01.13.2016 Taxpayer Prevails in Family Limited Liability Company Case
In a recent taxpayer victory, the Tax Court found in favor of the taxpayer with respect to three hotly contested gift and estate planning issues involving family limited liability companies. The Tax Court decided the case of Estate of Purdue v. Commissioner in a memorandum opinion released on December 28, 2015 (full opinion found here).
Beginning in 1995, Robert and Barbara Purdue were advised by their estate planning attorney to create an LLC to take advantage of valuation discounts available for non-marketable, non-controlling interests in such entities and to achieve various other nontax purposes. On August 2, 2000, the Purdues created the Purdue Family LLC (the “LLC”). In November 2000, the Purdues funded the LLC with income-producing assets, including $22 million of marketable securities (held in five separate accounts at three different firms) and an undivided one-sixth interest in a commercial building. In return, the Purdues received one hundred percent of the membership interests in the LLC. Although Mrs. Purdue had some serious, long-term health issues, it was believed that Mr. and Mrs. Purdue did not suffer from any life-threatening diseases at the time the LLC was created.
Mr. and Mrs. Purdue created the Purdue Family Trust (the “Trust”) on November 24, 2000. The beneficiaries of the Trust were the Purdues’ descendants and the spouses of their descendants. The Trust provided Crummey withdrawal rights to the beneficiaries.
During the spring of 2001, the LLC engaged a wealth management firm to provide coordinated investment advice to the LLC. The Purdues and their children agreed to the investment strategy proposed by the wealth management firm. Beginning in 2001, the Purdue children met annually with the family’s estate planning attorney and representatives of the wealth management firm to review family accounts and assets, ratify and approve LLC and Trust distributions, hear investment presentations, and receive legal updates and advice. The parties kept minutes of their annual meetings.
Mr. Purdue died unexpectedly on August 3, 2001. Mr. Purdue’s will established a bypass trust and GST exempt and GST non-exempt qualified terminable interest property (QTIP) trusts for the benefit of Mrs. Purdue.
From 2002 to 2007, Mrs. Purdue made annual exclusion gifts of LLC interests to the Trust. (By the time of Mrs. Purdue’s death, approximately twenty percent of the LLC interests had been transferred to the Trust.) During those years, the Trust made distributions to the Purdue children of nearly $2 million, largely representing dividends received from the LLC.
Mrs. Purdue died November 27, 2007. The assets of Mrs. Purdue’s estate (the “Estate”) were valued in excess of the estate tax applicable exclusion amount. The assets of the two QTIP trusts also were taxable in the Estate. The Estate and the QTIP trusts borrowed funds from some of the Purdue children to pay the Estate’s and QTIP trusts’ tax liabilities, and the Estate deducted the interest charged on the loan on the estate tax return.
IRS Challenge and Tax Court Rulings
In 2012, the IRS issued notices of deficiency to the Estate. The IRS assessed $3,121,959 of additional estate tax and a total of $925,807 of gift tax for the years 2001, 2002, and 2004-2007.
To support its tax adjustments, the IRS first argued that Mrs. Purdue’s contribution of assets to the LLC was a transfer with a retained interest. (In essence, the IRS argued that the assets should be included back in the Estate for estate tax purposes because Mrs. Purdue retained the income from the assets transferred to the LLC.) The Estate argued in response that Mrs. Purdue’s contributions to the LLC were bona fide sales for adequate and full consideration, qualifying for an exception to the retained interest rule.
To satisfy the bona fide sale for adequate and full consideration exception, the Court held that Mrs. Purdue must have had a legitimate and significant nontax reason for creating the LLC (the “bona fide prong”) and that she must have received an LLC interest proportional to the value of the property she contributed (the “adequate and full consideration prong”).
To satisfy the bona fide sale prong, the Court found that a significant nontax purpose for the creation of the LLC was “to consolidate investments into a family asset managed by a single adviser.” The Court pointed specifically to the consolidation of the Purdues’ marketable security accounts under the advice of a single wealth management firm. The Court found that other factors further supported its finding of a bona fide sale: (1) the Purdues were not financially dependent on the LLC; (2) the LLC’s funds were maintained separate from the Purdues’ funds, and other LLC formalities were observed; (3) assets were actually transferred to the LLC; and (4) the Purdues were believed to be in good health at the time of the creation of the LLC. The Court also found that Mrs. Purdue received a proportional LLC interest for her contributions, thus satisfying the adequate and full consideration prong. The Court found that Mrs. Purdue had satisfied the bona fide sale for adequate and full consideration exception, despite also being motivated by the transfer tax savings available through valuation discounts.
The IRS next argued that Mrs. Purdue’s gifts from 2002 to 2007 of interests in the LLC did not constitute “present interest” gifts that qualify for the annual exclusion from gift tax. The Estate responded that the donees received a present interest because of the income produced by, and regularly distributed from, the LLC.
For a right to income to satisfy the “present interest” annual exclusion gift requirement, there must be income that flows steadily to the donees and can be reasonably ascertained. The Estate showed that the LLC generated income through the commercial building it owned and dividend-paying marketable securities; that the Estate was required to make distributions for its members to pay their income tax liabilities; and that the LLC’s anticipated income was readily ascertainable or could be estimated. The Estate further showed that the Trust, from 2000 through 2008, actually distributed almost $2 million. Based on those facts, the Court found that Mrs. Purdue’s gifts of LLC interests were gifts of present interests qualifying for the annual exclusion.
The IRS’s final argument was that the loan made by the Purdue children to the Estate and QTIP trusts was not necessarily incurred, and therefore the interest on the loan could not be deducted on the estate tax return. The Court, however, found that the loan was necessary because other means of obtaining the required funds were not available. Specifically, a distribution from the LLC to the Estate could not be made to pay the tax because one of the Purdue children refused to approve the distribution. Accordingly, the interest on the loan was deductible because the loan was bona fide and necessary to pay the estate tax.
The Estate of Purdue case is a reminder that family limited partnerships and limited liability companies can be powerful wealth management and transfer planning tools for high net worth individuals and families when properly administered. The case also can be taken as a warning that the IRS continues to litigate issues involving family limited partnerships and limited liability companies. To withstand IRS scrutiny, it is critical that clients, with the help of their advisors, engage in such planning thoughtfully and follow through thoroughly.