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By Louis A. Mezzullo, Esq.
Luce, Forward, Hamilton & Scripps LLP, Rancho Santa Fe, CA
In Holman v. Comr.,1 a gift tax case, the Tax Court concluded that transfer restrictions in a family limited partnership agreement were not a bona fide business arrangement, were also a "device" for transferring property to the founding partners' children, and would therefore be disregarded under §2703(a)(2).2 Tom and Kim Holman (Tom and Kim), husband and wife, formed a limited partnership (the partnership) on November 2, 1999, and transferred shares of Dell Computer Corp. (Dell) to the partnership the same day. They each took back a .89% general partnership interest and a 49.04% limited partnership interest. In addition, a trust for the benefit of their children (the trust) transferred shares of Dell to the partnership for a .14% limited partner interest. They had four reasons for forming the partnership: very long-term growth, asset preservation, asset protection, and the education of their four children. In addition, they wanted to disincentivize their children from getting rid of the assets, spending them, or feeling entitled to them. The partnership agreement gave the general partners the exclusive right to manage and control the business and prohibited an assignment of an interest by a limited partner without the consent of all partners except to permitted assignees. The partnership agreement also gave the partnership the right to acquire an assignee interest acquired in violation of the agreement at fair market value based on the assignee's right to share in distributions. The partnership could only be dissolved with the consent of all partners.
On November 8, 1999, Tom and Kim gave limited partner interests (LP units) to the trust and to four uniform transfers to minors act custodianships for the benefit of their children (custodian accounts). The gifts had a reported value according to the gift tax returns roughly equal to Tom and Kim's $600,000 transfer tax exemptions at the time. On December 13, 1999, the custodian accounts transferred additional shares of Dell to the partnership. On January 4, 2000, Tom and Kim gave LP units to the custodian accounts having a reported value equal to the annual exclusions available to Tom and Kim for gifts to their children in 2000 ($80,000). On January 5, 2001, Tom and Kim transferred additional shares of Dell to the partnership in exchange for additional LP units. Finally, on February 2, 2001, Tom and Kim gave additional LP units to the custodian accounts with a reported value equal to the 2001 annual exclusions available to Tom and Kim ($80,000).
The Tax Court described the operation of the partnership as follows: there was no business plan; there were no employees nor any telephone listing in any directory; its assets consisted solely of Dell shares; there were no annual statements; at the time Tom decided to create the partnership he had plans to makes gifts of LP units in 1999, 2000, and 2001; and the partnership had no income and filed no tax returns for 1999, 2000, and 2001.
The IRS adjusted the value of the gifts based on the following alternate assertions: the transfer of assets to the partnership constituted indirect gifts of the Dell shares; the interests were more analogous to interests in a trust than an operating business; §2703 applied to ignore the restrictions in the partnership agreement; the partnership agreement's restrictions on liquidation should be ignored under §2704(b); and the appropriate discount for lack of control and lack of marketability should be 28%, rather than the taxpayer's 49.25% discount. At trial, the IRS abandoned the trust and §2704(b) arguments.
With regard to the application of §2703(a), the IRS asserted that the right of the partnership to acquire an assignee's interest at a value less than its pro rata share of the partnership's net asset value (NAV) should be disregarded under §2703(a) because it did not satisfy the three requirements of the statutory safe harbor; namely, (1) the right must be a bona fide business arrangement; (2) it must not be a device to transfer property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and (3) its terms must be comparable to similar arrangements entered into by persons in an arm's length transaction. The court agreed with the government, based on its opinion that the right did not satisfy the bona fide business arrangement and device requirements.
The court held that there was no closely held business and the reasons for forming the partnership were educating the Holman's children and disincentivizing them from getting rid of Dell shares, spending the wealth represented by the shares, or feeling entitled to the Dell shares. The court distinguished Estate of Amlie v. Comr., T.C. Memo 2006-76, because in that case the conservator was seeking to exercise prudent management of his ward's minority interest in a bank consistent with his fiduciary obligations to the ward and to provide for the expected liquidity needs of her estate.
While the court held that the gifts were not a device to transfer LP units for less than adequate consideration, the right to acquire an assignee's interest was such a device. The court reasoned that by purchasing a transferred interest for a value less then a pro rata share of the NAV, the value of the non-assigning children's LP units would be increased.
Although both parties' experts agreed that the restrictions in the partnership agreement were common in arm's-length arrangements, the government's expert believed that because of the nature of the partnership, nobody dealing at arm's length would get into the deal. Because the court found that the right to acquire an assignee's interest was not a bona fide business arrangement and was a device, it did not reach a conclusion as to whether the comparability requirement was satisfied.
