAWBACK FOR DUMMIES”)

[Okay, we are not dummies, but this is a very tough issue to follow in its entirety for most of us.]

Until recently, the term “clawback” did not mean much to estate planners and tax attorneys. Those with some knowledge of bankruptcy law were familiar with the term – it involves the forced return of assets to a debtor (and thus the bankruptcy estate and potentially to creditors) to void fraudulent transfers and transfers made shortly before the filing of bankruptcy.

With Bernie Madoff, the term reached broader use – relating to the risk that investors with Madoff who received from Madoff more than their original investment with him over the years may be required to return such excess amounts for redistribution to Mr. Madoff’s victims.

The term is now part of the estate tax lexicon. This use relates to whether persons who make large gifts that use some or all of the current $5 million plus unified credit equivalent amount, will be subject to estate taxes on all or a portion of those gifts at their later death if the unified credit equivalent amount is then lower than the exemption amount used for lifetime gift giving. If the answer is yes, the current advantages for making large gifts in 2012 before the exemption amount reverts to $1 million in 2013 are materially diminished (although not eliminated), and planning for who will pay the later increased estate tax will need to be undertaken.

The problem is one of statutory interpretation, involving provisions that are not well-understood nor precisely drafted. This posting will summarize the problem, list the principal arguments put forth for and against clawback, and provide my own thoughts. This will be an abridged version, so further reading may be needed if a more thorough understanding of these issues and arguments is needed – otherwise, this post could go one for 20 pages (which I am sure most of you would not want to read and I would not want to write).

THE PROBLEM. The problem comes out of Code §2001(b) which tells us what the total amount of estate tax will be, so let’s copy it here:

(b) The tax imposed by this section shall be the amount equal to the excess (if any) of—
     
        (1) a tentative tax computed under subsection (c) on the sum of—
     
                (A) the amount of the taxable estate, and
                 
                (B) the amount of the adjusted taxable gifts, over
    

(2) the aggregate amount of tax which would have been payable under chapter 12 with respect to gifts made by the decedent after December 31, 1976, if the provisions of subsection (c) (as in effect at the decedent's death) had been applicable at the time of such gifts. (emphasis added)

The first part of the problem is Code §2001(b)(1)(B) – in computing the estate tax, we add back to the taxable estate all of the adjusted taxable gifts made by the decedent during his or her lifetime. We then compute a tentative tax on this combined total.

Since gifts taxes were applicable to the lifetime gifts, Code §2001(b)(2) provides for a reduction in the estate tax for those gift taxes. Taxpayers will want the amount of the gift taxes to be as high as possible under this computation, since these gift taxes reduce the estate tax payable. A corollary to that desire is that taxpayers will want the unified credit amount applicable to the lifetime gifts to be as LOW as possible, so as to crank up higher the gift tax amount.

The second part of the problem is that this gift tax computation is a “constructive” computation of gift taxes – not an actual computation of those amounts as they applied at the time of the gift. To drill down further, the ultimate question is whether, in computing the constructive gift taxes at the time of the gift, should the unified credit amount be the amount of unified credit as it existed under law in the year of the gift, or in the year of death. As noted above, in circumstances where the unified credit amount is high in the year of the gift (e.g., 2011 or 2012), and low in the year of death (2013 or thereafter, under current law), taxpayers want to use the unified credit amount that applies in the year of death. This cranks up the constructive gift tax, and thus reduces the estate tax payable.

The gist of the problem is  that §2001(b)(2) tells us to compute the gift tax “which would have been payable under chapter 12 [i.e., the gift tax chapter],” but does not tell us which year to use for the unified credit portion of that computation. Compounding the problem is that in prior tax years, it has been the IRS’ interpretation that in making this computation, it is the unified credit amount applicable in the year of the gift that applies. If correct, this means that when a donor later dies, and substantial 2011 or 2012 gifts are added into his or her estate tax computation, the constructive gift tax reduction applied to the tentative estate tax will be low – and there will not be a corresponding high unified credit amount available for estate tax purposes to offset this enhanced tax. Thus, in effect, this statutory analysis recaptures some of the gift tax that avoided tax at the time of the gift under the then-available unified credit, as estate tax due at death.

