Navigating I.R.C. §2036 Tax Planning with Florida Law
For many years, a common estate planning technique has been to create a partnership or limited liability company (LLC) to hold valuable property and then transfer ownership interests in the LLC to an irrevocable trust by gift or sale to achieve family planning goals and to legally avoid federal estate tax from being imposed upon the assets of the LLC or the ownership interests of the LLC held in trust.[1] In some cases the Internal Revenue Service (IRS) challenges these types of transfers as representing a device by which the taxpayer improperly seeks “to have its cake and eat it too” by passing substantial untaxed wealth to future generations at discounted values while also maintaining some control of that wealth or otherwise benefiting from it.[2]
Section 2036 of the Internal Revenue Code[3] may be regarded as the cornerstone federal tax provision used by the IRS to bring the property back into the decedent’s taxable estate. This article briefly reviews §2036 in relation to applicable Florida law and presents recommendations to properly avoid the application of this section.[4] However, when representing clients in this area, it is essential to consider all of the relevant tax law, including income tax, gift tax, generation-skipping transfer tax, special valuation rules and judicial principles such as the step transaction doctrine.[5]
Applicable Federal Tax and Florida Law
Section 2036(a) generally provides that if a transferor retains the power to possess or control the beneficial enjoyment of an LLC interest gifted into a trust or the income derived from the interest, upon the death of the transferor, the interest will be included in the federal gross estate at its date of death value.[6] This is the result even if the transfer constituted a completed gift to an irrevocable trust and the LLC interest had a lower value at that time, which is often the case.
The applicable Florida law is the Florida Trust Code (trust code)[7] and the Florida Revised Limited Liability Company Act (LLC act).[8] In accordance with the trust code, the trustees must administer the trust in good faith solely in the interests of beneficiaries in light of the terms and purposes of the trust as a prudent person would while exercising reasonable care, skill, and caution.[9] In accordance with the LLC act, managers of the LLC and its members owe fiduciary duties of loyalty and care to each other and the company, and the managers must discharge these obligations in good faith and fair dealing.[10] In this article, the duties established by the trust code and the LLC act are referred to collectively as the “fiduciary duties.” It is essential to recognize these fiduciary duties and deal with them properly because, for federal estate tax purposes, they may restrain the extent to which the transferor is regarded as retaining control of the beneficial enjoyment of the LLC interest in the trust or enjoying its income, thereby preventing the application of §2036.[11]
Section 2036(a) Requirements
Section 2036(a) reads as follows:
(a) The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or any period which does not in fact end before his death –
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or income therefrom. (Emphasis added.)
The treasury regulations that interpret §2036 provide that it is immaterial 1) whether the power was exercisable alone or only in conjunction with another person or persons, whether or not having an adverse interest; 2) in what capacity the power was exercisable by the transferor or by another person or persons in conjunction with the transferor; and 3) whether the exercise of the power was subject to a contingency beyond the transferor’s control that did not occur before death.[12]
The broad wording of §2036(a) viewed in light of the expansive interpretation of it provided in the regulations, the inherently factual nature of the section itself, and the IRS propensity to challenge planning in this area has led to significant litigation over many years. With this in mind, the cases have shown the need to start with a well-prepared and coordinated LLC operating agreement and trust agreement for the trust that receives the LLC interest. Further, when gift or sale transfers are made to the trust, there should be formal legal documents supported by company and trustee resolutions as well as annual financial statements and tax returns prepared in a manner consistent with the terms of the transfers. This documentation is extremely helpful in proving the reason and validity of the company and trust structure and transfers made to it.
The Classic 2036 Case: Gift Transfers in Trust
Section 2036(a) has two distinct components: §2036(a)(1) focusing on retained “possession or enjoyment” by the decedent and §2036(a)(2) focusing on legally enforceable rights exercisable by the decedent “alone or in conjunction with any other person.” Both of these components should be considered in every case.
Section 2036(a)(1) “Possession or Enjoyment” — Substantial Present Economic Benefit
Section 2036(a)(1) is not dependent upon the existence of a legally enforceable right retained by the decedent. Rather, it presents a facts and circumstances test centered on whether the decedent, as transferor, nevertheless retained a substantial present economic benefit in the sense of benefiting or having the right to benefit from the property or income of the LLC or the trust.
