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CO-­‐OWNERSHIPS/MANAGING  UNDIVIDED  INTERESTS  IN  PROPERTY      

Santa  Clara  County  Estate  Planning  Council    

April  20,  2015    

             John  W.  Prokey,  Esq.  Ramsbacher  Prokey  Leonard  LLP  125  S.  Market  St.,  Suite  1250  

San  Jose,  CA  95113  408-­‐293-­‐3616  

jwp@rpllawfirm.com      

SKELETON OUTLINE (Table of Contents)

I. FOCUS AND OVERVIEW II. CO-OWNED PROPERTY DEFINITIONS A. Generally B. Joint Tenancy C. Partnership D. Tenants-In-Common E. Community Property 1. Definition a. Community Property b. Community Property with Right of Survivorship 2. Division on Death F. Applies to Real Property, Tangible Personal Property, and Intangible Personal Property III. CALIFORNIA RIGHT TO PARTITION A. Hypothetical B. California Law 1. The Partition 2. Getting the Property Sold 3. After the Sale C. Analysis IV. PROP 13 CONSIDERATIONS A. Tenancies-In-Common 1. General Principles 2. Exceptions a. Proportional b. De Minimis c. Between Spouses/Registered Domestic Partners

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d. Lineal Exclusion e. 2013 Cotenancy Exclusion B. Joint Tenancy 1. General Principles 2. Exceptions a. No Elimination of “Original Transferor(s)” b. Partial Elimination of “Original Transferor(s)” c. Elimination of Non-“Original Transferor(s)” d. Proportional e. Between Spouses/Registered Domestic Partners f. De Minimis g. Lineal Exclusion h. 2013 Cotenancy Exclusion

C. 2013 Cotenancy Exclusion (See Property Tax Rule Sections 462.020(b)(5), 462.040(b)(8)

1. Pre-Transfer a. Complete Ownership b. One Year Co-Ownership c. Principal Residence d. Continuous Inhabitance e. Affidavit 2. During the Transfer 3. Post-Transfer D. Partnership 1. General Principles 2. Transfer to the Entity 3. Transfers of Entity Interests 4. Avoiding Reassessment on Entity Transfers V. TENANTS IN COMMON PLANNING CONSIDERATIONS A. General Legal Considerations B. Day-to-Day Management and Control C. Maintaining Ownership within Family or Ownership Group D. Expense Sharing and Enforcement VI. INCOME TAX PLANNING A. IRC Section 761/CA Corp Code 16101 B. IRC Section 704 – Partners Distributive Share C. IRC Section 469 – Passive Activity Losses and Credits Limited D. IRC Section 1014 – Basis of Property Acquired from a Decedent E. Rev. Proc. 2002-22 F. IRC Section 1031 VII. VALUATION A. Joint Tenancy – Young B. Real Property Tenants-In-Common 1. Fractional Interest Valuation Cases a. Propstra

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b. Brocato c. Busch d. Stevens e. Baird f. Youle g. Pillsbury h. LeFrak i. Estate of Cervin j. Estate of Williams k. Estate of Forbes l. Ludwick 2. Service Rulings a. PLR 9336002 b. TAM 199943003 3. Valuation Approaches a. Fractional Interest Discounts

b. Co-Tenancy Interests: Current Thinking on the Valuation and Use in Estate Planning

4. Summary of Case Discount Results & Accepted Methodologies (Discount Focus) a. Propstra b. Brocato c. Busch d. Stevens e. Baird 5. Comment on Appraisal Methods C. Approaches in the Valuation of Artwork Held as Tenants-In-Common 1. The Business Appraiser 2. The Multi-Appraiser Approach a. Appraiser and Seller of Fine Art (Mr. Nash) b. Property Lawyer (Mr. Miller) c. Valuation Consultant (Mr. Mitchell) d. Court’s Holding e. Appeal to the 5th Circuit 3. Art Appraiser’s Point of View VIII. SPECIAL VALUATION ISSUES A. Valuation Standard and Legal Concepts 1. Generally 2. Standard of Value 3. What Is to Be Valued? 4. Determining Property Rights 5. Gift Tax Consideration – No Family Attribution 6. Estate Tax Consideration – Aggregation of Interests that Pass at Death a. General Rule

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b. QTIP Trust Exception 7. Actual Other Co-Tenants 8. Actual Lease and Tenants B. IRC Section 2036 1. Cases

a. Trafton b. Barlow c. Powell d. Winemann

e. Stewart 2. Proportionality 3. Additional Considerations Regarding Cotenancy and 2036 C. IRC Section 2703 IX. CONTRAST TO ENTITIES A. Annual Exclusion Planning 1. Hackl 2. Price 3. Fisher 4. Wimmer B. Formation Issues – Indirect Gifts 1. Indirect Gift a. Increase of Donee’s Capital Account b. Contrast to Jones and Gross c. Uncertainty of Events 2. Step Transaction Doctrine a. Holman b. Linton c. Heckerman d. Comments on Linton and Heckerman C. IRC Section 2703 Issues 1. Cases a. Church b. Strangi I c. Smith d. Blount e. Holman 2. Meeting the 2703 Exception D. IRC Section 2704 Issues 1. Law 2. Cases a. Kerr b. Harper c. Knight 3. Assignee Interests 4. Comments on Partnership Valuation a. Restrictions More Restrictive than State Law

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b. Transferring LP Interests to Charity c. FSA 200049003 E. IRC Section 2036 Issues 1. Introduction and Partnership Cases a. Perrachio/Lappo/Temple/Astleford b. Miller c. Keller d. Hurford e. Murphy f. Malkin g. Schauerhamer h. Reichardt i. Harper j. Thompson k. Estate of Strangi II l. Stone m. Abraham n. Hillgren o. Kimbell p. Bongard q. Bigelow r. Korby s. Schutt t. Keller u. Disbrow v. Rosen w. Erickson x. Gore y. Rector z. Mirowski aa. Jorgensen bb. Turner cc. Liljestrand dd. Kelly F. Income Tax Planning X. IDEAL TIME TO RELY UPON TENANCY-IN-COMMON A. High 2036 Risk B. California Property Tax C. Low Liability Concern D. Desire for Minimal Legal and Other Costs E. Low Tolerance for Planning Compliance/Complexity F. Low Risk Tolerance Clients G. Fewer Potential Owners XI. IDEAL TIME TO RELY IN ENTITY A. Controlled Management Succession Paramount B. Problem Heirs

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C. Estates in Excess of Estate Tax Exclusion Amount D. Corporate Trustee over Donee Trust E. Creditor Concerns F. Reinvestment of Gain

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I. FOCUS AND OVERVIEW Undivided interests in real and personal property must be considered in estate planning, and understanding the legal framework of undivided interests is critical to properly developing an appropriate estate plan. This presentation will explore management succession, valuation, property tax, and income tax issues as well as business entity alternatives relevant to estate planning. II. CO-OWNED PROPERTY DEFINITIONS A. Generally Under California Civil Code Section 682, the ownership of property by several persons is either (1) of joint interest; (2) of partnership interests; (3) of interests in common; or (4) of community interest of husband and wife. B. Joint Tenancy Under California Civil Code Section 683(a), two or more persons own a “joint interest” in equal shares when expressly declared in the transfer to be a joint tenancy. C. Partnership Under California Civil Code Section 684, a partnership interest is one owned by several persons, in partnership, for partnership purposes. D. Tenants-In-Common Under California Civil Code Section 685, an interest in common is own owned by several persons, not in joint ownership or partnership. E. Community Property

1. Definitions. a. Community Property. Under California Family Code Section 760, except as otherwise provided by statute, all property, real or personal, wherever situated, acquired by a married person during the marriage while domiciled in this state is community property. See also California Civil Code Section 687. b. Community Property with Right of Survivorship.

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Under California Civil Code Section 682.1(a), when community property is expressly declared in the transfer document to be community property with right of survivorship, such property shall, upon the death of one of the spouses, pass to the survivor, without administration, pursuant to the terms of the instrument, subject to the same procedures, as property held in joint tenancy. Prior to the death of either spouse, the right of survivorship may be terminated pursuant to the same procedures by which a joint tenancy is severed. 2. Division on Death. Under California Probate Code Section 100(a), notwithstanding an agreement otherwise, upon the death of a married person, one-half of the community property belongs to the surviving spouse and the other half belongs to the decedent. F. Applies to Real Property, Tangible Personal Property, and Intangible Personal Property Under California Civil Code Section 655, there may be ownership of all inanimate things which are capable of appropriation or of manual delivery; of all domestic animals; of all obligations; of such products of labor or skill as the composition of an author, the good will of a business, trade marks and signs, and of rights created or granted by statute. III. CALIFORNIA RIGHT TO PARTITION A. Hypothetical In a hypothetical scenario, you inherit a fractional interest in a piece of California real estate from a deceased relative. Seeing the opportunity for a nice return from the property if you owned more of it, you decide to try and turn that fractional interest into a whole interest in the real property. However, all of your amicable attempts to curry favor with your co-owners have been met with resistance, and all have steadfastly refused your bids to buy them out. Fed up, you’re looking to take the decision out of their hands with judicial intervention. You seek to partition the property, thereby dividing the property up between each of the interested parties based on their respective ownership interests. However, this division will not take the place of an actual physical division. Rather, in order to control the property and reach your goal, you’ll require a partition by sale and a public sale wherein you can purchase the property outright as (hopefully) the highest bidder, therein paying the other owners for their respective shares whether they like it or not. How do you go about doing this? On the flip side, if you’re one of the other co-owners, how could you put a stop to this madness? If a sale is inevitable, how can you make sure you’re getting the most possible money out of the property?

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B. California Law 1. The Partition. A partition may be commenced by an owner of property where such property is owned by several persons concurrently or in successive estates. CCP 872.210. The complaint seeking a partition must include the following: (a) a description of the property (including legal and physical description); (b) all interests the plaintiff has or claims in the property; (c) all interests of record or actually known to the plaintiff that other parties have and whose interests, as a result of plaintiff’s action, will be materially affected; and (d) the estate as to which partition is sought and a prayer for partition of the interests therein. CCP 872.230(a)-(d). If the plaintiff seeks sale of the property, an allegation of the facts justifying such relief in ordinary and concise language is furthermore necessary. CCP 872.230(e). If the complaint is successful, the court will divide the property amongst the parties in accordance with their interests in the property as determined by the judgment. CCP 872.810. Alternatively, the parties may agree to a partition by appraisal. CCP 873.910. However, if the court determines that such an outright sale would be more equitable than a division (and the parties do not otherwise agree to a partition by appraisal,) the court may order the property sold and the proceeds divided amongst the parties in accordance with their interests in the property. CCP 872.820. 2. Getting the Property Sold. The court may appoint a referee to assist in the sale process. CCP 873.010. If the court does so, then the referee shall sell the property at either a public auction or a private sale, whichever the court determines would be more beneficial to the parties. CCP 873.520. A sale at a public auction to the highest bidder shall be held in the county in which the action is pending or such other place as may be specified by the court. CCP 873.670. Conversely, a sale at a private sale shall not be made before the day specified in the notice of sale but shall be made within one year after. CCP 873.680(a). For a private sale, the bids and offers shall be in writing and left at the place designated in the notice at any time after the first publication or, if none, the posting of the notice. CCP 873.680(b). The following persons are not allowed to purchase property sold in the auction, either directly or indirectly: (1) the referee; (2) the attorney of a party; or (3) the guardian or conservator of a party, unless for the benefit of the ward or conservatee. CCP 873.690(a). 3. After the Sale. Upon the sale of property, the referee shall report the sale to the court. CCP 873.710(a). The report shall contain, along with other material facts relevant to the sale and the confirmation proceeding, the following information: (1) a description of the property sold to each purchaser; (2) the name of the purchaser; (3) the sale price; and (4) the terms and conditions of the sale and the security, if any, taken. CCP 873.710(b).

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A purchaser, the referee, or any party may move the court to confirm or set aside the sale. CCP 873.720(a). In this situation, the moving party shall give at least ten days notice of motion to (1) the purchaser if the purchaser is not the moving party and (2) all other parties who have appeared in the action. CCP 873.720(b). At the hearing, the court shall examine the report and witnesses in relation to the report. CCP 873.730(a). Even if the sale varies from the prescribed terms, the court may confirm the sale if it is in the beneficial interests of the parties involved and will not result in substantial prejudice to persons in the sale. CCP 873.730(b). The court may vacate the sale and direct that a new sale be made if it determines any of the following: (1) the proceedings were unfair or notice of the sale was not properly given (this must be found at the hearing); (2) the sale price is disproportionate to the value of the property; and (3) it appears that a new sale will yield a sum that exceeds the sale price by at least 10% on the first $10,000 and 5% on the amount in excess thereof, determined after a reasonable allowance for the expenses of a new sale. CCP 873.730(c). C. Analysis If you are a party seeking to buy out your curmudgeonly co-owners, your biggest obstacle is convincing the court to choose to dispose of the property via sale instead of via division. Even if the court is acquiescent, however, there are still other issues you must consider. 1. A private sale could seriously hamper your ability to obtain the property: given that you are unable to see the bids of others, you might not submit a bid nearly high enough, or, even more frighteningly, may go overboard and vastly overpay for the property. 2. A public sale is not without its risks as well: if the property is appealing in some capacity to a more general population, you could end up in a bidding war with someone holding a much more sizeable checkbook. 3. One other issue: whether or not a referee has been appointed, the court controls the whole process, from start to finish. In its sovereign capacity, if it feels inclined to exclude you as a petitioner/party-to-the-action/former co-owner from the proceedings, it seemingly can under CCP 873.610(a). In other words, beware a suspicious judge. If you are a party seeking to defend your property from a malicious former co-owner, you’ll need to do your best to keep the court from selling the property at all. However, if the sale can’t be avoided, then you have a few options left to ensure that you will receive the largest possible payout. 1. Showing that the sale proceedings were unfair would set aside the sale and allow you to form a strategy/counter-attack (if the malice caught you off-guard initially). However, if the evil former co-owner won the property fair and square, then it may be difficult to convince the court that you as the maligned co-owner were subject to unfair treatment.

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2. Even if the evil party won the property fair and square, if they won it for a pittance, you’re in luck! Because the court wants the former owners to receive as much money as possible for the property, they will set any judgment aside if the payout is too miniscule in comparison to the otherwise fair market value of the property. 3. Speaking of wanting you to have more money: as a last ditch effort, if the evil party won the property fair and square and at a fair price, you can still get the court to set aside the sale if you have a rich friend looking to invest their money. Here, all that is required are deep pockets guided by altruism. IV. PROP 13 CONSIDERATIONS A. Tenancies in Common 1. General Principles. Generally speaking, the creation, transfer, or termination of a tenancy in common interest constitutes a change in ownership of such interest. As a result, the portion of the property represented by the interest changing ownership will be reappraised. 2. Exceptions. However, this rule is subject to five notable exceptions. In the following five scenarios, the change will not trigger reappraisal: a. Proportional. The transfer is between or among co-owners and results in a change in the method of holding title but does not result in a change in the proportional interests of the co-owners, such as a partition, a transfer from a cotenancy to a joint tenancy, or a transfer from a cotenancy to a legal entity which results solely in a change in the method of holding title and in which the proportional ownership interests in the property remain the same after the transfer. Example: A and B own a parcel of real property as tenants in common, with each owning a 50 percent interest. They then transfer the property to a newly formed corporation each receiving 50 percent of the stock. Such a transfer would not be regarded as a change in ownership. b. De Minimis. The transfer is of an undivided interest of less than five percent of the value of the property and has a value of less than $10,000; provided, however, that transfers of such interests during any one assessment year (the period from January 1 through December 31) shall be accumulated for the purpose of determining the percentage interest and value transferred. When the value of the accumulated interests transferred during any assessment year equals or exceeds five percent of the value of the total property or $10,000, then that percentage of the property represented by the transferred accumulated interests shall be reappraised.

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Example: A and B own a parcel of real property as tenants in common, with each owning a 50 percent interest. A transfers to C 2% of her undivided interest, worth $4,000, on January 2nd, 2015. While this transfer by itself would not trigger a reappraisal, any future transfers made in the same assessment year, that together with this transfer exceed the 5%/$10K threshold, will trigger reappraisal. c. Between Spouses/Registered Domestic Partners. The transfer is one to which the interspousal exclusion applies. For more information, see CA Rev. and Tax. Code Section 63 (for spouses) or 62(p) (for registered domestic partners). d. Lineal Exclusion. The transfer is one to which the parent-child or grandparent-grandchild exclusion applies, and from which a timely claim has been filed. For more information, see CA Rev. and Tax. Code Section 63.1. e. 2013 Cotenancy Exclusion. The transfer is one to which the cotenancy exclusion applies. For more information, see CA Rev. and Tax. Code Section 62.3 and Part C of this Section. B. Joint Tenancy 1. General Principles. Generally speaking, the creation, transfer, or termination of a joint tenancy interest constitutes a change in ownership of the interest transferred. As a result, the portion of the property represented by the interest changing ownership will be reappraised. 2. Exceptions. However, this rule is subject to eight notable exceptions. In the following eight scenarios, the change will not trigger reappraisal: a. No Elimination of “Original Transferor(s)”. The transfer creates or transfers any joint tenancy interest and after such creation or transfer, all transferor(s) are among the joint tenants. Such a transferor who is also a transferee is, therefore, considered to be an “original transferor” for purposes of determining the property to be reappraised upon subsequent transfers. If a spouse of an “original transferor” acquires an interest in the joint tenancy property either during the period that the “original transferor” holds an interest or by means of a transfer from the “original transferor,” such spouse shall also be considered to be an “original transferor.” b. Partial Elimination of “Original Transferor(s)”. The transfer terminates an “original transferor’s” interest in a joint tenancy as described in Part 1 and the interest vests in whole or in part in the remaining “original transferors”; except that, upon the termination of the interest of the last surviving “original transferor,” there shall be a reappraisal of the property as if it had undergone a 100 percent change in ownership.

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c. Elimination of Non-“Original Transferor(s)”. The transfer terminates a joint tenancy interest held by “other than an original transferor” in a joint tenancy described in part (a) and the interest is transferred either to an “original transferor,” or to all the remaining joint tenants, provided that one of the remaining joint tenants is an “original transferor.” The “original transferor” status of any remaining joint tenants ceases when a joint tenancy is terminated. d. Proportional. For other than joint tenancies described in part (a), the transfer is between or among co-owners and results in a change in the method of holding title but does not result in a change in the proportional interests of the co-owners, such as: i. A transfer terminating the joint tenancy and creating separate ownerships of the property in equal interests. ii. A transfer terminating the joint tenancy and creating a tenancy in common of equal interests. iii. A transfer terminating a joint tenancy and creating or transferring to a legal entity when the interests of the transferors and transferees remain the same after the transfer. Such transferees shall be considered to be the “original co-owners” for purposes of determining whether a change in ownership occurs upon the subsequent transfer of the ownership interests in the property. e. Between Spouses/Registered Domestic Partners. The transfer is one to which the interspousal exclusion applies. For more information, see CA Rev. and Tax. Code Section 63 (for spouses) or Section 62(p) (for registered domestic partners). f. De Minimis. The transfer is of a joint tenancy interest of less than five percent of the value of the total property and has a value of less than $10,000; provided, however, that transfers of such interests during any one assessment year (the period from January 1 through December 31) shall be accumulated for the purpose of determining the percentage interest and value transferred. When the value of the accumulated interests transferred during any assessment year equals or exceeds five percent of the value of the total property or $10,000, then only that percentage of the property represented by the transferred accumulated interests shall be reappraised. g. Lineal Exclusion. The transfer is one to which the parent-child or grandparent-grandchild exclusion applies, and for which a timely claim has been filed. For more information, see CA Rev. and Tax. Code Section 63.1. h. 2013 Cotenancy Exclusion. The transfer is one to which the cotenancy exclusion applies. For more information, see CA Rev. and Tax. Code Section 62.3 and Part C of this Section.

