Has your tax attorney mentioned that Congress could someday sooner than you might think dramatically reduce the $5 Million gift exemption ($10 Million married) to which President Obama gave his blessing in December of 2012. If you are a baby boomer thinking of retiring with substantial assets, and want to take advantage of these historic large gift tax exemptions, you most likely will soon be aggressively gifting your assets to the kids and grandchildren with substantial discounts through a strictly controlled Family Limited Liability Company. But in case you have not yet started the gifting process but are thinking of doing so, or if you are in the process of gifting now, did you know the two basic steps that you need to take to protect your assets from adverse government action if you get audited by the IRS. Moreover, without including such steps in your estate and gifting plan, an IRS audit may dramatically increase you gift and estate tax liability to the Government many years from now, perhaps even many years after you are long gone. So I would recommend that you all continue with TaxView to review the basic two steps in bulletproofing your gift tax returns from harm in the likely event of an IRS audit.
Step one is to gift your children the LLC memberships, not the assets themselves. Let’s take a look why this matters as we review US Tax Court SUZANNE J. PIERRE VS IRS to learn the difference between valuations of underlying assets vs the valuation of LLC member interests and why this is so important. Pierre transferred over $4 Million in publically traded stock to a single member LLC and then days later transferred substantial memberships to trusts for her son and granddaughter. Gift tax returns were filed reflecting over 30% discounted gifts due to lack of marketability and control. The IRS audited the Gift Tax returns and issued a notice of deficiency of over $1 Million. The government argued that the underlying assets, the stocks and securities were the gift, not the LLC and that no discounts could be applied directly to those assets. Pierre argued the opposite view, that IRS rules do not control, that state law controls and more specifically under state law, a membership interest in an LLC is personal property, and a member has no interest in specific property of the LLC. You may want to also review “Cost Basis For Beginners” on the difference between inside and outside basis. Judge Wells sided with Pierre because pursuant to state law Pierre did not have a property interest in the underlying assets of Pierre LLC. Accordingly, the IRS could not create a property right in those assets.
The second and final step in gifting to the kids is a little more complicated. Your discount must be supported by an expert appraiser sometimes many years later in US Tax Court after you are long gone. While Pierre allowed for a 30% discount, other cases have not always been so generous to the taxpayers. For example, in Lappo vs IRS 2003 Lappogifted to children though a family partnership in 1996. In 2001 the IRS audited the 2006 gift tax return increasing the gift from $1,040,000 to $3,137,287, Larro appealed to US Tax Court. Larro’s expert concluded a 35% discount was appropriate. The Government’s expert concluded an 8% discount was appropriate. Judge Thornton’s rather short but very well thought out 27 page Opinion compacted with facts and details only appraisers could appreciate, concludes after an exhaustive examination of expert witnesses for both sides that a 24% discount was appropriate. Just in case you didn’t notice the average between 35% and 8% is 25.5%, and not too bad for Lappo. Unfortunately Tax Court judges do not usually average the discount valuations from the IRS and the Taxpayer and split the difference as clearly evidenced in our next case of True vs IRS.
The True family of Casper, Wyoming didn’t fare so well in US Tax Court case of True vs IRS in 2001. The True clan made their money in Oil and Gas Exploration and Drilling. True believed in the family partnerships and the strength of a unified family in business and America. Dave True gave each of his children general partnership interests in various family business interests. True created numerous operating agreements severely restricted the marketability and control of the family members through the use of buy sell agreements requiring family members to participate in the business or be bought out at predetermined appraised market values forming the basis of the gift tax returns filed in 1993 and 1994 using 30% discounts.
The IRS audited the 1993 1994 gift tax returns and found massive valuation understatements. The True family appealed to US Tax Court. Judge Beghe’s Opinion reviews the work of government expert witnesses, painstakingly detailing the reasoning behind the discounts and then analyzes the use of buy-sell agreements in gift tax valuations. It’s hard to believe but the True family did not retain expert appraisers. Instead, Dave True consulted Mr. Harris, the family’s accountant and longtime financial adviser. Mr. Harris advised True to use a tax book value purchase price formula under the buy-sell agreements for gift tax valuations. However, the Court noted Mr. Harris’s expertise was in accounting not appraisals….and he was the only professional with whom Dave True consulted in selecting the book value formula price” Id at 110. The Court rejected any notion that Mr. Harris was qualified to opine on the reasonableness of using the tax book value formula in the True family buy-sell agreements. The Court further noted that “Mr. Harris was closely associated with the True family; his objectivity was questionable and more importantly, he had no technical training or practical experience in valuing closely held businesses.” Id 111 Without the power of an army of experts to help True, the Government’s experts easily persuaded the Court that only a 10% discount should be allowed, costing the True family millions in dollars of additional taxes, penalties and interest.
How can we learn from True? How can you preserve and keep safe your assets for the next generation? In my view you need to consider gifting strategies in light of ever changing Congressional intent regarding estate and gift tax exemption amounts and tax rates. I personally prefer to save taxes now, as we may never know what “later” will bring. To save taxes now I recommend many of you baby boomers to consult with your tax attorney and estate planners asking them about the two step process in gifting to your kids and grandchildren through a Family Limited Liability Company. Make sure you retain the best and the brightest appraiser prior to filing your gift tax return with the US Government. Your gift tax valuations, your Family LLC Member Discounts, and all the taxes you saved now will be bulletproofed from adverse consequences later during an IRS audit many years from now. Happy Gifting to all from Chris Moss CPA and Thanks for joining me on TaxView.
Submitted by Chris Moss CPA