Securing the Annual Gift Tax Exclusion for Transfers of Interests in Family Entities

While encumbrances and restrictions are evaluated during the process of determining the actual gift, they cannot be applied until after the gift is identified. Any restriction which impedes the transferability of the gift or the income derived from the gift will serve to categorize it as a future interest. State laws, entity policies, procedures, and agreements are scrutinized to determine their effect on the gift’s exclusion. Specifically, the power to withdraw from the entity, sell the units, force a liquidation, join in decision making, or request a distribution are typical of rights that, when restricted, will deny the availability of the exclusion.

The IRS has addressed the annual exclusion in several private letter rulings (PLR). In PLR 9131006, a Washington state family limited partnership used the annual exclusion to gift units of both general and limited partnership interests in 1986 and 1988, a few months prior to the donor’s death. No gift exceeded $10,000 (the annual exclusion amount at that time), and the property was unimproved land being held for sale. Nominal income was received; this was paid to the managing partner as a fee. General partners are compared to corporate boards of directors in both their ability to determine the time and method of distributions and their fiduciary duty to limited partners. Right of first refusal was reserved in the event a partner wanted to sell or assign her units. The IRS determined that the gift of the partnership units qualified for the annual exclusion.

In PLR 9751003, a widow, using a series of transactions over a five-year period, transferred her assets to her family as limited partnership interests. The partnership was formed under her state’s Revised Uniform Limited Partnership Act (RULPA). The general partner was an S corporation of which the donor was the sole shareholder. The limited partnership agreement went into great detail concerning distributions of income, withdrawal and return of capital contributions, transfers of interest, and substitutions of limited partners, but did not qualify for the annual exclusion. This ruling seemingly reversed the IRS’ position on the ability of gifts of entity units to achieve the exclusion. In comparison to prior rulings, it becomes obvious that general partner or manager duties, in this set of facts, go beyond those duties as delineated under the RULPA that most states have adopted. The partnership agreement gave the general partner the ability to retain all funds within the partnership for any reason. Restrictions beyond the first right of refusal apply to the ability of a partner to sell or assign units. Agreements that extend restrictions beyond state law may jeopardize the exclusion.

In accordance with the Supreme Court ruling in Fondren v. Comm’r [324 U.S. 18, 20 (1945)], a gift may be broken down into parts, only some of which qualify for the exclusion. This allows for a separation and review of the different parts of transfers from the income derived thereon. The asset may be restricted in such a manner that it will not qualify for the annual exclusion, while the unrestricted income from the asset does qualify.

Judicial Decisions

Several early cases laid the groundwork for doctrines in the transfer tax area. In Gregory v. Helvering [293 U.S. 465 (1935)], the Supreme Court held that courts could disregard an entity or a transaction if it is lacking in economic substance. In Comm’r v. Hansen [360 U.S. 446 (1959)], the Supreme Court took the doctrine one step further by noting “the incidence of taxation depends upon the substance, not the form of the transaction.” The substance-over-form doctrine and the economic-substance doctrine, and supporting decisions, are the foundation on which the IRS contends that the entity should be disregarded in the first step of its analysis. The step-transaction doctrine evolved from the Supreme Court’s reasoning in U.S. v. Court Holding Company [324 U.S. 331 (1945)] that using a series of transactions to accomplish an end should not affect the tax consequences of the final result. These landmark decisions were initially income tax cases which were brought into the realm of transfer tax litigation by Estate of Murphy v. Comm’r (TC Memo 1990-472). Two early Supreme Court cases, Comm’r v. Tower and Comm’r v. Culbertson, spawned the valid-business-purpose doctrine. In viewing the facts and circumstances of these cases, the pattern fits closely with the sham-transaction theory, because the integrity of the form of entity was not adhered to.

Statutory language is the basis for the indirect-gift doctrine and the gift-on-formation doctrine. The indirect-gift doctrine was interpreted by the Supreme Court in Helvering v. Hutchings [312 U.S. 393 (1941), and the gift-on-formation doctrine was founded by Robinette v. Helvering [318 U.S. 184; 30 AFTR 384 (1943)]. Many of these delineated judicial doctrines have been used by the courts in assessing gift status and exclusion availability in recent cases.

