IS THERE A DEEMED GIFT UPON THE FORMATION OR RECAPITALIZATION OF A BUSINESS ENTITY?

It is the purpose of this article to discuss the possibility that the IRS might successfully argue that a gift has taken place on the formation of a limited partnership or other entity, equal to the difference between the asset value contributed and the value of the business interest received in exchange.

I. The Regulations

Before proceeding, let us review the pertinent regulations. We begin with Treas. Reg. §25.2511-1, pertinent parts of which are quoted below:

(a) The gift tax applies to a transfer by way of gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. For example, a taxable transfer may be effected by the creation of a trust, the forgiving of a debt, the assignment of a judgment, the assignment of the benefits of an insurance policy, or the transfer of cash, certificates of deposit, or Federal, State or municipal bonds. . . .

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(c)

(1) The gift tax also applies to gifts indirectly made. Thus, any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax. See further §25.2512-8 relating to transfers for insufficient consideration. . . .

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(g)

(1) Donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. The application of the tax is based on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor. However, there are certain types of transfers to which the tax is not applicable. It is applicable only to a transfer of a beneficial interest in property. . . The gift tax is not applicable to a transfer for a full and adequate consideration in money or money‘s worth, or to ordinary business transactions, described in §25.2512-8.

(h) The following are examples of transactions resulting in taxable gifts and in each case it is assumed that the transfers were not made for an adequate and full consideration in money or money’s worth:

(1) A transfer of property by a corporation to B is a gift to B from the stockholders of the corporation. If B himself is a stockholder, the transfer is a gift to him from the other stockholders but only to the extent it exceeds B‘s own interest in such amount as a shareholder. A transfer of property by B to a corporation generally represents gifts by B to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation. . . .

[Emphasis added.]

The regulation itself is clear that “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money‘s worth.”^[1] Further, the gift tax does not apply to transfers in the ordinary course of business:

. . . [A] sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm's length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money's worth. . . .^[2]

A line of defense along either of the lines just mentioned may be all that is required in the case of a pro rata partnership.

Treas. Reg. §25.2511-2 provides that the gift is not necessarily determined by the measure of enrichment resulting to the donee from the transfer:

(a) The gift tax is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer, nor is it conditioned upon ability to identify the donee at the time of the transfer. On the contrary, the tax is a primary and personal liability of the donor, is an excise upon his act of making the transfer, is measured by the value of the property passing from the donor, and attaches regardless of the fact that the identity of the donee may not then be known or ascertainable.^[3] [Emphasis added.]

Treas. Reg. §25.2512-1 sets forth the willing buyer/willing seller standard:

Section 2512 provides that if a gift is made in property, its value at the date of the gift shall be considered the amount of the gift. The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. ^[4]

Let us next examine IRC §2512(a) & (b), and ask whether a different approach to value is suggested between them:

(a) If the gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift.

(b) Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift, and shall be included in computing the amount of gifts made during the calendar year.

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II. Secondary Sources

There are two very good articles on this subject already, to which I refer anyone who wishes to make a thorough study of this issue. The first is an article by Jerold I. Horn, found in 23 ACTEC Notes 36, Summer 1997, entitled “Limited Partnerships: Some Thoughts and Theories about Key Issues.” The second is Stacey Eastland’s well known article “The Art Of Making Uncle Sam Your Assignee Instead Of Your Senior Partner: The Use Of Partnerships In Estate Planning,” a recent version of which can be found in ALI-ABA Course Materials, Sophisticated Estate Planning Techniques, Sept. 1999. Of the two articles just cited, Jerold Horn thinks the problem is more serious than does Stacey Eastland. My own position is somewhere between the two.

III. The Problem

Note first that there is a long line of authorities holding that a gratuitous contribution to a corporation results in a gift from the contributing shareholder to the noncontributing shareholder. A similar result obtains in a non prorata recapitalization.^[5] I don’t think that the idea that a gift can result under these circumstances is particularly controversial, and am willing to more or less concede the point. More relevant is the measure of value of the gift, and whether or not the theory can be extended to apply when an enterprise is formed, and if so, what circumstances negate a gift.

