IRS contention that company formed after gifts made overturned by Tax Court. David Eckstein is a managing director and co-founder of FMV Opinions, a New York-based valuation and financial-advisory services firm.

In Gross v. Commissioner (T.C. Memo. 2008-221, 29 September 2008), Ms. Gross claimed she formed a limited partnership called Dimar one July, contributed marketable securities from early October to early December, then made limited partnership gifts to her two daughters in mid December. Based on this, she valued the gifts at a 35% discount to the value of the underlying marketable securities.

The IRS claimed that the formation, funding and gifting all occurred on the same day. Accordingly, the IRS considered the gifts to be indirect gifts of marketable securities, with no valuation discounts, and assessed a gift-tax deficiency of over $120,000.

Under Judge Halpern, who decided similar issues in Holman v. Commissioner (130 T.C. No. 12, 27 May 2008), the Tax Court considered a mix of good and bad facts on both sides. The court ultimately sided with the taxpayer, in spite of its conclusion that Ms. Gross and her daughters did not validly form a limited partnership until the date of the gifts in mid-December.

Gross provides practitioners with (a) a succinct summary of the tests established by four prior indirect-gift cases; (b) a discussion of how certain formation and funding issues were viewed by the court; and (c) the criteria used by the court to decide whether the step-transaction doctrine should cause the gifts to be treated as indirect gifts of the underlying marketable securities, with the consequent loss of valuation discounts.

Prior indirect-gift cases

The Court considered four prior indirect-gift cases: Jones, Shepherd, Senda and Holman.

With regard to Estate of Jones v. Commissioner (116 T.C. No. 11, 6 March 2001), the Gross court summarized the key finding that led the court to conclude that certain gifts were not indirect gifts of the contributed assets."We found that the contributions of property were properly reflected in the capital accounts of the decedent, and the value of the other partners' interests was not enhanced by the decedent's contributions," the court said.

The Gross court summarized the contrasting finding from Shepherd v. Commissioner (115 T.C. No. 30, 26 October 2000) like so "Because the contributions were reflected partially in the capital accounts of the noncontributing partners, the value of the noncontributing partners' interests was enhanced by the contributions of the taxpayer. Therefore, we held, the transfers to the partnership were indirect gifts."

The Gross court made less use of Senda v. Commissioner (433 F.3d 1044, 8th Cir. 2006, affg. T.C. Memo. 2004-160), referring to it only in a footnote to the effect that "relying on the step transaction doctrine in affirming the Tax Court's finding that taxpayers made indirect gifts of shares of stock to partners in family limited partnerships since transfers of securities to partnerships and gifts of partnership interests were integrated and simultaneous transactions."

The Gross court devoted the most attention, in its opinion, to the recently decided Holman case, where the Tax Court rejected using the step transaction doctrine to treat a gift as an indirect gift of the underlying marketable securities.

"We described the Commissioner's argument with respect to that gift as being that the taxpayers' 'formation and funding of the partnership should be treated as occurring simultaneously with [the gift] since the events were interdependent and the separation in time between the first two steps (formation and funding) and the third (the gift) served no purpose other than to avoid making an indirect gift under Section 25.2511-1(h), Gift Tax Regs.' Without intending to draw any bright lines, we rejected the Commissioner's argument because of our conclusion that the taxpayers bore a real economic risk of a change in value of the partnership for the 6 days that separated their transfer of the shares to the partnership and the gift."

In summary, Jones and Shepherd indicate that indirect gifts may be avoided by allocating newly contributed assets only to the contributor's capital account. Senda and Holman refine this, suggesting that a simultaneous funding and transfer may be treated as an indirect gift under the step transaction doctrine, while a delay of as little as six days between funding and gift may avoid such treatment, at least where risk of change in value can be demonstrated in actively traded and volatile markets for the underlying assets."

Was Dimar validly formed prior to the gifts?

With the precedent of four prior cases in mind, the Court looked first at whether Dimar was properly formed.

In the taxpayer's version, the events unfolded as follows.

After several discussions, on or before 15 July 1998, Ms. Gross and her daughters agreed to form a family limited partnership with initial funding of $100 from Ms. Gross and $10 each from her two daughters. Certain terms were agreed to, including control by Ms. Gross and restrictions on transfer and dissolution. On 15 July 1998, Ms. Gross caused the Dimar certificate of limited partnership to be filed with the New York Department of State. Certain other steps were subsequently taken to address formation requirements, such as publishing notices of the formation in New York newspapers. On 31 July 1998, Ms. Gross and her daughters wrote checks payable to Dimar in the amount of $100, $10 and $10, respectively. From early October through 4 December 1998, Ms. Gross transferred ownership of the marketable securities from her name to Dimar's name, while maintaining records of the transfers in a notebook. On 15 December 1998, Ms. Gross and her daughters executed the Dimar partnership and executed a "Deed of Gift", transferring to each daughter a 22.25% limited partner interest in Dimar. Dimar filed a Form 1065 partnership tax return showing that Dimar commenced business on 15 July 1998. Ms. Gross filed a gift tax return that included capital account calculations showing the initial contributions, an increase in Ms. Gross's capital account for the entire amount of the securities, a decrease in Ms. Gross's account for the gifts, and an equal increase in the daughters' accounts.

In contrast, the Service's version of events was as follows.

Dimar was formed on 15 December 1998, when the limited partnership agreement was signed; each daughter acquired a 22.25% interest in Dimar on the same day; and also on the same day, Ms. Gross contributed the securities to Dimar, with 22.25% of the value of the contribution being credited to each daughter's capital account.

