NOTABLE DEVELOPMENTS OF INTEREST TO ESTATE PLANNERS Turney P

NOTABLE DEVELOPMENTS OF INTEREST TO ESTATE PLANNERS Turney P. Berry WYATT, TARRANT & COMBS, LLP 500 West Jefferson Street, Suite 2800 Louisville, KY 40202-2898 502.562.7505 direct dial 502.589.5235 502.589-0309 FAX tberry@wyattfirm.com TABLE OF CONTENTS A. INCOME TAX MATTERS ..........................................................................................................................1 1. 2. Investment Management Fees Subject to Two Percent Floor for Miscellaneous Itemized Deductions........................................................................................................................1 Material Participation for Passive Activity Loss Purposes .........................................................5 B. CHARITABLE AND TAX-EXEMPT MATTERS - Sections 170, 642, 664, 501, 509, 2055, 2522, and 4940-4947 ......................................................................................................................................8 1. 2. 3. 4. 5. 6. 7. Termination or Division of Charitable Remainder Unitrust.......................................................8 Contribution by Corporation.......................................................................................................13 IRS Issues Sample Charitable Lead Annuity Trust Forms .......................................................15 Charitable Allocation Clauses......................................................................................................15 Assignment of Income Issues ( Palmer Problems ) ...................................................................41 Charitable Distribution by Trusts and Estates...........................................................................48 Unrelated Business Income in Charitable Remainder Trust.....................................................50 IRAs AND RETIREMENT PLANS............................................................................52 C. SECTION 408 1. Inherited IRAs...............................................................................................................................52 D. SECTIONS 671-678 -- GRANTOR TRUST RULES ...............................................................................55 E. SECTION 1361 1. 2. S CORPORATIONS. ...................................................................................................55 Net Operating Losses ....................................................................................................................55 New Interest Deduction for Electing Small-Business Trusts .....................................................56 VALUATION .............................................................................................57 F. SECTIONS 2031 and 2512 1. 2. 3. Discounting Assets for Built-In Income Taxes............................................................................57 Lottery Payments and other Streams of Payments ....................................................................67 Undervalution Penalty ..................................................................................................................68 G. SECTION 2032 ALTERNATE VALUATION AND SECTION 2032A SPECIAL USE VALUATION...............................................................................................................................................71 1. Burden of Proof and Post-Mortem Restrictions.........................................................................71 GROSS ESTATE ..........................................................................................................80 H. SECTION 2033 1. 2. Value of Painting...........................................................................................................................80 Scrivener s Error ..........................................................................................................................80 RETAINED INTERESTS ................................................................................80 I. SECTIONS 2035-2038 1. 2. Application of Section 2036 to Family Limited Partnerships....................................................80 Power of Substitution in a Fiduciary Capacity ........................................................................125 GENERAL POWERS OF APPOINTMENT ....................................128 J. SECTIONS 2041 AND 2514 A-i K. SECTIONS 61, 83, 409A, 2042 AND 7872 - LIFE INSURANCE .........................................................128 1. Transfer Between Grantor Trusts Not a Transfer for Value..................................................128 L. SECTION 2053 and 2054 - DEBTS AND ADMINISTRATION EXPENSES .....................................128 1. 2. 3. Proposed Regulations under Section 2053 ................................................................................128 Attorneys Fees .............................................................................................................................144 Bona Fide Loan ...........................................................................................................................146 M. SECTIONS 2056, 2056A AND 2519- MARITAL DEDUCTION..........................................................151 1. 2. Obtaining Step-Up In Basis........................................................................................................151 Division of QTIP on Non-Pro-Rata Basis Followed by Renunciation Approved ..................153 N. SECTIONS 2501 TO 2524 - GIFTS.........................................................................................................153 O. SECTION 2518 1. DISCLAIMERS ..........................................................................................................153 Disclaimer to Charitable Lead Annuity Trust..........................................................................153 P. SECTIONS 2601-2654 - GENERATION-SKIPPING TRANSFER TAX ............................................155 1. 2. Final Regulations Regarding Qualified Severances .................................................................155 Proposed Regulations Regarding Extensions of Time for GST Allocations...........................162 Q. SECTIONS 2701-2704 - SPECIAL VALUATION RULES...................................................................169 1. Joint Purchase .............................................................................................................................169 EXTENSION OF TIME TO PAY TAX .................................................................169 R. SECTION 6166 1. No Extension of Time to Make Election Available...................................................................169 S. TAX ADMINISTRATION .......................................................................................................................174 1. Penalties .......................................................................................................................................174 T. MISCELLANEOUS ..................................................................................................................................189 1. Section 529 Plans.........................................................................................................................189 A-ii 2006-2007 NOTABLE DEVELOPMENTS OF INTEREST TO ESTATE PLANNERS A. INCOME TAX MATTERS 1. Investment Management Fees Subject to Two Percent Floor for Miscellaneous Itemized Deductions. In O Neill v. Commissioner, 994 F. 2d 302 (1993), the Sixth Circuit reversed the Tax Court and held that the investment advisory expenses of a trust are not subject to the two percent limitation for miscellaneous itemized deductions under section 67. The Federal Circuit, in Mellon Bank, N.A. v. United States, 265 F. 3d 1275 (2001), and the Fourth Circuit in Scott v. United States, 328 F. 3d 132 (2003), disagreed, and now the Tax Court, in a reviewed opinion, has reaffirmed its original opinion and held that the section 67 limitation does apply. William L. Rudkin Testamentary Trust v. Commissioner, 124 T.C. 304 (2005). Rudkin was appealed to the Second Circuit which upheld the Tax Court. 467 F.3d 149 (2006). The case was accepted for review by the United States Supreme Court, as Michael J. Knight v. Commissioner. On January 16, 2008 the Court held for the government in a 9-0 decision delivered by Chief Justice Roberts. The Court held for the government but on grounds different from the Second Circuit, instead embracing the Mellen Bank and Scott rationale: This brings us to the test adopted by the Fourth and Federal Circuits: Costs incurred by trusts that escape the 2% floor are those that would not commonly or customarily be incurred by individuals. See ( Put simply, trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers ); ( treats as fully deductible only those trust-related administrative expenses that are unique to the administration of a trust and not customarily incurred outside of trusts ). The Solicitor General also accepts this view as an alternative reading of the statute. See Brief for Respondent 20-21. We agree with this approach. The question whether a trust-related expense is fully deductible turns on a prediction about what would happen if a fact were changed-specifically, if the property were held by an individual rather than by a trust. In the context of making such a prediction, when there is uncertainty about the answer, the word would is best read as express[ing] concepts such as custom, habit, natural disposition, or probability. See Webster's Third New International Dictionary 2637-2638 (1993); American Heritage Dictionary 2042, 2059 (3d ed.1996). The Trustee objects that the statutory text does not ask whether expenses are customarily incurred outside of trusts, Reply Brief for Petitioner 15, but that is the direct import of the language in context. The text requires determining what would happen if a fact were changed; such an exercise necessarily*790 entails a prediction; and predictions are based on what would customarily or commonly occur. Thus, in asking whether a particular type of cost would not have been incurred if the property were held by an individual, excepts from the 2% floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur. With respect to the uncommon test, the opinion states: A-1 It is not uncommon or unusual for individuals to hire an investment adviser. Certainly the Trustee, who has the burden of establishing its entitlement to the deduction, has not demonstrated that it is. See (noting the familiar rule that an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer (quoting )); (stating that the burden of proof shall be upon the petitioner, with certain exceptions not relevant here). The Trustee's argument is that individuals cannot incur trust investment advisory fees, not that individuals do not commonly incur investment advisory fees. Indeed, the essential point of the Trustee's argument is that he engaged an investment adviser because of his fiduciary duties under Connecticut's Uniform Prudent Investor Act, . The Act eponymously requires trustees to follow the prudent investor rule. See n. 2, supra. To satisfy this standard, a trustee must invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements and other circumstances of the trust. § 45a-541b(a) (emphasis added). The prudent investor standard plainly does not refer to a prudent trustee; it would not be very helpful to explain that a trustee should act as a prudent trustee would. Rather, the standard looks to what a prudent investor with the same investment objectives handling his own affairs would do- i.e., a prudent individual investor. See Restatement (Third) of Trusts (Prudent Investor Rule) Reporter's Notes on § 227, p. 58 (1990) ( The prudent investor rule of this Section has its origins in the dictum of , stating that trustees must observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested ). See also, e.g., (noting the general rule that a trustee must exercise such prudence and diligence in conducting the affairs of the trust as men of average diligence and discretion would employ in their own affairs ). And we have no reason to doubt the Trustee's claim that a hypothetical prudent investor in his position would have solicited investment advice, just as he did. Having accepted all this, it is quite difficult to say that investment advisory fees would not have been incurred -that is, that it would be unusual or uncommon for such fees to have been incurred-if the property were held by an individual investor*791 with the same objectives as the Trust in handling his own affairs. The opinion leaves open full deductibility in certain instances: As the Solicitor General concedes, some trust-related investment advisory fees may be fully deductible if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts. Brief for Respondent 25. There is nothing in the record, however, to suggest that Warfield charged the Trustee anything extra, or treated the Trust any differently than it would have treated an individual with similar objectives, because of the Trustee's fiduciary obligations. See App. 24-27. It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary A-2 taxpayer would not be subject to the 2% floor. Here, however, the Trust has not asserted that its investment objective or its requisite balancing of competing interests was distinctive. Accordingly, we conclude that the investment advisory fees incurred by the Trust are subject to the 2% floor. Prior to the Supreme Court opinion, the IRS issued Proposed Regulations under Section 67(e). The Supplementary Information states: United States courts of appeals have interpreted the language of section 67(e)(1) differently in determining whether costs incurred by trustees are subject to the 2percent floor. The issue in each case has been whether the trust's costs (specifically, investment advisory fees) "would not have been incurred if the property were not held in such trust or estate." In O'Neill v. Commissioner, 994 F.2d 302 (6th Cir. 1993), the Court of Appeals for the Sixth Circuit held that investment advisory fees paid for professional investment services were fully deductible under section 67(e)(1) where the trustees lacked experience in managing large sums of money. The court found that, under state law, the trustee was required to engage an investment advisor to meet its fiduciary obligations and to incur fees that the trust would not have incurred if the property were not held in trust. The court held that estate or trust expenditures that are necessary to meet specific fiduciary obligations under state law are not subject to the 2percent floor. In contrast, in Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001), Scott v. United States, 328 F.3d 132 (4th Cir. 2003), and Rudkin v. Commissioner, 467 F.3d 149 (2d Cir. 2006), the courts held that investment advisory fees are subject to the 2-percent floor. These courts read the language of section 67(e) (1) differently than the Sixth Circuit. Specifically, the courts in Scott and Mellon Bank concluded that a trust expense is subject to the 2-percent floor if it is an expense "commonly" or "customarily" incurred by individuals; and the court in Rudkin looked to whether such an expense was "peculiar to trusts" and "could not" be incurred by an individual. The result of this lack of consistency in the case law is that the deductions of similarly situated taxpayers may or may not be subject to the 2-percent floor, depending upon the jurisdiction in which the executor or the trustee is located. The IRS and the Treasury Department believe that similarly situated taxpayers should be treated consistently by having section 67(e)(1) construed and applied in the same way in all jurisdictions. The proposed regulations are intended to provide a uniform standard for identifying the types of costs that are not subject to the 2-percent floor under section 67(e)(1). The Proposed Regulation states: Par. 2. Section 1.67-4 is added to read as follows: § 1.67-4 Costs paid or incurred by estates or non-grantor trusts. (a) In general. Section 67(e) provides an exception to the 2-percent floor on miscellaneous itemized deductions for costs that are paid or incurred in connection with the administration of an estate or a trust not described in § 1.67- A-3 2T(g)(1)(i) (a non-grantor trust) and which would not have been incurred if the property were not held in such estate or trust. To the extent that a cost incurred by an estate or non-grantor trust is unique to such an entity, that cost is not subject to the 2-percent floor on miscellaneous itemized deductions. To the extent that a cost included in the definition of miscellaneous itemized deductions and incurred by an estate or non-grantor trust is not unique to such an entity, that cost is subject to the 2-percent floor. (b) Unique. For purposes of this section, a cost is unique to an estate or a nongrantor trust if an individual could not have incurred that cost in connection with property not held in an estate or trust. In making this determination, it is the type of product or service rendered to the estate or trust, rather than the characterization of the cost of that product or service, that is relevant. A nonexclusive list of products or services that are unique to an estate or trust includes those rendered in connection with: fiduciary accountings; judicial or quasijudicial filings required as part of the administration of the estate or trust; fiduciary income tax and estate tax returns; the division or distribution of income or corpus to or among beneficiaries; trust or will contest or construction; fiduciary bond premiums; and communications with beneficiaries regarding estate or trust matters. A non-exclusive list of products or services that are not unique to an estate or trust, and therefore are subject to the 2-percent floor, includes those rendered in connection with: custody or management of property; advice on investing for total return; gift tax returns; the defense of claims by creditors of the decedent or grantor; and the purchase, sale, maintenance, repair, insurance or management of non-trade or business property. (c) "Bundled fees". If an estate or a non-grantor trust pays a single fee, commission or other expense for both costs that are unique to estates and trusts and costs that are not, then the estate or non-grantor trust must identify the portion (if any) of the legal, accounting, investment advisory, appraisal or other fee, commission or expense that is unique to estates and trusts and is thus not subject to the 2-percent floor. The taxpayer must use any reasonable method to allocate the single fee, commission or expense between the costs unique to estates and trusts and other costs. (d) Effective/applicability date. These regulations are proposed to be effective for payments made after the date final regulations are published in Federal Register. In finalizing the Proposed Regulations the government is almost certain to require unbundling of investment fees from administration fees, with a likely starting point being what the trustee charges when only investing assets. Safe-harbors would be desirable but are likely to be unfriendly to taxpayers. In larger accounts it may be worthwhile to consider whether special fiduciary requirements can justify deductibility. In Notice 2008-32, 2008-11 IRB 1, the IRS determined that taxpayers for taxable years beginning before January 1, 2008 need not unbundle fiduciary fees to determine the portion that should be subject to the 2% limitation A-4 and the portion that should not be. The Notice indicates that new regulations will be forthcoming that will set forth standards and provide examples. 2. Material Participation for Passive Activity Loss Purposes. In TAM 200733023 the Trustee engaged Special Trustees to deal with a business owned by the trust. The IRS determined that the Special Trustees were not fiduciaries and a trust does not materially participate unless its fiduciaries do. The Special Trustees were not fiduciaries because they could not legally bind the trust and the actual Trustees retained all decision-making responsibilities. On that issue the TAM states: Section 7701(a)(6) defines "fiduciary" as a "guardian, trustee, executor, administrator, receiver, conservator, or any person acting in any fiduciary capacity for any person." The regulations further provide that "fiduciary" refers to "persons who occupy positions of peculiar confidence toward others, such as trustees, executors, and administrators." Treas. Reg. § 301.7701-6. To date, the Service has issued only limited guidance expounding upon the definition of fiduciary under § 7701(a)(6). In Revenue Ruling 69-300, 1969-1 C.B. 167, a bank was appointed by court order to serve as the custodian of shares in a land trust. Among the powers granted to the bank was the power to vote at any stockholders' meeting, retain legal counsel, exercise or sell conversion or subscription rights, and petition the court to make any disposition concerning the property that it considered to be in the best interests of the owner. In holding that a trust was formed, the ruling notes that "where the bank or individual is vested with broad discretionary powers of administration and management, a fiduciary relationship exists within the meaning of § 7701(a)(6) of the Code." In contrast, Revenue Ruling 82-177, 1982-2 C.B. 365, as modified by Revenue Ruling 92-51, 1992-2 C.B. 102, holds that a fiduciary relationship does not exist for purposes of § 7701(a)(6) where a bank merely holds money for an estate and pays interest on the account, but performs no administrative duties. The case law is generally consistent with these rulings. United States v. Anderson, 132 F.2d 98 (6th Cir. 1942), a pre-7701(a)(6) case, involved the issue of whether an agreement between the taxpayer and a bank created a trust or an agency relationship. In that case, the bank could not invest or dispose of any corpus without the consent of the settlor and was relieved of all liability for any decline in the value of the corpus. The settlor had the power to vote any corporate stock held by the bank and could remove the bank and select a successor at any time. The court stated that while an agent undertakes to act on behalf of his principal and is subject to his control, a trustee usually has discretionary powers and acts for a term. Accordingly, because the bank did not have discretionary powers, the court held that the agreement created an agency relationship rather than a trust. See also City Nat'l Bank & Trust Co. v. United States, 109 F.2d 191 (7th Cir. 1940) (holding that no trust was formed where bank's investment decisions could be overridden by settlor and other evidence of managerial power was lacking). A-5 What is apparent from the line of authority in this area is that a fiduciary must be vested with some degree of discretionary power to act on behalf of the trust. Although Trust represents that Special Trustees were heavily involved in the operational and management decisions of Business, Special Trustees -- like the banks in Revenue Ruling 82-177 and Anderson -- were ultimately powerless to commit Trust to any course of action or control Trust property without the express consent of Trustees. The contract between Trust and Special Trustees is explicit on this point, and Trust itself has acknowledged that Trustees retained final decision-making authority with regard to all facets of Business. The services performed by Special Trustees appear to be indistinguishable from those that would be expected of other non-fiduciary business personnel. If advisors, consultants, or general employees can be classified as fiduciaries simply by attaching different labels to them, the material participation requirement of § 469 as applied to trusts would be meaningless. Trust cites the state law case of Matter of Will of Rubin, 540 N.Y.S.2d 944 (N.Y. Sur. Ct. 1989) to argue that, under the laws of many states, a trustee's powers may be "split" among more than one co-trustee or special trustee. However, Rubin and the cases cited therein involved actual delegations of discretionary power; specifically, the case involved whether one co-executor could be delegated the exclusive power to manage realty held by the estate. In the case of Trust, no such powers were delegated to Special Trustees. Trustees' ultimate power to control Trust property was unaffected by the appointment of Special Trustees, and Special Trustees could exercise no power over Trust property without first obtaining the permission of Trustees. Citing Revenue Ruling 61-102, 1961-1 C.B. 245, Trust argues that the Service's own rulings rely heavily upon the language of the trust instrument to determine whether someone is a fiduciary. The ruling, however, appears limited to its facts and cannot be read to create a presumption that a named trustee will be recognized as such for federal tax purposes. Consistent with the Service's position that substance, not form, governs the tax consequences of purported trust arrangements, the courts have repeatedly refused to recognize the status of appointed "trustees" who lack any indicia of discretionary power. See City Nat'l Bank & Trust Co. v. United States, 109 F.2d 191 (7th Cir. 1940); Dunham v. Commissioner, 35 T.C. 705 (1961). In light of the limited power vested with Special Trustees under the contract, we conclude that Special Trustees were not fiduciaries of Trust during Year 3 for purposes of § 469. Moreover, even if Special Trustees were fiduciaries of Trust, a review of the time logs submitted by Trust indicates that many of the duties performed by Special Trustees had a questionable nexus to the conduct of Business. As noted above, the legislative history of § 469 indicates that Congress was insistent that the material participation standard be satisfied through participation in the operations and management of the activity. See also Treas. Reg. § 1.469-5T(f)(2)(ii) (prohibiting "individuals" from counting certain "investor" hours toward the material participation requirement unless the individual is also involved in the day-to-day management or operations of the activity). Some of the hours reflected in the time logs of Special Trustees -particularly those spent negotiating the sale of Trust's interests in P as well as those spent resolving a tax dispute with another partner -- were not spent A-6 managing or operating Business. Thus, even if Special Trustees were fiduciaries of Trust, a number of hours reflected in the time logs of Special Trustees would be disregarded for purposes of analyzing Trust's involvement in Business. The TAM acknowledges it is contrary to the only published opinion on point: Trust submits that the opinion in Mattie K. Carter Trust v. United States, 256 F.Supp.2d 536 (N.D. Tex. 2003), provides the appropriate standard for evaluating material participation for trusts. In Mattie K. Carter, the court held that in determining material participation for trusts, the activities of the employees of the trust should be included in determining whether the trust's participation is regular, continuous, and substantial. In rejecting the government's position that the determination should be made solely with reference to the activities of the trustee, the court stated: Such a contention is arbitrary, subverts common sense, and attempts to create ambiguity where there is none. The court recognizes that [the] IRS has not issued regulations that address a trust's participation in a business . . . and that no case law bears on the issue. However, the absence of regulations and case law does not manufacture statutory ambiguity. Id. at 541. Determining the proper focus in § 469 for the activities of Trust is a question of federal tax law and must include an examination of the treatment of trusts under Subchapter J. The taxation of trusts under Subchapter J is a hybrid regime involving an entity-level tax as well as the pass-through of income to the beneficiaries. While a trust is sometimes required to pay tax on its own income under § 641, it may also generally deduct under § 661 income that is passed through to its beneficiaries under § 662. Although the beneficiaries of a trust do not generally participate in the activities of the trust, the designated trustee acts on behalf of, and in the interests of, the beneficiaries. The focus on a trustee's activities for purposes of § 469 accords with the general policy rationale underlying the passive loss regime. As a general matter, the owner of a business may not look to the activities of the owner's employees to satisfy the material participation requirement. See S. Rep. No. 99-313, at 735 (1986) ("the activities of [employees] . . . are not attributed to the taxpayer."). Indeed, because an owner's trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of other business owners, therefore, it is appropriate in the trust context to look only to the activities of the trustee. An interpretation that renders part of a statute inoperative or superfluous should be avoided. Mountain States Tele. & Tele. Co. v. Pueblo of Santa Ana, 472 U.S. 237, 249 (1985). Therefore, notwithstanding the decision in Mattie K. Carter, the Service believes that the standard annunciated in the legislative history is the proper standard to apply to trusts for purposes of § 469. Thus, the sole means for Trust to establish A-7 material participation in Business for Year 3 is if its fiduciaries are involved in the operations of Business on a regular, continuous, and substantial basis. B. CHARITABLE AND TAX-EXEMPT MATTERS - Sections 170, 642, 664, 501, 509, 2055, 2522, and 4940-4947 1. Termination or Division of Charitable Remainder Unitrust. Another ruling approving the early termination of charitable remainder trust is PLR 200441024. There is no self-dealing but the entire amount received by the settlor of the trust is long-term capital gain. The IRS position is that the a charitable remainder trust may not be terminated where the unitrust beneficiary receives a lump-sum payoff (a commutation) if the remainderman is a private foundation. PLR 200614032 revoked PLR 200525014 which would have allowed such without imposing a self-dealing penalty; PLR 200616035 is to the same effect. In PLR 200725044 the calculations of the remainder value was made using the lesser of the section 7520 rate and 10% where the CRUT was a NUMCRUT with a 10% payout. See also 200733014. This approach is controversial and may be difficult for the IRS to support. In Revenue Ruling 2008-41 the IRS provided guidelines on dividing charitable remainder trusts. The Ruling deals with two different situations, as follows: Situation 1. Trust qualifies as either a charitable remainder annuity trust (CRAT) described in §664(d)(1) or a charitable remainder unitrust (CRUT) described in § 664(d)(2). Under the terms of Trust, two or more individuals (recipients) are each entitled to an equal share of the annuity or unitrust amount, payable annually, during the recipient's lifetime, and upon the death of one recipient, each surviving recipient becomes entitled for life to an equal share of the deceased recipient's annuity or unitrust amount. Thus, the last surviving recipient becomes entitled to the entire annuity or unitrust amount for his or her life. Upon the death of the last surviving recipient, the assets of Trust are to be distributed to one or more charitable organizations described in § 170(c) (remainder beneficiaries). Trust has not committed any act (or failure to act) in the past giving rise to liability for tax under chapter 42 (Private Foundations and Certain Other TaxExempt Organizations). Moreover, Trust has made no distributions to charitable beneficiaries. The state court having jurisdiction over Trust has approved a pro rata division of Trust into as many separate and equal trusts as are necessary to provide one such separate trust for each recipient living at the time of the division, with each separate trust being intended to qualify as the same type of CRT (i.e., CRAT, CRUT, net income CRUT with makeup) as Trust. Either the court's order or the trust agreement itself incorporates the provisions described in these facts that will govern the separate trusts. A-8 The separate trusts may have different trustees. To carry out the division of Trust into separate trusts, each asset of Trust is divided equally among and transferred to the separate trusts. For purposes of determining the character of distributions to the recipient of each separate trust, each separate trust upon the division of Trust is deemed to have an equal share of Trust's income in each tier described in §664(b) and, similarly, on each subsequent consolidation of separate trusts by reason of the death of a recipient, the income in each tier of the consolidated trust is the sum of the income in that tier formerly attributed to the trusts being combined. The recipients pay all the costs associated with the division of Trust into separate trusts, including (i) legal fees relating to the court proceeding, and (ii) the administrative costs of the creation and funding of the separate trusts. Each of the separate trusts has the same governing provisions as Trust, except that: (i) immediately after the division of Trust, each separate trust has only one recipient, and each recipient is the annuity or unitrust recipient of only one of the separate trusts (that recipient's separate trust); (ii) each separate trust is administered and invested independently by its trustee(s); (iii) upon the death of the recipient, each asset of that recipient's separate trust is to be divided on a pro rata basis and transferred to the separate trusts of the surviving recipient(s), and the annuity amount payable to the recipient of each such separate CRAT is thereby increased by an equal share of the deceased recipient's annuity amount (the unitrust amount of each separate CRUT is similarly increased as a result of the augmentation of the CRUT's corpus, and each separate CRUT incorporates the requirements of § 1.6643(b) of the Income Tax Regulations with respect to the subsequent computation of the unitrust amount from that trust); and (iv) upon the death of the last surviving recipient, that recipient's separate trust (being the only separate trust remaining) terminates, and the assets are distributed to the remainder beneficiaries. The remainder beneficiaries of Trust are the remainder beneficiaries of each of the separate trusts and are entitled to the same (total) remainder interest after the division of Trust as before. In addition, each recipient is entitled to receive from his or her separate trust the same annuity or unitrust amount as the recipient was entitled to receive under the terms of Trust. Because the annual net fair market value of the assets in each of the separate trusts may vary from one another due to differing investment strategies of the separate trusts, in situations where Trust is a CRUT, the amount of the unitrust payments from each separate CRUT may vary over time, both from year to year and among the separate CRUTs. Nevertheless, the unitrust percentage of each separate CRUT remains the same as each recipient's share of the unitrust percentage under the terms of Trust, and the recipients and the remainder beneficiaries are entitled to the same benefits after the division of Trust as before. For example, assume Trust is a CRUT. Under the terms of Trust, X, Y, and Z are entitled to share equally the annual payments of a 15 percent unitrust amount (5 percent each) while all three are living, and upon the death of one recipient, the surviving recipients are entitled to the deceased recipient's share. Thus, if X dies first, the surviving recipients (Y and Z) are entitled to share equally in the annual payments of the 15 percent unitrust amount (7.5 percent each) while both are living. Thereafter, if Y predeceases Z, then upon the death of Y, Z is entitled to receive annual payments of the entire 15 percent unitrust amount for life. Upon A-9 the division of Trust, three separate trusts are created (one for each of X, Y, and Z) and each of the separate trusts holds one-third of the assets of Trust. X, Y, and Z are each entitled to annual payments of a 15 percent unitrust amount from his or her separate trust (15 percent of one-third of the assets is equivalent to 5 percent of all the assets of Trust). After the division of Trust and upon the death of X, each asset of X's separate trust is divided on a pro rata basis and transferred to Y and Z's separate trusts. Y and Z each remain entitled to annual payments of a 15 percent unitrust amount from his or her respective separate trust, each of which is now funded with the equivalent of one-half the assets of Trust (15 percent of one-half of the assets is equivalent to 7.5 percent of all the assets of Trust). Upon the death of Y, the assets of Y's separate trust are transferred to Z's separate trust, and Z remains entitled to annual payments of a 15 percent unitrust amount from Z's separate trust. These are the same interests to which X, Y, and Z would have been entitled under the terms of Trust if Trust had not been divided into separate trusts. Situation 2. The facts are the same as in Situation 1 except that Trust has only two recipients who are U.S. citizens married to each other but in the process of obtaining a divorce, and, instead of the provision described in (iii) of Situation 1, each separate trust in Situation 2 has governing provisions providing that upon the death of the recipient, that recipient's separate trust terminates and the assets of that separate trust then are distributed to the remainder beneficiaries. Because the remainder beneficiaries of Trust (and thus of each separate trust) receive a distribution of one-half of the assets of Trust upon the death of the first spouse to die and the remaining half of the assets upon the death of the surviving spouse (rather than a distribution of all of the assets of Trust upon the later death of the surviving recipient), the value of the remainder payable to the remainder beneficiaries as a result of the division of Trust into separate trusts may be larger than the present value of that interest as computed at the creation of Trust; no additional charitable deduction is permitted, however. Each recipient (spouse) is entitled to receive from his or her separate trust the same share of the annuity or unitrust amount as the recipient was entitled to receive under the terms of Trust. However, each spouse relinquishes all interests in Trust to which he or she would have been entitled by reason of having survived the other (survivorship right). The Ruling addressed the following issues. (1) Does the pro rata division of a trust that qualifies as a charitable remainder trust (CRT) under § 664(d) of the Internal Revenue Code into two or more separate trusts cause the trust or any of the separate trusts to fail to qualify as a CRT under § 664(d)? To carry out the division of Trust in Situation 1 and Situation 2, each asset of Trust is divided on a pro rata basis (in these cases, equally) among and distributed to the separate trusts. Each of the separate trusts has the same governing provisions as Trust, with the exceptions noted above, and the same recipients and remainder beneficiaries, collectively, as Trust. In Situation 1, after the division of Trust into A-10 separate trusts, the total annuity amount or unitrust percentage to be paid annually by the separate trusts remains the same as under the terms of Trust. Each recipient and remainder beneficiary essentially has the same beneficial interest after the division as before. A transfer of the assets from a deceased recipient's separate trust to the separate trust(s) of the surviving recipient(s) in Situation 1 is not treated as a transferred remainder interest that would violate § 664(d)(1)(C) or § 664(d)(2)(C), and is not treated as a prohibited additional contribution to a CRAT under § 1.664-2(b). In Situation 2, after the division of Trust into separate trusts, the total annuity amount or unitrust percentage to be paid annually remains the same as it was under the terms of Trust, with the exception of the survivorship right to the annuity or unitrust payments the recipients relinquish. Consequently, in Situation 1 and Situation 2, the division of Trust into separate trusts does not cause Trust or any of the separate trusts to fail to qualify as a CRT under § 664(d). (2) When a trust that qualifies as a CRT under §664(d) is divided pro rata into two or more separate trusts, is the basis under §1015 of each separate trust's share of each asset the same share of the basis of that asset in the hands of the trust immediately before the division of the trust, and, under §1223, does each separate trust's holding period for an asset transferred to it by the original trust include the holding period of the asset as held by the original trust immediately before the division? Section 1015(b) provides that, if property is acquired by a transfer in trust (other than by a transfer in trust by a gift, bequest, or devise) after December 31, 1920, the basis shall be the same as it would be in the hands of the grantor, increased by the amount of gain, or decreased by the amount of loss, recognized by the grantor on such a transfer in trust under the law applicable to the year in which the transfer was made. Section 1.1015-2(a)(1) provides that, if the taxpayer acquired property by such a transfer in trust, this basis rule applies whether the property is in the hands of the trustee or the beneficiary, and whether the property was acquired before, upon, or after termination of the trust and distribution of the property. Section 1223(2) provides that, in determining the period for which the taxpayer has held property, however acquired, there shall be included the period during which the property was held by another person if, under chapter 1 (Normal Taxes and Surtaxes), the