For federal estate tax purposes, I.R.C. §2031 "defines" the gross estate as the "value" of all of a decedent's property.

1. The Regulations set forth the "classic" description of fair market value as the determining factor: "The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."

2. A parallel provision is contained in the gift tax provisions. Reg. §25.2512-1.

3. These determinations of value are essentially factual determinations.

1. General approach: "A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases." Factors to consider when analyzing value include:

2. "The size of the block of stock itself is a relevant factor to be considered. Although it is true that a minority interest in an unlisted corporation's stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock." Id.

3. Revenue Ruling 59-60 continues (with amplification) as the fundamental pronouncement of value from the Internal Revenue Service. See: Rev. Rul. 83-120; Rev. Rul. 80-213; Rev. Rul. 77-287; Rev. Rul. 65-193.

"The lack of marketability discount applies to bridge the valuation gap between investment assets that are readily saleable in an active market and those which offer no such liquidity opportunity to the hypothetical purchaser. The absence of a market means that the purchaser cannot assume the availability of a buyer when his time comes to sell, with the result that the purchaser will probably experience trouble in disposing of the property, and, moreover, the selling price will often be hard to establish. The outcome may well be the acceptance of a lower price to attract a buyer. Almost 30 years ago the courts began to recognize this compensating discount over the objections of the Service. Wallace, "Now You See It, Now You Don't – Valuation Conundrums in Estate Planning," 24 Inst. Est. Plan. ¶ 803.2, 8-9 (Miami 1990).

1. "Registered stock and partnership interests sold in a public market can generally be sold immediately and for cash. Even without legal or contractual restrictions on an ownership interest, and even if the seller has voting control, the owner of a privately held company must wait until he or she can locate a willing and qualified buyer with whom he or she can negotiate and close the sale. Even then, the seller may be required to finance a part of the acquisition price to make the sale possible. His or her interest in the closely held company is not liquid, and he or she must discount the present value of his ownership interest to account for the time value of money. This discount is generally called a discount for lack of marketability. For a controlling interest, the market discount considers the time cost of money, the present value of the investment discounted by the cost of investment capital as determined by the investment risk." Gibbs, "Do You Speak Tax, Mr. Appraiser? Evaluating the Appraiser and the Appraisal Report After 1990," 27 Inst. Est. Plan ¶ 1502.5, 15-16, 15-16 (Miami 1993).

2. "In the past three or four years, the liquidity of the U.S. economy as a whole has vastly improved, and this new factor is reflected in almost all types of financial markets. It would be very much to be expected, therefore, in valuing closely held securities, that a tendency toward greater discounts in these times would be observed, especially if that discount were occasioned by a perceived lack of today's quite common liquidity. Wallace, supra. at ¶ 803.3, 8-13 (quoting from Moore, "Valuation Revisited," 126 Tr. & Est. 40, 43 (Feb 1987).

"A separate and distinct discount applies to reflect the fact that a shareholder who owns less than a majority interest cannot control current or long-range managerial decisions, impact the future earnings or growth potential of the enterprise, establish executive compensation, and the like. More significantly, the minority interest discount compensates for the inability of a minority owner to obtain a representative share of the underlying assets in the company, which often represent a premium value compared with the ongoing current yield produced by those assets. This latter valuation discrepancy is often exacerbated when the minority interest is in a holding company owning valuable properties invested for long-term growth, or operating businesses, such as a ranch or a timber company, which historically produce a relatively low level of earnings in comparison with the values of their underlying assets." Wallace, at ¶ 803.4, 8-14, 8-15.

1. Taxpayer victories have reversed long-standing Internal Revenue Service policy not to give discounts due to built-in gain problems. Since repeal of the General Utilities Doctrine, this is a serious issue. The pro-Taxpayer cases are: Est. of Davis, 110 T.C. 552 (1993) and Eisenberg v. Commissioner, 155 F.3d 50 (2nd Cir. 1998).

2. Estate of Jameson v. Comm., 267 F.3d 366 (5th Cir. 2001) discussed the issues involved in calculating the extent of the capital gains discount. The Internal Revenue Service argued that the purchaser would not sell off timber but would hold the property whereas the taxpayer argued that the hypothetical buyer would sell off timber creating immediate gain. The speed of sell-off would determine the present interest of the discount. The case was remanded for the factual determination.

3. In Jones v. Comm., 116 T.C. 121 (3/6/01), the Tax Court rejected a built-in gains discount for a family limited partnership based on the assumption that a limited partner could effectively get a §754 adjustment. See discussion below.

1. TAM 200247001 held that there should be no discount on an IRA to reflect income tax "taint" carried by § 691 property. The ruling recited that § 691 provides a statutory remedy to the double tax potential via the estate tax deduction.

2. Also see TAM 200303010 which rejected any discount for Series E US Saving Bonds.

1. Tax-effecting is an adjustment that is made to valuations based on a discounted cash-flow approach. An S Corporation pays no income tax at the corporate level. When a discounted cash-flow analysis is being made to an S Corporation, the issue is whether to normalize free cash/flow by subtracting a hypothetical income tax to make the calculation comparable to C Corporations. "[A]ppraisers disagree on whether it is appropriate to tax-effect the income of an S Corporation. The argument in tax-effecting stresses that many potential buyers of S Corporations are C Corporations. Because a C Corporation would be unable to maintain a target company's S Corporation status following an acquisition, the C Corporation would tax-effect the S Corporation's income (at C Corporation rates) in deciding how much it would pay for the S Corporation...by contrast, the argument against tax-effecting stresses that although an S Corporation's stockholders are subject to tax on the corporation's income, they are generally not subject to a second level of tax when that income is distributed to them. This would make an S Corporation at least somewhat more valuable than an equivalent C Corporation. However, tax-effecting an S Corporation's income, and then determining the value of that income by reference to the rates of return on taxable investments, means that an appraisal will give no value to S Corporation status." John E Wall, 81 T.C.M. 1425 (2001) at footnote 19.