This section has been successfully applied by the IRS in cases where the transferor calls upon assets or income of a family LLC or trust that he or she created in order to be able to pay for personal living expenses or other personal obligations, especially in cases where the transferor did not have sufficient assets outside of the LLC or trust for those purposes. These cases are often based upon an implied understanding inferred from the facts and circumstances that the decedent continued to have access to the income and property of the LLC or the trust.[13] The transferor should not have an express or implied agreement with trustees or family members that they will make distributions to the transferor or pay expenses or obligations of the transferor whenever requested or needed from the income or assets of the LLC or the property or income of the trust, since doing so would clearly violate §2036(a)(1).
Member and manager voting rights of the transferor in an LLC are highly significant in determining whether the transferor retains a substantial present economic benefit under §2036(a)(1) or a “designation right” under §2036(a)(2), explained subsequently. However, as a manager, the transferor may have the right to vote or take actions for the LLC relating to the management of the company that are related to day-to-day operations. These permitted actions include, for example, making ongoing decisions relating to the objectives and operations of the business of the LLC, purchasing and selling assets of the LLC, and financing the acquisition of assets or regular operations of the LLC. These types of management rights and activities have not been held to be within the scope of §2036(a)(1) because they have not, so far, been interpreted as conferring a substantial present economic benefit upon the transferor. Further, the management rights in this area must be exercised in the best interests of the company and its members consistent with applicable fiduciary duties expressed in the operating agreement, and if not expressed there, imposed by the LLC act,[14] so that the transferor would not be regarded as being completely free to act for his or her own personal benefit.
Section 2036(a)(2) “Alone or In Conjunction With” Others: Legally Enforceable Designation Rights
In contrast to §2036(a)(1), under §2036(a)(2) it must be established that the decedent had a legally enforceable right recognized under applicable state law to designate who would enjoy property or income of the LLC interest held in trust exercisable alone or in conjunction with any other person. Requiring the consent of a non-adverse party, such as an independent trustee, will not protect against the application of §2036(a)(2) if the decedent, nevertheless, could have participated in exercising the designation right. However, courts have recognized that this “designation right” is not regarded as legally enforceable if it is sufficiently constrained by state law, such as the fiduciary duties under Florida law. These fiduciary duties arise under, and are defined by, the terms of the operating agreement subject to the LLC act and the terms of the trust agreement subject to the trust code. Therefore, it is essential to examine the terms of both agreements and the applicable law, and to coordinate them in manner that clearly restricts the power of the decedent, so that he or she does not have a designation right within the scope of §2036(a)(2). Accordingly, to prevent the application of §2036(a)(2), one must show that the decedent did not have a legally enforceable designation right, or if the decedent did possess such a right, it was not freely exercisable because the right was limited by state law fiduciary duties.
Nature of the Designation Rights
In view of §2036(a)(2), planning conservatively without reliance on the possible protection afforded by fiduciary duties, the transferor of an LLC interest into a trust should not continue to hold certain rights that would allow him or her to designate who may benefit from income or property held by the trust by reason of actions taken by or through the LLC. In accordance with limitations expressly stated in the LLC operating agreement, the transferor should not be able to participate in decisions of the LLC relating to the determination of allocations of income to or among members, the timing or amount of distributions from the LLC, the dissolution of the LLC or any amendment of the LLC operating agreement relating to those matters.[15]
State Law Fiduciary Duties
The leading case regarding the significance of fiduciary duties is the 1972 Supreme Court decision in U.S. v. Byrum, 408 U.S. 125 (1972).[16] In that case, the Court found that Byrum did not have a legally enforceable right to designate who would enjoy trust property or income derived from shares of stock that he had placed in trust. Further, whatever rights he had were limited by a corporate trustee having fiduciary duties to beneficiaries and a board of directors having fiduciary duties to the corporation and its shareholders, and as majority shareholder his fiduciary duties owed to minority shareholders. Accordingly, Byrum did not have an “unconstrained de facto power” within the scope of §2036(a)(2). Put simply, he was not free to do whatever he wanted in voting the shares of the corporation and, thus, was without a right to designate who would enjoy trust income or property. He had no “designation right.”
