withstanding irs attacks on traditional and ‘edgy’ estate ... · withstanding irs attacks on...

Withstanding IRS Attacks on Traditional and ‘Edgy’ Estate and

Gift Tax Planning Techniques

June 2015

*Reading course materials without attending the seminar does not qualify for credit

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About the Presenters

Emily Litznerski Foster is an attorney at Whyte Hirschboeck Dudek S.C. where she practices as a member of the Trusts & Estates Team. She holds a B.S. with Distinction from the University of Michigan, and a J.D from the University of Michigan Law School. While in law school, she served as a Legal Extern for the Department of Water Affairs and Forestry in Pretoria, South Africa. Additionally, she was the Public Interest Chair of the National Women Law Students Association and participated in the 2006 Environmental Law Moot Court Competition. She is a member of the State Bar of Wisconsin and the Illinois State Bar Association. Robert E. Dallman is a shareholder with Whyte Hirschboeck Dudek S.C. and a former IRS attorney in Washington, DC and Milwaukee. He is one of the few (if not the only) actively practicing tax attorneys in Wisconsin to prevail in cases in the U.S. Tax Court, U.S. Court of Federal Claims, the U.S. Court of Appeals for the Seventh Circuit, the Wisconsin Tax Appeals Commission, and a Wisconsin Circuit Court. His practice includes tax and ownership succession planning and tax controversy. He has litigated (i) significant tax cases in the areas of partnership, valuation, gift, estate, inventories, sham transactions, economic substance, business purpose, and the real estate transactions and (ii) landmark cases in the area of executive/reasonable compensation and officer liability.

WHD/10719328.17 ©2015

Withstanding IRS Attacks on Traditional and “Edgy”

Estates and Gift Tax Planning Techniques

Presented to

State Bar of Wisconsin: Annual Meeting & Conference 2015

by

Emily Litznerski Foster Whyte Hirschboeck Dudek S.C.

33 East Main Street, Suite 300

Madison, Wisconsin 53701

Phone: 608-258-6047

[email protected]

www.whdlaw.com

Benjamin P. Brunette Whyte Hirschboeck Dudek S.C.

33 East Main Street, Suite 300

Madison, Wisconsin 53701

Phone: 608-258-7381

[email protected]

www.whdlaw.com

Robert E. Dallman Whyte Hirschboeck Dudek S.C.

555 East Wells Street, Suite 1900

Milwaukee, Wisconsin 53202

Phone: 414-881-4075

[email protected]

www.whdlaw.com

June 25-26, 2015

WHD/10719328.17 Litznerski Foster/Brunette/Dallman i

TABLE OF CONTENTS

Page

I. CHOICE OF ENTITY ISSUES ............................................................................... 1

II. INCOME TAX ISSUES CONCERNING FLPs and FLLCs ................................... 4

III. A COMPARISON OF INTER-GENERATIONAL WEALTH TRANSFER TECHNIQUES ....................................................................................................... 20

IV. HOW TO FIX THE VALUE OF STOCK, ETC. FOR ESTATE TAX PURPOSES PER A BUY/SELL AGREEMENT .................................................. 44

V. OBTAINING AN UPFRONT INTEREST DEDUCTION ON AN ESTATE TAX RETURN PRIOR TO PAYMENT ............................................... 49

VI. REDUCING ADDITIONAL GIFT TAX LIABILITIES WITH DEFINED VALUE CLAUSES ................................................................................................ 51

VII. GIFTS OF PRESENT INTERESTS (AS OPPOSED TO FUTURE INTERESTS) .......................................................................................................... 52

VIII. SELECTED ESTATE TAX ISSUES ..................................................................... 55

IX. WORKING WITH/NEED FOR VALUATION PROFESSIONALS ................... 56

X. STATUTE OF LIMITATION ISSUES/GIFT TAX DISCLOSURE ISSUES ................................................................................................................... 58

XI. AWARDING OF COSTS IN AN ADMINISTRATIVE APPEAL AND/OR JUDICIAL APPEAL .............................................................................................. 59

XII. SWITCHING THE BURDEN OF PROOF TO THE IRS IN AN IRS TAX AUDIT .................................................................................................................... 62

Resume of Emily Litznerski Foster ................................................................................... 63

Resume of Emily Litznerski Foster ................................................................................... 64

Resume of Robert E. Dallman ........................................................................................... 65

A Listing of Relevant Cases That Have Been Resolved By Robert E. Dallman When He Was The Lead Or Sole Tax Attorney ..................................................... 66

WHD/10719328.17 Litznerski Foster/Brunette/Dallman ii

Exhibit A–Article: IRS Chief Counsel Describes When Guarantors Are At Risk For Tax Purposes By Thomas R. Vance and Robert E. Dallman .......................... 68

Exhibit B–Article: Opportunities For Taxpayers To Be Reimbursed For Costs In Tax Audits And Cases By Amy Barnes and Robert E. Dallman ........................... 75

Exhibit C–Article: The Built-In Gains Discount for Transfer Tax Purposes By Robert E. Dallman .................................................................................................. 83

WHD/10719328.17 Litznerski Foster/Brunette/Dallman 1

I. CHOICE OF ENTITY ISSUES

A. Advantages Of LLCs And Partnerships Over “S” Corporations.

1. At risk rules.

(a) See Vance/Dallman article, IRS Chief Counsel Described When Guarantors Are At Risk For Tax Purposes (attached as Exhibit A).

2. Preferred Stock.

(a) In an LLC or a partnership setting, preferred “shares” (similar to preferred stock in a corporate setting) can be issued to Members and partners.

(b) Such shares cannot be issued in an S corporation.

3. Property Distributions.

(a) Distributions of property can be tax-free from an LLC and a partnership to a Member or a partner based on section 731. An exception could be the distribution of securities based on Section 731(c).

(b) They are not tax-free from an S corporation to a shareholder.

4. Qualified Shareholders/Members/Partners.

(a) There are no restrictions on who can be a Member of partner whereas there are as to who can be a shareholder in an S corporation due to the fact that C corporations, S corporations, many trusts, LLCs, partnerships and nonresident aliens cannot be shareholders.

(b) There can only be 75 shareholders in an S corporation and there is no similar limitation for LLCs and partnerships.

5. Loss Recognition.

(a) Certain loans to an LLC or partnership can increase the ability of Members/partners to recognize LLC and partnership losses (based on sections 705, 752 and 704(d)) and this does not occur in an S corporation setting.

(b) In an S corporation, only direct loans by shareholders to the corporation increase their ability to recognize S corporation losses. § 1366(d)(1).


6. Inside Basis Increase For Certain Transactions.

(a) The inside basis of LLC and partnership assets (the tax basis that and LLC and a partnership has in its assets) is increased for the relevant Members and partners in a redemption of Interests and Units at a gain, cross purchase of Interests and Units at a gain and on the death of a Member or partner based on sections 754, 734 and 743.

Example: Five years ago, Members A and B (equal Members) contributed land to an LLC (“LLC”). The adjusted basis at the time of the contribution of the land was $100,000 and the fair market value was $250,000. Thus, each Member had a basis in his/her Interest of $50,000 and the LLC had a basis in the asset of $100,000. Subsequently, income equaled deductions; there were no capital contributions; and there were no distributions. On January 1, 1993, one of the Members dies. The new Member (the Estate) and the LLC elects section 754 treatment. As a result, there is a special “inside” basis adjustment on the books of the LLC such that 50% of the LLC’s basis in the land is now equal to 50% of the current fair market value, or $125,000. This will reduce any gain to that extent on a future sale by the LLC, which is attributable to this member.

7. Guaranteed Payments.

(a) The LLC and partnership can pay out deductible interest on capital accounts by means of a guaranteed payment pursuant to section 707(c) whereas an S corporation cannot do that; in an S corporation setting, payments must be either for salary, rent or debt.

B. Possible Or Probable Advantages Of LLCs Over Partnerships.

1. Passive Activity Loss Rules.

(a) Limited Partners’ losses are deemed to be passive based on Treas. Reg. § 1.469-5T(e)(1).

(i) If the Senior Generation continues to hold limited partner units and if the limited partnership has net losses, the Senior Generation/limited partner may not be able to deduct those losses against its salary and other “active” income unless the limited partner also holds general partner interests based on Treas. Reg. § 1.469-5T(e).

(ii) This becomes more important based on the liberalization for taxpayers in real estate that is mentioned in Section


469(c)(7) wherein net losses from real estate operations can be used by such a taxpayer to offset his/her active income.

2. This probably does not apply to LLC Members.

3. Nontax Limited Liability Issue.

(a) Unless an S corporation or C corporation is inserted as a general partner, an individual will be liable for partnership operations as general partner. This is not an issue with Members or Managers of an LLC.

(b) If a corporation (S or C) is a general partner and senior generation is the majority shareholder, president and/or on the board of directors along with being a limited partner, the senior generation (as an individual) may be deemed (as an individual) to participate in the affairs of the partnership such that his/her status as limited partner may be ignored. But cf. § 179.23(2)(a), Wis. Stats.

(c) Can ignore the risk of a limited partner (who is also the president, a shareholder, and member of the board of directors of the corporation that is the sole general partner in a limited partnership) being deemed to be participating in management of the partnership and thus being treated as a general partner.


II. INCOME TAX ISSUES CONCERNING FLPs and FLLCs

A. Partnership Formation And Contributions Of Property.

1. Is it a Partnership?

(a) Obviously, the Check-the-Box Regulations now allow noncorporate entities to choose their tax status as either a partnership, corporation, or in some cases, no status at all.

2. Partnership Investment Company Rules of Section 721(b).

(a) General rule: A transfer of property to a partnership by a partner is a nontaxable transaction. IRC § 721(a).

(b) There are two exceptions.

(i) The partnership is an investment company.

(ii) When property contributed is encumbered by a mortgage over the tax basis that the transferor/partner has at the time of the contribution.

(c) Investment Company rules.

(i) A partnership will be an investment company if:

[a] the transfer results in a diversification of the interests of the transferor; and

[b] after the contribution, more than 80% of the value of the partnership’s assets are held for investment and consist of readily marketable stocks and securities.

Example: H, W and their three children formed HW Family Partnership by contributing stock in ABC Corp. valued at $10 million and marketable securities worth $5 million. ABC Corp. is not traded on an exchange or quoted over the market. The Partnership would not be deemed to be an investment company within the meaning of Code § 721(b) since readily tradable stocks and securities constitute only 33% of the partnership’s assets.

(ii) The transfer ordinarily results in the diversification of the transferor’s assets if two or more persons transfer


nonidentical assets to a partnership in exchange for partnership interests.

Example: A and B create the AB Partnership. A contributes 100 shares of XYZ Corp. stock valued at $10,000; B contributes 50 shares of TUV Corp. stock valued at $10,000. This creates an “investment company” because A has now “exchanged” 50 shares of XYZ Corp. stock for 25 shares of TUV Corp. stock. In this example both A’s and B’s contributions are taxable transactions.

(iii) If identical assets are transferred, the transfer will not be treated as resulting in diversification.

(iv) If any transaction involves one or more transfers of nonidentical assets which constitutes an insignificant portion of the total assets transferred, such transfers shall be disregarded in determining whether the diversification has occurred based on Treas. Reg. § 1.351-1(c)(5). Thus, if the Senior Generation transfers stock in publicly traded corporations in exchange for 99% of the partnership interests and the junior generation transfers cash for 1% of the outstanding partnership interests, diversification shall be deemed not to have occurred.

Example (1). Individuals A, B, and C organize ABC Partnership. A and B each transfer to it $10,000 worth of IBM Stock in exchange for 50 partnership units. C transfers $200 worth of stock in General Motors for one partnership unit. In determining whether or not diversification has occurred, C’s participation in the transaction will be disregarded. (C’s capital contribution represents less than 1% of total partnership capital.) There is, therefore, no diversification, and gain or loss will not be recognized. Treas. Reg. § 1.351-1(c)(6), Example (1).

Example (2). A, together with 50 other transferors, organizes a partnership with 100 partnership units. A transfers $10,000 worth of stock in IBM in exchange for 50 partnership units. Each of the other 50 transferors transfers $200 worth of readily marketable securities in corporations other than IBM in exchange for one unit. In determining whether or not diversification has occurred, all


transfers will be taken into account. Therefore, diversification is present, and gain or loss will be recognized. Treas. Reg. § 1.351-1(c)(6), Example (2).

(v) If the transaction comes within § 721(b), gain will be recognized on all appreciated property transferred to the partnership, not just on the appreciated stock and securities.

(vi) The initial transfers to a new partnership of stock in a single publicly traded company by the transferors did not flunk the diversification test when the initial transfers were purportedly pursuant to § 721 even though subsequently the transferee/partnership in a separate transaction (which was not contemplated at the time of the initial transfers) sold the newly contributed stock in taxable transactions and diversified. See Rev. Rul. 88-32, 1988-1 C.B. 113.

(vii) The IRS takes the position that an impermissible diversification can occur if one partner contributes marketable securities and other partner(s) contribute more than an insignificant amount of cash. Rev. Rul. 87-9, 1987-1 C.B. 134.

(viii) When a client is considering formation of a partnership primarily for marketable securities, the best approach may be to have the client contribute the securities (or perhaps the client and his or her spouse contribute identical securities) and have the other partners (such as children) each contribute a nominal amount of cash or securities. Subsequent to formation, the parents can make gifts of partnership interests to the children to increase their interests in the partnership. Unless the gifts follow so closely on the creation of the partnership as to create the appearance of a step transaction, this can be done without concern about falling into the investment company rules.

3. Mortgage Over Basis of Contributed Property.

(a) Based on section 752(b) and section 731, a decrease in a partner’s share of liabilities encumbering property owned by a partnership is considered a distribution of cash.