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C. 2013 Cotenancy Exclusion (see Property Tax Rule Sections 462.020(b)(5), 462.040(b)(8)) In 2012, the California Legislature added a new exception for transfers from one cotenant to another on death, regardless if whether the property is held in joint tenancy or in tenancy in common. Under CA Rev. and Tax. Code Section 62.3, a change in ownership shall not include a transfer of a cotenancy interest in real property from one cotenant to the other that takes effect upon the death of the transferor cotenant if ALL of the following conditions are met: 1. Pre-Transfer. a. Complete Ownership. The transfer is solely by and between two individuals who together own 100 percent of the real property in joint tenancy or as tenants in common. b. One Year Co-Ownership. For the one-year period immediately preceding the transfer, the real property was co-owned by the transferor and the transferee, and both cotenants have been the owners of record of that real property. c. Principal Residence. The real property constituted the principal residence of both cotenants immediately preceding the transferor cotenant’s death. d. Continuous Inhabitance. The transferor and the transferee continuously resided at that residence for the one-year period immediately preceding the transfer. e. Affidavit. The transferee has signed, under penalty of perjury, an affidavit affirming that he or she continuously resided with the transferor at the residence for the one-year period immediately preceding the transfer 2. During The Transfer. A transfer of cotenancy interest in real property from one cotenant to the other takes effect upon the death of the transferor cotenant under any of the following circumstances: a. Pursuant to the transferor cotenant’s will or trust, upon the death of the transferor cotenant. b. Through intestate succession from the transferor cotenant. c. By operation of law, upon the death of the transferor cotenant. 3. Post-Transfer. Complete Ownership by One Tenant. As a result of the death of the transferor cotenant,

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the deceased cotenant’s interest in the real property is transferred to the surviving cotenant, which results in the surviving cotenant holding a 100-percent ownership interest in the real property immediately after the transfer, thereby terminating the cotenancy. D. Partnership 1. General Principles. Generally speaking, property will be reassessed and therefore subject to a higher property tax basis upon a “change in ownership.” CA Rev. & Tax. Code Sec. 60. However, in the context of business entities, the analysis of whether or not a “change in ownership” has occurred differs based upon whether the transfer is a transfer of property to the entity or whether the transfer is of an interest in the entity. 2. Transfer to the Entity. Section 62(a)(2) of CA Rev. & Tax. Code states the general rule that a transfer that changes the method of holding title but not the identity and proportion of title does not trigger a change of ownership. Therefore, if two co-tenants who own a piece of property transfer the property to an FLP and their proportional ownership in the FLP is the same as it was in the property in co-tenancy, there is no change of ownership for real property tax purposes. To illustrate, John and Judy each own an undivided 50% interest in Blackacre. John and Judy form an FLP, and transfer Blackacre to the FLP. In exchange for this capital contribution, John receives a 1% interest as a general partner, and a 49% interest as a limited partner. Judy as well receives a 1% interest as a general partner, and a 49% interest as a limited partner. Because the proportion of ownership did not change, there is no property tax reassessment. 3. Transfers of Entity Interests. Section 64(a) of CA Rev. & Tax. Code provides the general rule that a transfer of interests in an entity does not trigger a change in ownership. There are two exceptions to this rule. The first is Section 64(c) of CA Rev. & Tax. Code. This section provides that when a person or legal entity obtains direct or indirect control over more than 50% of the total interests in a partnership capital and profits (or voting control of a corporation), there is a change of ownership and the property owned by the entity is reassessed. The 50% rule is cumulative and therefore the change in control does not have to occur in one transaction. It applies to any purchase or transfer of 50 percent or less through which control or a majority ownership interest is obtained. The other exception to the general no reassessment rule of Section 64(a) of CA Rev. & Tax. Code is found in Section 64(d). This rule is commonly known as the “original co-owner rule.” Application of this rule depends on there being no reassessment of the subject property upon its transfer to the entity pursuant to Section 62(a)(2) of CA Rev. &

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Tax. Code. If that section was relied upon, then the persons holding ownership interests in that the entity immediately after the transfer are referred to as the “original co-owners.” Under Section 64(d), where interests cumulatively representing more than 50% ownership are transferred by any of the original co--owners, a change in ownership occurs under Section 64(d). Therefore, if the partners who were the original co-owners over time cumulatively transfer more than 50% of the partnership, any of the underlying property previously excluded from reassessment under section 62(a)(2) will be reassessed for real property tax purposes. It is important to keep in mind that the exception under Section 64(c) applies to all transfers, i.e., once control is obtained all property owned by the entity is subject to reassessment. Section 64(d), on the other hand, only applies to property that was previously excluded from reassessment under Section 62(a)(2). Thus, when performing property tax analysis for an entity, it is critical to know how each property owned by the entity was acquired and whether any property was previously excluded from reassessment under section 62(a)(2). 4. Avoiding Reassessment on Entity Transfers. Generally speaking, transfers of interests in entities holding California property must be carefully considered. If property taxes are an issue, entity owners should avoid making transfers that result in a single person obtaining control. Further, if the entity owns any property that was previously excluded from reassessment under section 62(a)(2), the original co-owners- should avoid cumulative transfers of more than 50% of the entity. The facts related to each entity will vary, and thus should be carefully reviewed for these issues. Also, there may be times when the assessed value is higher than fair market value and it will be beneficial to trigger a reassessment using an entity. V. TENANTS IN COMMON PLANNING CONSIDERATIONS A. General Legal Considerations An important aspect of cotenancy ownership is control and operation of the property so it can be productive. Each cotenant has the right to control the whole and the right to occupy the whole; however, such control and occupancy cannot exist to the exclusion of the other cotenants. Under California Civil Code Section 843, a cotenant denied possession of the property can recover damages under a claim of ouster. Further, one cotenant cannot grant a third party exclusive right to occupancy of the subject property – all cotenants must act together to grant such right. Each cotenant is responsible for his or her proportionate share of necessary expenses. If a cotenant pays more than his or her share, he or she has a right of contribution against the cotenant that did not pay his or her proportionate shares. The right of contribution is an equitable lien against the noncontributing cotenant’s interest in the property. With respect to an optional improvement, a cotenant is only responsible for the costs if he or she agrees to the optional improvement. If a cotenant refuses to contribute to an optional

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improvement, then he or she cannot share in any increased value resulting from such optional improvement. Each cotenant has the right to share in the income from the property in proportion to his or her share of the property. To facilitate successful management of co-owned property, and to keep the cotenants out of court, we recommend the cotenants enter into a tenants-in-common agreement, referred to as a “TIC Agreement.” Following are some key considerations for TIC Agreements, especially in the estate planning context. B. Day-to-Day Management and Control To avoid disputes arising from cotenants, a property manager should be assigned to take on the day-to-day management of the property. Often this will be the senior generation during their lifetime, and then a selected family member thereafter. The following is sample language that may be included in a TIC Agreement for appointment of a property manager: JOHN DOE shall be “property manager” as the term is used in this Agreement. In the event JOHN DOE is unable or unwilling to act, a property manager shall be elected by a majority-in-interest of the cotenants. Any time there is more than one property manager, consent of a majority-in-number of the property managers shall be required to exercise any powers granted to the property manager. A property manager shall be entitled to reasonable compensation, approved by a majority-in-interest of the Tenants, for services rendered under this Agreement. C. Maintaining Ownership Within Family or Ownership Group An important objective of the cotenancy agreement is to maintain ownership of the subject property within the ownership group and/or family. Thus, the agreement should contain transfer restrictions and buy-out rights in the event of creditor issues, divorce, death, and voluntary lifetime transfers. Those provisions often mirror transfer restrictions in partnership agreements and limited liability company operating agreements. However, unlike partnerships and limited liability companies, there is no assignee issue. D. Expense Sharing and Enforcement Each cotenant is responsible for his or her share of expenses related to the property. However, collecting a cotenant’s share of expenses is another matter all together. As we all know, family members can be uncooperative, run out of money, or otherwise be unable or unwilling to contribute. If fortune shines on the property, there will be sufficient cash flow from property operations to cover expenses. But with low cash flow properties, or properties that need renovation or large lease commission payments, cash flow from the property may not be sufficient.

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Therefore, the TIC Agreement should include provisions to address cash needs of the property. These provisions should include a general requirement to provide cash when needed, and tough provisions when a cotenant fails to furnish required funds (a “defaulting cotenant”. Those provisions can include the ability of other cotenants to furnish the funds on behalf of the defaulting cotenant and be treated as a loan to such defaulting cotenant to a forced sale of the defaulting cotenant’s interest in the property equal to the amount of the required funds. The bottom line is that the property needs to continue to operate, even when one or more cotenant is uncooperative (intentionally or unintentionally). In addition, enforcing rights of reimbursement should be allowed without having to resort to court intervention. The TIC Agreement should provide adequate out-of-court remedies. VI. INCOME TAX PLANNING A. IRC Section 761/CA Corp Code 16101 Under IRC Section 761, the term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, a corporation or a trust or estate. Under CA Corporations Code 16101, “Partnership” means an association of two or more persons to carry on as co-owners a business for profit formed under Section 16202, predecessor law, or comparable law of another jurisdiction, and includes, for all purposes of the laws of this state, a registered limited liability partnership, and excludes any partnership formed under Chapter 2 (commencing with Section 15501), Chapter 3 (commencing with Section 15611), or Chapter 5.5 (commencing with Section 15900). The key issue here is whether the cotenancy arrangement will be considered a tax partnership, or whether it will be respected as a cotenancy. Under Treasury Regulation Sections 1.761-1(a) and 99 301.7701-1 through 301.7701-3, a federal tax partnership does not include mere co-ownership of property where the owners’ activities are limited to keeping the property maintained, in repair, rented or leased. However, a partnership for federal tax purposes is broader in scope than the common law meaning of partnership and may include groups not classified by state law as partnerships. See Bergford, 12 F 3d 166 (9th Cir. 1993) and Bussing, 88 TC 449 (1987). B. IRC Section 704 – Partner’s Distributive Share Under IRC 704, the partnership agreement controls the distributions, and each partner’s distributive share of income, gain, loss, deduction, or credit shall be determined in accordance with that partner’s interest in the partnership. Family partnerships were used to shift income among members of the family. IRC 704(e)(1) was added to the law as a safe harbor for partnership where capital is a material income-producing factor. To wit, IRC 704(e) provides in relevant part as follows:

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“A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person. In the case of any partnership interest created by gift, the distributive share of the done under the partnership agreement shall be includible in his gross income, except to the extent that such share is determined without allowance of reasonable compensation for services rendered to the partnership by the donor, and except to the extent that the portion of such share attributable to donated capital is proportionately greater than the share of the donor attributable to the donor’s capital…For purposes of this section, an interest purchased by one member of a family from another shall be considered to be created by gift from the seller, and the fair market value of the purchased interest shall be considered to be donated capital. The “family” of any individual shall include only his spouse, ancestors, and lineal descendants, and any trusts for the primary benefit of such persons.” Contrast this to a partnership where capital is not a material income-producing factor. In such partnerships, if a partner performs no services, partnership income is allocated to the partner who performs the services. See also Lucas v. Earl, 281 U.S. 111, 114-15 (1930) C. IRC Section 469 – Passive Activity Losses and Credits Limited Under IRC 469, within any taxable year, for any individual, estate, trust, closely held C corporation, or personal service corporation, neither a passive activity loss or passive activity credit is allowed. For purposes of this section, “passive activity” is any activity which (1) involves the conduct of any trade or business, and (2) is one in which the taxpayer does not materially participate. D. IRC Section 1014 – Basis of Property Acquired from a Decedent Under IRC 1014, unless otherwise noted, the transferee’s basis in property received from a decedent is the fair market value of the property at the date of the decedent’s death. Basis adjustments at death should be considered carefully in estate planning. Entity level discounts, especially on minority interests, tend to be higher that fractional interest discounts on fractional interests in real estate. In light of higher estate tax exclusions and higher income tax rates, more care needs to be taken to balance estate tax versus post-death income tax issues. E. Rev. Proc. 2002-22 Revenue Procedure 2002-22 specifies the conditions under which the Internal Revenue Service will consider a request for a ruling that an undivided fractional interest in rental real property (other than a mineral property as defined in section 614) is not an interest in a business entity, within the meaning of 9 301.7701-2(a) of the Procedure and Administration Regulations. This applies to co-ownership of rental real property (other than mineral interests) in an arrangement classified under state law as a cotenancy. The guidelines for requesting advance rulings are provided solely to assist taxpayers in

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preparing ruling requests and the Service in issuing advance ruling letters and are as follows:

1. The guidelines “are not intended to be substantive rules and are not to be used for audit purposes.”

2. Each of the co-owners must hold title to the property as co-owners under local law (either direct or through a disregarded entity).

3. There cannot be more than 35 co-owners (though husband and wife, as well as parties who together acquire an interest by devise, are treated as one co-owner).

4. The co-owners “must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any lease of a portion or all of the property or the creation or modification of a blanket lien.”

5. Any sale, lease or release of the Property, any negotiation or renegotiation of indebtedness secured by a blanket mortgage, the hiring of any manager, and the negotiation (or renegotiation) of any management contract, must be “by unanimous approval of the co-owners.”

6. For all other actions on behalf of the co-owners, the co-owners may agree to be bound by a vote of those holding more than 50% of the undivided interests in the property.

7. Restrictions on the right to transfer, partition, or encumber the co-owner’s interest in the property “that are required by a lender and that are consistent with customary commercial lending practices are not prohibited.”

8. “Customary” type services (typically performed in connection with maintenance and repair of the property), including cleaning of public areas and the furnishing of heat and light, can be provided to the tenant by the co-owners or their agents. The revenue procedure states that activities will be treated as “customary” if the activities would qualify as rent under 512(b)(3)(A). This would include heat, air conditioning, trash removal, unattended parking, and maintenance of public areas.

9. No business type activities can be conducted with respect to the property. For this purpose, all activities of the co-owners, their agents and any person related to the co-owners “with respect to the property” will be taken into account and attributed to the other co-owners, except to the extent that a particular co-owner holds his interest for less than six months.

10. Management agreements must be renewable no less frequently than annually. F. IRC Section 1031 Under IRC 1031, no gain or loss shall be recognized on the exchange of property for productive use in a trade or business of for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. However, this tax avoidance principle does not apply to interests in a partnership. VII. VALUATION A. Joint Tenancy - Young

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The court in Young held that section 2040 is not concerned with quantifying the value of the fractional interest held by the decedent (as would be the case under section 2033). The fractional interest discount, as applied in section 2033, is based on the notion that the interest is worth less than its proportionate share, due in part to the problems of concurrent ownership. These problems are created by the unity of interest and unity of possession. However, at the moment of death, the co-ownership in joint tenancy is severed, thus alleviating the problems associated with co-ownership. Therefore, joint tenancy property is not entitled to a fractional interest discount. B. Real Property Tenants-In-Common 1. Fractional Interest Valuation Cases. a. Propstra. In Propstra, 680 F.2d 1248 (9th Cir. 1982), the court applied a 15% discount on residential property owned as community property. Note IRS argued that discount should limited to cost of partition (which the court found inappropriate) and taxpayer only asked for 15%. b. Brocato. In Brocato, T.C. Memo 1999-424, the court applied a 20% fractional interest discount applicable to 8 apartment buildings. Taxpayer’s expert provided eight comparable sales of fractional interests. Court found this more appropriate measure than the limited analysis of the IRS's expert that based the fractional discounts on the costs to partition the properties. Note the Tax Court concluded an 11% blockage discounts was appropriate in addition to the fractional interest discount. c. Busch. In Busch, T.C. Memo 2003-3, the court applied a 10% fractional interest discount was found to apply to unimproved land the Tax Court believed would be sold to a housing developer because none of the owners were interested in farming the land. The Tax Court rejected Petitioner’s asserted 40% percent discount. See the discussion of the Busch case herein where voters would not allow the property to be developed. d. Stevens. In Stevens, T.C. Memo 2000-53, the court applied a 25% fractional interest discount applied to fractional interests in leased commercial properties. Cost to partition was not used because that approach does not account for the factors of control and marketability.

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e. Baird. In Baird, T.C. Memo 2001-258, the court applied a 60% fractional interest discount applied to fractional interests in timberland. Note that the IRS maintained the cost of partition analysis and Petitioner was awarded attorney’s fees. See Baird v. Commissioner, 416 F3d 442 (5th Cir. 2005), rev’g T.C. Memo. 2002-299. f. Youle. In Youle, T.C. Memo 1989-138, the taxpayer’s claim to a 12.5% fractional interest discount was upheld. Appraiser for taxpayer discussed the difficulties associated with tenancy in common as well as the difficulty and undesirability of partition the underlying property. Furthermore, the appraiser pointed out that a 12.5% sum was rather small given that difficulties found in similar cases often warranted a 20-25% discount. The Service countered that a partition was a simple process, but provided no expert testimony. g. Pillsbury. In Pillsbury, T.C. Memo 1992-425, the taxpayer’s claim to a 15% fractional interest discount was upheld. Here, a marital trust owned an undivided 77 percent interest in residential real property with the remaining 23 percent interest being held by the trustee of the same trust for the benefit of the children of the decedent’s spouse. The trustee of the trust for the benefit of the decedent and the trustee for the benefit of the children were the same bank. The estate’s expert provided evidence that a discount was warranted due to a lack of general control, a lack of marketability, illiquidity, and potential partitioning expenses. When the taxpayer asked for a 15% discount, the Service countered that a discount was inappropriate because the same trustee bank held all of the property. The court, however, dismissed this argument, saying that this “unity of ownership argument” is inconsequential in a “willing buyer-seller” analysis. h. LeFrak. In LeFrak, T.C. Memo 1993-487, the taxpayer’s claim to a 30% total discount was upheld. Taxpayer gifted interests in income producing property to his children and trusts for their benefit, but argued that such gifts should be discounted because they were minority interests and thus not readily marketable. The Service contended that discounts were not appropriate because the donor and donees were all members of the same family; however, the Tax Court rejected this argument, stating that the donees’ family ties should not preclude the allowance of a minority discount when dissension and discontent could alienate them from one another at any time. As such, the court granted a 20 percent discount for minority and a 10 percent discount for lack of marketability. i. Estate of Cervin. In Estate of Cervin, T.C. 1994-550, the taxpayer’s claim to a 25% discount was reduced to 20% by the court. Decedent owned an undivided 50 percent interest in a farm and an

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undivided 50 interest in a homestead. His son and daughter owned the rest. While the Estate argued that petitioning was impossible and a 25 percent discount as warranted, the Service contended that the costs of partitioning would only result in a 6.54 percent discount for the farm and an 8.20 percent discount for the homestead. Though the court refused to value the property as a whole, it permitted a discount of 20% based on what it saw as the substantial costs of a hypothetical partitioning. j. Estate of Williams. In Estate of Williams, the taxpayer’s claim to a 44% discount was upheld. Decedent owned undeveloped rural timberland and farmland, a one-half interest of which was transferred to the petitioner in this case. Petitioner showed that banks would not provide loans to the owner of a fractional interest in real property without the consent of the other owner, and petitioner’s expert stated that fractional interest in the property were not marketable and no comparable sales could be identified; as such, a 44 percent discount was justified. The Service contended that because the property had many potential uses and the petitioner had not shown evidence of actual sales of fractional interests in real property, only a 5 percent discount was warranted. Siding with the petitioner, the court was persuaded that the inability to present evidence of sales adduced the conclusion that there was no market for fractional interests in such property, thus necessitating the discount. k. Estate of Forbes. In Estate of Forbes, T.C. Memo 2001-72, the court sided with one of taxpayer’s two experts who called for a 30% discount. Decedent’s husband owned property held in a limited partnership and placed in a QTIP trust for the benefit of the decedent during her lifetime. The taxpayer’s first expert used, in the eyes of the court, faulty reasoning and did not fully articulate the present value calculations. However, the taxpayer’s second expert persuasively argued that a 30 percent discount was appropriate given the minority interests of the parties and that the corresponding market for such interests would shrink given the limited pool of potential buyers, the difficulty in finding financing, and the costs of partitioning the parcels. The Service’s expert tried to use a comparable sales approach, but after such “comparables” indicated discounts ranging from 25 to 64 percent, the Service without explanation concluded that a 19 percent discount was appropriate. Ignoring the Service’s approach, the court stated the taxpayer’s second expert was reasonably justified given the properties’ specific characteristics, the possible familial conflicts that would make a hypothetical sale more problematic, and other factors regarding marketability. l. Ludwick. In Ludwick, T.C. Memo 2010-104, the court dismissed the arguments of both experts, yielding a discount of 10%. Favoring the cost-to-partition approach, the judge asked the following question: “Why would a buyer of an undivided interest in a piece of property consider the interest worth any less than a proportional share of the fair market value of

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the whole property reduced by partition costs?” While both experts agreed that the lack of marketability of the interest, as well as the illiquidity resulting from the risk, uncertainty, and time lapse of the partition process were clearly relevant and required consideration, the two side’s experts differed sharply in the corresponding discount from the fair market value. The taxpayer’s expert foresaw a partition time frame of 2-3 years, $10K in appraisal costs, and $70K in litigation costs, whereas the Service’s expert painted no timeframe but listed only the “judicial costs”, including $10K for filing fees, 4-6% broker fees, and 1% closing costs. Rejecting both analyses, the judge used his own inputs. To the judge, if the partition was contested, it would take two years, but if not, it would only take one year to partition the property. Further, the judge decided on litigation costs equal to $72,500, selling costs of 6 percent, operating costs of $350,000, a growth rate for the property of 3 percent, and a discount rate for the present value of calculation of 10 percent. 2. Service Rulings a. PLR 9336002 The Service held that in valuing an undivided interest in property, a party should be allowed a discount only to the extent of the costs incurred in partitioning the property. In looking at the definition of fair market value, the Service noted that it required a hypothetical buyer and seller to act in their “own best economic interests.” It then pointed out two instances in which courts have pointed to the alternative of partitioning as resulting in a greater economic benefit to the holder of an undivided interest. See Estate of Frank Fittl v. Commissioner, T.C. Memo 1986-542 (1986) and Kennedy v. Commissioner, 804 F.2d 1332 (7th Cir. 1986). b. TAM 199943003 The Service found that the fair market value of a party’s undivided interests in real property is the price at which the property would change hands between a willing buyer and a willing seller with neither party being under any compulsion to buy or sell, and with both having reasonable knowledge of all relevant facts. Looking once more at Fittl, supra, the Service noted that an accurate way to deduce the fair market value of an undivided interest was to subtract the costs to partition the property (specifically those proportionally allocable to the interest itself) from the undiscounted fair market value of that party’s particular interest. 3. Valuation Approaches a. Fractional Interest Discounts. For both gift and estate tax cases, fractional interest discounts have attracted close IRS scrutiny. IRS commonly asserts the fractional interest discounts are limited to costs of partition. See PLR 9336002 and TAM 199943003.

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Fractional interest discounts still generate a lot of controversy. In most cases, fractional interest discounts are applicable to real estate holdings. Propstra, 680 F.2d 1248 (9th Cir. 1982), in the Ninth Circuit, and many other cases make this a certainty. The amount of applicable discount is a facts and circumstances test applied in each case, not one size fits all! i. Cost of Partition The IRS often argues that a fractional interest discount should be limited to costs of partition. An important consideration here is the value of the property as it relates to the costs of partition. With a low-value property, the costs of partition could be tremendous in relation to the value of the property, yielding a very high discount. With a high value property, costs of partition in relation to the value of the property could be minor, perhaps 3% or less. ii. What is the Fractional Interest Discount? A fractional interest discount is made up of lack of control and lack of marketability factors. Typically, a single discount is determined by appraisal to reflect both of these factors. Each property will have a different factual background enhancing or reducing each factor. x. Lack of Control In a co-tenancy relationship, no one co-tenant has control. For example if the property is to be leased, all tenants must approve the lease (otherwise the prospective tenant would not obtain exclusive use and possession of the property). If one small owner does not agree, then no owner is making money. For these and other reasons, many practitioners and appraisers believe a lack of control discount is warranted. xx. Lack of Marketability There is no ready market for fractional interests in real estate. As a result, generating liquidity can take some time, more time than a 100% interest in the same real estate. Further, lenders typically will not secure loans with fractional interests in real estate. Thus, in the case of larger interests (by value) financing is unavailable, thereby shrinking the pool of possible buyers (and buyers know that if they later need to sell, they will be hard pressed to find another buyer). A right to partition is not liquidity. A hypothetical buyer does not buy a fractional interest to file a lawsuit to partition. Reasonable people first try to work things out, which adds to delay. Further, courts often grant extensions and other delays in court proceedings. If the property is located in a falling real estate market, what is the cost then? Some real estate markets fell 40% or more during the recent economic recession. What a market will do over the next 6 months to 2 years cannot be known, and thus a significant discount is warranted.