IV. Is There a Gift, and If So, Of What?

If my brothers and I form a limited partnership, and each of us contributes $1 million in exchange for a one-third interest as both limited and general partners, which interest is worth $600,000, have each of us made a gift, and if so to whom? Whether a gift has been made will require special scrutiny where the transaction is among family members,^[6] particularly when what is received is not proportionate to what was given, as between the donors.

In the example posed, however, each brother would have contributed and received the same thing, so that it would appear that no gift was made at all. Further, even if there was a gift, the gifts were reciprocal, so that what one brother gave to the other in value, the other gave back. Such an offset was recognized in Chanin v. U.S.^[7]

The theory that there is a gift may arise from the fact that the value of that which is received on formation of a business entity may be less than that which was used to purchase the interest or contributed on its formation. The idea is that the value either disappeared or it didn’t. If the latter, it must have been transferred and that is a gift, unless made for full and adequate consideration, and the premise is that it was not. To this there are several responses. One is the reciprocal gift offset argument. Another is that the value didn’t disappear so much as it merely changed. Values change all the time without the remotest possibility of a gift having been made.

V. Theories of Value

My own belief is that, in the example given above, where the “fair market value” of the partnership on formation is worth less than the capital contributions to it, the “value” does not change, or that if it does it may actually have gone up; but, in any case the value to which I refer is not fair market value, but is rather a different kind of value, one which the law does not tax or even regard. My contention, which should not really be controversial, is that the actual economic (or for that matter, personal) value of an enterprise may be more or may be less than the market value to a hypothetical willing buyer.

We know what fair market value is (at least in theory), and, as tax practitioners, we are perhaps used to thinking that all value is entirely determined by the market. A moments reflection as a layperson will dispel this fallacy. It is in fact a commonplace that there are things that cannot be properly valued in dollars. If the government could figure out how to measure those things so that they could be taxed it probably would; but for now there are some orifices that the governments tentacles don’t yet violate.

The inherent or psychological value that owning a piece of real estate gives a rancher, the satisfaction that one feels knowing that one’s family is happy and secure, the value of having a good relationship with one’s spouse, these are one type of value that does not equate easily with market value; but, similarly, there are some purely economic values that do not equate either. Consider, for example, that when several individuals pool their capital to form a new enterprise, the fair market value of that enterprise may be worth less immediately after formation than the underlying assets were at the time of contribution. Are we therefore to conclude that the individuals have made gifts or that they must be terrible businesspersons? No; of course not. What the answer to the question tells us is that fair market value does not always reflect all elements of value, not even all elements of economic value. (Why else would anyone hold on to a small ranch?) This may be unfortunate from the viewpoint of the IRS, but it is fundamental to understanding the basis of many business transactions.

In the example last posed, a willing buyer who was not the brother of the other owners would not necessarily know and trust and work as well with the remaining owners as the selling brother did. This is just a fact of life, and as long as the IRC and the regulations base the transfer excise tax on fair market value, this discrepancy will exist. It is not a hoax, and there is nothing dishonest about it; it is just that the tax is based on fair market value and other elements of value to the parties are simply not taxable under the current state of the law. The Service has finally conceded this in the family context:

If a donor transfers shares in a corporation to each of the donor's children, the factor of corporate control in the family is not considered in valuing each transferred interest for purposes of section 2512 of the Code. For estate and gift tax valuation purposes, the Service will follow Bright, Propstra, Andrews, and Lee in not assuming that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest. Consequently, a minority discount will not be disallowed solely because a transferred interest, when aggregated with interests held by family members, would be a part of a controlling interest. This would be the case whether the donor held 100 percent or some lesser percentage of the stock immediately before the gift.^[8]

I once heard Jeffery Pennel suggest that if the owner of the Hope Diamond cut it into little pieces, which were worth less in the aggregate than the diamond was before being broken up, there is a gift to the market. In other words, the market value of a diamond is dependent upon the supply, and the supply of large diamonds just went down, meaning that everyone that owns a diamond is no infinitesimally wealthier after the break up of the Hope Diamond than before. This approach has some logic to it; nevertheless, I for one do not think that our transfer tax system contemplates this type of analysis, and I therefore don’t take it too seriously —at least where the donee is the market.