(b) The corollary to § 752(b) is § 752(a) which provides that any increase in a partner’s share of the liabilities of a partnership shall be considered a contribution of money by such partner to the partnership.


(c) If that deemed distribution of cash is in excess of that contributing partner’s basis in its contributed property plus its basis in its partnership interest and other property contributed at the same time as the encumbered property, the excess is taxable. In other words, the test for gain recognition is whether the portion of the encumbrances of which the contributing partner is relieved is greater than the adjusted basis for his partnership interest at the time of contribution.

Example (1): A, B and C create the ABC Partnership. A and B each contribute $40,000 to the partnership. C contributes real property with a gross value of $100,000, subject to a recourse mortgage of $60,000 (its net value is $40,000), and adjusted basis of $80,000.

In this instance, C has been relieved of a $60,000 liability by the partnership’s assumption of the liability and under § 752(b) is considered to have received a cash distribution from the partnership of that amount. However, since C is a one-third partner in the partnership, he, therefore, has a $20,000 share in the $60,000 increase in partnership liabilities by reason of the assumed mortgage. Under § 752(a), C considered to have made a cash contribution to the partnership in that amount. These transactions are netted against each other and C is deemed to have received a net cash distribution of $40,000 in connection with the contribution of property to the partnership.

Under § 731(a), if the amount of money distributed or deemed distributed to a partner exceeds the partner’s adjusted basis in the partnership interest, the partner has taxable gain to the extent of the excess. In this instance, C’s adjusted basis of $80,000 for the contributed property is reduced by the $40,000 net amount of the § 752 adjustments resulting in a $40,000 adjusted basis for C’s partnership interest. Thus, there is no taxable gain to C by reason of the contribution of property.

Example (2). Assume the same facts under Example (1) above, except that C contributes real property with an adjusted basis of $30,000. In that instance, C’s beginning adjusted basis for his partnership interest of $30,000 is increased by his share, $20,000, of the assumed mortgage and is decreased by the full amount of the assumed mortgaged of which he is relieved, $60,000. Thus, the net, deemed money distribution to C is $10,000 more than the adjusted basis for his partnership interest. Therefore, under § 731(a), C has a taxable gain of $10,000 as a result of the transfer of the mortgaged property.


(d) If the liability attached to the contributed property is nonrecourse, the results to the contributing partner would be different. Under the § 752 Regulations, nonrecourse liabilities are not allocated among the partners solely from the basis of their profits ratios. Rather, rules are provided for allocating the nonrecourse liability to the partners first, to reflect their shares of minimum gain under § 704(b), and second, their shares of the § 704(c) gain. The remainder of the liability is allocated based on the partners’ profit ratios. The minimum gain is defined as the excess of the amount of the liability over the adjusted basis of the property on the date of contribution, and that portion of the liability is allocated exclusively to the contributor.

Example (3). Assume the same facts under Example (2) above, except that the $60,000 mortgage is nonrecourse. In that instance, C would have a $30,000 ($60,000 mortgage less $30,000 basis) Section 704(c) share of the nonrecourse liability and a $10,000 share of the remainder (1/3 x $30,000). Thus, C’s share of the liability after the contribution is $40,000, while his Section 752(b) amount is $60,000. This generates a net liability relief of $20,000 and no gain recognition because of the $30,000 basis to C of the contributed property and of his partnership interest. Since the excess amount of the liability is attributed to the contributor, it is more unlikely for gain recognition to arise on the transfer of property encumbered by a nonrecourse liability.

4. Other Mortgage in Excess of Basis Issues and Transfer of Partnership Interest Issues.

(a) To the extent of the excess, the purported gift will be recharacterized as a part sale/part gift. Est. of Levine v. Commissioner, 634 F.2d 12, 46 A.F.T.R.2d 80-5349, 80-2 U.S.T.C. ¶ 9549 (2d Cir. 1980) (gift to children); Guest v. Comm’r, 77 T.C. 9 (1981) (gift to charity).

(b) The same is true when a partner has a negative capital account. O’Brien v. Comm’r, 77 T.C. 113 (1981) (abandonment of a partnership interest with a negative capital account).

5. Disguised Sales.

(a) Code § 707(a)(2)(B) provides that if:

(i) there is a direct or indirect transfer of money or other property by a partner to a partnership,


(ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and

(iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property.

(iv) Such transfers shall be treated either as a transaction described in paragraph (1) [relating to transfers between the partnership and a partner not acting in his capacity as a partner] or as a transaction between two or more partners acting other than in their capacity as members of the partnership.

(b) The following is an illustration of a transaction that may be treated as a disguised sale of property between partners under section 707(a)(2)(B):

Example: Assume that partner A contributes property with a fair market value of $100,000 and an adjusted basis of $40,000 to the AB equal partnership. Partner B contributes cash of $75,000. In order to equalize the contributions of the partners, partner A receives a cash distribution of $25,000. Under the rule of Code § 707(a)(2)(B), A could be treated as selling a 25% undivided interest in the property to B in exchange for the $25,000 of cash. As a result, A has a $15,000 gain computed by subtracting one quarter of the $40,000 basis for the property from the $25,000 cash received. A would be deemed to contribute $75,000 of property with a basis of $30,000 to the partnership under Code § 721, and B would be deemed to contribute $50,000 of cash and the $25,000 interest in the property.

(c) Although a complete discussion of the regulations is beyond the scope of these materials, the regulations generally provide that if a partner transfers property to a partnership and the partnership transfers money or other consideration (including the assumption of or the taking subject to a liability) to the partner, the transaction constitutes a sale of the property (in whole or in part) only if based on all the facts and circumstances (a) the transfer of the money or other consideration would not have been made but for the transfer of property and (b) if the transfers are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risk of partnership operations. The determination of whether a transfer constitutes a sale under this test is made based on all the facts and circumstances.


(d) Note there are Proposed Regulations that are issued.

(e) The Regulations set out 10 facts and circumstances that may tend to prove the existence of a sale. Treas. Reg. § 1.707-3(b)(2). For example, a sale is indicated if the “timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer.”

(f) Transfers made within two years are presumed to be sales, and transfers made more than two years apart are presumed not to be sales. Treas. Reg. § 1.707-3(c) and (d).

(g) As a general rule, “reasonable” guaranteed payments for capital and to reasonable preferred returns are presumed to be outside of the reach of the disguised sale rules, provided that the facts and circumstances do not clearly establish that such payments are part of a disguised sale. Treas. Reg. § 1.702-4(a)(ii), (iii), (2), (3).

(i) These rules must be consulted especially in connection with a freeze transaction since, by definition, one or more family members is entitled to receive a preferred cash distribution or guaranteed payment. As a general rule, guaranteed payments and preferential returns are deemed to be reasonable if they do not exceed 150% of the highest applicable Federal rate, using the appropriate compounding periods, in effect during the taxable year in which the binding obligation to make such payments is first established by agreement among the partners. Treas. Reg. § 1.707-4(a)(3)(ii).

(ii) A frozen partnership may fall outside the scope of deemed reasonableness if the preferential return on frozen partnership interest is set too high. It is possible that the preferential return necessary to support the value of a frozen interest may exceed 150% of the highest applicable federal rate than in effect. If this is the case, the practitioner should be careful to structure the partnership so there is no other aspect of the transaction that would lead the IRS to attempt to find a disguised sale.

(h) The Regulations also contain special rules for transfers of property subject to liabilities or transactions involving the assumption of liabilities by the partnership on behalf of a partner. Treas. Reg. § 1.707-5.


B. Partnership Distributions.

1. Distributions of Contributed Property to Partner Other Than Contributing Partner—Section 704(c)(1)(B).

(a) This section provides that a contributing partner generally will be treated as recognizing gain or loss from a sale of property if the contributed property is distributed by the partnership to a partner (other than a contributing partner) within five years of the contribution assuming the contribution occurred after October 3, 1989.

(b) A successor of the contributing partner assumes the “taint” from the contributing partner.

2. Contributions by and Distributions to Contributing Partner: A Deemed Sale to The Partnership by the Contributing Partner.

(a) Section 737 provides that, if a partner contributes appreciated property to a partnership and the partnership distributes other property to the contributing partner within five years of the initial contribution from the contributing partner, the contributing partner is required to recognize certain gain.

(i) The amount of the gain is the lesser of:

[a] The partner’s net precontribution gain; or

[b] The amount by which the fair market value of the distributed property (at the time of the distribution) exceeds the contributing partner’s basis for his partnership interest at the time of the distribution.

Example: Senior generation and junior generation from partnership. Senior generation contributes land with an adjusted basis of $100,000 and a fair market value of $500,000. Junior generation contributes artwork with an adjusted basis and fair market value of $500,000. Four years after the formation of the partnership, the artwork is distributed to senior generation at a time when its fair market value is $600,000. Assume that there had been no intervening distributions or dispositions of property by the partnership.

Under section 737, senior generation would recognize a gain of $400,000—the amount of its net precontribution gain. This amount is less than the


amount by which the fair market value of the artwork exceeds its basis for its partnership interest ($600,000 - $100,000 = $500,000). Prior to the enactment of section 737 in 1992, senior generation would have received the artwork without recognition of gain based on section 731(a)(1) and would apply the basis for its partnership interest ($100,000) to the artwork based on section 732.

(b) Based on § 737(b), the application of § 737 is limited to those situations where the distribution occurs within five years of the contribution and where the built-in gain has not already been recognized as a result of the previous sale by the partnership or distribution by the partnership subject to section 704(c)(1)(B).

3. A contributing partner(s) recognize gain on property distributed to another partner or on a distribution of other property to the contributing partner within seven years of the original contribution, as opposed to five years under pre-act law.

4. Possible Taxability When Securities Are Distributed—Section 731(c).

(a) In late 1994, Congress enacted Section 731(c) which provides for an additional category of property, the distribution of which by a partnership can result in gain recognition by the distributee partner. Section 731(c) provides that, for purposes of both Section 731(a)(1) and 737, the term “money” includes marketable securities and the amount thereof equals their fair market value on the date of distribution.

(b) In addition to the general limitation on recognizing gain on the distribution of money, i.e., gain is limited to the excess of the money distributed over the basis of the distributee’s interest in the partnership, Section 731(c) provides that the amount of determined gain is reduced (but not below zero) by the excess of the distributee’s share of the net gain which would have been recognized if all such marketable securities were sold by the partnership at fair market value over the distributee’s share of a similarly determined amount after the distribution. The cap on the potential gain is intended to insure that the portion of the distribution which does not represent overall profit potential is not taxed.


C. Sales By The Partnership Of Contributed Property That Had Precontribution Appreciation.

1. Section 704(c)(1)(A) provides rules to ensure that unrealized appreciation or depreciation inherent at the time of the contribution would eventual be allocated to the contributing partner.

Example: A contributes a building with a fair market value of $100,000 and an adjusted basis of $10,000 to a partnership. The partnership takes a $10,000 tax basis for the building, which has an inherent precontribution gain of $90,000. B contributes $100,000 cash to the partnership. A and B are equal partners and each are entitled to receive 50% of partnership profits and losses. If the building is then sold by the partnership for $100,000, $90,000 of gain is recognized by the partnership. If the Code did not contain § 704(c), the partnership would allocate that gain equally, i.e., $45,000 to each of A and B. Thus, A would be able to “shift” one-half of the tax liability applicable to such gain to his fellow partner B. Instead, IRC § 704(c) requires that the entire precontribution gain of $90,000 be allocated to A for federal income tax purposes. Any post contribution gain, that is gain attributable to value in excess of the $100,000 contribution value, would be allocated equally between A and B.

2. The Regulations (regarding precontribution gain or loss) generally require that a partnership must specially allocate items of income, gain, loss and deduction with respect to contributed property. Treas. Reg. § 1.704-3(a)(1). With certain exceptions, special allocations of depreciation attributable to depreciable property generally must be allocated to take into account precontribution gain (or loss) attributable to such property. See, Pluth, “Drafting for Alternatives Under the Section 704(c) Regs.,” Taxation for Lawyers (March/April 1994).

3. Like the Code § 704(b) rules, these provisions affect allocations of taxable gains, losses and deductions, not economic profits and losses. Also, like the Code § 704(b) rules, these provisions are mandatory, not optional. Code § 704(c) is not applicable, however, if all partners contribute cash or assets having fair market values equal to their tax basis.

4. The built in gain is not triggered by a gift of the partnership interest from the contributing partner to the junior generation based on Prop. Treas. Reg. § 1.704-3(d)(2)(ii)(A) and § 7701(a)(45). Of course, this assumes that the capital account related to the partnership interest that is gifted is not a negative capital account. When the property is sold by the partnership, the “taint” inherent in the partnership interest owned by the junior generation will result in the junior generation having to report its pro rata share of the built in gain based on Prop. Treas. Reg. § 1.704-3(d)(2)(ii)(A). If the contributing partner sells his/her partnership interest in a taxable transaction, the deferred gain will be recognized based on that


Treasury Regulation. If the partnership sells that property, the contributing partner/senior generation will recognize the deferred gain at that time based on Prop. Treas. Reg. § 1.704-3(b)(2)(iii)(B).

D. Optional And Required Basis Adjustments When Partnership Interests Are Transferred.

1. Unless an election is in effect, the basis of partnership property will not be adjusted as a result of a distribution of property to a partner or a transfer of a partnership interest due to a sale, exchange, or death of a partner. This can (and usually does) result in a discrepancy between a partner’s basis in his partnership interest (outside basis) and his share of the partnership’s basis in partnership property (inside basis) if the partnership’s basis in the property does not equal its fair market value when or a distribution takes place.