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b. Co-Tenancy Interests: Current Thinking on the Valuation and Use in Estate Planning. The following discussion details some of the more common methods used to derive the fractional interest discount. i. Undivided Interest Studies The most obvious source for co-tenancy valuation data is the small group of co-tenancy discount studies that have been published over the years. While the studies are the most on-point data source for valuation information, it’s important to conduct a thorough comparative analysis between the subject interest and the types of undivided interests that are included in each study. For example, if the subject interest is a cash-flowing rental apartment complex, it may not be directly comparable to studies focusing on undeveloped land assets. It’s imperative that the appraisal report shows the proper nexus between the comparables used in its analysis and the subject interest. Unfortunately, it’s easy to simply apply central tendencies from these studies without truly understanding the applicability to the subject interest. ii. Partition Analysis If partition is a viable path for the interest holder to achieve liquidity, the valuation professional must look at the cost and time required to go through a partition action. This analysis is set up as an income approach, in which the estimated future value of the real estate at the completion of the partition action is valued together with interim cash flows. Interim cash flows include any net income generated during the time from the date of valuation through the conclusion of the partition action, as well as all costs associated with the partition action. The discount rate should, at a minimum, be the real estate capitalization rate plus the long-term rate of appreciation in real estate value. However, there is theoretical support for using a higher rate to reflect the minority features of a co-tenant. iii. Partnership Studies Assuming there is a co-tenancy agreement in place in which the co-tenants waive the right to partition, a good case can be made for using LP transactions as a proxy for the valuation discounts. When developing discounts based on LP transactions, a thorough comparison should be made between a typical traded LP interest and the subject co-tenancy interest. Neither type of interest affords the holder control over the underlying assets. A limited partner has even less control than a co-tenant. On the other hand, while a limited partner has limited liability, a co-tenant has unlimited liability and is often jointly and severally obligated for any debt held by the co-tenancy. Based on the comparison, appropriate adjustments to the indicated discount should be made.

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iv. Minority Premium Method An IRS engineer presented this new methodology in 2011. With this methodology, the appraiser assumes a majority holder would pay a minority owner a premium to buy out his or her interest. IRS has applied this methodology in certain cases at exam, but is it untested in the courts. There are legal issues inherent in this method when applied in the context of the tax valuation hypothetical willing buyer and willing seller. As discussed above, the actual owners must be considered, not hypothetical owners. If all owners say they would not pay any premium, the method could not be used. Further, assuming what a hypothetical person would do is legally impermissible (see Mitchell, and the rejected lease buy-out). These and other valuation and legal aspects have most appraisers rejecting the approach. 4. Summary of Case Discount Results & Accepted Methodologies (Discount Focus) The following is a more detailed discussion of methodologies used in select cases. The purpose of the following discussion is to provide the reader with a flavor of how the courts have applied and discussed various methodologies to derive the fractional interest discount. Universally, the courts found: (i) the cost of partition is not the only factor to consider; (ii) the facts of each case drive the analysis; and (iii) ultimately the court will apply its judgment to determine the appropriate discount. That the court will apply its judgment to the facts of a subject case, and not apply a formula or discounts from prior cases, highlights the risks of taking valuation cases to trial. a. Propstra. In Propstra, infra, the court started its analysis by noting that upon requesting summary judgment, the estate submitted affidavits from two qualified appraisers. Their testimony showed that the value of an undivided, fractional interest in real property would be less than a proportionate share of the fair market value of the whole. One appraiser estimated the value of the interest in question at $1,639,500; the other made no specific estimate. The Government submitted no countervailing facts regarding the value of the undivided one-half interest in the parcels. Instead, IRS argued that, although it failed to tender any evidence that raised a genuine issue of fact, the estate failed to meet its burden of proof. Specifically, the Government contended that, not only must the estate prove the value of the interest if sold separately, but it must also prove that the interests in question were likely to be sold apart from the other undivided one-half interest in the property. The Government argued that, in the absence of such a showing, one can reasonably assume that the interest held by the estate will ultimately be sold with the other undivided interest and that interest's proportionate share of the market value of the whole will thereby be realized. After considering the language of sections 2031 and 2033 of the Internal Revenue Code of 1954 (I.R.C.) and their accompanying regulations, the Court was unwilling to impute to Congress an intent to have “unity of ownership” principles apply to property

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valuations for estate tax purposes. To the court, sections 2031 and 2033 provide that the value of a decedent's gross estate shall include the value of all property to the extent of his interest therein at the time of his death. Treas. Reg. Section 20.2031-1(b) defines “value” for the purposes of Sections 2031 and 2033 as “fair market value at the time of decedent's death.” It then defines “fair market value” as “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 sell and both having reasonable knowledge of relevant facts.” By no means, in the eyes of the court, is this language an explicit directive from Congress to apply unity of ownership principles to estate valuations. In comparison, Congress has made explicit its desire to have unity of ownership or family attribution principles apply in other areas of the federal tax law. See, e.g., I.R.C. Sections 267, 318, and 544. In the absence of similarly explicit directives in the estate tax area, the court decided to not apply these principles when computing the value of assets in the decedent's estate. Furthermore, the court saw good reason to consider the “willing seller” mentioned in Treas. Reg. Section 20.2031-1(b) as a hypothetical seller rather than the estate or any of decedent's beneficiaries. Defining fair market value with reference to hypothetical willing-buyers and willing-sellers provides an objective standard by which to measure value. The use of an objective standard avoids the uncertainties that would otherwise be inherent if valuation methods attempted to account for the likelihood that estates, legatees, or heirs would sell their interests together with others who hold undivided interests in the property. Executors will not have to make delicate inquiries into the feelings, attitudes, and anticipated behavior of those holding undivided interests in the property in question. b. Brocato. The petitioner’s appraiser examined eight comparable sales of fractional interests and the fractional interest discounts applied in each sale. In three of the comparable sales, no fractional interest discount was applied because the buyer was acquiring a controlling interest with the purchase of the fractional interest. However, in four others, there were fractional interests ranging from approximately 1 to 20 percent with discounts ranging from 6 to 50 percent. The appraiser adjusted three of the comparables downward and one upward to arrive at a 20–percent fractional interest discount. In making these adjustments, the appraiser examined the size of the comparable interests, lack of a market for the interests, special circumstances surrounding their sale, and whether there was a forced sale. The parties' arguments center upon the correct method for determining a fractional interest discount. Courts have often looked at costs to partition in determining an appropriate fractional interest discount. Courts, however, consider other factors, such as the historical difficulty in selling these interests and lack of control. See Estate of Pillsbury v. Commissioner, T.C. Memo.1992–425. As compared with the limited scope of the other appraiser, the court found the petitioner’s appraiser to be more persuasive in determining the fractional interest discount.

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c. Busch. Hulberg, petitioner’s first appraiser, used four different approaches to arrive at the amount of discount he used to account for decedent's partial interest. First, he discussed a “Company Survey Method”, which Hulberg described as a “survey of companies in the business of purchasing and selling partnerships.” The court’s review of Hulberg's analysis indicated that the partnerships involved were dissimilar to the Busch property situation. The information was derived from the purchase and sale of general partnership interests, a format different from the Busch property ownership, which was simply a coownership in real property with no partnership business or operational type activity. Accordingly, the discount percentages represented by that type of transaction are inapposite. Next, Hulberg called upon the “Fractional Discounting Method”. That method was set out in an April 1992 journal article, Davidson, “Fractional Interests in Real Estate Limited Partnerships, The Appraisal Journal, Apr. 1992, at 184–194, in which 10 factors were used to analyze the amount of a fractional interest discount. The factors employed, include: “Relative risk of the assets held, Historical consistency of distributions, Condition of the assets, Market's growth potential, Portfolio diversification, Strength of management.” Those factors, to which Hulberg assigned values to arrive at an estimated 41–percent discount, appear to be the type of factors that are used in analyzing a going partnership business and not the simple coownership of raw land. The remaining four factors address the control aspects, or lack thereof, of a fractional or partial interest. Of the cumulative 41–percent discount reached by Hulberg, only 12 percent of it was attributable to the lack of marketability/control factors. The remaining factors depended heavily on the fact that the entity was a going partnership (income sources, etc.) and would, therefore, not be applicable to measure the partial interest discount in this case. Then, Hulberg used a “REIT Survey Method” that “involves an analysis of discounts found in real estate investment trust (REIT's).” Hulberg indicated that the average discount was 39 percent with a range from 30 percent to 40 percent. Here, again, Hulberg's explanation reflected that REIT's are operating real estate entities that are dissimilar from the simple coownership of realty that we consider. The REIT is an entity in which investors purchase a percentage as an investor in the activity or business operation in which the REIT is involved. Accordingly, the REIT-based approach to calculate a discount is not appropriate. Finally, Hulberg referred to his four proposed comparable sales that he admits “are not highly similar to the subject property but they do indicate discounts are being taken by the [purchasers] of * * * fractional interests, and that there is a market for partial interests in a property.” The range of discounts was 29 percent to 41 percent. The sales selected by Hulberg included a produce terminal, undeveloped unapproved land, an office building, and ranchland. The undeveloped unapproved land was described as “Standard Oil Pond Grizzly Island (Solano Co.)”, and Hulberg explained that the property was valued at $800,000 for a fee and a 25–percent interest was sold for $130,000. No further information is provided, and it is not apparent that this property is comparable or how the

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$800,000 and $130,000 values relate to each other. Accordingly, the court found none of these examples to be helpful. Hulberg then proceeded to conclude that the various referenced approaches resulted in discounts approximating 40 percent and that 40 percent is therefore appropriate. Hulberg, in addition to addressing the lack of approval for residential development, factored in the lapse of time in arriving at a 40–percent discount rate. The court did not find any of Hulberg's approaches to be fitting or appropriate, though the court did admit that some discount would be appropriate. In summary, Hulberg first discounted by as much as 80 percent, and then discounted the resulting amount by an additional 41 percent reflecting various factors, including lack of control, passage of time, and factors that would only be relevant in the consideration of a going partnership. On the other hand, DeVoe, petitioner's appraiser who was used to provide a value for the estate tax return, started with a $137,500–per–acre value and discounted it by 40 percent to account for the partial interest. That approach resulted in a $3,810,000 value being reported on the estate tax return. The court concluded that the per acre cash value is $150,000 and discounted that amount to account for the passage of time and, to some extent, for the risk associated with the possibility that approval for development might not be obtained. That discount resulted in reducing the value of decedent's one-half interest from $6,805,500 ($150,000 x 90.74 x .50) to $4,656,496 (see present value computations, supra, p. 28) or a reduction of 31.6 percent. Based on the court’s evaluation of the evidence, it appeared to the court that DeVoe's valuation appraisal was conservatively performed favoring decedent's estate. The court reached that conclusion because he used a per acre value at the lower ranges of the true comparables and a discount rate at the highest end of the spectrum when considering the facts in our record. According to the court, a smaller partial interest discount than used by petitioner's appraisers would be appropriate in the circumstances of the case. As already noted, as of decedent's death, there were no owners or potential owners who, like decedent and his deceased brother/co-owner were solely interested in farming the land. The heirs of both owners were interested in selling or developing the land in light of the substantial difference in its value for that use. At the date of decedent's death, his co-owner was a trust for a 97–year–old woman, and there was no doubt that the highest value of the land was as residential property. Under these circumstances a 10–percent discount would be sufficient to account for the partial interest represented by a simple coownership in unimproved land. As already discussed, 10 percent would also be more than adequate to accommodate reasonable costs of partition (10 percent of the rounded one-half interest ($4,660,000) or $466,000) in the event that either set of heirs of the then-current co-owners might not be interested in selling the property for its highest and best use (residential development). As such, the court found that the fair market value of decedent's one-half interest in the Busch property at his date of death is $4,190,496 ($9,312,992 x .50 = $4,656,496—$466,000 = $4,190,496).

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d. Stevens. Hulberg, the same appraiser from Busch, used the same appraisal methods as in Busch: the “Company Survey Method,” the “Fractional Discount Method,” and the “Comparable Sales Method.” Considering the parties' experts' reports and opinions, the court found that the appropriate discount amount should be neither as low nor as high as those suggested. The court saw a 25–percent discount as appropriate for all three of the properties. To the court, this figure was supported by the factor analysis for fractional interests, which gave them a figure between 25 percent and 27 percent. The court did not limit the discount to the costs of partitioning because such a discount does not account for the factors of control and marketability in the circumstances of the case. An interest in income-producing, improved real property without control and in a closely held family property may be difficult to sell. e. Baird. The court began by noting that the evidence, experts' reports, and other testimony reflect that the market for partial interests was extremely limited. One of petitioners' experts reflected that partition under the facts of these cases would have been difficult, protracted, and expensive. The court then noted that while it may have been appropriate to consider the amounts of discounts decided by courts in prior cases, those discounts were not intended as minimum or maximum limits for certain types of discounts. The amount of discount in each case must be determined ad hoc, and the facts in each case must provide the basis for the proper amount of discount. The facts in a case, along with the court’s understanding of the actual marketplace, must drive the analysis. After considering the record and the experts' reports and testimony, the court held that the estates have established 55 percent as a mean and/or average amount by which fractional interests in Louisiana timberland which do not result in control are discounted. The court was also convinced that the peculiar circumstances shown to exist with respect to the decedents' remaining family members support an increased discount. The court noted how it placed reliance in the appraiser’s expertise and actual practical experience. His report and testimony were based on his personal knowledge and experience in the very marketplace under consideration. Mr. Steele's “at least 55–percent discount” in his written report comported with the other experts' findings and conclusions. However, the appraiser’s trial testimony suggesting a 90–percent discount, however, was unfounded and without support in the record. The court could not accept that a willing seller would accept 10 cents on the dollar for a partial interest in timberland, and no such comparables were shown to exist. 5. Comment on Appraisal Methods. IRS is attacking the appraisal methodology used by appraisers. The goal appears to be to

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discredit all approaches so we are left with cost to partition. In several recent cases, IRS asserted real estate partnership data is not appropriate to determine the fractional interest discount. The case cited for this proposition is Busch, infra. A careful reading of Busch reveals no such conclusion. In Busch, the Tax Court analyzed the approach for determining fractional discounts that relies upon real estate limited partnerships. The methodology looked at 10 factors, 6 of which the Tax Court found inappropriate to co-ownership of property because they depended heavily on the entity as a going partnership (income sources, etc.). The other 4 factors dealt with lack of marketability/control factors and yielded a discount of 12 percent according to Petitioner’s expert. The court did not say the method could not be used, only that its application in this case was not appropriate. Petitioner’s expert also looked at real estate investment trust (REIT's) data and the Tax Court found that REITs are not similar to simple co-ownership and accordingly, the REIT-based approach to calculate a discount was not appropriate. Note the Busch case was a Judge Gerber opinion. The Stevens, infra, case, also a Judge Gerber opinion released in year 2000 relied upon the “factor analysis” which was used by Petitioner’s expert. Judge Gerber did not find the real estate partnership data unreliable. Actual sales data is the best evidence of the fractional interest discount. However, in many cases that data is not available due to geographic region or reasonably close time period to the valuation date. In one case, IRS asserted the comparable sales were not comparable due to geographic location and instead wanted to rely upon a Florida law partition analysis to determine the cost of partition in California! Talk about picking and choosing. C. Approaches in the Valuation of Artwork Held as Tenants-In-Common Valuing fractional interests in tangible personal property poses unique questions and problems. There are very few cases in this arena and the law will continue to develop over time. As discussed below, the type of appraiser is an important consideration. In light of Elkins, infra, the identity of the other co-owners perhaps is more important (or perhaps the analysis an attempt to re-introduce concepts of family attribution). The law in this area will continue developing as taxpayers learn how to address the appraisal mistakes made in prior cases. An important tenant of valuation is to use an appraiser with knowledge and skill in valuing the type of property being valued. This is confirmed by Federal Rule of Evidence 702, which provides as follows: “A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if: (a) the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue; (b) the testimony is based on sufficient facts or data; (c) the testimony is the product of reliable principles and methods; and (d) the expert has reliably applied the principles and methods to the facts of the case.”

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Thus, the appraiser must have knowledge, skill, and experience valuing the type of property being valued. This includes, of course, the type of business being valued. If valuing a plumbing company, an appraiser with knowledge, skill, and experience in valuing plumbing companies should be retained. There is a lingering question regarding who should value fractional interests in real estate. Should it be a business appraiser or a real estate appraiser? There are arguments that support both. Fractional interests in tangible personal property are another matter entirely. Sales of fractional interests in tangible personal property are hard to come by. Further, very few people have experience valuing such interests. Business appraisers, while perhaps appropriate for valuation fractional interests in real property, may not be best suited for valuing fractional interests in tangible personal property. While this is not to say that no business appraiser could do the work, only such an appraiser with the appropriate knowledge, skill, experience, training, or education in this area should be retained. The following discussion reviews some of the approaches used by taxpayers in the few cases in this arena. 1. The Business Appraiser. In Stone v. United States, No. C06-0259, (No. Dist. Ca., 5/25/2007), the taxpayer retained a business appraiser to value fractional interests in artwork. The decedent owned a 50% interest in 19 expensive paintings. At trial the business appraiser admitted he could find no data regarding sales of undivided interests in art. As a result, he based his valuation (and the contended corresponding discount) of the Estate’s interest in the collection in part on sales data for undivided interests in real estate and limited partnerships holding real property. The court rejected this approach finding that the art market differs markedly from the real estate or business market. Namely, the court noted, art is simply not fungible, and found troubling the lack of evidence that sales of partial interests in artwork have been sold at a discount. As such, the court instead concluded that a hypothetical willing seller of an undivided fractional interest in art would likely seek to sell the entire work of art and split the proceeds, rather than seeking to sell his or her fractional interest at a discount. According to the court, at a minimum, “because an undivided interest holder has the right to partition, a hypothetical seller under no compulsion to sell would not accept any less for his or her undivided interest than could be obtained by splitting proceeds in this manner.” Thus, the court found that the discount “floor” in this context is the cost to partition. The court next considered costs of actually selling artwork, such as “commissions and sales” fees inherent in the process by which artwork is sold. The court also considered uncertainties involved in waiting to sell the art until after the partition action is resolved. In the Stone case, the court found that such considerations resulted in a 5% fractional interest discount, of which 2% was attributed to the costs to partition and the

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uncertainties involved in waiting to sell after the resolution of the hypothetical partition action. As with any case, the results are heavily driven by the evidence presented. Valuation cases are heavily driven by what the appraiser can bring to the table. The question from Stone is whether an art appraiser would have been more persuasive to the court. Of course the answer to that question is based, at least in part, on what the art appraiser could have brought to the table. 2. The Multi-Appraiser Approach. Using multiple appraisers can alleviate uncertainties inherent in valuation cases. Costs are always a concern, but in larger valuation cases (and cases involving more difficult valuation questions) the additional costs are justifiable. The taxpayer in Elkins, 767 F.3d 443 (5th Cir. 2014), aff’g in part and rev’g in part 140 T.C. 86, brought three experts to court to prove its case regarding fractional interests in 64 pieces of artwork includible in the decedent’s gross estate for estate tax purposes. Each expert had a different background and philosophy with regard to valuing fractional interests in artwork. a. Appraiser and Seller of Fine Art (Mr. Nash) Mr. Nash supported a deep discount, summarizing “key factors” which made the decedent’s fractional interests “unappealing” to potential buyers: i. the inability to sell the art at auction houses; ii. the lack of exclusive possession and the inability to force a sale of the art without litigation against the Elkins children as co-owners; iii. possible litigation involving time of possession and proper care, storage, or transportation of the art; iv. the difficulty or impossibility of insuring the purchased interest or using it as collateral for a loan. b. Property Lawyer (Mr. Miller) According to Mr. Miller, while the right to partition is absolute, cotenants may expressly or impliedly agree not to partition. Even if the cotenants so agree, however, such an agreement is not enforceable forever, and eventually a party will be able to bring suit to partition an interest from the whole. When that party does so, Mr. Miller noted, any partition action with respect to any single piece of art would start with a trial to determine (1) the enforceability of the cotenants’ agreement, (2) whether partition by sale or in kind is appropriate, (3) the co-owners’ interests, (4) whether the art is susceptible to partition, and (5) whether to appoint a

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receiver for any sale of the art. Then, a second trail would be held to determine (1) the terms of any proposed sale, (2) the property to be sold, (3) the method of sale, and (4) the distribution of proceeds among the co-owners. c. Valuation Consultant (Mr. Mitchell) Mr. Mitchell started with the proposition that there are two options for the holder of an undivided interest in art to monetize his holding (absent unanimous consent of all undivided interest holders): Option 1: A sale of his undivided interest. In this scenario, the holder and the hypothetical willing buyer would consider a number of adverse factors in arriving at a price for the holder’s undivided interest subject to an amended cotenant’s agreement. These include the following: i. the need to obtain unanimous consent of all cotenants to sell the work of art ii. limited possession of the art and, hence, reduced psychic benefit iii. the cost of transporting the art from another cotenant iv. joint responsibility for the insurance, maintenance, or restoration costs with respect to the work of art, and v. risk of damage to the art by other cotenants Together, all of these would induce a prospective collector-buyer to demand a substantial return premium (discount) related to the reduction of both the buyer’s psychic and financial returns attributable to fractional ownership. Given this enhanced return premium, there would necessarily entail a substantial reduction in value from the pro rata fair market value. Option 2: A successful partition action ultimately leading to a sale of the work and pro rata distribution of the proceeds among all interest holders. In this scenario, the dollar amount of any discount must exceed the anticipated partition litigation costs to make the investment worthwhile. Because a partition action would most likely provide a strictly financial outcome (share of proceeds of a court-ordered sale of the art), the buyer will have abandoned any psychic benefit and, therefore, is necessarily a speculator and not a collector. d. Court’s Holding The court held that there was no bar, as a matter of law, to an appropriate fractional interest discount. However, a hypothetical willing buyer and seller of decedent’s interests would agree upon a price at or fairly close to the pro rata fair market value of those interests. Given the circumstances of the case, the court held that a hypothetical buyer and seller of all or a portion of decedent’s interests would agree to a 10% discount from the pro rata fair market value in arriving at a purchase price for those interests. Such a

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10% figure, in the eyes of the court, would assure a hypothetical buyer a reasonable profit on a resale of those interests to the Elkins children.

e. Appeal to the Fifth Circuit

On Appeal to the Fifth Circuit Court of Appeals, IRS continued to assert that no discount should apply because there is no market in fractional interests in art. In fact, at trial the only expert IRS brought was one that testified as much. IRS took an aggressive position and did not have support in the event its position was thrown out. IRS’ position was founded on Treas. Reg. Section 20.2031-1, which states in relevant part as follows: “The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.” IRS took the opposite of the multi-appraiser approach. The Fifth Circuit affirmed the Tax Court’s rejection of IRS’s argument that no fractional interest discount should apply and affirmed the Tax Court’s conclusion that some level of discount is warranted.

