Significant recent developments in estate planning.

EXECUTIVE SUMMARY

* In Schuler, the Tax Court examined the reciprocal-transaction doctrine; in Rosano, the Second Circuit rejected application of the relation-back doctrine.

* In Notice 2001-10, the IRS reversed over 35 years of rulings and notices by announcing a new income tax treatment of split-dollar life insurance.

* In a series of significant cases, the Tax Court offered practitioners some clear guidance on whether the IRS's Chapter 14 pronouncements will bar FLP use.

This article--the second of two parts--examines recent developments in estate, gift and generation-skipping transfer tax planning. Specifically, this part highlights recent cases and rulings on grantor retained income trusts, valuation, gift disclosure, gift tax annual exclusion, family limited partnerships and split-dollar life insurance.

This two-part article focuses on recent developments in estate, gift and generation-skipping transfer taxes. Part I, in the last issue, discussed new legislation and regulations; Part II, below, examines cases and rulings on grantor retained income trusts (GRATs), valuation, gift disclosure, gift tax annual exclusion, family limited partnerships (FLPs) and split-dollar life insurance.

Cases and Rulings

Invalidated GRAT Regs.

In a landmark case, the Tax Court unanimously agreed that Example 5 of Regs. Sec. 25.2702-3(e) was invalid. Treasury had attempted, through this example, to bar practitioners from constructing GRATs with a zero gift tax value.

In Walton,(8) the taxpayer (the widow of Wal-Mart's founder) created two two-year GRATs, one for each of her daughters. Each trust was funded with over $100 million of Wal-Mart stock. Under the trust documents, if the grantor died before the end of the term, the remaining annuity payments would be made to her estate; the balance of the property would be paid to the remainder beneficiaries. The sole question before the Tax Court was whether the grantor's interest should be valued as an annuity for a straight two-year term (i.e., $6,200) or, under Example 5, for the shorter of the term or until her death (i.e., $3,822,000). The potential gift tax difference was enormous.(9) Relying on the legislative history, the Tax Court found the example, contained in an interpretive regulation, to be an "unreasonable interpretation and an invalid extension of Section 2702."

Lottery Winnings

Gribauskas(10) addressed valuing a state lottery prize. A married couple won approximately $16 million in the Connecticut state lottery, payable in 20 annual installments. The taxpayers divorced after receiving the first payment; the ex-husband died after the second payment. The divorce decree gave each party half of each installment; the decedent's share was included in his estate. The sole issue was the value at which the installments should have been reported on the estate tax return: the present value based on Sec. 7520 actuarial tables as a Sec. 2039 annuity (producing a 9.4% discount), or the present value under a willing buyer-seller arrangement, with a lack-of-marketability (LOM) discount (yielding a 15% discount). The court concluded the Sec. 7520 tables applied.

The court first noted that finding that an annuity does not exist under Sec. 2039 does not bar finding that one exists for Sec. 7520 valuation purposes. Thus, the central issue was the definition of an annuity for Sec. 7520 purposes, a question unanswered by the statute, regulations and case law. The court thus had to use the normal and customary meaning.

The court stated that the dictionary defined "annuity" as a fixed payment, made periodically, to a specified recipient. The estate argued such a narrow view ignored the nature of the underlying asset giving rise to the payment stream. It argued the winnings did not stem from an investment, but a wager; it also cited other payment streams that did not have to be valued using the Sec. 7520 tables. The court rejected all of these arguments.

It first rejected the narrow view of an annuity in favor of a broad interpretation and, in doing so, recognized the winnings as a private annuity. Next, the court stated that a fundamental difference between an annuity and other income streams not subject to Section 7520 is the interest factor. For example, notes are not the same as the lottery payments; the former involve an interest factor, while the latter do not.

The IRS argued that a departure from the Sec. 7520 tables is warranted only when the assumptions on which the tables are based depart substantially from the facts. The court rejected the estate's counter-argument that use of the Sec. 7520 tables made for an unreasonable result, because of the inability to dispose of the interest. Noting that other illiquid annuities (such as GRATs) have to be valued using Sec. 7520, the court rejected a California district court's decision in Shackleford(11) and noted that no case law supported considering marketability in the context of an annuity. Finally, the court envisioned a "policy" under Sec. 7520 to avoid unjust enrichment of the estate.