2. An adjustment to the basis of partnership assets is required when a partnership interest is sold and the partnership has “substantial built-in losses” ($250,000) or when the distribution of partnership assets results in a “substantial reduction in basis” ($250,000). §§ 734(b), 743(d).

3. The partnership may also make an optional election under § 754 to make the adjustments to eliminate these discrepancies even when not required. Once made with respect to one transaction, the election remains in effect for all future transactions and cannot be revoked without the consent of the IRS.

4. Whether optional or mandatory, the adjustment applies only to:

(a) transfers of a partnership interest by sale or exchange, or upon the death of a partner, or

(b) distributions of property to a partner.

5. Computation of the basis adjustment.

(a) Transfer of a partnership interest.

(i) If an election is in effect or adjustments are required, upon the transfer of a partnership interest from a sale, exchange, or death of a partner, the partnership will make special basis adjustments under § 743(b).

[a] The net amount of the adjustments will be the difference between the transferee’s outside basis (i.e., basis in the partnership interest) and the transferee’s share of the inside basis (i.e.,


proportionate share of the partnership properties adjusted basis).

[b] Section 755 and the regulations provide rules for allocating the net adjustment among the partnership’s assets.

[c] The adjustments only apply with respect to the transferee partner, so they do not affect capital accounts or the allocation of income. Once income is calculated and allocated under the partnership agreement, the partnership uses the adjustments to adjust the transferee’s share of partnership items (gain, loss, depreciation, etc.).

(ii) The optional basis adjustment election attempts to approximate a cost basis in partnership assets for the transferee partner.

(b) Distribution of property.

(i) If adjustments are required, upon the distribution of property to a partner, the partnership will increase its basis in the remaining partnership assets by:

[a] gain recognized by the distributee partner, and

[b] the excess of partnership’s basis of the distributed property over the basis of the property in the hands of the distributee partner.

(ii) Upon a liquidating distribution, the partnership must decrease its basis in the remaining assets by:

[a] loss recognized by the distributee partner, and

[b] the excess of the distributee’s basis of the distributed property over the basis of the property in the hands of the partnership before the distribution.

Example: Kevin wants to acquire Tom’s 30% partnership interest in ACE partnership, for $45,000 cash. Kevin will also assume Tom’s portion of the partnership debt. The sales price is based on the following balance sheet:


ACE Partnership/Balance Sheet

Adjusted Basis

Fair Market Value

Assets

Cash $ 5,000 $ 5,000 Accounts receivable 25,000 25,000 Inventory 40,000 60,000 Equipment 30,000 30,000 Building 70,000 97,000 Land 30,000 33,000

Total assets $ 200,000 $ 250,000

Accounts payable $ 10,000 $ 10,000 Mortgage 90,000 90,000 Capital:

Sam (40%) 40,000 60,000 Tom (30%) 30,000 45,000 Mark (20%) 20,000 30,000 Steve (10%) 10,000 15,000

Total liabilities and capital: $ 200,000 $ 250,000

There is no built-in-loss so the adjustments would be optional with a § 754 election. The optional basis adjustments would equal the difference between the transferee’s basis in his partnership interest (outside basis) and his allocable share of partnership basis in partnership property (inside basis). Generally, a partner’s share of basis in partnership property is the sum of the partner’s share of “previously taxed capital” plus the partner’s share of partnership liabilities. The partner’s share of “previously taxed capital” should equal the partner’s tax capital account.


Kevin’s outside basis will be:

Cash paid for partnership interest $45,000

Assumption of accounts payable (30% of $10,000) 3,000

Assumption of mortgage (30% of $90,000) 27,000

Total $75,000

His share of inside basis will equal:

tax capital account $30,000

30% of partnership liabilities 30,000

Total $60,000

The difference between Kevin’s outside basis ($75,000) and his proportionate share of the adjusted basis of the partnership property ($60,000) would result in a $15,000 positive optional basis adjustment. The adjustment would be allocated first by class between ordinary income property and capital gain property. Then, the adjustment is allocated among the assets within a class. The overall adjustment is a net amount of the adjustments to each asset. The adjustments to each asset is therefore based on the built-in gain or loss for that asset; with negative adjustments made to some assets and positive adjustments made to others. The net effect of the adjustments should be to reduce the difference between the fair market value and adjusted basis of each asset.

E. Is There A Business Purpose For The Formation Of The LLC Or Partnership And The Transaction.

1. There must be a business purpose.

(a) Business purpose found. Woodbury v. Comm’r, 49 T.C. 180 (1967).

(b) Business purpose not found.

(i) Payton v. United States, 425 F.2d 1324, 70-1 U.S.T.C. ¶ 9379, 25 A.F.T.R.2d ¶ 70-1124 (5th Cir. 1970), cert. denied, 400 U.S. 957 (1970); Swanson v. Comm’r, 518 F.2d 59, 75-2 U.S. T.C., 36 A.F.T.R.2d ¶ 75-5159 ¶ 9528 (8th Cir. 1975); Cirelli v. Comm’r, 82 T.C. 335 (1984); Borkowski v. Comm’r, T.C.M. ¶ 1982-87 (“S” Corporation stock).


(ii) Estate of Murphy v. Comm’r, T.C.M. 1990-472 (Transfers to donees were ignored). cf. Est. of Frank, 69 TCM 2255 (1995) (Gift to avoid control premium or to obtain minority discount respected as there was “substance” to the gift).

(iii) Technical Advice Memorandum (March 1, 1997) (97 Tax Notes Today 47-16) (Existence of FLP ignored on the ground that the creation of partnership and the transfer of the partnership interests therein was a single testamentary act; the sole purpose of the transfer was to reduce estate tax).

2. If there is a business purpose or the partnership conducts business activities, the partnership is typically not a sham. Moline Properties v. Comm’r, 319 U.S. 436, 30 A.F.T.R. ¶ 1291, 43-2 U.S.T.C. ¶ 9464 (1942).

3. Is a business purpose needed for estate and gift tax planning?

F. Does The Junior Generation Truly Own Its Member Interests Or Limited Partnership Units For Tax Purposes.

1. Section 704(e) And Treas. Reg. § 1.704-1(e).

2. Minors as Members or limited partners; they must truly be able to exercise dominion and control over the Interests or units and enjoy the economic benefits of owning the Interests or units and the Senior Generation cannot exercise “too much” control.

(a) Minors who “own” their own units directly held not to be partners. Pflugradt v. United States, 310 F.2d 412, 63-1 U.S.T.C. ¶ 9112, 10 A.F.T.R.2d ¶ 6068 (7th Cir. 1962) (Partnership units); Weiner v. Comm’r, T.C.M. 1984-163 (“S” corporation stock).

(b) Minor held to be a partner for tax purposes. Woodbury v. Comm’r, 49 T.C. 180 (1967) (18-year-old son participated in the partnership activities.)

(c) Uniform Gifts to Minors Act custodian (mother) held to own limited partner units for minors. Garcia v. Comm’r, T.C.M. 1984-340.

(d) If “young” minor is to be given Member Interests or limited partner units, it is better to assign those Interests or units to a trust. If (1) there is a business purpose, (2) capital is a material producing factor and (3) the formalities are observed, the Members or limited partners should be respected as owners. Stanback v. Comm’r, 271 F.2d 514, 59-2 U.S.T.C. ¶ 9759, 4 A.F.T.R.2d ¶ 5792


(4th Cir. 1959); Hartman v. Comm’r, 43 T.C. 105 (1964); Smith v. Comm’r, 32 T.C. 1261 (1959).

3. Thus, do not restrict cash flow distributions beyond reasonable needs of the business or investment and the general partner should not borrow excess cash flow.

G. Does The Charity Or Nonfamily Member/Key Employee Truly Own Its Interests Or Limited Partner Units For Tax Purposes.

1. Aiken Industries, Inc. v. Comm’r, 56 T.C. 925 (1971) (Taxpayer/middleman ignored for tax purposes when it could not make an economic gain in the transaction.); Atlee v. Comm’r, 67 T.C. 395 (1976).

2. Anders v. Comm’r, 68 T.C. 474 (1977) (Taxpayer/Middleman not ignored for tax purposes as it could and did make a profit in the transaction).

3. Bornstein v. Comm’r, 334 F.2d 779, 64-2 U.S.T.C. ¶ 9573, 14 A.F.T.R.2d ¶ 5015 (1st Cir. 1964) (If there is substance to a transaction (i.e., the gifting of Interests or units to a charity or nonfamily member/key employee of the Senior Generation), the tax planning motives may be immaterial); McLane v. Comm’r, 46 T.C. 140 (1966).

4. Thus, the Member or limited partner must own more than a minuscule number of Interests or limited partner units and be able to exercise dominion and control over them.


III. A COMPARISON OF INTER-GENERATIONAL WEALTH TRANSFER TECHNIQUES1

A. Introduction.

1. Beyond Exemption Planning. For many clients basic exemption planning using both spouses’ unified credit exemptions at death to shelter their assets from estate tax is adequate.2 This outline addresses the only substantial estate tax minimization planning available beyond unified credit planning; namely, shifting growth through lifetime transfers.

(a) Annual Exclusion Gifts. On a small scale, annual exclusion gifts can be used to shift assets tax-free and growth.

(b) Exemption and Beyond. This outline addresses shifting growth through large transfers beyond the annual exclusion and/or exemption amounts.

2. Valuation Discounts. Discounts for minority interest, marketability, etc. should always be considered when gifting property. The techniques in this outline should be utilized only after the property has been valued with appropriate discounts and perhaps in conjunction with a stock recapitalization and shareholder agreements.

3. Other Related Issues. To most effectively transfer assets from senior to junior generation, non-tax issues must be considered in conjunction with inter-generational transfer techniques.

(a) Control/Management Issues. In certain situations, the senior generation may be interested in tax savings and shifting growth to the junior generation, but may not have confidence in the junior generation’s ability to manage the assets wisely. In such situations, the techniques addressed in this outline should be used in conjunction with other planning, such as management trusts, a family partnership, etc., to postpone outright distribution and/or control of the transferred property.

1 This section of the outline was originally drafted by Jennifer D’Amato, a shareholder with (and member of the board of directors of) Reinhart Boerner Van Deuren s.c. in 1997. With Ms. D’Amato’s consent, the speakers have updated it effective 2014. 2 Each individual’s unified credit exemption is currently $5.34 million, which is indexed for inflation by the American Taxpayer Relief Act of 2012. Though 2015’s unified credit will not be released until November, it is projected to be approximately $5.42 million.


(b) Creditor Protection Issues. Certain techniques addressed in this outline may have the additional advantage of offering protection from creditors.

4. Techniques for Particular Purposes/Types of Property. This outline does not address personal residence trusts (“PRTs” or “QPRTs”), Employee Stock Ownership Plans (“ESOPs”) or the various split interest charitable trusts (“CRUTs,” “CRATs,” “CLATs,” and “CLUTs”), all of which can be useful in specific situations. These techniques are either limited to the transfer of a particular asset, as in the case of a personal residence trust; or, used to transfer assets to individuals and entities other than the junior generation. Instead, this outline addresses techniques which can be used to freeze value of all types of property and transfer growth to the junior generation.

5. Life Insurance. Irrevocable life insurance trusts can be extremely useful in providing liquidity for estate tax and other expenses and should be considered in conjunction with the techniques examined in this outline.

6. Techniques Compared. There are only two basic ways to transfer assets (and potential growth) from a senior generation to a junior generation, sales and gifts. This outline compares the transfer tax and income tax consequences of several techniques which combine the benefits of gifts (total removal of assets plus growth from the transferor’s estate) with the benefits of sales (step up in basis for transferee, no gift tax cost, and increased liquidity for transferor). In addition, any of the techniques could be combined with other techniques, only some of which are examined here. The techniques examined are:

(a) Outright Gifts.

(b) Straight Sales.

(c) Grantor Retained Annuity Trusts (GRATs).

(d) Installment Note Sales.

(e) Sale of Property in Exchange for an Installment Note from a Defective Trust.

(f) Self-Canceling Installment Note Sales (SCINs).

(g) Sale of Property in Exchange for a SCIN from a Defective Trust.

(h) Private Annuities.


B. An Overview Of The Techniques Compared.

1. Outright Gift. An outright gift is a complete transfer of all interests in an asset for no consideration.

(a) Transfer Tax Considerations. Gift and any appreciation through the date of the transferor's death will be completely excluded from donor’s estate. In addition, any gift tax paid on the gift will be excluded from the transferor’s estate provided the transferor survives the transfer by three years. § 2035(c).3

(i) Gift Tax. Complete taxable gift at time of transfer. However, the transferor will not pay gift tax until cumulative lifetime gifts exceed his unified credit amount. § 2010. In addition, gifts may qualify for the annual exclusion from gift tax. § 2503(b).

(ii) Estate Tax. Not applicable, but because of the unified transfer tax system, adjusted taxable gifts are added to the estate tax calculation for purposes of determining the estate tax bracket. § 2001(b)(1)(B).

(iii) Generation-Skipping Transfer Tax. Generation-Skipping Transfer (“GST”)4 exemption can be allocated at time of transfer, which effectively allows the transferor’s GST exemption to be leveraged. Automatic allocation will be made to a direct skip but not to a transfer from which a taxable distribution or termination may occur. § 2632(b)(1).

[a] Predeceased Child Exception. Predeceased child exception applies. § 2651(e)(1).

[b] Tax Exclusive Transfer. Tax is estate, gift and GST tax exclusive because the transfer is a direct skip. § 2623.

(b) Income Tax Considerations. An outright gift has straightforward income tax consequences.

(i) No Recognition of Gain or Loss. Transferor does not recognize gain or loss on transfer.

