Valuing Gifts of FLP Interests – Holman Part I

HOLMAN Part I

Summary:

A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships ("FLPs") and limited liability companies ("LLCs"). While it received much attention in the professional literature, most regular folk haven't heard much. www.leimbergservices.com had no less than 4 articles covering this case! (If you're an estate planner and haven't subscribed, you're missing great stuff). An overview analysis of the case will be presented. Next month, in Part II, planning lessons reviewed, and several important points that seem to have gotten short shrift in the professional literature will be discussed.

Facts.

Dad worked at Dell Computer and received substantial Dell stock options which he exercised, and both Dad and Mom bought additional shares. Mom and Dad formed an FLP and contributed their Dell stock to it. Thereafter, Mom and Dad gave FLP interests to one child's custodian account, and larger gifts to a trust for all four of their children.  They claimed discounts aggregating nearly 50% on the value of these FLP interests (e.g., if the Dell stock was worth $2 million and they gave away 10% they did not value it at 10% x $ 2M = $200,000 but more like about $100,000. This reduction reflected discounts (i.e., reductions in value) for minority interests (the recipients of the FLP interests could not control the partnership since they owned small percentages), and discounts for lack of marketability (tough to sell interests in a family entity). There were both good and bad facts in the case. Bad Facts: ◙  Tax returns were never filed. ◙ Almost no income was earned. ◙ Only one asset was owned, Dell stock.  ◙  No business plan. ◙ No employees. ◙ No letterhead or telephone listing. ◙ No accounting reports. Good Facts: ◙  FLP formalities were generally adhered to. ◙ The Dell stock was properly transferred to the FLP prior to gifts of FLP interests being made.

Issue One.

The IRS argued that the taxpayers made indirect gifts of Dell stock (i.e., no discounts) to their children's trust. If the gifts are considered indirect gifts of Dell stock, instead of gifts of FLP interests, no discounts would apply. Just the market price of Dell stock would determine the value of the gifts. See Sheperd v. Commr., 115 TC 376 (2000), aff'd 283 F.3d 1258 (11^th Cir. 2002) and Senda, TC Memo 2004-160. Point to the Taxpayer. Treas. Reg. Sec. 25.2511(a), (h)(1). A classic example of an indirect gift is illustrated if you make a gift to a corporation. This is treated as the equivalent of a gift indirectly from you, through the corporation, to each of the corporation's shareholders. Holman won this issue by observing the appropriate steps of first properly transferring assets to the FLP, waiting a period of time, then making the gifts of FLP interests. The Court did not find that a gift occurred on the FLP formation and funding. Had the Holman's transferred FLP interests to the trust on the same day, the court might well have held otherwise. Thus, Holman doesn't represent the end of the IRS indirect gift argument, but it seems pretty clear that if you observe the formalities and independence of the partnership, assure that assets are properly transferred, and so on, that argument should be toothless. Mishandle the paperwork (like the Sheperd case) and the indirect gift argument will still bite.

Issue Two.