Gift Disclosure

The Service provided additional guidance on the Sec. 6501(a) final regulations' procedures for late adequate disclosure of gift valuation. Rev. Proc. 2000-34(12) allows taxpayers to file an amended Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax Return, for the appropriate calendar year in which they failed to report or adequately disclose a gift under Regs. Sec. 301.6501(c)-1(f)(2). The amended return must be filed with the same Service Center as the original return and bear the following caption at the top of the first page: "Amended Form 709 for gifts made in calendar year-- --in accordance with Rev. Proc. 2000-34, 2000-34 I.R.B. 186." The three-year statute of limitations for the assessment of additional gift tax will commence from the date the amended return is filed.

Annual Gift Tax Exclusion

In three recent cases, the IRS has successfully challenged the $10,000 annual gift tax exclusion.

In Bies,(13) a taxpayer claimed annual exclusions for transfers of common stock in a family corporation to family members and in-laws who were active in the business; the in-laws immediately transferred the stock to the descendant spouses. The IRS showed that the transfers to the spouses were indirect transfers to the donor's descendants. The case supported the Service's informal position (as stated in IRS Information Letter 2000-0056), which reached the same conclusion as to gifts to grandchildren expected to be transferred to their parents.

In Schuler,(14) two brothers made gifts to their own and each other's children. The IRS concluded, and the Tax Court agreed, that the gifts were reciprocal in nature; the only reason each brother gave to his nieces and nephews was that he expected his brother to reciprocate. The additional annual exclusions were disallowed under the reciprocal-transaction doctrine.

Finally, the Second Circuit rejected annual gift tax exclusions for over 40 checks a decedent wrote on her deathbed to family and friends.(15) She died before most of the checks had cleared. The court refused to accept application of the relation-back doctrine to noncharitable gifts. Under applicable state law (New York), the decedent could have stopped payment at any time until the checks were paid. Thus, the gifts were not completed before the donor's death.

FLPs and Valuation

Measuring the value of gift and estate transfers continues to be a major battlefield for practitioners and the Service, particularly in the past 12 months. For years, the IRS has attempted to thwart practitioners from engaging in discount strategies, especially in the area of family limited partnerships (FLPs).

Before this year, the Service had been remotely successful in attacking FLPs only in the estate tax venue, arguing that under Sec. 2036(a)(1), a taxpayer had retained an interest in the FLP assets. In both Schauerhamer(16) and Reichardt,(17) the Service succeeded in including FLP assets in an estate, because the decedent had effectively retained control. Nothing had changed after the assets were transferred to the FLP, books and records were not maintained and income was deposited into the decedent's accounts.

In the gift tax arena (in which the Tax Court has not had an opportunity to rule), the IRS has continually launched one Chapter 14 theory after another as to why FLPs should be invalidated. Finally, the Tax Court has spoken--in a series of significant cases, it has given the practitioner community some clear guidance on whether the IRS's Chapter 14 pronouncements will bar FLP use.

The Tax Court cases have two common threads: first, they rely greatly on a written partnership document; second, they rely on state law to determine both partnership existence and the timing of gifted partnership interests.

Sec. 2703 business purpose: In Strangi,(18) the Tax Court determined that although a FLP's business purposes were not valid, it still had economic substance for estate tax purposes, by virtue of valid formation under state law. The concurring opinion notes this as an odd rationale and offers a different conclusion: if validly formed under state law, the economic-substance doctrine should not even be addressed. The court also held that Sec. 2703(a), which operates to disregard valuation discounts, did not apply. The court did not explain why it reached this conclusion, other than that Congress did not intend Sec. 2703 to ignore the partnership interest held by the transferor in favor of treating the underlying partnership assets as the property transferred.

