Transfers to LLC were not includable in decedent’s estate
Estate of Mirowski, TCMemo 2008-74
The Tax Court has held that assets the decedent transferred to a family limited liability company (LLC) shortly before she died were not includable in her gross estate under Section 2036(a).
Facts. The decedent’s husband was a cardiologist who developed an implantable cardioverter defibrillator (ICD) device to prevent people who suffered from ventricular fibrillation from dying because they were not in a hospital near an external defibrillator. The husband died in 1990, and, pursuant to his will, his interest under the ICD patents license passed to the decedent. Sales of ICDs increased significantly after the husband’s death, and royalties received under the ICD patents license increased dramatically from thousands of dollars a year to millions of dollars a year.
In 1992, the decedent created an irrevocable spendthrift trust for each of her three daughters and their respective issue and funded the trusts with the ICD royalties. After the funding, the decedent held a 51.09% interest in the royalties, and each trust held a 7.2616% interest in the royalties. The decedent named all three daughters as co-trustees of each of the trusts because she wanted them to have a close working relationship.
By 1998, after the royalties had increased dramatically, the decedent decided to begin to consolidate her investments in an account with Goldman Sachs. She finished the consolidation in early 2001. Prior to that, by early 2000, the decedent began to think of ways, in addition to the trusts, to provide for her daughters and grandchildren and to allow them to work together closely. She settled on an LLC to achieve her goals. On 8/31/00, the decedent’s attorney sent the decedent and her daughters a draft articles of organization and operating agreement for the LLC. The family decided to wait until their next annual get-together, which was scheduled to take place in August 2001, to discuss this matter.
In the meantime, in January 2001, the decedent developed a diabetic foot ulcer and began medical treatment. Although such an ulcer requires care and treatment, a patient is expected to recover. In August 2001, the daughters and their families took their annual vacation together and held their annual meeting on 8/14/01, at which the decedent was not present. At the meeting, the daughters discussed with the decedent’s lawyer:
(1) The decedent’s plans to form the LLC
(2) The decedent’s plans to make respective gifts of interests in the LLC to the daughters’ trusts.
(3) The manner in which the LLC was to function
(4) The daughters’ responsibilities with respect to the LLC.
After the meeting, the lawyer finalized the documents required for the decedent to form the LLC. Although the decedent understood that there could be tax benefits from forming the LLC, these benefits were not the most significant factor in her decision to form the LLC. Instead, the decedent had the following legitimate, nontax purposes for forming, and transferring the bulk of her assets to, the LLC:
(1) Joint management of the family’s assets by her daughters and eventually her grandchildren.
(2) Maintenance of the bulk of the family assets in a single pool of assets in order to allow investment opportunities that would not be available if the decedent were to make separate gifts of a portion of her assets to each of her daughters or to their trusts.
(3) Providing for each of her daughters and then her grandchildren on an equal basis.
Additionally, the decedent wanted to provide additional protection from potential creditors for the interests in the family assets that she intended to provide her daughters and grandchildren.
At the time of the family meeting, the decedent’s health was not rapidly deteriorating, and in fact, she was planning to have a cataract operation to enhance her vision and improve her quality of life. The following timeline shows the events in the weeks leading up to her death.
- 8/27/01: The decedent executed the LLC’s articles of organization and operating agreement.
- 8/30/01: The LLC’s articles of organization were accepted by the state for filing.
- 8/31/01: The decedent was admitted to the hospital for further treatment of her foot ulcer.
- 9/1/01: The decedent transferred property to the LLC, including the ICD patents and her 51.09% interest in the royalties; in exchange, she received a 100% interest in the LLC.
- 9/5-7/01: The decedent transferred to the LLC securities and cash worth more than $62 million that she held in the Goldman Sachs account. After the transfers to the LLC, the decedent retained more than $7.6 million of assets in her own name, which was more than enough to meet her living expenses.
- 9/7/01: The decedent gave a 16% interest in the LLC to each of her daughters’ trusts.
- 9/10/01: Unexpectedly, the decedent’s condition deteriorated significantly. She refused to consider amputation and all additional medical treatment. She developed sepsis and died the next day.
Pursuant to the decedent’s will, the daughters’ trusts inherited, in equal shares, the decedent’s 52% interest in the LLC. As a result, after probate, the trusts would own collectively 100% of the LLC in three equal shares. The LLC continued as a valid functioning investment operation and managed business matters related to the ICD patents and license agreement. As the decedent hoped, the daughters, in their capacities as officers of the LLC and trustees of the trusts have actively worked together to manage the LLC’s assets.
In 2002, the decedent’s estate paid estimated gift tax of $11,750,623 with funds that the LLC distributed to it. Thereafter, the decedent’s personal representatives reported the gifts of the 16% interests in the LLC at a value of $5.7 million each. They reported gift tax for 2001 of $9,729,280, which resulted in a $2,021,343 credit to the estate. The estate return showed estate tax of $14,119,863, which the estate paid with funds distributed from the LLC.