The Fifth Circuit then looked into how the Tax Court arrived at the 10% discount. IRS failed to provide any evidence as to the “quantum” of the discount. Only taxpayer provided such evidence. As a result, the burden of proof shifted to IRS. Since IRS chose not to produce any evidence whatsoever as to the quantum of the discount, the case should have ended at that point in favor of the taxpayer. Instead, the Tax Court made a mistake in concluding a nominal 10% discount applied and found the Tax Court’s conclusion constitutes reversible error under “any standard of review.” The Fifth Circuit held that “the correct quantums of the fractional-ownership discounts applicable to the [taxpayer’s] pro rata share of the stipulated FMVs of the various works of art are those determined by the [taxpayer’s] experts.” The result is an approximate 45% fractional interest discount on artwork! 3. Art Appraiser’s Point of View. When seeking a business appraiser, many practitioners are looking for the appraiser to have an “ASA” designation from the American Society of Appraisers. The ASA designation is available for many other categories of appraisal work, including personal property. In fact, there are twenty-six (26) specialties from fine arts to oriental rugs to Numismatics to fine wine. Thus, when looking for an appraiser it is advisable to look into appraisal specialties to make the best match between property and appraiser. When considering fractional interests in artwork, there are many ASA designated art appraisers. Further, there is at least one who has written on fractional interests in art work. Elin Lake-Ewald, President of O’Toole-Ewald Art Associates, Inc. and an esteemed appraiser of art, was approached in the mid-90’s for her input on how to value a fractional interest in artwork. Though analyzed through a case-specific lens, Ms. Lake-

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Ewald cites the following factors in choosing to apply a substantial fractional interest discount in artwork: a. There is no control over the sale or date of sale; b. There is no control as to the marketing of the paintings; c. There is no identifiable market for partial interests in paintings; d. There is limited value in utilizing the fractional interest as collateral because of illiquidity; e. There may be restrictions placed on transferring the interest; f. The fractional interest does not include the entire bundle of rights associated with 100% ownership; g. The potential purchaser of the fractional interest would be the single non-family member in an association of owners; h. Because only two works of art are involved, there is little opportunity for risk-spreading; i. The condition of the paintings in question mitigates against an easily facilitated sale; j. The volatility of the art market, in particular at the date of valuation, leads to the assumption that the process of attempting to reach agreement among a group of co-owners as to the most advantageous sale date would likely prolong the disposal of the art-works. For more information, see the article, entitled Viewpoint: Determining the Fair Market Value of Fractional Interests in Works of Article, Elin Lake-Ewald. VIII. SPECIAL VALUATION ISSUES A. Valuation Standard and Legal Concepts. 1. Generally. Valuation pervades the United States tax law, involving income tax, transfer tax, and other taxes. The focus of this outline is on transfer tax; however, many of the principles equally apply in the other tax arenas. In 2005, an important analysis of valuation issues in taxation was published, titled Business Valuation and Taxes: Procedure, Law, and Perspective, co-authored by Tax Court Judge David Laro and valuation pioneer Shannon Pratt. At page nine of this work, a keynote summary was provided regarding valuation:

"Determining Fair Market Value Today. Today, determination of fair market value is an inquiry in which the trier of fact must weigh all relevant evidence of value and draw appropriate inferences. An arms-length sale of property close to a valuation date is indicative of its fair market value. If actual arms-length sales are

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not available, fair market value represents the price that a hypothetical willing buyer would pay a hypothetical willing seller, both persons having reasonable knowledge of all relevant facts, with neither person compelled to buy or sell."

Further, the work states:

"The views of both hypothetical persons must be taken into account, and the characteristics of each hypothetical person may differ from the personal characteristics of the actual seller or a particular buyer. Focusing too much on the view of one hypothetical person to the neglect of the view of the other is contrary to a determination of fair market value."

In Estate of Auker v. Commissioner, T.C. Memo. 1998-185, Judge Laro stated:

"We cannot realistically expect that litigants will, will be able to, or will want to, settle, rather than litigate, their valuation controversies if the law relating to valuation is vague or unclear. We must provide guidance on the manner in which we resolve valuation issues so as to provide a roadmap by which the Commissioner, taxpayers, and valuation practitioners can comprehend the rules applicable thereto and use these rules to resolve their differences."

One wonders whether the judicial pronouncements on valuation since 1998 have met this goal of guidance to practitioners and their clients. 2. Standard of Value. For gift, estate, and generation-skipping transfer tax purposes, the concept of “fair market value” is pervasive, due to the fact that the Federal transfer tax is an excise tax, i.e. upon the transfer of property by inter-vivos gift or at death without adequate consideration in money or money’s worth. So a “transfer” is needed, and once that is found, valuation principles and standards are applied. For publicly traded assets, value is determined in reference to the public market. For example, the fair market value per share or bond traded on the public market is generally calculated by taking “the mean between the highest and lowest quoted selling prices on the valuation date.” Treas. Regs. § 20.2031-2(b)(1). Examples of other property generally sold to the public at retail may be found in Treasury Regulations sections 20.2031-6 and 20.2031-8. If there is no public market or the asset is not sold at retail, then the best evidence of value will be actual arm’s-length sales at or near the valuation date. Andrews v. Commissioner, 79 T.C. 938 (1982). See Scanlan, where the Tax Court considered actual sale three years after valuation date. Also see Busch (discussed in more detail below) and Estate of Noble, T.C. Memo. 2005-2, for similar actual sales.

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If there is no public market or the asset is not sold at retail and there are no actual sales at or near the valuation date, then value is determined by the hypothetical “willing buyer-willing seller” standard of value. See Treas. Regs. §§ 20.2031-1(b) and 25.2512-1. That standard, as set forth in Treasury Regulations section 20.2031-1(b), is as follows: “The fair market value 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. The fair market value of a particular item of property includible in the decedent's gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.” “The hypothetical willing buyer/seller test substitutes the actual owner's or purchaser's intent, with the most economically rational analysis of a sale.” See Estate of Jameson, 267 F.3d 366, 372 (5th Cir. 2001) (citing Eisenberg v. Commissioner, 155 F.3d 50 (2d Cir. 1998)). Application of this test is not easy. Appeals Courts have chastised lower courts for speculation and Solomon-like pronouncements. For example, the Tax Court in Kaufman v. Commissioner, T.C. Memo. 1999-119, found as follows:

“It is not unreasonable under the facts herein to conclude that a hypothetical buyer of the estate’s shares would contemplate that a member of the … family … would pay a greater price for those shares as long as they were owned by a nonfamily member who was not an employee.” A non-family member may “create an unpleasant and unrewarding working environment, or may strive to acquire a majority of the outstanding shares.”

The Ninth Circuit responded by stating:

“The Tax Court also engaged in the speculation that the Estate stock could be sold to a non-family member and that, to avoid the disruption of family harmony, the family members…would buy out this particular purchaser. The law is clear that assuming that a family-owned corporation will redeem stock to keep ownership in the family violates the rule that the willing buyer and willing seller cannot be made particular.”

Morrissey v. Commissioner, 243 F.3d 1145, 1148 (9th Cir. 2001), rev’g Kaufman v. Commissioner, T.C. Memo. 1999-119. The Tax Court in Simplot v. Commissioner, 112 T.C. 130 (1999), found as follows:

“The hypothetical buyer [of the voting shares] would probably be will financed, with a long-term investment horizon and no expectations of near-term benefits…a hypothetical buyer would consider the likelihood that one day decedent’s block of

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voting shares potentially could become the largest block of voting shares because” other family members intended to disperse his or her shares among descendants.

The Ninth Circuit responded with the following:

“The facts supplied by the Tax Court were imaginary scenarios as to who a purchaser might be, how long the purchaser would be willing to wait without any return on his investment, and what combinations the purchaser might be able to effect with [family members] and what improvements in management of a highly successful company an outsider purchaser might suggest.”

and

“In violation of the law the Tax Court constructed particular possible purchasers.” Simplot v. Commissioner, 249 F.3d 1191, 1195 (9th Cir. 2001), rev’g 112 T.C. 130 (1999). See also the following choice comments from the Eleventh Circuit regarding conclusions and approaches of the trier of fact:

- “Cases prior to the Estate of Dunn, prophesying as to when the assets will be sold and reducing the tax liability to present value, depending upon the length of time discerned by the court over which these taxes shall be paid, require a crystal ball.”

- “It is more logical and appropriate to value…without resort to present values or prophesies.”

- “This 100% approach settles the issue as a matter of law, and provides certainty that is typically missing in the valuation arena.”

Jelke v. Commissioner, 507 F.3d 1317, 1332 (11th Cir. 2007), cert. denied (Oct. 6, 2008). During the planning phase, practitioners must consider valuation issues. A transfer will occur, namely, a gift and/or sale; otherwise a testamentary transfer is only a matter of time. Due to the pervasive nature of valuation in transfer taxation, audits often relate to valuation of assets, as well as, in some cases, valuation of claims against the estate. The thrust of the transfer tax standard of value is to provide so-called objective evidence of value, not influenced by the actual intent of the seller, the nature or intent of the buyer, etc. In point of fact, this is the basis for the “valuation game,” involving the battle of appraisers, tax counsel and IRS, all using analogies and proxies for value, rather than what happens in the real world! Actual tenants, other co-owners, and other facts affecting the subject property must all be considered. This means the appraiser and the attorney may need to interview individuals to understand the total circumstances surrounding the subject property.

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The bottom line is that appraisers and other advisors must understand valuation issues and apply the appropriate standard. Additional issues for consideration are discussed in these materials. 3. What is to be Valued? The estate tax is not a tax on property, it is an excise tax imposed on the shifting of relationships in regard to property at the time of death. Ithaca Trust Co. v. United States, 279 U.S. 155 (1929). Therefore, in estate tax matters the relevant property rights and restrictions are those that exist under state law at the moment of transfer. This principle is well recognized by the Ninth Circuit, which has stated that the federal “estate tax is on the transfer of property at death and that, therefore, the property to be valued is the interest transferred at death, ‘rather than the interest held by the decedent before death or that held by the legatee after death.’” Estate of McClatchy v. Commissioner, 147 F. 3d. 1089 (9th Cir. 1998) (quoting Propstra v. United States, 680 F.2d 1248, 1250 (9th Cir. 1982)); see also Estate of Bright v. United States, 658 F.2d 999, 1001 (5th Cir. 1981). 4. Determining Property Rights. The general two-step principle of federal taxation is that state law determines the nature and scope of property rights, then federal law determines the appropriate tax treatment of those rights. United States v. National Bank of Commerce, 472 U.S. 713, 722 (1985); United States v. Rodgers, 461 U.S. 677, 683 (1983); Aquilino v. United States, 363 U.S. 509, 513 (1960); Morgan v. Commissioner, 309 U.S. 78, 80 (1940). 5. Gift Tax Consideration – No Family Attribution. Revenue Ruling 93-12 and Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981). In Rev. Rul. 93-12, 100% of a closely-held corporation’s stock was gifted simultaneously to children (20% to each of 5 children). The Service ruled each gift is to be valued separately, i.e. no aggregation. 6. Estate Tax Consideration – Aggregation of Interest that Pass At Death. a. General Rule. The value of a decedent's estate is the value of all property to the extent of the decedent's interest as of the time of his or her death. “There is nothing in the statutes or in the case law that suggests that valuation of the gross estate should take into account that the assets will come to rest in several hands rather than one.” Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981). Therefore, all interests in a single entity (e.g., voting and non voting stock) are to be aggregated for estate valuation purposes. Ahmanson Foundation, infra. b. QTIP Trust Exception.

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However, interests in a decedent’s estate and those in a QTIP Trust includible in the decedent’s gross estate are not aggregated for valuation purposes. See Bright, supra, Mellinger, 112 TC 26 (1999), A.O.D. 1999-006; Nowell, T.C. Memo. 1999-15; and Lopes, T.C. Memo. 1999-225. Also see Fontana, 118 TC 318 (2002), wherein the Tax Court held that for valuation purposes interests in an estate are to be aggregated with interests in a general power of appointment marital trust (i.e. a 2056(b)(5) trust), thus distinguishing IRC Secs. 2041 (general power of appointment) and 2044 (QTIP). 7. Actual Other Co-Tenants. When valuing a co-tenancy interest, the other co-tenants certainly affect the value of the subject interest. The Tax Court in Estate of Elkins, 767 F.3d 443 (5th Cir. 2014), aff’g in part and rev’g in part 140 T.C. 86 (2013) confirmed that the actual co-tenants should be considered when considering the fractional interest discount. In Elkins, the value of certain co-tenancy interests in art was the value issue. The other co-tenants were the decedent’s children. The court found:

“the Elkins children's probable resistance to any sale or partition of the art that would result in new ownership; and although, by opposing such a sale, the Elkins children might not be acting in their best economic interests, they undoubtedly would view continued retention of the entire collection as acting (to paraphrase Mr. Mitchell) in their best psychic interests; i.e., they would be willing to forgo the financial gain from a sale of the art in order to keep the collection intact and continue to enjoy it.”

The Fifth Circuit agreed that the actual other co-tenants must be considered. However the Appeals Court found that the Tax Court “inexplicably veer[ed] off course” when it turned its focus to the role of “the Elkins children” as owners of the remaining fractional interests in the works of art. In doing so, the Tax Court gave “short shrift to the time and expense that a successful willing buyer would face in litigating the restraints on alienation and possession and otherwise outwaiting those particular co-owners.” The Appeals Court also noted that the Elkins heirs are neither “hypothetical willing buyers nor hypothetical willing sellers” any more than the Estate is “the hypothetical willing seller.” That being said, the Appeals Court acknowledges that a hypothetical willing buyer would take into account all aspects of the remaining fractional interests in art owned by the Elkins heirs, and not just the likelihood that the Elkins heirs would want to acquire the Decedent’s fractional interests from a successful buyer. However, the Estate’s experts’ written reports and their testimony at trial “demonstrates beyond question” that the Elkins heirs’ wealth, avowed disinterest in selling their interests, and their willingness to legally frustrate a willing buyer minimize the effects of these “other” aspects. Furthermore, if the heirs were to purchase such interests, they would first consult experts as to the price, and these experts would likely be the same experts the Estate used at trial (who substantially discounted below FMV). Finally, any potential willing buyer would “undoubtedly insist” on a further discount due to the Elkins heirs formidably resisting any “quick resale” after a purchase.

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The facts were the driving force in the Court finding that only a 10% fractional interest discount applied to the subject interests. 8. Actual Lease and Tenants. While the buyer and seller must be hypothetical in the valuation standard, other parties with interests in the subject property are the actual parties. In Estate of Mitchell, TC Memo. 2011-94 (April 28, 2011), IRS argued that the tenants should also be hypothetical. As such, the argument was made we should look at what a reasonable hypothetical tenant would do, not the actual tenants. IRS made this argument to support its lease buy-out theory (see detailed discussion of Mitchell below). The Mitchell Court rejected this argument (citing Estate of Proctor v. Commissioner, TC Memo. 1994-208) stating that:

“An appraiser values a leased-fee interest subject to the actual lease and the actual tenant, rather than on hypotheticals.”

B. IRC Section 2036 IRC section 2036 (“2036”) is a concern with cotenancy planning. This section provides as follows: “(a) General rule The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death— (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.” The retained rights can be shown by actual or implied agreement. Implied agreement is typically shown by the conduct of the parties. Therefore, to trigger 2036 the decedent must have made a transfer during life and retained (for a period of time that did not end before his or her death), the right to possession, enjoyment, income of the property, or to designate those who would possess or enjoy the property, or the property’s income. The case law confirms that IRC section 2036 is a lesser concern in cotenancy cases than with family limited partnerships and LLCs.

1. 2036 Cotenancy Cases

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a. Trafton.

In Estate of Trafton, 27 T.C. 610 (1956), the decedent’s estate tax return listed the full value of two sets of securities: those that decedent had transferred to himself and his wife as joint tenants, and those that decedent had purchased in the joint names of himself and his wife. The petitioners contended that one-half of the value of both sets of these securities was erroneously included in the gross estate. First, the court found that the transfers of securities resulted not in a joint tenancy but rather in a tenancy in common. Though the Commissioner argued that the husband retained for his life the possession/enjoyment of, or income from, the securities, the court countered that one-half of that income that the husband received was the wife’s just as much as if she had received it in the first instance and paid it over to the husband. Furthermore, the husband’s possession and use of the wife’s one half interest in the securities was wholly dependent upon her consent, and at any time post-transfer she could have partitioned the securities and deprived her husband of the their possession and use. Second, the court found that the purchases of securities by the husband in the joint names of himself and his wife resulted in joint tenancies. As such, under 811(e) [the predecessor to 2036], the value of such securities are wholly includible in the husband’s gross estate. However, some of the securities were purchased with monies that originally belonged to the wife (via inheritance or the like). To the extent those were traceable to the wife’s separate property and the purchases were part of an agreement between the parties with consideration involved, the court reasoned, these co-funded securities were includible in the husband’s estate only to the extent of the husband’s contribution (and less any contribution by the wife).

b. Barlow.

In Barlow, 55 T.C. 666 (1971), the decedent and his spouse transferred a farm to their four children while renting the farm from their children for its fair market value. The Service argued that, in substance, the decedent transferred a remainder interest in the farm to his children while reserving a life estate for himself. As such, the Service viewed the payments made to the children (as part of the rental agreement) as additional gifts. The court, however, found differently. In examining the deed, the children acquired the right to economic benefits flowing from their ownership and use of the land (or here, the right to a fair rental for its use). Furthermore, in examining the lease, the court found that the decedent and his spouse were given the right to occupy the land and receive the benefits from its use as tenants; however, the court noted, the decedent and his spouse were legally obligated, as tenants, to pay a fair, customary rental for the rights which they enjoyed, and the children were entitled, as landlords, to require the rent to be paid. Finally, the court found that all the evidence pointed to the fact that the transfer was completed between the parties and that both sides had assumed their roles in the landlord-tenant relationship. As a result, the court found IRC Sec. 2036 inapplicable.

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c. Powell.

In Estate of Powell, T.C. Memo. 1992-367, decedent gifted a 60% fractional interest in a residence to her two sons and their wives. Upon her death, the Service argued that the entire value of the residence was includible her in her estate. The IRS argued that the decedent never abandoned the residence as her abode and that there was an agreement between the decedent and her sons that she would be able to enjoy the residence exclusively and without interference for as long as she wanted. As a result, according to the Service, the residence as a whole was includible in her gross estate per IRC Sec. 2036. The court, however, found that inherent in the nature of a tenancy in common is the limitation that each party’s interest in property places upon the other party. That is, while one party may act as the sole owner, a tenancy in common agreement by its very nature diminishes each party’s ability to exercise their ownership rights as a sole owner. Furthermore, the court saw no evidence of such an agreement between the parties. As a result, the court required that the taxpayer only include her partial ownership interest in the residence.

d. Winemann.

In Winemann, T.C. Memo 2000-193, the decedent gifted a 24% interest in her homestead property. Tax Court Judge Marvel (i) accepted as uncontroverted and credible the son's testimony that there was no actual or implied understanding between decedent and the children giving decedent continued use and possession of the entire property; and then (ii) concluded that decedent's use of the property, in which "she owned a controlling interest" was "natural in light of the children's minority ownership". The Tax Court found that IRC Sec. 2036 did not apply.

e. Stewart. In Estate of Margot Stewart, 106 AFTR 2d 2010-5710, (2nd Cir. 2010), reversing and remanding T.C. Memo 2006-225, a mother (decedent) gifted a 49 percent interest in real property located on 61st Street in New York City to her son. The gifted property was 5 stories; the bottom two used by the mom and son as a residence and the top three leased to an unrelated third party. After the gift, mom and son continued to live on the bottom two floors. Further, mom continued to receive all of the income from the rented three floors. Son testified that he and mom agreed to reconcile income and expenses form the property. The court held that the entire property was includible in mom’s gross estate. Judge Foley found that mom and son had an implied agreement that mom would enjoy the entire property for remainder of her lifetime. Therefore, the entire property was includible in her gross estate under Code section 2036.