Over the years, the IRS has continued to challenge the protection afforded by fiduciary duties as a limitation on the reach of §2036(a)(2). Responding to IRS claims, sometimes the Tax Court has found in favor of taxpayers by holding that those protections were sufficiently strong in light of the principles established by Byrum and other times not, depending upon the facts of each case. Most importantly, however, the Tax Court has always respected the fundamental holding of Byrum that real fiduciary duties recognized in applicable legal documents under local law and consistent with the conduct of the parties, in appropriate cases, can prevent the application of §2036(a)(2). For example, 36 years after Byrum in 2008, the Tax Court found in the Mirowski case that fiduciary duties created by Maryland limited liability company law were sufficient to deny the application of §2036(a)(2), and accordingly the court ruled in favor of the taxpayer.[17]
Typical unfavorable cases where the Tax Court has found state law duties to be illusory and, therefore, provide no protection from the reach of §2036(a) are the so-called “death bed” cases and cases where the manager of the entity was not independent, for example due to competing or conflicting fiduciary duties. Where the LLC is co-owned by the settlor and the trust, it is necessary to examine the requirements of the trust instrument under applicable law and the independence of the trustee or trustees who can exercise voting rights over the LLC so as to assure that there are no conflicting duties. The independence of the trustee was very important in Byrum because it meant that Byrum could not control the decisions of the trustee (which was a corporate trustee subject to fiduciary duties) and, therefore, could not regulate distributions of income from the corporation acting in conjunction with the trustee.
In Estate of Nancy H. Powell v. Comm’r, 148 T.C. 392 (2017), fiduciary duties were found to be illusory and ineffective to protect against §2036(a)(2) where a family member who was the general partner of a family partnership also was an attorney-in-fact acting under a durable power of attorney given by the decedent.[18] The court found the fiduciary duties as a general partner to be illusory because they conflicted with the family member’s duty to act in the decedent’s best interest under a general power of attorney and because any such fiduciary duties were nearly entirely owed to the decedent as 99% owner of the partnership.[19] Similarly, under Florida law, an attorney-in-fact is a fiduciary who acts in the principal’s best interest, and accordingly, a power of attorney executed by the transferor should be reviewed in connection with the gift of the LLC interest into trust so as not to inadvertently attribute powers over the LLC to the settlor of a trust.[20]
In the case of an attorney serving a client as legal counsel and also in one or more roles as a manager of the LLC, a trustee of an irrevocable trust holding the LLC interest or both, it is possible for the client to waive a conflict of interest that may arise in the attorney’s dual or multiple roles by providing informed written consent as required by the Florida Rules of Professional Conduct.[21] If the attorney will serve as manager or trustee, the attorney should not also serve as an attorney-in-fact for the client unless, perhaps, the attorney is excluded in the power of attorney document from taking actions relating to the LLC or trust.[22]
Section 2036(a): Certain Sale Transfers to LLCs or Trusts
Section 2036(a) does not apply in the case of a bona fide sale for an adequate and full consideration. To satisfy this “bona fide sale exception,” one must analyze each of its three components: whether there was sale, whether the sale was bona fide, and whether the sale was made for adequate and full consideration.
There have been numerous court decisions interpreting the bona fide sale exception. However, the Tax Court’s decision in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005), is widely recognized as a key opinion in this area. Since 2005, the litigation results have turned on the particular facts of each case, rather than a change in a two-part legal test established in Bongard, described below. At times, the IRS had argued that there cannot be a sale between related parties because it would not be an arm’s-length transaction. However, the Tax Court rejected this position in Bongard while nevertheless recognizing that “intrafamily transactions are subject to a higher level of scrutiny.”[23]
“Sale” Comprehends “Transfer”
Neither §2036 nor its related treasury regulations define the term “sale.” The regulations only refer to a “transfer.” However, the Tax Court has interpreted “sale” to include a tax-free contribution of property to a business entity, such as partnership or limited liability company, in exchange for an ownership interest in the entity.[24] Thus, forming and capitalizing the LLC with property represents a transfer within the scope of §2036, which may qualify as a sale, and in appropriate circumstances, within the bona fide sale exception.
Bona Fide Sale: A Legitimate and Significant Non-Tax Reason
In order for the sale to be bona fide, the first part of the Bongard test is that the transfer of money or property to the LLC must serve important family or business goals in the sense of establishing that the transferor had a legitimate and significant non-tax reason (LSNT reason) for organizing the LLC. Although it may be the case that only one such reason is legally necessary, having more than one may provide stronger support for a favorable outcome. Each reason should be real and credible at the time the LLC is formed and capitalized with the transfer of property to it and when a subsequent transfer of the LLC interest is made into the trust, and continue to be real and credible thereafter absent some unexpected, material change in circumstances beyond the control of the taxpayer.[25] There must be objective evidence that supports the LSNT reason; one should not rely solely upon bare statements of one or more LSNT reasons contained in the LLC operating agreement or trust agreement.