2. In Walter L. Gross, Jr., 78 T.C.M. 201 (1999) the Tax Court rejected the opinion of the taxpayers' expert that projected earnings should be tax-effected. A divided 6th Circuit affirmed the Tax Court ___ F.3d ____ 2001, WL 1456356 (6th Circ. 11/19/01). In the Court of Appeals, the Court held that the Tax Court did not abuse its discretion in allowing the Internal Revenue Service appraiser to testify as to value without making an adjustment for tax-effecting. The Court, in part, based this conclusion on the fact that it was factually determined that it was not established that there was any likelihood that the S election would be lost. Indeed, in the Gross case the shareholders had signed an agreement to maintain the S election.

3. Gross involved the gift of a small minority of shares in the S Corporation. See also Adams, T.C. Memo 2002-80 likewise rejecting tax-effecting.

1. Generally, there is no family attribution when determining "control" for gift or estate tax purposes.

2. In TAM 9436005, the Internal Revenue Service took the position that a gift of a minority interest in the family business should be adjusted upward when the gift represents the "swing vote" when all shareholders are relegated to minority status by virtue of the gift.

3. Chapter 14 imposes family attribution concepts in respect to transfers of junior equity if senior equity retained. See IRC §2701. Family control of entity is also required for application of §§2703 and 2704.

4. In Mellinger v. Commissioner, 112 T.C. No. 4 (1/1/99), acq. 1999-35 IRB, 314 (8/l999) (result only); also Action on Decision 1999-006 (full acquiescence), it was held that stock held in a QTIP trust would not be combined with the stock held by the surviving spouse to determine whether a control premium should be applied. The Court held that IRC §2044 requires the value to be included in the survivor's gross estate but that interest is not aggregated with holdings by the estate. In Mellinger the surviving spouse was not a trustee of the QTIP and therefore could not vote the shares. If this is an important element restrictions on the surviving spouse's power to vote the QTIP shares may be prudent. In AOD 1999-006, no mention of this fact was referenced. Mellinger followed a similar result in Bonner v. U.S., 84 F.3d 196, 198 (5th Cir.) for community property jurisdiction.

5. In Est. of Fontana, 118 TC No 16 (3/28/02) the Tax Court refused to extend the Mellinger treatment to general power of appointment trusts. Thus, stock held by the surviving spouse and the general power of appointment trust was aggregated for valuation purposes.

1. In Murphy v. Comm'r, 60 T.C.M. (CCH) 645 (1986), a transfer 18 days before death of a small amount of stock (1.76%) to "convert" the decedent's holding to a minority position (49.65% after the transfer) was ignored. The Court found that the sole purpose of the gift was to impact the federal estate tax. [The transfer did "not appreciably affect decedent's beneficiary interest except to reduce Federal transfer taxes." At 661.] Obviously non-tax motivating factors need to exist. Murphy did not involve a change in the legal form of the asset which would involve very real state law rights. Instead it only involved a transfer of a small holding of existing stock.

2. The treatment in Murphy should be contrasted to the treatment of Estate of Frank, T.C. Memo 1995 - 132 (3/28/95). In Frank, Mr. Frank held a controlling interest in a corporation which, in turn, owned and operated various motels located on the New Jersey shore. The other stock was held by his wife and children. Two days before his death, his son transferred corporate stock under a durable power of attorney from the father to the mother. The mother died approximately two weeks after the father. One result of the transfer of the substantial block of stock from the father to the mother was to reduce the father's ownership from 50.2% to 32.1%. The memo opinion held: "As a general rule, we will respect the form of a transaction. We will not apply substance over form principles unless the circumstances so warrant." The Court held that "if tax avoidance was the sole motive, a substantially smaller number of shares could have transferred. We find it unnecessary to decide this dispute over the motive for the transfer."

1. Obviously, the valuation report is key to negotiating through an audit, or winning in Court. Indeed, the best insurance against being in Court is having a solid valuation report that could be used in Court. Judge David Laro, of the U.S. Tax Court gave his recommendations for presenting an expert before the Tax Court on a valuation issues (from a speech given by Judge Laro 1/18/01 before the 2001 Advanced Estate Planning Institute of San Francisco, California):

2. The appraisal submitted with the 706 is difficult for an estate to later repudiate. See Estate of Leichter, 92 T.C. 312 (2003) where demonstrating that appraiser misstated date of death, failed to take into account liabilities, admitted improper methodology, etc. was not enough for the taxpayer to rebute the position taken on the 706. Those preparing the 706 need to focus on mistakes in factual assumptions before the position on the 706 is finalized.

The Revenue Reconciliation Act of 1990 enacted Chapter 14 to the Code (comprised of §§2701 - 2704) for transfers generally after 10/8/90. These new rules cover certain situations where an intra-family transfer occurs and the transferor (or certain other family members) retain certain other interests in the property (an "applicable retained interest"). Generally, Chapter 14 addresses the value of the gift.

1. Section 2701 generally attacks corporate and partnership recapitalizations designed to freeze the senior interest. Mechanically, the provision forces the "subtraction method" of valuation for gift purposes and dictates that certain discretionary rights are to be ignored for the purpose of calculating the interest.

2. Section 2702 addresses trust and/or term interests.

3. Section 2703 deals with restrictions on transfers (buy-sell agreements) in the family context.

4. Section 2704 deals with lapsing liquidation and/or voting rights in a corporation or partnership. This is the "anti-Harrison" provision.

