Tax Court Considers “Good Facts”
Challenge to an FLP/LLC
provides a roadmap for good planning, funding and presenting an FLP or similar
entity should it meet an IRS challenge
After a recent string of “bad facts” cases dealing
with family limited partnerships (FLPs) and LLCs, on March 26, 2008, the U.S.
Tax Court delivered some relief to taxpayers. The court’s ruling in Estate of Mirowski v.
Commissioner (T.C. Memo. 2008-74) also provides a potential “roadmap” for
good planning, funding and presenting an FLP or similar entity, such as an LLC,
should it meet an IRS challenge under Internal Revenue Code § 2036(a).
That section provides that a decedent’s taxable
gross estate should include the value of all property that the decedent
transferred during his or her lifetime while retaining the possession or
enjoyment of, or the right of income from, the property, or the right to
designate the persons who can do so.
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Long-Term Planning, Sudden Death
In the 1960s, Dr. Mirowski helped invent a patented
medical device. The device became enormously profitable, but only after his
death in 1990. Continuing a long history of family and charitable giving, Dr.
Mirowski’s widow retained a majority interest (51.09%) in the patent and
licensing agreements but gifted the remaining interest into three irrevocable
trusts for each of her daughters.
In August 2001, with the assistance of her
financial advisors, Mrs. Mirowski created a limited liability company, Mirowski
Family Ventures. Within a week of setting up the LLC, she funded it with more
than $60 million in assets, including her 51% interest in medical patents. She
immediately gave each of her daughters’ trusts a 16% member interest in the LLC,
for a total of 48%. The LLC’s operating agreements designated Mrs. Mirowski as
the managing member, but a sale or other transfer of the company required
approval of all members.
Although she made no arrangements for the payment
of the substantial gift tax liability that would result from the gifting of the
LLC memberships, Mrs. Mirowski retained over $7.5 million from which she could
have provided payments. However, four days after funding her LLC, she died.
Mrs. Mirowski’s estate paid over $14.1 million in
estate taxes. After an IRS audit, and pursuant to IRC § 2036, the IRS determined
that the estate owed an additional $14.2 million in taxes, based on the
inclusion of all of Mrs. Mirowski’s transfers to Mirowski Family Ventures.
The IRS tried to compare the LLC interest transfers
to prior “bad facts” cases in which the Tax Court rejected an FLP or similar
entity based on improper or belated funding, failure to observe partnership
structure and management procedures, or other “badges” of non-business purpose.
In those cases, the FLP generally had little use beyond an estate planning (and
tax avoidance) device.
In response, attorneys for the Mirowski estate
distinguished this case by its comparatively “good” facts.
For instance, even though Mrs. Mirowski died within
days of funding the LLC, her death was unexpected, and, thus, the transfers
could not be characterized as deathbed transactions. Further, the estate’s
attorneys presented evidence that, while Mrs. Mirowski realized that forming the
LLC could yield some tax benefits, her primary motivations were:
joint management of the family's assets by her
daughters and, eventually, her grandchildren;
pooling the assets to allow for investment
opportunities that would not be available if she made separate gifts to each
of her daughters or their trusts;
providing additional protection from potential
creditors for the interests in the family's assets; and
providing for each of her daughters and
ultimately her grandchildren on an equal basis.
A Win for the Estate
The Tax Court agreed with the estate, finding that
Mirowski Family Ventures had “real and significant non-tax business purposes”
that met the § 2036(a) criteria to apply the “bona fide sale” exception to the
transfers. In fact, the court found that Mrs. Mirowski’s stated wish for her
daughters to remain “closely knit and be jointly involved” in managing the
family assets was the most significant non-tax purpose, which, by itself,
qualified for the § 2036(a) exception.
The IRS had also argued that Mrs. Mirowski failed
to retain sufficient assets outside of the LLC to support her own expenses as
well as the substantial gift tax liability. That argument also proved
unsuccessful, as the court found that she could have paid those expenses from
her retention of over $7.5 million in assets or from the anticipated
distributions from the LLC. At no time before her death, the court found, did
the LLC’s members have any agreement, express or implied, to fund the liability
with LLC assets.
Finally, even though Mrs. Mirowski was the LLC’s
managing member, her powers and discretion were subject to the operating
agreement, including its requirement of other members’ approval for major
transactions. The court found no agreement, express or implied, that by her
position she retained a right or interest into the respective 16% LLC interests
that she gave to her daughters’ trusts. ■