For constitutional reasons, our transfer tax system is an excise tax on the transfer of property. I doubt that whatever increase in value is received by the “market” is property. Property may increase in value, but the two terms are not synonymous.

On the other hand, if we were able to substitute a small group of family member donees for the “market,” then perhaps I could see an argument for a deemed gift. This is not, however, what happens upon the formation of a business enterprise, especially where what everyone receives and contributes is proportionate.

There are cases where the transfer of a small percentage of a business confers liquidation control on the recipient. In that case, the recipient’s net worth may be increased in an amount far in excess of the value of the property given. The value of the gift for gift tax purposes, however, is not the increase in the net worth of the recipient,^[9] but, rather, is, or ought in theory to be, the price that a willing buyer would pay a willing seller for the transferred property, neither being under a compulsion to buy or sell.

There will ordinarily be no deemed gift on formation of a business, because no property is transferred from one person to another, and even if property is transferred, the value, under the willing-buyer/willing-seller test is certainly not properly to be measured by the diminution or increase in the net worths of the transferor and transferee.

VI. The Trenchard Case

In Estate of Helen M. Trenchard, et al v. Commissioner,^[10] a 1995 Tax Court Memorandum decision:

Ds, their daughter, and her three children each transferred property to a newly formed, closely held corporation, C, in exchange for debt and stock. Ds received most of C's preferred stock, which gave them approximately 61 percent of C's voting power; their daughter received C's remaining preferred stock and 40 percent of its common stock, which gave her approximately 35 percent of C's voting power; each of the three children received 20 percent of C's common stock, which gave each of them approximately 1 percent of C's voting power. The value of the property that each D transferred to C exceeded the aggregate value of the stock and debt that they each received in return.^[11] [Emphasis added.]

The portion of the case that is of interest was styled in the opinion as “Issue 1. The Decedents' Transfers of the Farmland to Corporation,” and the discussion of that issue was divided into four parts as follows:

a. Transfers in the Ordinary Course of Business

b. Value of the Decedents' Properties Transferred to Corporation

c. Value of Stock and Debentures Received by the Decedents

d. Effect of Greater Value Surrendered Than Received

The Court noted that IRC^[12] § 2518(b) provides:

(b) Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift, and shall be included in computing the amount of gifts made during the calendar year.^[13]

The taxpayer first unsuccessfully argued that the transfer was in the ordinary course of business, and therefore could not be a gift:

We disagree with the executrix' contention that the formation of Corporation was in the ordinary course of business within the meaning of respondent's regulations. We closely scrutinize a transfer involving related parties, such as family members and their closely held corporation, to determine whether the transfer is a gift. We presume that such a transfer is a gift. See Frazee v. Commissioner, 98 T.C. 554, 561 (1992); Harwood v. Commissioner, 82 T.C. 239, 258 (1984), affd. without published opinion 786 F.2d 1174 (9th Cir. 1986); Estate of Reynolds v. Commissioner, 55 T.C. 172, 201 (1970), and the cases cited therein; see also Estate of Muhammad v. Commissioner, 965 F.2d 520, 521 [70 AFTR 2d 92-6194] (7th Cir. 1992), affg. T.C. Memo. 1990-211 [¶90,211 PH Memo TC]. The executrix has failed to overcome this presumption. She has failed to convince us that the decedents' transfers of their farmland to Corporation without meaningful arm's-length bargaining was bona fide, at arm's length, and free from donative intent.^[14]

The Court next found that the value of the property transferred by the taxpayer to the corporation was $2,952,748. Next, it determined that the stock and debentures received in exchanged for the property was $1,281,951. Finally, it considered the effect of the discrepancy:

The value of the property that each of the decedents transferred to Corporation exceeded the value of the stock and debentures that they each received in return. Respondent determined that the excess values are gifts from each of the decedents to the executrix and the Children. The executrix disagrees. According to the executrix, the excess values are not gifts because the decedents' proportionate interests in all of the property transferred to Corporation did not exceed their interests in the total consideration that the Subscribers received in return. . . .

As applied to the facts at hand, we are unpersuaded by the executrix' novel theory. . .