1. Section 2704(a) treats the lapse of the liquidation and/or voting right as a transfer subject to the gift or estate tax in the family context.

2. Section 2704(b) deals with a gift of an interest whereby the transferor retains control of by disregarding the restriction.

4. Even if 2704(b) disregards a restriction on liquidation, the withdrawing partner may not be entitled to a proportionate share of the asset value of the Partnership.

5. Whether a retained liquidation right forces use of a valuation based on the underlying assets is far from certain:

I.R.S. Regs. §1.701-2 (an income tax regulation) provides general rules designed to impose a substance-over-form rule on partnerships for income tax purposes.

1. Generally these rules require that the partnership is bona fide and that the transactions accurately reflect the partners' economic agreement.

2. In the regulations, two examples raised questions as to whether §701 was to be extended to estate and gift tax treatment of family partnerships.

Retained powers under 2036(a)(1). Retention by the donor of a general partnership interest or voting stock is not a 2036(a)(1) retention of possession or enjoyment of, or the right to the income from, the transferred property.

1. Internal Revenue Service's defeat in Boykin v. Commissioner, 53 T.C.M. 3454 followed by the enactment and retroactive repeal of IRC Sec. 2036(c) with its estate tax inclusion model, and now the gift tax valuation approach of Sec. 2701 should discourage Internal Revenue Service from pursuing federal estate tax inclusion based upon the retention of income rights in a family limited partnership or other business entity. Nevertheless, caution must be exercised.

2. In a preferred partnership, it would be prudent to not retain 100% of the partnership profits, income or cash flow even if limited to a fixed dollar amount. Such total income retention might encourage Internal Revenue Service to argue for estate tax inclusion under 2036(a)(1) on the theory that the income of the transferred property has been retained by the transferor. Conceivably this could be a problem with Guaranteed Payments or Preferred Distribution Rights set at such high levels as to consume all of the income of the partnership. Although this should not cause an inclusion under 2036(a)(1) if the Guaranteed Payments or Preferred Return is based on a reasonable return for the capital and risk. Nevertheless, it would be prudent to structure the partnership distribution arrangement so that there is a sharing of profits and/or cash flow from the outset. This sharing can be accomplished by a tiered system of preferential distributions.

3. 2036(a)(1) also creates a risk if any beneficial use or enjoyment of the property of the partnership or business entity is retained by the transferor, for example, by living on or using the partnership property without full fair market value rent. See Estate of Dupont v. Commissioner, 63 T.C. 746 (1945) and cases cited therein. Rev. Rul. 7837003, Rev. Ruling 7842005 and the numerous other cases and Revenue Rulings dealing with retained beneficial enjoyment, "substance over form," sham, etc.

In Reichardt v. Comm., 114 T.C. 144 (2000) the Court ignored the partnership because of an implied agreement in the family that the decedent could retain use of partnership property just as he had before forming the partnership. The partnership included a residence that the father/transferor lived in rent free and the father/transferor retained all of the income from the other assets. Also see, Schauerhamer v.Comm., T.C. Memo 1997-244. See also, Knight v. Comm., 115 T.C. 506 (11/30/00) discussed below where the retained control was not enough to trip a § 2036(a) inclusion. There can be no doubt that retained beneficial enjoyment is a fruitful IRS attack position, however: Thompson v. Comm'r, T.C. Memo 2002-246; Strangi; an appeal as Gulig (5th Cir. 6/17/02); all discussed below.

IRC Secs. 2036(a)(2) and 2038(a)(1). Right to Designate Persons Who Shall Possess or Enjoy the Property or the Income Therefrom. 2036(a)(2) is usually considered in conjunction with 2038(a)(1) which includes in the grantor's gross estate the value of property transferred by trust or otherwise if the grantor has retained the right to alter, amend, revoke or terminate the enjoyment of the transferred property.

1. Case law has often applied 2036(a)(2) and 2038(a)(1) in cases where a settlor of a trust serves as trustee with fiduciary powers to determine the amount and/or timing of distributions from the trust, or the allocation of income between the income beneficiaries and remainderman. See U.S. v. O'Malley, 383 U.S. 627 (1966) and Lober v. U.S., 346 U.S. 335 (1953).

2. Cases have recognized, however, that a settlor's retention of mere managerial or administrative powers will not cause inclusion under 2036 or 2038. See Old Colony Co. v. U.S., 423 F.2d 601 (1st Cir. 1970). A settlor/trustee could even retain control over trust distributions if such power retained by the settlor/trustee is subject to an "ascertainable standard." See Leopold v. U.S., 510 F.2d 617 (9th Cir. 1975).

3. On first impression it might appear that the power of a general partner to distribute or retain partnership profits and assets would, if held by the settlor of a trust, be sufficient to cause inclusion under 2036(a)(2) and 2038(a)(1). Fortunately such estate tax inclusion is prevented by the important distinction articulated by the Supreme Court in U.S. v. Byrum, 408 U.S. 125 (1972) that the business interest effectively imposes an ascertainable standard on the Transferor's exercise of such fiduciary power.

4. In a series of Private Letter Rulings the Internal Revenue Service has consistently followed the Byrum distinction between fiduciary powers held as a majority shareholder or director of a corporation (or a general partner) and fiduciary powers held by the settlor of a trust. See T.A.M. 9131006, PLR 9310039 (involving a limited partnership created with a business purpose to invest partnership funds in stocks and securities for long-term growth), PLR 9415007 and PLR 9546006.