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The Second Circuit reversed and remanded the Tax Court decision, holding that even under a clear error standard, the Tax Court erred in finding an implied agreement between mom and son for mom to retain enjoyment of the 49% interest transferred to son. First, son lived in the residential portion, and thus possessed and enjoyed the residential portion of the transferred 49% cotenancy interest. Second, son was retaining all of the income from another property co-owned buy mom and son. After the gift, son stopped writing a check to mom for her share of the income from the other property. Mom and son agreed to reconcile what each received from the respective properties. Thus, even though mom retained all of the income from the gifted property, that did not mean should would keep it all. With respect to the rented portion of the gifted property, the Second Circuit held that mom retained the benefits of less than the total 49% cotenancy interest. 2. Proportionality. A central aspect of 2036 that it applies “to the extent of any interest therein of which the decedent has at any time made a transfer” and retained benefits. Thus, 2036 applies only to the portion over which the benefits were retained. Interestingly, this “proportionality” argument has never worked in an FLP case. The argument was made to no avail in Jorgenson, infra. IRS recognizes 2036 proportionality. Treasury Regulation section 20.2036-1(c)(1)(i) provides in relevant part as follows: “If the decedent retained or reserved an interest or right with respect to a part only of the property transferred by him, the amount to be included in his gross estate under section 2036 is only a corresponding proportion of the amount described in the preceding sentence.” Further, as applicable to GRATs and CRTs, Treasury Regulation section 20.2036-1(c)(2)(i) provides in relevant part as follows: “If a decedent transferred property into such a trust and retained or reserved the right to use such property, or the right to an annuity, unitrust, or other interest in such trust with respect to the property decedent so transferred for decedent's life, any period not ascertainable without reference to the decedent's death, or for a period that does not in fact end before the decedent's death, then … The portion of the trust's corpus includible in the decedent's gross estate for Federal estate tax purposes is that portion of the trust corpus necessary to provide the decedent's retained use or retained annuity, unitrust, or other payment (without reducing or invading principal).” In addition to these Treasury Regulations, Rev. Rul. 79-109, 1979-1 C.B. 297 provides “[W]hen a decedent retained an interest in only a part of the transferred property, or, in the alternative, in a corresponding portion of the income produced by the property, the amount includible in the gross estate is that portion of the transferred property that would be necessary to yield the retained income.” See also In re Estate of Uhl, 241 F.2d 867, 870-71 (7th Cir.1957). Cotenancy interests therefore present an opportunity to have a better defense against application of 2036. With respect to residential properties, the donee residing in the subject property may be a complete defense. With respect to rental properties, only the

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portion of the property corresponding to portion of net income retained by the transferor should be includible in the gross estate. As stated by the Second Circuit in Stewart, “retained ... possession or enjoyment” is not the end of the matter. The extent of the retained possession or enjoyment must also be determined. If the decedent retained or reserved an interest or right with respect to all of the property transferred by him, the amount to be included in his gross estate under section 2036 is the value of the entire property, less only the value of any outstanding income interest which is not subject to the decedent's interest or right and which is actually being enjoyed by another person at the time of the decedent's death. 3. Additional Considerations Regarding Cotenancy and 2036. The state law property rights, including California cotenancy rights such as partition, occupancy, use, and possession, can be used to defend against 2036 in the cotenancy arena. C. IRC Section 2703 IRC section 2703(a) provides that, for transfer tax purposes, the value of any property shall be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or any restriction on the right to sell or use such property. That being said, under subsection (b), the above will not apply to any option, agreement, right, or restriction meeting each of the following requirements: (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. (3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction. There are several cases applying IRC section 2703. Most of those cases are partnership cases. The only case applying IRC section 2703 in the cotenancy arena is Elkins, 767 F.3d 443 (5th Cir. 2014), aff’g in part and rev’g in part 140 T.C. 86 (2013). In Elkins, the coowners of artwork (62 pieces) entered into a cotenancy agreement restricting the owners’ rights to partition. Petitioners argued that 2703(a) was inapplicable because the restriction in question dealt with the sale of the works of art as a whole and did not touch upon the fractional interests in the art that was held by the parties as cotenants. Seeing as the valuation, for Federal estate tax purposes, was of only the fractional interests, the petitioners felt that the court could not apply 2703(a) against a restriction not facially existent against the interests facing valuation. Respondents looked at the purpose behind 2703, and claimed that “the only apparent reason for including the restriction on sale language in the Cotenants’ Agreement and the

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Art Lease Agreement was to reduce the value of Decedent’s retained fractional interests in the Artwork as part of a plan to make a testamentary transfer…at a reduced transfer tax rate.” This, they felt, was what 2703 was enacted to prevent. Accordingly, respondent argued, any restriction must fall within the purview of 2703, and must be disregarded in determining the value of decedent’s fractional interests in the art. In its analysis, the court held that the restriction did fall within the purview of 2703 and thus, the paragraph 7 restriction must be disregarded for purposes of valuation of the fractional interests. However, it did not give much credence to the arguments of either petitioner or respondent. Rather, the court looked to questions posed to the petitioner’s expert on partition (see Mr. Miller, supra). For a sale of any of the jointly owned properties (i.e., works of art) to occur, all of the cotenants would have to agree, and that would be so independent of the language of paragraph 7 of the cotenants' agreement. He agreed. The court then added: “So that the statement that an item of property may only be sold with the unanimous consent of all of the cotenants is a rather unremarkable statement of the obvious.” Mr. Miller agreed, and with respect to what the language of paragraph 7 accomplished, he testified: “If this language was not in the co-tenancy agreement, any individual interest owner would have the right to commence a partition action.” Returning to the law, the court then noted that section 2703(a)(2) instructs that “the value of any property shall be determined without regard to * * * any restriction on the right to sell or use such property.” To the court, whether paragraph 7 of the cotenants' agreement is a restriction on decedent's right to sell the cotenant art or is a restriction on his right to use the cotenant art is immaterial. However, what is apparent is that, pursuant to paragraph 7 of the cotenants' agreement, decedent, in effect, waived his right to institute a partition action, and, in so doing, he relinquished an important use of his fractional interests in the cotenant art. As a result, the court found that in determining the value of each of the items of cotenant art, it must disregard any restriction on decedent's right to partition. IX. CONTRAST TO ENTITIES A. Annual Exclusion Planning 1. Hackl. In Hackl, 118 T.C. 279 (2002) affirmed 335 F.3d 664 (7th Cir. 2003), the court noted that outright transfers of equity interests in a business or entity do not automatically qualify as a present interest. Holding that existing case law regarding indirect gifts (such as gifts in trusts) would apply to gifts of interests in entity, the court made note of “the right to substantial present economic benefit” requirement described in Fondren. It then described a two-step alternative analysis – the donee must have “an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such immediate

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use, possession, or enjoyment be of a nature that substantial economic benefit is derived from.” Here, the donees did not have “use, possession, or enjoyment” of the property within the meaning of section 2503(b). As a result, the Tax Court held that the gifts of member interests did not constitute present interest gifts and thus did not qualify for the annual exclusion. 2. Price. In Price, TC Memo 2010-2, gifts of limited partnership interests by parents to their three children did not constitute present interest gifts and therefore did not qualify for the gift tax annual exclusion. T.C. Memo. 2010-2. There was no immediate enjoyment of the donated property itself, because the donees had no ability to withdraw their capital accounts and because partners could not sell their interests without the written consent of all other partners. Furthermore, there was no immediate enjoyment of income from the donated property (which can also, by itself, confer present interest status) because (1) there was no steady flow of income, and (2) distribution of profits was in the discretion of the general partner and the partnership agreement specifically stated that distributions are secondary to the partnership’s primary purpose of generating a long-term reasonable rate of return. Interestingly, the IRS pursued this annual exclusion argument in litigation even though there were limited donees (three, unlike the 41 in Hackl) and even though there were over $500,000 of actual distributions to the children from the partnership’s creation in 1997 to 2002. 3. Fisher. In Fisher v. United States, 105 AFTR 2d 2010-1347 (S.D. Ind. March 11, 2010), parents gave membership interests in an LLC to each of their seven children over three years (resulting in 42 annual exclusion gifts). The principal asset of the LLC was undeveloped beachfront property. The IRS contested the availability of annual exclusions, and the court rejected the donors’ three arguments. First, the donors argued that the children had the unrestricted right to receive distributions. The court rejected this argument because distributions “were subject to a number of contingencies, all within the exclusive discretion of the General Manager.” Second, the donors argued that the children possessed the unrestricted right to use the beachfront property. The court responded that the Operating Agreement did not convey this right to members. Somewhat confusingly, the court added that “the right to possess, use, and enjoy property, without more, is not a right to a ‘substantial present economic benefit.’ Hackl, 335 F.3d at 667. It is a right to a non-pecuniary benefit.” Third, the donors argued that the children had the unrestricted right unilaterally to transfer their interests. Under the Operating Agreement, the children could transfer their “Interests” in the LLCs if certain conditions are satisfied. One of those conditions was

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that the LLC would have a right of first refusal over any such transfer. If the LLC exercises the right of first refusal it will pay “with non-negotiable promissory notes that are payable over a period of time not to exceed fifteen years” providing equal annual installments of principal and interest. The right of first refusal would not exist for transfers to the donors or to their descendants (but as noted below, the court said that other restrictions would apply, without explaining what those restrictions were). The Agreement defines “Interest” as a member’s share of profits and losses and the right to receive distributions. The children could only transfer “Interests” rights as opposed to the rights of “Members” admitted by the LLC, which also include the right to inspect the Company’s books and records and to “participate in the management of and vote on matters coming before the Company.” The rights that could be assigned seem analogous to “assignee” rights in the context of a partnership. The court did not comment negatively on the fact that the children could merely transfer the right to share in profits, losses and distributions rather than a full membership right. However, the court reasoned that the right of first refusal “effectively prevents the Fisher Children from transferring their interests in exchange for immediate value.” Even transfers to family members are “not without restrictions.” “Therefore, due to the conditions restricting the Fisher Children’s right to transfer their interests in Good Harbor, it is impossible for the Fisher Children to presently realize a substantial economic benefit.” The third argument is the one that most donors will use to support the availability of the annual exclusion for gifts of interests in partnerships or LLCs. If the donees had the immediate right to sell their interests for cash or other assets they could immediately enjoy, it would seem that the gifts would constitute present interests. The court did not explain its reasons that the right of first refusal kept the children from being able to transfer their interests for “immediate value.” However, the court was probably correct in reaching this result because the LLC could pay with non-negotiable notes. This means that if the LLC exercised its right of first refusal, the children had no ability to sell the LLC’s note for cash or other “immediate value.” While the court did not explain its specific reasons, limiting the right to transfer the interest for only a non-negotiable note does seem to be a substantial impediment to being able to receive “immediate value.” As suggested by Price, partnership or LLC agreements should not prohibit transfers. Fisher casts some doubt on whether merely subjecting transfers to a right of first refusal precludes annual exclusion treatment, but it would seem that the practical planning pointer from Fisher is that the partnership or LLC should not be able to exercise the right of first refusal by giving non-negotiable long term promissory notes. 4. Wimmer. In Wimmer, T.C. Memo 2012-157, the court noted that “an outright transfer of an equity interest in a business or property, such as limited partnership interests, is not necessarily a present interest gift.” The gift tax regulations describe a “present interest” as “an unrestricted right to immediate use, possession, or enjoyment of property or the income from property.” Treas. Reg. §25.2503-3(b). The U.S. Supreme Court in Fondren v. Commissioner, 324 U.S. 18, 20-21 (1945) stated that there must be a “substantial present

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economic benefit” to qualify as a present interest for this purpose. In summary, Wimmer stated: “Therefore, to qualify as a present interest, a gift must confer on the donee a substantial present economic benefit by reason of use, possession, or enjoyment (1) of property or (2) income from the property.” The court held that the donees did not have immediate use, possession or enjoyment of the gift property (i.e., the gifted limited partnership interests) because of restrictions on the ability of the donees to transfer their limited partnership interests. As to this issue, the court concluded that “the donees did not have the unrestricted and noncontingent rights to immediate use, possession, or enjoyment of the limited partnership interests themselves.” The partnership agreement imposed significant transfer restrictions on transfers to anyone other than existing partners or related parties (as defined in the agreement). Limited partnership interests could be transferred only with the prior written consent of the general partners and 70% in interest of the limited partners. Furthermore, a transferee would not become a substitute limited partner until the transferee had been accepted as a substitute limited partner by “unanimous written consent of the general partners and the limited partners.” (Apparently, the partnership agreement did not allow transfers subject to a right of first refusal by the partnership or the remaining partners.) As to whether the donees had the use, possession, or enjoyment of income from the property, the court applied a three-part test (as announced in Calder v. Commissioner, 85 T.C. 713, 727-28 (1985)), under which the estate had to “prove, on the basis of the surrounding circumstances, that: (1) the partnership would generate income [the opinion later referred to this as a “partnership that expected to generate income”], (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.” These requirements were satisfied. (1) The partnership assets consisted of publicly traded stocks that paid dividends quarterly. (2) The general partners owed fiduciary duties to the limited partners under the agreement and state law. One of the donee-partners was a trust for grandchildren that owned only the limited partnership interests and no other assets with which it could pay income taxes on the partnership’s flow-through income. The court reasoned that “the necessity of partnership distributions in these circumstances comes within the purview of the fiduciary duties imposed on the general partners. Therefore, the general partners were obligated to distribute a portion of partnership income each year to the trustee.” Because the agreement required that distributions of net cash flow be made to all partners proportionately, distributions would be made to all partners of at least a portion of the partnership income. Therefore, “on the date of each gift some portion of partnership income was expected to flow steadily to the limited partners,” and the partnership in fact made distributions pro rata from the dividends paid each year at issue. (3) The income could be readily ascertained because “the limited partners could estimate their allocation of quarterly dividends on the basis of the stock’s dividend history and their percentage ownership in the partnership.” The gifts of the limited partnership interests qualified for the gift tax annual exclusion, even though the donees did not receive all of the partnership income in some years.

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B. Formation Issues. 1. Indirect Gifts. a. Increase of Donee’s Capital Account. In Shepherd, 115 T.C. 376 (2000), an Alabama general partnership agreement was signed by the taxpayer father and funded with real estate on day one, but the partnership agreement was not signed by the two sons until day two. Over a month later, the father contributed certain bank stock to the same partnership. The Tax Court majority found the real estate transfer was neither a gift nor a transfer to a valid partnership (the latter due to needing more than one “partner” at date of transfer to have a valid partnership). The opinion of the majority then concluded that the creation of the partnership the next day was an indirect gift of real estate interests to the two sons, as was the later bank stock contribution. This analysis obviously adversely affected the valuation discounts, which the Tax Court determined to be limited to 15%. b. Contrast to Jones and Gross. In Jones, 116 T.C. 121 (2001), two FLPs were formed partially by father (“decedent”), one – JBLP – with his son and the second – AVLP – with his four daughters. IRS argued that decedent made taxable gifts upon contributing his property to the partnerships. This argument is more of a “gift on formation argument,” which is an indirect gift argument. The court found that like in Strangi, 115 T.C. 478 (2000), there was no gift because “the contributions of property [to the partnerships] were properly reflected in the capital accounts of decedent, and the value of the other partners’ interests was not enhanced by the contributions of decedent. Therefore, the contributions do not reflect taxable gifts.” Tax Court Judge Cohen followed the majority opinion in Strangi, authored by her, finding there was no gift at formation; and, citing Kerr, Harper (the first case), and Knight (all cited supra), Judge Cohen rejected IRS’ 2704(b) argument. In Gross, T.C. Memo 2008-221, mom and her daughters created a limited partnership, Dimar Holdings L.P. Each daughter contributed $10, mom contributed $100, and mom was also to contribute marketable securities. For two months mom transferred marketable securities to the partnership. Eleven days after transferring the last of the marketable securities to the partnership, mom gifted a 22.25% limited partnership interest to each daughter. IRS argued that these three events occurred on the date of gift in the following order: (i) the partnership was created; (ii) each daughter acquired a 22.25% limited partnership interest in the partnership; and (iii) mom then transferred the securities to the partnership enhancing the daughters’ capital accounts, thereby making an indirect gift. There were issues as to when the partnership was created. The partnership’s certificate of limited partnership was not filed until the date of the gifts. IRS argued that the partnership did not exist until the certificate was filed and, thus, assets could not have been contributed to the partnership until that date. The court dismissed this argument, finding that under New York law if parties fail to meet the

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requirements of a limited partnership, the parties are a general partnership on the essential terms and conditions of their partnership arrangement. The court found that mom and her daughters were partners five months prior to the date of gifts. With respect to the indirect gift argument, the court found that like in Jones, all contributions by mom were reflected on her capital account and she received increasing interests in the partnership as she contributed more marketable securities. She thereafter made the gifts to her daughters, and, thus, no indirect gifts were made. The court also looked at the step transaction doctrine, and found that 11 days was sufficient to create economic risk, and thus the step transaction doctrine did not apply. c. Uncertainty of Events. In Senda, T.C. Memo 2004-160, Petitioners, husband and wife, created two FLPs and shortly thereafter transferred stock to the FLPs. Either before or after transferring the stock (Petitioners failed to introduce credible evidence to prove the stock was transferred to the FLPs first), Petitioners made gifts of FLP interests to their children. Respondent IRS argued the transfers of the stock to the FLPs, coupled with the transfer of limited partnership interests to the children, were indirect gifts of the stock to the children as the transactions were “integrated transactions intended to pass the stock to the petitioners' children in partnership form." The Tax Court found, that like in Shepherd, the value of the children's limited partnership interests was enhanced by the donors' contributions of stock to the FLPs. Thus, the gifts were indirect gifts of stock and not gifts of FLP interests. Note the Tax Court stated at the end of the Senda opinion: “We have considered the other arguments of the parties, and they are either without merit or need not be addressed in view of our resolution of the issue.” However, the Tax Court did find that “[a]t best, the transactions were integrated (as asserted by respondent) and, in effect, simultaneous.” This is an important finding if the step transaction doctrine is to be considered. The Eighth Circuit affirmed the Tax Court. Senda v. Commissioner, 433 F.3d 1044 (8th Cir. 2006). 2. Step Transaction Doctrine. a. Holman. In Holman, 130 T.C. No. 12 (2008), Petitioners, husband and wife, set up custodial accounts for their children, then made annual gifts of stock thereto. Petitioners, as general partners, then formed an FLP in November of 1999, setting out nine stated purposes for the entity; the children's custodianships and certain trusts for the children’s benefits were the FLP’s limited partners. Petitioners had discussed the use and advantages of a limited partnership with their attorney, including the availability of valuation discounts in connection with the entity and gifting FLP interests to the children’s custodial accounts. The Tax Court respected the FLP as a valid entity. Ultimately, Petitioners defeated IRS’ two "indirect gifts" arguments. First, IRS argued that gifts of the stock, rather than FLP interests, were made. However, the Tax Court had no problem distinguishing the facts of the case from Shepherd (cited supra) and Senda

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(cited supra) because Petitioners’ gifts of FLP units occurred six days after the FLP’s formation and funding (and capital accounts of donors were properly credited). Second, the Tax Court rejected IRS’ step transaction argument, noting that the value of the assets contributed to the FLP were subject to real market risk in connection with the time that passed from date of formation to date of funding. Gross (cited supra) followed Holman on the step transaction doctrine issue. As discussed above, in Gross the Tax Court found that 11 days was sufficient to create economic risk, and thus the step transaction doctrine did not apply. b. Linton. In Linton v. United States, 104 A.F.T.R. 2d 2009-5176 (W.D. Wash. 2009), the court granted the government’s motion for summary judgment that contribution of assets to an LLC, followed by transfers of LLC interests to trusts for the benefit of the taxpayer’s children were really gifts to the trusts of the underlying assets. As indicated above, the government asserted the step transaction in Gross and Holman and lost in both cases. The government lost because the court in each case found that there was enough time between funding the partnership and the gift transfer of partnership interests to create economic risk. Why? Both cases involved marketable securities. If we learned anything in 2009, it is that marketable securities can fluctuate in value quite rapidly (anyone want some AIG stock?). There were 11 days between funding the partnership and the gift transfers in Gross and 6 days in Holman. Note that in Linton, the amount contributed to the LLC was chosen based on the amount the Lintons wanted to gift. Mr. Linton testified in his deposition as follows: “[The advisors] said somewhere between 40 and 49 percent discounting based on the blend of assets that you’re proposing. So, based on that, I just did some back math to figure out how much money to put into the LLC.” This testimony helps support application of the step transaction doctrine. Not clear from the opinion is whether the Lintons were allowed fractional interest discounts on the real estate portion of the assets. If the Lintons are really deemed to have gifted the underlying assets, such discounts would be appropriate. Before moving to Heckerman v. United States (discussed infra), it is prudent to look at the three tests set forth in Linton to determine whether a number of activities should be viewed as comprising one transaction or a series of transactions:

- Binding Commitment Test. This is the narrowest view of the step transaction doctrine. Under this test, if at the time the first step in entered into, there is a “binding commitment” to take later steps, the series of transactions are collapsed into one.

- End Result Test. This is the most flexible view of the step transaction doctrine. The steps are collapsed into one transaction if the series of separate steps are pre-

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arranged parts of a single transaction intended from the beginning to reach one ultimate result.