3 All section references are to the Internal Revenue Code of 1986, as amended. 4 The American Taxpayer Relief Act of 2012 unified the estate, GST and gift taxes. However, portability is not available for the GST tax.


(ii) Carry-over Basis. Transferee receives transferor’s basis in assets (or receives basis for purposes of determining loss equal to fair market value if transferor’s basis exceeds fair market value). § 1015.

(c) Other Considerations. A transferor must be willing to give up most or all benefit from or control over gifted property.

(i) Payment of Gift Tax. If gift plus prior gifts exceeds the transferor’s unified credit amount, transferor will have to pay gift tax.

(ii) Asset Considerations. Best result with high basis assets (as transferee receives carry-over basis) which are expected to appreciate rapidly, as the appreciation during the remainder of the transferor’s life passes gift and estate tax free. If property depreciates during transferor’s lifetime, gift was a wasted opportunity (especially if gift tax was paid).

(iii) Defined Value Clause. Noncash gift may be structured over time using defined value clause to make noncash gifts of a quantity to be determined over time, but of a value that will use donor’s gift tax annual exclusion. Wandry v. Comm’r, T.C. Memo 2012-88. Practitioners should use caution, however, as IRS continues to contemplate challenge to defined value clauses. All cases upholding defined value gifts have used recent appraisals. See Petter v. Comm’r, T.C. Memo. 2009-280, aff’d 653 F.3d 1012 (9th Cir. 2011). See also Hendrix v. Comm’r, T.C. Memo. 2011-133.

2. Straight Sale. A straight sale is an asset to asset exchange for fair market value.

(a) Transfer Tax Considerations. Assuming an arm’s length sale, there will be no direct transfer tax consequences but a sale may be beneficial in some instances.

(i) Gift. Not applicable.

(ii) Estate. Property received in exchange is included in estate; property transferred is excluded.

(iii) GST Planning. Sales to “skip persons” are not subject to GST.


(b) Income Tax Considerations. Both parties recognize gain or loss on the transaction at the time of the exchange and receive basis equal to fair market value.

(c) Other Considerations. Sale of specific assets prior to death can help assure that either party’s estate will qualify for special income and estate tax benefits relating to ownership of a family farm or closely-held business under Code sections 303, 2032A, 6166.

3. Grantor Retained Annuity Trust (“GRAT”). A grantor retained annuity trust (“GRAT”) is an irrevocable trust designed to hold assets for a specified time period. During the designated period, the GRAT makes specified annuity payments to the transferor. When the GRAT terminates, assets are distributed to the remainder beneficiaries designated by the transferor in the GRAT agreement.

(a) Transfer Tax Considerations. The transferor retains the annuity interest which is valued at 120 percent of federal midterm rate, the applicable federal rate or “AFR.” § 7520. If the property transferred to the GRAT actually produces a total return (income and appreciation) equal to the AFR, the gift will have been correctly valued (i.e., no leveraging will have occurred). However, if the transferred assets outperform the AFR, the gift will be undervalued.

(i) Gift Tax. The annuity payment is a qualified interest under § 2702(b). This means the value of the annuity payments is subtracted from the value of the assets transferred to the GRAT in determining the amount of the taxable gift to the remainder beneficiaries.

[a] “Zeroed Out” GRATs. Many planners calculate the term and annuity payment of a GRAT to “zero out” the gift. Example 5 of Reg. 25.2702-3(e) previously indicated that it is not possible to completely eliminate a taxable gift upon establishing a GRAT, but was revised after the holding in Walton v. Comm’r, 115 T.C. No. 115 (2000); See Notice 2003-72.

[b] Gift Tax Return. To the extent a GRAT is not “zeroed out,” gift tax will only be payable when transferor’s lifetime gifts exceed unified credit amount, but a gift tax return must be filed.


[c] Does Not Qualify for Annual Exclusion. The value of the taxable gift will not qualify for the annual exclusion as the remainder interest transferred to the ultimate beneficiaries is not a present interest.

(ii) Estate Tax. Estate tax consequences turn on whether the transferor survives the selected GRAT term.

[a] Grantor Outlives GRAT Term. If the GRAT term ends prior to the transferor’s death, the assets passing to the remainder beneficiaries are not subject to estate tax.

[b] Grantor Dies During GRAT Term. If transferor dies during the term of the GRAT, the GRAT assets (or a portion of them) are includable in the transferor’s estate. § 2039. The IRS will likely be successful in including the full amount. See PLR 9345035.

[c] Grantor Dies During GRAT Term, but Annuity Payable to Estate. If the annuity is payable for the remainder of the term to the estate of the deceased grantor, the interest remains qualified and the beneficiaries are not subject to estate tax. See Walton v. Comm’r, 115 T.C. No. 41 (2000), Notice 2003-72.

[d] Reversion Greater Than 5%. If the transferor is married, GRAT should provide for a reversion to the transferor’s estate (to assure that the interest be directed to spouse and can qualify for the marital deduction) if the transferor dies within the term. If the actuarial value of the reversion is greater than 5%, all GRAT assets will automatically be included in the transferor’s estate.

[e] Reversion Less than 5%. If the reversion is less than 5%, arguably, only that portion of the GRAT necessary to generate the annuity should be included in the estate. (For example, if the transferor dies in a month when the AFR is greater than the AFR for the GRAT, less than the entire GRAT should be included in the transferor's estate. See Rev. Rul. 82-105, 1982-1 C.B. 133 which discusses the amount of a charitable remainder trust includable in the transferor’s estate where transferor


died during the term (divides annual annuity by AFR at date of death).

(iii) Generation Skipping Transfer Tax. GRATs are not effective in GST planning.

[a] No Early Allocation. Section 2642(f) precludes allocation of a transferor’s GST exemption to a transfer during an estate tax inclusion period (ETIP). Section 2642(f)(3) defines ETIP as any period during which the transferred property would be included in the transferor’s estate (other than via section 2035) if the transferor were to die. Thus, allocation of GST exemption is not effective until the termination of the transferor’s interest in the trust (at which point all appreciation has accrued). This means that unlike an outright gift, GST exemption cannot be leveraged as a gift to a GRAT. However, consider creating a separate GST exempt trust which purchases the remainder interest in the GRAT, effectively providing GST exempt treatment to GRAT assets.

[b] No Predeceased Child Exception. Predeceased child exception does not apply as the GST will be a taxable termination, not a direct skip. § 2651(e)(1).

[c] Tax Inclusive Transfer. Tax is tax inclusive because the transfer is not a direct skip, but is a taxable termination. § 2622.

(b) Income Tax Considerations. Income tax considerations are relatively straightforward due to “grantor trust” status.

(i) Grantor Trust Status. In order to secure grantor trust status, transferor should retain reversion worth at least 5% of GRAT assets, § 673(a); or grant a nonadverse trustee the power to distribute income to the transferor’s spouse, § 677(a); grant a trustee (other than the transferor who is not an independent trustee via § 674(c)) the power to allocate income among a class of beneficiaries; give transferor the right to substitute assets of equivalent value in a non-fiduciary capacity. § 675(4)(c) and See PLRs 9248016 and 9352007. All income, capital gains and deductions from a grantor trust pass through to the transferor.


(ii) Avoids Realization of Capital Gain. “Grantor trust” status avoids realization of tax upon distributions of appreciated property. Rev. Rul. 85-13, 1985-1 C.B. 184.

(iii) Loans to GRATs. If transferor lends money to GRAT, interest paid by GRAT is not included in Grantor’s income. (A loan may be desirable if GRAT has not generated sufficient income to pay the annuity amount, but should be paid off before the term ends.) However, loans to GRATs can have adverse consequences.

[a] Not Qualified Interest. In PLR 9604005, trustee satisfied annuity payment with note from grantor. IRS ruled payments were not qualified annuity interests as the trustee was not obligated to make annual distribution.

[b] Qualified Interest. In PLR 9515039, trustee satisfied annuity payment with note. IRS ruled payments qualified as annuity interests as notes provided for annual payments. In addition, the note maker was personally liable for note payments and had substantial assets.

(iv) Payment of GRAT’s Income Taxes. Payment of the GRAT’s income tax by transferor results in tax-free gift to the trust; GRAT assets accumulate tax-free. Absent any unexercised right of reimbursement from the trust, transferor’s payment of the taxes should not result in a gift because transferor is personally liable for taxes generated by “grantor trust.” Commissioner v. Beck’s Estate, 129 F.2d 243 (C.C.A. 1942) see also Rev. Rul. 2004-64.

[a] IRS Position Unclear. In PLR 9444033, the IRS took the position that payment of taxes by the transferor without a reimbursement provision would result in an additional gift to the remainder beneficiaries. However, in PLR 9543049, the IRS issued the prior ruling but deleted the language as to the additional gift. Commenters note that the IRS may still be reconsidering the issue. Practitioners need take caution where the trust agreement or local law requires the trust to reimburse the grantor for payments of tax on trust income.

[b] Effect. Payment of taxes by transferor makes it easier to achieve gift and estate tax savings as the


GRAT’s net return (unreduced by taxes) is even more likely to be in excess of the AFR rate.

(v) Obtaining Basis Step-Up for GRAT Assets. The GRAT’s basis in assets contributed by the transferor is the transferor’s basis in the property—carryover basis rules apply. § 1015. The remainder beneficiaries’ basis likewise will be that of the transferor. Arguably, transferor can purchase assets from GRAT before the term ends. (i.e., substitute assets of equivalent value in a non-fiduciary capacity § 675(4)(c)). If successful, no gain is recognized on sale due to grantor trust status and upon transferor’s death, assets held in estate receive a step-up in basis. § 1014.

(c) Other Considerations. A GRAT works well for transferors who are concerned about estate taxes but are either not ready to completely do without benefits from the property or do not wish to pay gift tax.

(i) Assets Used to Fund GRAT. A GRAT will be most effective with assets that have a large cash flow. If the trust does not earn enough income to make annuity payments, then principal must be distributed which defeats the GRAT’s purpose (i.e., allowing principal and growth to pass to remaindermen).

(ii) Length of Term. Term which transferor is likely to survive must be chosen; consider a string of short-term GRATs instead of one longer term GRAT. Walton v. Comm’r, 115 T.C. 589 (2000) (2-year GRAT approved); Kerr v. Comm’r, 113 T.C. 449 (1999) (367-day GRAT not challenged).

(iii) Controlled Risk. The transferor cannot be certain that a gifted asset will appreciate. Unlike an outright gift, with a GRAT, there is little risk on the downside (especially if the gift is valued at close to zero) and a lot of upside potential.

(iv) Retention of Income Stream. Transferor may need an income stream from the transferred asset, making an outright gift impossible. Plus, like an installment note and unlike a private annuity, income stream is secured by underlying assets.

(v) Gift Tax. Over the exemption amount, transferor may balk at paying gift tax necessary for outright gift.


(vi) Unrestricted Resale. Unlike an installment note transaction, property in GRAT can be sold or exchanged for other property of equal value, without restriction.

4. Sale/Installment Note. A sale for an installment note is somewhat like GRAT in that an asset is exchanged in return for a stream of income.

(a) Transfer Tax Considerations. The installment note effective “freezes” the value of the underlying property as of the date of transfer. Because the applicable federal rate used is generally lower than the rate used to value an annuity or a GRAT, more appreciation passes tax free.

(i) Gift Tax. As long as note is for the full value of the property transferred and bears appropriate interest, no gift tax upon transfer:

[a] Full Value. Face value of note must reflect true value of obligation; obviously the property must not be undervalued. IRS has also indicated it may yet challenge defined value clauses in sale context—challenge will likely be with regard to undervalued property. Query whether risk of collectability could render note for full value worth less than full value?

[b] Interest Rate. Interest rate used to value note is AFR, depending on term of note. § 1274. Thus, a 3-to-9 year note is subject to the federal midterm rate, which will be 20% less than the rate which must be assumed for a GRAT or a private annuity.

[c] Taxable Gift. If note is not for full value, a taxable gift will result; i.e., a “bargain sale.” Gift will qualify for annual exclusion.

[d] Cancellations of Annual Exclusion Amount. Annual cancellation of part of the note can qualify for annual exclusion, but transferor will recognize gain upon cancellation. §§ 453B(f)(1) and 453(a). Haygood v. Comm’r, 42 T.C. 936 (1964) (IRS refuses to follow); Estate of Kelley, 63 T.C. 321 (1974); Rev. Rul. 77-299, 1977-2 C.B. 343.

(ii) Estate Tax.

[a] Underlying Asset. Transferred asset is excluded from estate. Sections 2702 and 2036(a) do not apply since the transferor has not retained the


“income from the transferred property.” The fact that the installment obligation is secured by the sold property should not alter the result. Commissioner v. Brown, 380 U.S. 563 (1965).

[b] Installment Note. If transferor dies while note is outstanding, note is included in estate, but may be able to be valued at less than face value if note’s interest rate is below the market rate at the time of the transferor’s death, the maturity date is unfavorable, the security is insufficient or the debtor is insolvent. In any event, any post sale appreciation should be excluded from the transferor’s estate.

(iii) Generation Skipping Transfer Tax. Unlike GRATs, and like private annuities, installment sales work well for GST planning.

[a] No Gift. If there is not a gift component (note value equals value of transferred property), no GST issue, which means you could enter into a transaction of unlimited value with a skip person without using any GST exemption. However, if gift is later assessed, late allocation of GST will be necessary.

[b] Gift. If there is a gift, GST exemption can be allocated to the gift at the time of transfer, which, like an outright gift or private annuity, effectively allows the transferor’s GST exemption to be leveraged. Arguably, a small gift should be made so that a fractional GST allocation can be made at the time of the sale.