5. Internal Revenue Service appears to be increasingly suspicious of family limited partnerships as evidenced by the withdrawn EXAMPLES 5 and 6 to the regulations under Section 707. The Byrum case is the key to avoiding federal estate tax inclusion under 2036 or 2038 by reason of a general partner's broad management power. It would be prudent in drafting partnership agreements to (i) clearly indicate that the general partner has a fiduciary duty to the partnership and to the other partners in exercising all managerial powers of a general partner, and (ii) avoid giving the general partner such sweeping powers or exoneration of liability that could weaken or eliminate the general partner's fiduciary duties.

6. A precursor to the Byrum approach of superimposing an objective ascertainable standard to "control" held in a business context was expressed in the family partnership income tax rules. See Legislative History to IRC 704(c)(1) S. Rep. No. 781, 82nd Congress 1st Session 40, 1951. Retained controls are not detrimental if they are incident to normal continuing business relationships. It confirms the reality that business and economic requirements impose ascertainable standards on the transferor's retained management powers over a transferred business interest.

7. Maryland law imposes strict fiduciary standards on partners. Allen v. Steinberg, (1966) 244 Md. 119 imposed a duty of the "utmost good faith." As of 2003, however, the provisions of Maryland statutory law is somewhat ambiguous. Prior to 2003, the Uniform Partnership Act ("UPA") "defined" the obligations of a general partner in a limited partnership. Such definition was generally left to the Common Law. Effective December 31, 2002, however, the Revised Uniform Partnership Act ("RUPA") supplanted the UPA. Under the RUPA, the general partners' duties were, for the first time, spelled out rather than left to the common law and, by its terms, the RUPA was no longer "coupled" to the limited partnership act. A committee consisting of the Business Law, Taxation, and Estates and Trusts Sections of the Maryland State Bar Association reviewed the Re-Revised Uniform Limited Partnership Act (2001) which had been updated to reflect the decoupling that occurred with ReRULPA. Under § 408, "General Standards of General Partnerships' Conduct" the commissioners for the Uniform Act provided that the only fiduciary duties a general partner would have to the limited partnership or to the other partners would be the duties of loyalty and care. Additionally, those duties were truncated by that article. The committee suggested changes to the 2001 Uniform Act § 408 to provide: "A general partner has a fiduciary duty not to withhold distributions of partnership cash flow to the partners beyond the reasonable needs of the partnership to maintain adequate reserves for liabilities and future expenditures. This duty may be waived or altered by the partnership agreement." The proposed revision to the Uniform Limited Partnership Act was not introduced in the 2003 Session of the General Assembly. Regardless of whether or not such act would become law it would be prudent to put in any limited partnership agreement an obligation for the general partners to have Byrum type fiduciary standards.

8. See Hackl and PLR 9751003, discussed below, for the penalty for sidestepping the fiduciary duty.

Estate Tax Inclusion under 2036(b). This is the "anti-Byrum" amendment to 2036, intended to reverse the Byrum rule in respect to voting rights directly or indirectly retained by the transferor in the stock of a controlled corporation. 2036(b) does not expressly apply to partnerships – only to a retained power to vote stock of a controlled corporation. The Senate Committee Report on P.R.95-600, i.e. 2036(b), clearly indicates that retaining voting stock and transferring nonvoting stock is not subject to inclusion under 2036(b).

1. Concern has been expressed that controlled stock transferred to a partnership might be brought within the scope of 2036(b) on the theory that the general partner has indirectly retained the power to vote such shares. One PLR has held that a partnership wrapper was over closely-held stock fails as "indirect" control of voting rights. TAM 199938005. The case involved settled after being docketed. Coulter v. Comm., T.C. Dkt. No. 17458-99 (filed 11/17/99; settled 11/23/01).

2. This potential 2036(b) exposure can be eliminated by recapitalizing the corporation and transferring only non-voting stock to the FLP, if the parent is to be the general partner, or have someone other than the original owner of such controlled corporation stock serve as the general partner.

Background. IRC §2503(b) permits an annual gift tax exclusion for "a present interest in property."

1. Gifts to a trust, absent a "Crummey Power" to withdraw the contribution to the trust are not present interests.

2. Various Internal Revenue Service rulings reject this analogy by arguing that the Byrum-type fiduciary duty of the general partner to the limited partners is undistinguishable from the duty the board of directors has to its shareholders.

1. The Tax Court held that gifts of units of a family LLC did not qualify as annual exclusion gifts under IRC §2503(b) because the gifts did not constitute present interests.

2. The LLC was established by the father to invest in tree farms as a method of setting up a long-term growth investment. The operating agreement named the father as managing member for his lifetime or until removed and authorized him to name his successor.

3. The Court held that the prohibition on transfer, demand rights to return the capital contribution, withdrawal from the LLC, or right to trigger dissolution meant that gift lacked a present economic right. Also the fact that no income could be expended for years from the LLC with respect to the units was a factor.

4. There have been lots of comments suggesting how to avoid the Hackl lack-of-present-interest problem. One would be to give the limited partner a right to transfer subject to a first right of refusal. This may only work if there is a market for the interest. Other suggestions include building in crummy-like powers to withdraw the donee's share of capital or give the donee a time-limited "put." These latter methods may, however, defeat the discount. A right to transfer coupled with a semi-realistic anticipation of distributions would seem to handle the present interest issue. For larger gifts, of course, Hackl is not the focus in any event.

