Significant recent developments in estate planning.

• Author: Ransome, Justin
• Position: Part 2

This article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2010 and May 2011. Part I, in the September issue, discussed estate tax reform and other estate tax developments. Part II covers gift tax, generation-skipping transfer (GST) tax, trust developments, and the annual inflation adjustments for 2011 relevant to estate and gift tax.

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Gift Tax

Step-Transaction Doctrine

In recent years, the IRS has attempted to use the step-transaction doctrine to collapse the formation and funding of family limited partnerships (FLPs) or limited liability companies (LLCs) and the transfer of an interest in such entity when these transactions have taken place close together in time. The Tax Court in Holman (1) indicated for the first time (in a footnote) that it might entertain such an argument in certain cases. In a recent case, the Ninth Circuit overruled a district court's decision to apply the step-transaction doctrine. (2)

The step-transaction doctrine treats a series of formally separate steps as a single transaction if the steps are in substance integrated, interdependent, and aimed toward a particular result. The courts have generally followed one of three alternative tests in determining whether a series of transactions should be stepped together. Those tests are (1) the binding commitment test, (2) the end result test, and (3) the interdependence test.

The binding commitment test collapses a series of steps if at the time the first step is entered into there was a binding commitment to undertake a later step. The end result test looks to whether a series of formally separate steps are prearranged parts of a single transaction intended from the outset to reach the ultimate result. The interdependence test considers whether, based on a reasonable interpretation of the objective facts, the steps are so interdependent that the legal relations created by one transaction will be fruitless without a completion of the series of transactions.

In Linton, the Ninth Circuit reversed the district court's decision granting the IRS's motion for summary judgment on one issue and remanded the case back to the district court for further development on another issue. The taxpayers in Linton thought they were creating an LLC and then transferring interests in the LLC to their children's trusts. In valuing the gifted LLC interests on their gift tax returns, they claimed a 47% discount for lack of control and lack of marketability. The IRS contended that the taxpayers had made gifts of the LLC interests prior to funding the LLC. Therefore, the transfer of assets to the LLC increased the value of the LLC interests previously transferred to the trusts, and the transfers of the assets to the LLC were indirect gifts of the assets themselves to the children's trusts for which no discount was appropriate. The district court, in granting the IRS's motions for summary judgment, concluded that the taxpayers made indirect gifts to the children's trusts of the assets transferred to the LLC because they could not establish that the transactions took place in the order they claimed and, in the alternative, because the step-transaction doctrine applied.

On appeal, the Ninth Circuit addressed the requirements for a gift to become effective under the laws of the state of Washington. The court concluded that the date when the gift of the LLC interests occurred was the first date at which objective circumstances existed that would suggest the gift documents were meant to be operative. Because there was insufficient information in the record to make a conclusion about the timing of the gifts, the court remanded the case to the district court for further development of the facts related to this issue.

The district court also granted the government's motion for summary judgment on grounds that the taxpayers had made indirect gifts under the step-transaction doctrine, even if the taxpayers could establish the proper sequence of events. The court, after examining the three tests of the step-transaction doctrine, determined that all the tests were met. The Ninth Circuit disagreed and concluded that none of the tests was met.

Regarding the binding commitment test, the Ninth Circuit determined that it applies only to transactions spanning several years, and the transactions in this case took place over no more than a few months. Regarding the end result test, the district court had focused on the taxpayers' efforts to minimize their gift tax liability by structuring the transaction to use available discounts. The Ninth Circuit focused on the taxpayers' desire to transfer LLC interests to their children without giving them management control over the LLC or ownership of the underlying assets.

Regarding the interdependence test, the district court had contended that the taxpayers would not have contributed assets to the LLC without the ability to claim the discounts for gift tax purposes. The Ninth Circuit concluded that transferring assets to an LLC is an ordinary and objectively reasonable business activity that makes sense with or without a subsequent gift of LLC interests. Because the Ninth Circuit concluded that none of the three tests was met, it reversed the district court's holding that the taxpayers had made indirect gifts under the step-transaction doctrine.

Sec. 2703

In Fisher (3) over a period of three years the taxpayers transferred to their children minority interests in an LLC that held undeveloped real estate on Lake Michigan. The issue before the district court was whether the value of the LLC interests should be determined without regard to any restriction on the right to sell or use the property under Sec. 2703(a).

Congress enacted Sec. 2703 to prevent the valuation of property for transfer tax purposes under agreements that artificially determine the value of property at less than its fair market value (FMV). Sec. 2703(a) provides that the value of property for transfer tax purposes is determined without regard to (1) any option, agreement, or other right to acquire or use property for a price less than its FMV or (2) any restrictions on the sale or use of the property.

Under Sec. 2703(b), Sec. 2703(a) does not apply to such an option, agreement, right, or restriction if:

* The restriction is a bona fide business arrangement;

* The restriction is not a device to transfer property to family members for less than full and adequate consideration; and

* The restriction is comparable to similar arrangements entered into by persons in an arm's-length transaction.

In determining whether a restriction constitutes a bona fide business arrangement, the district court looked to the standard applied by the Eighth Circuit in Holman. (4) The Eighth Circuit stated that maintenance of family ownership and control of a business may be a bona fide business purpose, but the restriction must foster active involvement in the business. A "mere asset container" is not sufficient to establish a business.

The district court determined that there was no evidence of any business activity with regard to an investment strategy concerning the active sale or development of the current property or, alternatively, the acquisition of additional property. It noted that the LLC sold a portion of the property but that the purchaser initiated the transaction and the sales proceeds were distributed to the LLC members. The court ruled that the taxpayers failed to establish that the LLC was a bona fide business, so the exception in Sec. 2703(b) was not applicable. As a result, the transfer restrictions applicable to the LLC interests were disregarded in valuing the gifts under Sec. 2703(a).

Disclaimers

In a very unusual but interesting case, a district court allowed a taxpayer to rescind his disclaimer because it was not a qualified disclaimer under Sec. 2518. In Breakiron, (5) the taxpayer's parents created two qualified personal residence trusts (QPRTs) for a period of 10 years by placing their undivided one-half interests in their personal residence in the trusts and naming themselves as the income recipients (i.e., the right to live in the home for 10 years) and their two children as the remaindermen. Upon the expiration of 10 years, the taxpayer and his sister would own the residence.

Approximately six months before the expiration of the 10-year term, the taxpayer decided that he wanted to transfer his interest in the residence to his sister. He consulted an attorney to determine the tax implications of the gift and was advised that if he executed qualified disclaimers (as that term is defined in Sec. 2518) within nine months of the expiration of the parents' interests in the QPRTs...