Article: "Good News" (Karmazin Settlement)
Cases:
Strangi T.C. Memo 2003-145.
McCord 120 T.C. No.13.
Lappo T.C. Memo 2003-258.
Peracchio T.C. Memo 2003-280.
Stone T.C. Memo 2003-309.
GOOD NEWS
In a year of controversial Tax Court decisions (see Strangi and McCord discussed herein), news of the pre-trial settlement in Karmazin v. Commissioner (Tax Court Document #002127-03) on October 15, 2003 was welcomed by estate planners. The IRS withdrew its position that a sale of limited partnership interests to an intentionally defective grantor trust in exchange for a note was not a bona fide transaction.
Jerome Deener, Esq. of Deener, Racusin & Stern, Hackensack, New Jersey, represented the taxpayer. He succeeded in reducing a $2,500,000 gift tax deficiency to $134,000. He has shared with us some information about the case.
The facts are straightforward. The taxpayer sold units in an FLP owning marketable securities to two family trusts in exchange for two promissory notes. The sold units and some previously gifted units were pledged by the trusts to secure payment.
Certain IRS arguments and Mr. Deener’s response were as follows:
IRS: The notes were equity and not debt. There was no recognized sale. The taxpayer retained a “junior” (growth) interest in the partnership under Section 2701 in the form of notes reclassified as equity.
Deener: If there were a reclassification, the debt must be a debt of the partnership not the trusts. Since the partnership was not indebted to anyone, reclassification was not possible.
IRS: The transaction was, in effect, a gift to the trust beneficiaries followed by the reservation of an annuity. As such, it did not meet the “qualified interest” requirements of Section 2702 because the source of payments was the FLP not the trusts.
Deener: The notes were valid debt with reliable income streams to fund their obligation. Payments due were independent of whether the FLP produced income for the trusts. Under “reality of sale” principles, the trust possessed sufficient assets to cover the debt and meet payments as they became due.
If necessary, a large commercial institution could provide the trust with a letter of credit to the trusts to secure the transaction.
MPI valued limited partnership interests in the Karmazin family limited partnership, using a 42% combined discount for minority interest and lack of marketability. The IRS agreed to a 37% discount as a part of the settlement.
Although the settlement is encouraging, Mr. Deener cautions that the case involved several complicated legal issues which should be reviewed by a qualified estate planning professional.
Estate of Strangi v. Commissioner, T.C. Memo 2003-145. Filed May 20, 2003.
A dying client worth $10 million (“Strangi”) transferred 98% of his assets to a limited partnership (“SFLP”) in exchange for a 99% limited partnership interest and 47% of the corporate general partner (“Stranco”). Based on the Tax Court’s first look, the plan worked. The court allowed a 31% discount in valuing the interests for estate tax purposes. However, the government’s appeal persuaded the Fifth Circuit to remand so the Tax Court could consider the application of Code Section 2036(a). After reviewing the facts once again, Judge Cohen decided Section 2036(a)(1) (retention of income) and 2036(a)(2) (retention of control over income) applied. This meant the partnership was ignored and the transferred assets were brought back into Mr. Strangi’s taxable estate.
Many believe Judge Cohen reached the right decision on the facts but got carried away in her analysis of 2036(a). Let’s review the facts:
- A son-in-law had Strangi’s general power of attorney and was manager of Stranco, thus having sole authority to make distribution decisions.
Retention of Income
A 2036(a)(1) argument was not hard to make. There does seem to have been an implied
understanding that Strangi would retain the income from the property he transferred. Since
he was only a minority owner of Stranco, he could not have enforced a right to the income
but his son-is-law had the wherewithal with the power of attorney, his management position
and backing of Strangi’s children to keep things as always. Finally, previous 2036(a)
cases (Reichardt, Thompson, Harper and Schauerhamer) had all gone
against the taxpayers.
Retention of Control over Income
Section 2036 (a)(2) requires the inclusion in the gross estate of property with respect to
which the decedent retained “the right, either alone or in conjunction with any
person, to designate the persons who shall possess or enjoy the property or the income
therefrom.” Even though Strangi was only a minority owner of Stranco, Judge Cohen
said he could join with other Stranco shareholders to control distributions of income and
even liquidate the partnership. The judge rejected a Byrum argument that Stranco
was constrained by fiduciary responsibilities, saying the arrangement was
“intrafamily.” After reviewing governing instruments requiring unanimous consent
of the limited partners and Stranco shareholders to dissolve, the judge said:
“decedent can act together with other Stranco shareholders essentially to revoke the SFLP arrangement and thereby to bring about or accelerate present enjoyment of partnership assets.”
COMMENT: Many believe the decision goes too far and should be appealed
to the Fifth Circuit because it suggests there can be 2036(a)(2) inclusion if a decedent
owns any interest at all in the general partner. In the meantime, we understand existing
FLP estate planning arrangements are being revisited.
McCord v. Commissioner, 120 T.C. No. 13. Filed May 14, 2003.
The Tax Court’s majority decision in McCord, an FLP case, probably disappointed the McCord family. The Court construed a formula clause so as to disregard its obvious intent, rejected the use of pre-IPO studies in determining the discount for lack of marketability and merely split the difference between the family and the IRS in its valuation conclusions. A bright spot was its ruling that gifted interests in the partnership were and should be valued as assignee interests, not limited partnership interests, under Texas law.