1. "A minority discount for an interest in real property may be allowed on account of the lack of control which accompanies co-ownership. Estate of Campanari v. Commissioner. However, a holder of a fractional interest in real property has the power to compel partition of property, which is not available with other types of shared ownership interests. Bittker & Lokken, Federal Income Taxation of Estates, Gifts, & Trusts, par. 135.3.4, at 135-41 (2d ed. 1993). Accordingly, Bittker & Lokken have suggested that the discount should reflect the cost of partition and the value of the interest secured thereby. Id. We have on several occasions considered the cost, uncertainty, and delays attendant upon partition proceedings as the basis for allowing a discount in valuing fractional interests in real property. Estate of Pillsbury v. Commissioner, T.C. Memo. 1992-425; Estate of Wildman v. Commissioner, T.C. Memo. 1989-667; Estate of Youle v. Commissioner, T.C. Memo. 1989-138; Sels v. Commissioner, T.C. Memo. 1986-501; see also Estate of Henry v. Commissioner, supra at 477. The marketability discount, by contrast, measures the diminution in value attributable to the lack of a ready market for the property. Ward v. Commissioner, 87 T.C. 78, 106-107 (1986). Accordingly, we will consider each discount separately."

2. The Court permitted a 20% minority discount and a 10% marketability discount.

1. The Tax Court granted a 44% discount (consisting of a blending of a 20% marketability discount with a 30% lack of control discount) for a 50% tenant in common interest in timberland.

2. In this case, the Internal Revenue Service expert did not evaluate the standing timber to give an opinion of the worth of that primary asset or give an opinion as to the discount due to the partial interest in the asset held by the taxpayer. The expert did, however, admit on cross-examination that an undivided 50% interest has a limited market and that a fractional interest should be discounted. This case shows the importance of presenting the factual elements of the case for supporting one's valuation position.

1. Husband and wife died within a year of each other holding tenant-in-common interests in timberland through separate revocable trusts. Large (60%) discounts were permitted based on lack of control and the delay in the ability to sell partial interests.

1. Kimbell was an estate tax case that involved a decedent with a 50% interest in an LLC general partner (the other 50% held by the decedent's son and daughter-in-law) and the decedent held a 99% limited partnership interest. The decedent was 96 years old at the time of her death. Two months before her death she formed the family partnership by having the LLC contribute 1% of the capital in exchange for the general partnership interest and the limited partner contributing 99% of the capital in exchange for limited partnership interest. The court pointed out that the term of the partnership was for 40 years which would make her 136 years of age when it terminated.

2. Kimbell was a refund case brought in the District Court for the Northern District of Texas. The District Court held that there was no effective transfer of property to the partnership because the transfers failed to qualify for either of the exceptions under § 2036.

First, the Court rejected that the decedent exchanged property for "money and money's worth" so as to come within the "bona fide sale" exception of § 2036. The District Court held that the decedent not only stood on both sides of the transaction but for all purposes "was both sides of the transactions." Thus, there was no arms length transfer. More to the point, of course, was the holding that an exchange of the underlying assets for a partnership interest was not adequate consideration.

3. The Court also held that the transfer violated § 2036: "Plaintiff contends that decedent did not have the power to take over the partnership because she had fiduciary duties. Plaintiff makes much of the Supreme Court case, US v. Byrum... in which the court held that § 2036 did not apply to a decedent who retained voting interest in several corporations. However, Byrum is not only distinguishable on its facts from our case, but was expressly overruled by congressional enactment of § 2036... Moreover, § 2.95 of the partnership agreement states: 'The general partner will not owe a fiduciary duty to the partnership or to any partner.'... assuming such fiduciary duties exist to whom does a partner which owns 99% of the partnership owe them? The fiduciary argument falls flat."

1. In Thompson, the IRS attacked two partnerships that the decedent established, one for each child. The IRS claimed the full fair market value of the assets in the partnerships should be included in the decedent's gross estate based on (i) that the FLP lacked economic substance or (ii) that the decedent retained the economic benefit and control over the assets under § 2036(a). The court held for the IRS, noting the following:

1. Harper involved another successful § 2036(a) attack by the IRS to include all of the partnership interests in the decedent's estate. In Harper, the court recited that the general purpose of § 2036(a) is to include in the decedent's gross estate transfers that are essentially "testamentary in nature." The court held that the term "enjoyment" contained in § 2036 is "synonymous with substantial economic benefit" and stated that this retention of benefit can be pursuant to an implied understanding even if such implied understanding is not legally enforceable.

2. The court found that there was retained enjoyment of the assets by the decedent based on certain indications of the implied understanding: (i) the commingling of funds which evidenced the lack of any degree of separation between the assets and the decedent, (ii) a history of disproportionate distributions to the decedent, and (iii) the "testamentary characteristics of the partnership agreement" which was seen by the fact that the "decedent continued to be the principal economic beneficiary of the contributed property after (the partnerships) creation."

3. The court also rejected the taxpayer's position that the cases (Shepherd, Jones, Strangi, Harrison, and Church) "established that a proportionate partnership interest constitutes per se adequate and full consideration for the contributed assets." Instead, the court looked at whether the partnership was a true pooling of assets or whether it was simply an estate planning vehicle.

4. It should be noted that Harper involved a tax planning attorney who seemed to have documented that (i) although he was sick that he was not making decisions based on end-life considerations and (ii) that he came up with a very good business purpose (asset protection which was a real consideration given some economic difficulties encountered by his daughter).

1. Shepherd was a gift upon creation case. In that case, a father contributed leased timberland and bank stock to a partnership which he had formed with himself as a 50% partner each of two sons holding 25% interest. Under these circumstances, the Tax Court concluded that the transfer of property to the partnership represented indirect gifts to each of the sons of undivided, 25% interests in the leased timberland and bank stock.

2. In Shepherd, the Court stated that a transfer to a partnership for less than full and adequate consideration may represent an indirect gift to the other partners. "Obviously, not every capital contribution to the partnership results in a gift to the other partners, particularly where the contributing partner's capital account is increased by the amount of his contribution, thus entitling him to recoup the same amount upon liquidation of the partnership. In the instant case, however, petitioner's contributions of the leased timberland and the bank stock were allocated to his and his sons' capital accounts according to their respective partnership shares."

