The IRS Uses Substance-Over-Form Doctrine to Evaluate Tax Savings Techniques
Tree Farmer Magazine: May/June 2007 - Volume 26 No. 3
If you expect your taxable estate to be worth more that $1 million, you need to think about ways to reduce it to no more than this amount. This applies to the estate of the first spouse to die and the second. Most estate plans provide flexibility to the administrator to balance the amount of wealth going to the surviving spouse and to heirs in the next generation to take maximum advantage of both excludable amounts, i.e., the amount not subject to the estate tax. A commonly used tool is for mother and father to form a family limited partnership (FLP) or family limited liability company (FLLC) using assets such as timberland. We need to look as this technique anew light of the IRS's recent focus on the substance of this technique, in addition to the mere form.
Believe it or not, tax laws are intended to support economic activity, wealth, and job creation. This, tax planning techniques that serve a genuine economic purpose are not audited as closely as those that appear to do little more than cut taxes, i.e., tax shelters. The IRS's increased use of substance-over-form principle was enhanced more generally by the U.S. Supreme Court in Dow Chemical Co. (435 F.3d 594) and Coltec Industries (454 F.3d 1340). The court let the IRS's use of the principle stand by not hearing these cases. In addition, the U.S. Congress is considering legislation that would explicitly make the principle part of the Internal Revenue Code.
What might this mean for Tree Farmers? Consider the Browns' situation. Pete and Dorothy are in their mid-50s and have owned a 1,200-acre tract of good timberland for the last 30 years. They use Longwell and Co. (L&C), a consulting forestry firm, to manage if for them. They meet with the L&C representative whenever a major decision is to be made. L&C is not authorized to act as the Browns' agent so Pete and Dorothy sign all timber sale contracts, but L&C is authorized to expend funds for day-to-day operations and vendor service not to exceed $10,000. The Browns file a joint Form 1040 with Tree Farm transactions reported on schedule C.
The Browns' son and daughter are both married with children and live more than a day's drive from the timberland. The "kids," as Pete and Dorothy refer to them both, keep themselves informed about what their folks are doing with the Tree Farm, but aren't involved when major decisions are made with L&C. Pete and Dorothy definitely want the kids and their families to be the primary beneficiaries of the Tree Farm wealth, but are just starting to consider the best way to do this.
They recently met with their attorney, John, and their L&C representative around the same table to seriously work on a new estate and financial plan. Based on fair market values at this time, they agreed to use $4.2 million as the value of the timberland - $3,500 per acre - given its proximity to a metropolitan area and relatively heavy timber stocking because they manage on a sawtimber rotation to draw down stocking to provide after-tax revenue for a gifting program benefiting the Kids and grandchildren, but, using $2 million as their combined excludable amount, the values in 2011 and later and the value of their other assets, they need to further reduce their taxable estate.
The Browns' are considering forming an FLP or FLLC to bring their children into the "business," John notes that a decision can be MADE later and their discussion applies to either form. More basic issues need to be discussed first.
All the taxable gifts they've made to date have come under the annual exemption, currently $12,000 per donor per donee. Thus, they haven't used any of their $1 million lifetime exemption on taxable gifts. they could elect to jointly give up to $2 million of their interest in the timberland business without paying any gift tax. They prefer, however, to save some of this exemption for later taxable gifts. They could make annual gift-tax exempt joint gifts of $24,000 each to their two children and their spouses, a total of $96,000 per year. But what's the best way to make the gifts?
Their attorney, John, mentions that IRS's Appeals Coordinated Issue Settlement Guidelines, Discounts for Family Limited Partnership, October 20, 2006 (UIL 2031.01-00), needs to be considered in their decision. He points out that the IRS's major concern is the use of FLP's with truly "passive investments" such as stock portfolios, mutual funds, bond portfolios, and cash. Nevertheless, the same issues apply to any situation where the activity is on the border between a passive investment and a truly active business.
John notes that the IRS would actually start by looking at the form of a FLP or FLLC. Was it properly established under state law? Were the required formalities for operation followed, or did nothing really change when the timberland went into the FLP? Did Pete and Dorothy use the FLP's checking account strictly for business purposes? If the answer to any of these questions is no, the IRS could take the position that the FLP was a shan and settle the estates of Pete and/or Dorothy as if the FLP didn't exists. This would mean that the entire value of the timberland would be included in their estates, even if the kids purportedly were also owners. If the FLP is a legitimate business operation, then the issues to be considered would focus on valuations.
The major valuation issue is the fair market value of an individual's ownership interests in the FLP. If Pete and Dorothy own a minority interest, say 49 percent by the time the firs one dies, and the fair market value of the FLP at that time is $5 million, is the value of this interest 24.5 percent of $5 million, the pro-rata share? Appraisers normally apply a lower value because the interest couldn't be sold on a public open market at this value. Why would a non-family member want to buy a minority interest in a business controlled by close-knit family members? Especially since the interest could most likely go the the children, assuming it's not needed to support the surviving spouse.
What if the interest went to a charity? Then, as high a fair market value as could be justified is desirable to reduce the taxable estate before the $1 million allowable excludable amount is applied. There are also income tax implications, since this value is the tax basis of ownership interests passed by a will.
Pete and Dorothy are a little overwhelmed at this point, but John goes on. He tells them there's also the issue of the fair market value of the interests they pass to the kids when the FLP is established and ownership interest are given. For gift tax purposes, a low value is desirable, of course. Is the value the pro-rata share of the underlying asset at the time each interest is given (i.e., the timberland) or of a minority interest in the FLP?
John emphasizes the fair market value of FLP interests will need to be professionally appraised as of each year a gift is made or one of the owners dies. The appraisal must stand up under close scrutiny by the IRS and, in the worst case, by the court. The L&C representative breaks in to point out that the cost of follow-up appraisals won't be as high as the original, depending on the time lapse since the last detailed appraisal.
John, Pete and Dorothy close their discussion by agreeing that there's a lot to think about and that the kids need to be included from here on. John knows the kids, and agrees that they are all capable of being involved and can focus on what's best for all members of the family, not just their interests. But he asks Pete and Dorothy if they can actually talk seriously about their deaths? The parents agree to work on improving their family's communication skills. Pete also says that he'll tell the kids that if any of then are concerned about what's best for them, they should retain their own legal counsel and have them involved in the discussion. John closes by emphasizing that, in the end, it's Pete and Dorothy who have to make the final decision, and that the planning process has just begun.