ARGUMENTS AGAINST CLAWBACK. The principal arguments against clawback are:

     a. Congress did not intend clawback, and this intent should override any contrary statutory interpretations.

     b. The sunset provisions of EGTRRA treat the $5 million unified credit amount as having never existed, once 2013 rolls around. If that is the case, how can such a large credit amount be used for computing gift taxes for a post-2012 estate tax return?

     c. Clawback is inconsistent with the entire unified gift and estate tax regime – such regime is not built to tax prior gifts at death that were exempt from tax at the time of the gift.

     d. Code §2001(b)(2) provides that the use of tax rates in effect at the decedent’s death (through the reference to Code §2001(c) and the parenthetical right after it) applies to the constructive gift tax computation – thus, unified credit amounts at death should likewise apply.

ARGUMENTS IN FAVOR OF CLAWBACK. The principal arguments in favor of there being a clawback are:

     a. The statute says what it says and has been interpreted in this manner for many years, both in the instructions to the Form 706 and other Treasury pronouncements. This supports the use of the unified credit amount as it existed at the time of the gift.

     b. There has been no change to the language of the law that merits a change in interpretation.

     c. Congress made changes to Code §2001(b)(2) and (g) in December 2010, but did not change this particular portion. Thus, Congress intended to continue the current application of the law.

     d. Gift tax computations are made on a calendar year basis, and thus it is nonsensical to apply a unified credit amount from a different year (the year of death) to the year of the gift.

     e. To apply the sunset provisions of EGTRRA to avoid clawback would require, from a consistency basis, that other unlikely results would be mandated, such as a fair market value date-of-death basis in all assets sold after 2012 even though EGTRRA provides for a reduced basis in many circumstances for those that elected out of estate tax in 2010, and loss of GST exemption to gifts made in 2011-2012 in excess of a $1 million exemption.

     f. The reference to estate tax rates at the time of death under Code §2001(c) does not mean that unified credit amounts at that time should also apply, since the credit amounts arise under a different Code section.

MY THOUGHTS. For what they are worth, here are my thoughts and observations.

     a. Hopefully, Congress will enact the provisions of the Sensible Estate Tax Act of 2009, which would statutorily fix this problem, and avoid clawback. However, this doesn’t help us in regard to present planning, since its passage at this time is speculative. If Congress materially increases the unified credit at death for 2013 and beyond, this will also reduce or eliminate the problem.

     b. The statute and its prior interpretation are clear – thus, on its face it appears clawback does apply. Further, that Congress thought it was necessary to Code §2001(b)(2) to add a specific modification to direct the use of rates in effect at the decedent’s death (through the reference to Code §2001(c) and the parenthetical right after it) in computing the constructive gift tax amount, implies that the rest of the constructive gift tax amount is undertaken using exemptions and other legal provisions in effect at the time of the gift. Otherwise, a reference to rates in effect at death would not have been needed.

     c. The “sunset” arguments perhaps may persuade the IRS or the courts that clawback does not apply, but uncertainty remains.

      d. Thus, while it is possible that the IRS or the courts may adopt a ‘no clawback’ interpretation, and indeed that would probably be the correct result as a matter of Congressional intent, a reasonable risk of clawback remains.

     e. Nonetheless, even with clawback, the benefits of a larger 2012 gifts remain. These include (1) enhanced GST exemption for generation-skipping gifts or gifts to trusts that may later have a skip, (2) shifting of appreciation in gifted assets to third parties after the gift that would not otherwise occur (which may provide future estate tax savings), and (3) in many circumstances overall tax savings may still result, even with clawback. Thus, while clawback at worst may reduce benefits of 2012 gifting, enough remain that it may still make sense in many situations.

     f. Estate tax apportionment agreements as part of the gift transaction may be in order, so that if increased estate taxes occur later, the proper beneficiaries bear the burden of the enhanced tax. Such agreements may come with their own issues, however.