3. The Tax Court permitted a 15% valuation for the gift of a partial undivided interest in the underlying property. Interestingly, a dissenting judge (Judge Beghe) would have denied any discount based on an "estate depletion" theory of gift tax where the value of the gift would be the loss to the donor not the gain to the donee.

4. The taxpayer appealed Shepherd to the 11th Circuit and the opinion was affirmed No. 01-12250 (11th Cir. 2002). See also TAM 200212006 when no discount was given on an indirect gift on formation where the property constituted publicly traded municipal bonds.

1. In Knight the Internal Revenue Service attacked the formation of a partnership as lacking economic substance. The taxpayers (parents) set up a family partnership with a management trust as the 1% general partner (wholly owned by the parents) and each parent holding 49.5% limited partnership interest. The partnership was funded with approximately $2 Million of assets which included a ranch, residences, a municipal bond fund and treasury notes. There was a lack of record keeping, no management participation by the non-parent partners, or much other indication that the change of ownership had occurred. Nevertheless, the Tax Court upheld the taxpayer's claim that the partnership form must be respected: "Petitioners content that their rights and legal relationships and other of their children changed significantly when Petitioners formed the partnership, transferring assets to it, and transferred interest in the partnership to those children...and that we must recognize the partnership for federal gift tax valuation purposes. We agree with the Petitioners. State law determines the nature of property rights and federal law determines the appropriate tax treatment of those rights. The parties stipulated that the steps followed in the creation of the partnership satisfied all requirements under Texas law, and that the partnership had been a limited partnership under Texas law since it was created. Thus, the transferred interests are interest in a partnership under Texas law. Petitioners have burdened the partnership with restrictions that apparently are valid and enforceable under Texas law. The amount of tax for federal estate and gift tax purposes is based on the fair market value of the property transferred...we do not disregard the partnership because we have no reason to conclude from this record that a hypothetical buyer or seller would disregard it."

2. Once funded the taxpayers each transferred a 22.3% interest to each of their two children. Thus, after the transfers, the children (in a children's trust) each held 44.6% and the parents each retained a 4.9% limited partnership interest (as well as holding the 1% general partnership interest). The taxpayers took a 44% discount for 709 purposes. This was based on a 10% portfolio discount, a 10% minority interest discount and a 30% lack of marketability discount which aggregated at 44%. The Tax Court set aside the evidence of the taxpayers expert based on the expert's use of inappropriate comparables and/or based on the lack of objective analysis: "We have rejected expert opinion based on conclusions which are unexplained or contrary to the evidence...an expert fails to assist the trier of fact if he or she assumes the position of an advocate...[the expert's] erroneously factual substance passed out on his objectivity." (Citations omitted). Instead, the Tax Court granted a 15% discount taking into account materials "in the record" related to closed-end bond funds.

3. The gifts of limited partnership interest were made pursuant to a transfer document that stated that each 22.3% gift was limited in value to $300,000. The Internal Revenue Service attacked this restriction as being a formula gift that is void as against public policy. Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944) and Ward v. Commissioner, 87 T.C. 78 (1986). "In Procter, the transfer document provided that, if a Court decided a value would cause a part of the transfer to be taxable, that part of the transfer would revert to the donor." The Tax Court, however, did not use the Procter analysis but factually distinguished the Knight situation as not being a formula gift but being a gift of a specific percentage interest in the partnership. Because the Tax Court found a 15% discount instead of a 44% discount, the Knights were liable for gift tax.

4. The Internal Revenue Service did not appeal Knight.

1. In Strangi, the partnership was formed under a power of attorney two months before the decedent's death. The decedent retained a 99% limited partnership interest. The decedent was also a 47% shareholder in the corporate general partner. The general partner held a 1% interest in the partnership. The decedent's children paid for the 53% interest in the corporate general partner. Much of the assets were marketable securities. Strangi (i) rejected a 2703(a) attack, (ii) rejected the gift on formation attack, and (iii) permitted a 31% discount. In reached its opinion, however, the majority clearly were not supportive of the extent of the discounts and suggested that it would have used an IRS §2036 attack per Reichardt v. Commissioner, 114 T.C. 144 (2000) but found that the Internal Revenue Service had not timely raised that argument in a timely fashion. It should be noted that there were spirited dissenting opinions that would have either found a gift on formation and/or set aside the transaction as under the Step-Doctrine (Murphy v. Commissioner, T.C. Memo 1990-472, 60 T.C.M. 645 (1990). The Internal Revenue Service has appealed Strangi to the 5th Circuit.

2. After expressed great skepticism as to the "business purpose" of the decedent establishing the partnership, the majority opinion found that form governed substance: "[The partnership] was validly formed under state law. The formalities were followed, and the preverbal 'i's' were dotted" and "t's were crossed". The partnership, as a legal matter, changed the relationship between the decedent and his heirs and the decedent's actual and potential creditors. Regardless of subjective intentions, the partnership has sufficient substance to be recognized for tax purposes. Its existence would not be disregarded by potential purchasers of the decedent's at death and we do not disregard it in this case."

3. As to the §2703(a) attack the Court stated: "Respondent next argues that the term 'property' in section 2703(a)(2) means that the underlying assets in the partnership and that the partnership form is the restriction that must be disregarded. Unfortunately for respondent's position, neither the language of the statute nor the language of the regulation supports respondent's interpretation. Absence application of some other provision, the property included in the decedent's estate is the limited partnership interest and decedent's interest in [the general corporate partner]." The Court cited Kerr v. Commissioner, 113 T.C. 449 (1999) and Church v. U.S., 268 F.3d 1063 (5th Cir. 7/18/01) (unreported decision) affirming per Curiam 85 AFTR 2d 2000-804, 2000 WL 206374 (W.d Texas 2000).