- Interdependence Test. This test focuses on the relationship between the steps instead of the end result. The steps are collapsed into one transaction if the steps are “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series of transactions.” A key determinant is whether one or more steps would not have been undertaken absent their “contemplation of the other integrating acts.”

c. Heckerman. In Heckerman v. United States, 104 A.F.T.R. 2d 2009-5551 (W.D. Wash. 2009), like the Linton court, the Heckerman court reviewed and contrasted the Shepherd, Jones (and Gross), and Senda cases, spending the most time on Senda. The court was not persuaded that the Heckermans could establish that their capital accounts were increased by the amount of their contributions to Investments LLC at the time of the transfer, thus entitling them to recoup the same amount upon liquidation. The Heckermans could not show that, at the time of the capital contribution, their capital accounts reflected their contribution and did not enhance the value of the trusts’ capital accounts. The court found that this case was more like Senda, and unlike Jones. The court found that the two-step transaction of transferring $2.85 million of cash to Investments LLC and the gifting of LLC units to the trusts is properly characterized as an integrated transaction in which the Heckermans indirectly gifted the cash to the children’s trusts. The court looked to the Linton opinion for the three step transaction doctrine tests, i.e., the binding commitment test, the end result test, and the interdependence test (discussed supra), and found the Heckerman facts support the finding that both the end result test and the interdependence test were met. The court looked to an email from counsel to support its finding that there was a pre-arrangement. That email detailed the mechanics of using an LLC to obtain discounts and structure gifts. The court also found that but for the LLC structure and the discounts it offered, the Heckermans would not have made the gifts to the trusts for their children. This finding was supported by an email from Mr. Heckerman stating, “once I know how much discount I can get as a function of how much value is in this LLC, I will determine the funding of this LLC.” d. Comments on Linton and Heckerman. In both cases there were statements by the taxpayers indicating they would back-into the funding amounts based on desired gifting. This indicated to the courts that the LLCs were created for gift tax avoidance purposes. As the step transaction doctrine continues to be forcefully argued by IRS in the courts, perhaps an IRC section 2036-type analysis will develop to determine whether the step transaction applies in those cases where there is no economic risk between formation and gifts. Will a significant and legitimate nontax

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reason be necessary to avoid IRS’ step transaction argument if there is no economic risk between funding and gifting? In both cases there was much focus about documents and transactions occurring on the same day. We now know clearly that entities should be formed and left to operate for some time, if for no other reason than to create economic risk. It should also be kept in mind that limited liability entities are still one of the best ways for families to protect and manage wealth regardless of tax benefits (see Keller below). Trusts alone are not always sufficient or appropriate, particularly for management succession issues. The push and pull of the step transaction doctrine falls between legitimate tax avoidance on the one hand and illegitimate tax avoidance on the other. Yes, there is a difference. As discussed in the Heckerman case, the Ninth Circuit (and many other courts) are attempting to place transactions in one of these camps. We cannot forget that the law recognizes that “anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose a pattern which will best pay the Treasury.” Brown v. United States, 329 F.3d 664, 671 (9th Cir. 2003) (quoting Grove v. Commissioner, 490 F.2d 241, 242 (2d Cir. 1973)). However, legitimate tax avoidance transactions are those that “although motivated in part by tax considerations, also have an independent purpose or effect.” Id. (citing Stewart v. Commissioner, 714 F.2d 977, 987–88 (9th Cir. 1983)). Now, more than ever before, planners must focus on the non-tax considerations for the use of entities in preserving and protecting family wealth. Specific facts in both Linton and Heckerman showed key decisions regarding funding of the entities that were driven significantly by tax avoidance, and in the view of both courts, more so that any non-tax reasons. Also note that in Senda, the Tax Court found, “[i]t is apparent from petitioner's evasive testimony and from the total record that petitioners were more concerned with ensuring that the beneficial ownership of the stock was transferred to the children in tax-advantaged form than they were with the formalities of FLPs.” C. IRC Section 2703 Issues 1. Cases IRS has consistently tried to use IRC section 2703 to attack entity level discounts. Initially, IRS argued that IRC section 2703 could be used to ignore the partnership as a whole. After losing that argument, IRS changed their argument in court cases to attack certain provisions of the partnership agreement. IRS continues to assert IRC section 2703 in gift and estate tax cases to reduce or eliminate valuation discounts using blanket concepts. Many times those arguments are disregarded by Appeals, except when focused on a specific provision of an entity agreement (such as buy-sell provisions). Below is a discussion of cases where IRS argued IRC section 2703 in the entity context. a. Church. In Estate of Church v. U.S., 2000 U.S. Dist. LEXIS 714; 2000-1 US Tax Case. (CCH) P60, 369 (W.D Tex.2000), the IRS argued that IRC section 2703 could be used to ignore

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the partnership “wrapper” and eliminate all discounts. Church is the first case to rule on the 2703 issue (and the first FLP case to be heard in a US District Court, as opposed to the Tax Court) in the entity context. IRS asserted two arguments in this context: (i) that IRC section 2703 meant that the property includible in the gross estate refers to the property transferred to the entity by the decedent; and (ii) the IRC section 2703 causes the term restriction in the partnership agreement and restrictions on sale in the partnership agreement to be disregarded for valuation purposes. With respect to the first argument, the court held that there is no statutory basis for the argument. The Decedent did not own the assets transferred to the partnership at death; rather, the decedent owned an interest in the partnership at death. With respect to the second argument, the court stated as following in rejecting IRS’ argument: “No case supports the Government's position, and nothing in the legislative history, or the regulations adopted by the IRS itself, convince this Court to read into [IRC s]ection 2703 something that is not there. By its very nature, a partnership is voluntary association of those who wish to engage in business together, and upon whom the law imposes fiduciary duties. Term restrictions, or those on the sale or assignment of a partnership interest that preclude partnership status for a buyer, are part and parcel of the property interest created by state law. These are not the agreements or restrictions Congress intended to reach in passing [IRC section] 2703. Reviewing the legislative history, and construing [IRC section] 2703 with its companion statute, [IRC section] 2704, it is clear that the former was intended to deal with below-market buy-sell agreements and options that artificially depress the fair market value of property subject to tax, and are not inherent components of the property interest itself.” b. Strangi I. In Strangi I, infra, the Tax Court rather forcefully shot down application of IRC section 2703 to the assets of the partnership, rather than the partnership includible in the estate stating “We conclude that Congress did not intend, by the enactment of section 2703, to treat partnership assets as if they were assets of the estate where the legal interest owned by the decedent at the time of death was a limited partnership or corporate interest.” c. Smith. In Smith, No. 02-264, 2005 U.S. Dist. LEXIS 20383 (W.D. Pa. Aug. 19, 2005), the court determined whether IRC section 2703 applied to gifts of limited partnership interests from Mr. Smith to his children. Defendant IRS filed a motion for summary judgment for a determination that IRC section 2703 applied, and certain rights and restrictions contained in a family limited partnership agreement be disregarded for gift tax valuation purposes. The court adopted the Report of the Magistrate Judge dated June 30, 2004 (the “Report”). The Report concluded that IRC section 2703 did apply to such provisions in the limited

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partnership agreement. The Report then reviewed the exception to application of IRC section 2703, i.e. the three requirements of IRC §2703(b). The Report made the following findings: i. Bona Fide Business Arrangement Test. In looking at the bona fide business arrangement test of IRC §2703(b)(1), the Report recognized courts have consistently recognized that an arrangement to facilitate the maintenance of family ownership and control of a business is a bona fide business arrangement. The Report found “there is little doubt” that the subject restrictive provision “was designed to maintain family ownership in, and control of, the Smith FLP” and found the restrictive provision at issue was a bona fide business arrangement. ii. Testamentary Device Test. The Report cited St. Louis County Bank v. U.S., supra, to find that this test should be adjudged based on the facts in existence at the inception of the agreement. The Report stated that this determination often includes such factors as “the transferor’s health at the inception of the agreement, significant changes in the business subject to the restrictive provision, selective enforcement of the restrictive provision; and the nature and extent of the negotiations that occurred among the parties regarding the terms of the restrictive provision.” The Report found that there was insufficient evidence and that this issue posed genuine issues of material fact that must be developed at trial. iii. Similar Arrangement Test. Both parties conceded it would be difficult to find an agreement between unrelated parties dealing at arm’s length comparable to a family limited partnership (which is restricted to related parties). Taxpayer plaintiff submitted affidavits of two attorneys who stated the subject provisions (installment payout and AFR rate of interest) were common in both family limited partnerships and transactions involving unrelated parties. The Report found the opinions were conclusory and were not sufficient evidence to “dispel any genuine issue of material fact” on this issue! d. Blount. In Blount, 428 F.3d 1338 (11th Cir. 2005), the Eleventh Circuit upheld a Tax Court ruling that a buy-sell agreement could be disregarded in determining the estate tax value of the closely-hold business stock subject to the agreement. However, the appellate court found that the tax court incorrectly added the value of life insurance proceeds to the value of the company’s assets in calculating the stock’s estate tax value. In 1981, Blount, his brother-in-law, and their company entered into a buy-sell agreement whereby they all agreed that no stockholder could transfer his shares of the company without the consent of the other stockholders. Furthermore, the agreement established the

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share price at book value and the company purchased a $3M life insurance policy on the life of each stockholder to fund a stock repurchase upon a stockholder’s death. When the brother-in-law died in 1996, his stock was redeemed by the company at book value pursuant to the aforementioned agreement. Later that year, when Blount was diagnosed with terminal cancer, Blount, as the individual shareholder (and without the ESOP’s consent,) entered into a new buy-sell agreement establishing the value of his company stock at $4M. When Blount then died, his estate valued his company stock at $4M, but the book value of his shares was $7.6M at date-of-death. Objecting to the estate’s valuation, the IRS argued that the FMV of Blount’s company stock was really $7.9M. The Eleventh Circuit affirmed the Tax Court in holding that Blount’s 1996 buy-sell agreement should be disregarded for two reasons. One, because Blount became BCC’s controlling shareholder following the death of his brother-in-law, Blount could change the buy-sell agreement at will, thus rendering it not controlling of value during his lifetime. Two, IRC Sec. 2703 provides that if any buy-sell agreement created before 1990 was “substantially modified,” then its provisions are unenforceable unless it contains terms entered into persons in an arm’s length transaction. Because the court found that the 1996 agreement substantially modified the 1981 agreement, and that the change was not as a result of an arm’s length transaction, Blount’s 1996 buy-sell agreement was ignored for valuation purposes. However, the Eleventh Circuit disagreed with the Tax Court’s decision to include the $3M life insurance policy in Blount’s taxable estate. The appellate court agreed that under the IRC, non-operating assets (i.e., life insurance proceeds payable to a company) should be included in valuing a company’s stock. However, the Eleventh Circuit felt that the insurance could not be included in this case because the company acquired it solely to fund its obligation to purchase Blount’s shares in accordance with the buy-sell agreement. e. Holman. In Holman, 130 T.C. No. 12 (2008), affirmed 601 F.3d 763 (8th Cir. 2010), the Tax Court disregarded certain transfer restrictions in the FLP’s partnership agreement that Petitioners claimed should reduce the value of the FLP interests. Petitioners set up custodial accounts for their children, then made annual gifts of stock thereto. Petitioners, as general partners, then formed an FLP in November of 1999, setting out nine stated purposes for the entity. The children's custodianships and certain trusts for the children’s benefits were the FLP’s limited partners. Petitioners had discussed the use and advantages of a limited partnership with their attorney, including the availability of valuation discounts in connection with the entity and gifting FLP interests to the children’s custodial accounts. The Tax Court respected the FLP as a valid entity. Ultimately, Petitioners defeated IRS’ two "indirect gifts" arguments. First, IRS argued that gifts of the stock, rather than FLP interests, were made. However, the Tax Court had no problem distinguishing the facts of this case from Shepherd v. Commissioner, 115 T.C.

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376 (2000), and Senda v. Commissioner, T.C. Memo. 2004-160, because Petitioners gifts of FLP units occurred six days after the FLP’s formation and funding. Second, the Tax Court rejected the IRS’ step-transaction argument, noting that the value of the assets contributed to the FLP were subject to real market risk in connection with the time that passed from date of formation to date of funding. On the other hand, the Tax Court had trouble with Petitioners alleged "business purposes" and certain restrictions in the partnership agreement, which Petitioners claimed should reduce the value of the FLP interests. More specifically, the IRS successfully argued that transfer restrictions in the FLP agreement should be disregarded because they did not satisfy two of the three elements of the "safe harbor" test of IRC § 2703(b) (i.e., it was not "bona fide business arrangement" and the restrictions involved a "device” to transfer the FLP interests to family members for less than full and adequate consideration in money or money's worth). Thus, the restrictions were disregarded for valuation purposes under IRC § 2703(a) and Petitioners’ valuation discounts claimed for lack of control and lack of marketability were reduced to 12.5%. On appeal, the taxpayers challenged the Tax Court’s holdings that certain restrictions in the FLP’s limited partnership agreement were not a bona fide business arrangement within the meaning of IRC Section 2703(b). Maintenance of family ownership and control of a business may be a bona fide business purpose, but not necessarily in the absence of a business. The Holman’s FLP was not a bona fide business arrangement. They made no showing of special investment knowledge or of any particular investment philosophy. Rather, the facts suggest the Holmans intended to diversify their investments. The restrictions in the FLP’s limited partnership agreement were, therefore, not a bona fide business arrangement within the meaning of IRC Section 2703(b). They were “predominately for purposes of estate planning, tax reduction, wealth transference, protection against dissipation by the children, and education of the children.” 2. Meeting the 2703 Exception. Recent cases have evidenced difficult issues that arise in dealing with Section 2703(a), i.e. especially meeting the three-pronged “safe harbor” test of 2703(b). First, refer to the 10th Circuit’s affirmance, 390 F.3d 1210, of the Tax Court in Estate of True, TC 2004-116, which found that the buy-sell agreements were a “testamentary device”. This was a pre-2703 case; but now there are three (3) 2703(a) court decisions, Estate of Blount, T.C. Memo. 2004-116, Smith v. U.S., 2004 U.S. Dist. LEXIS 14839 (6/30/04) and Holman, infra, that raise questions about meeting the 2703(b) tests: (i) bona fide business arrangement (ii) not a testamentary device, and (iii) terms of the buy-sell agreement must be “... comparable to similar arrangements entered into by persons in an arms-length transaction.” This latter requirement is a difficult issue of proof in a closely-held business context. Although, Holman, infra, suggests the bona fide business arrangement prong may be harder to meet. See also Amlie v. Commissioner, T.C. Memo. 2006-76, wherein

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the taxpayer was able to show, on unique facts, the price term in a buy-sell agreement was the value for estate tax purposes. When addressing a price term in a buy-sell agreement both IRC section 2703 and the prior case law will both have to be addressed. A price term specifies the price or a formula that sets a purchase price when a buy-sell trigger occurs. In addition to the three-pronged test of IRC section 2703(b), the taxpayer will need to show: (1) the price was fixed and determinable from the agreement, (2) it was binding during life and at death, (3) it was legally binding and enforceable, and (4) it served a bona fide business purpose and was not a testamentary device to pass the decedent’s interests for less than adequate and full consideration. See Estate of True, 390 F.3d 1210 (10th Cir. 2004), Estate of Gloeckner, 152 F.3d 208 (2d Cir. 1998), and St. Louis County Bank, 674 F.2d 1207 (8th Cir. 1982). D. IRC Section 2704 Issues 1. Law. IRC section 2704(a) and (b) provide as follows: (a) Treatment of lapsed voting or liquidation rights (1) In general For purposes of this subtitle, if— (A) there is a lapse of any voting or liquidation right in a corporation or partnership, and (B) the individual holding such right immediately before the lapse and members of such individual’s family hold, both before and after the lapse, control of the entity, such lapse shall be treated as a transfer by such individual by gift, or a transfer which is includible in the gross estate of the decedent, whichever is applicable, in the amount determined under paragraph (2). (2) Amount of transfer For purposes of paragraph (1), the amount determined under this paragraph is the excess (if any) of— (A) the value of all interests in the entity held by the individual described in paragraph (1) immediately before the lapse (determined as if the voting and liquidation rights were nonlapsing), over (B) the value of such interests immediately after the lapse. (3) Similar rights The Secretary may by regulations apply this subsection to rights similar to voting and liquidation rights. (b) Certain restrictions on liquidation disregarded

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(1) In general For purposes of this subtitle, if— (A) there is a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor’s family, and (B) the transferor and members of the transferor’s family hold, immediately before the transfer, control of the entity, any applicable restriction shall be disregarded in determining the value of the transferred interest. (2) Applicable restriction For purposes of this subsection, the term “applicable restriction” means any restriction— (A) which effectively limits the ability of the corporation or partnership to liquidate, and (B) with respect to which either of the following applies: (i) The restriction lapses, in whole or in part, after the transfer referred to in paragraph (1). (ii) The transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. (3) Exceptions The term “applicable restriction” shall not include— (A) any commercially reasonable restriction which arises as part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either, or (B) any restriction imposed, or required to be imposed, by any Federal or State law. Thus, the thrust of IRC section 2704 is to include in the value of transferred property the value of lapsing voting and liquidation rights that lapse as a result of a transfer of an interest in a partnership or corporation to a member of the transferor’s family. The transferor and members of the transferor’s family must control the entity immediately before the transfer. Note IRC section 2704 does not apply to a lapsing liquidation right to the extent the restriction is not more restrictive than the limitations under state law. This introduced a new element for forum shopping into FLP planning. Also note that restrictions imposed as a part of financing or equity participation with an unrelated party are not subject to IRC section 2704. Note IRC section 2704 was introduced into the law to counter IRS’ loss in Estate of Harrison v. Commissioner, T.C. Memo. 1987-8. In Harrison, decedent and his two sons were general partners of a limited partnership and decedent was also a 77.8% limited partner. Decedent’s pro rate share of partnership net asset value was equal to approximately $60 million. Each general partner had the right during life to dissolve the partnership, but neither a limited partner nor a successor to a general partner had such a

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right. Thus, while decedent was alive he could liquidate the partnership and get at his proportionate $60 million net asset value. However, decedent could not transfer the liquidation right at death to another person. The parties stipulated that if the liquidation rights were not included in the valuation, then decedent’s combined interests in the partnership had a value of $33 million. The court found, “it is apparent that the property transferred at the moment of decedent's death was the limited partnership interest that passed to decedent's estate, which did not include the right to dissolve the partnership. Nevertheless, [IRS] claims that when decedent's right to dissolve the partnership terminated at his death something of value passed to [his sons]. However, we are unable to agree because this contention is contrary to respondent's stipulation that the value of the interests of [his sons] were the same at the moment before decedent's death, at the moment of decedent's death, and at the moment after decedent's death.” The court then held that the value of the partnership interests was $33 million. While IRC section 2704 does not apply to transfers of cotenancy interests, it must be considered when looking at partnerships and LLCs as an alternative to a cotenancy arrangement. 2. Cases After enactment of IRC section 2704, IRS has forcefully argued that the section can be used to attack valuation discounts. The focus has primarily been on liquidation rights. While it can be effective, it’s factual application can be limited. This is especially true in light of various states increasing the default voting requirement to force liquidation of partnerships and LLCs. Some states move the requirement from a majority to a super-majority or unanimous vote. a. Kerr. In Kerr v. Commissioner, 113 TC 449 (1999), the Tax Court rejected the Service's argument that the restrictions on liquidation in the FLP were more restrictive than default state law. The Court ruled that Section 2704(b) did not apply to the transfer of limited partnership interests by husband and wife to their children and GRATs because the restrictions were no more restrictive than default state law. b. Harper. In Estate of Harper v. Commissioner, T.C. Memo. 2000¬-202 (the first Harper case), the Tax Court rejected the Service's request to revisit Kerr. The Court held that since the terms of the FLP agreement with respect to the partner's ability to force a liquidation were no more restrictive than state law, Section 2704(b) did not apply to the valuation of the limited partnership interests.

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c. Knight. See also, Knight, 115 T.C. No. 36 (2000), which also found that Section 2704(b) did not apply when the restriction on the FLP interest is no more restrictive than state law. 3. Assignee Interests. Most states’ laws, including California, provide that partners in partnerships and members in LLCs can only transfer economic rights. In California these are referred to as “transferable interests.” Voting rights cannot be transferred without the consent of the other partners/members. Thus, for gift and estate tax purposes, no voting rights are included in the valuation since they cannot be transferred (we are trying to tax what the person has a right to transfer). See, for example, Nowell, T.C. Memo. 1999-15, Kerr, supra, Jones, 116 TC 121 (2001), McCord, supra. IRS asserts that 2704 causes inclusion of these voting rights, including rights to liquidate, to be included in the gift/estate valuation. See FSA 200049003. 4. Comments on Partnership Valuation. a. Restrictions More Restrictive than State Law. None of these cases dealt with an FLP which had restrictions on liquidation more restrictive than state law. See FSA 200049003 which illustrates the National Office's belief that 2704(b) is applicable if the restriction in the agreement is more restrictive than state law and states that Kerr and Harper are inapplicable in such a case (note that the Knight decision was released before the FSA was drafted). Thus, when drafting an FLP agreement, make sure the restrictions on liquidation are no more restrictive than state law. b. Transferring LP Interests to Charity. Some commentators believe that another approach to overcome application of 2704(b) is to transfer limited partnership interests to a charity or private foundation so the family does not control the entire entity before and after the transfer. c. FSA 200049003. FSA 200049003 also indicates that 2704(b) may be inapplicable if the interest valued is less than that required to liquidate the entity under state law. See the discussion wherein the IRS suggests 2704(b) is more appropriate for estate tax situations than gift tax. E. IRC Section 2036 Issues 1. Introduction and Partnership Cases. The Service thus far has been unsuccessful in obtaining “relief” from Congress in the FLP/LLC area, and also was rebuffed by Congress in 1994 when Treasury sought to

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include the transfer tax, and especially FLPs, etc., in its partnership “anti-abuse” Regulations (Regs. Section 1.701-2). Therefore, beginning in 1997, rulings by the Service (FSAs, TAMs) developed the multiple attacks on FLP/LLC plans that are well-known to practitioners and have been drilled into IRS Estate Tax Attorneys (“ETAs” or “examiners”). Illustrative of these rulings are the following: TAM 9842003 (FLP), FSA 200049003 (LLC), and FSA 200143004 (“S” corporation). However, the Service recognized such rulings did not have the desired effect of broadly discouraging FLP/LLC plans that generally are perceived by IRS to be a threat to the integrity of the transfer tax. So in recent years, with mixed success, IRS has sought to identify and then to pursue appropriate cases via litigation. In light of this development, there are several issues to consider: What are the attack arguments? How effective have they been? Most importantly, how do we as estate planners properly and fully advise our clients so they can make prudent judgments and give “informed consent” to proposed entity and transactional planning that results, at least in part, in substantial valuation adjustments or discounts? The cases prove out that once the FLP is properly formed under state law, the attorney and CPA still need to be involved to make sure that the family is treating the FLP as the distinct entity that it is. The IRS makes several arguments to attack the viability of the FLP. There are many Tax Court decisions discussing different IRS arguments and several recent Tax Court and U.S. Court of Appeals decisions which cut-off certain IRS arguments. a. Peracchio/Lappo/McCord/Temple/Astleford. Practitioners involved with family limited partnership valuations should read, among others, the following cases: Peracchio, T.C. Memo. 2003 280, Lappo, T.C. Memo. 2003 258, McCord, supra, Temple v. U.S., (Ea. Dist. Texas, No. 9:03 CV 165 (TH), March 10, 2006) and Astleford, T.C. Memo. 2008-128. These cases deal with the so-called “discounts” applicable to minority interests in family limited partnerships. Of course, if valuation is the issue, then likely the taxpayer has already won issues such as gift on formation, economic substance, IRC §2703 and/or §2704 arguments on the gift tax side or IRC §§2036, 2038, 2703 and/or 2704 on the estate tax side. Peracchio, Lappo, McCord, and Astleford detail the Tax Court’s current approach to valuation discounts. What these cases show from a valuation perspective is that the Tax Court has allowed discounts in the range of 26.5% (cash) to 52% (real estate) (these aggregate discounts are based on asset classes). The types of assets held by the partnership are an important factor in determining the overall level of discount. For example, in McCord, the aggregate discount on marketable securities was 28% and the aggregate discount on real estate was 52%. The discounts applied to the same partnership, with the lack of control discount determined by asset class and the lack of marketability discount determined for the entire entity interest.

