LawyersUSA

Estate planning attorneys have welcomed a recent ruling from the U.S. Tax Court that allowed the assets in a family limited liability company to be excluded from the decedent's gross estate, thereby allowing a discount for tax purposes.

The assets fell under the "bona fide sale" exception to §§2036 and 2038 of the Internal Revenue Code, the court said.

"This is a total taxpayer victory," said Owen Fiore, an estate planning consultant in Kooskia, Idaho.

The decision comes on the heels of a spate of rulings going the opposite way.

"It is a welcome relief after a string of losses on most of the same issues," said Howard Zaritsky, an estate planning attorney in Rapidan, Va. "For a long time, it was starting to look like you needed to build a perfect case. This case says, 'No, you just have to build a good case.'"

The case was the result of good facts and good lawyering and can be instructive on how to structure and advise clients about family limited partnerships, estate planning lawyers told Lawyers USA.

Good facts

The case involved an 80-year-old mother of three who was the widow of the inventor of the heart defibrillator implant.

In 1992, she created a trust for each of her daughters and gifted a portion of her interests in patent licenses to those trusts. In 2001, less than a month before her death, she created a single-member LLC and made several substantial transfers to it.

She later gifted a 16 percent interest in the LLC to each of the three trusts, retaining a 52% membership interest. Four days later, she died unexpectedly from complications of a foot ulcer.

Section 2036(a) of the Internal Revenue Code provides that "[t]he 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 ... under which he has retained for his life ... the possession or enjoyment of, or the right to the income from, the property."

The Code includes an exception in the case of a "bona fide sale for full and adequate consideration in money or money's worth."

The IRS claimed a $14 million deficiency in estate taxes.

But the Tax Court held that the decedent had "legitimate and significant nontax reasons" for forming and funding the LLC, including (1) joint management of the family's assets, (2) pooling family assets to maximize investment opportunities, and (3) providing for each of her daughters on an equal basis.

The court also held that the LLC's activities need not rise to the level of a "business" in order for the bona fide sale exception to apply.

"We … find that the exception under §2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth applies to [the] transfers to [the LLC]," the court said.

It rejected the IRS's argument that the decedent retained income or enjoyment of the gifted interest to each of her daughters, noting that the operating agreement didn't give her the authority to make distributions of capital proceeds or to allocate profits or losses from capital transactions and was "unequivocal" in mandating annual distributions.

The IRS also argued that there was an implied agreement between the mother and her daughters that the $11 million in gift taxes on the gifted interests would be paid from the estate.

But the court disagreed, noting that the mother's death was unexpected and there was enough money outside the LLC to pay the taxes.

Good lawyering

Lawyers can learn some important lessons from the case, including how to properly draft a family LLC's operating agreement in order to get a discount. Most of the agreement used here was included in the appendix of the case.

"The opinion gives people a roadmap of what the document should look like," said L. Paul Hood, an estate planning commentator in Alexandria, La.

Here are some additional tips and strategies:

• 'Ferret out' clients

Lawyers should "ferret out" clients whose only interest is in the tax discounts that might apply, said Hood.

"It's important to document that there are legitimate and significant reasons for forming an entity apart from estate taxes," said Barbara Kogen, an attorney and CPA in Beverly Hills, Calif.

Although some of the reasons given here for allowing the discount – such as the pooling of assets and gifting on an equal basis – have not been successful in other instances, the case involved clear documents proving those motivations.

The documentation, for example, went as far back as the decedent's childhood in France working at her parents' tailoring business to evidence her long-held desire that her own children work together on financial matters.

A strategy to strengthen the pooling of assets is to contribute assets from each of the members, such as contributing at least a portion from each of the daughters' trusts in this case, said Fiore.

"One way to show it's a business or investment partnership is to have the investors pooling their assets – just like on Wall Street," he said.

• Continue the FLP after death

A major lesson of the case is to make sure the entity continues after the decedent's death, said Hood.

Even if the operating agreement says the purpose of the entity is to manage property together, people often collapse the entity once they receive an IRS closing letter, he said.

"Some people set up these vehicles and then collapse them so their kids can get the money, so it almost looks like a trust. But if you get into a tax dispute, you sure better keep the thing going," said Hood.

The case also shows that even if the entity was created within days of the owner's death, it may still pass muster as long as there is strong evidence of non-tax reasons for the partnership.

"You would think the fact that the donor set up, funded and made gifts within less than a month of her death would in and of itself blow it out of the water. But this was not a deathbed-type transaction," said Kogen.

The record in the case was also fully developed on the issue of the donor's health to show that her death was unexpected.

• Follow the operating agreement

A problem in many cases is that even if the operating agreements are drafted correctly, they are not followed.

"Someone who wants to learn from this case will make sure the donor follows things exactly as they are structured," said Kogen.

Common mistakes include comingling entity assets with bank accounts and treating the assets as the donor's own.

Another pointer from the case is to leave sufficient assets outside the FLP so the owner does not use partnership assets for living expenses.

"You have people who sink their entire estate, including the residence, into the entity and leave no assets outside," said Hood. "If you live by the agreement, a court will be more likely to uphold it. If you decide not to, a court is not going to either."

U.S. Tax Court. Estate of Mirowski v. Commissioner, T.C. Memo 2008-74. March 26, 2008. Lawyers USA No. 9939612. You can link to the full text of this opinion by going to www.lawyersusaonline.com and searching the Lawyers USA website.

Questions or comments can be directed to the writer at: sylvia.hsieh@lawyersusaonline.com