The executrix' theory further misses the mark because it fails to take into account the fact that the value of the property transferred to Corporation must equal the aggregate value of the preferred stock, debentures, and common stock received in return. [fn 21: Arguably, the value that respondent determined for Mrs. Trenchard's preferred stock should also be adjusted to reflect her minority interest in Corporation. See Estate of Chenoweth v. Commissioner, 88 T.C. 1577, 1582 (1987). A minority discount reflects the fact that a minority shareholder usually cannot control the policy or operations of a corporation. Harwood v. Commissioner, 82 T.C. 239, 267 (1984), affd. without published opinion 786 F.2d 1174 (9th Cir. 1986); Estate of Andrews v. Commissioner, 79 T.C. 938, 953 (1982). Because respondent has neither determined nor argued for a minority discount to Mrs. Trenchard's preferred stock, we do not consider the appropriateness of one.] To the extent that the value of all of the property transferred to Corporation exceeds the value of the preferred stock and debentures transferred to the Subscribers, the excess value naturally accrues to the benefit (and increases the value) of the common shareholders, of which neither of the decedents was one. The executrix basically asks us to ignore this excess value for purposes of determining whether the decedents made gifts to their fellow shareholders. This, we will not do. Corporation's assets must always equal its liabilities plus its shareholders' equity. Therefore, to the extent that the value of the property transferred to Corporation exceeds the value of its preferred stock and debentures transferred in return, the excess increases the value of the common stock held by the executrix and the Children. Because the value of the property transferred by each of the decedents to Corporation exceeded the value of the stock and debentures that they each received in return; the excess values flowing to the common shareholders are gifts for which the decedents are subject to the Federal gift tax provisions. Kincaid v. United States, supra at 1224; Hollingsworth Trust v. Commissioner, 86 T.C. 91 (1986); see also Estate of Hitchon v. Commissioner, 45 T.C. 96, 104 (1965) (Tannenwald, J., concurring); sec. 25.2511-1(h)(1), Gift Tax Regs.^[15] [Emphasis added.]

The court found that the gift was $1,670,797, which is the difference between $2,952,748 and $1,281,951.

The Trenchard case is no doubt troubling. The court’s statement that “The executrix' theory further misses the mark because it fails to take into account the fact that the value of the property transferred to Corporation must equal the aggregate value of the preferred stock, debentures, and common stock received in return,” is not well thought through because there is no economic principal holding that the fair market value of property transferred will always equal the fair market value of what is received. The discrepancy may indicate that there are other elements of economic value that are not reflected in the market value. It is often the case that a business is worth less than the capital contributed to it at the time the capital is contributed, just as it is true that a new car is worth less the moment it is driven off the lot, even where the dealings are at arm’s length.

The court’s statement confuses fair market value with true value, as if they were always the same, and they are not. The test is not what the transferor contributed but what was transferred. What was contributed is one thing, but what was transferred was an interest in the corporation, and it is that interest that should have been valued for transfer tax purposes.

Should it make any difference, as a matter of tax law, whether the transferor contributes to the corporation, takes stock and debentures in return, and then transfer some of that stock and debentures to the other shareholders, instead of achieving the same result in a recapitalization? This goes to the heart of the question of whether IRC §2512(a) & (b) call for a different definition of fair market value. That they don’t is clear from Estate of Mario E. Bosca v. Commissioner.^[16] Although this case was generally adverse to the taxpayer, it does stand for a couple of important principals worth noting.

In the Bosca case a decedent's exchanged 50% of his closely held voting common stock for nonvoting stock of lesser value in a recapitalization, with the result that his two sons then owned all the voting stock. The court held this to be a gift under IRC §2512(b), since the nonvoting stock received in the recapitalization was worth less than the voting stock exchanged for it.

The taxpayer was unsuccessful in claiming that amount of the gift determined under Code Sec. 2512(a) differed from amount deemed to be a gift under Code Sec. 2512(b). The court also found that the IRS properly valued the gift as being the difference between value of shares of the voting stock transferred and value of the nonvoting stock received. However, the court also held that the IRS improperly valued the voting stock as single block of 50% of the stock, since the deemed gifts were indirectly made separately to the transferors two sons, and thus had to be valued as two gifts of 25% of the stock rather than as one 50% gift.