The court further determined that no gift occurred on the transfer of over $10 million in assets in exchange for a limited partnership (LP) interest worth less than $7 million, because the transferor retained control over the assets (as the owner of over 99% of the FLP) and the contribution was allocated to his capital account; thus, it did not benefit the other partners. Finally, the court upheld the IRS's valuation discounts. In determining no gift had been made, the court stated that the difference between what the transferor gave versus the LP interest he received was due to the discounts. In this case, the transferor was a 99% limited partner; a corporation (owned 47% by the transferor) was a one-percent general partner. The transferor's four children owned the remaining 53% of the corporation. Noting that a hypothetical willing seller would not release his LP interest without also selling his corporate interest, the court agreed with the IRS discounts; only the IRS'S expert valued the transferor's corporate interest in conjunction with his LP interest. The court also stated that the IRS discounts upheld might have been "overgenerous."

Three separate dissents were filed with the opinion; all concluded that the majority had dismissed reality to rule in accordance with the FLP written agreement. First, the court rejected the stated business purposes, yet held a valid partnership existed, while at the same time upholding valuation discounts based on restrictions in the partnership agreement. The main restriction limited distributions, yet the FLP made numerous large distributions over four years--in effect, the dissent argued, the court looked at the FLP in one way for gift purposes and in another way for valuation purposes. Because the restriction was not a limiting factor, the dissent opined there should have been no valuation discount.

The second dissent also stressed substance over form, by arguing this was a clear case of tax avoidance. The transferor formed the FLP two months before his death, with the sole goal of transferring assets tax-free to his descendants. The dissenting judge would have applied Sec. 2512 to tax the excess of the transferred value as a gift.

The final dissent also looked at the substance of the events in question, by employing the step-transaction doctrine to value the property transferred based on the underlying assets. This doctrine considers each event as part of a combined result--the FLP's formation and subsequent admission of the children as owners of the corporate general partner were planned to transfer property to them; the individual steps should not be viewed in a vacuum. This dissent argued it would be unlikely any transferor would (1) accept a $7 million interest in exchange for contributing over $10 million in assets and (2) relinquish control over assets, unless his partners were family members. Clearly, although in poor health, the transferor was conscious of his descendants and his estate while the transactions were occurring.

Strangi hints at the multitude of issues and viewpoints that can arise with FLPs. The dissents are logical--the court must look at the facts and reality in addition to the written documents. The majority opinion seems to take but a cursory glance at the circumstances surrounding the FLP in question.

Sec. 2704 applicable restrictions: If the liquidation provisions contained in an LP agreement are no more restrictive than state law, the discount on a transferred LP interest will not be reduced by Sec. 2704. In Kerr,(19) a married couple formed two FLPs to benefit their descendants. In transferring interests to their children and GRATs, the couple took LOM and minority-interest discounts; the former was disputed, but upheld.

According to the court, the FLP agreement did not contain an "applicable restriction"; thus, Sec. 2704(b) did not apply to limit a LOM discount. Under Sec. 2704(b), if a transfer is to family members who control the entity before the transfer, any applicable restriction on the value of the interest transferred is disregarded. An applicable restriction limits liquidation of the entity, then lapses after the transfer. Under Sec. 2704(b)(3), any limit imposed by state or Federal law is not an applicable restriction. Regs. Sec. 25.27042(b) specifically defines an applicable restriction as one that is more restrictive than state law; the court thus determined that an applicable restriction did not exist, because the FLP agreement was no more restrictive than Texas partnership law.

No gift on formation: In Jones,(20) a cattle rancher formed two FLPs, one for his son, the other for his daughters. All parties contributed assets that were directly allocated to each capital account. The father also gifted LP interests to his children immediately after the FLPs were formed, for which valuation discounts were taken. The value of the interests gifted was the key issue. Determinative factors for discounts were the level of control of the limited partner as dictated by the partnership agreement and valuation evidence at the date of the transfer.

Following Strangi, the Tax Court held there was no gift on FLP formation, because each capital account was allocated only the respective partners' contribution; no partner received a benefit beyond his actual contribution. Following Kerr, the court determined that Sec. 2704 did not apply to reduce the valuation discounts, because the FLP written agreements were no more restrictive than state law; thus, they did not contain applicable restrictions.