property has, for purposes of determining gain or loss from a sale or exchange, the same basis, in whole or in part, in the taxpayer's hands as it would have in the hands of the other person. In Situation 1 and Situation 2, the pro rata division of Trust into separate trusts is not a sale, exchange, or other disposition producing gain or loss. Pursuant to § 1015(b), in Situation 1 and Situation 2, the basis of each separate trust's share of each asset immediately after the division of Trust is the same share of the basis of that asset in the hands of Trust immediately before the division. Furthermore, pursuant to A-11 §1223(2), each separate trust's holding period of each asset transferred to it by Trust includes the holding period of the asset as held by Trust immediately before the division. Similarly, upon the death of a recipient and the consolidation of the assets of the deceased recipient's separate trust into the separate trust(s) of the surviving recipient(s) in Situation 1, each separate trust of a surviving recipient receives the same share of each asset of the deceased recipient's separate trust and of the basis of each asset in the hands of the deceased recipient's separate trust immediately before the consolidation, and the holding period of each asset transferred to a separate trust of a surviving recipient includes the holding period of the asset as held by the deceased recipient's separate trust immediately before the consolidation. (3) Does the pro rata division of a trust that qualifies as a CRT under § 664(d) into two or more separate trusts terminate under §507(a)(1) the trust's status as a trust described in, and subject to, the private foundation provisions of § 4947(a)(2), and result in the imposition of an excise tax under §507(c)? In Situation 1 and Situation 2, the separate trusts have the same governing provisions as Trust, with the exceptions noted above, and collectively, the same recipients, remainder beneficiaries, and assets as Trust. In addition, each recipient and remainder beneficiary is entitled to the same benefits both before and after the division of Trust, with the exceptions noted above. Further, in both Situation 1 and Situation 2, Trust transfers all of its assets to the separate trusts pursuant to a transfer described in § 507(b)(2). Thus, in Situation 1 and Situation 2, Trust has not terminated its private foundation status under § 507(a)(1) as a result of the division of Trust (or a subsequent consolidation of the separate trusts arising from the death of a recipient in Situation 1), because no notice of termination was filed or was required to be filed. See § 1.507-1(b)(6). Accordingly, the excise tax imposed under § 507(c) does not apply. Section 1.507-1(b)(6) generally confirms that, if a private foundation transfers all or part of its assets to one or more other private foundations pursuant to a transfer described in §§ 507(b)(2) and 1.507-3(c), such transferor foundation will not have terminated its private foundation status under § 507(a)(1). (4) When a trust that qualifies as a CRT under §664(d) is divided pro rata into two or more separate trusts, does the division constitute an act of selfdealing under §4941? In Situation 1 and Situation 2, the recipients might be disqualified persons with respect to Trust under § 4946. The only interest that the recipients have in Trust is the right to the payment of the annuity or unitrust amount under § 664(d)(1) or (2), respectively. As a result of the division of Trust in Situation 1 and Situation 2, each separate trust holds a pro rata (in these cases, equal) share of each asset of Trust, and each recipient receives his or her annuity or unitrust payment from only one of the separate trusts. The annuity or unitrust payments a recipient A-12 receives from his or her separate trust remains equivalent to the recipient's share of the annuity or unitrust payments under the terms of Trust, with the exception of the survivorship right to the annuity or unitrust payments each recipient relinquishes in Situation 2. Thus, upon the division of Trust in Situation 1 and Situation 2, the recipients are insulated from selfdealing with respect to their annuity or unitrust interests. Because of the pro rata (equal) distributions to the separate trusts, none of the disqualified persons, if any, receive any additional interest in the assets of Trust, and no selfdealing transaction occurs within the meaning of § 4941(d). The remainder interest of Trust remains preserved exclusively for charitable interests, and there is no increase in the annuity or unitrust amount at the expense of the charitable interest. Additionally, the pro rata division of the assets of Trust among the separate trusts in Situation 1 and Situation 2 is not a sale or exchange and, therefore, is not a sale or exchange between a private foundation and a disqualified person. All legal and other expenses and costs incident to the division of Trust are paid by the recipients. Situation 1 and Situation 2 involve no other transactions with the recipients that affect the principal of Trust; accordingly, no selfdealing transaction occurs by reason of the division of Trust in either Situation 1 or Situation 2, or by reason of a subsequent consolidation of the separate trusts arising from the death of a recipient in Situation 1. (5) When a trust that qualifies as a CRT under §664(d) is divided pro rata into two or more separate trusts, does the division constitute a taxable expenditure under §4945? The transfers of Trust's assets to the separate trusts in Situation 1 and Situation 2 are not expenditures that require expenditure responsibility by Trust, pursuant either to §1.507-3(a)(9) (if Trust and the separate trust are controlled by the same person or persons) or §1.507-3(a)(7) (if Trust and the separate trust are not controlled by the same person or persons). Because Trust made no prior distributions for which expenditure responsibility is required, the separate trusts assume no preexisting expenditure responsibility from Trust under §1.507-3(a)(9). A similar analysis applies regarding a subsequent consolidation of the separate trusts arising from the death of a recipient in Situation 1. Thus, in Situation 1 and Situation 2, Trust is not required to exercise "expenditure responsibility" under § 4945(d) and (h) with respect to the assets transferred to the separate trusts. 2. Contribution by Corporation. In PLR 200715015, a corporation formed a limited partnership and contributed to it exclusive ownership of certain trademarks and other intellectual property; the other partner was the owner of the corporation who contributed cash. The partnership granted the corporation a license to use that property in exchange for a royalty based on the corporation s net sales. The corporation then contributed the limited partnership units to a private foundation (created and managed by the owner). Because the limited partnership A-13 receives 95% or more of its gross income from passive sources (here, royalties), the units are not an excess business holding. Further, the foundation has no unrelated business income because royalties are exempt. PLR 200644013 dealt with an S corporation contributing residential and commercial real estate to a 20 year charitable remainder unitrust. The facts presented were: Company owns, leases, and manages residential and commercial real estate. Company reported its taxable income as a C corporation for all taxable years ending on or before Date 1. Company elected to be taxed as an S corporation within the meaning of § 1361 of the Code effective for tax years beginning on Date 2. Company holds three separate parcels of real property (the "Real Estate") and represents that the Real Estate does not constitute "substantially all" of its assets. Company purchased the Real Estate prior to Date 2 and will recognize gain under § 1374 if it sells the Real Estate within ten years of Date 2 (the "Recognition Period"). Company intends to form a charitable remainder unitrust under § 664 (the "Trust"). Following the formation of the Trust, Company will contribute the Real Estate to the Trust. Subsequently, but before the end of the Recognition Period, the Trust will sell the Real Estate ("Sale Date") and use the sale proceeds to invest in stocks, bonds, and other securities that pay interest and dividends. For a period of 20 years, the Trust will be required to annually distribute a unitrust amount to the Company. At the end of 20 years, the Trust will terminate and all assets remaining in the Trust will be distributed to one or more charities described in §§ 170(c), 2055(a), and 2522(a). The Trust will be structured initially as a net income with makeup charitable remainder unitrust ("NIMCRUT") and, on the Sale Date, will convert to a fixed percentage charitable remainder unitrust ("CRUT"), as permitted under § 1.6643(a)(1)(i)(c). As a NIMCRUT, the Trust will annually distribute to Company a unitrust amount equal to the lesser of (1) the Trust's income (as defined under § 643(b) and the applicable regulations) for the year (the "Trust Income") or (2) the fair market value of the Trust's assets multiplied by a fixed payout percentage ("Fixed Percentage Amount"). The unitrust amount for any year will also include any amount of Trust income for such year that is in excess of the amount required to be distributed under (2), to the extent that the aggregate of the amounts paid in prior years was less than the aggregate of the amounts computed under (2) in prior years. After the Trust converts to a CRUT, the Trust will annually distribute to Company a unitrust amount equal to the Fixed Percentage Amount. The Service granted the following rulings: 1. Company will not have recognized built-in gain under § 1374 on its contribution of the Real Estate to the Trust. 2. Company will not have recognized built-in gain under § 1374 on the Trust's disposition of the Real Estate. A-14 3. Company will not have recognized built-in gain under § 1374 on unitrust amounts received by it during the Recognition Period, to the extent the unitrust amounts do not exceed Trust Income. 4. Company will not have recognized built-in gain under § 1374 on unitrust amounts received by it after the Recognition Period. 3. IRS Issues Sample Charitable Lead Annuity Trust Forms. Rev. Proc. 2007-45, 2007-29 IRB1, contains Inter Vivos CLAT forms and Rev. Proc. 2007-46, 2007-29, IRB1, contains Testamentary CLAT forms with helpful annotations. Two-points of particular interest: when creating a grantor lead trust the forms rely on a section 675(4)(c) power of substitution in any person other than the donor, Trustee, or disqualified person (to avoid selfdealing); and an annuity may increase annually by any percentage. The latter point gives rise to the profoundly accelerated CLAT, also known as the Shark-Fin CLAT. 4. Charitable Allocation Clauses. A charitable allocation clause is an attempt to minimize the negative effects that can result from the audit adjustment by the Internal Revenue Service of the value of noncharitable gifts. The donor makes annual exclusion gifts or adjusted taxable gifts, or both, to a trust that contains a charitable allocation clause. The clause directs the trustee to allocate contributed assets having a certain value to a fund for the benefit of the donor s noncharitable beneficiaries, and to allocate all contributed assets having value in excess of the certain value to charity. To illustrate, parents with two unused gift tax exemptions could contribute $3,150,000 in marketable securities to a partnership that has 100 general partnership units and 9900 limited partnership units. Parents could give the 9900 limited units to a trust at an appraised value of $2,027,000 (a 35% discount). The trust could provide that the first $2,000,000 of contributed assets be allocated to a fund for the benefit of parents children, grandchildren and other descendants (a family fund), with the remaining contributed assets being allocated to the parent s donor advised fund at the local community foundation (or to other designated charitable organizations). The Trustee would review the appraisal of the limited units and would provide a copy to the local community foundation. Assuming the appraisal were in good order, the community foundation would agree that it should receive $27,000 worth of units from the transfer but no more. a. Benefits. The benefits of a charitable allocation clause would seem to be two-fold. First, presumably the IRS would be reluctant to audit gifts made to a trust containing such a clause because gift or estate tax could be collected. Second, if the IRS did audit a gift made to such a trust, and increased the value of gifts, all that would result would be the reallocation of assets from the non-charitable fund to the designated charity. If that charity were a donor advised fund at a community foundation, the funds could be said to remain available for the benefit of the family. A-15 b. deduction Drafting the Clause. Such a clause could be drafted like a traditional formula marital exemption equivalent funding clause so that the maximum amount of a donor s $1,000,000 exemption is used. However, a simpler clause would simply specify a sum. For testamentary transfers the flexibility of a clause that is tied to the amount that can be disposed of without generating estate tax is desirable. Such flexibility is less useful for inter vivos gifts. c. Role of the Independent Charity. The charity must act independently of the donor and the donor s family. The trustee should notify the charity of the arrangement. Once the trustee obtains an appraisal of the gift the trustee should notify the charity of the amount the charity is to receive, if anything, and should furnish the charity a copy of the appraisal. The charity should not be asked to consent to having received all it is entitled to but rather should retain the option of an action against the trustee to receive additional assets. In many instances a reasonable charity will be uncomfortable as the certifying recipient if it receives nothing. Thus, having too much added to the trust, so that some assets are allocated to the charity would seem to be valuable. The charity receives assets today for its time and trouble and the trust appears to work because assets actually went to charity. May the donor s private foundation be the beneficiary? In principle the answer is yes. However, the purpose of the clause is to reduce IRS challenges. If the donor s private foundation is the potential recipient then not only may the IRS claim that no independent party valued the gift, but also that the private foundation improperly surrendered its legal right to collect from the trust thereby making a gift to a disqualified person, which would be an act of self-dealing. d. Contrast with Marital Allocation Clause. A marital deduction clause may be considered as an alternative to the charitable allocation clause. The reason is the avoid any assets going outside the family. If such a clause is used the spouse may be charged by the IRS with making a gift if the value of the assets has been incorrectly determined. In addition, if the trust is to be a QTIP trust a QTIP election will need to be made on the donor s next gift tax return, which must be timely filed, in order to avoid a tax. The filing may be avoided by using a general power of appointment marital trust. The purpose of the charitable allocation clause is to avoid an IRS audit by having evidence that an independent party has looked at the values and that no increase in value will result in any gift tax. The marital deduction alternative would not appear to accomplish but the second of these objectives. In Rev. Rul. 84-105, 1984-2 C.B. 197, the IRS determined that the surviving spouse made a gift by acquiescing to the under funding of a pecuniary marital bequest. A-16 In TAM 200245053 (discussed in detail below) the IRS distinguished charitable allocation clauses generally from marital deduction allocations: Taxpayer also argues that the Service has sanctioned the use of valuation formula clauses in other situations. For example, testamentary marital deduction formula clauses pursuant to which the amount of the marital bequest (and the amount of the marital deduction allowable under §§ 2056) fluctuates depending on the value of the gross estate as finally determined for estate tax purposes, are widely used, in order to take maximum advantage of the marital deduction and the unified credit available under §§ 2010. * * * However, in order for most estates to take maximum advantage of the marital deduction and unified credit, as intended by Congress, utilization of a funding formula clause (either for the marital bequest or the credit shelter trust) is a necessity. That is, full utilization of these benefits is dependent on the value of the testator s property as determined for estate tax purposes on the date of death or alternate valuation date. A testator cannot anticipate when he or she will die or the value of the property at the time of death. Further, in the case of certain assets, such as an interest in a closely-held business, opinions can reasonable differ as to value. It is not feasible to continuously redraft testamentary instruments each time asset values change, or to account for differences of opinion that may arise in the valuation process. Thus, utilization of a testamentary marital deduction or credit shelter valuation formula clause is the only practical way a testator can take full advantage of these Congressionally authorized benefits. e. Income Tax Deduction. There appears to be no reason why a charitable allocation e.g. an appraisal would need to clause would not result in an income tax deduction for the donor. All other rules be followed. The IRS could argue that the gift was of a partial interest. That argument was made in McCord, discussed in detail below, with a different type of clause. Here the donor has prescribed the required formula and the trustee is obligated to implement it. With respect to the initial allocation to charity, if any, it should be clear that the donor mandated the distribution. A stronger negative argument may be made with respect to future allocations to charity if values are increased. f. Authorities. The IRS takes a dim view of arrangements that limit its ability to change values and collect tax. For instance, a donor may not give assets to a donee with the proviso that assets having a value in excess of $X will be returned to the donor. On the other hand, marital deduction-exemption equivalent clauses have been used for decades, as have testamentary formula clauses of various types (e.g. a formula that zeros out charitable lead trust gifts). Which analysis is more appropriate for charitable allocation clauses? Any analysis A-17 must distinguish among types of clauses: those that call for a retransfer to the donor if too much is transferred originally; those that call for the donee to pay, or to pay more, if otherwise the donor would have transferred too much; those that purport to transfer only an amount which is not too much; and those that allocate the excess, if too much is transferred, to a third party such as a charity or a marital deduction trust. The key case is Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), cert. denied 323 U.S. 756 (1944). The applicable provision that was struck down in that case read as follows: Eleventh: The settlor is advised by counsel and satisfied that the present transfer is not subject to Federal gift tax. However, in the event it should be determined by final judgment or order of a competent federal court of last resort that any part of the transfer in trust hereunder is subject to gift tax it is agreed by all the parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of Frederic W. Procter free from the trust hereby created. In Rev. Rul. 86-41, 1986-1 C. B. 300, the IRS dealt with a Proctor type clause. By deed the donor transferred one-half of a tract of land to the donee but, the deed provided, if the one-half exceeded $10,000 in value then the share allocated to the donee would be diminished so that the transferred fraction was valued at $10,000. The ruling states that the only purpose of the clause was not to preserve or implement the original, bona fide intent of the parties but rather to recharacterize the transaction so as to discourage gift tax audit. The ruling distinguished a clause requiring a reallocation on account of an independent audit as sometimes occurs in an arms-length sale. The ruling reaches the identical conclusion for a defined value clauses. The Tax Court considered a price adjustment savings clause in a private annuity situation in Estate of McClendon v. C.I.R., T.C. Memo. 1993-459. In a reasonably comprehensive review of the case-law in this area up to that time the court stated: The private annuity agreement includes a paragraph allowing for an adjustment to the amount to be paid to Gordon in the event that a higher value is assigned to the remainder interest through a settlement with the Internal Revenue Service or as a result of a final decision of this Court. The paragraph in question states: The parties hereto recognize that the valuation of many of the assets set out on attached Exhibit A are, by their nature, as determined by the best judgment of the parties and independent consultants engaged to assist in the valuation process and may be subject to differing opinions. Therefore, the parties agree that, to the extent any of the values on the attached Exhibit A are changed through a settlement process with the Internal Revenue Service, or a final decision of the United States Tax Court, the purchase price hereunder shall be adjusted accordingly, with interest on said adjustment at the rate of ten percent (10%) from the date hereof until said final determination of value, and the annuity A-18 payments due and payable hereunder shall likewise be adjusted to reflect any such change in valuation. * * * The court in Proctor went on to point out that the adjustment clause should be viewed as contrary to public policy on the grounds that: (1) Public officials would be discouraged from attempting to collect the tax since the only effect would be to defeat the gift; (2) the adjustment provision would tend to obstruct the administration of justice by requiring the court to address a moot case; and (3) the provisions should not be permitted to defeat a judgment rendered by the court. Id. We followed Procter in Ward v. Commissioner, supra [87 T.C. 78 (1986)]. In the latter case, the taxpayers, husband and wife, each transferred 25 shares of stock to each of their three sons. At the time of the gifts the taxpayers and their sons executed a gift adjustment agreement that was intended to ensure that the taxpayers gift tax liability for the stock transfers would not exceed the unified credit against gift tax that the taxpayers were entitled to at that time. Id. at 87-88. In particular, the agreement stated that if it should be finally determined for Federal gift tax purposes that the fair market value of the transferred stock either was less than or greater than $2,000 per share, an adjustment would be made to the number of shares conveyed so that each donor would have transferred $50,000 worth of stock to each donee. Id. We concluded that the fair market value of the stock exceeded $2,000 per share for each of the years in issue. Id. at 109. In rejecting the taxpayers position in Ward, we first noted that honoring the adjustment agreement would run counter to the policy concerns articulated in Procter. Id. at 113. In addition, we were not persuaded by the taxpayers argument that the mere possibility of the application of the Federal estate tax to the excess gift was sufficient to distinguish Procter. Finally, we concluded that upholding the adjustment agreement would result in unwarranted interference with the judicial process, stating: Furthermore, a condition that causes a part of a gift to lapse if it is determined for Federal gift tax purposes that the value of the gift exceeds a given amount, so as to avoid a gift tax deficiency, involves the same sort of trifling with the judicial process condemned in Procter. If valid, such condition would compel us to issue, in effect, a declaratory judgment as to the stock s value, while rendering the case moot as a consequence. Yet, there is no assurance that the petitioners will actually reclaim a portion of the stock previously conveyed to their sons, and our decision on the question of valuation in a gift tax suit is not binding upon the sons, who are not parties to this action. The sons may yet enforce the gifts. Based upon our review of Procter and Ward, the adjustment clause at issue in the instant case does not merit consideration for purposes of determining petitioner s gift tax liability, and we so hold. In our view, it makes little sense to expend precious judicial resources to resolve the question of whether a gift resulted from the private annuity transaction only to render that issue moot. Equally important, A-19 our determination that the private annuity agreement resulted in a taxable gift is not directly binding on Bart or the McLendon Family Trust who are not parties to this case. See Ward v. Commissioner, supra at 114. Consequently, there being no assurance that the terms of the adjustment clause will be respected, it shall have no impact on this case. Petitioner s reliance on King v. United States, 545 F.2d 700 (10th Cir.1976) is misplaced. That case involved a sale of stock which the court found to be an arm s-length transaction, free from any donative intent. Like that in Ward v. Commissioner, 87 T.C. 78, 116 (1986), however, the transaction at issue in the instant case was not an arm s-length deal, and thus we distinguish the King case on this basis. Further, we have previously questioned the factual findings supporting the holding in King. See Harwood v. Commissioner, 82 T.C. 239, 271 n. 23 (1984). Harwood dealt with these facts: On December 29, 1976, Jack and Margaret Harwood and Bud and Virginia Harwood each created a trust for the benefit of their respective children, with the Bank of America acting as trustee for each trust. Each trust received from its grantors an 8.89-percent limited partnership interest in HIC. The trust agreements contained the following clause: Article FIRST. Property subject to this instrument listed in Schedule A is referred to as the trust estate and shall be held, administered, and distributed in accordance with this instrument. In the event that the value of the partnership interest listed in Schedule A shall be finally determined to exceed $400,000 for purposes of computing the California or United States Gift Tax, and in the opinion of the Attorney for the trustee a lower value is not reasonably defendable, the trustee shall immediately execute a promissory note to the trustors in the usual form at 6 percent interest in a principal amount equal to the difference between the value of such gift and $400,000. The note shall carry interest and be effective as of the day of the gift. The court concluded: We do not believe that the savings clause here under consideration falls within the ambit of Procter. The clause in issue provides that if the value of the gifts of interests in HIC are finally determined to exceed $400,000 for purposes of computing the * * * United States Gift Tax and in the opinion of the Attorney for the trustee a lower value is not reasonably defendable, the trustees shall execute notes to the respective grantors for any value in excess of $400,000. Procter is apposite only if we read the words finally determined to refer to a final judgment by a court of competent jurisdiction. Such an interpretation, however, would render a nullity the succeeding phrase and in the opinion of the Attorney for the trustee a lower value is not reasonably defendable, since it would be absurd for the trustee to defend a lower value after a final judgment had been rendered. We believe the more reasonable interpretation of the clause at issue is to read finally determined to mean either eventually determined by appraisers A-20 or determined by the IRS. Thus, if an appraisal of HIC or, alternatively, an IRS determination was received by the trustees which valued the donated interests at more than $400,000 each, and the trustees accepted such appraisal, the trustees were to execute promissory notes to the trust grantors in an amount sufficient to insure that no more than $400,000 worth of property was given to each trust. On this reading of the savings clause, the trustee has no power to issue notes to the grantors upon a determination by a court that the value of property transferred to the trustee exceeded $400,000. In TAM 200245053 the clause was phrased as a fractional share of partnership interests. The specific facts of the transaction were: On Date 2, Taxpayer as Trustee of Trust B of Family Trust (Trust B), and Taxpayer s three children, Child 1, Child 2, and Child 3, formed Partnership. The Partnership agreement states that Taxpayer as Trustee of Trust B transferred $F ($A in cash, $B in publicly traded securities, and $C in real estate) in exchange for a 0.85 percent general partnership interest and a 99 percent limited partnership interest. Child 1, Child 2, and Child 3 each transferred $D in cash (of which roughly $E was gifted to each child by Taxpayer) in exchange for a 0.05 percent general partnership interest. Also on Date 2, the following transactions occurred. Taxpayer created Irrevocable Trust for the benefit of Taxpayer s lineal descendants. Taxpayer is designated as trustee. The trust provides that during the term of the trust, trust income and principal is to be distributed in such amounts and at such times as the trustee deems appropriate for the health, support, maintenance or education of any of taxpayer s descendants selected by the trustee. The Taxpayer s children are granted the right to substitute property in exchange for trust assets of equivalent value. As trustee of Trust B, Taxpayer assigned a 0.1 percent limited partnership interest in Partnership to herself as trustee of Irrevocable Trust. In addition, Taxpayer, as trustee of Trust B, executed a Sale and Purchase Agreement (Sales Agreement) pursuant to which Taxpayer as trustee of Trust B (Seller) sold to herself, as trustee of Irrevocable Trust (Purchaser), a fractional share of the 98.9 percent limited partnership interest in Partnership owned by Trust B. Sales Agreement describes the fractional share subject to the sale as follows: The numerator of such fraction shall be the Purchase Price, and the denominator of such fraction shall be the fair market value of [the 98.9 percent limited partnership interest]. The fair market value of [the 98.9 percent limited partnership interest] shall be such value as finally determined for federal gift tax purposes based upon other transfers of limited partnership interests in the Partnership by Seller as of [Date 2], in accordance with the valuation principles set forth in Regulation Section 25.2512-1 as promulgated by the United States Treasury under Section 2512 of the Internal Revenue Code of 1986, as amended. A-21 (Emphasis added.) Under the Sales Agreement, the Purchase Price is defined as the value determined by an appraisal of the 98.9 percent limited partnership interest made as soon as practicable after Date 2. In payment of the Purchase Price, Taxpayer as trustee of Irrevocable Trust executed a promissory note in the amount of $X (identified in the note as the Purchase Price under the Sales Agreement) with interest at the rate of 6.2 percent compounded annually. Interest is payable annually and the note principal is due 9 years less one day after Date 2. The note may be prepaid in whole or in part at any time within the term. Under a security agreement, the promissory note was secured by all of Irrevocable Trust s interests in Partnership, whenever acquired by the trust. Child 1, Child 2, and Child 3 executed a guarantee, guaranteeing payment on the note. Subsequently, the parties agreed that the charity should be bought out at a stated price. They entered into an agreement which provided: [T]he parties hereto agree that the Assignment effected a transfer of a ninety-eight and nine tenths percent (98.9%) limited partnership interest in the Partnership from Seller to Purchaser, and that the books and records of the Partnership shall reflect this Agreement. The parties acknowledge that this Agreement is subject to modification if within the statute of limitations applicable to the Assignment it shall be determined that the Assignment actually conveyed a different percentage than that set forth above. The parties agree that if there shall be such a determination, the ownership interests in the Partnership and distributions previously made from the Partnership shall be adjusted. The IRS applied Procter and Ward to ignore the effect of the charitable allocation. The TAM states: We see no difference between the effect of the adjustment clauses at issue in Ward and Rev. Rul. 86-41, and the adjustment provision in this case. In the instant case, Spouse, as trustee of Trust B, transferred the entire 98.9 percent limited partnership to the Irrevocable Trust pursuant to the Sales Agreement and The Agreement. However, if the Service adjusts the value of the gift of the 0.1 percent limited partnership interest transferred by the Spouse on Date 2, then under the formula in the Sales Agreement, the denominator of the fraction must be adjusted, but not the numerator, thereby reducing the fractional portion of the 98.9 percent interest subject to the sale and compelling a retransfer of a portion of the 98.9 percent interest back to Trust B. Thus, we believe the case is indistinguishable from the facts presented in Ward and Situation 1 of Rev. Rul. 86-41. In all three situations, under the adjustment clause at issue, if the Service, or the courts, determined that the property subject to the transfer exceeds the value initially placed on the property by the donor, then a portion of the property sufficient to eliminate the imposition of any additional tax liability is transferred back to the transferor. As the court noted in Ward v. Commissioner, if in the A-22 instant case the condition is given effect, there would be no incentive for the Commissioner to challenge the value of the limited partnership interest subject to the sale, because any adjustment to value would be rendered moot. Similarly, any attempt by a court to opine on the value of the interests would also be rendered moot. Further, as was the case in Ward, there is no assurance that the agreement would be enforced and any excess partnership interest transferred back. Rev. Rul. 86-41, 1986-1 C.B. 300, dealt with the transfer of an interest in income producing real estate from A to B with B receiving a one-half interest. The TAM discusses the situations addressed by the Ruling: In Situation 1, the deed provided that, if for federal gift tax purposes, the Service determined the value of the one-half interest was more than $10,000, then B s interest would be reduced so that its value equaled $10,000. Under local law, the adjustment clause would compel B s reconveyance of a fractional share of the property. On examination of A s gift tax return, the Service determined the date of gift fair market value of the one-half interest to be $15,000. Situation 2 addresses the same facts except that, instead of reconveying any portion of the one-half interest, B was required to pay to A consideration equal to the excess value. The revenue ruling states that, in both cases, the purpose of the adjustment clause was not to preserve or implement the original, bona fide intent of the parties, as in the case of a clause requiring a purchase price adjustment based on an appraisal by an independent third party retained for that purpose. Rather, the purpose of the clause was to recharacterize the nature of the transaction in the event of a future adjustment to A s gift tax return by the Service. Accordingly, the revenue ruling concludes that in both situations, the adjustment clause will be disregarded for federal tax purposes. The taxpayer argued that the IRS expressly allows formula clauses in the marital deduction context and with respect to grantor retained annuity trusts. The TAM distinguishes both of those situations: Taxpayer also argues that the Service has sanctioned the use of valuation formula clauses in other situations. For example, testamentary marital deduction formula clauses pursuant to which the amount of the marital bequest (and the amount of the marital deduction allowable under §§ 2056) fluctuates depending on the value of the gross estate as finally determined for estate tax purposes, are widely used, in order to take maximum advantage of the marital deduction and the unified credit available under §§ 2010. Similarly, §§ 25.2702-3(b)(ii)(B) provides that the retained annuity in a grantor retained annuity trust may be a specified fraction or percentage of the initial fair market value of the trust as finally determined for federal tax purposes. Taxpayer argues that these clauses, that adjust the value of a testamentary or inter vivos gift based on the transfer tax value of the property as finally determined, have the same operative effect as the clause at issue in this case. However, in order for most estates to take maximum advantage of the marital deduction and unified credit, as intended by Congress, utilization of a funding A-23 formula clause (either for the marital bequest or the credit shelter trust) is a necessity. That is, full utilization of these benefits is dependent on the value of the testator s property as determined for estate tax purposes on the date of death or alternate valuation date. A testator cannot anticipate when he or she will die or the value of the property at the time of death. Further, in the case of certain assets, such as an interest in a closely-held business, opinions can reasonable differ as to value. It is not feasible to continuously redraft testamentary instruments each time asset values change, or to account for differences of opinion that may arise in the valuation process. Thus, utilization of a testamentary marital deduction or credit shelter valuation formula clause is the only practical way a testator can take full advantage of these Congressionally authorized benefits. Similarly, the formula for defining a retained annuity contained in §§ 25.2702-3(b)(ii)(B) sanctions a practical method which, when utilized in a bona fide manner, enables a donor to take advantage of a Congressionally approved mechanism for transferring a remainder interest in trust property, in situations where assets that may be difficult to value, such as real estate or stock in a closely held business, are transferred to the trust. Further, this regulation should not be viewed as sanctioning the utilization of the formula to zero-out a gift, as is the case in the situation presented here. The preamble accompanying the promulgation of this regulation explicitly expresses concern regarding the use of grantor retained annuity trusts that are structured such that the value of the remainder interest (and thus, the amount of the gift) is zero or of nominal value relative to the total amount transferred to the trust. The preamble states that the Service and Treasury view these gift arrangements as contrary to the principles of §§ 2702. See, Preamble to T.D.8395, 1992-1 C.B. 316, 319. We believe the legitimate and accepted uses of formula clauses as a practical way to implement Congressionally sanctioned tax benefits are in stark contrast to the situation presented in the instant case. The creation of the partnership and the use of the valuation formula clause in the sale of the partnership interests are all part of an integrated transaction the primary purpose of which is to transfer assets to the natural objects of Taxpayer s bounty at a discounted value, while foreclosing any realistic opportunity to challenge the transaction. The Taxpayer created and funded the limited partnership primarily, if not solely, to generate valuation discounts, with the goal of enabling her irrevocable trust to acquire the interests at a reduced purchase price. Taxpayer employed the formula clause as part of the transaction in an attempt to ameliorate any adverse consequences if the Service challenged the transaction and thereby to discourage any such challenge. The clause does not serve a legitimate purpose, such as ensuring that the purchase price accurately reflects fair market value. Rather, the clause recharacterizes the nature of the transaction in the event of a future adjustment to the value of the partnership interests by the Service. Under these circumstances the adjustment clause should not be effective for gift tax purposes. The Service also ignored the fact that an increase in the value of the partnership did in fact increase the value of the gift because the increase was de minimis: A-24 In this case, the gift of the 0.1 percent interest and the sale to Irrevocable Trust were part of an integrated transaction. The Taxpayer has placed an insignificant portion of the transaction at issue in order to circumvent well-established case law that has developed regarding savings clauses. We do not believe the courts would permit these decisions to be so easily avoided. For example, in Procter, under the clause at issue, the gift was revoked to the extent it was finally determined that the gift was subject to gift tax. The court determined that the savings clause device was contrary to public policy. It is doubtful that the court would have reached a contrary conclusion, if the gift was revoked in its entirety but for $1.00, thus creating the potential for a nominal deficiency, in the event the Service contests the matter. Such a provision would have the same effect of discouraging the collection of tax by public officials, and