If you read nothing else in this complex case study, read the last sentence. Carsten Hoffmann is a managing director of FMV Opinions, a valuation and financial-advisory services firm.

"Another 'bad facts' case makes for bad case law" - so end most discussions of cases involving Section 2036 of the tax code. Most practitioners agree that cases involving the commingling of assets, deathbed formations, non-pro-rata distributions and the payment of estate taxes out of partnership funds result in inclusion for estate-tax purposes.

But what happens when just one or two "abusive" fact patterns are present? Or what if abusive fact patterns exist for valid business reasons? The Tax Court case Estate of Anna Mirowski (T.C. Memo. 2008-74) goes further to answer these questions than any prior case. The 90-page opinion by Judge Carolyn Chiechi presents a thorough analysis of a limited liability company (LLC) holding marketable securities along with some patents and associated royalty-rights agreements.

Background

Mirowski's husband, Michel Mirowski was a professor of medicine at Johns Hopkins University School of Medicine and director of the coronary-care unit at Baltimore's Sinai Hospital. He worked with a group of physicians that developed a device that controls sometimes fatally irregular heartbeats.

As a result of his hard work and smart investing, Dr. Mirowski left his wife accounts worth millions of dollars at various financial institutions when he died in 1990.

In 2000, U.S. Trust introduced Mirowski to the concept of consolidating the assets into fewer accounts and contributing those assets to an LLC for estate-planning purposes. After discussing the matter with her attorney, Mirowski waited for the next annual family meeting in 2001 to present the matter and move forward with the plan. Although she understood that certain tax benefits could result from forming the LLC, those potential tax benefits were not the driving factor in her decision to form it. Her primary reasons were

To facilitate joint management of the family assets by her daughters and eventually her grandchildren,
To maintain the bulk of the family's assets in a single pool in order to allow for investment opportunities that would otherwise not be available
To provide for each of her daughters and eventually each of her grandchildren on an equal basis, and
To provide additional protection from potential creditors for the interests in the family's assets not provided by the existing trusts.

At the end of 2001, Ms. Mirowski executed the LLC's articles of execution, and in the next few months funded the LLC with the patents, royalty rights and securities totaling over $70 million -- with public securities accounting for most of the value. In exchange, she received a 100% interest in the LLC. Shortly after formation, Mirowski made three 16% member gifts to her three daughters.

Mirowski suffered from diabetes, but was generally in good health. Around the time the LLC was formed and the gifts were made to her daughters, Mirowski's health deteriorated quickly as a result of a foot ulcer that had caused an infection of the blood stream by toxin-producing bacteria. In September 2001, three days after completing the gifts, Mirowski passed away.

Issues raided by the IRS

The only issues for decision were whether the assets owned by the LLC were includible in Mirowski's gross estate under Section 2036(a), 2038(a)(1), or 2035(a).

In order to resolve the dispute under Section 2036, the court said it had to consider the following with respect to Mirowski's transfers to the LLC and with respect to her gifts to her daughters' trusts of 16% interests in the LLC.

Was there a transfer of property by Mirowski?
If there was a transfer of property, was such a transfer not a bona fide sale for adequate and full consideration in money or money's worth?
If there was a transfer of property that was not a bona fide sale (a) did Mirowski retain the possession or use and enjoyment of, or the right to the income from, the property transferred or (b) did she retain, either alone or in conjunction with any person, the right to designate the persons who shall possess or enjoy the property transferred or the income therefrom?

Findings

With regard to the transfers made from Mirowski to the LLC, the court found that the decedent had indeed transferred property. Accordingly, the court's analysis turned to the bona fide sale test. The IRS argued that there was no legitimate, significant non-tax reason for Mirowski's forming and transferring assets to the LLC.

Relying on the "candid, sincere and credible" testimony of the daughters, the court concluded that the previously mentioned joint management, maintenance of assets for investment opportunities and providing for each of her daughters were significant non-tax reasons. The court also analyzed the IRS's contention that the LLC lacked legitimacy because

Mirowski failed to retain sufficient assets outside of the LLC
the LLC lacked sufficient functioning business operation,
Mirowski delayed forming and funding the LLC,
Mirowski sat on both sides of the transaction,
the LLC made a large non pro-rata, one-time distribution to pay the gift tax and the estate tax, and
Mirowski's was failing.

The court concluded that the IRS's contentions were not supported by the facts. Some assets had been kept outside of the LLC (although not enough to pay estate and gift taxes), the activities of the LLC did not need to rise to those of a "business" under federal tax laws, there were no express or implied agreements between members, there was no commingling of assets, and Mirowski's death was unexpected.

So the court held that the bona fide sale exemption for an adequate and full consideration in money, or money's worth, did apply to Ms. Mirowski's transfers of property to the LLC.

In addition to the detailed analysis of the various contentions outlined above, it is also clear from a reading of the case that Judge Chiechi gave significant consideration to the family history of financial planning, involving the junior generation, having annual family meetings with professionals present, and running the LLC as a real business.

Since the transfers to the LLC were found to be bona fide sales, the court did not need to address, with respect to the LLC transfers the factual issues presented under Section 2036(a)(1), whether Ms. Mirowski retained for life the possession or the enjoyment of, or the right to the income from, the property transferred.

The second transfer in question was the gift transfer from the LLC to the three daughters.

Once again, the court agreed that property had been transferred. However, in this case both sides agreed that the transfers were not bona fide sales for adequate consideration and, accordingly, the analysis turned to the question of possession or enjoyment of, or the right to income from the property transferred, or the right to designate the persons who shall possess or enjoy the property transferred.

The parties agreed that an interest or a right as described in Section 2036(a)(1) and (2) is treated as having been retained if, at the time of the transfer of property, there was an express or implied agreement or understanding that the interest or right would later be conferred.

The IRS's primary argument hinged on the fact that Mirowski had retained a 52% managing-member interest and, as managing member, had the right (along with other rights) to decide over the distribution policy of the LLC and thereby control the use, enjoyment and income. Although the LLC agreement gave significant powers to the managing member, it did not provide the ability to determine the amounts of the distributions. This was stipulated in the agreement under a separate section that stipulated that distributions had to be made after accounting for required reserves.

In conclusion, the court stated: "On the record before us, we find that the discretion, power, and authority that the operating agreement granted the decedent as general manager do not require us to find that, at the time of Ms. Mirowski's gifts and at the time of her death, there was an express agreement that she retain an interest or a right described in Section 2036(a)(1) or (2) with respect to the 16 percent interests in the LLC that she gave her daughters' trusts."

The Court reached the same conclusions with regard to Section 2038 (revocable transfers) and did not have to address Section 2035 because this section deals with adjustments for certain gifts that are includible under sections 2036 or 2038.

Conclusion

The case contains many more pearls, such as the dismissal by Judge Chiechi of various other 2036 cases brought up by the IRS as "distinguishable," and the fact that valuation discounts of over 40% were agreed to for an interest in an LLC holding primarily marketable securities as well as a discount of over 20% for a majority managing-member interest in an entity with contractual distributions.

But the most relevant finding is the systematic dismissal of 2036 arguments in a case that included a death-bed formation, non pro-rata distributions, marketable securities and the retention of a majority managing interest.

And all this happened because the entity had excellent non-tax reasons and a history of family involvement in business affairs. -FWR

This is not intended or written to 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. This writing is not legal advice, nor should it be construed as such.

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