In appropriate cases supported by facts in the record, the following family and business purposes, among others, should be recognized as LSNT reasons: 1) providing for effective management of an operating business; 2) consolidating family assets for better investment management; 3) consolidating family assets to accomplish greater investment opportunity, for example, to satisfy qualified or accredited investor status necessary to make private equity investments; 4) avoiding fractional ownership among family members in specific, major assets and, thus, simplifying title to those assets; 5) providing investment training or continuing investment philosophy; 6) holding “legacy stock” for future generations; or 7) protecting family assets from marital claims in the event of divorce. The LSNT reasons may be seen as more credible in the case of an LLC formed to continue the operations of an active family business or to hold legacy stock than one formed to simply hold a portfolio of publicly traded securities that have no unique aspects.[26] Providing creditor protection has been found to be a legitimate, but not a significant, nontax reason, and therefore standing alone may not support a bona fide sale.[27]
Adequate and Full Consideration: Pro Rata Capital Accounts
To establish adequate and full consideration, the second part of the Bongard test is that each member of the LLC must receive a pro rata ownership interest in respect of his or her contribution of money or property made to the entity and also a pro rata reduction in its interest in respect of distributions from the entity, which generally are satisfied if there is capital account maintenance accounting for the LLC in accordance to the requirements of §704 and Treasury Regulation §1.704-1(b)(2). As previously indicated, the capital contribution of property to the LLC is treated as a “sale” for purposes of §2036 subject to a determination of whether there was “adequate and full consideration.” This should be distinguished from a subsequent gift or sale of the LLC interest to the trust, which constitutes another transfer subject to §2036 determined under the general rule of “fair market value” of the property.[28] A subsequent sale or gift of the LLC interest to the trust should be evidenced by appropriate legal documents with all of the terms of the gift or sale thereafter carried out in accordance with the documents.[29]
Some Useful Recommendations
Recommendations to help protect assets of an LLC or interests of an LLC held by a trust from potential federal estate tax due to §2036 include:
1) There should be well-prepared coordinated LLC operating and trust agreements demonstrating that settlor did not retain any §2036 rights over the LLC and trust property or income.
2) At all times, there should be well-documented activities of trust administration that are in accordance with the trust agreement[30] and of proper management of the company in accordance with its operating agreement and the LLC act.[31]
3) The managers of the LLC should have clearly defined duties and carry out them out in accordance with all requirements of the LLC operating agreement, including without limitation provisions of the operating agreement that establish fiduciary duties.[32]
4) If the transferor continues to have some ownership interest in the LLC or serve as a manager of it (and without reliance on protection from §2036 possibly afforded by fiduciary duties), the operating agreement of the LLC should prohibit the transferor from participating in decisions relating to the determination of allocations of income to or among members, the timing or amount of distributions from the LLC, the dissolution of the LLC, in some cases transfers of interests in the LLC, and any amendment of the LLC operating agreement relating to the foregoing.
5) A trustee who has authority to vote on decisions of the LLC relating to the matters described above should not also serve as the personal attorney-in-fact of the settlor of the trust. If an attorney serves in both roles, the attorney should obtain prior written informed consent from the client (settlor) in order to eliminate competing or conflicting duties or possibly provide in the power of attorney that the appointment does not extend to voting on such LLC matters.[33]
6) The operating agreement should be tailored to the specific needs of the client and reflective of the manner in which the company will actually be operated, for example by a) expressly recognizing fiduciary duties described earlier; b) establishing distribution requirements and specific definitions applicable to distributable cash;[34] c) establishing clear rules for borrowing so as not to become a source of contention among family members or possibly treated as a disguised distribution to the settlor; and d) making sure that the transfer of membership interest provisions work effectively and are not left within the control, acting alone or with others, of the settlor of a trust holding an ownership interest in the LLC.