STONE V. COMMISSIONER–KEY POINTS OF A FAVORABLE FAMILY LIMITED PARTNERSHIP CASE

In Stone v. Commissioner, the Tax Court ruled in favor of the taxpayer when the IRS sought to attack the favorable estate tax consequences of a family partnership under Code §2036(a). Code §2036(a) will result in gross estate inclusion for transferred property when the decedent retains income rights or dominion and control over the property. However, Code §2036(a) will not apply if the transfer was a bona fide sale for adequate and full consideration.

This exception can be broken down into two elements – (a) a bona fide sale, and (b) adequate and full consideration. The short story on this case is that absent bad facts, the presence of a legitimate and significant nontax purpose for the partnership will allow both (a) an (b) to be satisfied, at least under this interpretation of Code §2036.

Key points of this case are:

     A. In context of FLP transfers, the requirement of a “bona fide” sale is met if there is a legitimate and significant nontax reason for the transfer.

          1. Use of a limited partnership to facilitate ease of gift giving may not be enough of a nontax reason for this requirement.

          2. A desire for joint management of assets by family members can be an adequate nontax reason.

          3. A desire to avoid partition of an asset can be an adequate nontax reason.

          4. Per the enumeration of six listed “bad” factors, good or bad facts may sway the decision on whether an otherwise adequate reason will be deemed a legitimate and significant nontax reason. These six factors are: (1) the taxpayer standing on both sides of the transaction; (2) the taxpayer's financial dependence on distributions from the partnership; (3) the partners' commingling of partnership funds with their own; (4) the taxpayer's actual failure to transfer the property to the partnership; (5) discounting the value of the partnership interests relative to the value of the property contributed; and (6) the taxpayer's old age or poor health when the partnership was formed. Importantly, the case confirmed that presence of some of these facts will not be determinative. In the Stone case, (1) was present since the transferors were the former owners and also general partners of the recipient partnership, and that was not fatal to the use of this Code §2036 exception. Interestingly, and perhaps importantly for the court, there were no gift tax discounts taken when the partnership interests were transferred by the funding parents to gift recipients.

     B. In context of FLP transfers, the Tax Court’s “recycling of value” theory continues to be applied, as to whether adequate and full consideration exists. However, in regard to this theory, the court determined that a legitimate nontax purpose for the transaction was enough to escape a mere “recycling of value” finding that would prevent a finding of adequate and full consideration. Note that this method of analysis is significantly different from that applied in Bongard and Kimbell.

Stone v. Commissioner, TC Memo 2012-48

SECTION 2704 TACKLES ESTATE FOR A CLAIMS COURT LOSS

EXECUTIVE SUMMARY: A company formed to operate an NFL franchise runs afoul of Section 2704 at the death of its principal stockholder. While the estate put forth some creative arguments to elude the grasp of Section 2704, the Claims Court sides with the IRS and applies Section 2704 to substantially increase the estate tax value of the decedent's shares of stock.

FACTS:  The Five Smith's, Inc. was formed in 1965 to own and operate an NFL franchise. The decedent owned Class A common stock. Pursuant to a 1986 recapitalization, that stock had 11.64 votes per share, while the Class B common stock only had 1 vote per share. In 1991, third parties purchased Class B shares of 6% each. At that time, the company amended its Articles of Incorporation to provide that upon the decedent's death, or his sale or transfer of any of his Class A shares, the Class A shares would convert to Class B shares. The effect of the conversion would be a lapse of the enhanced voting power of the Class A shares.

The decedent died in 1997. The IRS disputed the estate tax value of the decedent's Class A shares. The IRS argued that Section 2704 applied, so that the enhanced voting power of the Class A shares should be included in valuing the shares. If Section 2704 applied, the estate and the IRS agreed that the the shares were worth $30 million on the date of death. The estate argued that Section 2704 did not apply. If that was correct, since the enhanced voting power disappeared at death it should not be included in value. This resulted in an agreed valuation of only $22.5 million.

The estate asserted several arguments, both as to whether Section 2704 applied, or if it did, whether its effects could be overridden by creating an inter vivos gift instead of a testamentary transfer, or by creating an arms-length exception to the statute. The Court of Claims rejected all of the estate's arguments and applied Section 2704 to the valuation.