Also following Kerr, the court held that the LP interests--not assignee interests--were transferred via the gifts. The court listed several evidentiary documents in support of its decision: the transfer documents, the gift tax return, an affidavit, Schedules K-1, the expert's written report and an amendment to the daughter's FLP, all of which described LP interests. Based on these cases, it seems the assignee argument will fail absent specific language in the partnership agreement that a recipient of LP interests is merely an assignee.

On the central issue, the court ultimately accepted discounts neither side had offered. Relating to a minority interest discount (lack of control/secondary market discount), the court found no reason to discount the gift to the son; after the transfer, he had total control. Technically, the son gained an 83.08% LP interest (essentially, complete control, because the partnership agreement granted authority to an aggregate 51% interest). Acting alone, the son could remove a general partner and force liquidation. On these facts, the court found a discount for lack of control unreasonable.

As for the four daughters, who each gained a 16.915% LP interest in their FLP, discounts were warranted for lack of control. In the end, the court chose a 40% discount, closer to that of the IRS'S figure, simply because the IRS expert based his opinion on data closer in time to the actual transfer.

On the LOM issue, the court determined eight percent, rather than the 20% offered by petitioners, was a reasonable discount. In so concluding, the court stated that the son's power to force liquidation triggered the possibility of litigation, which lessened the value of his interest. Limiting provisions on transferability in the daughters' FLP agreement justified the same discount. No discount was accepted for built-in capital gains to be realized on liquidation, because this tax was easily avoided by a Sec. 754 election in effect at the time of sale.

Evidence to support discount: State law determines property rights conveyed. In Shepherd,(21) a FLP agreement partially executed on Aug. 1, 1991, along with deeds gifting land to the "partial" partnership the same day, did not operate to effect actual gifts until the FLP agreement was fully executed the following day. The Tax Court's reasoning was simple: no donee existed until August 2 when, under state (Alabama) law, the FLP actually existed. But does not a gift only require a definitive transfer (which did take place)?

Following Jones and Strangi, the court went on to hold that property was gifted because the respective capital accounts were increased pro rata, rather than based on each partner's actual contributions. The value of the gifts and discount amounts then became the central issue.

Without delving into the valuation methods employed by the opposing parties and their differences, it is clear that the court agreed and upheld the discounts offered by the expert who explained how he computed the discount. At least four valuation experts were involved in this case; for each discount contested, the court ultimately upheld that which was thoroughly explained via convincing (i.e., detailed) evidence. This indicates that in FLP valuation cases, the court may believe the side with mom albeit no better--evidence.

No evidence, no discount: In Knight,(22) the Tax Court rejected the IRS's contention that a FLP lacked economic substance; it ruled that it had been validly formed under state law and so would not be disregarded for Federal transfer tax purposes. Using language the concurring opinion disputed, the court stated that a hypothetical willing buyer or seller would not disregard the entity. The concurrence emphasized that this analogy was misplaced--these hypothetical parties are useful to analyze the value of partnership interests, but do not relate to valid formation nor economic substance.

Having found a viable entity, the court focused on the valuation discounts of the LP interests the parents gifted to their children. As indicated in Strangi, the actual LP interest is what is valued (not, as the dissent argued, the underlying assets transferred). The petitioners argued for minority interest, LOM and portfolio discounts (the latter applies to an entity with multiple assets or operations that seem not to fit together). In this case, the FLP owned three parcels of real estate, bond funds, Treasury notes, insurance policies and cash. Despite the portfolio discount having merit, it was dismissed outright, because no evidence was offered to show why the FLP assets did not mix; thus, there was no evidence why a willing buyer would not purchase the assets in total.

The petitioner's lack-of-control discount was also rejected, on the grounds the evidence offered discussed unrelated entities and did not explain how the data was used. The court flatly stated it would reject contradictory and unexplained evidence.

As decided in Kerr, the court also pointed out that Sec. 2704 was inapplicable to reduce any discount, because the partnership restrictions were not more restrictive than state (Texas) law.

The Tax Court considered the core FLP cases very seriously; Shepherd, Stangi and Knight were all reviewed by the full court. Less than four percent of the Tax Court's written opinions in any given year are reviewed decisions; obviously, it is trying to send a strong message.