The IRS also argued that the taxpayers made indirect gifts of Dell stock under the step transaction doctrine. This doctrine provides that if a series of steps in a transaction are so integrated and interdependent, economic reality may be better reflected by collapsing the various steps into a single step. Thus, the IRS view of Holman under the step transaction doctrine was that the transfer of stock to the FLP and the gift of FLP interests to the children's trust would be more realistically viewed as a mere gift of the Dell stock direct to the trust (i.e., the formation of the FLP was really just part of making stock gifts to the trust). The doctrine might be applied if there is a binding commitment to consummate all of the steps involved. The taxpayer's in Holman, however, were not under any obligation to make gifts to their children's trust. The doctrine may be applied if the various steps involved are interdependent steps. This means that the legal implications of one step would be fruitless if the other step wasn't also completed. This was not the case in Holman. Mom and Dad could have stopped once the FLP was formed, that step would not have been irrelevant if the gifts were not made. Finally the step transaction doctrine might be applied by applying an "end result" test. This, however, was not discussed by the Holman Court. Point to the Taxpayer. The court reasoned that during the six day time period that the FLP held the Dell stock from the time stock was contributed to the FLP, until the date the gifts were made, created a "real economic risk of change in the value". The Court believed this risk occurred because the FLP was holding a highly volatile, heavily traded, stock. The court indicated that it might view the time period differently (i.e., six days would not be enough time for a real economic risk) if the FLP held a preferred stock or long term government bond. The court apparently viewed these as stable assets that would not have the likelihood of a "real economic risk of change in value" over a period as short as a week. Huh? So let's say that you contributed a 30-year Treasury to your FLP. But two weeks later, before you could make gifts of FLP interests to the kiddies, Bernanke decided to ratchet up interest rates to stave off inflation. That supposedly secure long term government bond that the Holman court presumes has a stable value, would look like the economic equivalent of a bowling ball heading down a ski slope. Now what about real estate? Yeah, real estate always holds its value over the short term (don't they get CNN in the Judges chambers?).  If you have a power shopping center with long term AAA tenant leases, that might not change much in the short term. But what if a key tenant goes bankrupt? What if you have a single use commercial property used as a back office for a residential mortgage processing company? That's about as stable as Sybil. Should either of these types of properties be evaluated differently then a strip mall with a bunch of mom and pop tenants? Should you analyze the credit worthiness of commercial tenants to determine how long real estate should be held in an FLP before gifts can safely be made? How much analysis is necessary to determine the requisite holding period? The Holman holding period is not practical, simple, clear or reasonable. But hey, if it was cookbook simple think of all the unemployed tax attorneys.

Comment.

Courts are often sticklers to find real non-tax business purposes for FLP and similar transactions. Yet, the concept of needing a time period between funding of the FLP and the gift is inconsistent with business reality. In real business deals, entities often have essential documents executed, then assets transferred to them, at the same meeting at which that same entity is then sold. If the Courts want to apply a business standard, they should do so consistently. If the Courts and the IRS don't like discounts on FLP transactions then they should encourage Congress to change the law. Instead, and Holman is yet another example, the IRS and the Courts continue the confusing fact based interpretations to attack FLPs, but whose reasoning often doesn't comport with business reality.

Issue Three.

The Holman FLP agreement, similar to most partnership agreements for close or family entities, contained significant restrictions and limitations on transfers. The court held that these restrictions were to be disregarded in determining the value of the FLP interests given away because the restrictions did not past muster under the requirements of Code Section 2703(a)(2). Under this provision, restrictions will not be respected unless they are:  1) Bona fide business arrangements. The Holman FLP had no real business. Holding one stock, Dell, didn't suffice (how many stocks must you hold?). While an FLP doesn't have to involve an actively managed business to have a business purpose for the Code Section 2703(a)(2) rules, there must be an adequate bona fide business purpose. Educating the kiddies and preserving assets by preventing the kids from dissipating them, were close, but this wasn't horseshoes.  2) The restrictions aren't a device to transfer value to the taxpayer's family. Holman used the FLP to transfer Dell stock to his heirs. 3) The terms are comparable to similar arrangements made by unrelated people. They were, but the Court never got passed the first two tests.  Point to the IRS. Some commentators describe this as match point in the FLP volley. While it's a biggie, that's might not really be the right characterization. The taxpayers still achieved a 16% - 22.4% discounts from the underlying value of a publicly traded stock with lots of bad facts. So to say that this was a major taxpayer defeat isn't right. For Holman, unfortunately, it was probably a Pyrrhic victory. Appraisal and legal fees might have devoured all tax bennies. That's called "hazards of litigation", something that needs to be carefully evaluated when planning your strategy for any tax audit.

Conclusion.

Next month's newsletter will conclude the analysis of the Holman case and present specific planning recommendations, and a review of several important issues that were overlooked in some of the professional literature.