Estate of Purdue v. Commissioner

T.C. Memo. 2015-249: A Checklist to Address 2036 Concerns

The issue raised in Estate of Purdue v. Commissioner was whether the “decedent’s desire to have the marketable securities and the building interest held and managed as a family asset constituted a legitimate non-tax motive for the transfer of property to PFLLC.”

The Internal Revenue Service (“IRS”) continued its attack on family limited partnerships and their lack of sufficient business purpose in Estate of Purdue v. Commissioner, (T.C. Memo. 2015-249, Dec. 28, 2015).  The case was brought before the United States Tax Court on the following issues:

• Were assets transferred to the limited liability company includable in the decedent’s gross estate at their undiscounted value, or were they not to be included in the estate under I.R.C. § 2036?
• Did gifts of LLC interests qualify for the annual exclusion?
• Was interest on a loan from beneficiaries, to pay the decedent’s estate tax, deductible?

Case Overview

The decedent and her husband formed and funded a limited liability, the Purdue Family LLC (“PFLLC”) company several years prior to her death.  The LLC was funded with marketable securities, as well as an undivided interest in a building.  In the years following the LLC’s formation, the decedent made annual gifts to a Crummey trust.  Annual exclusion gifts were made over the 2002 through 2007 time period.  The decedent passed away in 2007 and the estate beneficiaries made a loan to the estate to pay the estate taxes.  The estate deducted the interest associated with this loan as an administration expense for estate tax purposes.

Case History

The decedent and her husband had amassed a great deal of wealth in the form of marketable securities.  Prior to the formation of the LLC, the marketable securities were held in five different accounts with three different brokerage firms.

In approximately 1995, Mr. Purdue sought out an estate planning lawyer at his firm to explore estate planning options.  The lawyer recommended forming an FLP, citing the fact that it was a good vehicle to centralize asset management and to take advantage of valuation discounts.  Some years later, the attorney sent a draft LLC agreement to Mr. Purdue which included the following as the purpose for the formation of the entity.  It should be noted, each of the purposes listed below were included in the final LLC agreement:

• Consolidate the management and control certain property, and improve the efficiency of the management by holding the assets in a single, flexible entity;
• Avoid fractionalization of ownership;
• Keep ownership of the assets within the extended family;
• Protect assets from unknown future creditors;
• Provide flexibility and management of assets not available through other business entities; and
• Promote education of, and communication among, members of the extended family with respect to financial matters.

The LLC was originally formed in November 2000.  The Purdue’s contributed the following assets to the LLC:

• Approximately $22.0 million of marketable securities,
• A one-sixth interest in a commercial property located in Honolulu, Hawaii,
• A $375,000 promissory note from one of the Purdue children, and
• A certificate of deposit with a balance of $865,523.

Soon after the formation of the LLC, in April 2001, Mr. Purdue engaged the Rainer Group as the investment manager for the LLC’s assets.  The Purdue’s, and their children, signed an Investment Policy Statement in July 2001, and all of the marketable securities were managed under what the Tax Court termed an “overall well-coordinated professional investment strategy.”  Prior to the Purdue Family signing the Investment Policy Statement, in June 2001, the Purdue children met regularly with the investment manager to discuss the assets and the investment performance of the LLC.  The LLC and all members (Mr. and Mrs. Purdue and the Purdue children) have held annual meetings since 2001 to discuss the family assets and approve cash distributions from the LLC.  It should be noted that the LLC operating agreement requires that all LLC members must agree on distributions.

Mr. Purdue passed unexpectedly in August of 2001 and his estate (non-taxable) passed to a family trust and two QTIP trusts.

After the passing of Mr. Purdue, Mrs. Purdue made annual exclusion gifts, of LLC member interests, to an irrevocable Crummey trust.  These gifts were made, as set forth above, from 2002 through 2007.

The Purdue children received, in aggregate, approximately $2.0 million in cash distributions from the LLC over the 2001 through 2007 period.

Mrs. Purdue passed in November of 2007.  In August 2007, the Purdue’s estate lawyer sent a memo to the Purdue children outlining their options for making the estate tax payment.  The alternatives were as follows:

• A $6.2 million loan from the LLC to the estate and the QTIP trusts, or
• A $6.2 million distribution from the LLC.

One of the Purdue daughters refused to approve the distribution.  As such, the LLC was unable to make the distribution since, as discussed above, the LLC operating agreement requires the approval of all members to make a distribution.  Since the members were deadlocked over distributions, some of the beneficiaries loaned the estate and the QTIP trusts about $1.2 million to cover the shortfall in making the estate tax payment.

