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Estate of Barbara Purdue v Commissioner, T.C. Memo. 2015-249

Posted on February 27, 2016 at 7:20 PM

Estate of Baraba Purdue v Commissioner, T.C. Memo. 2015-249: The State of FLP and IRS Challenges to their Formation


In the past year there have been few FLP opinion from the U.S. Tax Court. Not to worry!  One of the more recent cases is from the west  side of WA, this a term thet folks in Central and Eastern Washington Stte to refer to cities west of the Cascade mountain range and often to folks from the Seattle metro area. 

This caught my eye too for other reasons, specificaly I focus on exit planning (in my role as an attorney), as a valuation advisor I provide valuatiohn advisory services where I emphaisze the importance of exit and succession planning, and  because it involves the IRS challenging an FLP established by the Purdue family, which is closely connected with the law firm of Montgomery Purdue Blankinship & Austin, LLC (a large Seattle firm) and I was curious to know more about the advise they gave to the Purdue family.

Issues:

1. Whether the value assets transferred by Barabare M Purdue (decedent) to the Purdue Family LLC (PFLLC) is includible in the value of her gross estate under section 2036(a) and 2035(a)?

2. Whether decedent's gift of PFLLC interests from 2001 through 2007 to teh Purdue Family Trust (PFT) are present interests giftd which qualify for exclusion under section 2503(b)?

3. Whether the estate is entitled to deduct interest on loans from the eneficiaries of the estate used to pay the estate tax liabilities?

Facts:

  • Decedent resided in Washington Strate when she died on November 27, 2007 at age 95;
  • Four of the five Purdue children acted  as personal representatives of the estate;
  • Decedent was married to Mr. Purdue(Mr. Purdue), a founding member of the Montgomery Purdue Blankinship & Austin PLLC (MPBA);
  • Mr. Purdue invested in Tele-Vue Systems,described by the US Tax Counrt as a pioneeering cable company, when it was a start-up company in the 1960s for a nominal value.
  • Tele-Vue was aqwuired in 1969 by Columbia Broadcasting ystem in an income tax free exchange (probably a 368(a)(1)(A) exchange);
  • At the end of 1999 decedent and Mr. Purdue had a net worth of approximately $28 million consisting mostly of marketable securities worth approximately $24 million.
  • In 2000 the marketable securities were held in five different brokerage accounts at three management firms and these firms did not consult with one another or consider how the assets held by teh other firm were managed) (side note to readers: this is not surprising, the client needs to insist that these communicate and get them together, as for management, the FLP is one option, along with the CRT and perhaps a CLT, since selling the stocks would have triggered a gain; the FLP is designed to pass the gain at a discount to family members for a good business reason ... which requires a qualified valuation calling for a conclusion of value attached to the gift tax return!)
  • Decedent and Mr. Purdue also owned a 1/6 interest in a Honolulu, Hawaii commercial building valued at approximately $480,000 as of December 1999 and that as subject to a 55-year triple net lease through 2022 and had been managed by a real estate firm since 1982).


Strategy Used for Estate and Gift Tax Planning (remember the exemption then was far lower!! than now)

  • The children consulted Mr. Montgomery, who suggested that the family consier several strategies including: creating an irrevocable family gift trust; a qualified personal residence trust, and a member-managed WA family LLC;
  • The firm drafted the PFLLC operating agreement and this indicated that the purpose behind it included:
      • consolidate management and control to achieve efficiencies;
      • avoid fractionalization of ownership;
      • keep ownership within the extended family;
      • protect assets from unknown future creditors;
      • provide flexible management of assets not available through other business entities; and
      • promote education of, and communication among, members of the extended family with respect to financial matters.
  • In August 2000 (8 months after the draft operating agreement was sent to Mr. Purdue) formed the PFLLC and Purdue Family Residence Trusts (PFRTs).
  • Deedent retained the right to income and distributions from the property she transferred to teh PFLLC in proportion to ther PFLLC ownership percentage;
  • The Purdue children were advised of the above mattes and the memorandum sent to them described four non-tax business reasons.
  • On or about August 14, 2000, the parents transferred their respective 50% interests in the Purdue residence, then appraised at $2,80,000 to the PFRTs.
  • On November 24, 2000, the parents funded the PFLLC with the Hawaii real property interest and the marketable securities, and a $375,000 promissory note for a loan made on beach house in Delaware, as well as an $865,523 ertificate of deposit.
  • That same day the parents signed new wills incorporating a bypass trust, a qualified marital trust, and GSTT-exempt qualified trust;
  • In addition, the parents formed the  Purdue Family Trust (PFT) that allowed PFT beneficiaries (descendants and spouses of their descendants) with Crummey withdrawal rights; these beneficiaries could annualy withdraw the lesser of the annual gift exclusion amount of each person making a transfer to teh PFT or a per capita share of the value of any assets transferred to teh PFT during the year).
  • Initially, the parents funded the PFT with cash (and distributed cash to teh Purdue children and other PFT beneficiaries).
  • From 2002 until 2007 decedent generally made an annual exclusion gift of PFLLC interests to the PFT effective on January 1 of each year in an amount  based upon the current number of PFT beneficiaries and then made an additional annual exclusion gift effective on December 31 of thaty year if the number of PFT beneficiries increased increased during the year or the value of teh PFLLC fell during the year.
  • The values of the PFLLC gift interests were based upon valuation summaries.
  • Mr. Purdue died in 2001 and in connection with the above the children were advised of estate tax liabilities (to pay the liabilities one proposal floated was for the PFLLC to loan the estate $6,254,744 or agree that PFLLC would pay a $8,863,571 divided (higher than the tax because the dividedn is taxable and the net amount would be used to pay the estate liability).
  • Deadlock ensued and the children loaned the estate money (they also loaned to the QTIP).
  • When decedent died the PFLLC was owned as follows: 24.9247% by decedent outright; 42.1608% by the QTIP Trust; 20.7615% by the PFT; 7.2969% by the Ourdue children; and 4.8561% by the Bypass trust;
  • Decedent's estate had liabilities.
  • The IRS issued the estate tax notice of deficiency on February 21, 2012 and the gift tax notice of deficiency for the taable years 2001, 2002, and 2004 through 207 on September 12, 2012.