would constitute the same trifling with the judicial process, as the actual clause involved in Procter. Accordingly, we do not believe the clause at issue is in any meaningful way distinguishable from those presented in Procter and Ward. In an earlier FSA, 200122011, a family limited partnership was formed between parents and sons. Parents then transferred limited interests to the sons, trusts for the sons, and charities pursuant to a transfer document that allocated certain specific dollar amounts to the sons and trusts with the charities receiving the remainder. The sons bought out the charities six months later. The interests were appraised when the charities received the interests and were bought out. In the buy-out the charities acknowledged payment in full for their interests. The IRS audited, adjusted the value of the gifts and denied an increase in the charitable deduction. The Service had three theories. First, that the step-transaction doctrine made the charities right to receive increased value illusory. Second, that the buy-out cut-off the charities rights so they would not actually receive any increase in value if the IRS audited. Third, that the clause s primary purposes was to defeat the gift tax and thus it violated public policy. See also TAM 200337012 for a disallowed fractional gift to a trust. The Tax Court attempted to deal with this area in Charles T. McCord v. Commissioner, 120 T. C. No. 13 (2003). In addition to the majority opinion there was a concurrence, two partial dissents, and a full dissent. The case is important for what it says about partnership valuation as well as charitable allocations. The Fifth Circuit reversed the Tax Court, at 98 A.F.T.R.2d 2006-6147 (5th Cir. 2006) as discussed below. The specific facts are important and were described by the majority opinion in the Tax Court as follows: On November 20, 1995, petitioners assigned their respective class A limited partnership interests in MIL [the family partnership] to the Hazel Kytle Endowment Fund of The Southfield School Foundation (the foundation) pursuant to an Assignment of Partnership Interest and Addendum Agreement (the Southfield agreement). The recitals to the Southfield agreement provide that all of the partners of the Partnership desire that Assignee become a Class A Limited Partner of the Partnership upon execution of this Assignment of Partnership Interest and all consents required to effect the conveyance of the Assigned Partnership Interest and the admission of Assignee as a Class A A-25 Limited Partner of the Partnership have been duly obtained and are evidenced by the signatures hereto . All of the initial MIL partners executed the Southfield agreement. Further Assignments On January 12, 1996 (the valuation date), petitioners, as assignors, entered into an assignment agreement (the assignment agreement) with respect to their class B limited partnership interests in MIL. The other parties to the assignment agreement (the assignees) were the children, four trusts for the benefit of the children (the trusts), and two charitable organizations Communities Foundation of Texas, Inc. (CFT) and Shreveport Symphony, Inc. (the symphony). By the assignment agreement, petitioners relinquished all dominion and control over the assigned partnership interests and assigned to the assignees all of their rights with respect to those interests. The assignment agreement does not contain language similar to that quoted above from the Southfield agreement regarding the admission of the assignees as partners of the partnership, and two of the partners of the partnership, McCord Brothers Partnership and the foundation, did not execute the assignment agreement in any capacity. The interests that petitioners assigned to the assignees by way of the assignment agreement (collectively, the gifted interest) are the subject of this dispute. Under the terms of a formula clause contained in the assignment agreement (the formula clause), the children and the trusts were to receive portions of the gifted interest having an aggregate fair market value of $6,910,933; if the fair market value of the gifted interest exceeded $6,910,933, then the symphony was to receive a portion of the gifted interest having a fair market value equal to such excess, up to $134,000; and, if any portion of the gifted interest remained after the allocations to the children, trusts, and symphony, then CFT was to receive that portion (i.e., the portion representing any residual value in excess of $7,044,933). The children (individually and as trustees of the trusts) agreed to be liable for all transfer taxes (i.e., Federal gift, estate, and generation-skipping transfer taxes, and any resulting State taxes) imposed on petitioners as a result of the conveyance of the gifted interest. The assignment agreement leaves to the assignees the task of allocating the gifted interest among themselves; in other words, in accordance with the formula clause, the assignees were to allocate among themselves the approximately 82-percent partnership interest assigned to them by petitioners. In that regard, the assignment agreement contains the following instruction concerning valuation (the valuation instruction): For purposes of this paragraph, the fair market value of the Assigned Partnership Interest as of the date of this Assignment Agreement shall be the price at which the Assigned Partnership Interest would change hands as of the date of this Assignment Agreement between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Any dispute with respect to the allocation of the Assigned Partnership Interests among Assignees shall be resolved by arbitration as provided in the Partnership Agreement. A-26 The Confirmation Agreement In March 1996, the assignees executed a Confirmation Agreement (the confirmation agreement) allocating the gifted interest among themselves ... * * * The assignees based that determination on an appraisal report, dated February 28, 1996, prepared at the behest of the children s counsel by Howard Frazier Barker Elliott, Inc. (HFBE). That report (the 1996 HFBE appraisal report) concludes that, taking into account discounts for lack of control and lack of marketability, the fair market value of a 1-percent assignee s interest in the Class B Limited Partnership Interests on the valuation date was $89,505. Representatives of CFT and the symphony, respectively (including their respective outside counsel), reviewed the 1996 HFBE appraisal report and determined that it was not necessary to obtain their own appraisals. Furthermore, under the terms of the confirmation agreement, CFT and the symphony (as well as the other assignees) agreed not to seek any judicial alteration of the allocation in the confirmation agreement and waived their arbitration rights granted under the assignment agreement. MIL s Exercise of the Call Right On June 26, 1996, MIL exercised the call right with respect to the interests held by the symphony and CFT. It did so pursuant to a document styled Agreement Exercise of Call Option By McCord Interests, Ltd., L.L.P. (the exercise agreement). The purchase price for the redeemed interests was based on a two-page letter from HFBE (the HFBE letter) previewing an updated appraisal report to be prepared by HFBE. The HFBE letter concludes that the fair market value of a 1-percent assignee s interest in the Class B Limited Partnership Interests as of June 25, 1996 was $93,540. CFT and the symphony raised no objections to the value found in the HFBE letter and accepted $338,967 and $140,041, respectively, in redemption of their interests. The Tax Court majority went on to discuss the effect of the assignment agreement with respect to the charitable allocation: By way of the assignment agreement, petitioners transferred to CFT the right to a portion of the gifted interest. That portion was not expressed as a specific fraction of the gifted interest (e.g., one-twentieth), nor did petitioners transfer to CFT a specific assignee interest in MIL (e.g., a 3-percent assignee interest). Rather, CFT was to receive a fraction of the gifted interest to be determined pursuant to the formula clause contained in the assignment agreement. The formula clause provides that CFT is to receive that portion of the gifted interest having a fair market value equal to the excess of (1) the total fair market value of the gifted interest, over (2) $7,044,933. The formula clause is not selfeffectuating, and the assignment agreement leaves to the assignees the task of (1) determining the fair market value of the gifted interest and (2) plugging that A-27 value into the formula clause to determine the fraction of the gifted interest passing to CFT. Petitioners argue that, because the assignment agreement defines fair market value in a manner that closely tracks the definition of fair market value for Federal gift tax purposes, see sec. 25.2512-1, Gift Tax Regs., the assignment agreement effects a transfer to CFT of a portion of the gifted interest determinable only by reference to the fair market value of that interest as finally determined for Federal gift tax purposes. We do not believe that the language of the assignment agreement supports petitioners argument. The assignment agreement provides a formula to determine not only CFT s fraction of the gifted interest but also the symphony s and the children s (including their trusts ) fractions.44 Each of the assignees had the right to a fraction of the gifted interest based on the value of that interest as determined under Federal gift tax valuation principles. If the assignees did not agree on that value, then such value would be determined (again based on Federal gift tax valuation principles) by an arbitrator pursuant to the binding arbitration procedure set forth in the partnership agreement. There is simply no provision in the assignment agreement that contemplates the allocation of the gifted interest among the assignees based on some fixed value that might not be determined for several years. Rather, the assignment agreement contemplates the allocation of the gifted interest based on the assignees best estimation of that value. Moreover, each of the assignees percentage interests was determined exactly as contemplated in the assignment agreement (without recourse to arbitration), and none can complain that they got any less or more than petitioners intended them to get.45 Had petitioners provided that each donee had an enforceable right to a fraction of the gifted interest determined with reference to the fair market value of the gifted interest as finally determined for Federal gift tax purposes,46 we might have reached a different result. However, that is not what the assignment agreement provides. Of course, the assignees determination of the fair market value of the gifted interest, while binding among themselves for purposes of determining their respective assignee interests, has no bearing on our determination of the Federal gift tax value of the assignee interests so allocated. Footnote 46 states: See, e.g., sec. 1.664-2(a)(1)(iii), Income Tax Regs. (providing that a sum certain may be expressed as a fraction or percentage of the value of property as finally determined for Federal tax purposes , but requiring that actual adjusting payments be made if such finally determined fair market value differs from the initially determined value); sec. 20.2055-2(e)(2)(vi)(a), Estate Tax Regs. (similar); sec. 25.2702-3(b)(1)(ii)(B), Gift Tax Regs. (similar); Rev. Proc. 64-19, 1964-1 C. B. 682 (discussing conditions under which the Federal estate tax marital deduction may be allowed where, under the terms of a will or trust, an executor or trustee is empowered to satisfy a pecuniary bequest or transfer in trust to a decedent s surviving spouse with assets at their value as finally determined for Federal estate tax purposes). A-28 The Tax Court majority opinion found it significant that the value of what each party received was based on what they agreed, or what an arbitrator determined if they failed to agree, were the values of the various interests, determined in the same manner as for federal gift tax purposes. Footnote 46 suggests that the lack of an enforceable right by the charity is ultimately the problem with the assignment. Judge Chiechi, concurring in part and dissenting in part, disagreed that there was no enforceable right under the clause: As can be seen from reading the foregoing paragraph, the purported valuation instruction consists of a paragraph in the assignment agreement which defines the term fair market value . Petitioners required the donees to use that definition when they allocated among themselves the respective portions of the gifted interest which petitioners transferred to them under the assignment agreement. The definition of the term fair market value for that purpose is the same definition used for Federal gift tax purposes. See sec. 25.2512-1, Gift Tax Regs. The last sentence of the above-quoted paragraph merely requires that any dispute with respect to the allocation of the gifted interest among the donees be resolved by arbitration as provided in the partnership agreement. Nothing in that paragraph mandates that if the fair market value of the gifted interest to which the various donees agreed is ultimately determined not to be the fair market value of that interest, no adjustment may be made to the respective assignee percentage interests allocated to CFT and the other donees, as set forth in the confirmation agreement. I believe that the majority opinion s construction of the above-quoted paragraph is strained, unreasonable, and improper and leads to illogical results. In essence, the majority opinion concludes that the donees of the gifted interest made a mistake in determining the fair market value of that interest and that petitioners are stuck with that mistaken value solely for purposes of determining the respective assignee percentage interests transferred to the donees under that agreement. The majority opinion states that: the assignment agreement contemplates the allocation of the gifted interest based on the assignees best estimation of that value. Moreover, each of the assignees percentage interests was determined exactly as contemplated in the assignment agreement (without recourse to arbitration), and none can complain that they got any less or more than petitioners intended them to get. * * * [Majority op. p. 63.] The assignment agreement does not contemplate , as the majority opinion states, that the allocation of the gifted interest be based on the assignees best estimation of that [fair market] value. Id. Under the assignment agreement, petitioners transferred to the donees specified portions of the gifted interest determined by reference to the fair market value of such portions, as defined in that agreement, and not upon some best estimation of that value. A-29 The assignment agreement required that the allocation be based upon fair market value as defined in that agreement, which the majority opinion acknowledges is the same definition of that term for Federal gift tax purposes. The majority opinion has found that the donees did not make the allocation on the basis of that definition. The donees thus failed to implement the donors (i.e., petitioners ) mandate in the assignment agreement when they arrived at amounts which they believed to be the respective fair market values of the specified portions of the gifted interest that petitioners transferred to them but which the majority opinion has found are not the fair market values of such portions. Judge Foley, in concurrence and dissent, went further in support of the taxpayer, stating that the IRS did not prove a substance over form argument and that the allocation clause did not violate public policy: Respondent contended that formation of the limited partnership, assignment of partnership interests, confirmation of the assignment, and redemption of the charities partnership interests were all part of an integrated transaction where petitioners intended to transfer all of their assets to their sons and the trusts. Respondent simply failed to meet his burden. Courts have employed the substance over form doctrine where a taxpayer, intending to avoid the gift tax, transfers property to an intermediary who then transfers such property to the intended beneficiary.7 In some instances the intermediary was used to disguise the transferor. See Schultz v. United States, 493 F.2d 1225, 1226 (4th Cir. 1974) (finding that brothers planned to avoid gift taxes through repeated reciprocal gifts to each others children); Griffin v. United States, 42 F. Supp. 2d 700, 707 (W.D. Tex. 1998) (finding that husband and wife engaged in a scheme where the wife was merely the intermediary through which the stock passed on its way to the ultimate beneficiary ); Estate of Murphy v. Commissioner, T.C. Memo. 1990-472 (disregarding an intrafamily stock transfer where the Court found an informal family agreement to control the stock collectively). In Heyen v. United States, 945 F.2d 359 (10th Cir. 1991) (disregarding as shams 27 transfers of stock to intermediate beneficiaries who then transferred the stock to the original transferor s family), however, the intermediary was used in an attempt to disguise the transferee. Respondent, relying on Heyen, asserts that the Symphony and CFT were merely intermediaries in petitioners plan to transfer their MIL interests to their sons and the trusts. In Heyen, a taxpayer, seeking to avoid the gift tax by taking advantage of the annual gift tax exclusion, transferred stock to 29 intermediate recipients, all but two of whom made blank endorsements of the stock, which the issuing bank subsequently reissued to the intended beneficiaries. The court stated: The [intermediate] recipients either did not know they were receiving a gift of stock and believed they were merely participating in stock transfers or had agreed before receiving the stock that they would endorse the stock certificates in order that the stock could be reissued to decedent s family. [ Id. at 361.] The court further stated: A-30 The evidence at trial indicated decedent intended to transfer the stock to her family rather than to the intermediate recipients. The intermediary recipients only received the stock certificates and signed them in blank so that the stock could be reissued to a member of decedent s family. Decedent merely used those recipients to create gift tax exclusions to avoid paying gift tax on indirect gifts to the actual family member beneficiaries. [ Id. at 363.] In order for us to ignore petitioners allocation in the assignment agreement, respondent must establish that petitioners coordinated, and the charities colluded in or acquiesced to, a plan to avoid petitioners gift taxes by undervaluing the transferred interests and intended to divert CFT s interest to their sons and the trusts. See Heyen v. United States, supra; Schultz v. United States, supra; Griffin v. United States, supra; Estate of Murphy v. Commissioner, supra. Respondent did not present the requisite evidence for us to invoke the substance over form doctrine. Respondent stated on brief that, after execution of the assignment agreement, petitioners washed their hands of the transaction, and the donees took over. Petitioners sons involvement in the subsequent allocation of the transferred interests does not affect the petitioners gift tax liability, particularly in the absence of a showing that petitioners retained some control over the subsequent allocation. See sec. 25.2511-2(a), Gift Tax Regs. (stating that the gift tax is measured by the value of the property passing from the donor). Petitioners sons and the estate planner made all the arrangements relating to the valuation. This Court, however, will not impute to petitioners an intent to avoid the gift tax merely from the appraiser s valuation of the transferred partnership interests, the sons involvement in the planning process, or the hiring of an estate planner charged with tax minimization. See Estate of Strangi v. Commissioner, 115 T.C. 478, 484-485 (2000) ( Mere suspicion and speculation about a decedent s estate planning and testamentary objectives are not sufficient to disregard an agreement in the absence of persuasive evidence ), revd. on other grounds 293 F.3d 279 (5th Cir. 2002); Hall v. Commissioner, 92 T.C. 312 (1989). Respondent failed to establish that the Symphony or CFT participated, knowingly or otherwise, in a plan to facilitate petitioners purported avoidance of gift tax. Indeed, the testimony and evidence established that the Symphony and CFT acted independently. CFT did not hire its own appraiser because it had confidence in the appraiser hired by petitioners sons. While in hindsight (i.e., after this Court s valuation) it was imprudent for the charitable organizations to forgo an independent appraisal,8 these organizations were not sham intermediaries. Prior to signing the confirmation agreement, the Symphony and CFT could have independently valued MIL, forced arbitration, and thwarted any purported plan to avoid the gift tax. Cf. Compaq v. Commissioner, 277 F.3d 778, 784 (5th Cir. 2001) (declining, in an income tax case, to disregard a transaction that involved even a minimal amount of risk and was conducted by entities separate and apart from the taxpayer), revg. 113 T.C. 214 (1999). There is no evidence of an implicit or explicit agreement, between petitioners and either the Symphony or CFT, that the Symphony or CFT would accept less than that which petitioners transferred to each organization. In fact, respondent A-31 stipulated that Before the call right was exercised, there was no agreement among Mr. or Mrs. McCord, the McCord brothers, the Symphony or CFT as to when such a buyout would occur or to the price at which the buyout would occur. In sum, respondent failed to establish that the undervaluation of MIL, reallocation of MIL interests, and subsequent transfer of a portion of CFT s MIL interest to the sons and the trusts, were parts of a plan by petitioners to avoid the gift tax. CFT s retention of a much smaller interest (i.e., 3.62376573 percent) than petitioners transferred, pursuant to the assignment agreement, has no effect on the value of the transferred property on January 12, 1996, the date the gift became complete. III. Formula Clause Does Not Violate Public Policy Relying primarily on Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), respondent contended that petitioners formula clause was against public policy, and therefore void, because such clause is a poison pill created to discourage audit of the gifts and to fabricate phantom charitable gift and income tax deductions. In Commissioner v. Procter, supra, the court considered a clause causing a gift to revert to the donor if a court determined that the gift was taxable. The court held that such a clause is clearly a condition subsequent and void because contrary to public policy. Id. at 827. The court reasoned that the clause would discourage the collection of tax because attempted collection would defeat the gift, the clause would obstruct the administration of justice by requiring the courts to pass upon a moot case , and the clause, if allowed to stand, would defeat the judgment of a court. Id. Likewise, in Ward v. Commissioner, 87 T.C. 78 (1986), a clause allowed the taxpayer to revoke a gift of stock if it was determined that, for gift tax purposes, the fair market value of such stock exceeded $2,000 per share. The Court similarly concluded that such a clause was a condition subsequent and void because it was against public policy. Contrary to the valuation clauses in Commissioner v. Procter, supra, and Ward v. Commissioner, supra, which adjusted the amount transferred based upon a condition subsequent, petitioners valuation clause defined the amount of property transferred. Simply put, petitioners gift does not fail upon a judicial redetermination of the transferred property s value. Petitioners made a legally enforceable transfer of assignee interests to CFT, with no provision for the gift to revert to petitioners or pass to any other party on the occurrence of adverse tax consequences. CFT merely failed to protect its interest adequately. Procter and Ward are distinguishable. Petitioners formula clause was not against public policy. Going the other way, in dissent Judge Laro stated that the clause should be ignored because it violates public policy and no increased charitable deduction should be allowed: A-32 To reach the result that the majority desires, the majority decides this case on the basis of a novel approach neither advanced nor briefed by either party and concludes that the Court need not address respondent s arguments as to public policy and integrated transaction. Majority op. p. 64 note 47. Specifically, under the majority s approach (majority s approach), the term fair market value as used in the assignment agreement denotes simply the value ascertained by the parties to that agreement (or, in certain cases by an arbitrator) and not the actual amount determined under the firmly established hypothetical willing buyer/hypothetical willing seller test that has been a fundamental part of our Federal tax system for decades on end. Majority op. p. 64 note 47; see also United States v. Cartwright, 411 U.S. 546, 550-551 (1973) ( The willing buyer-willing seller test of fair market value is nearly as old as the federal income, estate, and gifts taxes themselves ). Whereas the majority ostensibly recognizes that firmly established test in its determination of the fair market value of the subject property, majority op. p. 64 note 46, the majority essentially holds that the parties to the assignment agreement are not bound by that test when they themselves ascertain the fair market value of that property, id. at 61-64. As I understand the majority s rationale, the parties to the assignment agreement are not bound by that test because the assignment agreement only uses the phrase fair market value and not the phrase fair market value as finally determined for Federal gift tax purposes . To my mind, the subject property s fair market value is its fair market value, notwithstanding whether fair market value is ascertained by the parties or finally determined for Federal gift tax purposes . I know of nothing in the tax law (nor has the majority mentioned anything) that provides that property such as the subject property may on the same valuation date have one fair market value when finally determined and a totally different fair market value if ascertained beforehand.1 The majority s interpretation of the assignment agreement is at odds with the interpretation given that agreement by not only the trial Judge, but by both parties as well. The majority allows petitioners an increased charitable contribution that would be disallowed under either the public policy or integrated transaction doctrine. In that both of these doctrines are fundamental to a proper disposition of this case, it is incumbent upon the Court to address one or both of them. The majority inappropriately avoids discussion of these doctrines by relying on the principle that the Court may approve a deficiency on the basis of reasons other than those relied upon by the Commissioner . Majority op. p. 64 note 47. The majority, however, fails to recognize that the majority is not approving respondent s deficiency in full but is rejecting a portion of it. In fact, the majority even acknowledges that the application of respondent s integrated transaction theory would result in an initial increase in the amount of petitioners aggregate taxable gift by only $90,011 . Id. Whereas the majority attempts to downsize the significance of a $90,011 adjustment by recharacterizing it as only and less than 1 percent , id., the fact of the matter is that the dollar magnitude of a $90,011 increase is significant to the fisc (as well as to most people in general) notwithstanding that it may constitute a small percentage of the aggregate taxable gift as found by the majority.2 I know of no principle of tax law (nor has the majority cited one) that provides that an adjustment otherwise required by A-33 the tax law is inappropriate when it is a small percentage of a base figure such as aggregate taxable gifts. 2. Increased Charitable Deduction Is Against Public Policy Allowing petitioners to deduct as a charitable contribution the increase in value determined by the Court is against public policy and is plainly wrong. No one disputes that CFT will never benefit from the approximately $45,000 that each petitioner is entitled to deduct as a charitable contribution pursuant to the majority opinion. Nor does anyone dispute that the only persons benefiting from the increased value are petitioners and that the only one suffering any detriment from the increased value is the fisc. I do not believe that Congress intended that individuals such as petitioners be entitled to deduct charitable contributions for amounts not actually retained by a charity. See Hamm v. Commissioner, T.C. Memo. 1961-347 (charitable contribution under sec. 2522 requires a reasonable probability that the charity actually will receive the use and benefit of the gift, for which the deduction is claimed ), affd. 325 F.2d 934 (8th Cir. 1963). * * * All of the steps which were taken to effect the transfer of petitioners partnership interests to their sons (inclusive of the trusts) were part of a single integrated transaction. The purpose of that transaction was to transfer the interests with an avoidance of Federal gift taxes, while, at the same time, discouraging audit of the transfer and manufacturing phantom charitable gift and income tax deductions in the event that the value of the transfer was later increased. I reach my conclusion in light of the following facts which were found by the trial judge or are reasonable inferences therefrom: (1) Petitioners were seeking expert advice on the transfer of their wealth with minimal tax consequences, (2) the transaction contemplated that the charities would be out of the picture shortly after the gift was made, (3) the transfers of the partnership interests to the charities were subject to a call provision that could be exercised at any time, (4) the call provisions were exercised almost contemporaneously with the transfers to the charities, (5) the call price was significantly below fair market value, (6) the charities never obtained a separate and independent appraisal of their interests (including whether the call price was actually the fair market value of those interests), (7) neither charity ever had any managerial control over the partnership, (8) the charities agreed to waive their arbitration rights as to the allocation of the partnership interests, and (9) petitioners sons were at all times in control of the transaction. I also query as to this case why a charity would ever want to receive a minority limited partnership interest, but for an understanding that this interest would be redeemed quickly for cash, and find relevant that the interest was subject to the call provision that could be exercised at any time. Judge Swift wrote a concurrence that is most interesting. Essentially he argued that the taxpayers gift to charity failed to qualify for the gift tax charitable deduction because it was a partial interest. In particular, Judge Swift focused on the rights that the charitable donee did not receive because it only received an assignee interest; his discusses this issue as follows: A-34 Focusing on the gift to the fourth level charitable donee (the gift to CFT), petitioners themselves allege (in order to beef up the valuation discounts they seek) and the majority opinion finds, majority op. pp. 19-24, that the gifted MIL partnership interest transferred to CFT included only certain economic rights with regard to the gifted interest and did not consist of all of the donors rights as limited partners in that particular limited partnership interest. Upon petitioners transfer and upon CFT s receipt of the gifted interest in the MIL partnership, petitioners retained, and CFT never received, the following rights associated with petitioners interest in MIL (references are to the MIL amended partnership agreement): (1) (2) The right to vote on MIL partnership matters (section 3.10); The right to redeem the MIL partnership interest (section 9.02(b)); The right to inspect financial and other pertinent information relating to MIL (section 3.09(d)(i)-(v)); The right to access any properties or assets owned by MIL (section 3.09(d)(vi)); and The right to veto early liquidation of MIL, unless such liquidation is required by State law (section 10.01). (3) (4) (5) Under section 7.02 of the Texas Revised Limited Partnership Act, a partnership agreement may, but is not required to, limit the partnership rights that may be transferred when a partner transfers or assigns an interest in a partnership. In this case, petitioners made their retention of the above rights (and the nonreceipt thereof by CFT) explicit by the terms of the MIL partnership agreement that they adopted. Section 8.03 of the MIL partnership agreement, discussing the transfer of a limited partnership interest to an assignee, is set forth, in part, below: [A]n Assignee shall be entitled only to allocations of Profits and Losses * * * and distributions * * * which are attributable to the Assigned Partnership Interests held by the Assignee and shall not be entitled to exercise any Powers of Management nor otherwise participate in the management of the Partnership nor the control of its business and affairs. * * * As explained, the above limitations on the charitable gift transferred by petitioners to CFT are the basis for petitioners claimed characterization and valuation of the gift to CFT as an assignee interest in MIL, as distinguished from an MIL partnership interest, and (as petitioners themselves contend) they would appear to constitute substantive and significant limitations. Such limitations would necessarily make the gifts partial interests, according to Judge Swift, based in part on Rev. Rul. 81-282, 1981-2 C. B. 78, which disallowed a charitable deduction for corporate stock where the donor retained the right to vote the stock. Judge Swift s opinion states: A-35 As stated, the retained rights involved in Rev. Rul. 81- 282, 1981-2 C.B. 78, appear to be analogous to the rights retained by petitioners herein. By providing in the MIL partnership agreement limitations on transfers of MIL partnership interests and by transferring to CFT only an assignee interest in MIL, petitioners retained the voting and the other rights in the MIL limited partnership associated with the assignee interest transferred to charity. Because the rights retained by petitioners with regard to their MIL limited partnership interest would be treated as substantial, under section 170(f)(3)(B)(ii) the portion thereof transferred to CFT would appear not to qualify as an undivided portion of petitioners entire MIL limited partnership interest. I would reiterate that it is the perceived substantial significance of petitioners retained rights on which petitioners themselves, petitioners valuation experts, and the majority opinion rely to justify assignee status and increased valuation discounts for the gifted interest. It would appear that for the above analysis not to apply to the gift involved in the instant case, petitioners MIL limited partnership interest would have to be interpreted as consisting of two separate and distinct interests (an economic interest and a noneconomic interest) with petitioners transferring to CFT an undivided portion of the separate economic interest. I submit that the correct interpretation would be to treat petitioners MIL limited partnership interest as one interest consisting of both economic and noneconomic rights, with petitioners having transferred to CFT only their economic rights therein. Under this interpretation, it would appear that petitioners should be regarded as having made a charitable gift to CFT of a partial interest in their MIL limited partnership interest, which charitable gift would be subject to the gift tax disallowance provision of section 2522(c)(2). The Fifth Circuit ignored Judge Swift s concerns, and Judge Laro s, instead focusing, and largely adopting, Judge Foley s opinion. The court specifically noted that on appeal the government did not raise substance over form or public policy objections to the clause, and thus the court did not address them. Instead, the court found that the Tax Court had used post-gift events to determine gift tax value, which it found impermissible. The opinion states: The Majority's holdings for the Commissioner were not, however, based on any of the overarching equitable doctrines that the Commissioner had advanced at trial. Instead, the Majority crafted its own interpretation of the Assignment Agreement and gave controlling effect to the post-gift Confirmation Agreement, all based entirely on a theory that the Commissioner had never espoused. At the core of the novel methodology thus conceived and implemented, sua sponte, by the Majority is the consistently rejected concept of postponed determination of the taxable value of a completed gift -- postponed here until, two months after the Taxpayers gifts were completed, the donees decided among themselves (with neither actual nor implied participation of or suasion by the donors) how they would equate the dollars-worth of interest in MIL given to them on January 12, 1996, with percentages of interests in MIL decided two months later by the donees in the Confirmation Agreement. Stated differently, the Majority in essence suspended the valuation date of the property that the Taxpayers donated A-36 in January until the date in March on which the disparate donees acted, post hoc, to agree among themselves on the Class B limited partnership percentages that each would accept as equivalents of the dollar values irrevocably and unconditionally given by the Taxpayers months earlier. As shall be seen, we hold that the Majority's unique methodology violated the immutable maxim that postgift occurrences do not affect, and may not be considered in, the appraisal and valuation processes. Under the instant circumstances, the ultimate-valuation "fact" is at most a mixed question of fact and law, and thus a legal conclusion.25 Particularly when, as here, the determination of the fair market value for gift tax purposes requires legal conclusions, our review is de novo.26 Indeed, it is settled in this circuit and others that a trial court's methodology in resolving fact questions is a legal issue and thus reviewable de novo on appeal.27 The Majority's key legal error was its confecting sua sponte its own methodology for determining the taxable or deductible values of each donee's gift valuing for tax purposes here. This core flaw in the Majority's inventive methodology was its violation of the long-prohibited practice of relying on postgift events.28 Specifically, the Majority used the after-the-fact Confirmation Agreement to mutate the Assignment Agreement's dollar-value gifts into percentage interests in MIL. It is clear beyond cavil that the Majority should have stopped with the Assignment Agreement's plain wording. By not doing so, however, and instead continuing on to the post-gift Confirmation Agreement's intra-donee concurrence on the equivalency of dollars to percentage of interests in MIL, the Majority violated the firmly-established maxim that a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.29 In this respect, we cannot improve on the opening sentence of Judge Foley's dissent: Undaunted by the facts, well-established legal precedent, and respondent's failure to present sufficient evidence to establish his determinations, the majority allow their olfaction to displace sound legal reasoning and adherence to the rule of law. [footnote omitted; bold in original] Judge Foley's "facts" are those stipulated and those adduced (especially the experts' testimony) before him as the lone trial judge, including the absence of any probative evidence of collusion, side deals, understandings, expectations, or anything other than arms-length, unconditional completed gifts by the Taxpayers on January 12, 1996, and arm's-length conversions of dollars into percentages by the donees alone in March. Judge Foley's "well-established legal precedent" includes, without limitation, constant jurisprudence that has established the immutable rule that, for inter vivos gifts and post-mortem bequests or inheritances alike, fair market value is determined, snapshot-like, on the day that the donor completes that gift (or the date of death or alternative valuation date in the case of a testamentary or intestate transfer).31 And, Judge Foley's use of "olfaction" is an obvious, collegially correct synonym for the less-elegant vernacular term, "smell test," commonly used to identify a decision made not on A-37 the basis of relevant facts and applicable law, but on the decision maker's "gut" feelings or intuition. The particular olfaction here is the anathema that Judge Swift identifies pejoratively in his concurring opinion as "the sophistication of the tax planning before us."32 The Majority's election to rule on the basis of this olfaction is likewise criticized by Judge Laro, dissenting in part, as the Majority Appl[ying] Its Own Approach: To reach the result that the majority desires, the majority decides this case on the basis of a novel approach neither advanced nor briefed by either party. . . .33 Judge Foley also disagrees with the Majority -- and rightly so, we conclude -- for basing its holding on an interpretation of the Assignment Agreement and an application of the Confirmation Agreement that the Commissioner never raised. To this criticism we add that the Majority not only made a contractual interpretation of the Assignment Agreement that rests in part on the non sequitur that it uses the term "fair market