The Tax Court's application of the statutory safe harbor under §2703 greatly restricts its usefulness in family entities that do not engage in an active trade or business. The court implies that the bona fide business arrangement requirement can only be satisfied if there is a closely held business involved or the reasons for the restrictions are business related. Some commentators have argued that the court ignores language in the Finance Committee Report that "[b]uy-sell agreements are commonly used to control the transfer of ownership in a closely held business…to prevent the transfer to an unrelated party" [emphasis added]. If the court's premise is that the bona fide business arrangement requirement can only be met if there is a closely held business, which in its opinion does not include an investment in one company's stock, or the reasons for the restrictions are business related, the reasons for having any restrictions are irrelevant in meeting the requirement unless there is a closely held business or the reasons are business related.
Although the court did not treat the gifts of the LP units themselves as a device, it held that the right to acquire an assignee interest at a value below its proportionate NAV could result in value being transferred to objects of the decedent's bounty for less than adequate consideration. However, the subsequent shift in value to the non-assigning children would not involve a transfer from the parents to the children, but merely a shifting of value among all the non-assigning partners. The result reached by the court can be avoided by including a true right of first refusal rather than the provision giving the partnership the right to acquire an assignee's interest. Presumably the purchase price in a good faith offer by a third party would be based on a value considerably less than a pro rata share of the NAV.
Finally, as has been noted by other commentators, the willingness of the Tax Court to accept testimony concerning the comparability requirement other than actual buy-sell agreements, which would be difficult to obtain for closely held businesses, is a welcome approach to that issue.
The taxpayers in Holman appealed the Tax Court's decisions with regard to the application of §2703 and the appropriate lack of marketability discount. The Eighth Circuit, in a two to one decision,3 upheld the Tax Court on both the §2703 issue and the valuation issue. The majority believed that the issues were questions of fact, and therefore applied a "clear error" standard of review, while the dissenting judge believed that the issues were questions of law or mixed questions of law and fact and would have applied a "de novo" standard. Consequently, the majority opinion relies heavily on the facts in the case in affirming the Tax Court's holdings.
With regard to the bona fide business arrangement test, the Court found that:[i]n the present case, looking at the entirety of the surrounding transactions—including the contemporaneous execution of wills, Mr. Holman's understanding of the potential tax benefits of his actions, Mrs. Holman's educational goals, and the absence of any business activity—we find ample support for the Tax Court's determination. When viewed in this context, there is little doubt that the restrictions included in the Holmans' limited partnership agreement were not a bona fide business arrangement, but rather, were predominately for purposes of estate planning, tax reduction, wealth transference, protection against dissipation by the children, and education for the children.
At the outset, the court refuted the taxpayers' argument that the Tax Court had imposed an operating business requirement in order to satisfy the bona fide business arrangement test. Citing earlier cases, the Eighth Circuit did postulate that the bona fide business arrangement test was less difficult to satisfy when an active business was involved. According to the court, context matters. "Here that context shows that the Tax Court correctly assessed the personal and testamentary nature of the transfer restrictions. Simply put, in the present case, there was and is no "business," active or otherwise. The donors have not presented any argument or asserted any facts to distinguish their situation from the use of a similar partnership structure to hold a passbook savings account, an interest-bearing checking account, government bonds, or cash." The court characterized the Holmans' family partnership as a "mere asset container," citing Estate of Erickson v. Comr., T.C. Memo 2007-107.
The taxpayers cited several Tax Court cases addressing the business purpose element of §2703(b)(1), involving passive investments. The court distinguished Estate of Amlie v. Comr., T.C. Memo 2006-76, where the Tax Court found that a buy-sell agreement was a bona fide business arrangement where a fiduciary had entered into the agreement to ensure the ability to sell stock that represented an otherwise illiquid minority interest in a closely held bank. It also distinguished a line of cases involving investment entities with restrictions imposed to ensure perpetuation of an investment model or strategy. Estate of Black v. Comr., 133 T.C. No. 15 (2009); Estate of Murphy v. U.S., 104 AFTR 2d 2009-7703 (W.D. Ark. 2009); and Estate of Schutt v. Comr., T.C. Memo 2005-126. In the present case, in contrast to the cited cases, the donors did not purport to hold any particular investment philosophy or possess any particular investing insight. Because the Holmans had no overall, long-term plan, unlike Schutt [and presumably the other cited cases], the family membership, educational, and tax reduction purposes overshadowed any claim of a business purpose for the restrictions.
Because the majority found that the first requirement of the statutory exception was not satisfied, it did not deal explicitly with the other two requirements, the device test and the comparability test.
With regard to the valuation issue, the court found that the government's expert's analysis comported with the general rule of casting the potential buyer merely as a rational economic actor.