Conclusion
Protecting against the imposition of federal estate tax under §2036 can be challenging in a structure that involves a trust holding ownership of an LLC, particularly if the settlor of the trust also has some ownership of the LLC or decision-making power over it. A comprehensive understanding of the complex rules of federal income, gift, estate and generation-skipping tax law and their relationship with applicable Florida trust and corporate law is essential in order to accomplish effective planning in this area. Further, any structure of this type needs to be established properly and thereafter administered properly at all times in order for it to achieve all of the desired family goals and federal tax savings. Due to the complexity and interaction of these laws and always bearing in mind that their application depends upon the facts of each case, it is impossible to discuss every major issue, much less even identify them, in this article. Perhaps then the best recommendation of all is that an attorney needs to proceed carefully with a client who desires to form an LLC and place ownership of some or all of it in trust, and explain thoroughly the requirements of establishing and maintaining the LLC and trust year after year. This is not the case of simply executing foundational LLC and trust documents one day and then returning to “business as usual” the next without planning to provide continuing, proper attention to them.
[1] Originally, family partnerships were formed as limited partnerships. However, after the adoption of limited liability company acts throughout the U.S. starting in the 1980s and the adoption of the “check-the-box” Treas. Reg. 301.7701-3, use of limited liability companies treated as partnerships for federal tax purposes has become common. In this article the terms “LLC” or “company” refer to a limited liability company treated as a partnership for federal tax purposes.
[2] See Rev. Rul. 59-60, 1959-1 CB 237 and numerous Tax Court decisions recognizing valuation discounts for minority interests, lack of liquidity and lack of marketability having a combined range of 40% to 50% (in rare cases greater) and where 25% to 35% is not unusual. See also the recent Tax Court decision in Estate of Michael J. Jackson v. Comm’r, T.C. Memo 2021-48 (May 3, 2021), demonstrating extensive valuation analysis.
[3] All section references in the text or in these footnotes are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.
[4] Although outside the scope of this article, §2038 can also be a basis for estate taxation of property transferred into trust if the decedent retained the power however exercisable, alone or in conjunction with any other person, to alter, amend, revoke or terminate the trust. The recent case of Estate of Clara M. Morrissette v. Comm’r, T.C. Memo 2021-60 (May 13, 2021), provides a brief but useful description of the relationship between §§2036 and 2038.
[5] The grantor trust income tax provisions that would establish an irrevocable trust as a “intentionally defective grantor trust” are beyond the scope of this article but should be considered in connection with the settlement of the trust. A discussion of the gift tax issues associated with the transfer of an LLC membership interest to an irrevocable trust is also outside of the scope of this article. However, given that the value of the interest transferred may be finally determined for federal tax purposes to be greater than the value reported in the Form 709 gift tax return, adequate disclosure should be made in the tax return to start the statute of limitations. Further, Ch. 14 (I.R.C. §§2701-2704) should be considered in appropriate cases because, if these provisions were applicable, valuation discounts would not be available in connection with certain gift transfers in trust. Finally, one must consider the step transaction doctrine that might be used to deny valuation discounts in cases where property is contributed to a newly formed entity and the ownership interest in the entity is promptly transferred into a trust or to a family member at a substantially discounted value. See, for example, step transaction cases such as Holman v. Comm’r, 130 T.C. 170 (2008), aff’d 601 F.3d 763 (8th Cir. 2010), and Linton v. Comm’r, 630 F.3d 1211 (9th Cir. 2011).
[6] Section 2036(a) also applies to a gift of an LLC interest to one or more family members directly rather than in trust. This article primarily focuses on gifts made in trust.
[7] Fla. Stat. Ch. 736 (2021), including Part XIV (Florida Uniform Directed Trust Act, effective July 1, 2021). The Florida Uniform Directed Trust Act may provide some planning opportunities in relation to §2036-type planning because, under this new law, it is possible to more clearly delineate the full legal relationships in the trust agreement related to investment powers that a settlor may retain as an “investment advisor” in appropriate cases from dispositive powers assigned to an independent trustee or trust director over whom the settlor has no control and who would make all decisions relating to distributions or other applications of trust income or property.
[8] Fla. Stat. Ch. 605 (2021).
[9] Fla. Stat. §§736.0801, 736.0802, and 736.0804 (2021).
[10] Fla. Stat. §§605.015 and 605.04091 (2021). The duties of loyalty and care are fiduciary duties; the obligations of good faith and fair dealing are contractual in nature. In limited circumstances, aspects of these fiduciary duties can be altered or eliminated in the operating agreement if not manifestly unreasonable.
