By: Espen Robak

In Estate of Holliday, decided March 17, 2016, the IRS won a small (dollar-wise) yet meaningful victory on the Sec. 2036 retained interest issue. The case is instructive, since the facts were not particularly bad for the taxpayer. Thus, and especially in conjunction with recent cases, it can serve as a guide to others dealing with this rather murky issue.

I will provide a very brief summary and some thoughts here. Since the recent Purdue case dealt with almost exactly the same issue, and on relatively similar facts – and went the other way – I also think it makes sense to compare the two.

Oak Capital Partners, LP

In 2006, Ms. Holliday, who was in a nursing home but otherwise in relatively good health, created Oak Capital with a limited liability company (OVL) as GP and herself as LP and transferred about $6 million in marketable securities to the partnership. Subsequently, her interest in OVL was sold to her two children and a 10 percent interest in the partnership was transferred to an irrevocable trust. The remaining 89.9 percent interest in Oak Capital was held by Ms. Holliday until her death in 2009.

The decedent’s interest in Oak Capital was valued at an approximate 34 percent discount, but the Service issued a notice of deficiency including all of the assets transferred to the partnership, undiscounted, as if in the hands of the decedent.

The Tax Court (Judge Gerber) holds, first, that the decedent had a retained interest in the transferred assets (because the partnership agreement required the GP to distribute funds “to the extent … the Partnership has sufficient funds in excess of its current operating needs”) and, second, that the original 2006 transfer of the securities was not a bona fide sale for full and adequate consideration. The Court’s conclusion is that the assets are includible in the estate and, thus, the entire estate planning transaction fails, from the perspective of the taxpayer.

Purdue Family LLC

The facts of Purdue are somewhat more complex so this will serve only as a very brief overview of the facts relevant to the Sec. 2036 “bona fide sale” considerations considered important by the Court. Ms. Purdue formed with her husband (who later predeceased her) PFLLC in 2000. Over the years, various transfers were made to their children of PFLLC interests. At death, in 2007, the decedent owned approximately 25 percent of PFLLC outright and certain other amounts through various trusts.

The Court (Judge Goeke) focuses, in its opinion on the Sec. 2036 issue, exclusively on whether the transfer of assets to PFLLC was a bona fide sale for full and adequate consideration. Holding that it was, it does not need to investigate whether or not the estate had a retained interest, and the transaction works, from the valuation and tax-planning perspective, for the taxpayer.

Small Distinctions Make A Difference

Generally, neither of these is the typical “bad facts” case so often seen in the past (while the Service was still, so to speak, sharpening its knives for this broader attack). These were not death bed gifts, nor did the taxpayer in either case transfer all of their assets into the entity. There is no commingling of personal and partnership assets and the decedents weren’t using the entities as their own personal piggy banks. Partnership formalities were by and large observed, albeit more so in Purdue than in Holliday.  So what makes for the different outcomes?

Bona Fide Sales

The first prong of the bona fide sale for full and adequate consideration test (the two are obviously interrelated) attempts to separate the very obvious tax motives – i.e., valuation discounts – from reasonable and true non-tax motives. A reasonable and true non-tax motive is, basically, one that isn’t completely fake, or in the Tax Court’s more refined wording in Purdue, “those that merely clothe transfer tax savings motives.”

In Purdue, the Court held that the management of the brokerage accounts holding the family’s marketable securities was consolidated by the establishment of the entity, and that the management was noticeably more coordinated and professional thereafter. The PFLLC also incorporated an investment in real estate. While Ms. Holliday wanted to preserve assets for the benefit of her family, the assets were already in trusts and the Court held that there had been no issues with the management of these assets. And nothing changed after entity formation.

In Purdue, the Court also held that full and adequate consideration was received for the assets transferred and, therefore, there is no need to consider whether a retained interest exists. In Holliday, since the court holds that the transfer wasn’t a bona fide sale, it isn’t necessary to consider the full and adequate consideration prong of the analysis.

In Holliday, the taxpayer also makes typical asset protection arguments, but these are not persuasive enough for the Court. The Court also puts some weight on the failure of Oak Capital to maintain books and records other than brokerage statements and ledgers, and the failure to hold formal meetings.

A Test For Future Cases?

So, is this it? When considering marketable securities partnerships in the future, it seems that these two cases provide a further narrowing of what falls within permissible lines. Based on the Court’s summary of each case, here are the facts that appear to have been the downfall of the Holliday estate:

  • When forming entities with mostly or exclusively marketable securities, there needs to be some evidence that the family members managing the entity actually does something with the accounts post-transfer.
  • Entity agreement language mandating distributions of income to the partners, including the decedent, are unhelpful and should probably be avoided.
  • Maintaining books and records, formal meetings with minutes, and other entity formalities remains an important part of the process and should be respected.

Overall, these two cases provide a narrower range of what-to-dos and what-not-to-dos than many of the bad facts cases we’ve seen in the past.