value" without including the modifying language "as finally determined for tax purposes,"34 but also indicated a palpable hostility to the dollar formula of the defined value clause in that donation agreement. This is exacerbated by the Majority's lip service to, but ultimate disregard of, the immutable principal that value of a gift must be determined as of the date of the gift. The Majority violates this doctrine when it relies in principal part on the post-gift actions of the donees in their March 1996 execution of the Confirmation Agreement. Judge Foley correctly notes that the Majority erred in conducting [A] tortured analysis of the [A]ssignment [A]greement that is, ostensibly, justification for shifting the determination of transfer tax consequences from the date of the transfer [January 12, 1996] . . . to March 1996 (i.e., the date of the [C]onfirmation [A]greement). The majority's analysis of the [A]ssignment [A]greement requires that [Taxpayers] use the Court's valuation to determine the [dollar] value of the transferred interests, but the donees' appraiser's valuation to determine the [percentages of] interests transferred to the charitable organizations. There is no factual, legal, or logical basis for this conclusion.35 We obviously agree with Judge Foley's unchallenged baselines that the gift was complete on January 12, 1996, and that the courts and the parties alike are governed by § 2512(a). We thus agree as well that the Majority reversibly erred when, "in determining the charitable deduction, the majority rely on the [C]onfirmation [A]greement without regard to the fact that [the Taxpayers] were not parties to this agreement, and that this agreement was executed by the donees more than 2 months after the transfer."36 In taking issue with the Majority on this point, Judge Foley cogently points out that "[t]he Majority appear to assert, without any authority, that [the Taxpayers'] charitable deduction cannot be determined unless the gifted interest is expressed in terms of a percentage or a fractional share."37 As implied, the Majority created a valuation methodology out of the whole cloth. We too are convinced that "[r]egardless of how the transferred interest was described, it had an ascertainable value" on the date of A-38 the gift.38 That value cannot, of course, be varied by the subsequent acts of the donees in executing the Confirmation Agreement. Consequently, the values ascribed by the Majority, being derived from its use of its own imaginative but flawed methodology, may not be used in any way in the calculation of the Taxpayers' gift tax liability. The Fifth Circuit decision in McCord is helpful but not determinative with respect to defined value or charitable allocation clauses because the court did not confront head-on the Procter type public policy issue. Nonetheless, what the opinion clearly states is that at least one circuit court is sympathetic to taxpayer claims where the taxpayer makes a gift and leaves it up to others to determine the specific donees. Judge Holmes authored the majority opinion in the reviewed decision, Estate of Helen Christiansen v. Commissioner, 130 T. C. No. 1 (2008). Most of the opinion dealt with the disclaimer of assets into a charitable lead annuity trust, but of interest with respect to charitable allocation clauses is the Court s determination that a disclaimer of assets to a private foundation would be given effect for estate tax purposes even when estate values were adjusted upward on audit. Helen Christiansen died leaving everything to her only child, Christine Hamilton. Any amounts Christine Hamilton disclaimed would go 75% to a charitable lead annuity trust and 25% to a private foundation. Ms. Hamilton disclaimed a fraction of the estate the numerator of which was the fair market value of the estate, before payment of debts, expenses, and taxes, less $6,350,000, and the denominator of which was the fair market value of the estate, before payment of debts, expenses, and taxes. Fair market value was defined using the willing buyer, willing seller formula and referencing the value as finally determined for Federal estate tax purposes. The estate included some cash and real estate but also 99% interests in two limited partnerships. The estate tax return reported a total value of $6,512,223.20; in the litigation the parties agreed that the value of the estate was $9,578,895.93. The government argued that the disclaimer to the Foundation should generate an estate tax charitable deduction only for the amount originally set forth on the estate tax return, not the amount agreed to after audit. The Court disagreed. The government first argued that the increase amount passed as a result of a contingency - - the IRS audit increasing the value of the estate - - but the Court noted that merely because the estate and the IRS bickered about the value of the property being transferred doesn t mean the transfer itself was contingent in the sense of dependent for its occurrence on a future event. The government also argued public policy, Procter like, grounds for disallowing an increased charitable deduction. The Court rejected that contention holding: This case is not Procter. The contested phrase would not undo a transfer, but only reallocate the value of the property transferred among Hamilton, the Trust, and the Foundation. If the fair market value of the estate assets is increased for A-39 tax purposes, then property must actually be reallocated among the three beneficiaries. That would not make us opine on a moot issue, and wouldn t in any way upset the finality of our decision in this case. We do recognize that the incentive to the IRS to audit returns affected by such disclaimer language will marginally decrease if we allow the increased deduction for property passing to the Foundation. Lurking behind the Commissioner s argument is the intimation that this will increase the probability that people in Hamilton s situation will lowball the value of an estate to cheat charities. There s no doubt that this is possible. But IRS estate-tax audits are far from the only policing mechanism in place. Executors and administrators of estates are fiduciaries, and owe a duty to settle and distribute an estate according to the terms of the will or law of intestacy. See, e.g., S.D. Codified Laws sec. 29A-3703(a) (2004). Directors of foundations--remember that Hamilton is one of the directors of the Foundation that her mother created--are also fiduciaries. See S.D. Codified Laws sec. 55-9-8 (2004). In South Dakota, as in most states, the state attorney general has authority to enforce these fiduciary duties using the common law doctrine of parens patriae. Her fellow directors or beneficiaries of the Foundation or Trust can presumably enforce their observance through tort law as well. And even the Commissioner himself has the power to go after fiduciaries who misappropriate charitable assets. The IRS, as the agency charged with ruling on requests for charitable exemptions, can discipline abuse by threatening to rescind an exemption. The famed case of Hawaii s Bishop Estate shows how effectively the IRS can use the threat of the loss of exempt status to curb breaches of fiduciary duty. See Brody, A Taxing Time for the Bishop Estate: What Is the I.R.S. Role in Charity Governance? , 21 U. Haw. L. Rev. 537 (1999). The IRS also has the power to impose intermediate sanctions for breach of fiduciary duty or self-dealing. See sec. 4958. The disclaimer issue generated various concurrences and dissents, however the disclaimer to the private foundation holding of the majority obtained unanimous approval by the Tax Court. This is a favorable development for taxpayers. g. the following: Upon receipt of assets by gift during the initial taxable year of this trust, Trustee will allocate the first $_________ to the trust administered by Article __ for the benefit of my descendants and will allocate any additional assets to WORTHY CHARITY, INC., to be added to the Mr. and Mrs. Donor fund created thereunder (or, if such organization is not in existence or is not described in sections 170(b)(1)(A), 170(c), 2055(a), and 2522(a) of the Internal Revenue Code, at such time to another organization which is so described selected by Trustee within 60 days of such allocation). The allocation will be made as a fractional share of all assets added to the Trust by gift and Trustee may make a preliminary allocation with subsequent adjustment if desirable. In calculating the amount to be allocated hereunder, Trustee will determine fair market value in An Effective Clause? Consider a transfer made in trust pursuant to a clause similar to A-40 such manner as it would be determined for Federal gift tax purposes whether or not such tax applies. The clause ties the value to Federal transfer tax, unlike in McCord but like Christiansen. Another factor like Christiansen but unlike McCord would be for the charity to retain the interest through audit. h. Limitations of the Clause. As described, the charitable allocation clause is useful when making gifts. Different issues arise in an estate tax context. For example, if assets in a limited partnership are included in a decedent s estate by reason of section 2036, providing that a certain value of partnership units pass to individuals with any excess to charity will not produce the desired result. In addition, it may be that the value of interests are different for state law purposes (which is how the charitable interests would be valued) and for Federal estate tax purposes. An example is provided by Holman discussed elsewhere in these materials. 5. Assignment of Income Issues ( Palmer Problems ). In PLR 200230004 husband and wife proposed to transfer 495 of 500 shares of a C corporation to a charitable remainder unitrust and asked whether the redemption would be treated as an assignment of income. The ruling states: This request involves Palmer v. Commissioner, 62 T.C. 684 (1974), affd. on other grounds, 523 F.2d 1308 (8th Cir. 1975), acq., 1978-1 C.B. 2. In the Palmer case, the Tax Court held that a taxpayer s gift of stock in a closely held corporation to a private foundation, followed by a redemption, was not to be recharacterized as a sale or redemption between the taxpayer and the corporation followed by a gift of the redemption proceeds to the foundation, even though the taxpayer held voting control over both the corporation and the foundation. The Tax Court based its opinion, in part, on the fact that the foundation was not legally obligated to redeem the stock at the time it received title to the shares. In Rev. Rul. 78-197, 1978-1 C.B. 83, the Internal Revenue Service announced that it will treat the proceeds of a redemption of stock under facts similar to those in the Palmer case as income to the donor only if the donee is legally bound or can be compelled by the corporation to surrender the shares for redemption. In the present case, at the time X shares are transferred to Trust, X will be under no legal obligation to redeem the contributed stock. There is no agreement among the parties under which X would be obligated to redeem, or Trust would be obligated to surrender for redemption, the stock. Trust is not legally obligated to accept any offer of redemption made by X. Accordingly, any redemption by X of the stock contributed by Grantors to Trust will be respected. Based on the representations submitted and information described above, we conclude that a purchase by X of the stock transferred by Grantors to Trust will be treated as a redemption of the stock from Trust, and will not be treated as a redemption of stock from Grantors or a distribution by X to Grantors. Therefore, the sale or redemption by Trust of its X stock will not result in the capital gain in such sale or the redemption price being attributed for tax purposes to Grantors. A-41 Among the representations made whether required or given voluntarily was: In addition, A, as president and sole shareholder of X and grantor and co-trustee of Trust, represents the following: (1) I, A, grantor and co-trustee of Trust, hereby represent that neither I nor any family member of me will acquire, offer to acquire, or become obligated to acquire shares of X stock from Trust earlier than at least one year after the date of any transfer of shares of X stock to Trust. (2) I, A, President and sole shareholder of X, hereby represent that X will not redeem, offer to redeem, or become obligated to redeem shares of X stock from Trust earlier than at least one year after the date of any transfer of shares of X stock to Trust, directly or indirectly, by the grantor of Trust or a family member of the grantor. (3) I, A, President and sole shareholder of X, and grantor and co-trustee of Trust, hereby represent that neither X nor I am aware of any plan or intention of Trust to transfer any corporate stock, or to have any person acquire any corporate stock from Trust. The application of Revenue Ruling 78-197 arose in Gerald A. Rauenhorst, et ux. v. Commissioner, 119 T.C. No. 9 (2002). Arbeit (a partnership) owned warrants enabling it to purchase NMG stock. On September 28, 1993, WCP (a corporation) offered to purchase all NMG stock. On November 9, 1993 the partnership assigned come warrants to four charities. On November 19 sold its remaining warrant to WCP, and the charities sold their warrants to WCP. On November 22, 1993, WCP and NMG agreed on a sale of all the NMG stock. The government argued that the bright-line rule of Rev. Rul. 78-197 was not controlling. The Opinion states: Respondent argues that petitioners are not entitled to judgment as a matter of law and that genuine issues of material fact remain for trial. Respondent argues that the question whether the donees were bound or could be legally compelled to surrender their NMG warrants is not the critical issue to be resolved and, accordingly, neither Carrington v. Commissioner, supra, nor Rev. Rul. 78-197, supra, controls this case. It is respondent s position that the critical issue in this case is a factual one : whether petitioners rights to receive the proceeds of the stock transaction involving WCP ripened to a practical certainty at the time of the assignments. Respondent relies on Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), Jones v. United States, supra, Kinsey v. Commissioner, 477 F.2d 1058 (2d Cir. 1973), affg. 58 T.C. 259 (1972), Hudspeth v. United States, 471 F.2d 275 (8th Cir. 1972), and Estate of Applestein v. Commissioner, supra. Respondent purports to distinguish both Carrington and Rev. Rul. 78-197, supra, on the facts of the case and the ruling. To that end, he contends that Carrington and Rev. Rul. 78-197, supra, are not inconsistent with the cases he relies upon A-42 above. Respondent claims that in this case, and the cases upon which he relies, there was a pending global transaction for the purchase and sale of all the stock of a corporation at the time of the gift or transfer at issue. He then surmises that because Carrington and Rev. Rul. 78-197, supra, did not involve a pending global transaction, the legal principles of those authorities do not apply. Instead, he argues that we must apply the principles of the cases he relies upon, and, accordingly, we must conduct a detailed factual inquiry for purposes of determining whether the sale of the stock warrants had ripened to a practical certainty at the time of the assignments. We cannot agree that respondent has effectively distinguished Carrington and Rev. Rul. 78-197, supra, on their facts. First, neither this Court nor the Courts of Appeals have adopted respondent s theory of a pending global transaction as a means of distinguishing cases such as Carrington and Palmer v. Commissioner, 62 T.C. 684 (1974). Indeed, the case law in this area applies essentially the same anticipatory assignment of income principles to cases of a global nature as those applicable to cases of a nonglobal nature. See, e.g., Greene v. United States, supra at 581. We can only interpret respondent s use of the phrase pending global transaction as simply a restatement of the principles contained in the cases upon which he relies. Thus, we cannot agree that respondent s reliance on a pending global transaction distinguishes either Carrington, Rev. Rul. 78-197, supra, or other cases upon which petitioners rely. With that being said and leaving Carrington and those other cases aside at this point, the bright-line test of Rev. Rul. 78-197, supra, which focuses solely on the donee s control over the contributed property, stands in stark contrast to the legal test and the cases upon which respondent relies and which consider the donee s control to be only a factor. The Court took a dim view of the government s urging that Rev. Rul. 78-197 be ignored: While this Court may not be bound by the Commissioner s revenue rulings, and in the appropriate case we could disregard a ruling or rulings as inconsistent with our interpretation of the law, see Stark v. Commissioner, 86 T.C. 243, 251 (1986), in this case it is respondent who argues against the principles stated in his ruling and in favor of our previous pronouncements on this issue. The Commissioner s revenue ruling has been in existence for nearly 25 years, and it has not been revoked or modified. No doubt taxpayers have referred to that ruling in planning their charitable contributions, and, indeed, petitioners submit that they relied upon that ruling in planning the charitable contributions at issue. Under the circumstances of this case, we treat the Commissioner s position in Rev. Rul. 78-197, 1978-1 C.B. 83, as a concession. Accordingly, our decision is limited to the question whether the charitable donees were legally obligated or could be compelled to sell the stock warrants at the time of the assignments. On the facts, the court found in favor of the taxpayer: Petitioners argue that as of November 12, 1993, the date the warrants were transferred on the books of NMG, the donees had not entered into any agreement to sell the warrants and could not be compelled by any legal means to transfer the warrants. Accordingly, they contend that, as a matter of law, there was not an A-43 assignment of income. Petitioners submitted affidavits from representatives of the donees in support of their motion for partial summary judgment. Each of those affidavits outlines the events which preceded the assignments, each states that the stock warrants were received on November 12, 1993, and each also states that, as of that date, the donees had not entered into agreements to sell the stock warrants. Respondent questioned the reliability of those affidavits, and he contended that the affidavits were deficient in that they failed to state the personal involvement of the representatives with respect to petitioners contributions. He also asserted that the testimony of those affiants is unknown , and he questioned whether they were involved in any negotiations or discussions with NMG, WCP, or Arbeit regarding WCP s proposed acquisition of NMG stock and warrants. Respondent also questioned the affiants competency to opine upon, or reach any conclusion as to, what constitutes a binding agreement or whether their respective organizations had indeed entered binding agreements in connection with the transactions at issue. We do not share respondent s reservations with respect to the affidavits, and we find those affidavits credible. First, in response to respondent s allegations, petitioners submitted additional affidavits from each of the affiants. Each of those affidavits states: (1) The affiants were personally involved with respect to petitioners contributions; (2) before the donees execution of the warrant purchase and sale agreement, there were no agreements amongst the donees, Arbeit, Mr. Rauenhorst, or any other person or entity regarding the sale of the warrants; and (3) through November 12, 1993, there were no negotiations or communications between the donees and NMG or parties representing NMG, except for the letters from NMG s legal counsel requesting that the donees sign an Additional Party Signature Page. Second, respondent relies on nonspecific allegations of an informal agreement or understanding between the donees and NMG, WCP, Mr. Rauenhorst, and/or Arbeit. Summary assertions and conclusory allegations are simply not enough evidence to raise a genuine issue of material fact. [citations omitted] Respondent alleges no facts or evidence to substantiate his position, and he has submitted no affidavits in response to the affidavits that petitioners submitted. Instead, he points out that the record lacks information regarding any discussions, deliberations, or negotiations which may have taken place between the donees and the other parties. Respondent has had ample opportunity to investigate the facts surrounding these transactions, and it is clear that respondent could have requested additional information from the individuals involved. See Rule 121(e). He has requested neither additional discovery nor a continuance for purposes of additional discovery. He has not demonstrated to our satisfaction that the only available method for opposing the statements in the affidavits is through cross- examination at trial. Further, it is insufficient for the opposing party to argue in the abstract that the legal theory involved in the case encompasses factual questions. Hibernia Natl. Bank v. Carner, 997 F.2d 94, 98 (5th Cir. 1993); Daniels v. Commissioner, supra. Since petitioners have offered affidavits directly supporting their position on a material issue of fact, and since respondent has failed to counter those affidavits with anything other than unsupported allegations, respondent cannot avoid summary judgment on this A-44 issue. See Greene v. United States, 806 F. Supp. 1165, 1171 (S.D.N.Y. 1992), affd. 13 F.3d 577 (2d Cir. 1994). Thus, we find that there is no genuine issue of material fact regarding whether the donees entered into a legally binding agreement to sell their stock warrants before, or at the time of, the assignments by petitioners. Footnote 14 states: The record indicates that no agreement was entered into by the donees before Nov. 19, 1993, the date they signed the warrant purchase and sale agreement. On Nov. 16, 1993, NMG s legal counsel sent letters to each of the donees enclosing a warrant purchase and sale agreement. Those letters state that pursuant to the warrant purchase and sale agreement, the donees would agree to sell their reissued warrants to WCP and to abstain from either exercising its Warrant or selling or otherwise transferring it to any other party through Dec. 31, 1993. Certainly, the formality of having the donees enter into the warrant purchase and sale agreements suggests that they had not entered into any binding agreements before Nov. 19, 1993. Subsequent to the decision, the government has reiterated its intention, generally, to follow its own rulings in litigation. In PLR 200321010 a retired officer of a corporation intended to give shares of the corporation to a CRUT. The corporation had the right to purchase the stock if it so desired, and the agreement also bound the trust: X proposes to establish a CRUT (as defined in § 664 of the Internal Revenue Code). Upon establishment of the CRUT, X will notify Company of X s intent to transfer a portion of X s Company stock purchased under the Plan to the CRUT, thereby triggering Company s option to purchase the stock for the formula price set forth in the stock restriction agreements applicable to such stock. Taxpayer represents that Company will likely decline to purchase the stock for the formula price set forth in the stock restriction agreements and thus X will be free to transfer the stock to the CRUT. The stock transferred to the CRUT will continue to be subject to the terms of the stock restriction agreements under the Plan in accordance with the terms of the stock restriction agreements. Therefore, if the trustee of the CRUT wishes to sell or otherwise dispose of the stock, Company will have a right to purchase the stock for the formula price set forth in the stock restriction agreements. The trustee will notify Company that the CRUT wishes to sell Company stock prior to any proposed sale or disposition. X represents that Company has always exercised its option under the stock restriction agreements in the past for the formula price set forth therein. The ruling described the bright-line test of Palmer, citing Rauenhorst: The Service has acquiesced in the Palmer decision. See 1978-1 C.B. 2. In Rev. Rul. 78-197, 1978-1 C.B. 83, the Service concluded that it will treat the proceeds of a redemption of stock under facts similar to those in Palmer as A-45 income to the donor only if the donee is legally bound or can be compelled by the corporation to surrender the shares for redemption. The Tax Court has characterized the legally bound standard in Rev. Rul. 78-197 as a bright line test for determining if a contribution of stock to a charity followed by a redemption of that stock from that charity should be respected in form or recharacterized as a redemption of the stock from the donor followed by a contribution of the proceeds by the donor to the charity. See generally, Rauenhorst v. Commissioner, 119 T.C. No. 9 (October 7, 2002). Thus, the ruling concludes: Consequently, the test for purposes of this ruling request, is whether the CRUT will be legally bound or can be compelled by Company to surrender the stock for redemption at the time of the donation. Here, X proposes to transfer the Company stock to the CRUT. Under the restrictions contained in each year s stock restriction agreement, the CRUT must first offer the stock to Company at a set formula price should the CRUT propose to dispose of the shares. This provision amounts to a right of first refusal. However, it does not mean that the CRUT is legally bound or can be compelled by Company to surrender the stock to Company at the time of the donation. The information submitted contains no indication that the CRUT will be legally bound, or could be compelled by Company, to redeem or sell the gifted stock. That all or a portion of the gifted stock was subject to restrictions upon transfer to a third party by X, and thus by the CRUT following the transfer, does not give Company the ability to compel its redemption or sale from the CRUT. The CRUT is free to retain title to and ownership of the stock indefinitely. Because the CRUT is not legally bound and cannot be compelled by Company to redeem or sell the stock, we conclude that the transfer of the Company stock by X to the CRUT, followed by any subsequent redemption of the stock by Company, will not be recharacterized for federal income tax purposes as a redemption of the stock by Company from X followed by a contribution of the redemption proceeds to the CRUT. See Palmer v. Commissioner, supra, and Rev. Rul. 78-197, supra. The same principles apply if the stock is sold by the CRUT rather than redeemed by Company. Thus, provided there is no prearranged sale contract whereby the CRUT is legally bound to sell the stock upon the contribution, we conclude that any subsequent sale will not be recharacterized for federal income tax purposes as a sale of the stock by X, followed by a contribution of the sale proceeds to the CRUT. Accordingly, any redemption proceeds or sales proceeds received by the CRUT for the stock will not be treated as taxable income received by X. In Ian G. Koblick v. Commissioner, T. C. Memo 2006-63, 45% of a corporation was given by taxpayer to a charity, at the same time as other owners gave the remaining 55% of the corporation to the charity. The corporation owned undersea diving equipment. The corporation s bylaws restricted sales without the corporation s consent and also gave it a right of first refusal. The corporation was not formed, apparently, for purposes of donating equipment to charity. The taxpayer argued, and the court largely accepted, that the transfer to charity was part of a prearranged A-46 plan in which the taxpayer and other donors walked in lockstep. interest discount to the stock gift. Thus the court applied only a 10% minority In PLR 200821024 the donor owned shares of voting common stock individually and through a grantor trust as did other members of the donor s family. The donor intended to contribute the shares to a donor advised fund that had as an investment policy to diversify and thus will intend to sell the shares. The donor s attorney and various family members would serve as advisors to the fund. The donor was trustee of a trust for the benefit of the donor s spouse and descendants that was a potential buyer for the stock if the donor advised fund offered it for sale. The ruling recites: You represent that your contributions of g shares of X voting common stock to Y under the terms of the Fund are not subject to any condition or legally binding obligation requiring Y [the fund] to sell the shares, or offer them for sale. The contributed shares will not be subject to any option or right by any person to acquire them from Y. Y has the sole discretion regarding whether or when to sell the contributed shares and to whom those shares may be sold. Further, you will not retain any rights or interest in the contributed shares. At issue was whether the gift would be construed as an assignment of income. The IRS determined that it would not be, stating: Under the anticipatory assignment of income doctrine, a mere transfer which is in form a gift of appreciated property may be disregarded for tax purposes if its substance is an assignment of a right to income. Rauenhorst v. Commissioner, 119 T.C. 157, 164 (2002). By contrast, the mere anticipation or expectation of the receipt of income is insufficient to conclude that a fixed right to income exists. S.C. Johnson & Son, Inc. v. Commissioner, 63 T.C. 778, 787-788 (1975). In Palmer v. Commissioner, 62 T.C. 684 (1974), aff'd on other grounds, 523 F.2d 1308 (8th Cir. 1975), acq., 1978-1 C.B. 2, the Tax Court held that a taxpayer's gift of stock in a closely held corporation to a private foundation, followed by a redemption, was not to be recharacterized as a sale or redemption between the taxpayer and the corporation followed by a gift of the redemption proceeds to the foundation, even though the taxpayer held voting control over both the corporation and the foundation. The Tax Court based its opinion, in part, on the fact that the foundation was not legally obligated to redeem the stock at the time it received title to the shares. In Rev. Rul. 78-197, 1978-1 C.B. 83, the Internal Revenue Service announced that it will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound or can be compelled by the corporation to surrender the shares for redemption. You retain no rights or interest in the g shares that you have contributed and will contribute to the Fund. At the time you contribute the shares to Y under the A-47 terms of the Fund, Y will not be under any legal obligation to sell the shares. Y has the sole discretion to decide whether or when to sell the contributed shares, and cannot be compelled by you or any other individuals to sell them. 6. Charitable Distribution by Trusts and Estates. The IRS has published proposed regulations dealing with the treatment of amounts paid to the charitable beneficiary of a trust or estate under sections 642 and 643. REG-101258-08 (Jun. 18, 2008). The introduction to the proposed regulations states: The regulations under § 1.642(c)-3 provide guidance concerning adjustments and other special rules for computing the charitable contributions deduction. The regulations under § 1.643(a)-5 provide guidance concerning rules for computing the amount of tax-exempt income included in distributable net income. These proposed regulations clarify the existing regulations under §§ 1.642(c)-3(b) and 1.643(a)-5(b). Section 1.642(c)-3(b)(2) provides that, in determining whether an amount of income paid to a charitable beneficiary includes particular items of income not included in gross income (for example, tax exempt income), provisions in the governing instrument will control if they specifically provide as to the source out of which amounts are to be paid to the charitable beneficiary. In the absence of specific provisions in the governing instrument or in local law, the amount of income distributed to each charitable beneficiary is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes. Section 1.643(a)-5(b) provides rules for reducing the amount of tax-exempt interest includable in distributable net income when tax-exempt interest is deemed to be included in income paid, permanently set aside, or to be used for the purposes specified in section 642(c). As similarly provided in § 1.642(c)3(b), § 1.643(a)-5(b) provides "[i]f the governing instrument specifically provides as to the source out of which amounts are paid, permanently set aside, or to be used for such charitable purposes, the specific provisions control. In the absence of specific provisions in the governing instrument, an amount to which section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes." The IRS and the Treasury Department believe that the current regulations under §§ 1.642(c)-3(b) and 1.643(a)-5(b) require that such a specific provision in a governing instrument or in local law that identifies the source(s) of the amounts to be paid, permanently set aside or used for a purpose specified in section 642(c) must have economic effect independent of income tax consequences in order for the specific provision in the governing instrument or in local law to be respected for Federal tax purposes. This belief is based on the structure and provisions of Subchapter J as a whole, as well as on an analysis of the existing regulations with their interrelated cross-references. Section 1.642(c)-3(b) and § 1.643(a)-5(b) refer to examples in §§ 1.662(b)-2 and 1.662(c)-4 to illustrate the rules of §§ 1.642(c)-3(b) and 1.643(a)-5(b). Section 1.662(b)-2 provides that, in determining the character of amounts distributed to a beneficiary when a charitable contribution is made, "...the principles contained in §§ 1.652(b)-1 and 1.662(b)-1 generally apply." Section 1.652(b)-1 provides that "[i]n determining A-48 the gross income of a beneficiary, the amounts includible under § 1.652(a)-1 have the same character in the hands of the beneficiary as in the hands of the trust." Section 1.652(b)-2(a) elaborates on the general principle in § 1.652(b)-1 by providing that the amount distributed to a beneficiary and includible in gross income under § 1.652(a)-1 generally consists of the same proportion of each class of items included in the trust's distributable net income (DNI) as the total of each such class bears to the total DNI. These principles are repeated in § 1.662(b)-1. In addition, § 1.652(b)-2(b) defines the exception to this rule by providing that "[t]he terms of the trust are considered specifically to allocate different classes of income to different beneficiaries only to the extent that the allocation is required in the trust instrument, and only to the extent that it has economic effect independent of the income tax consequences of the allocation." Section 1.681(a)-2(b)(2) provides guidance on the method of allocating gross income to unrelated business income that is not deductible under section 642(c). This regulation provides that "[u]nless the facts clearly indicate to the contrary..." the payment to charity consists of the same ratio of unrelated business income as the ratio of unrelated business income to all of the trust's taxable income. Examples given in this regulation confirm that a specific allocation of income items will be recognized when such specific allocation has economic effect independent of its tax consequences, such as when the amount of the charitable distribution will be dependent upon the amount of the class of income. Explanation of Provisions The IRS and the Treasury Department believe that the chain of references discussed above requires that a specific provision of the governing instrument or a provision under local law have economic effect independent of income tax consequences in order to be respected for Federal income tax purposes, and that this principle applies throughout Subchapter J. To make this concept clearer and easier to understand, the proposed regulations amend the regulations under section 642(c) to add the principle of economic effect directly into the language of the regulation itself, rather than being incorporated by reference to other regulation provisions. Thus, the proposed regulation will amend the regulations under section 642(c) to confirm that a provision in a governing instrument or in local law that specifically provides as to the source out of which amounts are to be paid, permanently set aside or used for a purpose specified in section 642(c) must have economic effect independent of income tax consequences in order to be respected for Federal tax purposes. If such provision does not have economic effect independent of income tax consequences, income distributed for a purpose specified in section 642(c) will consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes. See § 1.642(c)-3(b)(2). As an example, CLTs pay an annuity or unitrust amount to a charity for a determinable period, measured by a term of years or by reference to the life of one or more individuals. See section 170(f)(2)(B). At the end of the term, the remainder passes to one or more non-charitable beneficiaries. CLTs may earn various types of income (such as ordinary income, capital gains, unrelated business tax income and tax-exempt income) in any given taxable year. Some A-49 trust instruments attempt to source the payments to charity so as to maximize the tax benefits to the trust and beneficiaries. For example, the governing documents might include a provision directing that the charity's annuity or unitrust payment be made first out of ordinary income and capital gains in order to minimize the trust's tax liability. Thus, the trust attempts to retain the unrelated business taxable income and tax-exempt income (for which no section 642(c) deduction may be claimed or for which the deduction is limited by section 681). Such a provision in the governing instrument does not have economic effect independent of the income tax consequences, because the amount paid to the charitable beneficiary is not dependent upon the type of income it is allocated. Rather, such amount is the same regardless of the source of the income. An annuity payment is a fixed amount from year to year, and a unitrust amount is based upon a predetermined percentage of the trust's value. Thus, the amount of each type of income the trust earns is irrelevant to the amount the charity is entitled to receive. Accordingly, a provision under local law or in the governing instrument of a CLT that provides that the payment to charity (eligible for a deduction under section 642(c)) is deemed to consist of particular classes of income, determined on a non-pro rata basis, will not be respected because such a provision does not have economic effect independent of income tax consequences. Instead, such a payment to a charity will consist of the same proportion of each class of the items of income of the trust as the total of each class bears to the total of all classes. See § 1.642(c)-3(b)(2). This proposed amendment to the regulation serves only to confirm the economic effect requirement of the current regulations. 