A buyer possessed of all relevant information would know that (1) the underlying assets are highly liquid and easily priced; (2) the amount held by the partnership could be absorbed by the broader market and represents but a small fraction of the total outstanding market capitalization of Dell corporation; (3) the partnership agreement permits the buying out of exiting partners or dissolution upon unanimous consent of all partners; and (4) there would be little or no economic risk and likely no capital infusion necessary for the remaining partners to buy out an exiting partner.
Therefore, the Eighth Circuit agreed with the Tax Court that there was a cap on the amount of lack of marketability discount that was appropriate under the facts in this case, because the remaining partners would have paid more than a third party for the withdrawing partner's interest.
The dissenting opinion believed that all three requirements of the statutory exception to the application of §2703(a) applied. The restrictions in the agreement represented a bona fide business arrangement, the device test only applied in the case of a decedent and not a donor, and the comparability test was satisfied. The dissent also believed that the Tax Court and the majority had misapplied the willing buyer, willing seller standard by assuming that the hypothetical buyer owned Holman limited partnership interests.
The dissent believed that the partnership agreement restrictions[were] bona fide business arrangements because they were not created for the primary purposes of avoiding taxes, and they served the following legitimate business purposes: (1) maintaining family control over the right to participate as a limited partner; (2) maintaining family control over the right to receive income from the partnership's investment assets; (3) protecting partnership assets from creditors and potential future ex-spouses; and (4) preserving the partners' fundamental right to choose who may become a partner.
The dissent also found that the device test only applies to transfers at death, because the statutory language uses the term "decedent" rather than the broader term "transferor," and would have held the regulation that changes the word "decedent" to "transferor" as invalid because it does not give effect to the plain language of the statute. Finally, the dissent would have held the comparability requirement satisfied because the experts for both parties agreed that the transfer restrictions were comparable to those found in agreements entered into at arm's length.
The dissent also believed that the majority and the Tax Court had misapplied the willing buyer, willing seller standard. It believed that the majority and the Tax Court plucked rational economic actors out of the existing "thin" private market, placed Holman limited partnership shares in their pockets, and asked them what they would pay for a wishing-to-assign partner's interest in light of the partnership's dissolution provisions. According to the dissent, courts commit legal error where, as in this case, they substitute hypothetical buyers for "particular possible purchasers" based on "imaginary scenarios" as to who a purchaser might be, citing Estate of Simplot v. Comr., 249 F.3d 1191 (9th Cir. 2001)
If other courts adopt the reasoning of the Tax Court and the Eighth Circuit with regard to the bona fide business arrangement requirement of the statutory exception to the application of §2703(a), appraisers may be forced to disregard restrictions in buy-sell agreements, limited partnership agreements, and LLC operating agreements in connection with entities that hold only passive investments that would be normal in such agreements in connection with an operating business, unless there is a business purpose for the arrangement. For example, in Amlie, the business purpose was to provide liquidity to Mrs. Amlie's estate and to protect her minority interest. In Schutt, the business purpose was to preserve Mr. Schutt's investment philosophy. On the other hand, in Holman, the stated purposes for creating and funding the partnership did not include any particular investment strategy; rather the Holmans wanted to protect the assets from dissipation by their children and to teach them about wealth and the responsibility of that wealth. Certainly, if the word "business" in the first requirement has any meaning, the Tax Court and the Eighth Circuit got it right.
This may mean that the bona fide business arrangement test is more difficult to satisfy than the bona fide sale exception to §2036(a). It appears that as long as there is a legitimate and significant nontax reason for creating and funding the entity and the interests the contributors receive in the entity are proportionate to the fair market value of the assets contributed, the bona fide sale exception is satisfied. Perhaps it is the absence of the word "business" in the bona fide sale exception that causes this apparent difference between the two standards. Keep in mind, even with the application of §2703(a), the taxpayers still obtained significant discounts.
The Eighth Circuit's upholding the Tax Court's analysis of the appropriate lack of marketability discount may also affect entities holding only marketable investments. While the dissent may have it right that the majority misapplied the "willing seller, willing buyer" standard, there is merit in the majority's analysis. If the assets held by the entity are marketable, the owners who do not wish to withdraw can easily muster the necessary funds to buy out an owner who is seeking to sell his or her interest to a third party. Presumably the third party would be willing to pay less for the interest than the remaining owners, and therefore, the true fair market value of the interest in such a case may be more than what a third party would pay, unlike a situation involving an entity holding non liquid assets, such as an operating business, where the remaining owners would have to come up with funds to buy out the withdrawing owner from other sources.
For more information, in the Tax Management Portfolios, see Mezzullo, 812 T.M., Family Limited Partnerships and Limited Liability Companies, and in Tax Practice Series, see ¶4095, Family Business Entities.
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