(b) Income Tax Considerations for Transferor. The primary benefit of an installment note sale is that it allows deferral of gain. Transaction must comply with § 453 to defer gain over term of note. Otherwise, transferor will be currently taxable on the entire realized gain even though the cash used to pay the taxes is received over the term of the note.

(i) Installment Reporting of Gain. Transferor may elect to report gain over the term of the note (on a pro rata basis) as he receives payments for the property.

(ii) Effect of Change in Tax Rates. If tax rates increase, tax paid on deferred gain may exceed tax due if installment


treatment had not been elected. If tax rates decrease, tax paid will not only be deferred but will also be taxed at lower rates.

(iii) Reporting Payments Received. Payments received have three components, calculated as follows:

[a] Capital Gain. Divide gross gain by total sale price and multiply percentage by the annual payment. Reg. § 15A.453-1(b)(2)(i).

[b] Return of Capital. Divide transferor’s adjusted basis by sales price and multiply by annual payment.

[c] Interest. Notes have stated interest rate, interest paid is reported as income. Interest should be at least equal to, if not greater than applicable AFR. True v. Comm’r, T.C. Memo 2001-167.

(iv) Death During Term of Note. The income tax consequence of a disposition of an installment note at death turns on the type of disposition.

[a] Distribution to Non-Transferee.

[i] Non-Pecuniary Distribution. If the note is not returned to the transferee, generally not an event which triggers recognition of the gain inherent in the note. § 453B(c); § 691(a)(4). Instead, the beneficiary who receives the note will continue to recognize gain over the remaining term of the note.

[ii] Pecuniary Distribution. If the note is distributed in satisfaction of a pecuniary bequest (i.e., a specific dollar amount), the transfer will result in recognition of the previously unreported gain to the decedent’s estate. The estate will receive a partially offsetting income in respect of decedent, or “IRD” deduction for the estate tax attributable to the gain.

[b] Distribution to Transferee. Transfer of the note by bequest, devise or inheritance to the transferee will result in recognition of the previously unreported gain to the decedent's estate. This rule also applies


to a cancellation by will or by the executor after death. § 691(a)(5). The estate will receive a partially offsetting IRD deduction for the estate tax attributable to the gain. § 691(c).

(v) Death After Term of Note. If transferor outlives the term, then no gain remains to be reported on his final income tax return or his estate’s fiduciary income tax return.

(c) Income Tax Considerations for Transferee.

(i) Basis. Obtains a basis equal to fair market value, at the time of the transaction. This is preferable to a private annuity where the transferee’s basis is not fixed until the death of the transferor.

(ii) Deductibility. Interest is deductible but subject to investment income limitations. However, if S corporation interests are involved, will not be subject to investment income limitations if transferee is materially participating in S corporation. C corporation and other business interests are investment interests subject to applicable limitations.

(d) Other Considerations.

(i) Assets Sold Under Installment Method. Personal property sold under a revolving credit plan, publicly-traded stocks and public securities cannot be reported under the installment sale method. In addition, related parties generally cannot report sales of depreciable property on installment method. In addition, property which is subject to liabilities exceeding basis will not be eligible for installment treatment unless a “wrap around” note is used.

(ii) Retention of Property. If the transferee and transferor are related parties and transferee disposes of the property within two years after the original sale, the transferor will recognize gain on an accelerated basis. § 453(e)(2)(A).

(iii) Ability to Secure Income Stream. Like a GRAT, installment note payments are secured by the underlying property.

(iv) Use as Collateral for Loan. Note cannot be used as collateral for loan without triggering immediate recognition to extent of loan proceeds.


(v) No Mortality Risk. Transferee does not bear “mortality risk” that transferor will outlive actuarial life expectancy, unlike private annuity.

(vi) Estate Inclusion. However, also unlike an annuity, if transferor dies during term, note will be included in estate.

(vii) Payment Prior to Death. Use of highly-appreciated property may produce unsatisfactory results. The note is included in the grantor’s estate, but property does not receive a stepped-up basis under § 1014(a); this result can be avoided if note is paid prior to death.

(viii) Flexibility in Terms of Note. Note may be structured with a balloon payment which offers more flexibility than a private annuity.

(ix) Loss Property. Installment sales work well with loss assets as loss is recognized in the year of sale even though payments are deferred.

5. Sale to Defective Trust/Installment Note. Same as III.B.4., above, except that transferor sells assets to a defective trust using a regular note. A “defective trust” is an irrevocable trust which is structured to be excluded from the transferor's estate (by avoiding §§ 2036, 2037 and 2038) but to be treated as a grantor trust for income tax purposes.

(a) Transfer Tax Considerations. This technique is a variation of the installment sale with the added benefit of “grantor trust status.” Thus, no gain is recognized and the transferor may pay income tax on the assets transferred to the trust. This means all appreciation (not just net after income taxes) over the note’s AFR escapes taxation in the transferor’s estate. Note will be included in estate if transferor dies during term.

(i) 2036 Concerns. The IRS could treat a promissory note as a retained interest rather than a creditor’s right. Generally, if the transferor’s right to payment is not explicitly tied to trust income, no retained interest is found to exist. However, See Ray Estate v. U.S., 762 F.2d 1361 (9th Cir. 1985).

(ii) Chapter 14 Concerns. Sections 2701 and 2702 should not apply as note is debt and not an applicable retained interest in the trust or a term interest (equity). See PLRs 9436006, 9535026. However, See PLR 9251004, IRS initial argument in Dallas v. Comm’r, T.C. Memo 2006-212 that


note was not debt, but retained equity. IRS did not make argument at trial.

(iii) Generation Skipping Transfer Tax. If initial funds with which trust purchases property are gifted by Transferor, Transferor must allocate GST as necessary to cover initial contribution. The remainder of the trust assets, however, are received free of gift tax and are not subject to GST tax. BUT NOTE – subsequent valuation adjustments to property in trust could trigger GST issues at time of adjustment.

(b) Income Tax Considerations. Like a GRAT, a defective trust is intentionally structured as a grantor trust (usually by invoking § 675(4)(c)). See Reg. § 1.675-1(b)(4).

(i) No Recognition of Gain. Because the trust is a grantor trust, no gain is recognized on the initial transfer from the grantor to the trust. Rev. Rul. 85-13, 1985-1 C.B. 184.

[a] Payments Non Deductible. Payments are not deductible by transferee or included in transferor’s taxable income.

[b] Death During Term. If death occurs during term, arguably no realized gain exists, so no recognition. However, See Bernard Mandorin, 84 T.C. 667 (1985).

(ii) Payment of Taxes. As with a GRAT, payment of trust’s income tax results in a tax-free gift to the trust. (See, however, II.C.2(d), above.) Payment of taxes by the transferor makes it easier to achieve gift and estate tax savings as the trust’s net return (unreduced by taxes) is likely to be in excess of the interest rate on the note.

(iii) Obtaining Basis Step-Up for Defective Trust Assets. As with a GRAT, the defective trust’s basis in assets contributed by the transferor is the transferor’s basis in the property-carryover basis rules apply. § 1015. Thus, arguably, transferor can exchange high basis assets (such as cash) for the trust assets prior to death. (i.e., substitute assets of equivalent value in a non-fiduciary capacity § 675(4)(c)). No gain is recognized on exchange due to grantor trust status. Upon transferor’s death, assets held in trust will not receive a step-up in basis as they will not be included in estate. § 1014.


(c) Other Considerations. Generally, same as III.B.4., above.

6. Sale/Self-Canceling Installment Note (SCIN). Same as D, above, except note is structured to “self-cancel” upon the note holder’s death.

(a) Transfer Tax Considerations. Generally, same as D, above, except for state tax considerations if transferor dies during the term.

(i) Estate Tax Exclusion. The major difference between a regular note and a SCIN is that a SCIN is not included in the transferor’s estate. (However, Treasury has authority to issue regulations under § 2704(a)(3) to rights similar to voting and liquidation rights which could render SCINs problematic where interests in partnerships or closely-held corporations are the subject of an installment sale).

(ii) Risk Premium. To achieve this favorable treatment, a SCIN must provide for a “risk premium.” If no risk premium is paid, arguably § 2703(b) applies.

[a] Calculation. The risk premium may be either an increase in sales price or a higher interest rate. See PLR 8906002.

[b] Life Expectancy. Risk premium should be set in reference to actuarial life expectancy

[c] (Table 80CNSMT). Therefore, the older the transferor, the greater the risk premium. See Estate of J.A. Moss v. Comm’r, 74 T.C. 1239 (1980).

[d] Balloon Notes. Structuring the note as a balloon will greatly increase the risk premium, as transferor is less likely to receive payment at the end of the note term.

[e] Risk. Very little precedent exists for valuing risk premiums. See Catherine L. Wilson v. Comm’r, T.C. Memo 1992-480, where a note with a face value of three times the property value was found to incorporate an appropriate risk premium.

(iii) Generation-Skipping Tax. Note that if risk premium is insufficient and IRS determines that a gift has occurred, GST issues could be triggered.


(iv) Length of Term. IRS position is that SCINs must have a term shorter than actuarial life expectancy. GCM. 39503 (1986); if not, private annuity treatment is applicable. Private annuity must also be bona fide. Kite v. Comm’r, T.C. Memo 2013-43.

(b) Transferor’s Income Tax Considerations. If transferor dies during term of note, remaining unrecognized gain must be recognized by the Estate under section 691(a)(5)(A)(iii). Estate of Frane v. Comm’r, 93-2 USTC 50, 386, 998 F.2d 567 (8th Cir. 1993). This is the same result as with a regular note which is distributed to the transferee or in funding pecuniary bequest, but with a SCIN, no off-setting section 691(c) deduction (IRD deduction) is available as notes are excluded from transferor’s estate and IRD deduction is only applicable to assets included in decedent’s estate.

(c) Transferee’s Income Tax Considerations. Same as D, above. IRS will carefully examine Transferee’s ability to repay note. CCA 201330033.

(d) Other Considerations. Same as III.B.4., above, and:

(i) Risk. Risky to use a SCIN if assets are not easily valued, as 2703 could be invoked to cause note to be included in taxable estate.

(ii) Mortality. SCIN does not make sense if transferor is likely to outlive the term of the note, as payment of risk premium means transaction will likely result in wealth being transferred to, instead of away from, senior generation. If transferor is unlikely to outlive term of the note and is unlikely to outlive actuarial life expectancy, private annuity should be considered, as no estate inclusion or risk premium.

7. SCIN Sale to Defective Trust. A combination of E and F, above. Major difference from E is that if transferor dies during term, note is not included in estate. Major difference from F is that cancellation of note at death (arguably) does not trigger gain. Trust should hold assets in addition to note or will be subject to increased scrutiny by IRS.

(a) Retained Interest. IRS could argue that interest payments on note were a retained income interest under § 2036(a). But see Estate of Fabric, 83 T.C. 932 (1984).

(b) Valuation Concern. If SCIN has face amount significantly greater than the value of the assets held by the trust (due to high risk premium), there could be gift tax valuation problems as face value


of note significantly greater than assets available to pay it (i.e., analogy to Example 5 under Reg. § 25.7520-3(b)(2)(v)). These complications could also extend to GST depending on donees of gifts.

(c) Risk. IRS is likely to scrutinize such a tax-driven transaction very closely.

8. Private Annuity. Private annuities consist of a transfer of property in exchange for an income stream. Provided the present value of the income stream equals the fair market value of the asset transferred, no gift occurs. As with a GRAT, the AFR used to value a private annuity is 120% of the federal midterm rate. § 7520.

(a) Transfer Tax Considerations. If transferor lives to exact life expectancy and assets transferred earn exactly 120% of the federal mid-term rate, transaction is transfer tax neutral. However, if transferor predeceases life expectancy and/or assets transferred out-perform AFR, transaction is transfer tax efficient.

(i) Gift Tax. The establishment of a private annuity will involve a gift if the value of the property transferred is greater than the income stream received. If there is a gift, it will qualify for the annual exclusion. § 2503(b).

(ii) Estate Tax. The annuity ends upon the transferor’s death and is not included in estate unless transferor retains a security interest in property transferred in exchange for the annuity interest.

[a] § 2033 does not reach an annuity right that expires on the transferor’s death;

[b] § 2036 is avoided because the annuity is not a right to “income from the property” transferred. Purchasers must be able to pay annuity and formal agreements must be followed. Estate of Hurford v. Comm’r, T.C. Memo. 2008-278;

[c] § 2039 does not apply because there is no “annuity or other payment receivable by any beneficiary by reason of surviving” the transferor; and

[d] § 2701 does not apply as it applies only to retained equity interests-note payments should not be dependent on earnings, or could be deemed to be an equity interest.


(iii) Generation Skipping Transfer Tax. Private annuity works well for GST planning as there is no ETIP period so GST exemption can be allocated at the time of transfer.

[a] No Gift. If there is no gift, no GST issue, which means donor can enter into the transaction with a skip person without using any GST exemption. However, if the transaction is later deemed to be part gift, late GST allocation will have to be made.

[b] If there is a gift, GST exemption can be allocated to the gift at the time of transfer, which, like an outright gift, effectively allows the transferor’s GST exemption to be leveraged. Arguably, a small gift should be made at the time of the transaction so that a fractional allocation can be made.

(b) Transferor’s Income Tax Considerations. Formerly, the primary benefit of a private annuity was that it allowed the transferor to defer capital gain over his actuarial life expectancy, as opposed to a straight sale, where he would recognize all gain at the time of transfer. In 2006, however, IRS proposed regulations that cause gain to be recognized at the time of the transfer. See Prop. Reg. § 1.72-6(e), § 1.001-1(j).