The estate timely filed its estate tax return in March of 2009.  The IRS issued an estate tax notice of deficiency in February 2012, citing a deficiency of approximately $3.1 million.  The IRS also filed gift tax notices of deficiencies for various years between 2001 and 2007 totaling about $925,000.  The gift tax notices of deficiency were filed in September of 2012.

Tax Court Rulings

The IRS argued, to the Tax Court, that the transfer of the assets used to form the LLC was a transfer with a retained interest and that the assets should be includable in Mrs. Purdue’s estate under Section 2036.  Alternately, the estate argued that the transfer was a bona fide sale for full consideration, which is one of the exceptions to Section 2036.  The Tax Court analyzed the above-mentioned exception by bifurcating into: (1) a bona fide sale, and (2) full consideration.

Bona Fide Sale Test

To pass the bona fide sale test requires that the petitioners establish a legitimate and significant non-tax reason for forming the LLC.  In essence, the petitioners had to prove that the formation of the LLC was not merely a testamentary transfer to avoid the payment of certain transfer taxes.  The Tax Court reiterated a list of factors that have been discussed in prior cases which are considered in deciding whether a non-tax reason existed:

1. The taxpayer’s standing on both sides of the transaction;
2. The taxpayer’s financial dependence on distributions from the partnership;
3. The taxpayer’s commingling of LLC funds with the taxpayer’s personal funds;
4. The taxpayer’s actual failure to transfer the property to the LLC;
5. Discounting the value of the partnership interest relative to the value contributed; and
6. The taxpayer’s old age or poor health when the LLC was formed.

The estate argued the decedent had seven non-tax reasons for forming the LLC.  It should be noted that the reasons, set forth below, are somewhat different than those stated in the operating agreement:

1. To relieve the decedent and Mr. Purdue from the burdens of managing their investments;
2. To consolidate investments with a single advisor to reduce volatility according to a written investment plan;
3. To educate the five Purdue children to jointly manage a family investment company;
4. To avoid repetitive asset transfers among multiple generations;
5. To create a common ownership of assets for efficient management and meeting minimum investment requirements;
6. To provide voting and dispute resolution rules and transfer restrictions appropriate for joint ownership and management by a large number of family members; and
7. To provide the Purdue children with a minimum amount of annual cash.

It is of interest that the Tax Court specified that simplifying the gift giving process and assuring transfer tax savings alone is an unacceptable non-tax motive.  The court focused on the purpose of “consolidating investments into a family asset managed by a single advisor.”  The court noted that the assets were managed differently before and after the creation of the LLC.  Keep in mind, the marketable securities were held in five accounts with three different brokerage houses prior to the formation of the LLC; after the LLC’s formation, they were held in one account and managed by one investment advisor.

By way of background, this is an important factor for the IRS as well.  In many Section 2036 challenges, the IRS raises several issues, one of which is how the assets contributed to the LLC or whether the FLP assets were managed differently before and after the creation of the entity in question.

In the case at hand, the Tax Court noted the difference in the manner in which the assets were managed after the formation of the LLC.  The court observed that the assets were moved to a single investment advisor, and the fact Mr. Purdue no longer handled all financial decisions.  The court was also moved by the fact that the Purdue children handled all LLC investment decisions jointly.  It should be noted that the centralized management theory was cited by the Tax Court in petitioner wins in the Stone, Kimbell, Mirowski, and Black cases.

The Tax Court ultimately ruled the “decedent’s desire to have the marketable securities and the building interest held and managed as a family asset constituted a legitimate non-tax motive for the transfer of property to PFLLC.”

The Tax Court also dealt with the IRS’ argument that the decedent stood on both sides of the transaction.  The court acknowledged that if the taxpayer stands on both sides of a transaction there is no arm’s-length bargaining and the bona fide transfer exception does not apply.  But, the court reasoned that, “an arm’s-length transaction occurs when mutual legitimate and significant non-tax reasons exist for the transaction and the transaction is carried out in a way in which unrelated parties to a business transaction would deal with each other” (citing Estate of Bongard v. Commissioner).  The court noted, “there was a legitimate non-tax motive, and the decedent received an interest in the LLC proportional to the property contributed, so this factor does not weigh against the estate.”

The Tax Court also ruled favorably on the remaining factors, namely:

• The parents were not financially dependent on distributions;
• There was no commingling of personal and LLC funds;
• Formalities of the LLC operating agreement were respected;
• The LLC maintained its own bank accounts and held annual meetings (with written agendas, minutes, and summaries);
• The parents transferred properties to the LLC timely; and
• The parents were in good health at the time of the formation of the LLC (and date in which assets were contributed to the LLC).