Contrary to the premise of petitioner's brief, subsections (a) and (b) of section 2512 do not prescribe different methods of valuing property. The value of the property transferred by gift whether described by section 2512(a) or section 2512(b) is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. Sec. 25.2512-1, Gift Tax Regs. There is no authority for the premise of petitioner's brief that the amount of the “gift” determined under section 2512(a) differs from the amount “deemed a gift” under section 2512(b).

Second, we agree with respondent's approach in these cases under which respondent measured the difference between the value of the 402.5 shares of voting stock that the decedent transferred to the corporation and the value of the 402.5 shares of nonvoting stock that he received in return. See, e.g., Kincaid v. United States, 682 F.2d 1220 [50 AFTR 2d 82-6175] (5th Cir. 1982); Estate of Trenchard v. Commissioner, T.C. Memo. 1995-121 [1995 RIA TC Memo ¶95,121], T.C. Memo. 1995-232 [1995 RIA TC Memo ¶95,232]; Estate of Higgins v. Commissioner, T.C. Memo. 1991-47 [¶91,047 PH Memo TC]. We agree with respondent that pursuant to section 2512(b), the difference between those values is deemed a gift.

The final issue is whether the voting common stock that the decedent transferred to HBC should be valued as a single block of 50 percent of the stock of the corporation or as two blocks of 25 percent. As mentioned above, if the decedent's voting stock is valued as a single block, then the parties have stipulated that each share of stock was worth $11,827 immediately before the recapitalization. In that event, the difference between what the decedent transferred to HBC and what he received in return is $2,412, and the decedent's gifts to his sons will be valued in the aggregate amount of $970,830. On the other hand, if the stock is valued as two 25-percent blocks, then the parties have stipulated that each share of stock was worth $9,671 immediately before the recapitalization. In that event, the difference between what the decedent transferred to HBC and what he received is $256 and the gifts will be valued in the aggregate amount of $103,040. In passing, we note respondent does not take the position that, for purposes of valuing decedent's stock, we must take into account the voting stock transferred to the corporation by Ms. Baker.^[17]

VII. TAM 9842003

Most of us are already familiar with Technical Advice Memorandum 9842003. The Service has yet to consistently prevail on any of the theories it proffered in this TAM. One of those theories was gift on formation. Here is the argument made in the TAM.

Gift Tax Treatment

Alternative Argument – The Decedent Made a Gift Subject to Gift Tax When She Transferred Assets to the Partnership

In the alternative, assuming the Decedent's partnership interest is properly valued on the date of death at 60 percent of the value of the proportionate share of the underlying assets, then we believe the Decedent made a gift to the other partners on the transfer of assets to the partnership.

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Section 25.2511-1(h)(1) provides that if a shareholder transfers property to a corporation for less than adequate consideration, the transferor has made a gift to the other shareholders to the extent of their proportionate interest in the corporation.

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The Supreme Court has consistently confirmed the broad application of the gift tax to all transfers of property however conceptual or contingent. As the Court stated in Commissioner v. Wemyss, 324 U.S. 303 (1945), the gift tax is intended:

to hit all the protean arrangements which the wit of man can devise that are not business transactions within the meaning of ordinary speech …

Commissioner v. Wemyss, at 307.

The Court affirmed that any transfer of property in exchange for less than adequate consideration is a gift subject to the gift tax:

[The gift tax statute by] taxing as gifts transfers that are not made for 'adequate and full [money] consideration' aims to reach those transfers which are withdrawn from the donor's estate.

Commissioner v. Wemyss, at 307-308.

As discussed above, intrafamily transfers are subject to special scrutiny and are presumed to be other than arm's length transactions. Kincaid v. United States, supra; Frazee v. Commissioner, 98 T.C. 554, 561 (1992); Harwood v. Commissioner, 82 T.C. 239, 258 (1984); Estate of Reynolds v. Commissioner, 55 T.C. 172, 201 (1970); Knott v. Commissioner, T.C. Memo. 1988-120 (1988).

