Bona fide sales in the estate environment.

Many tax advisers have faced a situation in which an elderly couple--for various reasons--either never considered or procrastinated in implementing a wealth preservation plan. Because it is difficult to determine whether the couple will live an additional three years, time is of the essence in planning for the removal of assets from their estates. Often, a starting point is a family limited partnership (FLP) or limited liability company (LLC), to protect and diversify the family's investments, wealth and commercial endeavors. Entity formation (including ownership and controlling agreement), funding and operation planning are done to prevent the IRS from pulling transferred assets back into the estate.

Both Secs. 2035 and 2036 operate to pull back into an estate certain assets transferred. Sec. 2035 recasts assets transferred within three years of the taxpayer's death; Sec. 2036 has no time limit on inclusion. Both sections contain exceptions for transfers constituting a bona fide sale for an adequate and full consideration in money or money's worth. This has been (and, most likely, always will be) a facts-and-circumstances test without a bright-line test or safe harbor. Thus, prudent tax advisers should implore their clients to make good business decisions, keep their fact patterns in line with the cases and rulings that have treated transfers as bona fide sales and avoid those that have recast transfers and included them in the decedent's gross estate. This item looks at two recent rulings dealing with post-transfer estate inclusions that have held differently based on the facts-Est. of Stone, TC Memo 2003-309, and Letter Ruling (TAM) 200432015.

Background

The bona fide sale requirement mandates a good faith, arm's-length transaction. In Mollenberg's Est., 173 F2d 698 (2d Cir. 1949), the Second Circuit stated, "[t]he word 'sale' means an exchange resulting from a bargain.... "According to the Merriam-Webster Online Dictionary (www.m-w.com), a "bargain" is "an agreement between parties settling what each gives or receives in a transaction between them or what course of action or policy each pursues in respect to the other" This point is extremely important in illustrating the part that negotiations and their documentation play in determining whether a transfer is at arm's length. Often, cases fall short of the requirement of a transfer, because no bargaining occurs between the potential partners in the new entity, in many scenarios, including Est. of Harper, TC Memo 2002-121, the decedent independently determined how the entity was to be structured, funded and operated. This is not a change in ownership, but merely a change in the form of ownership. The IRS will scrutinize a transaction's economics and apply substance-over-form doctrine.

TAM 200432015

This was clearly evident in TAM 200432015, in which a husband, wife and their three children formed a family LLC by transferring a life insurance policy payable on the husband's death, cash and bonds. The IRS clearly stated that it was "not known whether the Spouse and the children participated in determining the structure and operation of the LLC." As in any practice of transaction law, the IRS argues substance over form only after the form establishes clear legal standing. The need for contemporaneous documentation of the transaction is essential, and should include detailed minutes, memorandums of understanding and final executed documents that give a complete picture of the formation process, rather than after-the-fact recollections, or nothing at all (as is often the case when the catalyst of the transactions has since passed on). In the TAM, the IRS held, in part, that the insurance policy proceeds were including in the decedent's estate.

Est. of Stone

In Stone, detailed discussions, drafts, bargaining and other contemporaneous documentation painted a picture of a true negotiation that supported the decedents' motivations of primarily investment and business concerns as to the management of assets, not a mere gift to other partners in the FLP.

Rather than having continued ownership of the transferred assets in a different form, Stone evidenced the intent to conduct a joint enterprise for mutual profit. Key factors in Stone that led to a ruling of no estate inclusion were that (1) each family member was represented by independent counsel and had input into the decisionmaking process related to structure; (2) each of the FLPs had economic substance and operated as joint enterprises (as evidenced by the children's active management and development of assets); and (3) the decedents retained sufficient assets to enable them to maintain their respective accustomed standards of living. Further, three essential characteristics proved that the contributions of assets were not gifts to the other partners:

* All partners held respective partnership interests that were proportionate to the fair market values of the assets transferred;

* The respective transfers were properly credited to their respective capital accounts; and

* On termination or dissolution, the partners were entitled to distributions equal to their respective capital accounts.

Of course, this does not infer or preclude the use of appropriate valuation discounts. On the contrary, valuation discounts were validly taken in Stone to reflect the pooling of property and services in a true enterprise operated for profit.

Conclusion

This item briefly summarized the pitfalls of unfocused family wealth planning. Many families can plan for the preservation of wealth, reduction of estates and business continuity, even within three years of death, when the appropriate time and resources are allocated to do it with the same diligence applied in accumulating the wealth.

FROM DANIEL E. RYAN, CPA, MST, CFP, AND LUCY HOEKEMA, CPA, MST, THE CONDON GROUP, LTD., TINLEY PARK, IL