When the IRS finally realizes it cannot stop FLPs merely with procedural or technical arguments, the battle will shift to where it belongs: valuation. A foreshadowing of the future battlefield can be found in Judge Foley's concurring opinion in Knight. The valuation evidence that is constantly presented in these cases looks to the "willing buyer." How would a willing buyer react to a minority interest, an LP interest, nonvoting stock or lack of control? Judge Foley reminds us that the analysis is two-sided: what would the "willing seller" demand? Perhaps there will be greater focus on the "willing seller" side of the equation in some of the more traditional and mundane valuation cases considered by the Tax Court. In Borgatello,(23) the Tax Court concluded that some of the estate's assertions on minority interest lacked merit, because a willing seller under no compulsion to sell would seek assurances from the buyer before parting with a swing vote.

Split-Dollar Life Insurance

Many closely held businesses use split-dollar arrangements to assist their shareholders to finance life insurance policies to fund cross-purchase obligations.

In Notice 2001-10,(24) the IRS reversed over 35 years of rulings and notices by announcing a new income tax treatment of split-dollar life insurance. Previous rulings(25) had held that an employee was taxable only on the imputed value of the life insurance protection provided (i.e., the P.S. 58 table cost or the lowest comparable term insurance rates).

The new notice applies Secs. 83 and 7872 to employer payments under equity plans. The notice offers three choices as to the characterization of the employer payments--compensation, non-loans (taxable under Secs. 61 and 83) or non-loans (subject to taxation under Sec. 7872). Taxpayers may not use the P.S. 58 tables after 2001; the notice provides an interim-rate table to be used to determine the value of the current life protection. The new table is predicated on Sec. 79's Table I, a group-term life insurance measure.

The life insurance lobby is in an uproar. The new guidelines do not grandfather existing split-dollar arrangements, but they may change, "pending consideration of public comments and the publication of further guidance"; conventional wisdom urges taking no action and watching for further developments.

For more information about this article, please contact Mr. Whitlock at [phone] or [e-mail].

(8) Audrey J. Walton, 115 TC No. 41 (2000).

(9) Ironically, the GRAT strategy was a complete tax planning failure for Mrs. Walton. The trust was funded with Wal-Mart stock that paid little or no cash dividends. The strategy's success hinged on the stock's value increasing faster than the required annuity payment. The stock price failed to increase sufficiently during the two-year GRAT term; thus, the trustee was forced to return all of the Wal-Mart stock to Mrs. Walton as part of the annuity payments.

(10) Est. of Paul C. Gribauskas, 116 TC 142 (2001).

(11) Est. of Thomas J. Shackleford, ED CA, 8/6/99.

(12) Rev. Proc. 2000-34, IRB 2000-34, 186.

(13) Est. of Marie A. Bies, TC Memo 2000-338.

(14) Est. of Robert V. Schuler, TC Memo 2000-392.

(15) Robert Rosano, 2d Cir., 4/4/01.

(16) Est. of Dorothy M. Schauerhamer, TC Memo 1997-242.

(17) Est. of Charles E. Reichardt, 114 TC 144 (2000).

(18) Est. of Albert Strangi, 115 TC 478 (2000).

(19) Blaine P. Kerr, 113 TC 449 (1999).

(20) Est. of W. W. Jones II, 116 TC 121 (2001).

(21) J. C. Shepherd, 115 TC No. 30 (2000).

(22) Ina F. Knight, 115 TC No. 36 (2000).

(23) Est. of Charles A. Borgatello, TC Memo 2000-264.

(24) Notice 2001-10, IRB 2001-5, 459.

(25) Rev. Ruls. 64-328 1964-2 CB 11, and 66-110 1966-1 CB 12.

Brian T. Whitlock, J.D., LL.M., CPA
Partner-in-Charge, Wealth Transfer Services Group
Blackman Kallick Bartelstein, LLP
Chicago, IL

Jill McNamara, J.D.
Wealth Transfer Consultant
Blackman Kallick Bartelstein, LLP
Chicago, IL