Formula Clause
Agreements for the assignment of limited partnership interests to children and trusts
included a formula clause allocating additional value to a charity in the event “fair
market value” of the assigned interests exceeded a specified amount. This was
designed to provide a charitable deduction for any increase in value from an audit of the
parents’ gift tax returns. However, the court noted that “fair market
value” was not necessarily “fair market value as finally determined for Federal
gift tax purposes” and held the formula clause should not be given effect.
Pre-IPO Studies
It is arguable that some portion of the IPO premium over the private market price is
attributable to factors other than lack of a ready market. For example, the buyer may be
an insider who wants a bargain price for his services to the company. He might also want a
low price for assuming the risk that the IPO may not happen or, if it does, that the IPO
price may be lower than expected. These were arguments made by the IRS valuation expert
which helped convince the Court to reject the IPO approach.
Valuation Discount Conclusions
The partnership owned marketable securities (65%), interests in real estate limited
partnerships (30%) and oil and gas interests. The Court’s 32% combined discount for
minority interest and lack of marketability was right in the middle:
| Minority Interest | Lack of Marketability | Combined | |
| IRS | 8.34% | 7% | 14.8% |
| Court | 15% | 20% | 32% |
| Taxpayers | 22% | 35% | 49% |
The family’s expert relied on four restricted stock studies (private placements of unregistered stock) to support his 35% discount for lack of marketability. The expert for the IRS pointed out that private placement prices of registered stock were also at a discount from the public price and suggested that a buyer’s “assessment and monitoring costs,” not just illiquidity, contributed to the spread between private and public prices. The Court seemed to favor the IRS expert’s analysis in concluding a 20% discount.
Lappo v. Commissioner, T.C. Memo 2003-258. Filed September 3, 2003.
This case involved the value of 1996 gifts of all the limited partnership interests in an FLP which held municipal bonds (40%) and two pieces of commercial real estate in Michigan (60%). MPI served as expert witness for the taxpayer. There were economic substance, 2703 (a)(2) and gift on formation issues raised by the IRS which were withdrawn prior to trial.
The Court was critical of the expert witnesses for both the taxpayer and IRS. The expert for the Service relied on a study which purported to calculate a 7.2% discount for impaired marketability. The court stated, “Absent further explication … we are unpersuaded that a 7.2 percent discount is an appropriate quantitative starting point for determining the marketability discount applicable to the gifted interests in this case.”
The Court ultimately determined a 15% minority interest discount from the partnership’s net asset value and a 24% discount for lack of marketability. The combined discount was 35.4%.
Peracchio v. Commissioner, T.C. Memo 2003-280. Filed September 25, 2003.
Peracchio Investors, L.P. was a family limited partnership owning cash and money market funds (44%) and marketable securities (56%). Mr. Peracchio either gave or sold most of the limited partnership interests to a trust. His 1997 gift tax return showed that a combined 40% discount for minority interest and lack of marketability had been used in valuing the transferred interests.
Judge Halperin’s decision on valuation discounts was 6% for minority interest and 25% for lack of marketability, meaning a combined discount of 29.5%. The IRS had been at just under 19%.
The opinion offers a good explanation of how each asset category (e.g. cash, municipal bonds, equities, etc.) must be looked at separately and properly weighted in calculating the minority interest discount. The minority discount assigned to cash and equivalents was a mere 2%.
One of Mr. Peracchio’s valuation experts tried to argue that the Mandelbaum case (T.C. Memo 1995-255) established a 35% to 45% “benchmark” for the lack of marketability discount but Judge Halperin said the quoted range should be confined to “the resolution of that case.”
COMMENT: If the partnership had plans to invest some or all of its large cash position, placing cash in another asset category might have increased the minority interest discount. Investment of cash is not mentioned in the Court’s opinion.
Estate of Stone v. Commissoner, T.C. Memo 2003-309. Filed November 7, 2003
.An IRS string of successes in Section 2036(a) cases, e.g. Harper, Thompson, Reichardt, Kimbell, Strangi, etc., has been broken.
Mr. and Mrs. Stone transferred certain assets, including real estate and family holding company stock, to five family limited partnerships only two months before Mr. Stone’s death in 1997. However, the process which led to funding the partnerships actually started in 1992 with the onset of litigation among the children over the family’s assets. The children had become actively involved in managing the assets in 1995 by which time the parents had lost interest in such matters. Final settlement of the litigation coincided with funding the partnerships.
Judge Chiechi ruled that transfers to the FLPs were for adequate and full consideration. This is Section 2036(a)(1)’s exception to including transferred assets in the taxable estate where a decedent retains enjoyment of the assets.
The IRS relied on the Harper case where the Court said a transfer of assets to an FLP was a “unilateral” recycling of value and mere change of form of ownership. Judge Chiechi distinguished Harper and similar cases, emphasizing the following facts:
- Mr. and Mrs. Stone received pro rata partnership interests in return for contributions properly credited to their capital accounts.
Since these facts supported the 2036(a)(1) exception, the Judge found it unnecessary to address the issue of whether enjoyment of transferred assets had been retained.
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