June 2008

Finally: Tax Court Considers “Good Facts” Challenge to an FLP/LLC

Court’s ruling provides a roadmap for good planning, funding and presenting an FLP or similar entity should it meet an IRS challenge

After a recent string of “bad facts” cases dealing with family limited partnerships (FLPs) and LLCs, on March 26, 2008, the U.S. Tax Court delivered some relief to taxpayers. The court’s ruling in Estate of Mirowski v. Commissioner (T.C. Memo. 2008-74) also provides a potential “roadmap” for good planning, funding and presenting an FLP or similar entity, such as an LLC, should it meet an IRS challenge under Internal Revenue Code § 2036(a).

That section provides that a decedent’s taxable gross estate should include the value of all property that the decedent transferred during his or her lifetime while retaining the possession or enjoyment of, or the right of income from, the property, or the right to designate the persons who can do so.

Long-Term Planning, Sudden Death

In the 1960s, Dr. Mirowski helped invent a patented medical device. The device became enormously profitable, but only after his death in 1990. Continuing a long history of family and charitable giving, Dr. Mirowski’s widow retained a majority interest (51.09%) in the patent and licensing agreements but gifted the remaining interest into three irrevocable trusts for each of her daughters.

In August 2001, with the assistance of her financial advisors, Mrs. Mirowski created a limited liability company, Mirowski Family Ventures. Within a week of setting up the LLC, she funded it with more than $60 million in assets, including her 51% interest in medical patents. She immediately gave each of her daughters’ trusts a 16% member interest in the LLC, for a total of 48%. The LLC’s operating agreements designated Mrs. Mirowski as the managing member, but a sale or other transfer of the company required approval of all members.

Although she made no arrangements for the payment of the substantial gift tax liability that would result from the gifting of the LLC memberships, Mrs. Mirowski retained over $7.5 million from which she could have provided payments. However, four days after funding her LLC, she died.

IRS Challenge

Mrs. Mirowski’s estate paid over $14.1 million in estate taxes. After an IRS audit, and pursuant to IRC § 2036, the IRS determined that the estate owed an additional $14.2 million in taxes, based on the inclusion of all of Mrs. Mirowski’s transfers to Mirowski Family Ventures.

The IRS tried to compare the LLC interest transfers to prior “bad facts” cases in which the Tax Court rejected an FLP or similar entity based on improper or belated funding, failure to observe partnership structure and management procedures, or other “badges” of non-business purpose. In those cases, the FLP generally had little use beyond an estate planning (and tax avoidance) device.

In response, attorneys for the Mirowski estate distinguished this case by its comparatively “good” facts.

For instance, even though Mrs. Mirowski died within days of funding the LLC, her death was unexpected, and, thus, the transfers could not be characterized as deathbed transactions. Further, the estate’s attorneys presented evidence that, while Mrs. Mirowski realized that forming the LLC could yield some tax benefits, her primary motivations were:

• joint management of the family's assets by her daughters and, eventually, her grandchildren;

• pooling the assets to allow for investment opportunities that would not be available if she made separate gifts to each of her daughters or their trusts;

• providing additional protection from potential creditors for the interests in the family's assets; and

• providing for each of her daughters and ultimately her grandchildren on an equal basis.

A Win for the Estate

The Tax Court agreed with the estate, finding that Mirowski Family Ventures had “real and significant non-tax business purposes” that met the § 2036(a) criteria to apply the “bona fide sale” exception to the transfers. In fact, the court found that Mrs. Mirowski’s stated wish for her daughters to remain “closely knit and be jointly involved” in managing the family assets was the most significant non-tax purpose, which, by itself, qualified for the § 2036(a) exception.

The IRS had also argued that Mrs. Mirowski failed to retain sufficient assets outside of the LLC to support her own expenses as well as the substantial gift tax liability. That argument also proved unsuccessful, as the court found that she could have paid those expenses from her retention of over $7.5 million in assets or from the anticipated distributions from the LLC. At no time before her death, the court found, did the LLC’s members have any agreement, express or implied, to fund the liability with LLC assets.

Finally, even though Mrs. Mirowski was the LLC’s managing member, her powers and discretion were subject to the operating agreement, including its requirement of other members’ approval for major transactions. The court found no agreement, express or implied, that by her position she retained a right or interest into the respective 16% LLC interests that she gave to her daughters’ trusts. ■