7. Unrelated Business Income in Charitable Remainder Trust. The IRS has published proposed regulations providing guidance under section 664, as amended by the Tax Relief and Health Care Act of 2006, on the tax effect of unrelated business taxable income on charitable remainder trusts. REG-127391-07 (Mar. 7, 2008). The Explanation of Provisions states: The proposed regulations amend the regulations under section 664(c) to provide that charitable remainder trusts with UBTI in taxable years beginning after December 31, 2006, are exempt from Federal income tax, but are subject to a 100-percent excise tax on the UBTI of the charitable remainder trust. The proposed regulations provide that the excise tax is reported and payable in accordance with the appropriate forms and instructions. Currently, the appropriate form to report and pay the excise tax on charitable remainder trusts with UBTI is Form 4720, "Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code." The rules that apply with respect to charitable remainder trusts that have UBTI in taxable years beginning before January 1, 2007, are contained in § 1.664-1(c) as in effect for taxable years beginning before January 1, 2007. (See 26 CFR part 1 § 1.664-1(c) revised as of April 2, 2007). The proposed regulations clarify that, consistent with § 1.664-1(d)(2), the excise tax imposed upon a charitable remainder trust with UBTI is treated as paid from corpus and the trust income that is UBTI is income of the trust for purposes of A-50 determining the character of the distribution made to the beneficiary. The proposed regulations provide examples illustrating the tax effects of UBTI on a charitable remainder trust for taxable years beginning after December 31, 2006. Those examples are as follows: Example 1. For 2007, a charitable remainder annuity trust with a taxable year beginning on January 1, 2007, has $60,000 of ordinary income, including $10,000 of gross income from a partnership that constitutes unrelated business taxable income to the trust. The trust has no deductions that are directly connected with that income. For that same year, the trust has administration expenses (deductible in computing taxable income) of $16,000, resulting in net ordinary income of $44,000. The amount of unrelated business taxable income is computed by taking gross income from an unrelated trade or business and deducting expenses directly connected with carrying on the trade or business, both computed with modifications under section 512(b). Section 512(b)(12) provides a specific deduction of $1,000 in computing the amount of unrelated business taxable income. Under the facts presented in this example, there are no other modifications under section 512(b). The trust, therefore, has unrelated business taxable income of $9,000 ($10,000 minus the $1,000 deduction under section 512(b)(12)). Undistributed ordinary income from prior years is $12,000 and undistributed capital gains from prior years are $50,000. Under the terms of the trust agreement, the trust is required to pay an annuity of $100,000 for year 2007 to the noncharitable beneficiary. Because the trust has unrelated business taxable income of $9,000, the excise tax imposed under section 664(c) is equal to the amount of such unrelated business taxable income, $9,000. The character of the $100,000 distribution to the noncharitable beneficiary is as follows: $56,000 of ordinary income ($44,000 from current year plus $12,000 from prior years), and $44,000 of capital gains. The $9,000 excise tax is allocated to corpus, and does not reduce the amount in any of the categories of income under paragraph (d)(1) of this section. At the beginning of year 2008, the amount of undistributed capital gains is $6,000, and there is no undistributed ordinary income. Example 2. During 2007, a charitable remainder annuity trust with a taxable year beginning on January 1, 2007, sells real estate generating gain of $40,000. Because the trust had obtained a loan to finance part of the purchase price of the asset, some of the income from the sale is treated as debt-financed income under section 514 and thus constitutes unrelated business taxable income under section 512. The unrelated debt-financed income computed under section 514 is $30,000. Assuming the trust receives no other income in 2007, the trust will have unrelated business taxable income under section 512 of $29,000 ($30,000 minus the $1,000 deduction under section 512(b)(12)). Except for section 512(b)(12), no other exceptions or modifications under sections 512-514 apply when calculating unrelated business taxable income based on the facts presented in this example. Because the trust has unrelated business taxable income of $29,000, the excise tax imposed under section 664(c) is equal to the amount of such unrelated business taxable income, $29,000. The $29,000 excise tax is allocated to corpus, and does not reduce the amount in any of the categories of income under paragraph (d)(1) of this section. Regardless of how the trust's income A-51 might be treated under sections 511-514, the entire $40,000 is capital gain for purposes of section 664 and is allocated accordingly to and within the second of the categories of income under paragraph (d)(1) of this section. C. SECTION 408 1. IRAs AND RETIREMENT PLANS. Inherited IRAs. PLR 200750019 considered the following facts: Individual A, whose date of birth was * * *, 1929, died on December 18, 2005 at age 76. Individual A's spouse predeceased her on December 26, * * *. Individual A was survived by three daughters, including Individual B, all of whom were alive as of the date of this ruling request. On April 3, * * *, Individual A established Trust A, which has not been amended, revoked or otherwise changed since that date. Section First, paragraph B of Trust A provides that the Trust was revocable by Individual A; thus, at the death of Individual A, Trust A became irrevocable. Individual A's three daughters are the trustees of Trust A. Trust A is valid under the laws of State C, wherein Individual A resided on the date of her death. It has been represented that Section of Statutes X exempts an individual retirement arrangement (IRA) from any and all claims against a decedent. As of December 18, 2005, Individual A was the owner of two IRAs, one maintained with Company M and the other maintained with Company N. By means of a beneficiary designation dated January 29, * * *, Trust A was named the beneficiary of Individual A's IRA maintained with Company M. By means of a beneficiary designation dated May 29, * * *, Trust A was named the beneficiary of Individual A's IRA maintained with Company N. Company M, the custodian of one IRA, has been provided with information concerning the terms of Trust A and the identities of the beneficiaries thereof. Company N, the custodian of the other IRA, has also been provided with information concerning the terms of Trust A and the identities of the beneficiaries thereof. Both Company M and Company N were provided with this information prior to October 31, 2006. Section Third, paragraphs A through C, of Trust A provides that at the death of Individual A, the balance of the Trust A assets, including the IRAs, was to be held in trust for the beneficiaries, Individual A's three daughters. Pursuant to the terms of Trust A, Individual B would receive 40 percent of the assets, another daughter would receive 40 percent of the assets, and the third daughter would receive 20 percent of the assets. The language of Trust A contains no conditions limiting the payment of the IRA assets held in Trust A to the three daughters. The co-trustees of Trust A propose to divide the Company M and Company N IRAs, by means of trustee-to-trustee transfers, into six distinct IRAs, each for the separate benefit of the named daughter. Each transferee IRA will be maintained A-52 in the name of Individual A (deceased). For example, one transferee Company M IRA and one transferee Company N IRA will be maintained in the name of Individual A (deceased) for the benefit of Individual B, beneficiary thereof, as a result of being named such under Trust A. Distributions from each of these transferee IRAs will be made over the life expectancy of the eldest of the three beneficiary-daughters of the IRAs. Your authorized representative has asserted that the funds in both IRAs have not been distributed except for required minimum distributions intended to meet the requirements of section 401(a)(9) of the Code. In 2006, subsequent to the death of Individual A, the required minimum distributions were paid to Trust A. The ruling determines: The issue raised in this ruling request is whether a beneficiary-daughter of an IRA holder may, after the death of the IRA holder, transfer her 40 percent interest in the deceased's IRAs to IRAs set up to solely benefit her, and whether she may receive distributions from her beneficiary IRAs without regard to the distribution decisions made by the other IRA beneficiaries. Although neither the Code nor the regulations promulgated under section 401(a)(9) of the Code preclude the posthumous division of the Company M IRA into more than one IRA or the Company N IRA into more than one IRA, the regulations do preclude separate account treatment for Code section 401(a)(9) purposes where amounts pass through a trust. Additionally, a trustee-to-trustee transfer, as described in Revenue Ruling 78406, does not constitute a distribution or payment as those terms are defined for purposes of section 408(d) of the Code. Thus, such a transfer may be accomplished by the beneficiary of an IRA of a deceased individual. Furthermore, a trustee-to-trustee transfer from one IRA to another may be accomplished after the date of death of an IRA owner by a beneficiary of said IRA owner as long as the transferee IRA account remains in the name of the decedent for the benefit of the beneficiary. In this case, Trust A was the named beneficiary of Individual A's IRAs maintained with Companies M and N. Trust A was established by Individual A, was valid under the laws of State C, and became irrevocable at the death of Individual A. In addition, relevant documentation relating to Trust A's status as beneficiary of Individual A's interest in the IRAs maintained by Companies M and N was given to the IRA administrators by the date required under the regulations. Furthermore, the Service notes that the identity of each person entitled to receive any portion of Individual A's interest in the IRAs upon her death is determinable by perusing the provisions of Trust A. The beneficiaries of Trust A were Individual B and her two sisters, who were all daughters of Individual A. Individual B intends to accomplish trustee-to-trustee transfers of her interest in Individual A's IRAs. Such transfers will be into IRAs established and maintained in the name of Individual A to benefit Individual B. A-53 The regulations cited above provide that only individuals may qualify as designated beneficiaries for purposes of section 401(a)(9) of the Code; thus, trusts were ineligible to qualify as such. Of the Trust A beneficiaries, one of the daughters other than Individual B has the shortest life expectancy. As noted above, the separate account rules of section 1.401(a)(9)-8, Q & A-2(a) of the regulations do not apply to amounts passing through a trust. Thus, the required minimum distributions from any IRAs created by trustee-to-trustee transfers from Trust A on behalf of Individual B, irrespective of her age, must be based on the life expectancy of the eldest beneficiary-daughter. In this case, the Table to be used to determine required minimum distributions is found at section 1.401(a)(9)-9, Q & A-1 of the regulations. Furthermore, the applicable distribution period must be computed in accordance with section 1.401(a)(9)-5, Q & A-5(c)(1) of the regulations. Therefore, with respect to your ruling requests, we conclude as follows: 1. The beneficiary IRAs created by means of trustee-to-trustee transfers, which will be titled "Individual A (deceased) fbo Individual B", constitute inherited IRAs as that term is defined in section 408(d)(3)(C) of the Code. 2. The creation of the above-referenced IRAs for the benefit of Individual B, by means of trustee-to-trustee transfers as provided in Revenue Ruling 78-406, shall not constitute taxable distributions or payments, as those terms are defined for purposes of section 408(d)(1) of the Code, to Individual B, nor will they be considered attempted rollovers of the IRAs to Individual B. 3. The IRA created by a trustee-to-trustee transfer of a portion of the IRA maintained by Individual A at her death with Company M to an IRA set up in the name of Individual A to benefit Individual B, may be maintained separately from the IRA created by a trustee-to-trustee transfer of a portion of the IRA maintained by Individual A at her death with Company N to an IRA set up in the name of Individual A to benefit Individual B, for purposes of determining the required minimum distributions under section 401(a)(9) of the Code. 4. The minimum distribution requirements under section 401(a)(9) of the Code concerning the IRAs created by trustee-to-trustee transfers on behalf of Individual B may be met by distributing amounts annually from each distinct IRA created for the benefit of Individual B, calculating the remaining life expectancy using the age of the eldest daughter-beneficiary and the Single Life Expectancy Table provided at section 1.401(a)(9)-9, Q & A-1 of the regulations, beginning with the calendar year 2007, reduced by one for each subsequent calendar year in accordance with section 1.401(a)(9)-5, Q & A-5(c)(1) of the regulations. A-54 D. E. SECTIONS 671-678 -- GRANTOR TRUST RULES SECTION 1361 1. S CORPORATIONS. Net Operating Losses. In ILM 200734019 the IRS determined that where a net operating loss was carried forward from an estate to an Electing Small Business Trust it could be used to offset only non-S income. The ILM states:Section 642(h)(1) provides that a NOL carryover under § 172 or a capital loss carryover under § 1212 shall be allowed as a deduction, in accordance with regulations prescribed by the Secretary to the beneficiaries succeeding to the property of the estate or trust. Section 1.642(h)-3(a) of the Income Tax Regulations provides that the phrase "beneficiaries succeeding to the property of the estate or trust" means those beneficiaries upon termination of the estate or trust who bear the burden of any loss for which a carryover is allowed, or of any excess of deductions over gross income for which a deduction is allowed, under § 642(h). Section 1.642(h)-3(c) provides that in the case of a testate estate, the phrase normally means the residuary beneficiaries (including a residuary trust), and not specific legatees or devisees, pecuniary legatees, or other nonresiduary beneficiaries. Section 1361(a)(1) defines an "S corporation" as a small business corporation for which an election under § 1362(a) is in effect for the taxable year. Section 1361(b)(1)(B) provides that the term small business corporation is a domestic corporation which is not an ineligible corporation and which does not have as a shareholder a person (other than an estate and other than a trust described in § 1361(c)(2) or an organization described in § 1361(c)(6)) who is not an individual. Section 1361(c)(2)(A)(i) provides that a trust all of which is treated (under subpart E of part 1 of subchapter J of chapter 1) as owned by an individual who is a resident of the United States is an eligible shareholder. Section 1361(c)(2)(A)(iii) provides that for purposes of § 1361(b)(1)(B), a trust with respect to stock transferred to it pursuant to the terms of a will may be a shareholder, but only for the 2-year period beginning on the day on which such stock is transferred to it. Section 1361(c)(2)(A)(v) provides that an ESBT is an eligible shareholder. Section 1361(e) defines an ESBT. Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), an ESBT means any trust if (i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in § 170(c)(2), (3), (4), or (5), or (IV) an organization described in § 170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary, (ii) no interest in such trust was acquired by purchase, and (iii) an election under § 1361(e) applies to such trust. Section 1361(e)(3) provides that an election under § 1361(e) shall be made by the trustee. Any such election shall apply to the taxable year of the trust for A-55 which made and all subsequent taxable years of such trust unless revoked with the consent of the Secretary. Section 1.641(c)-1(a) provides that an ESBT is treated as two separate trusts for purposes of determining income tax. The portion of an ESBT that consists of stock in one or more S corporations ("the S portion") is treated as one trust. The portion of an ESBT that consists of all the other assets in the trust is treated as a separate trust ("the non-S portion"). Section 641(c)(2)(C) provides that the taxable income of the S portion is determined by taking into account only items of income, loss, deduction, or credit that are (i) the items required to be taken into account under § 1366, (ii) any gain or loss from the disposition of stock in an S corporation, and (iii) to the extent provided in regulations, State or local income taxes or administrative expenses to the extent allocable to items described in § 641(c)(2)(C)(i) or § 641(c)(2)(C)(ii). No deduction or credit shall be allowed for any amount not described in § 641(c)(2)(C), and no item described in § 641(c)(2)(C) shall be apportioned to any beneficiary. We conclude that § 641(c)(2)(C) provides a complete list of the items of income, loss, deduction, or credit that the S portion of an ESBT may take into account. Section 642(c)(2)(C), flush language, provides that "no deduction or credit shall be allowed for any amount not described in this paragraph." The NOLs that Trust succeeded to under § 642(h)(1) are not described in § 641(c)(2)(C); therefore, the S portion of Trust is precluded from taking deductions attributable to those NOLs. However, the NOLs should be available as a deduction to the non-S portion Trust following Trust's ESBT election. CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS This memorandum responds to a private letter ruling request from Trust, requesting a ruling that the NOLs to which it succeeded from the terminating estate will be available to Trust following the ESBT election. After we informed the taxpayer's representative that this office would require, as part of the private letter ruling, that no portion of the NOLs shall be available as a deduction to the S portion of Trust, the taxpayer withdrew its ruling request. This memorandum is necessary to inform your office of our position on the transaction. The taxpayer does not agree that the NOLs should not be available to the S portion of Trust. The taxpayer argues that the NOL should be allocated to the S portion of Trust because the NOL is attributable to losses sustained by X, an S corporation whose stock is held within the S portion of the Trust. We disagree with this interpretation. We conclude that the plain language of § 641(c)(2)(C) excludes the NOL from being available to the S portion of Trust. 2. New Interest Deduction for Electing Small-Business Trusts. The Small Business and Work Opportunity Act of 2007 created new section 641 (c)(2)(C)(iv) which allows an ESBT to deduct interest expense paid or accrued on indebtedness incurred to acquire S corporation stock. A-56 F. SECTIONS 2031 and 2512 1. VALUATION Discounting Assets for Built-In Income Taxes. No discount was allowed in valuing retirement plans by the U.S. District Court in Estate of Louis R. Smith v. United States, 300 F. Supp. 2d 474 (S.D. Tex. 2004), aff d 391 F.3d 621 (5th Cir. 2004). A willing buyer would not have income tax and thus under the hypothetical willing buyer - willing seller test there should be no discount said the court. That the estate and its beneficiaries would have IRD is not relevant because they are particular parties, not the hypothetical parties required by the test. Further, the IRD deduction under section 691(c) remedies any fairness concerns of the estate. See also In re: Neiderhiser, Pa. Commw. Ct., No. 1625 C.D. 2003 (May 14, 2004). The Tax Court, in a reviewed decision, has reached the same result dealing with IRAs. Estate of Doris F. Kahn v. Commissioner, 125 T.C. #11 (2005). In Estate of Frazier Jelke III v. Commissioner, T. C. Memo 2005-131, the decedent s estate included 6.44% of a closely-held C corporation (CCC) the assets of which included $178,000,000 in marketable securities (out of a total value of $188,000,000) with $51,000,000 of built-in capital gains. The issue before the court was what discount should be allowed on account of eventual tax on the built-in gains. The court reviewed the state of the law: Since the repeal of the General Utilities doctrine, this Court has, on several occasions, considered the impact of built-in capital gain tax liability in valuing corporate shares. Our approach to adjusting value to account for built-in capital gain tax liability has varied and has often been modified or overruled on appeal. See, e.g., Estate of Davis v. Commissioner, 110 T.C. 530, 552-554 (1998); Estate of Dunn v. Commissioner, T.C. Memo. 2000-12, revd. 301 F. 3d 339 (5th Cir. 2002); Estate of Jameson v. Commissioner, T.C. Memo. 1999-43, revd. 267 F. 3d 366 (5th Cir. 2001); Estate of Welch v. Commissioner, T.C. Memo. 1998167, revd. without published opinion 208 F. 3d 213 (6th Cir. 2000); Eisenberg v. Commissioner, T.C. Memo. 1997-483, revd. 155 F. 3d 50 (2d Cir. 1998); Gray v. Commissioner, T.C. Memo. 1997-67. In one case, we held that a discount for built-in capital gain tax liability was appropriate because even though corporate liquidation was unlikely, it was not likely the tax could be avoided. See Estate of Davis v. Commissioner, supra. However, this Court has not invariably held that discounts or reductions for built-in capital gain tax liability were appropriate where it had not been shown that it was likely the corporate property would be sold and/ or that the capital gain tax would be incurred. See, e.g., Estate of Welch v. Commissioner, supra; Eisenberg v. Commissioner, supra; Gray v. Commissioner, supra. Appellate courts in two of these cases reversed our decisions that a reduction in value for built-in capital gain tax liability was inappropriate. The Court of Appeals for the Second Circuit reasoned that, although realization of the tax may be deferred, a willing buyer would take some account of the built-in capital gain tax. Eisenberg v. Commissioner, 155 F. 3d at 57-58. Likewise, the Court of Appeals for the Sixth Circuit disagreed with our specific holding that the potential for a capital gain tax liability was too speculative. Estate of Welch v. Commissioner, supra. The Court of Appeals for the Sixth Circuit, to some extent, A-57 agreed with the Court of Appeals for the Second Circuit's approach in Eisenberg. Neither the Court of Appeals for the Second Circuit nor the Court of Appeals for the Sixth Circuit prescribed the amount of reduction or a method to calculate it. The Commissioner has since conceded the issue of whether a reduction for capital gain tax liability may be applied in valuing closely held stock by acquiescing to the Court of Appeals for the Second Circuit's decision in Eisenberg. See 1999-1 C.B. xix. In addition, in this case the parties agree and we hold that a reduction for built-in capital gain tax liability is appropriate. However, controversy continues with respect to valuing such a reduction. In two such cases involving the question of valuing reductions for built-in capital gain tax liabilities, the Court of Appeals for the Fifth Circuit has reversed our holdings. See Estate of Dunn v. Commissioner, supra; Estate of Jameson v. Commissioner, supra. How should the discount be computed? The court agreed with Mr. Shaked, the IRS expert, stating: Having held that an assumption of complete liquidation on the valuation date does not apply in this case, we must consider the amount of the reduction to be allowed for the built-in capital gain tax liability. Respondent's expert began with the total amount of built-in capital gain tax liability ($ 51,626,884); and after determining when the tax would be incurred, he discounted the potential tax payments to account for time value principles. The estate attacks that approach by contending that CCC's securities will appreciate, increasing the future tax payments and thereby obviating the need to discount. The estate's expert, in an effort to support this theory, testified that if the premise is that the liquidation or sale of substantially all of a corporation's assets would occur in the future, there should also be: a long term projection * * * that the stock will appreciate. If the stock appreciates, the capital gains tax liability will appreciate commensurate [sic]. The present value of the capital gains tax liability will be the same. Only if you assume there's no appreciation in the stock would you discount the capital gains tax. And that's a completely unreasonable assumption. Thus, the estate through its expert, Mr. Frazier, contends that irrespective of the unlikelihood of liquidation there should be a dollar-for-dollar decrease for the built-in capital gain tax liability, representing the present value of that liability because the liability will increase over time. In that regard, the estate argues that Mr. Shaked incorrectly assumed that the stock would not appreciate. In addressing this argument, Mr. Shaked explained that the need to discount the built-in capital gain tax liability is analogous to the need to discount carryforward losses because they cannot be used until years after the valuation year. Mr. Shaked's approach is to calculate the built-in capital gain tax liability by determining when it would likely be incurred. We agree with Mr. Shaked's approach of discounting the built-in capital gain tax liability to reflect that it will be incurred after the valuation date. A-58 Because the tax liabilities are incurred when the securities are sold, they must be indexed or discounted to account for the time value of money. Thus, having found that a scenario of complete liquidation is inappropriate, it is inappropriate to reduce the value of CCC by the full amount of the built-in capital gain tax liability. See Estate of Davis v. Commissioner, 110 T.C. at 552-553.12 If we were to adopt the estate's reasoning and consider future appreciation to arrive at subsequent tax liability, we would be considering tax (that is not "built in") as of the valuation date. Such an approach would establish an artificial liability. The estate's approach, if used in valuing a market-valued security with a basis equal to its fair market value, would, in effect, predict its future appreciated value and tax liability and then reduce its current fair market value by the present value of a future tax liability. In that same vein, the estate argues that the Government, in other valuation cases, has offered experts who computed the capital gain tax on the future appreciated value of assets and discounted the tax to a present value for purposes of valuing a corporation. In one of those cases, the Court was valuing a corporation that owned rental realty (shopping centers). Estate of Borgatello v. Commissioner, T.C. Memo. 2000-264. As part of a weighting of factors to arrive at a discount, the Commissioner's expert calculated the potential for appreciation in the real estate market and the amount of built-in capital gain tax liability. This Court, to some extent, relied on the expert's methodology in its holding on value. In the other case relied upon by the estate, although the Commissioner's expert advanced a similar analysis, this Court rejected that expert's approach as an unsubstantiated theory. Estate of Bailey v. Commissioner, T.C. Memo. 2002152. The guidance of the expert was rejected in one of the cases cited by petitioner and was part of a discounting approach to assist the finder of fact (Court) to decide upon a discounted value in the other case. Although the expert's guidance in the latter case was considered in reaching a factual finding, the expert's approach does not represent the ratio decidendi of the case. In our consideration of the value of the marketable securities in this case, we are not bound to follow the same approach used by an expert in other cases. More significantly we do not find that approach to be appropriate in this case. Therefore, we find that in valuing decedent's 6.44-percent interest, CCC's net asset value need not be reduced by the entire $51,626,884 potential for built-in capital gain tax liability and that future appreciation of stock need not be considered. We find Mr. Shaked's use of a 13.2-percent discount rate to be reasonable.13 In addition, the turnover rate of securities used by Mr. Shaked is conservative and reasonable under the circumstances. The asset turnover rate reasonably predicts the period over which the company's assets will be disposed of and thus built-in capital gain tax liability would likely be incurred. Consequently, we find it appropriate to use a 16-year period of recognition for the tax liability attributable to the built-in capital gain. We therefore accept Mr. Shaked's computation arriving at a $3,226,680.25 annual tax liability and a discounted total liability of $21,082,226. A-59 The court also determined a 10% lack of control discount and a 15% lack of marketability discount for a total combined discount of 23.5%. Looked at as whole, the 6.44% interest in CCC, with no reductions, was worth $12,148,000; the Tax Court value was $8,255,000. The Eleventh Circuit has vacated the Tax Court decision and remanded the case ordering the Tax Court to use the valuation method of the Fifth Circuit in Estate of Dunn. The opinion summarizes the case law background: By 2001, the issue presented itself squarely in the Fifth Circuit. In Estate of Jameson v. Comm'r, 267 F.3d 366 (5th Cir. 2001), the decedent owned 98% of the stock of her predeceased husband's closely-held operating company. Id. at 367. The company was both an operating timber company and an investment company. Id. at 367-69. The Tax Court, based on its recent decision in Estate of Davis, concluded that some discount for built-in capital gains should be acknowledged. Estate of Jameson, 267 F.3d at 371. Using a net asset valuation approach, the Tax Court allowed a partial discount based upon the court's estimate of the net present value for the capital gains tax liability on the timber property that would be incurred as the timber was cut, over a nine-year period.31 Id. As to the investment property, the Tax Court refused to allow any capital gains discount for that property. Id. at 370. Relying on the Second Circuit case of Estate of Eisenberg, the Fifth Circuit in the Estate of Jameson concluded that the Tax Court had clearly erred in crafting its own valuation method. Id. at 371. The method was flawed because it was based upon the Tax Court's conclusive assumption that a strategic, not a hypothetical, buyer would continue to operate the company for timber production. Id. at 371-72. The Fifth Circuit determined that the first, or economically rational, purchaser of the stock cannot be presumed to operate the company. Estate of Jameson, 267 F.3d at 371-72. The rational economic actor or willing buyer would have to take into account the consequences of the unavoidable, substantial built-in tax liability on the property. Id. The economic reality was that any reasonable willing buyer would consider the company's low basis in the investment property in determining a purchase price. Id. Citing internally inconsistent assumptions within the Tax Court opinion, the Fifth Circuit vacated the judgment and remanded the case back to the Tax Court. The instructions given were that the Tax Court reconsider the amount of capital gains on the operating timber property, and, to consider and allow a discount for the built-in capital gains on the investment property. Estate of Jameson, 267 F.3d at 372. A year later, the Fifth Circuit went one step further in Estate of Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002). At the time of her death, Mrs. Dunn owned a majority 62.96% of the stock of a family-owned corporation engaged in the A-60 rental of heavy equipment. The family company also managed certain commercial property as an investment. Id. at 347. As Texas corporate law required a 66.66% interest in the voting shares to affect a liquidation, with 62.9%, Mrs. Dunn did not own a "supermajority," or 66.6%, that could force a liquidation. Id. The facts further indicated that the family company planned to remain viable and in operation for some time.32 Id. Using a willing buyer-willing seller fair market value test, the Tax Court in the Estate of Dunn, while agreeing with the Commissioner's argument that the tax was certainly speculative, still agreed to discount the stock price by 5% of the built-in capital gains as a matter of law. Id. at 347. This holding was in response to the existence of a very small possibility that a hypothetical buyer would liquidate the company. The 5% discount was in lieu of the 34% reduction sought by the taxpayers. Id. The Tax Court concluded that it was much more likely that a hypothetical buyer would continue to operate the company. Id. The Fifth Circuit disagreed emphatically with the Tax Court. In the Estate of Dunn, under a net asset valuation approach, the Fifth Circuit determined value by totaling the corporation's assets and subtracting its liabilities. It held that a hypothetical willing buyer-willing seller must always be assumed to immediately liquidate the corporation, triggering a tax on the built-in gains.33 Id. at 354. Thereby substantially altering the Tax Court's fair market value test, the Fifth Circuit held, as a matter of law, that, as a threshold assumption, liquidation must always be assumed when calculating an asset under the net asset value approach.34 Id. The Fifth Circuit labeled as a 'red herring' the fact that no liquidation was imminent or even likely.35 Id. Turning to the proper amount of the discount, the Fifth Circuit concluded that the value of the assets must be reduced by a discount equal to 100% of the capital gains liability, dollar for dollar.36 Id. at 352. The court relied upon the assumption that, in a net asset valuation context, the hypothetical buyer is predisposed to buy stock to gain control of the company for the sole purpose of acquiring its underlying assets. Id. This, in turn, triggers a tax on the built-in gains.37 Id. Hence, the discount should be 100%, dollar-for-dollar. An era of valuation certainty had begun.38 Footnote 38 notes that the government s own expert adopted a favorable position on a dollar for dollar reduction in Simplot v. Comm r, 112 T.C. 130, 166 n.22 (1999), rev d on other grounds 249 F.3 1191 (9th Cir. 2001). With respect to this case, the court held: Juxtaposed against the backdrop of this emerging case law, the question before the Tax Court in this case, and now before us, is what was the value of Jelke's 6.44% interest in CCC on March 4, 1999? Which dollar figure do we use to discount the fair market value of CCC's securities for built-in capital gains on March 4, 1999? Is it dollar-for-dollar, as the estate contends, under the rationale A-61 set forth in 2002 by the Fifth Circuit in the Estate of Dunn, or $51 million? Or is it the present value of the capital gains indexed over a sixteen-year period, as the Commissioner contends, or $21 million? Is the Commissioner's present value approach incomplete and inconsistent, as the estate contends, as CCC's securities will very likely appreciate over this time period, thereby increasing capital gains tax liabilities and undermining the rationality of a present value approach? What if the value of CCC's securities were to decline over this sixteen-year period, and, concomitantly, the capital gains tax also declined? Is the Commissioner correct in contending that the Estate of Dunn's threshold "assumption of liquidation" is unreasonable and unrealistic in the present case as CCC is precluded from liquidation until 2019? Does such a minority interest such as we have here, with no power to "force" CCC's liquidation, render the Estate of Dunn distinguishable, as it concerned a majority interest? Does it matter that the corporation in the Estate of Dunn was primarily an operating company, while CCC is exclusively an investment holding company? Recently, on other issues and other facts, in Estate of Blount v. Comm'r, 428 F.3d 1338 (11th Cir. 2005), we were also asked to determine the fair market value of shares of stock in a closely-held corporation owned by a decedent for estate tax purposes.41 Id. An economic reality approach to valuation, in its dicta, is referenced: "To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value." Id. at 1346. To properly reflect the economic realities of the transaction, in other words, it is important to take liability costs into account when negotiating a marketsupported price for a share of a company's stock, such as CCC, for example. In our case, why would a hypothetical willing buyer of CCC shares not adjust his or her purchase price to reflect the entire $51 million amount of CCC's built-in capital gains tax liability? The buyer could just as easily venture into the open marketplace and acquire an identical portfolio of blue chip domestic and international securities as those held by CCC. Yet the buyer could accomplish this without any risk exposure to the underlying tax liability lurking within CCC due to its low cost basis in the securities.42 Here, the Tax Court distinguished the majority interest held by the decedent in the Estate of Dunn from our case on the basis that the Jelke estate's minority interest was single-handedly insufficient to "force" a liquidation on its own. The Tax Court chose a sixteen-year period to reflect when the corporation would reasonably incur the tax. This distinction is not persuasive to us. We are dealing with hypothetical, not strategic, willing buyers and willing sellers. As a threshold assumption, we are to proceed under the arbitrary assumption that a liquidation takes place on the date of death. Assets and liabilities are deemed frozen in value on the date of death and a "snap shot" of value taken. Whether or not a majority or a minority interest is present is of no moment in an assumption of liquidation setting. A-62 The Commissioner also argues that the Estate of Dunn is distinguishable on its facts as the company being valued was primarily an operating company and CCC is an investment holding company. As the company in the Estate of Dunn was both an operating company and an investment company, the Fifth Circuit was forced to use two different methods of valuation, an earnings-based valuation method for the operating side of the company, and a net asset valuation method for the investment side. It assigned a percentage weight to them of 85% and 15%, respectively. Estate of Dunn, 301 F.3d at 358-59. Here, CCC was solely an investment holding company. We need examine only the Estate of Dunn analysis as it applies to the net asset valuation method used in valuing investment holding companies; there is no need for weighting. The Commissioner's argument on this point is without merit. It is only recently that, the Tax Court in the Estate of Davis, the Second Circuit in the Estate of Eisenberg and the Sixth Circuit in the Estate of Welch, courts are receptive to the concept that some sort of discount for capital gains tax liability exists.43 Yet, in the more than twenty years since the TRA 1986 was enacted, none of these three cases provide any precise rules for calculating the downward adjustment with any specificity, nor give guidance to tax practitioners in future cases. The Fifth Circuit in the Estate of Dunn is the first court to emerge with a precise valuation approach as to the amount of the reduction and how to calculate it. As a threshold matter, the court creates the arbitrary assumption that all assets are sold in liquidation on the valuation date, and 100% of the built-in capital gains tax liability is offset against the fair market value of the stock, dollar-fordollar.44 Estate of Dunn, 301 F.3d at 352-54. 