Recent litigation. In Hackl v. Comm’r [118 TC 14], the taxpayers sought to diversify in conjunction with their estate planning objectives by purchasing two tree farms possessing little merchantable timber but capable of long-term growth. Under Indiana law, A.J. and Christine Hackl created Treeco, LLC, to shield their other assets from potential liability associated with tree farming. They wanted to create an entity in which their family could become involved and to facilitate the transfer of ownership in the tree farms to their descendants. On December 7, 1995, the Hackls contributed two tree farms and $500 each to Treeco, in exchange for voting and nonvoting shares. The husband and wife each held 50% ownership. On the same day, the Hackls adopted an operating agreement for Treeco. Pursuant to this agreement, the manager was exclusively vested with prudently running the business in the best interests of the company. The manager had approval rights over all distributions and withdrawals; the members could not sell, transfer, or encumber their units without the manager’s approval. Members could remove the manager with a majority vote and amend the agreement with an 80% majority. A.J. Hackl was appointed manager for life, and subsequently, the Hackls made additional contributions to Treeco. On December 29, 1995, they began a gifting program with the Treeco units and claimed the annual exclusion. The gifting program was continued during 1996. The IRS disallowed the 1996 exclusion and contested the valuations.

The sole issue to be determined by the Tax Court was the availability of the annual exclusion. The issue became whether the gift was a present or future interest. The petitioners contended that the gift was the units of Treeco, which, under Indiana state law, are personal property separate and distinct from the Treeco assets.There were no restrictions placed on the Treeco units, and donees received the same rights as the donors. Under statute, postponement attaches to the transfer, not the transferred property. As a result, their transfer had no restrictions. The IRS contended that the restrictions contained within the operating agreement made this a gift of a future interest. The court sided with the IRS, reasoning that judicial interpretations for IRC section 2503(b) infer a substantial present economic benefit. Where immediate use, possession, and enjoyment are based on some future event, the gift is not of a present interest.

In Knight v. Commissioner (115 TC 506), Herbert D. and Ina F. Knight formed the Herbert D. Knight family limited partnership under Texas law on December 28, 1994. They transferred $2 million in real and personal property to the partnership. In return, each spouse received 50 units and a 50% interest in the partnership. Simultaneously, the Knight Management Trust and trusts for their two grown children were created. Each child was beneficiary and trustee of their own trust. The Knights each transferred 1.5 units to the Knight Management Trust and 22.3 units to each of the children’s trusts. The partnership agreement prohibited withdrawal from the partnership or return of contributions or capital account balances. It set the life of the partnership at 50 years, unless all partners agreed to dissolution.

The IRS contended that the partnership lacked economic substance, such as records, employees, financial reports, business meetings, operational discussions, business activities, and rental payment, which are required under federal law. It cited decisions based on both the economic-substance and substance-over-form doctrines.

The court agreed with the cited substance-over-form transfer tax cases because, in this case, the limited partnership form would be taken into account by a willing buyer. While Judge Foley concurred with the result, he wrote on several points, emphasizing that the economic-substance doctrine is generally used successfully when a taxpayer tries to disguise the donor or the donees. It is not useful to disregard an entity under state law for transfer tax purposes in order to disallow valuation discounts. One aim of estate planning is tax minimization. If taxpayers are willing to reduce the value of their assets through the entity form, the court cannot disregard such facts.

The facts in Estate of Strangi v. Comm’r (115 TC 478) are as follows: After Albert Strangi was diagnosed with supranuclear palsy, his son-in-law, under a power of attorney, formed Stranco, Inc., and SFLP, a limited partnership, under Texas law in August 1994. Strangi became the 99% limited partner by contributing $10 million in assets, and Stranco became the general partner. Stranco was funded with cash from Strangi for a 47% interest; Strangi’s four children contributed cash proportionately for their combined 53% interests. Albert Strangi died in October 1994.

The IRS contended there was no business purpose or economic substance to the partnership. The court agreed with the IRS that the nontax motives for the partnership were weak. After disproving each economic motive listed by the estate, the court noted that the partnership was valid under Texas state law. The partnership form changed the relationship of Strangi to his heirs and any potential creditors. Regardless of the subjective nature of the taxpayer’s motives, the partnership would not be disregarded by a willing buyer. The IRS contended that the value of the partnership interest received by Strangi should equal the value of the underlying assets given up. Because the transfer was not equal, there was a gift on formation. The court sided with the taxpayer on this issue, and refuted the IRS’ argument because the value of the contribution had been allocated in whole to Strangi’s capital account. No other interests were enhanced by the contribution.

The taxpayer in Shepherd v. Comm’r (115 TC 376) signed the Shepherd family partnership agreement on August 1, 1991, under Alabama law. Shepherd and his wife transferred two parcels of land to the partnership at the same time, which was recorded on August 30, 1991. On August 2, 1991, Shepherd received a 50% interest in the partnership and each of his two sons received a 25% interest. On September 9, 1991, Shepherd and his wife transferred stock in three banks to the partnership. All the contributions were recorded proportionately to their capital accounts. The Shepherds’ 1991 returns listed the gifts as land and bank stocks, and the IRS issued a deficiency notice, contesting the land’s valuation.