The IRS determined that there was an estate tax deficiency of $14,243,208. The Service said that the total of the date-of-death fair market value of all the assets the decedent transferred to the LLC of $71,153,000 was includable in her gross estate under Section 2036(a), an increase of $43,385,000 from the value of the decedent’s LLC interests reported.
Transfers to the LLC. The estate argued that although the decedent’s transfers to the LLC were transfers of property under Section 2036(a), they fell under the exception for a “bona fide sale for an adequate and full consideration in money or money’s worth.” The estate pointed out that (1) the decedent had legitimate and substantial nontax reasons for forming and transferring assets to the LLC; (2) she received an interest in the LLC proportionate to the value of the assets transferred to it; (3) her capital account was properly credited with those assets; and (4) in the event of LLC’s liquidation and dissolution, she had the right to a distribution of property from her capital account.
The IRS argued that the exception did not apply to the decedent’s transfers because she had no legitimate, significant nontax reason for forming and transferring assets to the LLC. The Service urged the Tax Court to disregard the testimony of the decedent’s children regarding the nontax reasons the decedent decided to form and fund the LLC because of their relationship to the decedent and the estate. The court refused to do so and found that the decedent had the following legitimate nontax reasons for forming and funding the LLC:
(1) Joint management of the family assets by the daughters and eventually the grandchildren.
(2) Maintenance of the bulk of the family’s assets in a single pool to provide better investment opportunities.
(3) Providing for each daughter and grandchild on an equal basis.
The court also rejected the Service’s other contentions that the exception did not apply:
(1) The decedent did not fail to retain sufficient assets outside of the LLC for her anticipated financial obligations. According to the court, the decedent’s only anticipated significant obligation was the substantial gift tax liability resulting from her gifts of the 16% LLC interests to the daughters’ trust. The court said that there was no express or unwritten agreement to use LLC assets to pay that liability, which the decedent could have paid by using a portion of the substantial assets she retained and did not transfer to the LLC, by using the distributions she expected to receive as a 52% interest holder in the LLC from the royalty payments, or by borrowing against her personal asserts and her 52% LLC interest.
(2) The LLC was a valid functioning investment operation and was managing the business matters related to the ICD patents and patent license.
(3) The decedent did not delay forming and funding the LLC until shortly before her death and her health began to fail. The court pointed out that the decedent’s death was unexpected, so she and the daughters did not anticipate the estate taxes and obligations arising as a result of her death. Although the decedent had been treated for her foot ulcer for eight months and was admitted to the hospital a week before she died, until the day before she died, expectations were that she would recover
(4) The court said that the Service’s contention that the decedent sat on both sides of her transfers to the LLC ignored the fact that the decedent fully funded the LLC and that the daughters’ trusts did not contribute any assets. According to the IRS, the Service’s argument would mean that single member LLCs would not be able to take advantage of the bona fide sale exception under Section 2036(a).
(5) Although the LLC distributed more than $36 million to the decedent’s estate to pay estate obligations, including transfer taxes, the court again pointed out that the decedent died unexpectedly, and the parties did not discuss the estate obligations that would arise as a result of the decedent’s death.
(6) The Service argued that, in substance, the decedent received only a 52% interest in the LLC in exchange for transfers to the LLC of 100% of its assets because she did not contemplate forming and funding the LLC without making the gifts to the daughter’s trusts. As a result, according to the IRS, the decedent did not receive an interest in the LLC in proportion to her investment, and thus the bona fide sale exception to Section 2036 did not apply. The court rejected this argument, pointing out that although related, the transfers and the gifts were separate.
Gifts to the trusts. The estate acknowledged that the gifts of the 16% interests in the LLC to the trusts were transfers of property and were not bona fide sales for adequate and full consideration. It argued, however, that there was no express or implied agreement that the decedent would retain the possession or enjoyment of, or the right to income from, the property transferred. The IRS claimed that at the time she made the gifts and at the time of her death, there was an agreement, both express and implied, that the decedent retain the possession or enjoyment, or the right to the income from, the respective 16% interests in the LLC that she gave to the trusts.
The IRS argued that, as the LLC’s general manager, the decedent under the LLC’s operating agreement expressly retained the authority to decide the timing and amounts of distributions from the LLC. It also claimed that the operating agreement expressly gave the decedent, as the majority LLC holder (or as general manager), the authority to determine the timing and the amount of distributions when the LLC is liquidated and dissolved. The court rejected these contentions, pointing out that the operating agreement provided specific distribution methods, which had to be followed. Thus, there was no express agreement in the operating agreement (or elsewhere) that the decedent retain possession or enjoyment, or the right to income from the 16% gifts (Section 2036(a)(1)), or the right to designate persons who would possess or enjoy the 16% interests or the income from the interests (Section 2036(a)(2))
In support of its claim that there was an implied agreement that the decedent retained an interest or right described in Section 2036(a)(1) with respect to the 16% gifts, the court pointed out that the Service relied on essentially the same contentions that it used to argue that the LLC transfers were not bona fide sales. It did not fare any better here, as the court rejected the contentions for the reasons stated above.