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. The longer the time, the lower the discount. The shorter the time, the higher the discount. The downside of this approach is that, not only is it fluidly ethereal, it requires a type of hunt-and-peck forecasting by the courts. In reality, this method could cause the Commissioner to revive his "too speculative a tax" contentions made prior to the Estate of Davis in 1998. This methodology requires us to either gaze into a crystal ball, flip a coin, or, at the very least, split the difference between the present value calculation projections of the taxpayers on the one hand, and the present value calculation projections of the Commissioner, on the other. We think the approach set forth by the Fifth Circuit in the Estate of Dunn is the better of the two. The estate tax owed is calculated based upon a "snap shot of valuation" frozen on the date of Jelke's death, taking into account only those facts known on that date. It is more logical and appropriate to value the shares of CCC stock on the date of death based upon an assumption that a liquidation has occurred, without resort to present values or prophesies. A-63 The rationale of the Fifth Circuit in the Estate of Dunn eliminates the crystal ball and the coin flip and provides certainty and finality to valuation as best it can, already a vague and shadowy undertaking. It is a welcome road map for those in the judiciary, not formally trained in the art of valuation. The Estate of Dunn dollar-for-dollar approach also bypasses the unnecessary expenditure of judicial resources being used to wade through a myriad of divergent expert witness testimony, based upon subjective conjecture, and divergent opinions. The Estate of Dunn has the virtue of simplicity and its methodology provides a practical and theoretically sound foundation as to how to address the discount issue. The Fifth Circuit preempted its critics by stating: "As the methodology we employ today may well be viewed by some (valuation) professionals as unsophisticated, dogmatic, overly simplistic, or just plain wrong, we consciously assume the risk of incurring such criticism from the business appraisal community . . . In this regard, we observe that on the end of the methodology spectrum opposite oversimplification lies over-engineering." Estate of Dunn, 301 F.3d at 358 n.36 (emphasis in original). This type of "economic reality approach" mimics the marketplace and places a practical, transactional overlay upon the proverbial willing buyer-willing seller analysis. It allows the issue to conform to the reality of the depressing economic effect that the lurking taxes have on the market selling price. The hypothetical willing buyer is a rational, economic actor. Common sense tells us that he or she would not pay the same price for identical blocks of stock, one purchased outright in the marketplace with no tax consequences, and one acquired through the purchase of shares in a closely-held corporation, with significant, built-in tax consequences. This 100% approach settles the issue as a matter of law, and provides certainty that is typically missing in the valuation arena. We thereby follow the rationale of the Fifth Circuit in the Estate of Dunn, that allows a dollar-for-dollar, $51 million discount for contingent capital gains taxes in valuing CCC on the date of Jelke's death, and his 6.44% interest therein. This result prevents grossly inequitable results from occurring and also prevents us, the federal judiciary, from assuming the role of arbitrary business consultants.45 A dissent objected that the majority rule was easy but inaccurate. The dissent states: The majority's approach assumes that the holding company was liquidated on the date of Jelke's death, and therefore all of its built-in capital gains were incurred (and therefore passed on to its shareholders) immediately. Maj. Op. at 36-37. The majority makes that assumption despite the fact that: historically the company has sold only 5.95 percent of its investments and therefore precipitated only that small portion of the total built-in capital gains liability per year, Jelke, 2005 WL 1277407, at *8; the company is earning an annual return of more than 23 percent on its portfolio investments, id. at *2; and, "[a]s of the date of decedent's death, CCC's board of directors had no plans to liquidate an appreciable portion of CCC's portfolio, and they intended to operate CCC as a A-64 going concern," id. Under these circumstances, the notion that the company would suddenly dispose of its highly profitable portfolio, ending the enviable earnings stream, and inflicting a substantial capital gains tax on its shareholders is preposterous. The fact that Jelke died does not make it any less so. The death of a human being is profoundly important to the person who dies, but it matters not one whit to the laws of economics, which dictate the self-interest of the living. Because the interests of the majority shareholders did not change when Jelke died, the only reasonable expectation is that the holding company will continue to be run as it was before that immaterial event occurred. Yet, the majority insists on pretending that contrary to the economic interests of its shareholders, and contrary to everything that has come before, the company must be assumed to have sold all of its securities on the date of Jelke's death. The majority suggests that subtracting the entire $51 million in embedded capital gains liability from the $188.6 million value of the company's portfolio is the best approach, because "why would a hypothetical willing buyer of CCC shares not adjust his or her purchase price to reflect the entire $51 million amount of CCC's built-in capital gains tax liability?" Maj. Op. at 31. The answer, of course, is that the buyer would adjust downward the price he was willing to pay in order to reflect that liability, but the buyer could not reasonably expect the seller to agree to a price that ignored completely the time value of money. No rational seller would accept a price that subtracted the entire amount of the future tax liability as though it were due immediately, when that liability will almost certainly be spread out over future years instead -- the next 16.8 years if existing practices continue. Jelke, 2005 WL 1277407, at *8. Assets with liabilities that will not come due until future years are worth more than those with the same amount of liabilities that are due immediately. Any rational being would prefer to pay $51 million in taxes spread out over the next 16.8 years, which is how long it would take for the embedded tax liability to come fully due under the company's historical rate of liquidation, instead of paying the entire $51 million immediately. Ask yourself: If you had the choice would you prefer to pay the taxes you are going to owe over the next 16 or so years in advance, right now, or would you choose to pay those taxes only when they come due in the future? The majority would assume, because it makes the calculations easier, that you would choose to pay all of your future taxes now. The dissent also references other decisions that it found relevant: We will also have to get rid of the Meader ex rel. Long v. United States, 881 F.2d 1056 (11th Cir. 1989), precedent and decisions like it. The Meader case arose under the Federal Tort Claims Act and involved the calculation of an award for future medical expenses and lost future earnings. We held, among other things, that "[i]t is a settled principle of law that [such] an award . . . must be adjusted to its present value to account for two factors: first, the interest the award will earn before it is used to pay for medical expenses or to replace earnings; second, the depreciation the award will suffer over time on account of inflation." Meader, 881 F.2d at 1057-58; see also Dempsey ex rel. Dempsey v. United States, 32 F.3d 1490, 1492 (11th Cir. 1994) (FTCA medical malpractice A-65 case stemming from injuries to a newborn, required not only calculating an award for future medical expenses but also calculating a dollar value for the parent's "loss of society and affection of the child" and their loss of the child's services in the future). Then there is our decision of just a few months ago in Advanced Telecommunications Network, Inc. v. Allen (In re Advanced Telecommunications Network, Inc.), 490 F.3d 1325 (11th Cir. 2007). There the bankruptcy court had been faced with the difficulty of valuing a company's contingent liability arising from pending litigation against it in state court. Not sure how the result of that litigation against the company could have been predicted, the bankruptcy court took the easy way out and arbitrarily assumed that the value of the contingent liability was zero. Id. at 1335-36. In reversing, we explained: Although it may be true, as the bankruptcy court put it, that "no one could have predicted this result with any reasonable certainty," such a precise prediction was not required. The court was instead required to calculate the present value of the liability -- the expected cost of the liability times the estimated chance of it ever occurring. Unless either the expected cost or the chances of it occurring are equal to zero (that is, the liability is costless, or the chances of it happening are negligible), the estimated value should be more than zero. Id. at 1335 (emphasis omitted). The majority approach in the present case cannot be reconciled with our holding in the Advanced Telecommunications case. Requiring a district court to predict the amount of damages that may be awarded in a pending lawsuit and then to discount that amount by its estimate of the chance of a liability verdict is, the majority here would say, equivalent to "flip[ping] a coin" and is no better than "gaz[ing] into a crystal ball." Maj. Op. at 34. So, the Advanced Telecommunications decision, like so many others of ours that require estimating present value based on predictions about future events, will have to go. All of those prior precedents will have to yield to the easy arbitrary assumption method of valuation, to the judicial equivalent of the doctrine of ignoble ease. The issue also arose in Dallas v. Commissioner, T. C. Memo 2006-212. Robert Dallas sold 55% of the nonvoting stock of the Dallas Group of America (DGA) to trusts for his sons in exchange for cash and notes. DGA is an S corporation. Father and sons all agreed to be bound by the value determined by an independent appraiser and the sales agreement, and accompanying notes, included a share adjustment clause that purported to reduce the number of shares transferred if their value per share were increased in any IRS proceeding. self-cancelling. With respect to the tax-affecting issue, the Court stated that there was no evidence DGA would cease being an S corporation in the foreseeable future nor was there any evidence that it would alter the pattern of regularly distributing sufficient income for shareholder s to pay their income taxes. The Court ignored the taxpayer s experts The notes were also A-66 who argued that appraisal standards require tax-effecting because the government s experts disagreed and there was no evidence introduced as to the standards. Further the Court refused to look to Department of Labor standards when valuing ESOPs, because, it stated, there was no evidence DOL definition of value is similar to the transfer tax definition. Similarly, the Court rejected a Delaware Chancery Court opinion, Del. Open MRI Radiology Associates, P. A. v. Kessler, 898 A. 2d. 290 (Del. Ch. 2006), holding that fair value in a minority stock appraisal case is not equivalent to fair market value in a transfer tax case. Thus the Court concluded that there was no evidence that a hypothetical buyer and seller would tax-effect DGA s earnings. The Court applied a lack of control discount of 15% for non-operating assets, 20% for operating assets, and a 20% lack of marketability discount. The taxpayer also argued that the notes were not intended to be self-cancelling, perhaps because that would increase the value of the notes and thus reduce the value of the gift and the accompanying gift tax, but the Court found the notes were clear on their face and could not be disavowed. 2. Lottery Payments and other Streams of Payments. Valuation of a stream of lottery payments continues to generate litigation. In Estate of Paul C. Gubauskas v. Commissioner, 342 F. 3d 85 (2003), the Second Circuit reversed the Tax Court and held that lottery winnings in an estate should not be valued using section 7520. The Ninth Circuit held the same in Shackleford v. U.S., 262 F.3d 1028 (2001). On the other hand, the Fifth Circuit applied section 7520 in Cook v. Commissioner, 349 F.3d 850 (2003). So, there is a split among the Circuits which may lead to Supreme Court review. Meanwhile, a U. S. District Court in Massachusetts followed Cook in Estate of John R. Donovan, Jr. v. United States, 95 A.F.T.R.2d 2005-2131(D. Mass. 2005). In Mary C. Davis v. United States, 97 A.F.T.R.2d 2006-332 (D. N.H. 2005)(motion for reconsideration denied but with same result, January 27, 2006), the court denied summary judgment to both the taxpayer and the government stating that it cannot conclude as a matter of law whether the tables are appropriate or inappropriate to use in valuing the annuity. In Tincy Anthony v. United States, 520 F.3d 374 (5th Cir. 2008), the Fifth Circuit considered the application of section 7520 to annuities that were part of a structured settlement that resulted from litigation. The Court followed its prior opinion in Cook. The taxpayer has petitioned the U.S. Supreme Court for a writ of certiorari. In Carol Negron v. United States, 2007 WL 1662767, 99 A.F.T.R.2d 2007-3127 (N.D. Oh. 2007), the Court followed the Second and Ninth Circuits. On the other hand, in Davis ex rel. Estate of Freeman v. U.S., 491 F.Supp2d 192 (D. N.H. 2007) the court applied the tables, where the taxpayer s expert could only show that non-assignability reduced the Section 7520 determined value by 5%: Unlike either Shackleford or Gribauskas, the record in this case simply does not permit the court to conclude that the IRC tables substantially overvalue the A-67 estate's annuity. At most, the court could plausibly conclude that there is a five percent (5%) difference between the "true" fair market value of the estate's annuity and the value yielded by the IRC tables. That discrepancy, however, is insufficient to warrant a departure from those tables. Even if the IRC tables are, in this particular case, off by as much as five percent (5%), plaintiff has failed to demonstrate that such a relatively minor discrepancy is sufficient to warrant the conclusion that the value those tables ascribe to the decedent's annuity is "unrealistic and unreasonable." A similar issue arose in Anthony v. United States, 2005-2 USTC 60,504 (D.C. La.), where the decedent was the beneficiary of several annuity contracts purchased as part of a structured settlement after he was injured in an automobile accident. The payments were made monthly and could not be accelerated , deferred, increased or decreased, nor could the decedent anticipate, sell, assign, or encumber the interest. The estate argued that the interest should be valued on a willing buyer, willing seller basis, and the IRS argued that section 7520 applied. The court applied section 7520, holding that unless the underlying assumptions of the section 7520 were in question, i.e. the interest rate or mortality of the annuitant, the tables should apply. The effect is no discount for lack of assignability. Estate of Sarah M. Davenport, T. C. Memo 2006-215, reached the same conclusion with respect to annuities payable on account of the settlement of a lawsuit. The sale of a stream of lottery payments has been determined to generate ordinary income, by the Tax Court in Davis v. Commissioner, 119 T. C. 1 (2002), the Ninth Circuit in United States v. Maginnis, 356 F.3d 1179 (2004), and the Third Circuit in George Lattera et. ux. v. Commissioner, 437 F.3d 399 (3d Cir. 2006). In the latter case the court applied a family resemblance test to determine whether the stream of payments was more like a capital asset (stock, bond, land) or a income asset (rents, interest) and determined that it was really like neither. So the court then looked to the nature of the sale, whether it was a horizontal carve out, which gives rise to ordinary income treatment, or a vertical carve-out, which is a capital transaction if the lump-sum payment is for the right to earn income but is taxed as ordinary income if the lump-sum payment is for the future right to earned income. The Latteras sold their right to all remaining lottery payments which was a vertical carve out, and the right is not to earn something but rather is payment for something already achieved. The Third Circuit was attempting to avoid the criticism of the Maginnis decision which rested on the substitute-for-ordinary-income doctrine. In Shirley B. Prebola v. Commissioner, CA2, 99 AFTR 2d 2007-1660, the Second Circuit upheld the Tax Court and followed Maginnis. 3. Undervalution Penalty. Josephine Thompson died on May 2, 1998 a New York resident. Here executors were New York residents as well and a substantial asset in her estate was 20.57% of a New York closelyheld company, TPC. TPC published business directories. The executors hired an Alaskan lawyer to appraise the decedent s interest in the business apparently in hopes of having the IRS Alaska office audit the return (to that end, the appraiser was also given limited administrative authority in the estate). The lawyer hired an accountant to help A-68 him and they valued the estate s TPK interest at $1,700,000. The IRS hired an expert who arrived at a higher value, about $32,388,000. In Estate of Josephine T. Thompson, et. al. v. Commissioner, T. C. Memo 2004-174, the court considered the appropriate value and determined it was about $13,500,000. The court allowed a 15% minority interest discount and a 30% lack of marketability discount in its determination. It would be fair to say that the court was not impressed with either expert. Whether the estate should be subjected to a underpayment penalty was also at issue. Section 6662 applies a 40% penalty where the value reported is less than 25% of the value finally determined. Section 6664 provides an exception if the estate shows reasonable cause for the understatement and that it acted in good faith. An appraisal is an indication of good faith under the regulations. The opinion states: The valuation herein of the estate s 20-percent stock interest in TPC was particularly difficult and unique. Companies comparable to TPC were not found. Valuation of the estate s 20-percent TPC stock interest under the capitalization of income and under the discounted cashflow methods involved a number of difficult judgment calls. We believe it noteworthy and relevant to the appropriateness of the section 6662 penalty that even respondent s expert made significant errors in his various calculations. Complicating the valuation presented to the parties and to the Court herein was the difficult question as to how the Internet and the risks and opportunities associated therewith should be regarded as affecting TPC. The evaluation in this case of such intangible risks and opportunities was difficult and imprecise. Certainly, the experts for the estate were aggressive in their relatively low valuation of TPC. Respondent s expert was aggressive in his relatively high valuation of TPC. We note that our valuation of TPC and of the estate s 20percent interest in TPC is closer to the estate s valuation than to respondent s valuation. On the record before us, we believe it inappropriate to impose the accuracyrelated penalty. The estate is not liable for the accuracy-related penalty. The Second Circuit has vacated and remanded the case to the Tax Court. Estate of Josephine Thompson, 2007 WL 2404434 (2d Cir. 2007). The opinion states: The Tax Court determined that the Estate's share of the Company was worth $13.5 million; the Estate valued its share at $1.75 million -- less than 15% of the value determined as correct by the Court.3 Under the version of IRC § 6662 then in effect, if the claimed value of the Estate is not more than 25% of the amount determined to be correct, the taxpayer must pay an accuracy-related penalty equal to 40% of its underpayment. See 26 U.S.C. § 6662(a), g(1), (h)(1), A-69 (h)(2)(C) (2006), amended by Pension Protection Act of 2006 § 1219, Pub. L. No. 109-280, 120 Stat. 780, 1083 (2006). With one exception, this penalty is mandatory. See id. § 6662(a) ("there shall be added to the tax an amount equal to [40] percent of the . . . underpayment" (emphasis added)). An exception is allowed if "it is shown that there was a reasonable cause for such [underpayment] and that the taxpayer acted in good faith with respect to such [underpayment]." Id. § 6664(c)(1). The Tax Court invoked this reasonable-cause exception and declined to impose an accuracy-related penalty. Its decision was based on the following considerations: [i] the valuation "was particularly difficult and unique"; [ii] the valuation "involved a number of difficult judgment calls"; [iii] the valuation was "difficult and imprecise" because of "the difficult question as to how the Internet and the risks and opportunities associated therewith should be regarded as affecting TPC"; and [iv] while "the experts for the estate were aggressive in their relatively low valuation of TPC," the Court's own valuation was "closer to the estate's valuation than to [the Commissioner's] valuation." Estate of Thompson, 2004 WL 1658404, at *23. "We review the tax court's factual determinations of whether a taxpayer qualifies for the reasonable cause exception for clear error." Sather v. Comm'r, 251 F.3d 1168, 1177 (8th Cir. 2001); accord Van Scoten v. Comm'r, 439 F.3d 1243, 1260 (10th Cir. 2006). However, while it is a question of fact whether "the elements that constitute 'reasonable cause' are present in a given situation," it is a question of law "what elements must be present to constitute 'reasonable cause.'" United States v. Boyle, 469 U.S. 241, 249 n.8 (1985). Accordingly, we review the factual determinations for clear error, but we review de novo whether those determinations were sufficient to satisfy the elements of reasonable cause. Under agency regulations, the existence of reasonable cause is determined "on a case-by-case basis, taking into account all pertinent facts and circumstances. . . . Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." 26 C.F.R. § 1.6664-4(b)(1). "Reliance on . . . an appraiser does not necessarily demonstrate reasonable cause and good faith," but such reliance does satisfy the reasonable cause exception if, "under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith." Id. Thus reliance on an expert's opinion "may not be reasonable or in good faith if the taxpayer knew, or reasonably should have known, that the advisor lacked knowledge in the relevant aspects of Federal tax law." Id. § 1.6664-4(c)(1). The Tax Court's findings are insufficient to support a determination of reasonable cause under § 6664. The factors set out in the regulations search the good faith of the taxpayer -- either in assessing its own liability or in relying on an expert to do so. But the Tax Court made no finding as to whether the Estate's reliance on its experts was reasonable and in good faith, or whether the Estate knew or should have known that they lacked the expertise necessary to value the Company. To prepare its valuation of a New York publishing company, the Estate turned to George E. Goerig of Anchorage, Alaska. The Tax Court found that an Alaska A-70 lawyer was retained so that the Commissioner's audit of the Estate would not be conducted by the Commissioner's New York staff, but by the Commissioner's office in Alaska, "where Goerig believed and apparently represented to the estate's representative that he would be able to obtain for the estate a more favorable valuation of the estate's [Company] stock." Estate of Thompson, 2004 WL 1658404, at *8. "[T]he estate had learned about Goerig from an attorney for decedent's family who had met Goerig on a fishing trip." Id. Goerig was assisted by Paul Wichorek, an accountant in the same remote location. Id. The Court found that these experts "demonstrated no experience with . . . Internet- and technology-related companies," id. at *11, and were "too inexperienced, accommodating, and biased in favor of the estate," id. The Court summarized their qualifications as follows: Goerig is a lawyer with an audit and tax dispute resolution practice, and a tax return preparer, and he undertakes occasional valuations for small businesses and private individuals. From his resume, he appears to have attended limited appraisal courses, other than a few courses while working for [the Commissioner] many years ago. Goerig also was appointed to act as administrator for the estate to handle the anticipated audit by respondent of the estate's Federal estate tax return, a role which we regard as somewhat in tension with his role as a purported independent valuation expert for the estate. Wichorek provides accounting and tax preparation services, does business consulting, and undertakes occasional valuations for small businesses, generally in the context of divorce and property settlement disputes. He belongs to no professional organizations or associations relating to his appraisal or valuation work. Although we admitted into evidence the estate's valuation reports and treated them as credible, we regard those reports and the testimony of the estate's experts to be only marginally credible. Goerig and Wichorek were barely qualified to value a highly successful and well-established New York City-based company with annual income in the millions of dollars. Id. at *17-*18. A determination as to the Estate's good faith is required. Accordingly, we vacate the Tax Court's decision not to impose an accuracy-related penalty, and we remand so that the Court can determine whether the Estate's reliance on Goerig and Wichorek was reasonable and in good faith. G. SECTION 2032 VALUATION 1. ALTERNATE VALUATION AND SECTION 2032A SPECIAL USE Burden of Proof and Post-Mortem Restrictions. Section 7491 of the Code allows the burden of proof to shift from the taxpayer to the IRS if the taxpayer introduces credible evidence explaining its valuation and establishes that it substantiated items, maintained required records, and cooperated with reasonable informational A-71 requests from the IRS. In Kohler v. Commissioner, 92 TCM 48 (2006), the IRS argued that the burden should not shift because the estate did not cooperate with reasonable requests from the IRS for information when it filed a motion to quash a summons from the IRS requesting additional information. The Court determined that the estate had a good faith belief that the documents sought were irrelevant, sealed or contained sensitive Kohler business information and that once the Court denied the estate s motion it furnished the documents. The estate introduced numerous fact witnesses and two valuation experts which, the Court held, was credible evidence to support its valuation position. The Tax Court shifted the burden of proof from the estate to the IRS. When Frederick Kohler died on March 4, 1998 he owned 12.85% of the privately held Kohler Co., a 100 year old maker of kitchen and bathroom fixtures. Since 1900 the company had paid dividends and its stated policy has been to reinvest 90% of its earnings and to distribute 7% - 10%. The Kohler family owned most of the company s stock but on May 11, 1998, after the decedent s date of death but before the alternate valuation date, a reorganization occurred to cash out some non-family members. After the reorganization the estate owned 14.455 of the outstanding shares. On the estate tax return the decedent s shares were valued at $47,000,000; the IRS valued the shares at $144,500,000 and also assessed almost $11,000,000 in undervaluation penalties. Under Treas. Reg. §20.2032-1(c)(1) a tax-free reorganization is not treated as a distribution or other disposition, thus the stock, after the reorganization, was valued on the alternate valuation date. The Court rejected and gave no weight to the IRS expert s (Dr. Hakala) report. The opinion states: We have several significant concerns about the reliability of Dr. Hakala's report. These concerns lead us to place no weight on Dr. Hakala's report as evidence of the value of the Kohler stock the estate held. We have previously discussed the lack of customary certification of Dr. Hakala's report and that his report was not prepared in accordance with all USPAP standards. We also have already noted that Dr. Hakala admitted that his original report submitted to the Court before trial overvalued the estate's Kohler stock by $11 million, or more than 7 percent of the value he finally decided was correct. This is not a minor mistake. When we doubt the judgment of an expert witness on one point, we become reluctant to accept the expert's conclusions on other points. Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo. 2003- 200 [TC Memo 2003-200], affd. 122 Fed. Appx. 88 [94 AFTR 2d 2004-7141] (5th Cir. 2004). Moreover, we are convinced from his report and trial testimony that Dr. Hakala did not understand Kohler's business. He spent only 2-1/2 hours meeting with management. He decided the expense structure in the company's projections was wrong and decided to invent his own for his income approach analysis. He did not discuss his fabricated expense structure with management to test whether it was realistic. Dr. Hakala also decided to weight the operations plan model 80 percent and the management plan model only 20 percent under the income approach, despite the admonitions of management that the operations plan A-72 projections were only what could be created in a perfect environment while the management plan forecasted realistic, achievable targets. In addition, Dr. Hakala did not use a dividend-based method under the income approach, although the record reflects that periodic dividends were the primary means of obtaining a return on Kohler stock due to the privately held nature of the company. When asked why he did not use the dividend method at trial, Dr. Hakala argued first that the DCF analysis made other income approaches redundant and then stated that dividend-based methods were unreliable. We are concerned by Dr. Hakala's choice to ignore any dividend- based method for Kohler, a privately owned company that periodically and historically has paid large dividends as a return to its shareholders, recognizing that no ready market exists for a shareholder wishing to sell. The estate used two appraisers, Robert Schweihs of Willamette Management Associates and Roger Grabowski from Duff & Phelps. The Court was favorably impressed with both: Mr. Schweihs is a managing director of WMA, has been accredited as a senior appraiser in business valuation by the ASA, and is a Certified Business Appraiser of the Institute of Business Appraisers. He has authored several books, including co- authoring Valuing a Business with Shannon Pratt and Robert Reilly, and has written between 50 and 100 articles on valuing businesses. Mr. Schweihs also gives two to four lectures a year on the topic. He has appraised businesses since the early 1980s, and his core work is valuing businesses and business interests, including advising acquirers and sellers, taxation matters, and dispute resolution. Mr. Schweihs had periodically performed valuations of Kohler stock in the several years before the valuation date and is very familiar with the company. For this assignment in particular, he was required to review significant information regarding the company and interview Kohler management. Mr. Schweihs used the income approach and the market approach to value the estate's Kohler stock. Under the income approach, Mr. Schweihs used not only the DCF method, but also the discounted dividend method and the dividend capitalization method. He recognized that the dividend methods were important indicators of value where dividends represent the best, if not the only, opportunity for a minority shareholder to receive a cash return on his or her investment. Under the market approach, Mr. Schweihs used the capital market method, also known as the guideline company method. Mr. Schweihs did not use the transaction method, unlike Dr. Hakala, because he was unable to find transactions in companies sufficiently similar to Kohler where there was adequate information available. Mr. Schweihs also did not account for prior sale transactions of Kohler stock in determining the value. He determined that the transactions included a premium for being able to be a shareholder in a prominent, privately held company like Kohler, and that this premium could not be quantified. Mr. Schweihs also determined that the prices paid in the transactions were not justified by analyzing the company's historical and expected future performance. A-73 Mr. Schweihs also did not rely on the asset-based approach because Kohler is a going concern operating company. An asset- based approach, in his view, generally is not a reliable indicator of value for going concern companies. Mr. Schweihs applied a 45-percent lack of marketability discount to the values he determined under the DCF method and the capital market method, and a 10percent lack of marketability discount to the values he determined under the discounted dividend method and the capitalization of dividends method. He used a lower discount for lack of marketability under the dividend methods because, in his view, the dividend method more directly reflected the value of the shares. Mr. Schweihs also determined that a 26-percent discount for lack of control applied to the value he determined under the DCF method. Mr. Schweihs weighted the DCF method and the capital market method each 20 percent in his final analysis, and gave 30 percent weights to each of the dividend methods. He concluded that the fair market value of the Kohler stock the estate owned on the alternate valuation date was $47.010 million. Mr. Schweihs used a similar analysis to value the pre-reorganization shares on the date of Frederic's death, 6 months earlier, and determined the fair market value of those shares on the date of Frederic's death was $50.115 million. *** Mr. Grabowski was another expert who prepared an appraisal report and testified for the estate. He has been valuing companies since 1974, first with S&P Corporate Value Consulting and since September 2005, as a managing director with Duff & Phelps. He is a member of the ASA and is an accredited senior appraiser with the ASA in business valuation. He has taught finance and valuation courses at Loyola University, taught classes for the ASA, and teaches a class on cost of capital. The majority of his work is valuation services in nonlitigation settings, and he has valued several businesses similar to Kohler, including plumbing fixture businesses and closely held companies. Mr. Grabowski spent 3-1/2 days at the company and interviewed 12 employees, spending considerable time with 6 of them, including Herbert (the President and Chairman of the Board) and Natalie (the General Counsel). Mr. Grabowski also reviewed numerous documents and considered general economic conditions and the industries in which Kohler operates. Mr. Grabowski used the income approach and the market approach to value the Kohler stock. Under the income approach, Mr. Grabowski used the DCF method, the discounted dividend method, and the adjusted discounted dividend method. Mr. Grabowski used the management plan to perform these analyses because he considered it the most accurate estimate of the future performance of the company. Under the market approach, Mr. Grabowski used the guideline publicly traded company method. He identified publicly traded companies in each market segment in which Kohler operated and applied valuation multiples to these entities to estimate the value of each Kohler market segment. He then weighted A-74 the valuation conclusion as to each segment of the business based on the relative portion of Kohler's business that the segment comprised. Mr. Grabowski did not use the cost approach because Kohler was a growing and profitable business that was likely worth more than the values of its assets. Mr. Grabowski then considered each of the values he had determined and found that they all resulted in values fairly close to each other. He assessed the strengths and weaknesses of each method and ultimately decided that the adjusted discounted dividend method was the most appropriate method because it reflected the actual cash flows a shareholder could expect to receive. The adjusted discounted dividend method also reflected the remote possibility that Kohler would be sold or undergo an initial public offering. The closeness of the values determined by the other methods acted as a check that this value was correct. He also reconciled his conclusion to prior sales of Kohler stock to confirm the reasonableness of the analysis. Mr. Grabowski then made adjustments to the value determined under the adjusted discounted dividend method to reflect that Kohler was closely held and the number of shares of stock the estate owned. Mr. Grabowski settled on a 35percent discount for lack of marketability. He determined this discount was correct by considering studies of restricted stock and the stock of other companies similar to Kohler. He found that the restricted stock studies did not give the full picture of the appropriate marketability discount because the studies involved only companies that eventually went public and therefore their shares eventually became marketable. Mr. Grabowski concluded an eventual public offering was not likely with Kohler and therefore determined that a slightly higher discount was appropriate. Mr. Grabowski determined that a 25- percent adjustment for lack of control was warranted only in considering the value of the Hospitality group and in considering the price paid to dissenting shareholders in the reorganization. In making the 25-percent adjustment, he considered factors such as the Kohler family's stated intention to control the company long term, certain sales of Kohler stock, transactions in the industry involving acquisitions of businesses with control premiums, and published benchmark data Schweihs used a discounted cash flow analysis and a dividend analysis in calculating value, using a 45% lack of marketability discount with the former and a 10% lack of marketability discount with the latter. His calculated value for the decedent s shares was $47,000,000. Grabowski looked at discounted cash flow as well as dividends but also various market multiples, and determined all the values were reasonably close. He applied a 35% lack of marketability discount and calculated a value of $63,000,000. Importantly, and in direct contrast to the IRS expert, the Court noted that Grabowski spent three and half days at the company and interviewed 12 employees to develop the facts relied on in his report. The Court determined that the IRS did not meet its burden of proof and thus allowed the estate s proffered value of $47,000,000. A-75 In AOD 2008-01 the IRS refused to acquiesce in Kohler with respect to the post-mortem restriction issue that was described as follows: Whether I. R. C. § 2032 allows a discount for transfer restrictions and purchase option ( restrictions ) imposed on closely-held corporate stock pursuant to a post-death tax-free reorganization in determining the fair market value of the decedent s stock on the alternate valuation date. The IRS noted that the Kohler court focused on whether property had been disposed of rather than whether the character of the property had changed. The IRS cited Flanders v. United States, 347 F. Supp. 95 (N. D. Cal. 1972) for the proposition that a post-death restrictions do not give rise to a discount (there the restriction was a conservation easement). The IRS has responded to Kohler by issuing proposed regulations under section 2032. REG-112196-07 (Apr. 24, 2008) that limit the ability of an estate to manipulate the value of assets between date of death and the alternate valuation date by providing that only reductions due to market conditions will be allowed. In general, the proposed regulations will be effective for decedents dying after April 25, 2008. The proposed regulations describe the case-law in this area, in addition to Kohler, as follows: In 1941, the U. S. Supreme Court addressed whether rents, dividends, and interest received and accrued during the alternate valuation period are includible in the decedent's gross estate under section 811(j). Maass v. Higgins, 312 U.S. 443 (1941). In that case, the Court stated that the purpose of section 811(j) is "to mitigate the hardship consequent upon shrinkage in the value of estates during the year following death. Congress enacted it in the light of the fact that, due to such shrinkages, many estates were almost obliterated by the necessity of paying a tax on the value of the assets at the date of decedent's death." Id. at 446. In 1954, section 811(j) was recodified as section 2032. Congress considered proposals to amend section 811(j) and, again, Congress stated that, "The option to value property [on the alternate valuation date] initially was provided during the depression of the early 1930's because by the time estate taxes were paid, property values had dropped substantially, sometimes to such an extent that the proceeds of the sale would not pay the estate tax due." H. Rep. No. 83-1337 at 90 (1954). See, also, S. Rep. No. 83-1622, at 122-123 (1954). In 1958, § 20.2032-1 of the Estate Tax Regulations was published. This regulation restates the rule in section 2032(a)(3) and provides an example that illustrates the rule that only changes in the value of the decedent's gross estate due to market conditions, and not changes to the value due to a mere lapse of time, are to be considered in valuing the decedent's gross estate under the alternate valuation method. See example in § 20.2032-1(f)(1). A-76 Two judicial decisions have interpreted the language of section 2032 and its legislative history differently in determining whether post-death events other than market conditions may be taken into account under the alternate valuation method. In Flanders v. United States, 347 F. Supp. 95 (N.D. Cal. 1972), the district court held that the reduction in value of property included in the decedent's estate as a result of a voluntary act by the trustee, instead of as a result of market conditions, could not be taken into consideration in valuing the property under the alternate valuation method. In that case, a few months after the death of the decedent, the trustee of the trust owning decedent's undivided one-half interest in real property entered into a Land Conservation Agreement pursuant to the California Land Conservation Act of 1965. In exchange for restricting the property to agricultural uses for a period of 10 years, the trustee was allowed to reduce the assessed value of the land for purposes of paying property taxes. The estate elected to use the alternate valuation method for estate tax purposes and reported the value of the decedent's interest in the land as $25,000. This value represented one-half of the value of the ranch after the land use restriction was placed upon it, less a lack of marketability discount. The district court stated that, "It seems clear that Congress intended that the character of the property be established for valuation purposes at the date of death. The option to select the alternate valuation date is merely to allow an estate to pay a lesser tax if unfavorable market conditions (as distinguished from voluntary acts changing the character of the property) result in a lessening of its fair market value." Id. at 98. In Kohler v. Commissioner, T.C. Memo. 2006-152, the U.S. Tax Court held that valuation discounts attributable to restrictions imposed on closely-held corporate stock pursuant to a post-death reorganization of the Kohler Company should be taken into consideration in valuing stock on the alternate valuation date. In that case, approximately two months after the death of the decedent, the Kohler Company underwent a reorganization that qualified as a tax-free reorganization under section 368(a) and, thus, was not a sale or disposition for purposes of section 2032(a)(1). The estate opted to receive new Kohler shares that were subject to transfer restrictions. The estate elected to use the alternate valuation method under section 2032(a)(2) and took into account discounts attributable to the transfer restrictions on the stock in determining the value for Federal estate tax purposes. In the Internal Revenue Bulletin No. 2008-9 on March 3, 2008, the IRS nonacquiesced to the Tax Court opinion in Kohler (AOD 2008-1). The proposed regulations provide: § 20.2032-1 Alternate valuation. ***** (f) Post-death market conditions and other post-death events -- (1) In general. The election to use the alternate valuation method under section 2032 permits the property included in the gross estate to be valued as of the alternate valuation date to the extent that the change in value during the alternate valuation period is the result of market conditions. The term market conditions is defined as events A-77 outside of the control of the decedent (or the decedent's executor or trustee) or other person whose property is being valued that affect the fair market value of the property being valued. Changes in value due to mere lapse of time or to other post-death events other than market conditions will be ignored in determining the value of decedent's gross estate under the alternate valuation method. (2) Mere lapse of time. * * * The application of this paragraph (f)(2) is illustrated in paragraphs (f)(2)(i) and (f)(2)(ii) of this section: (3) Post-death events -- (i) In general. In order to eliminate changes in value due to