4. The majority opinion in Strangi also rejected the gifts on formation argument. This pointed out that, using the values reported by the Petitioners on the estate tax return, the decedent gave up property worth over $10 Million and received back a limited partnership interest worth less than $6.5 Million. Under those circumstances the Court stated, there would be no business purpose, only a donative one, to accept something radically worth less than what was given up. "Nevertheless, in this case, because we do not believe the decedent gave up control over the assets, his beneficial interest in them exceeded ninety-nine percent, and his contribution was allocated to his own capital account, the instinctive reaction that there was a gift at the inception of the partnership does not lead to a determination of gift tax liability. In a situation such as in Kincade [682 F.2d 1220 (5th Cir. 1982)], where other shareholders or partners have a significant interest in an entity that is enhanced as a result of a transfer to the entity or in a situation such as Shepherd v. Commissioner, 115 2C _____ (2000) (Slip Op. at 21), where contributions of a taxpayer are allocated to the capital accounts of other partners, there is a gift. However, in view of decedent's continuing interest in the [the partnership] and the reflection of the contributions in his own capital accounts, he did not transfer more than a minuscule portion of the value that would have been "loss" on the conveyance of his assets to the partnership in exchange for the partnership interest...the actual control exercised by [the decedent's agent], combined with the ninety-nine percent limited partnership interest in [the partnership] and the forty-seven percent interest in [the corporation general partner], suggest the possibility of including the property transferred to the partnership in decedent's estate under Section 2036. See, E.G., Estate of Reichardt v. Commissioner, 114 T.C. 144 (2000). Section 2036 is not an issue in this case, however, because respondent asserted it only in a proposed amendment to answer tendered shortly before trial. Respondent's motion to amend the answer was denied because he it was untimely."

5. On appeal, the 5th Circuit reversed and remanded the case to Tax Court on the § 2036 argument. It in effect, however, affirmed all other the Tax Court's holdings other than the denial of the right of the IRS to amend to bring it's § 2036 argument. Gulig v. Commissioner, 5th Cir. (6/17/02)

1. The decedent was the son of the founder of J.R. Simplot Company, a large agro business that produces, among other things, french fried potatoes for McDonalds. The decedent owned 18 of a little more than 76 shares of the company's voting stock and about 4,000 shares of the company's 14,000 issued non-voting stock. Other siblings owned the rest of the voting stock and the non-voting stock was family held and held in an employee stock ownership plan. The Tax Court valued the voting stock independently from the total stock and gave it a very large premium based on the theory that voting control of the corporation must always be worth between 3% and 10% of the total value of the corporation regardless of how small a percentage the actual voting shares constitute of the overall stock.

2. The 9th Circuit reversed the Tax Court holding and stated that the Tax Court should not attribute a premium to the minority block of voting stock: "The Tax Court committed a third error of law. Even a controlling block of stock is not to be valued at a premium for estate tax purposes, unless the Commissioner can show that a purchaser would be able to use the control 'in such a way to assure an increased economic advantage worth paying a premium for.' Ahmanson Foundation v. United States, 674 F.2d 761, 770 (9th Cir. 1981). Here, on liquidation, all Class B shareholders would fare better than Class A shareholders; any premium paid for the 18 Class A shares be lost. Class A and B had the right to the same dividends. What economic benefits attended 18 shares of Class A stock? No 'seat at the table' was assured by this minority interest; it could not elect a director. The Commissioner points out that Class A shareholders had formed businesses that did business with Simplot. If these businesses enjoyed special advantages, the Class A shareholders would have been liable for breach of their fiduciary duty to the Class B shareholders. See Estate of Curry v. United States, 706 F.2d 1424, 1430 (7th Cir. 1983)."

1. In Jones a father set up two partnerships: (i) one with his son and (ii) one with his four daughters. The father transferred real property to each of the partnerships and the children likewise contributed real property to the partnerships. The value of the father's contribution, however, was greatly disproportioned to the value of the children's contributions. In the partnership with the son, for example, the father held a 95.5% limited partnership interest and an 88% limited partnership interest in the daughters' partnership. The son received a 1% general partnership interest and the daughters (collectively) received a 1% general partnership interest in exchange for their contributions and the remaining limited partnership interests. Immediately after formation, the father transferred by gift an 83% limited partnership interest to his son and approximately a 17% in the partnership interest to each of his four daughters in the second partnership.

2. The Court held that the transfer of property by the father into the partnerships did not constitute a gift on formation (citing Strangi) because all of the contributions were properly reflected in the capital accounts of the contributing partners.

3. The Court rejected the argument by the Internal Revenue Service that the partnership itself was a restriction under §2704(b) applying Kerr.

4. The Internal Revenue Service, however, severely limited the discount of the interest to the son giving that transfer a mere 8% discount for lack of marketability because the holder of the majority limited partnership interest (the son) could remove the general partner, refuse to name a successor and force dissolution of the partnership. The Tax Court, on the other hand, permitted a 48% marketability discount for the gifts to the daughters because a 17% limited partner could not compel liquidation. The Tax Court rejected the taxpayer's argument that the transferred interest should be valued as "assignee interest" rather than partnership interest based on a factual finding that the donees had implicitly waived the requirement of consent to the admission of a new partner in this family setting. Unfortunately, the Court also rejected a discount due to the built-in gains because the hypothetical buyer would rightfully be able to have the general partner make a §754 election to adjust the basis of the partnership asset on purchase.