(i) Effect of Change in Tax Rates. New regulations requiring payment of tax at transfer may be beneficial in low interest rate environment, as greater portion of future payments are tax free. Future payments consist of interest and tax-free return of capital. Can also “lock in” low capital gain rate. See Is the Private Annuity Really Dead for Estate Planning? by Alexander A. Bove, Jr., 2011.

[a] Note that annuity payments need not be equal (though practitioners need take care not to inadvertently create an installment sale when using varied annuity payments). Therefore initial annuity payment could be “grossed-up” to pay the tax, and future payments could be lesser amounts or deferred

(ii) Annuity Payments. Each annuity payment consists of three parts: return of capital, capital gain and ordinary income.

[a] Return of Capital. The portion of each payment which is return of capital is equal to the ratio of the “investment in the contract” to the “expected return.” § 72(b). The investment in the contract is


the transferor’s adjusted basis in the transferred property; the expected return is the life expectancy of the transferor multiplied by the annual payment.

[b] Capital Gain. The transferor will recognize the capital gain realized at the time of the transfer. The amount is based on the aggregate amount of the premiums and other consideration paid for the contract. See Prop. Reg. § 1.72-6(3)(e)(1).

[c] Ordinary Income. Any remaining amount of the payment is ordinary income.

[d] Death After Actuarial Life Expectancy. If transferor outlives actuarial life expectancy, all future payments are ordinary income (as investment and gain have been completely recognized).

[e] Death Prior to Actuarial Life Expectancy. If, on the other hand, the transferor dies prior to actuarial life expectancy, any remaining gain is extinguished and if total investment has not been recovered, transferor receives deduction for amount of unrecovered investment on final income tax return.

(c) Transferee’s Income Tax Considerations.

(i) Basis. The transferee’s basis in the property ultimately equals the sum of annuity payments actually made multiplied by the payment amount. If the transferee sells the property during the transferor’s life, basis is computed according to the actuarial value of the annuity obligation. Subsequent payments are additional losses on the sale of property. Thus, transferee’s basis is constantly fluctuating. See Rev. Rul. 55 119, 1955-1 C.B. 352.

(ii) Deductibility. Annuity payments are nondeductible capital expenditures.

(iii) Transferee’s Death Prior to Transferor’s Death. If transferee predeceases transferor, his estate will include the value of the property but will be liable to continue making annuity payments to the transferor and so will receive partially offsetting debt deduction on the estate tax return.


(d) Other Considerations.

(i) Mortality Risk. If transferor outlives actuarial life expectancy, property is overvalued; wealth is shifted to, instead of from, senior generation. Therefore, best result occurs with transferor who is not expected to reach actuarial life expectancy. However, amendments to regulations under section 7520 provide that the actuarial tables cannot be used if the individual is terminally ill. If the individual survives for 18 months or longer, the individual will be presumed to not have been terminally ill unless the contrary is established by clear and convincing evidence. §§ 1.7520-3(b); 25.7520-3 Example 5(3).

(ii) Lack of Security. Formerly, Transferor could not secure annuity payments by a promissory note, as note renders transaction subject to immediate taxation. Estate of Lloyd G. Bell v. Comm’r, 60 T.C. 469 (1973). With proposed regulations taxing transfer immediately, however, commenters have noted that it is likely the annuity may now be secured with exchanged assets or other assets. See (b), supra. But caution: this may result in the annuity being included in transferor’s estate.

(iii) Unrestricted Resale. Unlike most installment note transactions, transferee can sell property without restriction.

C. Rules Of Thumb.

1. Mortality Risk.

(a) If the health of the transferor indicates that he is unlikely to live to actuarial expectancy (but he is not terminally ill), private annuity or SCIN are the best options as there is nothing included in the transferor’s estate. With a private annuity, unlike a SCIN, no risk premium is paid and any remaining gain is extinguished upon death.

(b) When using GRATs a term which the transferor will outlive should be set.

(c) Use a regular note instead of a SCIN if transferor is likely to survive term. Otherwise, you overvalue the note by the risk premium.

(d) Generally, do not need to be concerned about transferor’s actuarial life expectancy (as opposed to likelihood of surviving applicable term). However, with a private annuity, if the


transferor outlives his actuarial life expectancy, he will continue to receive payments which means wealth is being transferred to instead of from transferor.

2. Asset Considerations.

(a) Return vs. AFR.

(i) GRATs, Notes, SCINs and Annuities will perform best in periods of low AFRs as the growth on the transferred asset will be more likely to exceed the assumed rate.

(ii) Regular notes have lower AFRs than GRATs and Private Annuities (because 120% of AFR is used) and SCINs (because of risk premium).

(iii) GRATs and sales for installment notes (both regular and self-canceling) to defective trusts allow payment of income tax by the transferor, which results in a better likelihood of beating AFR.

(iv) In contrast, personal residence trusts and charitable remainder annuity trusts will perform best in periods of high AFRs.

(b) Other Concerns.

(i) If assets to be transferred do not generate income, installment sales provide better results than GRATs or private annuities due to ability for flexibility in terms of note.

(ii) If the asset transferred has inherent gain (low basis), installment sales (regular note or SCIN) to defective trust avoid gain; regular note and SCIN sales to transferee other than defective trust will result in gain being recognized if transferor dies during note term. Obviously, where gain is avoided the beneficiary will ultimately end up with a lower (carryover) basis.

(iii) If asset is not easily valued, notes are more problematic than private annuities and GRATs due to Chapter 14 concerns from which annuity payments are specifically excluded.

(iv) S corporation stock works extremely well with GRATs and defective trusts.


(v) Property limitations apply to installment sales.

3. Miscellaneous.

(a) GRAT will not leverage generation-skipping transfer tax exemption.

(b) If transferee plans to sell property within two years of transaction, installment notes will not result in deferral of gain, as gain to transferor will be triggered upon sale by transferee. With a GRAT, sale of the underlying property by transferee does not trigger gain to transferor.

(c) Uncertainty as to whether private annuity cannot be secured by transferred property. Historically not, but with proposed regulations taxing the gain upon the formation of the contract, commenters have suggested the annuity may now be secured with the transferred assets. No longer fear of causing recognition event, as gain must be recognized at transfer. (See above at 8(d)(ii)) Securing annuity may cause annuity to be included in transferor’s estate, however.


Gift Estate Consideration GST Planning Recognition

Event Basis Recognition of Gain at Death Other

Outright Gift Yes No N/A Yes Not a recognition

event Carryover N/A Payment of Gift

Tax

Straight Sale N/A* No Yes, Property

Received N/A

Recognize all gain at the time

of sale FMV at time of

Sale N/A

Grantor Retained Annuity Trust Varies

Depends on whether

transferor survives term

Yes, Annuity Payments No

Not a recognition event

Carryover, if term is survived, otherwise FMV

at d/o/d** N/A

Grantor Trust; No annual exclusion

Sale/Installment Note N/A*

Yes, (Note) if transferor dies

during term Yes, Note Payments Yes

Deferral of gain over term of note

FMV at time of Sale

IRS to estate or beneficiary; IRD

deduction

Deductibility of Interest for

Transferee***

Sale/Note to Defective Trust N/A*

Yes, (Note) if transferor dies

during term Yes, Note Payments Yes

Not a recognition event Carryover** Uncertain****

Grantor Trust Risky

Sale/SCIN N/A* No Yes, Note Payments Yes

Deferral of gain over term of note

FMV at time of Sale

IRD to estate; no IRD deduction

Deductibility of Interest for

Transferee*** Risky

Sale/SCIN to Defective Trust N/A* No

Yes, Note Payments Yes

Not a recognition event Carryover** Uncertain****

Grantor Trust Riskier

Private Annuity N/A* No Yes, Annuity

Payments Yes

Recognize gain at time of transfer

Varies-problematic for

transferee

Eliminated and Loss for

unreturned capital

Unsecured Mortality Risk; Can’t Deduct

Payments

___________________________ * As long as transfer is for fair market value. ** Arguably transferor can repurchase low basis assets prior to term to obtain “step up.” *** If transferee is “materially participating.” **** State of law uncertain.


IV. HOW TO FIX THE VALUE OF STOCK, ETC. FOR ESTATE TAX PURPOSES PER A BUY/SELL AGREEMENT

A. Can a Buy/Sell Agreement Fix The Value of Stock/Partner Interests For Estate Tax Purposes.

B. Yes, under certain circumstances. Estate of Amlie v. Comm’r, 91 TCM 1017, 1023-28 (2006).

1. Amlie is the first taxpayer victory as to this issue under Code section 2703 (which was enacted in 1990).

C. Discussion Of The Law.

1. Sections 2031 and 2033 provide that the value of a gross estate should include the value of all property, to the extent of the Decedent’s interest therein at the time of death. The value included is the fair market value, which 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 sell and both having reasonable knowledge of relevant facts.” Treas. Reg. § 20.2031-1(b).

2. When determining the price at which property changes hands between a buyer and seller, section 2703(a) provides that the property (i.e., the Stock) should be valued for estate tax purposes without regard to any option, agreement or other right to acquire property at less than fair market value and any restriction on the right to sell the property. § 2703(a)(1) and (2).

3. However, there is an exception to Section 2703(a). The section will not apply if seven (7)5 tests are satisfied. Four tests are based on Section 2703(b). Three are based on the legislative history to that section.6

5 Pursuant to Estate of Lauder v. Comm’r, 64 T.C.M. 1643, 1659 (1992), it appears that tests 2 and 3 (which are mentioned in the text below are separate tests. Other courts have stated there is only one combined test. See Estate of True v. Comm’r, 82 T.C.M. 27, 51-53 (2001). Even if there is only one test, there are two parts to it. Thus, they will be separately addressed below. Amlie considered them as one test. 91 T.C.M. at 1026. 6 The legislative history to this Code Section makes clear that certain requirements (which have been suggested by the courts prior to the enactment of this Code Section and which are not stated in this Code Section) must also be satisfied. 136 Cong. Rec. S15683 (October 18, 1990). Amlie also agrees with this. 91 T.C.M. at 1024.


(a) The tests are as follows:

(i) The agreement “[i]s a bona fide business arrangement.” § 2703(b)(1).

(ii) The agreement”[i]s ... not a [testamentary] device to transfer the subject property to members of the decedent’s family . . . .”7 § 2703(b)(2).

(iii) The agreement”[does] . . . not . . . transfer the subject property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.” § 2703(b)(2).8

(iv) The agreement “[h]as . . . terms that are comparable to similar arrangements entered into by persons in arm’s length transactions.” § 2703(b)(3).

(v) The agreement imposes an obligation upon the owner to sell and the buyer to purchase.9

(vi) The agreement was binding on the Decedent during her lifetime and after death.10

(vii) The agreement provides for a determinable price or valuation formula.11

(b) Each requirement must be separately satisfied. Treas. Reg. § 25.2703-1(b)(2).

4. Each test will be discussed below.

(a) First Test: Bona fide Business Arrangement. This test addresses whether the agreement was entered into in good faith and whether there were non-tax reasons for entering into it.

(b) Second Test: Device. An agreement will not be deemed to be a substitute for a testamentary disposition if the consideration paid

7 See footnote no. 5. 8 See footnote no. 5. 9 Estate of Seltzer v. Comm’r, 50 T.C.M. 1250, 1252 (1985); Estate of Lauder v. Comm’r, 64 T.C.M. 1643, 1656 (1992). 10 Id. 11 Id.


for the stock was equal to the fair market value of the stock.12 Lauder v. Comm’r, 64 T.C.M. at 1660 . Another relevant factor is whether the drafting of the agreement was a part of an overall testamentary plan affected by the impending demise of the decedent. Littich v. Comm’r, 31 T.C. 181, 186 (1958); see Estate of Lauder v. Comm’r, 64 T.C.M. at 1658-59 (Court found the existence of a “device” when the price was arbitrarily determined without the help of professionals and devoid of arm’s length negotiations); see Estate of Gloeckner v. Comm’r, 152 F.3d 208, 216 (2nd 1998).

(c) Third Test: Adequate Consideration. The phrase “adequate and full consideration” is not defined in Section 2703 and the Regulations thereunder. However, prior Courts have defined it as a price that is not “lower than that which would have been agreed upon by persons with adverse interests dealing at arm’s length.” Bensel v. Comm’r, 36 B.T.A. 246, 252-53 (1937), aff’d, 100 F.2d 639 (3d Cir. 1938). “Under this standard, the formula price generally must bear a reasonable relationship to the unrestricted fair market value of the stock in question” (based on Lauder v. Comm’r, 64 T.C.M. 1643, 1660 (1992)) which determination is made at the time the agreement is executed, as opposed to the date of decedent’s death (based on Estate of Bischoff v. Comm’r, 69 T.C. 32, 41 fn. 9 (1977); St. Louis County Bank v. United States, 674 F.2d 1207, 1210 (8th Cir. 1982)).

(i) Reciprocal options (like those granted in the agreement) plus the other benefits received by a party may constitute adequate consideration. Amlie, 91 T.C.M. at 1024; Fiorito v. Comm’r, 33 T.C. 440, 446 fn. 1 (1959).

(ii) The circumstances surrounding the negotiation and execution of the agreement are also relevant. The extent of the harmony within the family at the time of the execution of the agreement is also relevant such that there is an inference that the consideration was or was not adequate. Bensel v. Comm’r, 36 B.T.A. 246, 252-53 (1937), aff’d, 100 F.2d 639 (3d Cir. 1938); see Estate of Gloeckner v. Comm’r, 152 F.3d 208, 215 (2nd Cir. 1998). Thus, if the family members at the time of the execution of the relevant agreement were estranged, this would favor a finding that the consideration was adequate and full. Amlie, 91 T.C.M.