COMMENT: Section 2704 is a special valuation rule that favors the government, and one that planners seek to work around. It is rare to see a disputed case that fits so squarely within it. The case is interesting as a review of Section 2704 and its application, and for the creative arguments put forth by the taxpayer.

     General Application of the Statute. Section 2704(a) reads as follows:

(1)    In general.

            For purposes of this subtitle, if-

(A)    there is a lapse of any voting or liquidation right in a corporation or partnership, and

(B)    the individual holding such right immediately before the lapse and members of such individual's family hold, both before and after the lapse, control of the entity,

such lapse shall be treated as a transfer by such individual by gift, or a transfer which is includible in the gross estate of the decedent, whichever is applicable, in the amount determined under paragraph (2).

      (2) Amount of transfer.

For purposes of paragraph (1), the amount determined under this paragraph is the excess (if any) of-

(A) the value of all interests in the entity held by the individual described in paragraph (1) immediately before the lapse (determined as if the voting and liquidation rights were nonlapsing), over

(B) the value of such interests immediately after the lapse.

      (3) Similar rights.
   
The Secretary may by regulations apply this subsection to rights similar to voting and liquidation rights.

    Thus, on its face, under the above facts there was a lapse of a voting right. Both before and after the decedent's death, his family held more than 80% of the voting power of the company, and thus meets the requirement for family control. For this purpose, the definition of control under Section 2701(b)(2) applies. Under Section 2701(b)(2)(A), in the case of a corporation "the term 'control' means the holding of at least 50 percent (by vote or value) of the stock of the corporation." Thus, applying Section 2704(a)(2)(A), the loss of value relating to the lapse of the extra voting power is disregarded, and the $30 million valuation applies.

     Control Argument. Section 2704(a)(1)(B) requires that "such individual's family hold, both before and after the lapse, control of the entity." Section 2701(b)(2)A) defines control as "the holding of at least 50 percent (by vote or value) of the stock of the corporation."

     Despite this simple definition of control, the estate asserted that for the family to have control, it must be able to reverse the lapsing of the voting power that occurred, if it wanted to. Since the family apparently did not have the power to do this after the decedent's death, the estate argued Section 2704(a) did not apply. The estate crafted this argument from the legislative history of Section 2704, which explicitly reflected the intent to overcome the Tax Court's ruling in Estate of Harrison v. Commission, 52 TCM (CCH) 1306 (1987). In Harrison, a decedent's partnership interest was valued at a lower value because the decedent's estate did not have the liquidation or dissolution rights that the decedent had prior to death as a general partner. However, the decedent's successors in Harrison did have the requisite control after the decedent's death to restore the lapsed liquidation right. Since the successors here did not have the requisite control or rights to restore the decedent's enhanced voting power, the estate argued that they did not have the requisite control to trigger Section 2704(a).

     The Claims Court rejected this interpretation. It noted examples in the legislative history that applied Section 2704(a) while noting only that a power lapsed, without discussion whether the successors needed the power to reinstate the lapsed power. Further, it distinguished Harrison as dealing with a liquidation right, which is different from a voting right. Lastly, it found no hint of any additional requirements in the statute or the regulations that would authorize the additional 'control' requirement that the estate sought to read into the law.

     Timing of the Lapse. Alternatively, the estate sought to have Section 2704(a) apply in 1991, as a gift of the lapsed enhanced voting rights, instead of a testamentary transfer subject to estate tax. More particularly, the estate argued that the lapse occurred at the time the restriction was incorporated into the Articles of Incorporation, and not the later date (death) when the loss in voting power actually occurred.What did the estate have to gain by treating the transfer as a gift? No gift tax return was filed in 1991 to commence the statute of limitations on assessment of a gift tax for the year. Instead, the strategy of the estate was to assert that notwithstanding Section 2704(a) operating in 1991, no gift tax liability came into being because the changes in the Articles of Incorporation arose from an arm's length transaction. Thus, Treas. Regs. §25.2512-8 would void a taxable gift because the property transfer would have been for adequate and full consideration. The Claims Court did not need to address whether adequate and full consideration existed for this transfer and whether that would override Section 2704(a) and its special valuation rules, since it ruled that the transfer occurred at death.