[11] The fiduciary duties established under the LLC act apply as a matter of law and may be especially significant where the LLC operating agreement does not expressly require these duties. When the operating agreement does expressly require fiduciary duties, they may be regarded as more protective from a federal estate tax standpoint because they may be seen as clearly recognized by the members.
[12] Treas. Reg. 20.2036-1(b)(3).
[13] Estate of Albert Strangi et al. v. Comm’r, T.C. Memo 2003-145 (May 20, 2003), aff’d sub nom; Strangi v. Comm’r, 417 F.3d 468 (5th Cir. 2005); Erickson v. Comm’r, T.C. Memo 2007-107 (Apr. 30, 2007).
[14] Except as the fiduciary duties may be modified or waived to the extent permitted by the LLC act. Fla. Stat. §605.0104(4)(c) (2021).
[15] Estate of Nancy H. Powell v. Comm’r, 148 T.C. 392 (2017) (relating to the right to dissolve the partnership acting with others). Consider also prohibiting the transferor from participating in decisions relating to transfers of LLC interests that would be made by other members.
[16] In Byrum, the IRS asserted that the decedent, Milliken Byrum, retained a right of designation under §2036(a)(2) because he could vote the shares of stock of a closely held company that he transferred into an irrevocable trust that he had created along with voting shares he kept for himself and veto transfers of the shares held by the trust. The IRS argued that, combining the voting power of shares he owned together with the voting power of the shares held by the trust, Byrum could elect directors to the company and then through the directors, control the dividend policy of the company. This would allow him to control the dividends paid by the company to the trust he had established for his children. In that manner, Byrum could designate who could enjoy the income of the trust and, thus, this designation right should make the shares transferred into the trust subject to estate tax under §2036(a)(2).
[17] Estate of Anna Mirowski, et al. v. Comm’r, T.C. Memo 2008-74 (Mar. 26, 2008).
[18] Powell, 148 T.C. at 392.
[19] Id.
[20] See Fla. Stat. §709.2114 (2021).
[21] See Fla. Rul. Prof. Con. 4-1.7(b) (informed consent) and comments to Rule 4-1.8(c) (gifts to lawyer or lawyer’s family). Rule 4-1.7 prohibits an attorney from a accepting an engagement to serve as an LLC manager or trustee if doing so would create a “substantial risk” that the attorney’s representation of the client would be materially limited unless written informed consent is obtained from the client. Rule 4-1.8 permits an attorney to serve as a fiduciary for a client provided that written informed consent is obtained and there is no undue influence by the attorney in seeking that representation. To comply with these rules and properly inform the client, the attorney should provide a letter to the client explaining the points set forth below, review the letter with the client, and receive the signed letter from the client waiving any and all potential conflicts of interest before accepting to serve in either role: 1) the persons who are eligible to serve in the roles of manager and trustee; 2) the persons serving in these roles are eligible for compensation; 3) the lawyer’s compensation for serving in these roles (the attorney may wish to refer to Fla. Stat. §733.616, Compensation of personal representative); and 4) the client can remove the attorney from the role at any time and for any reason, and if so, that will not affect the legal services owed to the client individually. Obtaining written consent in this manner is important to establish the lawyer’s independence to carry out the fiduciary duties and to minimize the risk of miscommunication to the client about the nature of the attorney’s role.
[22] See Fla. Stat. §709.2114(1)(a) (2021) (stating that an attorney-in-fact acts as authorized under the power of attorney).
[23] See Wheeler v. United States, 116 F.3d 749, 759 (5th Cir. 1997) (stating adequate and full consideration requires that the sale not deplete the gross estate); Turner v. Comm’r, 382 F.3d 367 (3d Cir. 2004); Kimbell v. U.S., 371 F.3d 257, 265 (5th Cir. 2004) (describing adequate and full consideration as an exchange of a “commensurate (monetary) amount” that “does not deplete the estate”); Estate of Eugene E. Stone, III, et al. v. Comm’r, T.C. Memo 2003-309 (Nov. 7, 2003); Estate of Bongard, 124 T.C. 95 (2005).
[24] Treas. Reg. 20.2036-1(a) and §2043 relating to transfers for insufficient consideration. See also cases dealing with contributions of property to partnerships subject to analysis under the bona fide sale exception, including for example Estate of Bongard; Estate of Stone; Estate of Thompson v. Comm’r, T.C. Memo 2002-246, aff’d 382 F.3d 367 (3d Cir. 2004).