1. Dailey involved a family limited partnership holding marketability securities, some of which include substantial unrealized capital gains. Mrs. Dailey gave limited partnership interests in the partnership to her son and daughter-in-law and valued the gifts by discounting the net asset value of the partnership by 40%. At the time, the son acquired control of the partnership and at his mother's death he was the general partner. The issue before the Court was the value of a 40% limited partnership interest held by the decedent at death. The sole issue addressed by the Court was the extent of the discount. Both experts compared the partnership to a closed-end mutual fund which trades at a discount to net asset value. The appraisers, however, disagreed to the amount of the discount. The Internal Revenue Service appraiser "could not recall" reviewing the partnership agreement and although admitted unrealized capital gain is an important element to the discount, he failed to review the documents to determine if the family limited partnership had an such gains. The Tax Court determined that: "Respondent's expert's testimony was contradictory, unsupported by the data, and inapplicable to the facts. We are 'not bounded by the opinion of any expert witness when that opinion is contrary to our own judgment'." Estate of Dilford v. Commissioner, 88 T.C. 38, 56 (1987). "Although neither expert was extraordinary, Petitioners' expert provided a more convincing...analysis than Respondent's expert. We conclude that an aggregate marketability and minority discount of forty percent is warranted and is applicable to the aforementioned interest." The taxpayers' expert gave an opinion that a 40% discount should be held.

2. Part 2 of Dailey was a claim for litigation costs based on two positions by the IRS that were not substantially justified: (1) its valuation position and (2) its position that the FLP should be disregarded for tax purposes. The taxpayer prevailed on the second point (but lost its valuation argument). The court held that valuation is difficult and the appraiser was qualified and the deficiencies of the appraisal were not revealed until cross-examination.

1. This case involved the valuation of the minority share in the company that makes Corbel Champagne. The estate successfully argued that a market approach to value should not be used because there was only one company that could be a "guideline company" when fixing market value and more than one company must be found if using a market comparison. The Court then examined the discounted cash flow method used by the taxpayer and government's experts. This case is a good example of the necessity of looking at the underlying assumptions being made to analyze a company's books when basing valuation on that particular company's books.

1. The decedent held 49% of the stock of a company he founded to market hair-care products. In the Tax Court, the estate's experts valued the stock between $20 Million and $30 Million. The Internal Revenue Service's experts valued the stock between $57 Million and $165 Million. The Tax Court found the value of the stock was approximately $31.5 Million. The methodology of the Tax Court was to take the value of the whole company at $150 Million then apply a 10% discount because of the death of the decedent as a key person and a 35% marketability and lack of control discount. It also added a small discount because of the potential of a lawsuit over the compensation of the other shareholder. The stock was held by a second shareholder who had the controlling interest. That shareholder had turned down an offer by Gillette to purchase the company at something close to $150 Million – the Tax Court's starting point on value.

2. The Court of Appeals reversed the Tax Court holding that the burden of proof had shifted to the Internal Revenue Service and that the evidence demonstrated that the Internal Revenue Service assessment was arbitrary and excessive. It faulted the Tax Court on its methodology: "The Tax Court, on the other hand, started with an acquisition value, the One Hundred Fifty Million bid by Gillette Co. and began discounting from there. Acquisition value and publicly traded value are different because acquisition prices involve a premium for the purchase of the entire company in one deal. Such a lump-sum valuation was not taken into account when the minority interest value of the stock was calculated by the experts." There are at least two problems with this methodology: that the Gillette offer was probably an offer by a strategic purchaser and therefore not indicative of fair market value and also the offer was rejected by the majority owner demonstrating rather dramatically that the minority owner has no power to get at the underlying value.

1. In Kaufman, in the Tax Court, the Internal Revenue Service rejected the use of two sales that occurred soon after the decedent's death.

2. In reversing, the 9th Circuit Court of Appeals said that the price which the same stock sells for between willing and knowledgeable buyers and sellers is dispositive unless there can be good reason shown to reject those sales: (i) the Commissioner tries to make something out of the family connection [of] the seller with the buyers. They were not especially close...the Commissioner notes [the buyer] was a very successful businessman, so that the Seminole stock may not have meant much to him. People don't get to be very successful in business by treating valuable property carelessly.

1. The Internal Revenue Service set out its position for agents in the field when examining valuation discounts in the context of a family limited liability company. This field service advice was written before Shepherd, Strangi, and Knight but released in late 2000 after those cases were decided. This FSA is a good thumbnail sketch as to the Internal Revenue Service's position and should be reviewed along with the cases as part of the planning, audit preparation or case defense procedure.

1. At the Miami Heckerling Institute in Miami, a U.S. Treasury official kicked off a controversy. Mary Lour Edelstein, national coordinator for the Internal Revenue Service Appeals office, stated that family limited partnership discounts (as upheld in appeals) where running thus:

Obviously, these figures give practitioners benchmarks when dealing with auditors or, when second guessing appraisers. Ms. Edelstein's comments have been widely publicized.

2. The Internal Revenue Service – or at least the auditors – are reputing Ms. Edelstein's comments. At a New York Bar Association meeting held Spring 2003, an Internal Revenue Service representative has challenged Ms. Edelstein's remarks stating that the Internal Revenue Service has not established any rule of thumb as to the discounts.

3. The official policy may be that there are no discount guidelines, however, Ms. Edelstein was commenting on the results coming out of Appeals. She has had the various Appeals offices report to her since 1999 regarding the extent of the discounts in various types of cases. Thus, Ms. Edelstein's benchmarks probably reflect what is actually happening at the Appeals level. You do not get to Appeals, of course, unless you disagree with an auditor so the auditor may also be correct that at his level there is no consistent treatment.