     The estate's argument of an inter vivos gift was not totally without merit. Treas. Regs. §25.2704-1(b) provides that "[a] lapse of a voting right occurs at the time a presently exercisable voting right is restricted or eliminated." Arguably, the voting rights were "restricted" in 1991, even though they were not eliminated until the later death.

     However, examples in the Regulations convinced the court that the lapse occurred at death. For example, Treas. Regs. §25.2704-1(f), ex. 1. reads:

Prior to D's death, D owned all of the preferred stock of Corporation Y and D's children owned all the common stock. At that time, the preferred stock had 60 percent of the total voting power and the common stock had 40 percent. Under the corporate by-laws, the voting rights of the preferred stock terminated on D's death. The value of D's interest immediately prior to D's death (determined as if the voting rights were nonlapsing) was $100X. The value of that interest immediately after death would have been $90X if the voting rights had been nonlapsing. The decrease in value reflects the loss in value resulting from the death of D (whose involvement in Y was a key factor in Y's profitability). Section 2704(a) applies to the lapse of voting rights on D's death. D's gross estate includes an amount equal to the excess, if any, of $90X over the fair market value of the preferred stock determined after the lapse of the voting rights.

    Thus, the example supports a reading that a lapse in voting rights at death occurs at death and not on the adoption of the provision providing for the lapse. The court noted that Treas. Regs. §25.2704-1(f), ex. 3 also supports such a reading, as do excerpts from the committee reports for Section 2704.

    Bona Fide Business Arrangement. The estate also argued that the 1991 limitations were a restriction on the sale of shares that invoked Section 2703. Since Section 2703(b)(1) excepts out from Section 2703 agreements, rights, and restrictions that are a bona fide business arrangement (if sections (b)(2) and (3) are also met), that exception should insulate the estate from Section 2704(a). The court was not convinced, finding that Section 2703 dealt with restrictions on the sale of shares. Instead, this case involved only the voting rights of the shares, and further Section 2704 specifically applies to lapses of voting rights.

    It is uncertain from the opinion whether the decedent's planners were cognizant of the Section 2704 issue before the decedent's death. If they were, perhaps there were no other viable planning alternatives, they had comfort in the arguments they put forth in the Court of Claims, or otherwise thought they could eek out some favorable settlement from the IRS that perhaps never was offered.

Estate of Rankin M. Smith, Jr. v. U.S., 109 AFTR 2d 2012-XXXX (Ct Fed Cl), 2/13/12

IRS DOES NOT RESPECT SPLIT ELIGIBLE ENTITY INTEREST TRANSACTIONS

An owner of an interest in a disregarded entity, such as a sole owner of a domestic LLC, is treated as incurring directly the income and expense items of the entity – hence the term “disregarded.” Some taxpayers have taken to creating multiple types of interests in disregarded entities, based on various preferences or types of income or properties held by the LLC. This is akin to a partnership being able to define different interests in property, income and expenses among its partners.

In the partnership scenario, different partners will obtain different outside basis in their interests over time, as different types of income and expense are allocated to them. Sole owners of LLC’s that create similar disparate interests assert that each such interest has its own separate adjusted basis computation. This can allow for tax manipulation of the basis of interests for sale, upon distributions, and other purposes. For example, if the owner sells part of his ownership interest in the LLC, he or she may assert that the adjusted basis (for gain/loss determination purposes) is not a pro rata portion of the underlying basis of the LLC assets, but perhaps is higher than that (and the proportionate adjusted basis of the interests not being sold) due to the above allocations.

No way, says the IRS in Associate Chief Counsel Legal Advice. A disregarded entity will not allow for the creation of interests with different tax attributes in the hands of its sole owner. This makes sense, but you have to admire the creativity of some of these tax planners.

Office of Chief Counsel Memorandum Number AM2012-001 (February 9, 20120