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The Temple case is a District Court case, as opposed to a Tax Court case. The case involved a donor who gifted interests in four different entities (3 partnerships and 1 LLC) to his children and grandchildren. It was found that two of these partnerships were formed to “further plan his estate” and these two partnerships “did not conduct business operations” in the years of gifts. Further, the Court allowed the testimony of one of the donees as to the value of the minority interests in the entities. Temple is a very interesting case, finding applicable discounts ranging from 15% to 60%. b. Miller. In Miller v. Commissioner, T.C. Memo 2009-119, two sets of transfers were made to the FLP, one set in April 2002 and the other in May 2003. The court found that the transfers made in April 2002 satisfied the bona fide sale for adequate and full consideration exception to IRC section 2036 and that Decedent had significant and legitimate nontax business reasons for forming the FLP and contributing assets thereto. Those reasons were as follows: (i) Decedent wanted to continue her late husband’s investment philosophy (court found this was a significant non-tax business purpose); (ii) Decedent was able to insure her assets would be managed and invested in a manner that Decedent both desired and trusted; (iii) the FLP was engaged in an active trading operation and the FLP the assets were not regularly traded before; and (iv) Decedent kept sufficient assets out of the FLP. With respect to the transfers made in May 2003, the court agreed with IRS that Decedent did not have a significant and legitimate nontax business reason for those transfers. The court found that the purpose for those transfers was the “precipitous decline in decedent’s health in the weeks before the transfers.” Also, funds were distributed from the FLP to fund the estate tax liability. Miller confirms that marketable securities FLPs can withstand IRC section 2036 scrutiny. Further, it confirms that the activities of an FLP “need not rise to the level of a ‘business’ under the Federal income tax laws in order for the exception under section 2036(a) to apply.” c. Keller. In Keller v. U.S., 104 AFTR 2d 2009-6015, 08/20/2009 (U.S. Dist. Ct. So. Dist. of Tx.), the court found that since decedent (acting on behalf of all partners either as trustee or owner of the LLC) intended there to be a partnership and intended to contribute the bonds (which were identified in planning documents), a partnership existed with respect to the bonds as of her date of death. The court then went on to hold that the transfer of the bonds to the partnership was a bona fide sale for adequate and full consideration, and thus IRC sections 2036 and 2038 did not apply. Why? According to the court, the transfers were bona fide because: (i) “the lengthy discussions that went into creating the Partnership Agreement, which [decedent] signed, provide sufficient objective evidence that the Partnership transaction was “real, actual, genuine,

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and not feigned;” and (ii) “the primary purpose underlying the Partnership's formation was to protect family assets from depletion by ex-spouses through divorce proceedings. This was accomplished by creating an entity that, by altering the legal relationship between Mrs. Williams and her heirs, could facilitate the administration of significant family assets. In other words, the creation and funding of the Partnership was undertaken for a legitimate business purpose and not the mere ‘recycling’ of wealth;” and (iii) “the fact that Mrs. Williams had a significant collection of assets outside of the Partnership—well over $100 million—further supports the conclusion that the transfer was made pursuant to a bona fide sale.” According to the court, the transfers were for full and adequate consideration because: (i) the percentage interests of the partners were proportionate to their respective contributions; (ii) the contributions of the partners were credited to the respective capital accounts; and (iii) “the Partnership agreement provides that, upon liquidation, the partners are to receive their capital accounts in accordance with their percentage interests.” d. Hurford. In Estate of Hurford, T.C. Memo 2008-278, after the FLPs were created and purportedly funded, wife sold a 96.25% interest in each FLP to two of her children in exchange for a private annuity. There were problems with the sale as well. First, wife did not own 96.25% of each FLP. She owned 48%. The explanation was that she transferred all assets of the bypass trust and QTIP trust to herself, before contributing the assets to the FLPs. Further, in determining the value of the FLP interests, the assets of the FLPs were substantially undervalued. This resulted in annuity payments that were much too low. Also, the annuity payments were made from distributions from one of the FLPs. Wife died about 10 months after the private annuity sales. The court first looked at the private annuity sales and determined they were a disguised gift or sham. Why? Because of the two key facts as follows: (1) wife transferred the FLP interests to two of her three children. She trusted, instructed and expected these two children to share the assets with the third child (to give him a 1/3rd share). The goal was to not allow the third child to have control over the assets yet be able to share in the assets’ value; and (2) the annuity payments came from the assets transferred. The children did not use their own assets and they could not afford the annuity payments. The court stated: “Even collectively [the children] could not afford to pay [wife] $80,000 a month. What [wife's] children did instead was to hold the assets in the exact same form that they were in before the private annuity and then slowly transfer bits and pieces of them back to her, planning to divide what was left over (including a share for [the third child]), after she died. Again, this makes the private annuity look much more like a testamentary substitute than a bona fide sale.” The court then stated the legal standard as follows: “To be bona fide, a transaction need not be between strangers. Estate of Bongard, 124 T.C. at 123. But there must be some objective proof that the transaction wouldn't materially differ if the parties involved were negotiating at arms' length. Id. Any such finding would be insupportable here.”

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Ultimately the court found that the bona fide sale exception of 2036 and 2038 were not met with respect to the annuity sales and 2036 and 2038 applied to the FLP interests sold by wife. The court next looked at whether wife’s transfers of assets to the FLPs were subject to 2036. The petitioner’s main assertion of nontax reasons included: (i) asset protection, claiming “the assets needed protection from the liabilities associated with the farm and ranch properties and from creditors;” and (ii) asset management, claiming “the FLPs would consolidate the management of the cash and securities held by [wife], the Marital Trust, and the Family Trust.” The court dismissed these purported purposes, finding that asset protection, “without supporting evidence,” is insufficient proof of a significant nontax purpose, and the court could not “find in this case any advantage in consolidated management that [wife] or the two trusts gained from the transfer, particularly because the partners' relationship to the assets didn't change after formation.” The court also cited factors indicating the transfers to the FLPs were not bona fide, such as: (i) the Hurfords disregarded partnership formalities; (ii) wife was financially dependent on the FLP assets; (iii) treated FLP assets as wife’s in a tax filing; (iv) wife transferred non FLP assets to the FLPs; and (v) there were significant delays in transferring assets to the FLPs. The court concluded that wife retained interests in the assets transferred to the FLPs within the meaning of 2036(a)(1). Therefore, all assets wife transferred to the FLPs (including those she took from her late husband’s trusts) were directly includible in her gross estate. e. Murphy. In Estate of Murphy v. U.S., U.S. Dist. Ct. W.D. Ark. El Dorado Division, Case No. 07-CV-1013 (October 2, 2009), at decedent’s death the FLP assets had grown from $91 million to $131 million. Decedent died owning a 95.25365% limited partner interest and a 49% LLC interest. On the 706, the FLP interest was valued at $74,082,000, reflecting an aggregate 41% discount (12.5% LOC and 32.5% DLOM). The LLC interest was valued at $706,000. Note the LLC interest received two levels of discount, a 20% discount on the 2.2% general partnership interest owned by the LLC and an aggregate 40% discount (11.1% LOC and 32.5% DLOM) on the 49% LLC interest, resulting in a 52% discount to underlying asset value. The court found that all transfers met the bona fide sale exception for the following reasons: i. The purpose was to pool the Legacy Assets for central management. One child was actively involved with management of the FLP and the Legacy Assets. The FLP acquired assets consistent with its purpose. Also, the 2 “chosen” children did contributed assets to the LLC, and thus to the FLP.

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ii. Decedent retained sufficient assets outside the FLP ($130 million). iii. The formalities of the FLP were respected, no commingling of assets. iv. Decedent’s “chosen” two children were involved with the FLP and its formation. One of the children was represented by her own counsel. Therefore, decedent did not stand on all sides of the transaction. Therefore IRC section 2036 did not apply. The court followed the valuation conclusions of the estate’s expert. Thus, the reported values and discounts, as detailed above, were the conclusions of the court. As the estate paid the tax and interest to get into District Court, the estate received a $41 million refund (tax and interest). Murphy also involved the use of a “Graegin” loan. These loans are structured such that pre-payment is not allowed, or if it is, all interest that would otherwise accrued cannot be pre-paid. This allows the interest not yet paid to be currently deducted on the estate tax return. The “Graegin” loan in Murphy was confirmed by the court to be valid and the interest to be paid to qualify for an estate tax deduction. f. Malkin. In Malkin v. Commissioner, T.C. Memo 2009-212, Respondent IRS asserted Decedent’s transfer of assets to the FLPs was subject to IRC section 2036, and thus the assets he transferred thereto are includible in Decedent’s gross estate for estate tax purposes. The Court held that:

- Transferred LLC Interests. With respect to LLC interests Decedent transferred to Cotton FLP, the Court found: “Nothing in the record suggests that any express or implied agreement gave decedent the right to retain the present economic benefits of [the transferred LLC] interests.

- Transferred D&PL Stock. With respect to the D&PL stock Decedent transferred to Stock LLC and Cotton LLC, the Court found: “We agree with Respondent that an implied agreement existed between decedent and the [trustees of the Stock Trusts and Cotton Trusts] that decedent would retain the right to use the transferred stock.” This finding turned mostly on the use of the FLPs’ D&PL stock to secure Decedent’s personal debts. The court then turned to whether Decedent met the “Bona Fide Sale Exception” to IRC section 2036 with respect to the transferred D&PL stock. The Court found that Decedent had no significant and legitimate nontax reason for creating either FLP. The Court reviewed the following Petitioner asserted reasons for formation of the FLPs:

o Provide for Decedent’s children. The Court found this asserted purposes was not significant and legitimate because (citing Thompson) a “ ‘good faith’ transfer to a family limited partnership must provide the transferor

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some potential for benefit other than the potential estate tax advantages that might result from holding assets in the partnership form.”

o Business purpose of preventing sale of D&PL stock. The Court found this asserted purposes was not significant and legitimate because son also owned D&PL shares. Had Decedent wanted to prevent sale of D&PL shares, Decedent’s son would have contributed his own shares to one or both of the FLPs. Further, Decedent did not need the FLPs to control his own stock, he already owned it.

o Centralize management of the family’s wealth. The Court found this asserted purposes was not significant and legitimate because Decedent contributed all or almost all of the assets. With no pooling of family assets, there was no pooled wealth to manage. The passively held stock was only Decedent’s wealth.

Even though IRC section 2036 was found inapplicable to the LLC interests Decedent transferred to Cotton FLP, the Court found, “Decedent made indirect gifts to his children when he transferred [the LLC interests to Cotton FLP] and subsequently transferred to his children’s trusts limited partnership interests in [Cotton FLP].” g. Schauerhamer. In Schauerhamer, TC Memo. 1997-242, from date of FLP formation until her death 11 months later, the donor continued to manage all FLP assets and deposited all income from FLP investment assets in her own bank account. Based on a tracing analysis, the donor did not draw out any of such income. However, the Tax Court found that there was an implied agreement among the partners for the donor to maintain control of and income from FLP property. Thus, the Tax Court held that FLP assets were includible in the donor’s estate under Section 2036(a)(1). h. Reichardt. In Estate of Reichardt v. Commissioner, 114 TC 144 (2000), the Tax Court found that the decedent did not curtail his use of property transferred to the FLP, he deposited some FLP income into his own account, used the FLP account as his own checking account and lived at an FLP owned property without paying rent. In short, the decedent's relationship to the assets remained the same before and after FLP formation. The Tax Court further found that there was an implied agreement among the partners that the decedent could continue to use the assets of the FLP and retain the right to income from those assets. Pursuant to these findings, the Tax Court held that, pursuant to Section 2036(a)(1), the assets transferred by decedent to the FLP were includible in his estate. i. Harper. This is the second Harper case, but unrelated to the former as to the tax issue. In Estate of Harper v. Commissioner (II), TC Memo. 2002-121, the decedent established a limited partnership (HFLP) on January 1, 1994 capitalized with the majority of his assets. The

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Certificate of Limited Partnership was filed six months later, funding of HFLP started 7 months later and continued for 4 months. Decedent’s medical history showed a history of cancer and decedent received distributions whenever necessary without pro rata distributions to the other partners. The court found decedent retained enjoyment of the contributed property within the meaning of Section 2036(a). j. Thompson. In Thompson, TC Memo 2002-246, Decedent, the father of two children, formed two FLPs, naming a corporate general partner. One partnership was formed in Colorado (where his son lived) and the other was formed in Pennsylvania (where his daughter lived). Each child owned shares in his or her respective corporate general partner, and after formation of the partnerships, decedent made gifts of limited partnership interests to each child. Decedent’s children purchased a “Fortress Financial” family limited partnership plan, which was also used in Strangi. Based on facts indicating that Decedent transferred almost all of his assets to the FLP and received distributions to cover personal financial needs (making gifts to his children), the court found there was an implied agreement that Decedent would retain the enjoyment and economic benefit of the property he transferred and all assets of both partnerships were included in Decedent’s gross estate (at date of death value) under Section 2036. On appeal, the 3rd Circuit, in Thompson, sub.nom. Turner v. Comm’r, 382 F.3d 367 (3d Cir. 2004), affirmed the Tax Court and refused to apply the 2036(a) bona fide sale exception. See, for an excellent discussion of the exception as a “safe harbor” of sorts, see Korpics, “Qualifying New FLPs For The Bona Fide Sale Exception: Managing Thompson, Kimbell, Harper, and Stone”, Journal of Taxation, Feb. 2005, at p. 111. k. Estate of Strangi II. In Strangi II, TC Memo. 2003-145, affirmed, 2005-2 USTC ¶60,506 (5th Cir. 2005), the Fifth Circuit focused on the existence of an implied agreement between Mr. Strangi and his children that he would maintain the economic benefit of the assets transferred to the FLP and on whether the transfer of assets by Mr. Strangi to the FLP satisfied the bona fide sale for an adequate consideration in money or money’s worth exception of 2036. On the implied agreement, the Fifth Circuit found for IRS, with the following three factors supporting an implied agreement between Mr. Strangi and his children that he would maintain the economic benefit of the assets transferred to the FLP: i. FLP made distributions to meet Mr. Strangi’s personal needs and expenses, and then after his death, distributions to meet funeral and estate administration expenses; ii. Mr. Strangi’s continued physical possession of his residence transferred to the FLP. The Fifth Circuit further found that booking, but not collecting, rent from Mr. Strangi provided him a substantial economic benefit; and

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iii. Mr. Strangi did not retain sufficient assets outside of the FLP, indicating he and his children had at least an implicit understanding Mr. Strangi could access assets of the FLP for his personal needs. The Fifth Circuit next turned to whether Mr. Strangi’s transfer of assets to the FLP was a (1) bona fide sale, for (2) adequate and full consideration. After noting that the adequate and full consideration prong is generally met where assets are transferred to a partnership in exchange for proportional interests (and IRS conceded that was the case here), the Fifth Circuit found this prong was met by the Estate. The larger discussion was whether the transfer of assets to the FLP by Mr. Strangi was a bona fide sale. The Fifth Circuit noted that use of a bona fide standard requires a court to analyze the subjective intent of a party and the objective results of his or her actions, but the Fifth Circuit had not yet set forth what the objective inquiry entails in the 2036(a) context. The Fifth Circuit stated “We think the proper approach was set forth in Kimbell, in which we held that a sale is bona fide if, as an objective matter, it serves a ‘substantial business [or] other non-tax’ purpose.” After reviewing the Estate’s asserted non-tax purposes behind creation of the FLP, the Fifth Circuit found the Tax Court did not clearly err in finding that Mr. Strangi’s transfer of assets to the FLP lacked a substantial non-tax purpose, and held the exception to 2036(a) was not triggered. The Fifth Circuit did not review or analyze the Tax Court’s 2036(a)(2) analysis and Byrum analysis. Thus, the Tax Court’s view on Byrum in the context of 2036(a)(2) and family limited partnerships remains unreviewed (by the entire Tax Court or an Appeals Court). Section 2036(a)(2) and its implications should still be carefully reviewed by planners in every FLP situation. l. Stone. In Estate of Stone, TC Memo. 2003-309, Mr. and Mrs. Stone created 5 FLPs with their 4 children in settlement of litigation. The 4 children were involved in protracted litigation regarding trusts established by the Stones for their children and grandchildren and their operating business. There was real concern that the litigation among the children could negatively affect the Stone’s operating business. Mr. and Mrs. Stone controlled the process of creating the FLPs and the assets that each would receive. The Court ultimately found that the transfers of assets by Mr. and Mrs. Stone to each of the five limited partnerships were bona fide sales for adequate and full consideration in money or money’s worth within the exception to Section 2036(a) application (and thus Section 2036(a) did not apply). Important factors to this holding include: (i) transfers to FLPs were motivated primarily by investment and business concerns; (ii) the partners contemplated and intended each limited partnership to operate as joint enterprises for profit; (iii) all partners received interests proportionate to the fair market value of the assets each contributed; (iv) assets contributed were properly credited to the each partner’s capital account; and (v) upon termination or dissolution, the partners of each FLP were entitled to distributions equal to their capital accounts.

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m. Abraham. In Estate of Abraham v. Commissioner, TC Memo. 2004-39, affirmed 408 F.3d 26 (1st Cir. 2005. Mrs. Abraham’s guardians and children obtained court approval to establish an estate plan for Mrs. Abraham involving several FLPs. The court documentation made clear that Mrs. Abraham's needs were paramount and that her limited guardian ad litem would be the sole person to determine what portion of the FLPs’ income, up to 100% thereof, would be distributed to or for her benefit. Further, at trial, the children testified that there was an agreement that their mother’s needs would be provided for out of the FLPs. The court held that the underlying assets of the FLPs were includible in the decedent’s estate under Section 2036. The First Circuit confirmed the Tax Court. n. Hillgren. In Estate of Hillgren v. Commissioner, TC Memo. 2004-46, Ms. Hillgren worked closely with her brother, Mark Hillgren, on real estate investment matters for several years prior to her death. Ms. Hillgren and Mark Hillgren formed an FLP with Ms. Hillgren contributing seven pieces of real estate to the FLP. Legal title to the real properties and the applicable leases were never transferred to the FLP, the contributions merely reflected by the FLP documents. Business related to the partnership properties was conducted without disclosure of the partnership’s existence. The court found the FLP assets were used to support Ms. Hillgren and was kept "invisible" and held that the underlying property of the partnership was includible in the decedent’s estate under Section 2036(a)(1). Note the estate actually won the case because of a business loan agreement that was found to encumber the real estate. o. Kimbell. In Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004), the Fifth Circuit dealt IRS a serious blow in its Section 2036 attack on FLPs. The focus of this Kimbell decision is on the bona fide sale for adequate consideration exception to Section 2036. The court found that for a transfer to be a bona fide sale, the transferor must have actually parted with his or her interest in the transferred property and the partnership actually parted with the partnership interest issued in exchange. For a transfer to be for adequate and full consideration, the exchange of property for partnership interests must be roughly equivalent so the transfer does not deplete the estate. The court confirmed that transactions between family members are subject to heightened scrutiny to make sure the sale is not a sham transaction or disguised gift. This case means that, at least in the Fifth Circuit, if the FLP is properly funded and respected by the parties, it will meet the bona fide sale for adequate consideration exception of Section 2036. p. Bongard. In Estate of Wayne C. Bongard v. Commissioner, 124 TC 95 (3/15/05, Tax Court Judge Goeke, reviewed by the Court), the Tax Court continued to struggle with the reality of FLPs, IRC Section 2036(a), and, in effect, the “substance governs over form” issue.