The gift tax has been consistently applied by the courts to contributions to family business entities. In Estate of Trenchard v. Commissioner, supra, the decedent transferred real property to the corporation in exchange for preferred stock and debentures. The court found that the value of the land transferred to the corporation exceeded the value of the preferred stock, etc. that the decedent received in exchange. The court concluded that this unequal exchange constituted a gift by the decedent subject to the gift tax. In reaching this conclusion, the court rejected the estate's contention that the transfer was a transaction in the ordinary course of business. That is, although there was arguably a business purpose for formation of the corporation, the court focused on whether there was a business purpose for the decedent's transfer of assets to the corporation in exchange for the debt and equity. As noted above, the court found it “incredible” that the decedent would relinquish outright ownership, control and income from his assets in exchange for the interests he received, if he was dealing at arm's length. Courts have reached similar conclusions in situations involving contributions to the capital of family entities. See e.g. Hollingsworth v. Commissioner, 86 T.C. 91 (1986) (contribution of land to existing corporation treated as a gift to other shareholders).

In the instant case, Decedent transferred assets worth approximately $2,240,000 and after the transfers, held a partnership interest purportedly worth 40 percent LESS than the value of the assets she transferred to the partnership. Under the regulations discussed above, and the Court's discussion in Commissioner v. Wemyss, this unequal exchange constitutes a gift for gift tax purposes, unless the transfer can be characterized as a transfer in the ordinary course of business.

The estate argues that the Decedent had business reasons for the formation of Family Partnership. However, as discussed above, and as was the case in Estate of Trenchard, notwithstanding these purported business reasons for forming the partnership, we cannot agree that there was any business reason for the DECEDENT'S relinquishment of ownership, control and income flow from HER assets, in exchange for an interest worth 40 percent less than the assets she transferred to the partnership. A party dealing at arm's length would simply not enter into such a transaction.

The estate contends that the formation of and transfers to the partnership did not result in any gifts by the Decedent. The Decedent held a partnership interest representing a proportionate interest in the value of the property transferred to the partnership. Thus, any difference between the value of the property transferred and the partnership interest results as a consequence of the partnership form; the value of the other partners' interests were not enhanced. Rather, the net worth of each partner decreased as a result of their respective transfers to the partnership. In the absence of any increase in a partner's net worth, there was no donee and therefore, no basis for asserting that a gift was made. The estate further argues that any attempt by the Service to tax the decrease in wealth experienced by the Decedent would be an impermissible direct “wealth tax” on property, rather than an indirect excise tax on the transfer of property.

Initially, we disagree that the parties held proportionate interests in the partnership. Rather, in the instant case, the Decedent supplied 99 percent of the value of the partnership assets in exchange for a 99 percent LIMITED partnership interest, and Child A and Child B supplied the remaining 1 percent of the value of the partnership assets in exchange for a 1 percent GENERAL partnership interest. By taking back a LIMITED partnership interest, the Decedent relinquished control over partnership assets. According to the estate, this lack of control, in part, resulted in a 40 percent reduction in the value of Decedent's interest. On the other hand, the general partnership interests of Child A and Child B enable them to effectively control the entire partnership, not just the $10,050 that each contributed. This control element should necessarily enhance the value of their interests. Thus, in this case, the parties (the Decedent, compared with Child A and Child B) did not each receive partnership interests that were proportionate in value to the assets e ach contributed.

Further, we don't agree that the difference in value between the assets transferred and the partnership interest received, should be characterized, in this case, as “disappearing” as a natural consequence of the partnership form. Rather, the entire transaction (i.e., the creation of the partnership, the subsequent death of the Decedent, and the passage of the partnership interests to the family members) must be viewed as an integrated donative plan. The Decedent intentionally transferred assets in exchange for a partnership interest worth significantly less than the assets transferred, enabling the other partners, in conjunction with other family members, to ultimately realize the full value of the underlying assets on the death of the Decedent, when the Decedent's retained partnership interest passed to her beneficiaries. Thus, there was no “disappearance” of value when Decedent transferred assets to the partnership. Rather, the difference in value between the Decedent's assets and Decedent's partnership interest was transferred by the Decedent to the other partners and to the testamentary beneficiaries of Decedent's partnership interest, to be ultimately realized in the future.[fn. 1. With respect to Child A's and Child B's contributions to the partnership, their transactions are in the ordinary course of business. That is, they entered into the transaction to ultimately ACQUIRE additional assets, and not to transfer value to other partners. Child A and Child B are not making gifts because, not only do they lack donative intent, but their participation is designed to facilitate the donor's transfer to them and other family members. Thus, with respect to Child A and Child B, the transaction is a business transaction, exempt from the gift tax.]

