Estate of Holliday, T.C. Memo 2016-51 (March 17, 2016)

A Taxpayer Loss—Assets Included in the Estate

We find ourselves in a familiar place once again—that is, analyzing a case in which the IRS attacked an FLP under I.R.C. § 2036. Just two months ago, I wrote an overview of Estate of Purdue v. Commissioner, (T.C. Memo 2015-249), in which the IRS attacked a closely-held asset holding company, in that case it was an LLC, under I.R.C. §2036. While both holding companies were attacked under Section 2036, the cases could not have ended up more differently for the taxpayers. Purdue was a taxpayer win; Holliday was not.

We find ourselves in a familiar place once again—that is, analyzing a case in which the IRS attacked an FLP under I.R.C. § 2036.  Just two months ago, I wrote an overview of Estate of Purdue v. Commissioner, (T.C. Memo 2015-249), in which the IRS attacked a closely-held asset holding company, in that case it was an LLC, under I.R.C. §2036.  While both holding companies were attacked under Section 2036, the cases could not have ended up more differently for the taxpayers.  Purdue was a taxpayer win, Holliday was not.

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I think it is important to provide an overview of the Purdue case, since that case will be referenced throughout this article.

The Purdue family formed an asset holding company (an LLC) several years prior to the decedent’s death.  The LLC’s assets were largely comprised of marketable securities, as well as an undivided interest in a commercial building.  Prior to the formation of the LLC, the Purdue’s marketable securities were held in multiple brokerage accounts.  After the LLC was formed, the Purdue’s consolidated their security holdings into one brokerage account managed by one brokerage group—The Rainer Group.  In addition, the Purdue’s, and their children, met with the investment manager to discuss the assets and the investment performance of the LLC.  After discussing the assets, and the general asset management plan, the Purdue’s signed an Investment Policy Statement.  After the LLC Investment Policy Statement was signed, all LLC members attended annual meetings, where investment management and distributions were discussed.  The Purdue operating agreement requires all LLC members agree on distributions.  The Tax Court commented the LLC had an “overall well-coordinated professional investment strategy.”

The IRS argued the petitioners did not establish a legitimate and significant non-tax reason for forming the LLC.  The Tax Court did not accept the IRS’ argument, noting the difference in manner in which the assets were managed after the formation of the LLC.  The Tax Court ultimately ruled that 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 the property to the LLC.”

The Tax Court ultimately ruled in favor of the taxpayers in Purdue.

Estate of Holliday v. Commissioner Case Overview

The primary issue before the U.S. Tax Court was whether assets contributed to an FLP, and subsequently transferred out of the decedent’s estate, should be included in the decedent’s estate under Section 2036.

The decedent was moved to a nursing home in 2003 and her financial affairs were managed by her sons.  She later formed a family limited partnership.  Immediately after the formation of the FLP, the decedent’ held a 99.9 percent limited partnership interest, as well as wholly-owning the LLC that was the sole general partner, holding a 0.1 percent general partnership interest.  The sole assets of the FLP were marketable securities with a value of approximately $5.9 million.

The same day the $5.9 million in marketable securities were contributed to the LLC, decedent sold all of her membership interest in the LLC (that held the 0.1% general partnership interest) to her sons and gifted a ten percent limited partnership interest to an irrevocable trust.

It should be noted that the decedent held significant assets outside the partnership to cover all living and associated expenses.  In the two years that the partnership was operational, it made only one small $35,000 distribution.

The estate timely filed the decedent’s Form 706 estate tax return, on which they claimed a combined forty percent discount for her remaining 89.9 percent limited partnership interest.

The IRS took issue with the Form 706 and issued a notice of deficiency, arguing that the transfer of assets to the partnership triggered Section 2036(a)(1).  As such, the IRS took the position that the 0.1 percent general partnership interest, as well as the ten percent limited partnership interest were includable in the decedent’s gross estate.  Further, the remaining 89.9 percent limited partnership interest, which was in the decedent’s estate at the time of her death, was to be included at its undiscounted value.

Section 2036(a)(1) requires the following:

• The decedent made an inter vivos transfer of property;
• The decedent retained (either explicitly or by implied agreement) the possession or enjoyment of, or the right to income from the transferred property; and
• The transfer was not a bona fide sale for adequate and full consideration.

It should be noted, the IRS acquiesced that the contribution of assets to the FLP constituted an inter vivos transfer of property, and thus satisfied the first required element.  As such, at trial the IRS argued the last two elements.

Implied Agreement of Retained Enjoyment

The IRS’ position on this issue was essentially that the decedent, by implied agreement, retained possession or enjoyment of, or the right to income from the assets transferred to the partnership.  The IRS argued, and the Tax Court agreed, that the partnership agreement required the distribution of “distributable cash” on a periodic basis.  It should be noted that the term distributable cash was defined in the agreement (as it is in most partnership or operating agreements) as cash in excess of current operating needs, as determined by the general partner.  In essence, petitioners could have argued that there was no implied agreement of retained enjoyment because, in effect, there was no distributable cash.  The decedent’s son’s testimony at trial quickly put the nail in the coffin (for the estate) on this issue.  An excerpt of the transcript of the son’s testimony found below:

When asked at trial what he believed the term “operating needs” meant, the son testified, “It seemed to me when I reviewed this document, when it was signed, that it was created, that this seemed to come from some sort of boilerplate for Tennessee limited partnerships, this sort of gave you broad powers to do anything you needed to do, including make distributions.  But that wasn’t necessary; no one needed a distribution.”