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Decedent Bongard incorporated Empak, Inc. (“E”) in 1980, established an irrevocable trust in 1986 (funding it with some E stock), and in the mid-90s pooled all the E stock into a holding company – WCB Holdings, LLC, to be better positioned for a “corporate liquidity event necessary to raise capital and to remain competitive.” So, following this plan, decedent and the trust capitalized the LLC with all the E stock, taking back two classes of units. The next day decedent and the trust formed “BFLP” (partnership), with decedent transferring his class B member units for a 99% limited partnership interest and the trust transferring part of its class B units for a 1% general partnership interest in BFLP. Thereafter, about a year later, decedent gifted a 7.72% class B interest in BFLP; and then, again about a year later, died. The IRS 90-Day Letter, using Section 2035 (gift within 3 years of death) and Section 2036(a), essentially ignored both the gift and the two entities, i.e. both the LLC and the FLP. Taxpayer, of course, argued the “bona fide sale” exception to 2036(a), per Stone and Kimbell. The majority of the Tax Court, in Judge Goeke’s opinion, found that the E stock transfer to the LLC was within the “bona fide sale” exception; however, that the FLP transfer was not so protected, and thus 2036(a) applied. Importantly, in this fully reviewed decision with 10 of the currently serving 18 judges concurring in the opinion (with 4 more concurring in the result), the court sets forth a “test” applicable to FLPs and 2036. The bona fide sale for adequate and full consideration exception is met where the record establishes a legitimate and significant non-tax reason for creating the FLP and the transferors received partnership interests proportionate to the value of the property transferred. The objective evidence must indicate that the non-tax reason was a significant factor that motivated the partnership’s creation. In analyzing Kimbell, the Court noted the following legitimate and significant non-tax reasons: i. protection of the taxpayer from personal liability related to oil and gas properties contributed to the FLP; ii. pooling of all of the decedent’s assets to provide greater financial growth than splitting the assets; and iii. establishment of a centralized management structure. q. Bigelow. In Estate of Virginia A. Bigelow v. Commissioner, TC Memo. 2005-65, Judge Colvin applied the legitimate and significant non-tax reason test in determining whether the transfer of assets to the FLP was bona fide and for full and adequate consideration. The court held that the transferred property was so included – under Section 2036(a)(1). Note

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that Judge Colvin decided Reichardt, 114 TC 144 (2000), and once again, on the facts, concluded that “… there was implied agreement between decedent and her children that she would retain for her life the present economic benefit of the Padaro Lane property.” The failure to respect partnership formalities was an important issue to the court, as was the absence of non-tax benefits of the partnership to the decedent. Judge Colvin in Bigelow dismissed application of the “bona fide sale” exception to 2036(a) (ala Stone and Kimbell), stating that “… the transfer of the Padaro Lane property to Spindrift [the FLP] was not made in good faith.” Finally, the court made rather clear that the facts of this case were distinguishable from Kimbell. r. Korby. In Estate of Korby v. Commissioner, TC Memo. 2005-102, Judge Goeke found Mr. and Mrs. Korby had serious medical conditions that would cause them to incur medical expenses in excess of their social security income. The FLP paid their home expenses and made distributions for other basic living expenses. The FLP also made distributions, characterized as management expenses, to pay nursing home expenses and other expenses of Mr. and Mrs. Korby. No management contract was expected and fees were paid in various amounts as requested by decedent’s husband. One of their sons “testified that he caused the FLP to make payments to his parents whenever [his father] requested them because he was raised not to say no to his father.” On these facts, the Court found an implied agreement existed between the decedent, her husband and her children that income from the FLP assets would continue to be available to the decedent as long as she needed income. The Tax Court found (1) the decedent’s husband stood on all sides of the FLP’s formation, (2) FLP income was used by the decedent for basic living expense, and (3) the terms of the FLP agreement were not shown to protect partners from personal injury or commercial liability from the family bridge building business or divorce. Based on these findings, the Court found the FLP was created to meet testamentary objectives while allowing Mr. and Mrs. Korby to retain the income from the transferred assets for their lifetimes and held the transfer of assets to the FLP by decedent did not meet the bona fide sale exception to 2036. s. Schutt. In Estate of Schutt v. Commissioner, TC Memo. 2005-126, Judge Wherry presided over the first case where the petitioner estate passed the new Bongard bona fide sale for full and adequate consideration test. This test is a higher standard than Stone and appears tougher than Kimbell, but now we know it can be met. Decedent transferred stock to two Delaware business trusts (the DBTs). The decedent, who maintained large holdings in two companies, and his advisors decided to create the DBTs to perpetuate the decedent's "buy and hold investment philosophy." After extensive negotiations, the decedent, through his revocable trust, and a trust company, as trustee of several trusts created for the benefit of the decedent's children and grandchildren, contributed stock in the two companies to the DBTs. The furtherance of the decedent's buy and hold investment

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philosophy with respect to the stock owned by the decedent and the trust company was a legitimate and significant non-tax reason for the formation of the DBTs. Although estate tax ramifications were considered, the primary motivation behind the DBT formation was to perpetuate the decedent's investment philosophy. IRS argued the stock transferred to the trusts was includible in Decedent’s gross estate under Code Sections 2036 and 2038. The Tax Court found that transfers were a bona fide sale for adequate and full consideration. The bona fide sale exception was satisfied because: (1) the contributed property was actually transferred to the DBTs in a timely manner; (2) the decedent's assets were not commingled with the assets of the DBTs; (3) the decedent retained sufficient assets to support his lifestyle and needs; and (4) the DBTs were formed as a result of arm's-length negotiations. Further, the decedent and the trust company received interests in the DBTs representing adequate and full consideration because: (1) the interests received were proportionate to the value of the property contributed; (2) the respective assets contributed by the decedent and the trust company were properly credited to the appropriate capital accounts; (3) distributions from the DBTs required a negative adjustment in the distributee's capital account; and (4) a legitimate and significant non-tax reason existed for creating the DBTs. t. Keller. In Keller v. United States, Docket No. V-02-62, U.S. Dist. Court, Southern Dist. Of Texas (9/30/2005), the federal government (as a defendant) filed a motion for summary judgment that 2036 and/or 2038 applied to an FLP. The court found that Kimbell and Strangi illustrate that summary judgment should not be used to discern whether 2036 or 2038 apply to a particular FLP estate tax case; these determinations are too factually driven. u. Disbrow. In Estate of Disbrow v. Commissioner, T.C. Memo. 2006-34, Judge Laro found that there were express and implied agreements between the decedent and her children and step-children that she would continue to have possession and enjoyment of the residence for the remainder of her lifetime. The court found the lease agreements themselves memorialized that agreement, which suggests that even if fair market rent were paid and the full amount of rent paid, it would have made no difference. v. Rosen. In Estate of Rosen v. Commissioner, T.C. Memo. 2006-115, the estate argued that the transfer of assets from Ms. Rosen to the FLP in exchange for a 99% limited partnership interest was a bona fide sale for an adequate and full consideration in money or money’s worth. Judge Laro concluded “[n]otwithstanding the incredible subjective expressions of contrary intent espoused at trial by individuals connected with the [FLP], the objective facts in the record support our conclusion that the transfer of decedent's [Ms. Rosen’s] assets to the [FLP] was not a bona fide sale.” The Court’s conclusion, was based on the following findings of fact: (i) “the [FLP] was not engaged in a valid, functioning business

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operation, and the [FLP] served no legitimate or significant nontax purpose; it operated simply as a vehicle for changing the form in which decedent held her beneficial interest in the transferred assets”, (ii) “the partners of the [FLP] did not negotiate or set any of the terms of the [FLP], and decedent's daughter (as decedent's attorney-in-fact, co-trustee of the Lillie Investment Trust, and general partner of the [FLP]) stood on all sides of the transaction”, (iii) the time between formation and funding was lengthy and the “reported contributions of assets by decedent's children also were de minimis in relation to the assets contributed by decedent; in fact, given the cash gifts that decedent made to each of her children surrounding their contributions to the capital of the [FLP], decedent arguably funded the [FLP] all by herself”, (iv) Ms. Rosen “transferred substantially all of [her] assets, including all of her investment assets, to the [FLP]”, (v) “after the transfer of the assets to the [FLP], decedent was unable to meet her financial obligations without using funds of the [FLP]. In fact, all of the funds that were withdrawn from the [FLP] were used for decedent's benefit”, (vi) “assets that were contributed to the [FLP] consisted solely of marketable securities and cash” and little trading occurred, and (vii) Ms. Rosen’s “age and health when the [FLP] was formed.” The Court went on to find that Ms. Rosen retained the possession or enjoyment of, or the right to income from, the transferred assets after her assets were transferred to the FLP (and thus the assets she transferred thereto were includible in her gross estate despite the gifts of FLP interests). In support of this finding, the Court found (i) “the FLP was not a business operated for profit; it was a testamentary device whose goal was to reduce the estate tax value of decedent's assets”, (ii) “decedent's relationship to her assets did not change following their transfer to the [FLP] and was not treated differently by either decedent's daughter (as decedent's attorney-in-fact) or the general partners of the [FLP]”, and (iii) “decedent's assets were transferred to the [FLP] on the advice of counsel in order to minimize the tax on the passage of her estate to her descendants.” w. Erickson. In Estate of Hilde E. Erickson, T.C. Memo. 2007-107, the FLP was established when the decedent was older (88 here) and in poor health. Also, decedent retained insufficient assets outside of the FLP. Judge Kroupa further found that there was an implied agreement that decedent could retain the income or the benefits from the property decedent transferred to the FLP because: (1) there was a significant delay in funding; (2) the FLP distributed funds to the estate so that the estate could meets its tax obligations; and (3) the FLP had no practical effect during the decedent's life, largely because it was not fully funded until days before the decedent's death. The court also found that the transfer of assets to the FLP by the decedent was not a bona fide sale for full and adequate consideration because the FLP was not formed for a "legitimate and significant nontax reason." x. Gore. In Estate of Sylvia Gore, T.C. Memo. 2007-169, Judge Marvel found that during her lifetime Mrs. Gore continued to receive all income from property allegedly transferred to

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LP and had unrestricted use and access to assets allegedly transferred to LP. The Tax Court also found that LP had no business or investment activity and had no accounting records until after Mrs. Gore’s death. Accordingly, the Tax Court determined that to the extent Mrs. Gore actually transferred assets to LP 2036(a) caused such assets to be includible in her gross estate for estate tax purposes. y. Rector. In Estate of Concetta H. Rector v. Commissioner, T.C. Memo. 2007-367, the FLP was established when the decedent was older (92 here) and in poor health (at least perceived as she concurrently moved into a convalescent hospital). The FLP was created and funded with real property. Judge Laro found that the transfer of real estate to the FLP was not a bona fide sale for adequate and full consideration (the formation entailed no change in assets or likelihood of profit and there was no legitimate nontax business purpose). The court also found that the decedent retained the right transferred property within the meaning of Code Sec. 2036(a) because as general partner she had total control over the management and the distributions of the assets (decedent retained all of the interests in the FLP and was the only one to contribute assets thereto). The court further found an implied agreement that the assets decedent transferred to the FLP could be used by here at any time (that the decedent did not retain sufficient assets outside of the FLP and assets of the FLP were used for the decedent’s needs. z. Mirowski. In Mirowski v. Commissioner, T.C. Memo. 2008-74, the Internal Revenue Service (the “IRS”) attempted, unsuccessfully, to increase the Decedent’s estate tax deficiency by over $14 million pursuant to Internal Revenue Code (“IRC”) §§ 2036(a), 2038(a), and 2035(a). However, the Tax Court ruled that the Decedent’s transfer of assets to the LLC qualified for the “bona fide sale for adequate and full consideration in money or money’s worth” exception under IRC § 2036(a). The Tax Court rejected the IRS’ arguments that: (1) the Decedent failed to retain sufficient assets outside of the LLC, holding instead that she had no financial obligations other than her gift tax liability, and could have used a combination of her remaining assets, LLC distributions, or loans to raise the necessary cash; (2) the LLC’s assets needed to rise to the level of a “business” in order for the bona fide sale exception to apply; (3) the close proximity of the LLC’s formation to the Decedent’s death was relevant, holding instead that the timing was both coincidental and unforeseeable; (4) the Decedent should not be allowed to qualify for the bona fide sale exception where she was the only contributor of assets to the single member LLC; (5) the LLC’s payment of the Decedent’s estate taxes was dispositive of the issue, holding instead that neither the Decedent nor her family considered such issues at the time of the LLC’s formation. Ultimately, the Tax Court found the Decedent received interests in the LLC proportionate to the assets she contributed, that her capital account was properly maintained, that she was entitled to pro rata distributions from the LLC, that there was no comingling of personal assets, no contribution of personal use assets to the LLC, that the Decedent

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could not liquidate the LLC without unanimous approval of all members, and that in the event of liquidation any such liquidating distribution had to be in accordance with the members’ respective capital accounts. Furthermore, the Tax Court rejected the IRS’ step transaction doctrine argument, instead respecting “the two separate, albeit integrally related, transfers of property” namely her formation and funding of the LLC and her subsequent gift of LLC interests to the trusts. The Tax Court did not consider whether the Decedent retained possession or enjoyment of, or the right to income from, the assets contributed to the LLC within the meaning of IRC § 2036(a)(2) in connection with the 52% of the LLC the Decedent retained. However, the Tax Court did discuss the IRC § 2036(a)(2) issue in connection with the three gifts of LLC interests the Decedent made in trust. Despite the fact that the Decedent retained a 52% interest in the LLC, and that she was its general manager, the Tax Court rejected the IRS’ contention that the Decedent retained possession or enjoyment of, or the right to income from, the assets she contributed to the LLC but gifted to the trusts. Certain restrictions in the LLC’s operating agreement coupled with state law fiduciary duties meant that the Decedent did not retain such possession or enjoyment. Moreover, the Tax Court rejected the IRS’ contention that there was an express or implied agreement the Decedent retained such a prohibited interest. The operating agreement did not afford the Decedent, as general manager, the ability to determine the timing or amount of LLC distributions. Moreover, the credible testimony and evidence offered at trial rebutted the IRS’ suggestion that such an implied agreement existed. aa. Jorgensen. In Estate of Jorgensen, TC Memo 2009-66, the decedent needed assets to make cash gifts to family in the manner that she desired and that a substantial amount of FLPs' assets were used to pay estate obligations. Additionally, there was implied agreement that the decedent would retain the economic benefits. The Court held that the contributions were transfers within meaning of IRC 2036 and didn't qualify for statute's bona fide sales exception. Given the totality of facts and circumstances, including facts that FLPs were often used for personal expenses and that decedent stood on both sides of transactions, the Court found that there lacked a significant and legitimate non-tax reason for the transfers. Though the estate claimed to the contrary (that the transfers were made for management succession purposes, to promote family education and unity, and for other purported non-tax reasons,) the Court found these unpersuasive. As a result, the Court held that the estate was required under IRC 2036 to include in gross estate value of securities decedent voluntarily contributed before death to purported investment FLPs. bb. Turner. In Estate of Turner, TC Memo 2011-209, the evidence showed that contrary to the claims of the estate, the FLP wasn’t formed as a vehicle for resolving disputes or to manage and protect the family assets. Rather, the Court found that the FLP was formed as part of a testamentary plan, one that lacked any bargaining between the decedent and his

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wife/other parties/family members. Furthermore, the evidence showed that decedent commingled FLP and personal funds and that he did not complete the asset transfers until 8 months after he had formed the FLP. Finally, decedent retained possession or enjoyment rights, both implied and in fact, for purposes of IRC 2036 upon consideration of the FLP’s testamentary purpose and his practice of at-will withdrawals of the funds. Although decedent received adequate consideration for the transfers, the overall picture showed that there was no bona fide sale for purposes of IRC 2036(a). As a result, ½ of the value of the cash, stock, and the other assets that the deceased business owner and his wife contributed before their deaths to the newly formed FLP were includible in the decedent’s gross estate pursuant to IRC 2036. cc. Liljestrand. In Estate of Liljestrand, TC Memo 2011-259, the decedent transferred during his life significant real estate assets from a trust to a FLP. When hailed into court, the taxpayer depicted these transfers as bona fide sales nominated by non-tax reasons. These included the desire (1) to protect assets from partition and (2) to ensure that decedent’s son/co-trustee would have a management role. However, in looking at how the FLP was operated, the court found that (1) the basic partnership formalities were not followed, (2) the decedent stood on all sides of the transfers, and (3) the transfers were not arm’s length. Furthermore, the fact that the interests credited to each partner were not proportionate to the fair market value of the assets contributed, and that those assets weren't properly credited to partners' respective capital accounts undermined the petitioner’s claim that transfers were for full and adequate consideration. In addition, the court found that the decedent did not significantly change his relationship to assets after transfers, continued to use the same assets to pay personal expenses, and was primarily using partnership as alternate testamentary vehicle through which he would provide for his children at death. As a result, given all of the above, the Court held that the transfers were considered transfers of property within meaning of Code Sec. 2036 over which decedent retained right to enjoyment and in respect to which there was no bona fide sale for adequate and full consideration. dd. Kelly. In Estate of Kelly, TC Memo 2012-73, the decedent transferred (with the help of her guardians/children) various assets at the time of her mental incapacitation to new FLPs in exchange for 99% FLP interests. The evidence showed that the FLPs were created for legitimate and significant nontax reasons: (1) to ensure equal distribution of the estate, (2) to avoid potential litigation, and (3) to achieve effect asset management. Also, there was no discrepancy in value between the interests that the decedent received in the exchange and the interests that the decedent contributed. When the decedent later gifted her FLP to her children, she avoided IRC 2036’s general inclusion rule because she did not retain any income or rights in the FLP. As a result, the Court held that the value of these assets qualified for the bona fide sales exception to IRC 2036’s general inclusion rule.

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F. Income Tax Planning On January 2, 2013, President Obama signed into law the America Taxpayer Relief Act of 2012 (the “2012 Act”). The 2012 Act made “permanent” higher applicable exclusion amounts. The basic exclusion amount is now $5 million plus inflation adjustments. On the income tax side, federal income tax rates have increased (and we have a new tax, the net investment income tax). Of course, California also has increased income tax rates. This all means that income tax is much more important in estate planning. Under IRC section 1014, the income tax basis of inherited property is generally equal to the estate tax value. In light of higher estate tax exclusions, valuation discounts taken to reduce estate tax can be less important, or even harmful to many heirs. Thus, when looking at entities, careful planning should be used. After years of finding ways to enhance discounts, planners may now be planning looking at ways to use entities without being subject to substantial discounts. In smaller estates where the increased estate tax exclusion can absorb the additional value, it may be best to grant the senior generation a liquidation right that lapse at death. This will trigger IRC section 2704 and increase the value of the interest in the senior generation’s estate. This will also increase the income tax basis in the assets inherited by the junior generation. In many estates there will be careful balance between estate tax objectives and income tax objectives. X. IDEAL TIME TO RELY UPON TENANCY-IN-COMMON While Cotenancy Agreements can alleviate much of the concern with control of assets and maintaining ownership within the family group, ultimately due to the nature of co-owned property all of the owners will need to cooperate in some fashion. This will be required to sign a lease, modify the Cotenancy Agreement, or some other aspect of property management and ownership. Thus, coownership arrangements should be carefully considered and contrasted with entities. The following are some considerations that weigh in favor of using coownership arrangements, assuming a Cotenancy Agreement will be used. None of these, or any other, considerations will be dispositive of the inquiry. Rather, a balance of several factors most important to the client and planning situation will drive the decision. A. High 2036 Risk In situations of high 2036 risk, such as transfers soon before death, cotenancy can be the preferred ownership structure. The nature of real property ownership provides better defenses to 2036. Further, the Stewart case, while not a Ninth Circuit case, supports the notion of proportional application of 2036. Contrast this to the all or nothing outcome of the family partnership cases. In cases of high 2036 risk, risk can be further minimized by making gifts in trust with a bank or trust company trustee. The fiduciary duties cannot be questioned. Note in

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Mitchell, supra, the fractional interest gifts were made 5 days before death to Whittier Trust as trustee of trusts for the decedent’s children. IRS contemplated using 2036, but ultimately did not raise the issue. Also, consider having the gift made to one trustee, then changing the trustee before the transferor dies. It is really hard to have an implied agreement with the transferee at the time of transfer if he or she was not the donee trustee. Another consideration with 2036 is prior annual exclusion gifts, or numerous prior gifts that benefited from the annual exclusion. In many cases, the years of annual exclusions are more valuable that discounts. If 2036 applies, it could eliminate the benefit of those annual exclusions. Thus, consider future gifting plans and use of the annual exclusion. It could be that cotenancy is preferred so as to reduce 2036 exposure. Also consider existing entities where numerous past gifts utilizing the annual exclusion were made. Could it be best to terminate the entity and move forward based on cotenancy? B. California Property Tax For planners in California, property tax planning can be a significant factor in coownership of property. The parent-child exclusion does not apply to entity interests. Thus, some planning situations warrant using cotenancy to protect low property tax basis properties. C. Low Liability Concern When the property involved has low liability exposure, cotenancy can be appropriate. Most artwork has low liability exposure. Similarly, residences due to homeowner’s insurance, also may have low liability exposure. Certainly, real property with environmental contamination or high liability uses should be held in an entity, preferably never allowing the donee to directly own an interest in the real estate. The other end of this spectrum is creditor issues of the co-owners themselves. If one of the co-owners has his or her own creditor problems, cotenancy is not the best option. If a judgment is issued against that co-owner, the other co-owners could be forced to buyout that co-owner, or be a co-owner with the creditor. D. Desire for Minimal Legal and Other Costs Many clients are focused more on overall costs than on achieving the best structure for co-owned property. In these cases, a cotenancy may be best. Entities generally have higher setup and maintenance costs. This is not always true, so it’s important to understand how operations of the co-owned property will function. In some cases an entity will be significantly more expensive to operate (such as with artwork). In other cases, an entity may result in lower overall costs (such as several co-owned rental real properties).

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E. Low Tolerance for Planning Compliance/Complexity While entities are commonplace, they are not common for all clients. Some clients have no tolerance for the complexities of an entity. In such cases, use of cotenancy may be the best option. This factor ties somewhat to the next one, i.e. low risk tolerance clients. Entities operated improperly will cause full estate tax inclusion under 2036. Cotenancies, on the other hand, appear to have more leeway in this regard. F. Low Risk Tolerance Clients Many clients will not to employ planning that creates perceived or actual risks with IRS. For these clients, the cotenancy structure is likely best. As discussed herein, cotenancy offers state law property rights that can better defend against 2036. Further, 2036 proportionality may come to the rescue (at least it has a better chance of success). Of course, the client’s tolerance for complexity may result in improper entity operations, and thus enhance risks associated with IRS examination. G. Fewer Potential Owners If the number of owners is smaller, say under 5 or so, a cotenancy could be preferable due to simplicity. Every situation is different. But certainly, if the number of owners approaches 10 or more, an entity is likely the way to go. XI. IDEAL TIME TO RELY IN ENTITY A. Controlled Management Succession Paramount Use of entities for succession planning is still the best option. In this context, the only way to really control co-owned property is with a trust or an entity. Direct ownership does not offer the desired level of control. As discussed above, even with a cotenancy agreement, the signature of all property owners will be needed. Clients often chose their most responsible child to manage assets for other children or descendants. This child should manage the assets via a partnership or an LLC and be subject to business fiduciary duties (such as the business judgment rule) rather than trust fiduciary duties. This does not mean the partnership or LLC will not be held in trust, only that the coownership should be via entity over a trust. B. Problem Heirs In many planning situations there is one or more beneficiary that will be a problem. The problem could be mental illness, substance abuse, a disagreeable personality, a spouse who exerts too much control, or the beneficiary’s own creditor issues. In these situations, the entity form of coownership is ideal. The property must be operated without this persons input and without this person holding-up operations for the other owners. Certainly, if the clients can give liquid assets to the problem beneficiary and other assets

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to the functional beneficiaries this can avoid the coownership issues. However, people change over time, especially when there is money on the table. Thus, the best coownership structure is often the entity. C. Estates in Excess of Estate Tax Exclusion Amount For larger estates, discounts are still important. While management succession and control is of paramount importance (loss of assets is a 100% loss, estate tax is only a 40% loss), the desire for discounts can be considered in the planning. Entities generally offer higher levels of discounts (because of the centralized control aspects) and thus may be more appealing for discount considerations. D. Corporate Trustee over Donee Trust One of the foundational arguments for 2036 is an implied agreement between the donor and donee that the donor can continue using and benefiting from the transferred property. If the transfer is made to a trust that has a bank or trust company trustee, that argument becomes much more difficult. Thus, when using FLPs, consider whether a bank or corporate trustee can be used to reduce or eliminate this exposure. E. Creditor Concerns Creditor concerns come in two flavors. One is derived from the assets themselves. The other is derived from the co-owners. For assets with liability exposure, an LLC or a limited partnership with a corporate or LLC general partner will be a must. For those planning situations with heirs who have, or may have, creditor problems, entities are also a must. With an LLC or limited partnership interest, creditors will be limited to a charging order. With cotenancy, the creditors may be able to get to the cotenancy interest, resulting in a forced sale (and the need to obtain raise cash) or the creditor becoming a co-owner directly. F. Reinvestment of Gains Many families desire to grow wealth and assets over time. If the planning situation dictates that the product derived from the co-owned property will be used to acquire additional assets, then an entity will be ideal. Many planning situations result in cash reserves being invested in marketable securities (at least until real estate or other high value asset can be acquired). Entities are ideally suited to growing wealth in a protected and controlled manner.