post-death events other than market conditions, any interest or estate affected by post-death events other than market conditions is included in a decedent's gross estate under the alternate valuation method at its value as of the date of the decedent's death, with adjustment for any change in value that is due to market conditions. The term post-death events includes, but is not limited to, a reorganization of an entity (for example, corporation, partnership, or limited liability company) in which the estate holds an interest, a distribution of cash or other property to the estate from such entity, or one or more distributions by the estate of a fractional interest in such entity. (ii) Examples. The following examples illustrate the application of this paragraph (f)(3). In each example, decedent's (D's) estate elects to value D's gross estate under the alternate valuation method, so that the valuation date of the property included in D's gross estate as of D's date of death is either the date the property is distributed, sold, exchanged, or disposed of under section 2032(a)(1) (the date of distribution (distribution date)) or the date that is 6 months after the date of the decedent's death under section 2032(a)(2) (the six month alternate valuation date (AVD)). Example 1. At D's death, D owned common stock in Corporation, a closely-held subchapter C corporation. At that time, the common stock was not subject to transfer restrictions. D's stock was valued at $50X at the date of death. Two months after D's death, D's estate participated in a tax-free reorganization of Corporation that qualified under section 368(a) with respect to which no gain or loss was recognized for income tax purposes under section 354 or 355. Pursuant to the reorganization, D's estate opted to exchange its stock for stock subject to transfer restrictions. Although the value of the stock did not change during the alternate valuation period, discounts for lack of marketability and lack of control (totaling $20X) were applied in determining the value of the stock held by D's estate on the AVD, and D's estate reported the value of the stock on the AVD as $30X. Because the claimed reduction in value is not attributable to market conditions, the discounts may not be taken into account in determining the value of the stock on the AVD. Accordingly, the value on the AVD is $50X. Example 2. The facts are the same as in Example 1 except that the value of the stock declined from $50X to $40X during the alternate valuation period because of changes in market conditions during that period. D's estate may report the value of the stock as $40X on the AVD. As in Example 1, however, no discounts resulting from the reorganization are allowed in computing the value on the AVD. A-78 Example 3. At D's death, D owned property valued at $100X. Two months after D's death, the executor of D's estate and other family members formed four limited partnerships. The estate contributed the estate's property to the partnerships in exchange for a 25% interest in each partnership. Discounts for lack of marketability and lack of control (totaling $25X) were applied in determining the value of the estate's partnership interests, and the estate reported $75X as the total value of the estate's partnership interests on the AVD. Because the reduction in value is not attributable to market conditions, the discounts for lack of marketability and control may not be taken into account in determining the value of the partnership interests on the AVD. The result would be the same if the limited partnerships were formed prior to D's death, and the estate transferred property into the partnerships after D's death but prior to the AVD. Example 4. At D's death, D owned 100% of the units of a limited liability company (LLC). The executor elected the alternative valuation method. During the 6 months following D's death and in accordance with D's will, the executor made 6 distributions, each to a different residuary legatee on a different date and each of a 10% interest in the LLC. Pursuant to section 2032(a)(1), each distribution is valued on the distribution date. On the AVD, the estate held 40% of the units in the LLC. Pursuant to section 2032(a)(2), the 40% is valued on the AVD. In valuing the 10% interests distributed and the 40% interest held on the AVD, discounts for lack of control and lack of marketability were applied. The reduction in value of the units is not attributable to market conditions. Accordingly, the discounts for lack of marketability and control may not be taken into account in determining the value of the units distributed or held by the estate. The value of each 10% distribution is determined by taking 10% of the value on the distribution date of the units (100%) owned by the estate at D's death. The value of the units held by the estate on the AVD is determined by taking 40% of the value on the AVD of all of the units (100%) owned by the estate at D's death. If because of market conditions, the units had declined in value as of each distribution date or as of the AVD, D's estate would take such reduction in value into account. Example 5. D died owning 100% of Blackacre. D's will directs that Blackacre be divided between two trusts, 70% to Trust A for the benefit of S, D's surviving spouse, and 30% to Trust B for the benefit of C, D's surviving child. The executor of D's estate distributed a 70% interest in Blackacre to Trust A three months after D's death, and distributed a 30% interest in Blackacre to Trust B four months after D's death. On the estate tax return, the executor elected to value the estate's property under the alternate valuation method under section 2032. There was no change in the value of Blackacre during the four-month period following D's death. The 70% interest in Blackacre is to be valued as of the distribution date to Trust A, and that value is determined by taking 70% of the value of all (100%) of Blackacre as of the distribution date. The 30% interest in Blackacre is to be valued as of the distribution date to Trust B, and that value is determined by taking 30% of the value of all (100%) of Blackacre as of the distribution date. If, however, because of market conditions such as a decline in the real estate market, Blackacre's value had declined by 10% between D's date of death and the distribution date of the 30% interest, the value of the 30% interest would be determined by ascertaining 30% of the value of all (100%) of A-79 Blackacre as of the distribution date, which would equal 30% of 90% of the date of death value of Blackacre. H. SECTION 2033 1. GROSS ESTATE In Robert Grove Stone et al. v. United States, 2007 WL 1544786, 99 Value of Painting. A.F.T.R.2d 2007-2992 (N.D. Cal. 2007), the court allowed for the 50% interest in 19 paintings owned by the decedent. The decedent s expert had claimed a 44% discount. The court determined that because a 50% owner has a right of partition the expenses and delays of partition should be the basis of any discount. 2. Scrivener s Error. In PLR 200730015 a trust was drafted providing for mandatory distributions to descendants. By court order, based on grantor s statement that the intent had been for trustee to have discretion, the trust was reformed. The IRS determined that the grantor had not retained a power over the trust. I. SECTIONS 2035-2038 1. RETAINED INTERESTS Application of Section 2036 to Family Limited Partnerships. In March, 2005 the Tax Court attempted to bring some order to its section 2036 jurisprudence in the family partnership context, in Estate of Wayne C. Bongard v. Commissioner, 124 T. C. No. 8 (2005), a reviewed opinion. Judge Goeke authored the majority opinion signed by nine judges. Two judges concurred in a separate opinion, one wrote separately to concur and dissent, and three wrote separately to concur and dissent. Mr. Bongard transferred shares of stock in a closely-held company (Empak, Inc.) to an irrevocable trust (ISA Trust) in 1986. He retained a power to persuade the trustees to follow his wishes, at least in part, because at various times he suggested the trustees make certain stock distributions and those suggestions were followed. The stock was subsequently redeemed by the company. In the mid-1990s the family and advisors decided that all of the family s stock in Empak should be combined so that Empak could sell stock publicly or privately in order to raise capital. So, Mr. Bongard and the trust capitalized WCB Holdings, LLC by transferring to it their respective shares in Empak. In exchange, Mr. Bongard and the trust received interests in each of four classes of stock: Class A governance, Class A financial, Class B governance, and Class B financial. Mr. Bongard received 86.39% of each class and the trust received 13.61% of each class. The Class A governance units had effective control over the LLC. Within days of contributing the Empak stock to the LLC, Mr. Bongard contributed his Class B governance and Class B financial units to Bongard Family Limited Partnership (BFLP) in exchange for a 99% limited partnership interest. The trust received a 1% general partnership interest in BFLP. Mr. Bongard also gave portions of his Class A governance interests to trusts for his descendants and to a lifetime QTIP for his wife. A-80 In early 1998 Mr. Bongard wanted cash to go to his four children to see how they would handle the funds. Empak redeemed some shares from the LLC and the LLC redeemed some units from the trust and the trustees of the trust made distributions of $100,000 each to the four children. On November 16, 1998 Mr. Bongard, age 57, died unexpectedly. At issue before the Tax Court was whether the Empak stock should be included directly in Mr. Bongard s estate, and whether the LLC interests should be included in Mr. Bongard s estate. Stated another way, did section 2036 apply to the transfers into the LLC or to the transfers into BFLP. The Tax Court applied section 2036 to the transfers to the partnership but not to the LLC. In each analysis, the central question was whether the funding of the entities avoided section 2036 by reason of being a bona fide sale for full and adequate consideration. First, with respect to the transfer of Empak stock to the WCB Holdings, LLC, the court stated that the transfer was a bona fide sale because there were legitimate non-tax reasons for creating the LLC: It is axiomatic that intrafamily transactions are subjected to a higher level of scrutiny, but this heightened scrutiny is not tantamount to an absolute bar. In that connection, we have already concluded that decedent and ISA Trust had mutual legitimate and significant nontax reasons for forming WCB Holdings. In addition, both decedent and ISA Trust received interests in WCB Holdings proportionate to the number of shares transferred. We believe that had this transaction occurred between two unrelated parties the majority interest holder in Empak would have received similar powers to those the decedent received via WCB Holdings's member control agreement. An important purpose for creating WCB Holdings was to position Empak for a corporate liquidity event, and the record does not contain any credible evidence that unrelated parties would not have agreed to the same terms and conditions. Given these facts, we cannot hold that the terms of the transaction differed from those of two unrelated parties negotiating at arm's length. Respondent's final argument is that the formation of WCB Holdings was not a bona fide sale because there was not a true pooling of assets. WCB Holdings's purpose was to pool the Bongard family's Empak stock within a single entity, which decedent and ISA Trust satisfied through their respective contributions. WCB Holdings's creation was part of a much grander plan, to attract potential investors or to stimulate a corporate liquidity event to facilitate Empak's growth. Moreover, when WCB Holdings was capitalized, the members' capital accounts were properly credited and maintained, WCB Holdings's funds were not commingled with decedent's, and all distributions during decedent's life were pro rata. The amalgamation of these facts evinces that this transaction resulted in a true pooling of assets. The majority also found that the transfer was for full and adequate consideration because Mr. Bongard s ownership of 86.31% of the Class A governance units gave him practical control over the LLC. Thus, there was no reason Mr. Bongard should have received a control premium when he gave his Empak stock to the LLC. A-81 On the other hand, the court found no legitimate, non-tax purpose for the limited partnership. The estate argued that the partnership was needed to allow gifts to be made, including a gift to Mrs. Bongard, for asset protection, as a trust substitute, and to help manage the partnership assets. The court found that Mr. Bongard made gifts after he formed the partnership but did not give away partnership interests other than to Mrs. Bongard. The estate argued that the gift of partnership units to her supported a general non-tax reason for the partnership but the court found that the decedent needed to give some assets to Mrs. Bongard in connection with a postnuptial agreement and he used the partnership interest because that is where the assets were. Further, Mr. Bongard made gifts to trusts after the partnership was formed and the partnership never actually managed the LLC interests it owned - - it did not try to diversify, for instance. The court having failed to apply the bona fide sale for full and adequate consideration exception to section 2036 with respect to the transfer of LLC interests to the partnership, the next issue was whether Mr. Bongard retained an interest in the partnership. The court found that because Mr. Bongard controlled whether the partnership could sell its sole asset - - the LLC interests - - into something liquid he exercised practical control over the partnership. The opinion states: The decedent did not need the membership interest in WCB Holdings class B shares to continue his lifestyle. However, decedent retained ownership of more than 91 percent of his BFLP interest and did not make gifts of such interest prior to his death. More importantly, decedent controlled whether BFLP could transform its sole asset, the class B WCB Holdings membership units, into a liquid asset. Decedent as CEO and sole member of Empak's board of directors determined when Empak redeemed its stock in each of the seven instances of redemptions prior to his death, including the last redemption of about $750,000 worth of Empak stock in 1998 after WCB Holdings was formed. None of the seven redemptions reduced the membership units owned by BFLP. In order for BFLP to be able to diversify or take any steps other than simply holding the class B membership units, decedent would have had to cause the membership units and the underlying Empak stock to be redeemed. He chose not to do this. By not redeeming the WCB membership units held by BFLP, decedent ensured that BFLP would not engage in asset management. Thereby, decedent exercised practical control over BFLP and limited its function to simply holding title to the class B membership units. Whether decedent caused the WCB membership units held by BFLP and the underlying Empak stock to be redeemed or not, his ability to decide whether that event would occur demonstrates the understanding of the parties involved that decedent retained the right to control the units transferred to BFLP. The estate's argument that the general partner's fiduciary duties prevents a finding of an implied agreement is overcome by the lack of activity following BFLP's formation and BFLP's failure to perform any meaningful functions as an entity.12 We conclude that decedent's transfer to BFLP for a 99-percent ownership interest in the partnership did not alter his control of the WCB Holdings class B membership units transferred to BFLP. See Estate of A-82 Thompson v. Commissioner, 382 F.3d at 376-377 (finding "nothing beyond formal title changed in decedent's relationship to his assets" where the practical effect on his relationship to the transferred assets during decedent's life was minimal). Judge Laro wrote a concurrence (Judge Marvel joined) in which he argued that a transfer to a partnership could not be for full and adequate consideration unless the value of the partnership units received on account of the transfer were equal in value to the assets transferred to the partnership. That is, if the funding of the partnership depletes the estate there is no full and adequate consideration. In short, the opinion would side with Thompson over Kimbell with respect to the meaning of full and adequate consideration. Judge Halpern concurred and dissented. He disagreed with the majority to the extent the majority considered the motive of the transferor. Further, he argued for a gift on formation theory if the interests received back by the transferor were less than those transferred. Obviously, Judge Halpern would agree in substance with Judge Laro s understanding of full and adequate consideration, although perhaps not with his reasoning, but in any event would go further. He agreed with the result that the Empak stock should not be included directly in Mr. Bongard s estate. Judge Chiechi also concurred and dissented, joined by Judges Wells and Foley. These judges rejected the notion that merely because there is no non-tax reason for the formation of the partnership that means Mr. Bongard retained beneficial enjoyment of the assets transferred to the partnership. The opinion states: The majority opinion's rationale is factually, logically, and legally flawed.8 The majority opinion's rationale is factually flawed for various reasons. One reason is that it concludes that decedent could have caused WCB Holdings to redeem the WCB Holdings class B membership units owned by BFLP. That conclusion is not supported by, and is contrary to, the following findings of fact of the majority opinion regarding the circumstances under which the chief manager of WCB Holdings (chief manager), who was decedent's son Mark Bongard, was required to obtain the approval of a majority of the WCB Holdings class A governance units before he could take certain actions on behalf of WCB Holdings: the chief manager needed the approval of the members representing the majority of the class A governance units before he could issue additional membership units, lend, borrow, or commit WCB Holdings's funds in excess of $25,000, authorize capital expenditures in excess of $10,000, sell any of WCB Holdings's assets, including its Empak stock, worth over $10,000 in any twelve month period, or vote any securities, including its Empak stock, owned by WCB Holdings. Majority op. p. 14; emphasis added. A-83 After decedent funded, by gift, on March 15, 1997, the Children's Trust, the Grandchildren's Trust, and the QTIP Trust, each with certain class A governance units and certain class A financial units in WCB Holdings, decedent no longer owned a majority of the class A governance units in WCB Holdings, the only voting units in WCB Holdings. Thus, decedent could not have approved, and certainly could not have required, that the chief manager commit any of WCB Holdings's funds in excess of $25,000 for the purpose of redeeming the WCB Holdings class B membership interests owned by BFLP. In addition, decedent could not have approved, and certainly could not have required, that the chief manager sell to Empak, through a redemption by Empak, Empak stock owned by WCB Holdings worth over $10,000 in any 12-month period. Another factual flaw in the majority opinion's rationale relates to the conclusion that decedent had the ability to cause Empak to redeem the Empak stock owned by WCB Holdings. That conclusion disregards not only the implications of the majority opinion's finding that decedent and ISA Trust transferred their respective shares of Empak stock to WCB Holdings in order to position Empak for a liquidity event9 but also decedent's fiduciary duties as Empak's CEO and the sole member of its board of directors. Depleting Empak's assets by causing Empak to redeem the Empak stock owned by WCB Holdings in order to be able to diversify BFLP's assets through a redemption by WCB Holdings of the WCB Holdings class B membership units owned by BFLP would not have been consistent with the objective of positioning Empak for a liquidity event. Indeed, given that objective, it would have been, at best, bad business judgment on the part of decedent and a misconception by him of what was involved in positioning Empak for a liquidity event if he had decided to cause Empak to redeem the Empak stock owned by WCB Holdings in order to effect a diversification of BFLP's assets. Moreover, irrespective of the objective to position Empak for a liquidity event, any decision by decedent to deplete Empak's assets by causing Empak to redeem the Empak stock owned by WCB Holdings in order to effect such a diversification would have been, at worst, a breach by decedent of his fiduciary duties as Empak's CEO and the sole member of its board of directors. Any such decision by decedent might have been actionable by the stockholders of Empak, which, as of March 7, 1997, were: (1) WCB Holdings, a 90-percent stockholder whose class A governance unitholders, other than decedent,10 owned in the aggregate on and after March 15, 1997, a majority of the voting class A governance membership units in WCB Holdings; (2) Marubeni Corp. (MC), a 6-percent stockholder and a Japanese trading entity which had more than 700 subsidiaries and whose stock was listed on various international stock exchanges; and (3) Marubeni America Corp., a 4- percent stockholder and the U.S. sales and marketing subsidiary of MC. Cf. United States v. Byrum, 408 U.S. at 137-143. Thus, any ability of decedent to cause Empak to redeem the Empak stock owned by WCB Holdings was not unconstrained. Instead, any such ability was subject to the fiduciary duties imposed upon decedent as Empak's CEO and the sole member of its board of directors and to business and economic realities and variables over which he had little or no control and which he could ignore, but only at his peril. Cf. id. The majority opinion's rationale contains other factual flaws. According to that rationale, A-84 decedent controlled whether BFLP could transform its sole asset, the class B WCB Holdings membership units, into a liquid asset. * * * In order for BFLP to be able to diversify or take any steps other than simply holding the class B membership units, decedent would have had to cause the membership units and the underlying Empak stock to be redeemed.11 He chose not to do this. By not redeeming the WCB membership units held by BFLP, decedent insured that BFLP would not engage in asset management. Thereby, decedent exercised practical control over BFLP and limited its function to simply holding title to the class B membership units. Whether decedent caused the WCB membership units held by BFLP and the underlying Empak stock to be redeemed or not, his ability to decide if that event would occur demonstrates the understanding of the parties involved that decedent retained the right to control the units transferred to BFLP. * * * decedent's transfer to BFLP for a 99-percent ownership interest in the partnership did not alter his control of the WCB Holdings class B membership units transferred to BFLP. * * * Majority op. pp. 57-59; emphasis added. As is evident from the foregoing, the majority opinion establishes a "control" standard in applying section 2036(a)(1). However, the majority opinion never actually tells us what it means when it uses the terms "control" or "controlled" four times in the above-quoted excerpt.12 Nonetheless, under any commonly accepted meaning of those terms, it is factually incorrect for the majority opinion to conclude that "decedent controlled whether BFLP could transform its * * * class B WCB Holdings membership units * * * into a liquid asset * * * [,] exercised practical control over BFLP and * * * retained the right to control the units transferred to BFLP" and that "decedent's transfer to BFLP * * * did not alter his control of the WCB Holdings class B membership units transferred to BFLP." Majority op. pp. 57-58. After decedent and ISA Trust capitalized BFLP, which the majority opinion acknowledges was a validly created and existing partnership under Minnesota law, neither decedent nor ISA Trust had the same relationship to the respective WCB Holdings class B membership units that they transferred to BFLP. Decedent owned a limited partnership interest, and ISA Trust owned a general partnership interest, in BFLP. BFLP, in turn, owned such units transferred to it. Decedent, as a limited partner of BFLP, did not have, and did not exercise, control over BFLP, its assets, its activities, or its general partner, ISA Trust. In addition to the factual flaws in the majority opinion's rationale, that rationale is logically flawed. It is a non sequitur for the majority opinion to conclude that, because of decedent's alleged ability to cause Empak to redeem the Empak stock owned by WCB Holdings and to cause WCB Holdings to redeem the WCB Holdings class B membership units owned by BFLP, "decedent controlled whether BFLP could transform its * * * class B WCB Holdings membership units * * * into a liquid asset * * * [and] exercised practical control over BFLP". Majority op. pp. 57-58. It also is a non sequitur for the majority opinion to conclude that any such alleged ability "demonstrates the understanding of the parties involved that decedent retained the right to control the units transferred to A-85 BFLP" and that his transfer to BFLP of his WCB Holdings class B membership units "did not alter his control" of such units. Majority op. pp. 58-59. The alleged ability of decedent to cause Empak to redeem the Empak stock owned by WCB Holdings and to cause WCB Holdings to redeem the WCB Holdings class B membership units owned by BFLP does not logically lead to any of the foregoing conclusions. Nor does any such alleged ability logically lead to the majority opinion's holding that "an implied agreement existed that allowed decedent to retain the enjoyment of the property held by BFLP." Majority op. p. 59. The majority opinion's rationale is also legally flawed. The language of section 2036(a)(1)13 "plainly contemplates retention of an attribute of the property transferred -- such as a right to income, use of the property itself, or a power of appointment with respect either to income or principal." United States v. Byrum, 408 U.S. at 149. Moreover, the term "enjoyment" used in section 2036(a)(1) is not a term or art; it "connote[s] substantial present economic benefit". Id. at 145. Decedent did not retain any attribute of the WCB Holdings class B membership units that he transferred to BFLP. Nor was decedent's alleged ability to cause Empak to redeem the Empak stock owned by WCB Holdings and to cause WCB Holdings to redeem the WCB Holdings class B membership units owned by BFLP a substantial present economic benefit of such units. Any such alleged ability was not a present benefit at all; it was "a speculative and contingent benefit which may or may not * * * [have been] realized."14 Id. at 150. There simply are no circumstances surrounding decedent's transfer of his WCB Holdings class B membership units to BFLP and no subsequent use of such units by decedent from which an implied agreement may be inferred that decedent retained the enjoyment of such units. See Estate of Reichardt v. Commissioner, 114 T.C. 144, 151 (2000). Section 2036(a)(1) rejects the majority opinion's holding that decedent retained the enjoyment of the WCB Holdings class B membership units that he transferred to BFLP. With respect to Byrum the opinion states: The Supreme Court teaches us in United States v. Byrum, 408 U.S. 125 (1972), that section 2036(a)(1) (and section 2036(a)(2)) does not apply to a transfer by an individual to an irrevocable trust of shares of stock in certain corporations in which the transferor owned stock,17 where such ownership gave the transferor the ability, inter alia, to liquidate or merge such corporations and where the powers of the independent trustee of such trust were subject to the following rights expressly reserved by the transferor: (1) To vote the shares of unlisted stock held in the trust; (2) to disapprove the sale or transfer of any trust assets, including the shares transferred to the trust; (3) to approve investments and reinvestments; and (4) to remove the trustee and to designate another corporate trustee to serve as successor trustee. Id. at 126- 127. A fortiori, under the principles that the Supreme Court established in United States v. Byrum, supra, even if in the instant case decedent had the ability to cause Empak to redeem the Empak stock owned by WCB Holdings and to cause WCB Holdings to redeem the WCB Holdings class B membership units owned by BFLP, any such ability does not demonstrate, and did not result in, decedent's A-86 retention of the enjoyment of the WCB Holdings class B membership units that he transferred to BFLP within the meaning of section 2036(a)(1).18 In reaching a contrary holding, the majority opinion loses sight of, or chooses to disregard, the fact that any such ability is qualitatively different from the retention of the enjoyment (i.e., substantial present economic benefit, id. at 145) of the WCB Holdings class B units that he transferred to BFLP. See id. at 143, 145. In this connection, assuming arguendo the propriety of the majority opinion's conclusions that decedent had the ability to cause Empak to redeem the Empak stock owned by WCB Holdings and to cause WCB Holdings to redeem the WCB Holdings class B membership units owned by BFLP, any such ability does not demonstrate, and did not result in, the retention by decedent of the right to compel BFLP or ISA Trust, the general partner of BFLP, to distribute such units to or on behalf of decedent or otherwise to permit decedent to have substantial present economic benefit of such units. The majority opinion not only fails to apply section 2036(a)(1) and principles under section 2036(a) that the Supreme Count established in United States v. Byrum, supra, it also fails to apply principles established by Minnesota law regarding the fiduciary duties of the partners of partnerships and the trustees of trusts, which the majority opinion acknowledges exist.19 This is evidenced by the following passage from the majority opinion's rationale: The estate's argument that the general partner's fiduciary duties prevents a finding of an implied agreement is overcome by the lack of activity following BFLP's formation and BFLP's failure to perform any meaningful functions as an entity. We conclude that decedent's transfer to BFLP for a 99-percent ownership interest in the partnership did not alter his control of the WCB Holdings class B membership units transferred to BFLP. * * * Judge Wherry has written the first post-Bongard Tax Court opinion dealing with section 2036(a)(1) in Estate of Charles Porter Schutt v. Commissioner, T. C. Memo 2005-126. There two Delaware Business Trusts (Schutt I and Schutt II) were formed using assets from the decedent s revocable trust and various irrevocable trusts of which Wilmington Trust Company was trustee. Schutt I was funded with almost $68,000,000 in DuPont stock of which almost $31,000,000 came from the decedent s revocable trust and Schutt II was funded with almost $24,000,000 in Exxon stock of which about $11,000,000 was from the revocable trust. After the funding, the decedent owned about $30,000,000 in other assets (residences, other land, tangible personal property, and other investments). The decedent was trustee of the Delaware Business Trusts, and thus had effective control over the assets, and the net cash flow of the trusts was required to be, and was, distributed pro rata through the decedent s date of death. The issue facing the court was whether the transfer of the stock to the Delaware Business Trusts was a bona fide sale for full and adequate consideration, in which case the trust interests would be valued (presumably) at a discount, or whether the DuPont and Exxon stock itself would be included in the decedent s estate. The court A-87 reviewed many conversations, memoranda, and letters among Mr. Dinneen, a CPA in charge of the Schutt family office, Mr. Sweeney, the Schutt s attorney in private practice, Mr. Howard, an officer of Wilmington Trust Company (WTC), and others. The court summarized its findings as to the purposes of the Delaware Business Trusts as follows: The estate's position is that Schutt I and II were "formed primarily to put into place an entity to perpetuate Mr. Schutt's buy and hold investment philosophy with respect to the DuPont and Exxon stock belonging both to Mr. Schutt and to the Wilmington Trust Company Trusts." In service of this objective, Schutt I and II were aimed at "the furtherance and protection of * * * [decedent's] family's wealth by providing for the centralized management of his family's holdings in duPont [sic] stock and Exxon stock during his lifetime and to prevent the improvident disposition of this stock during his lifetime and to the extent possible after his death." The estate contends that the desired preservation of decedent's investment policy "could not be accomplished without the creation of Schutt I and Schutt II, as the WTC Trusts were scheduled to terminate at various intervals and the assets of those trusts would be distributed, free of trust, to their respective beneficiaries." Respondent's argument to the contrary is summarized as follows: (1) it was not necessary to transfer stock from Mr. Schutt's revocable trust to the business trusts to perpetuate his investment philosophy; (2) the record establishes that obtaining valuation discounts for gift and estate tax purposes was the dominant, if not the sole, reason for forming the business trusts; and (3) in any event, Mr. Schutt's desire to perpetuate his investment philosophy was itself a testamentary motive. *** The totality of the record in this case, when viewed as a whole, supports the estate's position that a significant motive for decedent's creation of Schutt I and II was to perpetuate his buy and hold investment philosophy. That decedent was in fact a committed adherent to the buy and hold approach is undisputed. His longstanding concern with disposition of core stockholdings by his descendants is also well attested. Mr. Sweeney testified that decedent "would raise, at least annually and, quite often, more than annually, his concern about the ability of children or grandchildren or whoever it might be to sell principal rather than using the income from the principal". Mr. Dinneen likewise testified that decedent expressed concern about Schutt family members' selling of stock from "Back in the early seventies and on a regular basis from there on out." The documentary record also furnishes at least a measure of objective support for the decedent's willingness to act based on these worries. In 1994, decedent declined to make annual exclusion gifts of limited partnership interests in the Schutt Family Limited Partnership to his daughter Sarah S. Harrison and her children. The estate attributes this decision to concern about the investment philosophy of these individuals, and the limited evidence does reflect 13 occasions on which DuPont or Exxon stock was sold by Harrison grandchildren from 1989 through 1997. A-88 Further corroborating the bona fides of the professed intent underlying creation of Schutt I and II is the fact that formation of the business trusts did serve to advance this goal. Respondent's contention that the business trusts were unnecessary to perpetuate decedent's investment philosophy unduly emphasizes management of the assets held by the Revocable Trust and minimizes any focus on the considerable assets held in the WTC trusts. Respondent points out that, under the Revocable Trust indenture, decedent could control investment decisions pertaining to the assets until his death, at which time various successor trusts to be administered by his son and son-in-law would be funded. Respondent argues that the situation under the business trusts was functionally equivalent, with decedent as trustee setting investment philosophy during his lifetime, followed by his son and son-in-law as successor trustees. However, by only considering the Revocable Trust assets in isolation, this analysis disregards more than half of the property involved in the business trusts. Decedent in effect used the assets of the Revocable Trust10 to enhance his ability to perpetuate a philosophy vis-a-vis the stock of the WTC trusts, such that none of the contributions should be disregarded in evaluating the practical implications of Schutt I and II. Mr. Howard testified that he did not believe he would have considered a proposal involving contribution only of the WTC trusts' assets to entities structured as were Schutt I and II, without decedent's willingness to place his own property alongside. As Mr. Howard explained: "it made real to me, certainly, when someone is willing to contribute that sum of money and tie it up the same way we were tying it up with respect to distributions, if not with respect to management, that this was something that he and the family, if they were willing to agree to it, felt strongly about." This importance of decedent's contributions to those negotiating on behalf of WTC, at least on a psychological level, reflects a critical interconnectedness between decedent's contributions and those of the WTC trusts. The effect of Schutt I and II on the assets of the WTC trusts shows that the business trusts advanced decedent's objectives in a meaningful way. Respondent's argument, however, to the extent that it takes into account the WTC assets, seeks to counter this conclusion by once again placing unwarranted emphasis on certain features or results of the structure to the exclusion of others. In discussing the alleged motive for involving the WTC trusts in the transaction, respondent states that "even if the decedent formed the business trusts to prevent his heirs from dissipating the family's wealth, this is itself a testamentary motive." More specifically, respondent dismisses the estate's contentions as follows: The decedent's testamentary motives are particularly evident in this case as it is clear that he was concerned about the dissipation of the family's wealth after his death as opposed to during his lifetime. While he was alive, he controlled the sale of stock held by his revocable trust. Similarly, as the direction or consent advisor to the bank trusts, none of the stock held by those entities could be sold without his consent. The only risk that assets held by the bank trusts could be sold without his consent was if one of his children predeceased him, thereby causing a distribution of a portion of the trust assets to that child's issue. Since his surviving children were all in good health when the business trusts were A-89 formed and the decedent was not, there is little doubt that the decedent was concerned about what would happen to the family's wealth after his death. The Court disagrees that decedent's motives may properly be dismissed, in the unique circumstances of this case, as merely testamentary. The record on the whole supports that decedent's greatest worry with respect to wealth dissipation centered on outright distribution of assets to the beneficiaries of the various WTC trusts. It is clear from the structures of the WTC trusts involved that outright distribution created the single largest risk to the perpetuation of a buy and hold philosophy, and testimony confirmed decedent's concern over a termination situation. Because none of the events that would trigger such a distribution turned on decedent's own death, to call the underlying motive testamentary is inappropriate. The court was clearly concerned about deciding that the perpetuation of a buy and hold investment strategy qualifies as a legitimate and significant non-tax reason within the meaning of Bongard. The opinion states: The Court of Appeals for the Third Circuit has in a similar vein suggested that the mere holding of an untraded portfolio of marketable securities weighs negatively in the assessment of potential nontax benefits available as a result of a transfer to a family entity. Estate of Thompson v. Commissioner, 382 F.3d at 380. As a general premise, this Court has agreed with the Court of Appeals, particularly in cases where the securities are contributed almost exclusively by one person. See Estate of Strangi v. Commissioner, T.C. Memo. 2003-145; Estate of Harper v. Commissioner, T.C. Memo. 2002-121. In the unique circumstances of this case, however, a key difference exists in that decedent's primary concern was in perpetuating his philosophy vis-a-vis the stock of the WTC trusts in the event of a termination of one of those trusts. Here, by contributing stock in the Revocable Trust, decedent was able to achieve that aim with respect to securities of the WTC trusts even exceeding the value of his own contributions. In this unusual scenario, we cannot blindly apply the same analysis appropriate in cases implicating nothing more than traditional investment management considerations. To summarize, the record reflects that decedent's desire to prevent sale of core holdings in the WTC trusts in the event of a distribution to beneficiaries was real, was a significant factor in motivating the creation of Schutt I and II, was appreciably advanced by formation of the business trusts, and was unrelated to tax ramifications. The Court is thus able to conclude in this case that Schutt I and II were formed for a legitimate and significant nontax purpose without further probing the parties' disagreement as to whether, in theory, an investment strategy premised on buy and hold should offer just as much justification for an entity premised thereon as a philosophy that focuses on active trading. As regards other factors considered indicative of a bona fide sale, these too tend to support the estate's position. The contributed property was actually transferred to Schutt I and II in a timely manner. Entity and personal assets were not commingled. Decedent was not financially dependent on distributions from Schutt I and II, retaining sufficient assets outside of the business trusts amply to A-90 support his needs and lifestyle. Nor was decedent effectively standing on both sides of the transactions. Concerning this latter point, it is respondent's position that "there were no 'arm'slength negotiations' between the decedent and the bank concerning any material matters affecting the formation and operation of the business trusts." Respondent maintains that WTC, while ostensibly an independent third party, simply represented the interests of decedent's children and grandchildren and that decedent dictated all material terms. The Court, however, is unpersuaded by respondent's attempts to downplay the give-and-take reflected in the record. As detailed in the facts recounted above and the stipulated exhibits, WTC representatives thoroughly evaluated the business trust proposals, raised questions, offered suggestions, and made requests. Some of those suggestions or requests were accepted or acquiesced in; others were not. Such a scenario bears the earmarks of considered negotiations, not blind accommodation. There is no prerequisite that arm's-length bargaining be strictly adversarial or acrimonious. Once the court found a bona fide sale, it was not difficult for it to determine that the decedent received full and adequate consideration for the transfer into the Trusts from the revocable trust because the capital accounts were properly credited and maintained. circumstances of the case. Estate of Lillie Rosen, 91 TCM 1220 (2006), decided by Judge Laro, is another case decided on bad facts but with broad, negative language. Mrs. Rosen died four years after forming a family partnership, funded almost entirely with her funds. At the time of funding she was incapacitated and the actions were taken by her family. During the four year period she made gifts of partnership interests to her family and received numerous loans that provided funds to pay her expenses. The court found that there was no non-tax purpose for the partnership and that the loans were in substance a retained interest. The court included all the partnership assets in Mrs. Rosen s estate even the proportionate amount given away. That is, because the court concluded that Mrs. Rosen retained income from all the assets in the partnership all of the assets should be included in her estate under section 2036(a)(1). This is a harsh result and was likely dictated by the bad facts. It could have been avoided either through two partnerships, one for gifts and one for retained interests, or by liquidating the donee interests after the gifts were made. The IRS has issued redacted Settlement Guidelines for family limited partnerships and family limited liability companies. The Guidelines deal with four issues: The court emphasized throughout the opinion what it termed the unique A-91 1. Whether the fair market value of transfers of family limited partnership or corporation interests, by death or gift, is properly discounted from the pro rata value of the underlying assets. 