A recent Tax Court Memorandum Opinion, Estate of Miller v. Commissioner, T.C. Memo 2009-119 (May 27, 2009), adds to the long line of cases involving taxpayers who claim valuation discounts for transfers of assets to family members. The intended result is that, because the asset values are reduced for tax purposes, significant estate tax saving result. As in Estate of Miller, the preferred entity to obtain discounts is often a Family Limited Partnership (FLP). Limited Liability Companies are also often used.
For purposes of highlighting the importance of Estate of Miller, I am eliminating details of the facts. Simply assume the taxpayer transferred marketable securities into an FLP and then gifted limited partnership interests to her children. The gifts occurred over a two year period. The taxpayer claimed a 35% discount from the asset value of the publicly traded securities inside the FLP because the gifts consisted of limited partnership interests. That is, although the marketable securities were in Merrill Lynch and Fidelity accounts, because they had first been transferred into the FLP, and then limited partnership interests were transferred not the public securities, discounts for lack of market and control should apply.
The Tax Court agreed with the taxpayer in concept and allowed discounts for the gifts made in Year One but not Year Two. In broad terms, the importance of the Tax Court’s decision is the following:
- A 35% discount may be reasonable. Indeed, the IRS did not challenge the amount of the discount. Thus, in theory a discount more or less may be appropriate, depending on the facts.
So, what did the Tax Court determine was the distinguishing factor between Year One when the gift (and 35% discount) was allowed and the second year when the Court said there was not a legitimate gift? It comes back to business purpose and the non-tax reason for creating the FLP and making the gifts. (The relevant Internal Revenue Code Section is 2036.) The Tax Court stated there was a legitimate non-tax reason to create the FLP. Here, it was primarily the need for an entity to allow a child to continue the active investment philosophy of his parents. The child worked full-time in this activity. Perhaps other factors were important, such as asset protection, succession planning for the family and centralized management. The court also noted the taxpayer had other assets to live on beyond those gifted to her children. Thus, the Year One gift was legitimate.
However, in Year Two when the second round of gifts was disallowed, the taxpayer was not in good health. The Court concluded the gifts were motivated by death bed planning. Also, after this round of gifts, the taxpayer did not have other assets in her own name sufficient to pay her bills. Thus, the Court held the gifts in Year Two were motivated by the taxpayer’s desire to reduce estate tax.
In general, Estate of Miller v. Commissioner is a pro-taxpayer case because it illustrates that FLP’s and LLC’s remain viable gift and estate tax planning tools if set up for valid reasons. However, if thrown together at the last minute as part of death bed planning or without any credible non-tax reason, they will be subject to challenge. The IRS will also challenge the discounts if the formality of the structure is not observed, e.g., commingling assets, failure to make pro rata distributions, opening appropriate accounts, etc.
As I have written about in the past, whether Congress renders these cases moot through legislation that would curb or eliminate discounting in family settings remains an open question.