The Commisioner's Position/IRS Position

  • Section 2036(a). The Service contends that decedent's inter vivos gift was not a bona fide sale for adequate and full consideration and because deedent retained  an interest or right enumerated in 2036(a)(1) or (2) or (b) in the transferred property which was not relinquished before death.
  • More speciically, the Service contends the bona fide sale for adequate and full consieration was not met (no legitimate business reason and argues that the motivation in forming the PFLLC is tax avoidance).
  • the Service also argues that  made for the years in qustion were not giftd of present interests.

The Estae argues:

  • There was a bona fide sale and non-tax reasons for creating the FLP
  • That transferors received a partnership interest proportional to teh value of the property transferred

Court Holding

  • Whether a transfer is abona fide sale is a question of motive and the court's role is to separate nontax reasons for the PFLLC's formation from those that merely clothe the transfer tax savings motives;
  • The court gave weight to the memorandum from the law firm and the PFLLC operating agreement to establish a legitimate motive;
  • Despite Mr. Purdue standing "onboth sides of the transaction" and case law --Estate of Liljestrand v. Commissioner, TC Memo 2011-259, Estate of Strangi v Commissioner, TC Memo 2003-145, aff'd 417 F.3d 468 (5th Cir. 2005), standing for the proposition that "we have concluded that there is no arms'-length bargaining and thus the bona fide transfer excpetion does not apply"--"we have also stated that an arm's length transaction occurs when mutual legitimate and significant nontax reasons exist for the transaction and the transaction is carried out in a way in which unrelated parties to a business transaction would deal with each other." Estate of Bongard v. Commissioner, 124 TC 95. 123 (2005);
  • Hence, the court found the existence of a legitimate nontax motive for the transaction between decedent and teh PFLLC.  (i.e., the bona fide sale issue was setteld in the estate's favor)
  • As for the gift tax challenge, the court found that "decedent's transfer to the PFLLC was a bona fide transefer an that deedent received full and adequate consideration from the PFLC as a result of the transfer ... section 2036(a) is inapplicable to the transfer and does not operate to include the value of property in the value of decedent's gross estate. 'If section 2036(a) does not apply to decedent's transfer, section 2035(a) annot apply to the gifts *** the PFLLC made' either." 
  • As for whether or not the gifts made were a presenet interst gift, the Court noted that "a gift must confer on the donee a substantial present economic benefit by reason of use, possession, or enjoyment (1) of property or (2) of income from the property".  The property in this case is an ownership interest in limited liability company interests. It viewed its duty here as one where it muneeded to inquire "whether donees in fact received rights differing in any meaningful way from those that would have flowed from a traditional trust arrangement."  here, the PFLLC operating agreement was the source of donee's' rights and trestrictions to the use, possession, or enjoyment of the property. The rights were found to be limited; members of the PFLLC could not transfer their interests without unanimous consent by the other members. This was problemaic and the Court added that "we will consier whether the donees received such rights in the income." "To ascertain whether rights toincome satisfy the criteria for apresent interest under 2503(b), the estate must prove, on the basis of surrounding circumstances, that: (1) the PFLLC would generate income, (2) some portion of that income would flow stedily to the donees, and (3) that the portion of income could readily be ascertained."
  • The court found that the Hawaii commercial property was expected to generate rent income and that the marketable securities paid a a dividend.

Taxpayer Victory

Taxpayer won here, but it was close. The ase provides more insight reagrding what is a bona fide sale and provides us guidance regarding when a security is considered a present interest gift.  One immediate take away here is that funding a FLP with closely held shares of an entity that does not regularly pay dividends or generate rental income is risky!

Categories: Business Valuation, Litigation Support: Cases

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