Shepherd asserted the value of the land was in fact overstated on the returns. He contended the transfer of land was actually to the partnership in exchange for his interest. Subsequently, he transferred 50% of the partnership to his sons. The actual gifts were a partnership interest and an enhancement of an already held partnership interest. The IRS thought that the land transfer was actually a gift on formation to the partnership and, consequently, an indirect gift to the partners. Moreover, the transfer of the bank stocks was also a gift to the partnership and indirect gifts to the partners pursuant to Treasury Regulations section 25.2511-1(h)(1).

The Tax Court held for the IRS on this issue. The Court of Appeals affirmed the Tax Court decision. In a dissenting opinion, Justice Ryskamp of the Eleventh Circuit noted that the affirmation constituted form over substance. The intention was to have the sons holding family assets in the partnership form. As rebuttal, the court provided that while the substance-over-form doctrine is applicable, concrete actions had been taken by the taxpayer, who cannot later assert that he did not intend to take those actions.

In Stinson Estate v. United States [(CA-7), U.S. Court of Appeals for the Seventh Circuit, No. 99-3333, May 26, 2000, affirming U.S. District Court for Northern District of Indiana], the children and grandchildren of Lavonna J. Stinson formed a family corporation, Stinsons, Inc., under Indiana law. In exchange for their stock, 160 acres of farmland was contributed to the corporation. After the corporation was formed, Stinson sold her property to the corporation for a note of approximately $400,000. Over the course of four years, she forgave $147,000 of the note via the annual exclusion. Upon her death, the IRS audited the estate and disallowed her use of the annual exclusion for the forgiveness of debt. The IRS’ position was that the gift of debt forgiveness was an indirect gift to the shareholders. The IRS also noted that, inasmuch as no one shareholder could force liquidation of the corporation or declare a dividend, the gift was a future interest. The court concurred with this analysis and found for the IRS.

In Larry L. Sather, Donor, et al v. Comm’r (U.S. Court of Appeals for the Eighth Circuit, No. 00-2171, June 7, 2001, 2001 U.S. App. LEXIS 11844; affirming in part and reversing in part 78 TCM 456, T.C. Memo 1999-309), three brothers, each with a wife and three children, transferred their interests in the family business to three irrevocable trusts over the course of two years. The children of each family were beneficiaries of one trust. Each brother and his wife gifted their shares to all three trusts, utilizing nine annual gift exclusions. A fourth, unmarried, brother likewise transferred his shares to the trusts. Upon conclusion of the gifting program, each trust owned one-third of the family business. The IRS disallowed six of the nine exclusions claimed each year by the brothers and their wives, based on the reciprocal trust doctrine established by the Supreme Court. Each brother’s children received exactly what they would have received from their parents, had they received all that their parents gave. The Tax Court concurred with the IRS, and the Eighth Circuit affirmed this position on appeal.

In Estate of W. W. Jones II v. Comm’r (116 TC 121), W. W. Jones II owned the surface rights to two large ranches in Texas, and his five grown children owned the surface rights to one ranch. On January 1, 1995, Jones created two family limited partnerships under Texas law. Jones contributed one ranch to each partnership. In the first partnership (JBLP), Jones received a 96% limited partnership interest, and his son contributed his one-fifth interest in the ranch he owned with his sisters in return for a 1% general partnership interest and a 3% limited partnership interest. In the second partnership (AVLP), Jones received an 88% limited partnership interest, and his four daughters, in return for their contribution of their interests in the ranch owned with their brother, each received a 3% interest, some general and some limited. On that same day, Jones gifted 86% of his interest in JVLP to his son and split 77% of his interest in AVLP equally among his four daughters. Each partnership agreement placed stringent restrictions on the transfer of units in an attempt to create deep discounts on valuation. Timely gift tax returns were filed.

The first issue to be decided by the Tax Court was the issue of gift on formation evinced by the IRS. Using the values reported on the gift tax returns for the limited partnership units, the IRS contended that, on formation of the partnerships, W.W. Jones II contributed more value than he received, and this difference should be recognized as a gift on formation under IRC section 2511(a). The court disagreed and found for the estate. The court held that, because Jones received a continuing limited partnership interest and the contribution was credited to his capital account, no gift on formation had been made.