It was undisputed that the limited partnership agreement was not signed until 15 December 1998. The two sides argued their cases as to whether this kept Dimar from being properly formed as a limited partnership prior to the date of the gifts. The court concluded: "Neither party makes a compelling argument for their interpretation of New York partnership law and we have found no persuasive authority on our own." At that point, the court turned to the taxpayer's back-up position, that Dimar had been formed as of 15 July 1998, as a general partnership.

Under New York law, when parties seeking to form a limited partnership do not satisfy the requirements necessary to form a limited partnership, they may be deemed to have formed a general partnership if their conduct indicates that they have agreed, whether orally and whether expressly or impliedly, on all the essential terms and conditions of their partnership arrangement. We agree with petitioner that the record contains sufficient evidence for us to conclude that, at the time petitioner caused the Dimar certificate to be filed on 15 July 1998, she and her daughters had agreed to form a partnership essentially on the terms set forth in the Dimar agreement.

Although Dimar was not deemed to be a limited partnership prior to the date of the gifts, it was deemed to be a general partnership, which was sufficient to overcome the IRS's argument that Dimar did not exist until the date of the gifts and, therefore, could not have been funded prior to that date.

Was Dimar funded prior to the gifts?

Having prevailed on the back-up formation argument, in spite of the fact that the limited partnership agreement was not signed until 15 December, the taxpayer still had to overcome two bad facts to establish that the funding was completed by 4 December.

First, the taxpayer's gift tax return included a list of Dimar's securities in a schedule titled "Securities Contributed to Partnership on 12/15/98." Second, although it was noted by the court only in a footnote, Dimar's capital account calculations do not allocate any of the $41,107 of net portfolio appreciation up to 15 December to the daughters' accounts. The court dismissed these two facts. It felt the title of the schedule was an error that did not reflect the intent of the schedule, and it considered the capital account issue to be an immaterial error of less than 0.1%. Thus, Dimar was considered by the court to have been formed and funded by 4 December 1998.

Should the step-transaction doctrine be applied?

At this point, the court focused on the test established by Holman, that the step transaction doctrine will not be applied where "the taxpayers bore a real economic risk of a change in value of the partnership" between the funding and the gift. Fortunately for the taxpayer, with the formation and funding issues decided favorably, the facts of the case were now very similar to Holman, which had gone in the taxpayer's favor. The Court concluded: "We reach the same result [as in Holman] here, where (1) 11 days [compared with six in Holman] passed between petitioner's conclusion of her transfer of the Dimar securities to the partnership and her gifts of interests in the partnership to her daughters, and (2) the Dimar securities were mostly, if not all, common shares of well-known companies."

However, it should be carefully noted that, in a footnote to this sentence, the court warned:

"We caution, however, in terms similar to those as we used in Holman v. Commissioner: The real economic risk of a change in value arises from the nature of the Dimar securities as heavily traded, relatively volatile common stocks. We might view the impact of an 11-day hiatus differently in the case of another type of investment; e.g., a preferred stock or a long-term Government bond." In other words, there must be a material risk of a change in value. Assets with stable (low volatility) values may be considered not to have material risk over a period of six or 11 days. However, the reference to "heavily traded" assets suggests that certain alternative investment assets, such as investments in venture capital or private equity funds, might not meet the test over a matter of days. Although such assets would generally be considered to have highly volatile values, the volatility is observed only infrequently, typically when capital accounts are updated quarterly.

So, the value risk that blocked the application of the step-transaction doctrine may be accepted only where there is observable volatility that could cause capital accounts to change during the relevant period. A gift of an interest in a partnership or LLC with less liquid assets may fall victim to the step transaction doctrine unless the gift is made months, not days, after funding.

Final Observations

Ms. Gross seems to have been very careful in certain aspects of her estate planning. Possibly with a potential §2036(a) challenge in mind after her death, she documented the fact that, "because she deemed one of her daughters extravagant, she considered a trust arrangement, but she rejected that because her other daughter declined to serve as a trustee." She also seems to have kept careful records of such things as the transfer of the securities from her name to Dimar's name in a notebook titled "Dimar."

However, one particular action of Ms. Gross and her daughters almost caused them to lose the benefit of the 35% valuation discount they applied in valuing the gifts - the partnership agreement was not signed until the date of the gift. Certain other mistakes - a reference in the gift tax return to the securities being contributed on December 15, 1998, and not allocating a portion of portfolio gains to the daughters' accounts - also could have proved problematic. Even though she ultimately prevailed, the mistakes landed Ms. Gross in Tax Court.

Nevertheless, Ms. Gross's misfortune is our gain because the case provides useful insights for practitioners on how to avoid indirect-gift treatment from the step transaction doctrine, as well as yet another reminder of the importance of following all the formalities of forming, funding, and operating a partnership or LLC in an estate planning context.

As an interesting final note, the parties stipulated that 35% valuation discounts would apply if the court decided that the gifts should be treated as limited partnership interests. Because the gifts were treated as general partnership interests, the stipulation did not apply. Nevertheless, the court allowed the 35% discounts because the petitioner's expert witness gave uncontradicted testimony that, if Dimar were a general rather than a limited partnership, and petitioner and her daughters had agreed that the daughters would be subject to the same limitations as set forth in the Dimar agreement, viz, neither daughter could dispose of all or any portion of her interest in the partnership, neither would have the right to withdraw either her capital or participation in the partnership or to receive distributions from the partnership, and neither would have control of management or the business and affairs of the partnership, then the fair market value of a 22.25% interest in the partnership received by each of the daughters would be worth the same as a 22.25% limited partnership interest in a limited partnership governed by the Dimar agreement. -FWR

Purchase reproduction rights to this article.

This is not intended or written to be used, and cannot be used by any taxpayer or advisor to a taxpayer, for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. Nor is this writing legal advice and it should not be construed as such.