Adequate and Full Consideration Test

As to the issue of adequate and full consideration, the court reiterated their position from prior cases that the full consideration prong is satisfied if, “the transferors received LLC interests proportional to the value of the property transferred.”  There were no allegations that the Purdues failed to receive interests proportional to their transfers, but the IRS argued, based on the ruling of Estate of Gore v. Commissioner, that the transaction represented a mere change of form and a “recycling” of value.  The court rejected this argument, citing Estate of Shutt v. Commissioner for its conclusion when a “decedent employs his capital to achieve a legitimate non-tax purpose, the Court cannot conclude that he merely recycled his shareholdings.”

The Tax Court then moved to the issue of whether the annual transfers qualified for the annual exclusion.  The court’s analysis is similar to the analysis of the Tax Court in Estate of Wimmer.  To qualify as a gift of a present interest, the gift must confer on the donee “a substantial present economic benefit by reason of the use, possession, or enjoyment (1) of property or (2) income from the property.”  In the context of a gift of LLC or limited partnership interests, this requires that the donees “obtained use, possession, or enjoyment (1) of the membership interests or (2) income from those interests within the meaning of Section 2503(b).”

The Tax Court ruled that the donees’ rights were limited noting the transfer restrictions set forth in the agreement, namely the fact that a member could not transfer their interests without unanimous consent by other members.  The court noted, “the donees did not receive unrestricted and non-contingent rights to immediate use, possession, or enjoyment of the PFLLC interests themselves.”  The court did note, in the alternate, that the donees did receive income from those interests to satisfy the present interest requirement.  The court applied a three-pronged test, each prong of which was satisfied.  The three-prongs were from Calder v. Commissioner, and included: 1) the LLC would generate income, 2) some portion of the income would flow steadily to the donees, and 3) that portion of the income would be readily ascertained.

Finally, the Tax Court moved to the issue of the interest deduction.  The Court noted that in order for interest expense to be deductible as an administration expense under Section 2053, “the loan obligation must be bona fide and actually and necessarily incurred in the administration of the decedent’s estate and essential to the proper settlement of the estate.”

It should be noted that the IRS never argued the loan was not bona fide, but rather if the loan was necessary.  The Tax Court ruled that the loan was necessary because the LLC operating agreement required its members to vote unanimously to make decisions, and one daughter created deadlock by not voting for the distribution.  The court noted this deadlock made the loan necessary.

Case Commentary

Valuation practitioners may be asking the question, “what does this case have to do with valuations of FLPs?”  The answer is convoluted.  A valuation professional is not going to read the Purdue case and walk away with a new understanding of the intricacies of valuing an FLP.  However, the valuation analyst is a trusted advisor in the client’s estate planning advisory group.  Your understanding of this case will assist your clients and their advisors in creating a stronger and more defensible estate plan.

Section 2036 issues have been on the IRS’ radar screen for some time now, and probably will remain for there for the foreseeable future.  As such, valuation analysts must be aware of all potential Section 2036 areas of attack and if they see them, they should immediately bring them to the attention of the estate planner.  The following are the major areas of IRS focus/attack:”

• Was the decedent financially dependent on distributions from the FLP? In common parlance, did the client transfer “everything but the kitchen sink” to the FLP (e.g., personal use assets, personal bank accounts, etc.).
• Has there been commingling of FLP and personal monies? Is there the potential for the commingling of business and non-business monies?
• Have all partners respected the terms of the partnership agreement? A good starting point to check for this issue is to look at the FLP’s historical K-1s and determine if each partner’s capital balance matches their actual ownership percentage.  If not, the FLP probably made non pro-rata distributions, and you need to determine why.  The analyst can determine if the partners have respected formalities of the partnership agreement during their management interview; that is why interviews are imperative even for a holding company.
• Does the FLP have a separate bank account?
• Has the FLP held annual meetings? The analyst should, by default, ask for all relevant annual meeting notes.  If they are missing, the analyst needs to determine why annual meetings have not been held and again try to diagnose if there are any formality issues with respecting the terms of the agreement.
• Were the clients (or are they) in poor health at the time the FLP was formed (e.g., was this a death bed gift).
• How were the assets managed differently before and after the formation of the FLP?
• Were assets managed according to a plan? Who developed the plan—all partners?  Or just the GPs?

Of course, each case has its own set of facts and circumstances that make them unique, but the list above is a great starting point to diagnose any looming or potential Section 2036 issues.

Peter H. Agrapides, MBA, CVA, is with the Salt Lake City, Utah, and Las Vegas, Nevada, offices of Western Valuation Advisors. Mr. Agrapides’ practice focuses primarily on valuations for gift and estate tax reporting. Mr. Agrapides has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1 billion.

Mr. Agrapides can be reached at (801) 273-1000 ext. 2, or by e-mail to panayotiagra@yahoo.com.