In Estate of Morton B. Harper v. Comm’r (TC Memo 2002-121), Harper, an entertainment industry lawyer, created the Morton B. Harper Trust, a revocable living trust, in December 1990. Sometime in 1994, Harper formed a limited partnership and contributed the majority of his assets to the partnership. The Harper Trust became the 99% limited partner. The general partners were Harper’s two grown children, with .6% and .4% partnership interests. Michael Harper, the donor’s son and .4% general partner, was appointed managing general partner. The trust capital account was credited with 99% of the value of the contributed property; the general partners were credited with the balance in their respective proportionate shares. In addition to California state law requirements, the partnership agreement placed severe restrictions on the abilities of the general partners to act without consent of the limited partner. An amendment to the agreement of limited partnership on July 1, 1994, transferred 60% of the limited partnership units from the trust to Harper’s children. His son received a 24% interest and his daughter received a 36% interest, credited to each of their capital accounts. Harper died on February 1, 1995. A gift tax return was filed for 1994, and an estate return was received by the IRS on November 2, 1995.

The estate’s position was that the partnership was legal under California law and must be recognized. The IRS’ position was that all of the decedent’s assets were includable in the estate under IRC section 2036(a), making the partnership’s existence a moot point. Their alternative argument was that the partnership lacked economic substance and should be disregarded. The court found for the IRS. The court noted that the facts of this case showed little respect for the form of the entity. Commingling of funds and disproportionate distributions constitute an implied agreement allowing the donor to retain the benefit of the partnership assets even as he transferred title. Because the revocable living trust was the limited partner, with 99% ownership, the court viewed this as merely changing the form in which Harper held his assets; he had full control in either form.

The courts have been reluctant to disregard the entity form in recent cases when the entity has complied with state laws. Restrictions in excess of state laws will compromise the annual exclusion. The Exhibit gives a summary of recent judicial decisions in the matter.

Additional Considerations

The IRS has had little litigation success in having intrafamily gift transfers treated differently from transfers among unrelated parties for valuation purposes. Congress enacted Chapter 14 in 1990, which outlined special valuation rules for intrafamily transfers of interests in corporations, partnerships, or trusts (IRC section 2701, 2702), in order to prevent potential abuses. IRC section 2703 dictates that certain restrictions will be disregarded in valuations unless the restrictions are comparable to similar bona fide business arrangements in an arm’s-length transaction. The use of lapsing voting or liquidation rights will cause inclusion in the gross estate of the donor pursuant to IRC section 2704. Among other statutory exceptions, restrictions imposed by federal or state laws are not governed by IRC section 2704.

Appraisals. Appraisals can be pivotal when valuation issues are litigated. Case law allows the court much flexibility. The evidence submitted by experts provides the guidelines, and the experts’ opinions are evaluated in light of their qualifications. An experienced valuation specialist will bolster the valuation contentions of both petitioner and respondent. Perceived bias will serve to discount any expertise presented.

Procedure. In its simplest form, the required information to be filed with the gift tax return is delineated in the instructions for Form 709, Supplemental Disclosures. An appraisal must be included with the return to support valuations and discounts. IRC section 6501 extends the statute of limitations to six years when more than 25% of the value of total gifts is omitted from a return. This can be avoided if enough information is included with the return to inform the IRS of the nature and amount of the item. The documents forming the family entity and the policies and procedures used in managing the entity usually contain enough information to properly evaluate the transfer, and supporting evidence should be attached and explained.

Bartering. Using the exclusion and valuation discounts is essential to estate planning; however, the two techniques can work at odds with one another. From a financial perspective, the choice depends upon what the figures show. Valuation discounts are based upon restrictions. Stringent restrictions thereby move the transfer away from a present interest to a future interest.

Aggressive strategy. When the underlying assets of a family entity are interests in a closely held entity, multiple discounts could be available. An aggressive position would initially discount the assets held within the closely held entity. Additional discounts would then be taken on the value of the entity units transferred as a gift.

Planning Strategies

Even though the IRS is trying to disregard the entity as a first step in gift tax cases, the courts are somewhat reluctant to accept this. If the taxpayers themselves disregard the entity, however, the courts have sided with the IRS. The IRS’ gift-on-formation doctrine has been successfully defended. In spite of value disparities between what is contributed and what is received, the entity’s validity is usually upheld when only the donor’s interest is enhanced. The IRS has generally considered gifts of family entity units to be gifts of a present interest. The exclusion could be jeopardized if state law or agreements do not serve to restrict the interests beyond those of the RULPA and the synonymous corporate rules.

Estate planning techniques have consistently integrated family entities into the overall plan. It may not be possible to simultaneously secure the annual exclusion and valuation discounts. Nonetheless, restrictions, especially in the area of distributions, withdrawals, and transfers, should be no more stringent than state laws permit. For withdrawals, addressing and adhering to some system of distribution will supportive the donor’s position of a present interest. In addition, rights beyond the first right of refusal on transfers can jeopardize the present nature of the interest.

Ted Englebrecht, PhD, is the Smolinski Eminent Scholar Chair, and Mary Anderson, MPA, CPA, is a doctoral candidate, both in the school of professional accountancy at Louisiana Tech University, Ruston, La.