Estate of Barbara M. Purdue v. Commissioner, T.C. Memo. 2015-249 (filed December 28, 2015)
Barbara Purdue died on November 27, 2007, at age 95, owning a minority interest in Purdue Family LLC (PFLLC). The Purdues had formed PFLLC in 2000 and funded it with marketable securities of $22 million, a real estate interest valued at $900,000, a $375,000 promissory note, and an $866,000 certificate of deposit. From 2002 until 2007, Mrs. Purdue made annual exclusion gifts of PFLLC interests.
The IRS determined an estate tax deficiency of $3.1 million and gift tax deficiencies totaling almost $800,000. The primary issue of this case centered on whether the value of the assets transferred by the decedent to PFLLC were includible in the value of her gross estate under sections 2036(a) and 2035(a). Secondary issues pertained to whether annual exclusion gifts qualified as present interest gifts and whether the estate was entitled to deduct interest on loans from the beneficiaries of the estate to pay the estate tax liabilities.
Section 2036(a) is applicable when three conditions are met: (1) the decedent made an inter vivos transfer of property, (2) the decedent’s transfer was not a bona fide sale for adequate and full consideration, and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he or she did not relinquish before death.
In addressing the section 2036(a) issue, the Tax Court identified the following factors to be considered when deciding whether a nontax reason exists: (1) the taxpayer’s standing on both sides of the transaction, (2) the taxpayer’s financial dependence on distributions from the LLC, (3) the taxpayer’s commingling of LLC funds with the taxpayer’s own, (4) the taxpayer’s actual failure to transfer the property to the LLC, (5) the discounted value of the LLC interests relative to the value of the property contributed, and (6) the taxpayer’s old age and poor health when the entity was formed.
The estate argues the decedent had several nontax motives for transferring the property to PFLLC: (1) to relieve the decedent and her husband, Mr. Purdue, from the burdens of managing their investments, (2) to consolidate investments with a single adviser to reduce volatility according to a written investment plan, (3) to educate the five Purdue children to jointly manage a family investment company, (4) to avoid repetitive asset transfers among multiple generations, (5) to create a common ownership of assets for efficient management and for meeting minimum investment requirements, (6) to provide voting and dispute resolution rules and transfer restrictions appropriate for joint ownership and management by a large number of family members, and (7) to provide the Purdue children with a minimum annual cash flow.
The IRS argues that PFLLC was a testamentary substitute and that transfer tax savings were the primary motivation for the formation and funding of PFLLC.
The Tax Court found that the decedent’s desire to have the marketable securities and the real estate interest held and managed as a family asset constituted a legitimate and actual nontax motive that satisfied the bona fide sale prong. Further, the Tax Court concluded that in situations where a taxpayer stands on both sides of a transaction, there is no arm’s-length bargaining. As such, the bona fide transfer exception does not apply. The Tax Court commented that the decedent received interests in PFLLC proportional to the property she contributed. Accordingly, the decedent’s transfer was for full and adequate consideration. Other factors supporting the bona fide sale include the following: (1) Mr. and Mrs. Purdue were not financially dependent on distributions from PFLLC, (2) Mrs. Purdue retained substantial assets outside of PFLLC to pay her living expenses, (3) no commingling of the decedent’s funds with the funds of PFLLC occurred, and (4) the formalities of PFLLC were respected. PFLLC maintained its own bank accounts and held meetings at least annually with written agendas, minutes, and summaries.
Regarding the present interest issue, the Tax Court focused on PFLLC’s ability to generate income, whether some portion of income would flow steadily to the donees, and whether income could be readily ascertained. Given that PFLLC’s marketable securities generated income from dividends, and its real estate interest generated rent that could be estimated, the Tax Court determined the gifts for the annual exclusion under section 2503(b) qualified.
With respect to the deduction of interest on loans from PFLLC to pay estate taxes, the PFLLC operating agreement required its members to vote unanimously to make decisions, including making distributions to members to cover estate tax liabilities. One of the members refused to consent, which made this loan necessary. Therefore, the Tax Court allowed the deduction of the accrued interest on the loan.
The Purdue case is an all-around taxpayer win that serves as a good checklist of the major areas the IRS may attack and provides a roadmap of a successful fact pattern for avoiding section 2036 inclusion.