In any event, under the regulations, it is neither necessary to demonstrate that any person's net worth increased as a result of the transfers by Decedent, nor is it necessary to identify the donee or donees at the time of the transfer. Rather, once it is determined that the Decedent's transfer was not in the ordinary course of business, section 2512 statutorily mandates that the unequal exchange results in a gift. See section 25.2511-2(a).

The discussion above also responds to the estate's constitutional argument that the Service's position results in the imposition of an impermissible direct tax on property. As discussed above, the Decedent has made an unequal exchange that results in an actual transfer of value by the Decedent. It is this transfer that is subject to gift tax. See Commissioner v. Wemyss, supra, at 307-308.

In summary, the estate's assertion that the formation and transfer of assets to the partnership by the Decedent was an arm's length transaction for which the Decedent received adequate consideration, is wholly inconsistent with the estate's assertion that the decedent's partnership interest on her death was worth 40% less than the assets she transferred to the partnership within the 4 month period prior to her death. The estate and gift tax are in pari materia and must be construed harmoniously. Estate of Sanford v. Commissioner, 308 U.S. 39 [23 AFTR 756] (1939); Merrill v. Fahs, 324 U.S. 308 [33 AFTR 587] (1945). Consequently, when the Decedent transferred assets to the Family Partnership, Decedent made a gift subject to the gift tax. The amount of the gift is the fair market value of the assets transferred to the partnership less the fair market value of Decedent's partnership interest after the transfers.^[18]

VIII. Practical Application Of The Rules

Assuming arguendo that there is a gift on formation of an enterprise, what are the consequences? One must assume that if everyone involved pays the same thing for the same thing, then there simply cannot be a gift. Perhaps the reason is that there is a reciprocal offset or perhaps there is some other reason, but in any event the idea that there would be a gift in such situation that was subject to our present transfer tax system strikes one as immediately ludicrous.

If the formation is not pro rata, e.g., one person contributes 99% of the capital in exchange for a 99% limited partnership interest, and another person contributes 1% of the capital in exchange for a 1% general partnership interest, then even then there are good arguments that no gift is being made. After all, the general partnership interest may be worth less, not more, because of the liability attached to it. On the other hand, since a general partner has more control than does a limited partner, the conventional wisdom may be that the general partnership interest is worth more. But even so, the privilege of control is linked to the responsibilities and duties that the general partner assumes, and these responsibilities and duties may more than offset the value of control. And there is the dichotomy between fair market and other types of value to consider.

Assuming the worst —that the general partnership interest is worth more and hence there must have been a gift? What is the value of the gift? Although there are statements in Trenchard that cause me worry, I cannot believe that the measure of value for transfer tax purposes would be the disparity between the value of the business and the value of the assets in the business. This flies in the face of the willing buyer and willing seller rule that is enshrined in the regulations. The value of the gift simply cannot exceed the value of what was received by the donee, viewing the donee as a willing buyer. So if there is a gift, it ought to be nominal.

If, in the example given, the 99% limited partner is a QTIP trust, then §2519 is a real consideration. §2519 provides:

“Any disposition of all or part of a qualifying income interest for life in any property to which this section applies shall be treated as a transfer of all interests in such property other than the qualifying income interest.”

So if the transaction could be viewed as a disposition of a part of the qualifying income interest, the spouse will be treated as having made a gift of the entire QTIP trust. This is a frightening consideration, but it is also a fairly weak (as well as overly aggressive) argument for the IRS to be making. (It is also worth noting that for the wealthy decedent who is old enough, the application of §2519 might actually save transfer taxes overall, and that possibility should be factored in any weighing of the risks.)