12 This is determined upon the date of the execution of the agreement as opposed to on the decedents death. Amlie, 91 T.C.M. at 1026; Estate of Bischoff v. Comm’r, 69 T.C. 32, 41 fn. 9 (1977); St. Louis County Bank v. United States, 674 F.2d 1207, 1210 (8th Cir. 1982).


at 1026-27. This would also include the health of the decedent at the time. Estate of Gloeckner v. Comm’r, 152 F.3d at 215-16. If the decedent’s health was good, there is an inference that this test is satisfied.

(iii) Finally, the time to determine the adequacy of the consideration is at the time the agreement was entered into, as opposed to the date of the decedent’s death. Amlie, 91 T.C.M. at 1026; Estate of Bischoff v. Comm’r, 69 T.C. 32, 41 fn. 9 (1977); St. Louis County Bank v. United States, 674 F.2d 1207, 1210 (8th Cir. 1982).

(d) Fourth Test: Comparable to Similar Arrangements. This test is satisfied if the estate shows that the right or restriction “could have been obtained in a fair bargain among unrelated parties . . . .” Treas. Reg. § 25.2703-1(b)(4). This test is also satisfied if the right or restriction “conforms with general practice of unrelated parties under negotiated agreements . . . .” Treas. Reg. § 25.2703-1(b)(4).13 Amlie v. Comm’r, 91 TCM at 1027-29. Some of the relevant factors mentioned in the Treasury Regulation (in determining whether this test is satisfied) are “. . . the current fair market value of the property, anticipated changes in value during the term of the agreement, and the adequacy of any consideration given in exchange for the rights granted.” Treas. Reg. § 25.2703-1(b)(4)(ii).

(i) Need for expert testimony.

(e) Fifth Test: Agreement Imposing Obligations On A Seller and Buyer. This test is satisfied if a buyer would not have purchased the stock for more than the fixed price. Lomb v. Sugden, 86 F.2d 166, 167-68 (2d Cir. 1936). Stated similarly, this test will be satisfied if no one would purchase the stock of the decedent at its value unrestricted by the options set forth in the agreement. May v. McGowan, 194 F.2d 396, 297 (2d Cir. 1952).

(f) Sixth Test: Binding on Decedent and Decedent’s Estate. This test is satisfied if the agreement is binding on the Decedent during her lifetime and on her Estate after her death. Estate of Lauder v. Comm’r, 64 T.C.M. 1643, 1656 (1992).

13 While this test (as a separate requirement) is new, it has been a factor that has been used in the past to determine if restrictions will determine the fair market value of the relevant property for estate tax purposes. Estate of True v. Comm’r, 82 T.C.M. 27, 65 (2001).


(g) Seventh Test: Determinable Amount. This test is satisfied if the purchase price is fixed and determinable under the agreement. Estate of Lauder v. Comm’r, 64 T.C.M. at 1656.


V. OBTAINING AN UPFRONT INTEREST DEDUCTION ON AN ESTATE TAX RETURN PRIOR TO PAYMENT

A. General Principles Of An Estate Deducting Interest On Its Estate Tax Return Prior To Payment.

1. Section 2053(a)(2) provides that gross estate shall be determined by deducting administration expenses as are allowable by the laws of the local jurisdiction.

(a) Treas. Reg. § 20.2053-3(a) provides the ‘administration expenses’ are limited to such expenses as are actually and necessarily, incurred in the administration of the decedent’s estate.

(b) Treas. Reg. § 20.2053-1(b)(3) also provides that an item may be deducted on the estate tax return “though its exact amount is not then known, provided it is ascertainable with reasonable certainty, and will be paid. No deduction may be taken upon the basis of a vague or uncertain estimate.”

2. Estate of Graegin v. Comm’r, T.C. Memo. 1988-477.

(a) The Court held that the obligation to make a balloon payment of interest upon the maturity of a 15-year promissory note for repayment of an amount borrowed from the decedent’s closely held corporation to pay his estate’s Federal estate tax liability entitled the estate to an immediate deduction for the interest as an administration expense under section 2053(a)(2).

(i) Both principal and interest were due in a single payment on the 15th anniversary due date, and prepayment of both was prohibited.

(ii) The Court noted that the amount of interest was capable of precise calculation. Although the Court was “disturbed” by the single payment of principal and interest, the Court found it “not unreasonable” in the light of the anticipated availability of the assets of decedent’s spouse’s trust to repay partially both principal and interest upon maturity of the note, the term of which had been set according to decedent’s spouse’s life expectancy.

3. Courts held that interest on the loan may be deductible to pay the debts of an estate when an executor borrows money instead of selling illiquid assets. See, e.g., Estate of Bahr v. Comm’r, 68 T.C. 74 (1977); Estate of Todd v. Comm’r,57 T.C. 288 (1971); Estate of Graegin v. Comm’r, supra.


4. The loan was made by a company (the stock of which was included in the value of the gross estate and which (a) was owned by the decedent’s family and (b) “was neither able nor required to redeem enough * * * [company] shares to provide funds to pay * * * [all debts of the estate] when due”); the interest was deductible. McKee v. Comm’r, T.C. Memo. 1996-362. (Executors (who were also directors of the company lender) anticipated that the company stock would increase in value; the Court concluded that “borrowing funds, rather than selling stock, allowed decedent’s estate to more easily meet its burdens by taking advantage of the increasing value of the stock”.)

B. Recent Cases.

1. Taxpayer victory: Murphy v. U.S., ____ F.Supp. ____, 2009-2 USTC ¶ 60, 583 (W.D. Ark. 2009); Estate of Gilman v. Comm’r, T.C. Memo. 2004-286.

2. Taxpayer defeat: Black v. Comm’r, 133 T.C. 340 (Dec. 14, 2009); Estate of Stick v. Comm’r, T.C. Memo. 2010-192.


VI. REDUCING ADDITIONAL GIFT TAX LIABILITIES WITH DEFINED VALUE CLAUSES

A. Price Adjustment Clauses.

1. Procter v. Comm’r, 142 F.2d 824 (4th Cir. 1944).

2. Ward v. Comm’r, 87 T.C. 78 (1986); McLendon v. Comm’r, 66 T.C.M. 946 (1993), rev’d on other issues, 77 F.3d 477 (5th Cir. 1995); Harwood v. Comm’r, 82 T.C. 239 (1984), aff’d, 786 F.2d 1174 (9th Cir. 1986).

B. Definition Clauses.

1. Est. of Wandry v. Comm’r, T.C. Memo. 2012-88.

2. McCord v. Comm’r, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003); Petter v. Comm’r, T.C. Memo. 2009-280, aff’d, 653 F.3d 1012 (9th Cir. 2011); cf. Estate of Christiansen v. Comm’r, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009).


VII. GIFTS OF PRESENT INTERESTS (AS OPPOSED TO FUTURE INTERESTS)

A. Key cases.

1. Hackl v. Comm’r, 118 T.C. 279 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003). (IRS prevailed.)

2. Price v. Comm’r, T.C. Memo. 2010-2. (IRS prevailed.)

3. Fisher v. United States, 105 A.F.T.R.2d (RIA) 2010-1347 (S.D. Ind. 2010). (IRS prevailed.)

4. Est. of Wimmer v. Comm’r, T.C. Memo. 2012-157. (Taxpayer prevailed.)

B. Analysis.

1. Legal Framework.

(a) Section 2501 generally imposes a tax on the transfer of property by gift. Section 2503(b) provides an inflation-adjusted annual exclusion of $14,000 per donee. The annual exclusion applies to “other than gifts of future interests in property.” Sec. 2503(b)(1).

(b) The Supreme Court has stated in Fondren v Comm’r, 324 U.S. 18 (1945): it is not enough to bring the exclusion into force that the donee has vested rights. In addition he must have the right presently to use, possess or enjoy the property. The question is of time, not when title vests, but when enjoyment begins.

(c) In Hackl, 118 T.C. at 293, the Tax Court held that:

(i) a taxpayer must establish that the transfer in dispute conferred on the donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment:

[a] of property or

[b] of income from property, and

(ii) both of which alternatives in turn demand that such immediate use, possession, or enjoyment be of a nature that substantial economic benefit is derived therefrom.

(d) In Fisher, supra, the Court held that the gifts of LLC interests did not qualify for the annual exclusion because

(i) any potential distribution of capital proceeds to the donees was subject to various contingencies, all within the general manager’s discretion;


(ii) the donees’ right to possess, use and enjoy the underlying real estate was only a non-pecuniary benefit; and

(iii) due to restrictions on transfer (including the LLC’s right of first refusal), the donees could not presently realize a substantial economic benefit.

2. Analysis.

(a) Application to the Transferred Property.

(i) Under the partnership agreement, do the donees have an unilateral right to withdraw their capital accounts?

(ii) As stated with respect to analogous circumstances in Hackl, transfers subject to the contingency of approval (by the LLC manager in Hackl and by all partners in Price) “cannot support a present interest characterization, and the possibility of making sales in violation thereof, to a transferee who would then have no right to become a member or to participate in the business, can hardly be seen as a sufficient source of substantial economic benefit.” Consequently, the donees lack the ability “presently to access any substantial economic or financial benefit that might be represented by the ownership units.” Hackl v. Comm’r, 118 T.C. at 296.

(b) Application to Income From the Transferred Property.

As stated in Hackl, show that the gifts of the partnership interests afforded the donees the right to immediately use, possess, or enjoy the income therefrom, petitioners must show that:

(i) the partnership would generate income at or near the time of the gifts;

[a] Property owned by the partnership (probably traded securities?).

(ii) some portion of that income would flow steadily to the donees; and

(iii) the portion of income flowing to the donees can be readily ascertained.


3. Key facts as to rights of a donee:

(a) Ability to use it as collateral;

(b) Partnership interest or assignee interest?

(c) Ability to transfer (by gift or sale) a partnership interest (as opposed to an assignee interest);

(d) Ability to transfer (by gift or sale) a partnership interest without the consent of any partner; and

(e) Does the partnership have cash flow:

(i) If yes, must some or all of that be distributed?

(f) Restrictions as to the ability to receive cash flow.


VIII. SELECTED ESTATE TAX ISSUES

A. Section 2036.

1. General Rule. Under section 2036(a), if a transferor transfers property while retaining for life the right to possess or enjoy or receive the income from the transferred property, the property will be taxable in the transferor’s estate.

2. Example. Donor gives his house to his child while retaining the right to live in the house for life. The house will be taxable in donor’s estate.

B. Section 2036(b).

1. Does retention of a general partner interest cause inclusion in senior shareholder’s estate under section 2036?

(a) U.S. v. Byrum, 408 U.S. 125 (1973).

(i) Generally, a gift of an interest in an entity where the donor retains the right to vote. The interested giver is not taxed under section 2036 because the transferor has a fiduciary duty to the other owners of the entity.

(b) Congress passed section 2036(b) to overrule Byrum in certain situations. Specifically, the stock is included in the estate where the donor retains the right to vote stock in a corporation which is gifted and the donor holds (with family attribution) the right to vote 20% or more of the stock within three years of death.

(c) T.A.M. 9131006 (4/30/91):

(i) Senior Generation/transferor/general partner’s retained powers as a general partner to control the management of the partnership did not cause the value of the partnership interests (that were gifted to the junior generation) to be included in the estate of the senior generation under section 2036 because the senior generation (as general partner) has a fiduciary duty to the other partners in the management of the partnership. See also Ltr. Rul. 9332006 (8/20/92).

(d) Prop. Reg. § 20.2036-2(c).

(i) While section 2036(b) does not apply to partnerships, it is possible the partnership’s voting stock may be taxed to the donor if the partnership owns voting stock contributed by the donor of limited partner units, the 20% test is met, and the donor controls the partnership.


IX. WORKING WITH/NEED FOR VALUATION PROFESSIONALS

A. What do Judges and the IRS rely upon in determining whether a person is an expert?

1. Credentials.

2. General valuation experience.

3. Specific valuation experience in asset/business being valued.

4. Valuation company name—”surface value” only generally.

5. Thoughtfulness of the report.

6. Data, etc. provided in the valuation report.

(a) As noted in Section IV.B. below, this is very important.

7. Experience in testifying.

8. Hall, Does Your Expert Need To Be Credentialed? Business Valuation Alert (Vol. 15, Issue No. 2, 2014).

B. Important aspects of the valuation report.

1. “The persuasiveness of an expert’s opinion depends upon the disclosed facts on which it is based.” A mere “opinion” (without detailed facts/data on which it is based) will be given little weight.

(a) Menard v. Comm’r, 88 T.C.M. 229, 249 (2004), TCM ¶ 2004-207, supplemented by, T.C. Memo. 2005-3, supplemented as to other issues by, 120 T.C. 54 (2008), rev’d on other issues, 560 F.3d 620 (7th Cir. 2009);

(b) Gray v. Comm’r, 73 TCM 1940, 1947-48 (1997).

2. The valuation discount should not be based upon a statistical computation of reported tax cases and reported discounts.

C. Working with the expert.

1. Limits of experts determinations/representations of the taxpayer/role of the taxpayer’s attorney as to state law and CPA or attorney for tax law.

2. The attorney and CPA should review drafts prior to the report being finalized but should not dictate.

3. Do not assume an expert is an expert in all aspects of the project.


D. Need for an expert.

1. Estate of Berg v. Comm’r, 61 TCM 2949 (1991), aff’d and rev’d, 976 F.2d 1163 (8th Cir. 1992).

2. Est. of Richmond v. Comm’r, 107 T.C.M. 1135 (2014).

3. Valuation penalties.

4. Overall credibility.

5. Starting the three-year statute of limitations.

E. Property to be valued in a family limited partnership.

1. Valuation of the underlying assets of a partnership or a closely-held corporation.

2. The valuation of the partnership interests or stock in a closely-held corporation.

(a) The valuation discounts should usually be based on an analysis of sales in the marketplace of partnership interest or stock in the same or similar industries.