Two issues come to light here.  The first, and perhaps the most obvious, was the fact that the decedent’s son was horribly prepared to provide testimony in this case.  The second, and the contrast with the Purdue case is the fact that, based on the son’s testimony, it looked as if the only reason the decedent formed the LLC was for testamentary purposes, or to avoid paying transfer taxes.  Remember, the Purdue family, who spent a significant amount of time performing tasks pertinent when forming an asset holding or investment company, such as discussing the assets, setting up a structure to centrally manage the assets, and (most importantly) authoring a document which would provide an ongoing guidance in managing the Purdue LLCs assets—the Investment Policy Statement.  The Purdue assets were then managed in accordance with the Investment Policy Statement.

Another important contrast in the Purdue case was the fact the members followed the terms of the agreement with respect to making distributions.  Remember the Purdue agreement stated that all members had to agree on distributions.  As such, the Purdue’s held an annual meeting every year and one of the issues they discussed on an ongoing basis was distributions.  In the Holliday case, the agreement stated all distributable income was to be distributed on an ongoing basis.  As such, even if nobody “needed” distributions, the decedent may have been better served if some level of distributions were made on a periodic basis and, if not, if it was documented as to why no distributions were made.  The best place to make such documentation as to why distributions were not made would have been in an annual meeting memorandum.  There are many reasons why distributions could have not been made, including to take advantage of gains available in the securities markets and avoid consumption, thus reinvesting all dividends and such back into the partnership so as to grow the capital base of the entity.  In the Holliday case, no annual meetings were held and no books or records were kept, which could have been used to show why there was no “distributable cash” since, after all, the Holliday partnership agreement gave the GP unilateral discretion with regards to setting the level of distributable cash.

In regards to the son’s testimony, the Tax Court noted it “makes it clear that had decedent required a distribution, one would have been made.”

From a planning perspective, some planners, such as the one in the Holliday case, set up agreements to require periodic distributions (so as to avoid Sec. 2036(a)(2) or even Sec. 2038).  As a contrast, other agreements do not require distributions of distributable cash, but merely allow the distribution of same.

Bona Fide Sale for Adequate and Full Consideration

Petitioner’s cited three non-tax reasons for forming the FLP, including the following:

• Protection from litigators’ claims,
• Protection against undue influence of caregivers, and
• Preservation of assets for the decedent’s heirs.

The IRS argued in the contrary with regards to each of the aforementioned and the Tax Court agreed, noting the following.

• In response to the first issue—protection from litigators’ claims—the court noted the decedent’ had never been sued. The court also noted that since she lived in a nursing home, her risk of being sued was minimal.  Finally, the court noted she retained significant assets that could be reached by someone.
• In regards to the second issue—the protection against undue influence of caregivers—the court noted that caregivers had taken advantage of or stolen from other family members, but the decedent’s situation was different because her sons managed her affairs and visited her often. Most notably, the court noted this was not a concern discussed among the petitioners when the FLP was formed.
• Regarding the last issue—preservation of assets for the decedent’s heirs—the court noted other structures for preserving assets were “quickly dismissed” because they were difficult to manage. The court found this argument unconvincing since the decedent’s previously deceased husband’s assets were being managed in trusts without difficulty.  The court also noted the decedent was not involved in selecting the structure to preserve her own assets.

The Tax Court also noted the following:

• The decedent “stood on both sides of the transaction” and it was not an arm’s length transaction because there was no meaningful negotiation or bargaining associated with the transaction. It should be noted, this issue was discussed in the Purdue  The Purdue case looked at this issue in conjunction with the bona fide sale for full consideration exception issue.  The Purdue court noted, this factor does not apply if there is a legitimate and significant non-tax reason (which must exist for the bona fide sale exception to apply) and if the transaction is carried out in the way unrelated parties to a business transaction would act.  The Purdue court reasoned the last requirement was met because the decedent received interest proportional to the assets contributed.
• Various formalities were not followed. The Court noted the FLP did not keep accounting books or records other than brokerage statements.  The Court also noted the FLP did not hold formal meetings and, as such, no minutes were kept.  Finally, the requirement under the agreement to make distributions was not followed and compensation was not paid to the general partner as required under the agreement.

Not following entity formalities is a big red flag for the IRS and, as in this case, continues to be a “real world” problem, despite the fact that leading planners and tax litigators have warned of the dire consequences facing those that do not follow the formalities set forth in the agreement.  While not a valuation issue, it is an issue that oftentimes is uncovered in the due diligence process of the valuation.  I have oftentimes detected this issue when performing my management interview.  Yes, it is impetrative to perform management interviews even for a partnership or LLC that simply holds assets.  When such an issue is uncovered, it should immediately be brought to the attention of the planning attorney and they can determine the best manner in which to proceed.

• The assets (marketable securities) were not actively managed. This gave the appearance, largely to the Tax Court, that the assets were transferred to the FLP just to take advantage of valuation discounts.  Contrast this with Purdue, where prior to the formation of the LLC, the marketable securities were held in multiple brokerage accounts; after the LLC was formed, the assets were consolidated into one brokerage account managed by one investment manager.  Further, the investment manager would actively manage the account in accordance with the Investment Policy Statement that was drafted by all members of the LLC.

As noted at the beginning of this article, we see the importance the IRS places on Section 2036.  Again, this is not a valuation issue and noticing 2036 issues will not necessarily affect your valuation.  However, as noted above, valuators need to perform a level of due diligence they would perform for any other valuation engagement, and that level of due diligence will allow you to uncover any perceived Section 2036 issues, and bring them to the attention of the planning attorney.  The attorney may decide to move forward with the transaction, or they may determine they want to postpone the transaction until the issue is resolved.

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.