[25] See Mirowski, where the decedent passed unexpectedly very soon after establishing the family partnership.
[26] See Estate of Charles Porter Schutt, et al. v. Comm’r, T.C. Memo 2005-126 (May 26, 2005) (purpose of a trust was to continue the family philosophy of buying and holding DuPont stock); see also Estate of Samuel P. Black, Jr., et al. v. Comm’r, 133 T.C. 340 (2009).
[27] See Mirowski, T.C. Memo 2008-74 at 388.
[28] Section 2031 and Treas. Reg. 20.2031-1(b). 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. See Rev. Rul. 59-60, establishing principles to determine the fair market value of stock of closely held corporations. These principles also are applied in determining the fair market value of ownership interests in closely held partnerships and limited lability companies.
[29] In the case of a gift, there should be an appropriate gift assignment or other conveyance instrument supported by documents indicating donative intent. In the case of a sale, there should be appropriate commercial documentation including the following: 1) a purchase and sale agreement that demonstrates by its terms a sale and not a gift; 2) a purchase price that reflects full and adequate consideration of the LLC interest being sold supported, in certain cases, by an appraisal; 3) a purchase price that is paid in full in cash and, if not, through a down payment in cash at closing at a minimum in the range of 10% of the total purchase price and a promissory note for the balance; 4) a promissory note (if applicable) with normal commercial terms, including interest charged at a rate at least equal to the applicable federal rate; 5) a promissory note (if applicable) that is capable of being performed based upon the credit worthiness of the maker and is actually performed by such party; and 6) financial and tax reporting and recordkeeping by both the purchaser and the seller that is proper and consistent with the terms of the sale transaction.
[30] This should include 1) having regular trustee communications and meetings, and documenting them through letters, agreements, and resolutions; 2) preparing annual financial statements approved by the trustees; and 3) providing the annual accounting to beneficiaries in accordance the trust code.
[31] This should include 1) having regular manager and member communications and meetings and documenting them through letters, agreements, and resolutions; 2) preparing annual financial statements approved by the members; and 3) preparing the annual income tax return (Form 1065) in accordance with the operating agreement, particularly as to allocation of income or loss, distribution, and any other capital account maintenance requirements in full compliance with §704 and related Treasury Regulations.
[32] Consider having 1) a written management or service agreement that defines the duties and reasonable compensation of the manager; 2) an express recognition in the operating agreement that the fiduciary duties (care and loyalty, and obligations of good faith and fair dealing prescribed by the LLC act) extend to all managers and all members; 3) a clarification in the operating agreement that fiduciary duties expressly means and includes that one must act for the benefit of the company and its members, and not for personal benefit; and 4) a separate written acknowledgment of these fiduciary duties signed and delivered to the company by any person acting as a manager.
[33] See Fla. Rul. Prof. Con. 4-1.7(b) (informed consent) and comments to Rule 4-1.8(c).
[34] In Mirowski, the Tax Court held that the decedent, Ms. Mirowski, did not retain rights under §§2036(a)(1) or 2036(a)(2) with respect to interests in a limited liability company she gifted to her daughters. Although she retained a majority interest in the company and served as manager of it, the operating agreement provided for mandatory distributions of “cash flow” and “capital proceeds” (each of which were defined terms in the operating agreement), the allocation of profits and losses among the members as well as important provisions regarding dissolution of the company, and there was no implied agreement or understanding that Ms. Mirowski would retain an interest in the gifts. Therefore, her estate had no inclusion under §2036. The appendix to the opinion cites several provisions from the operating agreement, including the definitions of the foregoing terms.
Alyssa R. Wan is a shareholder at Fowler White Burnett, P.A., and handles a variety of domestic and international matters for high-net-worth individuals and families, such as structuring and preparing sophisticated estate plans and trust agreements, forming private foundations and public charities, structuring investment in and transfer of U.S. real property by non-residents, and pre-immigration planning.
Richard Razook is a shareholder at Fowler White Burnett, P.A., and has practiced law for more than 40 years concentrating in the areas of income tax aspects of investment and real estate, and domestic and international estate planning. He has also advised on the creation and qualification of tax-exempt charitable organizations domestically and internationally.
This column is submitted on behalf of the Tax Section, Harris L. Bonnette, chair, and Taso Milonas, Charlotte A. Erdmann, Daniel W. Hudson, and Angie Miller, editors.