(b) The report should be prepared based on the assumption that the expert will not be able to examine your expert other than on redirect examination as those are the rules in the United States Tax Court.

F. Another Discount.

1. See Exhibit C.


X. STATUTE OF LIMITATION ISSUES/GIFT TAX DISCLOSURE ISSUES

A. Finality With Respect To Adequately Disclosed Gifts And Adjusting The Value Of Reported Gifts.

1. Regulations preclude IRS adjustments with respect to all issues for “adequately disclosed” transfers once the statute of limitations (which is generally three years) has run. Treas. Reg. §§ 20.2001-1, 20.2504-2, 301.6501(c)-1(f)(8).

B. Adequate Disclosure.


XI. AWARDING OF COSTS IN AN ADMINISTRATIVE APPEAL AND/OR JUDICIAL APPEAL

A. Overview.

A taxpayer who prevails in either of the following may be awarded reasonable costs, including attorneys’ fees:

1. A civil suit against the United States that was brought in a U.S. District Court, a U.S. Court of Appeals, the U.S. Supreme Court, the U.S. Tax Court or the U.S. Court of Federal Claims, in connection with a determination, collection or refund of any tax, interest, or penalty.

2. Administrative appeal within the IRS in connection with a determination, collection or refund of any tax, interest, or penalty.

B. Tests to Satisfy.

1. Prevailing Party.

(a) The taxpayer needs to establish that he has

(i) Two Alternatives:

[a] Substantially prevailed with respect to the amount in controversy or with respect to the most significant issue or set of issues presented or

[b] Received As Judgment Equal To Or Less Than The Taxpayer’s Settlement Offer (The “Qualified Offer Rule”).

[i] The qualified offer must be made during the “qualified offer period.” This is the period that begins on the date on which the first letter of proposed deficiency that allows the taxpayer an opportunity for administrative review in the IRS Office of Appeals is sent and ends 30 days before the date the case is first set for trial. Code Sec. 7430(g)(2); Treas. Reg. § 301.7430-7(c)(7).

[ii] The qualified offer must remain open for acceptance from the date made until the earliest of

(A) the date it is rejected in writing by the United States,


(B) the date the trial begins, or

(C) the 90th day after being received by the United States.

[iii] The offer may, however, provide that it will remain open after the occurrence of one or more of the above events. The taxpayer may extend the period of a qualified offer, provided that the minimum period for remaining open was met without regard to the extension (Reg. § 301.7430-7(c)(5)).

2. Exhausted all available administrative remedies. Code Sec. 7430(c)(4)(A), Reg. § 301.7430-1.

(a) In a tax audit, must Protest from a 30-day letter if one is sent.

(b) A taxpayer’s failure to agree to extend the time for assessment of any tax cannot be taken into account when determining whether the available administrative remedies have been exhausted. Code Sec. 7430(b)(1); Reg. § 301.7430-1(b)(4).

3. Net worth limitations.

(a) The net worth of the party seeking the award must not exceed $2 million. Individuals who file a joint return are treated separately and are subject to a combined net worth limitation of $4 million. Code Sec. 7430(c)(4)(D)(ii).

(b) Businesses and local organizations, including units of local government, will not be eligible for an award if their net worth exceeds $7 million or they have more than 500 employees. Estates and trusts are subject to the same $2 million net worth limitation that applies to individuals. Code Sec. 7430(c)(4)(D)(i).

C. Justification For Government’s Position.

1. The taxpayer does not have the burden of proof on the issue of whether the government’s position was substantially justified. Instead, the government must prove that it was substantially justified in maintaining its position against the prevailing party in order to avoid liability for the taxpayer’s costs.

D. Reasonable Litigation Costs.

1. Hourly limit on fees.


(a) For calendar years 2010 and 2011, the limit is $180 per hour.

(b) In awarding fees, a court may determine that a higher hourly rate is warranted due to special factors such as the limited availability of qualified attorneys, the difficulty of the issues raised, or the availability of local tax expertise.

E. Administrative Costs.

1. The prevailing taxpayer may also be awarded reasonable administrative costs.

2. Under Code Sec. 7430(c), reasonable administrative costs include

(a) administrative fees or similar charges imposed by the IRS and

(b) the reasonable expenses incurred with respect to compensating expert witnesses, financing necessary studies and reports, and paying attorneys’ fees.

3. Reasonable administrative costs only include costs incurred on or after the earliest of

(a) the date the taxpayer receives the notice of the decision of the IRS Office of Appeals,

(b) the date of the notice of deficiency, or

(c) the date on which the first letter of proposed deficiency is sent that allows the taxpayer an opportunity for administrative review in the IRS Office of Appeals. Code Sec. 7430(c)(2).

4. A taxpayer may contest the IRS’s denial of administrative costs in the Tax Court, but must file a petition with the court within 90 days of the denial notice. Code Sec. 7430(f)(2).

F. A court may deny awards of court costs and attorneys’ fees to a prevailing party who unreasonably protracts the proceedings.


XII. SWITCHING THE BURDEN OF PROOF TO THE IRS IN AN IRS TAX AUDIT

A. Generally the burden of proof in a Tax Court case is on the taxpayer. However, a taxpayer may shift the burden of the proof so as the IRS has the burden with respect to factual issues related to the taxes. I.R.C. § 7491(a). To shift the burden of proof to the IRS, the taxpayer must:14

1. Comply with substantiation requirements;

2. Comply with recordkeeping requirements; and

3. Cooperate with reasonable IRS requests for meetings, interviews, witnesses, documents and information.

14 In addition to the requirements listed above, the Code sets forth a new worth limitation for certain taxpayers. There is no net worth requirement for individuals or estates.


EMILY LITZNERSKI FOSTER

Ms. Litznerski Foster is an attorney with Whyte Hirschboeck Dudek S.C. Emily concentrates her practice in trusts and estates, working with a variety of clients including business owners, executives, real estate developers and other high net worth individuals and families.

Formerly an attorney in the Private Wealth Group of a Chicago law firm, she is presently a member of the Trust & Estates Team in the Madison office of Whyte Hirschboeck Dudek S.C.

Her experience includes the following areas: complex trust planning, family business succession planning, leveraging lifetime wealth transfer techniques, structuring family limited partnerships and family limited liability companies for tax purposes, establishing private foundations, preparing and negotiating premarital agreements, and probate and trust administration.

Emily earned her Juris Doctor from the University of Michigan Law School and her Bachelor of Science with Distinction from the University of Michigan. Emily is admitted to practice in Wisconsin and Illinois.


BENJAMIN P. BRUNETTE

Mr. Brunette is an attorney in the Madison office of Whyte Hirschboeck Dudek S.C. As a member of the Trusts & Estates Team, he assists clients with a broad spectrum of estate planning needs, from the preparation of basic plans to those involving complex wealth transfer, gift, and tax issues. Mr. Brunette advises throughout the estate planning process, from initial plan preparation through probate and estate/trust administration. He has also lectured on estate planning considerations for same-sex couples and estate planning with retirement assets. He commonly assists clients with estate and gift planning for complex, technology-related assets. Mr. Brunette also frequently works with business owners to craft plans that facilitate succession of business leadership to family members, business leaders and key employees. He works closely with clients and other members of their advisory team, such as accountants and financial advisors, to ensure that business succession plans enable the business to flourish while facilitating owners’ gradual exit. In this role, Mr. Brunette commonly works with multiple generations of families, and encourages open communication about each key player’s role in business succession. He also has substantial experience working with new businesses, advising entrepreneurs on issues such as entity choice and the proper integration of their business with their estate plan.

Mr. Brunette earned his Juris Doctor from the University of Michigan Law School and a Bachelor of Arts with Honors from Marquette University.


ROBERT E. DALLMAN

Mr. Dallman is an attorney with Whyte Hirschboeck Dudek S.C. His practice includes ownership succession planning, federal and state tax controversy and tax and business planning.

Formerly an IRS trial attorney in Washington, DC and Milwaukee, he is presently a member of the Firm’s Tax and Corporate Departments, a member of the IRS Liaison Committee in Wisconsin, the Chair of the Milwaukee Tax Club, and the founder of the Wisconsin State and Local Tax Club.

He is one of the only actively practicing tax attorneys in Wisconsin to prevail in tax cases before the U.S. Tax Court, the Seventh Circuit Court of Appeals, the U.S. Court of Federal Claims and the Wisconsin Tax Appeals Commission.

His experience includes the following technical tax areas: valuation, Midco transactions, intangibles, ownership succession, reasonable compensation, mixing bowl transactions, transfer pricing, payroll tax, selected excise tax issues, selected inventory issues, purchase price allocations, REIT Mirror Transactions, UPREIT transactions, DOWNREIT transactions, tax accounting, material distortion/clear reflection of income, sham companies, sham transactions, tax shelters (corporate and individual), merger and acquisition issues, passive activity losses, venture capital, LBO’s, service corporations, tax aspects of damages and malpractice awards, Indopco issues, partnership tax issues (including special allocations), and state and local tax.

His tax litigation experience includes representing clients before the United States Tax Court in numerous cities, United States District Court in Michigan and Wisconsin, U.S. Court of Federal Claims, U.S. Court of Appeals for the Seventh Circuit, The Wisconsin Tax Appeals Commission, Wisconsin Circuit Court and Wisconsin Court of Appeals.

Mr. Dallman has litigated (1) significant cases in the areas of partnership taxation, valuation, gift tax, estate tax, the taxation of inventories, sham transactions and the income tax aspects of real estate transactions (including like-kind/tax-deferred exchanges and passive activity loss issues) and (2) landmark cases in the area of executive/reasonable compensation and officer liability.


A Listing of Relevant Cases That Have Been Resolved

By Robert E. Dallman When He Was The Lead Or Sole Tax Attorney

Client Name

IRS/State DOR

Determination

Payment by

client (Refund to

Client) Upon

Resolution Savings

A (1st Audit) $2,426,849 $197,276 $2,229,57315 B (1st Audit) $981,443 $0 $981,443 A’s Retirement Plan $254,900 $0 $254,900 A (2nd Audit) $2,319,909 $1,044,196 $1,275,71416 B’s Employee’s Retirement Trust

$33,000 $0 $33,000

A (3rd Audit) $1,732,000 $353,000 $1,374,00017 C $29,926 $4,395 $25,531 D (1st Audit) $385,988 $2,832 $383,156 D (2nd Audit) $205,000 $10,500 $194,500 E $401,000 $0 $401,000 F (1st Audit) $21,460,929 $1,818,947 $19,641,982 F (2nd Audit) $633,000 $59,958 $573,042 F (3rd Audit) $83,000 $35,100 $47,90018 F (4th Audit) $240,372 $96,14819 $144,224 G (5th Audit) $2,100,010 $1,090,000 $1,010,00020 H $81,523,000 $0 $81,523,00021 I $5,669 ($146,214) $151,883

15 $574,876 of unclaimed deductions for future years were also agreed to by the Government. 16 $754,386 of unclaimed deductions for future years were also agreed to by the Government. The client was in error on 38% of the assessment. 17 $325,240 of unclaimed deductions for future years were also agreed to by the Government. The client was in error on about $80,000 of the assessment. 18 The Government also agreed to waive interest. 19 Interest was also waived by the Government and also agreed to concede another $200,310 in potential income tax liability. 20 The client conceded about 90% of this as it was in error. 21 The Government also agreed to formally concede approximately $41,200,000 in three subsequent years as a result of this settlement.


Client Name

IRS/State DOR

Determination

Payment by

client (Refund to

Client) Upon

Resolution Savings

J $563,000 $563,000 $0 K $989,000 $62,000 $927,000 L $29,500 $7,100 $22,40022 M $2,356,439 $286,000 $2,070,439 N $125,000 $3,157 $121,843 O $93,276 ($2,200) $95,476 P $357,900 $4,298 $353,602 Q $2,311,000 $0 $2,311,000 R $136,000 $0 $136,000 S $26,554,000 $654,000 $25,900,000 T $386,000 $26,700 $359,300 U $80,400 $20,700 $59,400 V $0 $286,000 $286,000 W $26,100,000 $485,000 $25,615,000 X $3,500,000 $520,000 $2,980,000 Y $40,500,000 $362,000 $39,638,000 Z $62,500,000 $2,500,000 $60,000,00 AA $900,000,000 $0 $900,000,00023 AB $9,976,000 24 24

AC $20,000,000 24 24

AD $860,000 $0 $860,000 AE $52,000,000 24 24

AF $3,000,000 24 24

22 This is a significant tax case which represented a major victory in this area. There will also be a continuing annual benefit. 23 Brief (although very strategic) representation. 24 This case is pending.

WHD/10719328.17 Litznerski Foster/Brunette/Dallman Exhibit A 68

Exhibit A–Article: IRS Chief Counsel Describes When Guarantors Are At Risk For Tax Purposes By Thomas R. Vance and Robert E. Dallman

WHD/10719328.17 Litznerski Foster/Brunette/Dallman Exhibit B 75

Exhibit B–Article: Opportunities For Taxpayers To Be Reimbursed For Costs In Tax Audits And Cases By Amy Barnes and Robert E. Dallman


Exhibit C–Article: The Built-In Gains Discount for Transfer Tax Purposes By Robert E. Dallman

This article is reprinted with permission from ThomsonReuters

WHD/10719328.17 Litznerski Foster/Brunette/Dallman Exhibit C 84

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