The threat is real enough, however, for the cautious practitioner to take a few extra measures to avoid having to face the argument. What is the easiest way to avoid having the issue come up to begin with. Perhaps the simplest is for everyone to receive prorata general and limited partnership interests to begin with. A single person could even create a wholly owned LLC to act as general partner.

It is interesting that, after the enterprise has been formed, there appears to be little controversy about how to value a subsequent gift. There it is more or less clear that the value is determined by valuing what was transferred, rather than what disappeared.

Treas. Reg. §25.2704-1(c)(1) provides:

(1) In general. A lapse of a liquidation right occurs at the time a presently exercisable liquidation right is restricted or eliminated. Except as otherwise provided, a transfer of an interest that results in the lapse of a liquidation right is not subject to this section if the rights with respect to the transferred interest are not restricted or eliminated. However, a transfer that results in the elimination of the transferor's right or ability to compel the entity to acquire an interest retained by the transferor that is subordinate to the transferred interest is a lapse of a liquidation right with respect to the subordinate interest. [Emphasis added.]

Treas. Reg. §25.2704-1(f) Example 7 tells us that the regulation just quoted means that if a transfer takes the donor from a majority to a minority position, this is not ordinarily a lapse of a liquidation right subject to §2704:

Example 7. D owns all the stock of Corporation X, consisting of 100 shares of non-voting preferred stock and 100 shares of voting common stock. Under the by-laws, X can only be liquidated with the consent of at least 80 percent of the voting shares. D transfers 30 shares of common stock to D's child. The transfer is not a lapse of a liquidation right with respect to the common stock because the voting rights that enabled D to liquidate prior to the transfer are not restricted or eliminated. The transfer is not a lapse of a liquidation right with respect to the retained preferred stock because the preferred stock is not subordinate to the transferred common stock.

In Texas, state law gives the general partners (assuming there are any) the ability to continue the partnership following the death of one of them. This will probably prevent a deceased general partner from having liquidation control in any event. But to be on the safe side, Jerold Horn, Keeping Treas. Reg. §25.2704-1(f) in mind, has suggested that the partnership should initially be formed prorata, but that the older generation partners could always sell their general partnership interests later for fair market value, prior to death, so that there clearly would not be any possibility of having liquidation control over the partnership for estate tax purposes.^[19]

^[5] IRS authorities include, Treas. Reg. §25.2511-1(h)(1) which is directly on point on the first issue. See also, Rev. Ruls. 86-39, 84-105 and 79-225; and PLRs. 9114023 and 8737022. Cases which treat this issue in varying degrees include Trenchard v. Commissioner, T.C. Memo 1995-121 (quoted at length in this paper); Commissioner v. Wemyss, 324 U.S. 303 (1945), 45-1 USTC, 10,179; Heringer v. Commissioner, 235 F.2d 149 (9th Cir. 1956), 56-2 USTC 11,622, cert. denied, 352 U.S. 927; Tilton v. Commissioner, 88 T.C. 590 (1987); Ketteman Trust v. Commissioner, 86 T.C. 91 (1986); & Hitchon v. Commissioner, 45 T.C. 96 (1965).

^[6] Estate of Helen M. Trenchard, et al v. Commissioner, TC Memo 1995-121, at 747.

^[7] Chanin v. U.S., 21 AFTR 2d 1643 (393 F.2d 972), 04/19/1968.

^[10] Estate of Helen M. Trenchard, et al v. Commissioner, TC Memo 1995-121.

^[11] Estate of Helen M. Trenchard, et al v. Commissioner, TC Memo 1995-121, Official Report.

^[12] All references herein to the "IRC" are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

^[14] Estate of Helen M. Trenchard, et al v. Commissioner, TC Memo 1995-121, at 751.

^[15] Estate of Helen M. Trenchard, et al v. Commissioner, TC Memo 1995-121, at 756-757.

^[16] Estate of Mario E. Bosca v. Commissioner, TC Memo 1998-251.

^[17] Estate of Mario E. Bosca v. Commissioner, TC Memo 1998-251.

^[19] Jerold I. Horn, found in 23 ACTEC Notes 36, Summer 1997, entitled “Limited Partnerships: Some Thoughts and Theories about Key Issues.”