2. Whether the fair market value at date of death of I.R.C. §§ 2036 or 2038 transfers should be included in the gross estate. 3. Whether there is an indirect gift of the underlying assets, rather than the family limited partnership interests, where the transfers of assets to the family limited partnership (funding) occurred either before, at the same time, or after the gifts of the limited partnership interests were made to family members. 4. Whether an accuracy-related penalty under I.R.C. § 6662 is applicable to any portion of the deficiency. The Guidelines generally recapitulate the case-law background in a fair manner. Redacted appear to be the discounts allowed by the IRS and factors used in setting those discounts. The Guidelines begin with Background information that, conveniently, omits the government s role in creating the technique by surrendering the family attribution argument in Rev. Rul. 93-12: Background Family limited partnerships and family corporations have long been used in the conduct of active businesses, primarily to provide a vehicle for family involvement in the enterprise and for succession planning. In the early 1990's, however, estate planners began using family limited partnerships and family limited liability corporations to hold and transfer passive assets such as stock portfolios, mutual funds, bond portfolios, cash, and similar passive assets that are easily liquidated. The alleged "business" purpose for forming family partnerships or corporations with passive assets was to engage a younger generation in investment decision making. The IRS initially focused on the question of whether the family limited partnership was valid for tax purposes. Substance over form, step-transaction analysis, and lack of business purpose theories were used by the IRS to essentially set aside the transaction for estate and gift tax purposes and include the full value of the assets in determining estate or gift tax liabilities. These arguments are not always successful in litigation. As a result of some wellarticulated court decisions, there is now a set of recognized criteria that estate planners can use in establishing family limited partnerships and family limited liability corporations that head off such challenges. The IRS still raises the issue of legitimacy, however, when these criteria have not been followed. In cases where the IRS cannot successfully argue to set aside the family limited partnership's existence for tax purposes, the focus shifts to determining the correct valuation of its assets. The amount of discount to be applied to the fair market value of the assets is often a source of dispute, with taxpayers arguing A-92 that lack of marketability and minority interest factors should result in deep discounts that significantly reduce the tax base. Thus, the IRS generally considers two basic issues with family limited partnerships: the validity issue (often known as the IRC § 2036 and § 2038 issue) and the valuation issue. The issue of indirect-type gifts, where the transfers of family limited partnership interests are made before, at the same time as funding, or shortly thereafter, is also raised where facts and circumstances support it. The above should not be taken to preclude Compliance raising other arguments or legal theories that might apply to cases involving family limited partnerships or family limited liability corporations. Each case is factually unique, and interpretation of the law in this area continues to evolve. At the time of this writing Compliance has not published a coordinated issue paper. The IRS has pursued coordination of family limited partnership issues at both the Compliance and Appeals levels in response to abusive practices. Recently, taxpayers have been forming family limited partnerships and taking excessive discounts from the net asset value of the partnership. More often than not, these cases undervalue passive and/or liquid assets. In addition, there have been cases where the partnership formalities were not followed or where the donor/decedent used the family limited partnership to pay personal expenses. These practices are often tax-avoidance in nature, and therefore looked upon as tax shelters. When the practices described above clearly violate the intent of the tax law and undermine voluntary compliance, they are considered abusive. The negative impact on our tax system is manifested most immediately in estate and gift tax reporting for transactions involving family limited partnerships. But there is a carryover impact on income taxes as well. Liquidations of, or distributions from, family limited partnerships and limited liability corporations generally result in a recognizable gain subject to income tax. Frequently, however, taxpayers use the undiscounted value of the partnership interest to compute the gain, thus improperly understating the reportable income tax on the transaction. Although related to the valuation issue discussed below, the income tax implications will not be addressed in this document. Another bad facts case is Estate of Hilde E. Erickson v. Commissioner, T. C. Memo. 2007-107, that involved a partnership created by a daughter through a power of attorney when her mother had Alzheimer s and was otherwise in poor health. The opinion recites other facts as follows: Karen originally considered the possibility of forming a family limited partnership in a meeting with counsel in March or April 2001 where Chad and Karen's own financial affairs were being discussed. Karen waited to discuss the family limited partnership idea in detail with Sigrid because of the expense of calling Russia to speak with her sister. Instead, Karen suggested the idea to her sister briefly in an e-mail. When Sigrid visited her family in Minnesota for Mrs. A-93 Erickson's hip replacement surgery in 2001, Sigrid and Karen met with counsel together to talk about a family limited partnership. Karen also discussed the concept with Mrs. Erickson, but not the financial aspects of the transaction in any detail. The parties signed the limited partnership agreement creating the Partnership in May 2001. Karen acted on behalf of her mother and herself and as co-trustee of the credit trust in forming the Partnership. The same law firm represented all of the parties to the limited partnership agreement although Sigrid informally mentioned the idea to an attorney friend of hers. Sigrid admitted that she did not understand the particulars of the transaction. She was aware, however, that a family limited partnership would have estate tax advantages due to valuation discounts that apply to the partnership interests. The limited partnership agreement provided that Karen and Sigrid were both general partners and limited partners. Mrs. Erickson (acting through Karen as her attorney-in-fact), Chad, and the trustees of the credit trust (Karen and Sigrid) were limited partners. Karen signed the limited partnership agreement in multiple capacities. She signed in her personal capacity as well as co-trustee of the credit trust and as attorney-in-fact for Mrs. Erickson. The limited partnership agreement provided that Mrs. Erickson would contribute securities plus a Florida condominium she owned in exchange for an 86.25percent interest in the Partnership. The parties stipulated that the fair market value of these assets Mrs. Erickson contributed was approximately $2.1 million. The limited partnership agreement also provided that Karen would contribute two partial interests in a Colorado investment condominium she and Chad owned in exchange for a general partnership interest and a limited partnership interest, representing 1.4 percent of the Partnership in the aggregate. Sigrid would contribute two partial interests in a Colorado investment condominium she owned in exchange for a general partnership interest and a limited partnership interest, representing 2.8 percent of the Partnership in the aggregate. Chad would contribute a partial interest in the Colorado condominium he and Karen owned in exchange for a 1.4-percent limited partnership interest. The total of Chad and Karen's contributions equaled a 100-percent interest in the Colorado condominium they jointly owned. Finally, the limited partnership agreement also provided that the credit trust would contribute a Florida condominium in exchange for an 8.2-percent limited partnership interest. The credit trust did not contribute any of the $1 million in marketable securities it owned to the Partnership. Both Karen and Sigrid were aware that there were no estate tax concerns regarding the assets in the credit trust unlike the estate tax concerns they had regarding Mrs. Erickson's personal assets. Instead, Karen and Sigrid would receive the credit trust assets free of estate tax after Mrs. Erickson's death. They thus opted to leave the credit trust securities outside the Partnership. Transfer of Assets to the Partnership A-94 Although the limited partnership agreement contemplated that the partners' assets would be contributed to the Partnership concurrently with the signing of the limited partnership agreement, no transfers to the Partnership occurred upon execution of the agreement. Karen took care of some administrative matters first, such as obtaining a certificate of limited partnership from the State of Colorado and applying for an employer identification number. The certificate of limited partnership listed a Snowmass Village, Colorado, address for service of process, an address that had no mail delivery. No transfer of assets to the Partnership began for about 2 months. Karen instructed Merrill Lynch to transfer all of Mrs. Erickson's assets it held, totaling over $1 million in securities, to the Partnership's account in July 2001. Karen also instructed Wells Fargo to transfer over $500,000 of Mrs. Erickson's assets it held to the Partnership's account. No other transfers occurred before Karen went to visit Sigrid in Moscow in September 2001, other than the execution of quitclaim deeds relating to the Colorado investment condominiums. Mrs. Erickson's Failing Health and the Remaining Partnership Transfers When Karen returned from her Moscow trip, she visited her mother and noticed that Mrs. Erickson was not feeling well. Karen took Mrs. Erickson to the hospital on September 27, 2001. Mrs. Erickson was suffering from a decreased level of consciousness and pneumonia. The pneumonia did not appear to be improving, and the family decided to opt for medical care to simply keep Mrs. Erickson comfortable in accordance with her wishes. The following day, September 28, 2001, while Mrs. Erickson's health was failing, Karen scrambled to make transfers. Karen, acting on behalf of Mrs. Erickson, executed a deed transferring Mrs. Erickson's Florida condominium unit to the Partnership. Karen, acting as co-trustee of the credit trust, also signed a trustee's deed transferring the Florida condominium unit the credit trust owned to the Partnership the same day. Karen, on behalf of Mrs. Erickson, then finalized gifts to Mrs. Erickson's grandchildren by giving limited partnership interests in the Partnership to three trusts for the grandchildren's benefit (the grandchildren's gifts). These gifts reduced Mrs. Erickson's 86.25-percent interest in the Partnership to only a 24.18-percent interest. Karen called Sigrid in Moscow on September 28 to tell her that their mother's health was failing. Sigrid arrived in Minnesota from Russia on September 29, 2001. Mrs. Erickson died the following morning. Shortly before she died, Karen, acting as attorney-in-fact, transferred over $2 million of Mrs. Erickson's assets to the Partnership and then substantially reduced Mrs. Erickson's partnership interest by making the grandchildren's gifts. Most of the retained personal assets, including the substantially reduced retained partnership interest, were illiquid. Operation of the Partnership and Partnership Transactions A-95 The family continued to operate the Partnership after Mrs. Erickson's death. The condominiums in Florida and Colorado were managed by the same onsite management companies both before and after they were contributed to the Partnership. The management companies were responsible for the day-to-day work such as booking reservations, checking in guests, cleaning the units, and responding to emergencies. The marketable securities the Partnership held continued to be managed by investment advisers at Wells Fargo and Merrill Lynch after they were contributed to the Partnership. The Partnership has explored investment opportunities in real estate and has bought and sold some securities. Over time, the Partnership has become less invested in bonds and more heavily invested in real estate. The Partnership has made three loans, two of which were to its partners. The Partnership lent $140,000 to Sigrid to enable her to purchase a Florida condominium in her individual capacity. The Partnership did not take a security interest in the condominium but accepted Sigrid's partnership interest as collateral. When Sigrid learned that she could receive a more favorable interest rate from a different lender, she brought this to the Partnership's attention, and the Partnership agreed to reduce the interest rate on Sigrid's loan. Sigrid, acting as general partner of the Partnership, approved both the original loan to herself and the subsequent rate reduction. The Partnership also lent Chad $70,000. Sigrid and Chad each repaid the loans timely. The court found the delay in funding the partnership to be troubling, as well as its operation, and found no non-tax motive: We are troubled by the delay in transferring the assets to the Partnership. The delay suggests that the parties did not respect the formalities of the Partnership. Specifically, the partnership agreement provided that the partners would contribute assets concurrently with the execution of the partnership agreement, yet no assets were transferred then; many transfers occurred only 2 days before Mrs. Erickson died. Although the Partnership had separate accounts from its partners, the record reflects that the partners were in no hurry to alter their relationship to their assets until decedent's death was imminent. The Partnership also had to provide the estate with funds to meet its liabilities. This fact is telling in two respects. First, disbursing funds to the estate is tantamount to making funds available to Mrs. Erickson (or the estate) if needed. Second, although the estate designated the funds disbursed to the estate as a purchase of Mrs. Erickson's home and a redemption of units rather than a distribution, the estate received disbursements at a time that no other partners did. These disbursements provide strong support that Mrs. Erickson (or the estate) could use the assets if needed. Finally, the Partnership had little practical effect during Mrs. Erickson's life, particularly because the Partnership was not fully funded until days before she died. Indeed, the Partnership was mainly an alternate method through which Mrs. Erickson could provide for her heirs. Karen, acting on behalf of Mrs. Erickson, transferred substantial amounts of her partnership interests in making A-96 the grandchildren's gifts 2 days before she died. Moreover, Mrs. Erickson had been in declining health for some time. She was diagnosed with Alzheimer's disease in March 1999 and died at age 88 after a period of declining health and physical problems. Although no one factor is determinative, these facts and circumstances, when taken together, show that an implied agreement existed among the parties that Mrs. Erickson retained the right to possess or enjoy the assets she transferred to the Partnership. The transaction represents decedent's daughters' last-minute efforts to reduce their mother's estate's tax liability while retaining for decedent the ability to use the assets if she needed them. *** We now examine both the estate's asserted nontax purposes for forming the Partnership and the objective facts. While Sigrid admitted at trial that the estate tax advantage of obtaining a decreased fair market value of Mrs. Erickson's assets was certainly a motivating factor, the estate asserts several possible nontax reasons for forming the Partnership. First, the estate argues that forming the Partnership allowed the family to centralize the management of the family assets and give the management responsibilities to Karen. We note, however, that Karen already had significant management responsibilities with respect to family assets before the Partnership was formed. In fact, Karen had held Mrs. Erickson's power of attorney since 1987. It is not clear from the record what advantage the family members believed they would receive through another layer of "centralized management" of these assets.5 Second, the estate argues that the Partnership afforded greater creditor protection. A creditor who sought funds from the Partnership, however, would have a significant asset base from which to recover from the Partnership, over $2 million. Finally, the estate argues that the Partnership facilitated Mrs. Erickson's gift-giving plan. Facilitating a gift-giving plan is not a significant nontax purpose. See Estate of Rosen v. Commissioner, supra. We find none of the estate's asserted nontax purposes for forming the Partnership compelling. Moreover, the facts and circumstances surrounding the transaction also fail to show any nontax purpose for the Partnership. The Partnership was mainly a collection of passive assets, primarily marketable securities and rental properties that remained in the same state as when they were contributed. In addition, the same investment advisers and property managers managed the assets both before and after the transfers to the Partnership. The estate highlights the slight shift in the Partnership's investment allocation from bonds to real estate as proof that the partners made deliberate, businesslike investment decisions. We cannot discern, however, any business goals or any particular reasons for the Partnership to invest in certain assets. We note also that the Partnership made loans to family members and, indeed, in at least one instance, even lowered an interest rate that a partner had previously agreed to pay. We find that the Partnership was a mere collection of mostly passive assets intended to assist Mrs. Erickson's tax planning and benefit the family. A-97 While Karen and Sigrid discussed the Partnership before it was formed, the circumstances suggest that the Partnership was essentially formed unilaterally, with Karen controlling the transaction. Sigrid admitted at trial that she did not understand the particulars of the transaction, nor is there any credible evidence that Mrs. Erickson understood the transaction. Karen was on every side of the transaction. She acted as attorney-in-fact for her mother, she was the personal representative of her mother's estate, she was both a general partner and a limited partner in the Partnership in her individual capacity, and she was a co-trustee of the credit trust, which was also a partner in the Partnership. Moreover, the same law firm represented all parties to the transaction. While retaining counsel to assist in an important transaction is entirely appropriate, the fact that no family member was represented by different counsel also suggests a unilateral approach to the transaction.6 Another key fact indicating that no significant nontax purpose existed was the delay in contributing assets to the Partnership. The need to manage Mrs. Erickson's assets existed early. Karen had been assisting her mother for years with her financial affairs. Despite the need to assist Mrs. Erickson, the partners did not immediately fund the Partnership when they executed the partnership agreement. Meanwhile, Mrs. Erickson's health continued to decline. It was only after Mrs. Erickson had been admitted to the hospital with pneumonia, two days before she died, that the partners finally completed their transfers. While we acknowledge that a few months' delay is not a long time in absolute terms, the months' delay here was significant as it came as Mrs. Erickson's health was declining and ultimately resulted in the family members' finalizing the transfers to the Partnership while Mrs. Erickson was dying in the hospital. The haste with which they were able to transfer the assets shortly before Mrs. Erickson died belies the estate's argument that the parties needed time to transfer their assets and the delay was out of the partners' control. Despite Mrs. Erickson being an octogenarian in declining medical health, the parties waited until the prospect of her death loomed to finish the transaction and make sure the partnership affairs were in order. The estate was financially dependent on the Partnership and needed approximately $200,000 to help pay its liabilities. We are unpersuaded by the estate's arguments that Mrs. Erickson's death was unforeseen and a decline in the stock market caused her assets to decrease in value. The record reflects that insufficient assets were left to allow the estate to pay its debts. We acknowledge that the Partnership characterized the disbursements of funds to the estate as a purchase of Mrs. Erickson's home and redemption of some of the estate's partnership interests. The form of the transaction, however, is not controlling. Moreover, the record does not reflect that the Partnership and the estate would have engaged in these transactions absent the estate's need for funds. Mrs. Erickson's age and health at the time of the transaction strongly indicate that the transfers were made to avoid estate tax. Mrs. Erickson was 88 years old when the parties formed the Partnership in 2001 and had been suffering from Alzheimer's disease for several years. Mrs. Erickson was by then unable to handle her own financial affairs, was no longer cooking for herself or driving, had difficulties recalling family members, and was disoriented regarding the date, time, or place. Mrs. Erickson's age and declining health weigh against a A-98 finding that the parties formed the Partnership for any reason other than to help reduce Mrs. Erickson's estate tax liability. Interestingly, Mrs. Erickson really did not require partnership distributions for her living expenses during her lifetime. On the other hand, her estate did not have sufficient liquidity to pay transfer taxes at her death and the Court seized on this feature in finding a retained interest by Mrs. Erickson. If arrangements had been made, not using the partnership assets, would there have been a different result. In Estate of Virginia A. Bigelow et al. v. Commissioner, 503 F.3d 955 (9th Cir. 2007), the court affirmed the Tax Court and held that real property transferred by a decedent to a family limited partnership was includable in the gross estate because the decedent and her children had an implied agreement that she would retain economic rights and benefits from the property. The opinion states: Applicability of § 2036(a)(1) turns on whether "there is an express or implied agreement at the time of transfer that the transferor will retain lifetime possession or enjoyment of, or right to income from, the transferred property." Thompson, 382 F.3d at 375. The existence of an implied agreement is a question of fact reviewed for clear error. See Estate of Korby v. Comm'r, 471 F.3d 848, 852 (8th Cir. 2006). "In reviewing for clear error, we ask only whether the Tax Court's findings are supported by evidence in the record as a whole, not whether we would necessarily reach the same conclusions." Strangi, 417 F.3d at 480. The Tax Court found that there was an implied agreement between decedent and the Bigelow children that decedent would retain income and the benefit of using the Padaro Lane property to secure her debt. As to the retained income, the Tax Court explained: After the partnership was formed, decedent used $2,000 of the $2,150 net income from the rental of the Padaro Lane property to make monthly payments on the Great Western loan. After the AARP/Prudential residential care insurance policy expired in August 1995, decedent's expenses exceeded her income by $2,700. The partnership continued to make the $2,000 payments on the Great Western loan, and Mr. Bigelow transferred partnership funds to decedent's trust to support decedent. No distributions were made to any other partner before decedent's death. Bigelow v. Comm'r, 89 T.C.M. (CCH) 954, 959-60 (2005). As to the decedent's retention of the Padaro Lane property as security for her personal debt, the Tax Court found: After the transfer of the Padaro Lane property to Spindrift, the property continued to secure decedent's legal obligation to pay the $350,000 Great Western Bank loan and the $100,000 Union Bank line of credit. Thus, decedent retained the economic benefit of ownership of the Padaro Lane property after it was transferred to the partnership. A-99 Id. at 960. The Estate disputes the Tax Court's first finding, arguing that decedent did not receive income in the form of debt cancellation or otherwise because under the partnership agreement each debt payment toward the principal was reduced from decedent's share in Spindrift and shifted to the other partners. The Estate disputes the Tax Court's second finding, claiming that Spindrift assumed a "practical liability" for the Great Western loan, even though the decedent remained personally liable for this debt and the Union Bank line of credit. The Estate rests its theory of practical liability on two grounds. The Estate first contends that under the Deed of Trust, the trust assigned rental income from the Padaro Lane property to Great Western as additional collateral for the loan; and second that the transfer of the Padaro Lane property to Spindrift carried with it a practical obligation to meet the loan repayment schedule with the rental income to avoid foreclosure. The Commissioner responds that the practical necessity that Spindrift repay the debt is evidence itself of an implied agreement that the Bigelow children would supplement decedent's financial needs because decedent's transfer of her main asset, while retaining the indebtedness secured by it, would have left her unable to meet her monthly expenses without resort to partnership funds. [4] We agree with the Commissioner. A key problem with the conveyance of the Padaro Lane property to Spindrift is, for estate tax purposes, that the Great Western and Union Bank debt that was secured by the property was not also transferred. This discrepancy indicates that Spindrift repaid the debt in decedent's stead despite no legal obligation to do so. Because Spindrift used funds to make these payments of debt that were derived from income on the property decedent had purported to transfer to Spindrift, it supports the Commissioner's position that decedent retained an interest in the property. In an effort to deflect the significance of decedent's legal obligation to repay her debt, the Estate argues that it had a "practical liability" to make the $2,000 monthly payment purportedly to avoid foreclosure. But whether or not Spindrift had any practical need to make monthly payments does not undercut the finding that decedent retained the economic benefit from the transferred property. [5] As to the Estate's second theory, the Tax Court also did not clearly err in finding an implied agreement, in light of the entire record, that decedent was to receive income from the Padaro Lane property. Bigelow testified that his mother, the decedent, wanted her initial contribution of the property, and any potential gifted partnership shares "to be free and clear of the debt . . . -- she felt it was her responsibility to keep . . . those obligations." As a practical matter, however, decedent shifted her responsibility to the partnership. First, assuming arguendo the propriety of debiting decedent's capital account post mortem to reflect the extent to which these payments went toward the principal of the Great Western loan, Bigelow testified before the Tax Court and conceded at oral argument that any payment toward the loan interest was not similarly debited. Bigelow also testified that interest payments consumed the majority of each payment. In light of this concession, it is clear that decedent received income each month -slightly less than $2,000 according to the Estate's testimony -- because Spindrift paid the interest on the loan that she was legally obligated to pay, and in this A-100 sense decedent retained an interest in the property that decedent had purported to transfer to Spindrift. The record also supports the Tax Court's finding that decedent received piecemeal income to supplement her financial needs. In the absence of an expectation that the partnership would supplement decedent's monthly income as necessary, the transfer of the Padaro Lane property -- her major asset -- would have impoverished decedent and left her vulnerable to monthly shortfalls. The Bigelow children knew that the decedent's long-term care coverage was of fixed duration -- the AARP/Prudential residential care insurance policy was set to expire in August 1995 and the Fireman's Fund/American Express policy in August 1996 -- with the foreseeable possibility that decedent might outlive the coverage. In this event, decedent stood to lose $3,600 per month after the expiration of the second policy in August 1996. Yet both Bigelow and Burke testified that they were unwilling to pay for their mother's care out of their own funds. This testimony supports the Tax Court's finding. In the foreseeable absence of other funds, and the fact that decedent received a $1,500 "loan" in July 1997 and Spindrift advanced $2,000 after decedent's death to cover funeral expenses, it is a reasonable inference that the Bigelow children and decedent had an implied agreement that decedent could access funds as needed that were derived from the Padaro Lane property. The Bigelow children also testified that as the expiration of the Fireman's Fund/American Express policy in August 1996 approached, the Bigelow children began taking steps to put the Padaro Lane property on the market to liquidate the asset and have funds available to cover the decedent's living expenses. In fact, Burke testified that because she would not pay decedent's additional expenses out of her own pocket, she viewed liquidation of decedent's Spindrift shares through sale of the house as the only option. The Bigelow children also testified that they were committed to their mother's care and maintaining her in a manner to which she was accustomed. This testimony suggests that the decedent's need of funds, rather than other unrelated business criteria that might have informed partners operating at arm's length, drove Spindrift's decision after August 1996 to consider liquidating the asset. The Tax Court's finding that partnership formalities were not observed buttresses the conclusion that there was an implied agreement. Bigelow testified that the partnership accounts were not regularly re-balanced to reflect the monthly $2,000 payments toward the Great Western debt that Spindrift made for decedent. The Estate relies on a provision in the partnership agreement that Spindrift funds could be used "to retire any of the principal of the Contribution Debt (at the time of the sale of the Property, or, otherwise)" to suggest that the partners' capital accounts could have been re-balanced after the sale of the Padaro Lane property in compliance with partnership formalities. Reliance on this provision in the partnership agreement is unavailing. It is inconsistent that decedent's capital account was duly debited in annual updates to reflect the yearly gifts made to children and grandchildren between 1994 and 1997, yet a similar annual update was not implemented to reflect the payments of the Great Western debt during the same period. Moreover, no other partner benefited from such an informal and ad hoc access to partnership funds. Finally, the post mortem accounting indicates that the decedent and FLP had an implied A-101 agreement that decedent could access income from the transferred asset. See Estate of Reichardt v. Comm'r, 114 T.C. 144, 155 (2000) (finding "year-end and . . . post mortem adjusting entries made by [a certified public accountant] were a belated attempt to undo decedent's commingling of partnership and personal accounts"). *** [8] We agree with the Third and Fifth Circuits and the Tax Court that an inter vivos transfer of real property to a family limited partnership, which inherently reduces the fair market price of the resultant partnership interests, does not per se disqualify the transfer from falling under § 2036(a)'s exception. As the qualifying language in all the cases suggests, however, the Estate must demonstrate more than a proportional exchange between $1,450,000 fair market value and 14,500 B Units valued at $100. To avoid the reach of § 2036(a), the Estate must also show the "genuine" pooling of assets, see Harper v. Comm'r, 83 T.C.M. (CCH) 1641, 1654 (2002), and a "'potential [for] intangibles stemming from pooling for joint enterprise,'" Thompson, 382 F.3d at 381 (alteration in original) (quoting Harper, 83 T.C.M. at 1654). The validity of the adequate and full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in making the bona fide transfer inquiry. [9] In this context, we consider the "bona fide sale" and "adequate and full consideration" elements as interrelated criteria. See Estate of Bongard v. Comm'r, 124 T.C. 95, 118-19 (2005) ("In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant non-tax reason for creating the family limited partnership, and the transferors received partnership interests proportionate to the value of the property transferred."). But see Strangi, 417 F.3d at 478 (treating § 2036(a) exception as having two "discrete requirements"). *** As discussed supra, Spindrift did not assume the Great Western debt when decedent's trust conveyed to Spindrift the Padaro Lane property, yet the partnership nonetheless made monthly payments for decedent. Although the Estate argues that Spindrift had a "practical liability" to make the $2,000 monthly payment (purportedly to avoid foreclosure), that does not erase the fact that when the trust transferred the property decedent did not, as a legal matter, receive adequate and full consideration in light of her assumption of the debt. Conversely, that the Estate repaid the debt gratuitously suggests that the transfer without the debt would have impoverished her and that any anticipated shortfall could not be remedied absent an implied agreement that Spindrift would supplement decedent by servicing her debt. [12] As to the Tax Court's second finding, any attempt to treat other disbursements as "loans" is unpersuasive because the partnership formality of proper accounting was not adequately observed in re-balancing the partners' capital accounts to reflect the disbursements. As discussed supra, the Estate's A-102 post mortem debiting of decedent's account is insufficient in the face of evidence of an implied agreement. See Reichardt, 114 T.C. at 155. Finally, the Estate argues that the Tax Court clearly erred in not recognizing that Spindrift had non-tax-related benefits. First, the Estate argues that a partnership shielded the included family members from personal liability for any injuries occurring on the Padaro Lane property, whereas as tenants in common they would have been exposed. This argument is unsupported by the record. The Tax Court correctly found that the partnership provided no liability protection to decedent because her trust was both a limited partner and a general partner. Also, there was no evidence that any of Spindrift's partners reasonably faced any genuine exposure to liability that might have validated the partnership formation for a non-tax purpose. *** Finally, we evaluate these arrangements through the heightened scrutiny of intrafamily transactions. While FLPs are not vehicles to circumvent estate tax liability per se, see Kimbell, 371 F.3d at 263, we consider whether "the terms of the transaction differed from those of two unrelated parties negotiating at arm's length." Bongard, 124 T.C. at 123. Here, it is improbable that two persons operating at arm's length would either assume that debt repayment would occur due to a "practical liability," or that interest-free "loans" between partners would not be memorialized in a promissory note or accompanied by prompt adjustment to the partners' capital accounts. Moreover, the fact that decedent retained personal liability for $439,062 in debt secured by the transferred asset further supports the Tax Court's finding that the parenthetical exception to § 2036 did not apply for lack of adequate and full consideration for the Padaro Lane property. Judge Laro wrote the Tax Court opinion in Estate of Concetta H. Rector et al. v. Commissioner, T.C. Memo. 2007-367 which is appealable to the Ninth Circuit. Mrs. Rector died at age 95 with two sons, John and Frederic, having formed a family partnership at age 92 a few months after moving into a nursing home. The opinion states: 5. Plans To Create a Limited Partnership Among decedent, John Rector, and Frederic Rector, John Rector was the first to consider forming a limited partnership to which to transfer decedent's assets. John Rector learned of the idea from Ed Anderson (Anderson), an attorney who had created a trust for John Rector and his wife and had amended decedent's 1991 revocable trust agreement. Anderson advised John Rector that such a limited partnership would allow decedent to give limited partner interests to her sons and grandchildren, protect her assets from her creditors, and significantly reduce the value of her gross estate through discounts for lack of marketability and lack of control. John Rector discussed Anderson's advice with decedent and Frederic Rector, and decedent and her sons decided to pursue the idea. A-103 On September 3, 1998, John Rector met with Anderson and two of Anderson's colleagues to discuss forming a limited partnership to which to transfer decedent's assets.3 Afterwards, John Rector met with decedent and Frederic Rector, and the three of them discussed using a limited partnership to save Federal estate tax, to allow decedent to give limited partner interests to her sons, to diversify her assets, and to protect her assets from the reach of her creditors. Decedent and her sons decided to form RLP without any negotiation over the terms of a partnership agreement. The three of them intended for decedent to contribute to RLP all assets she held in the 1991 revocable trust, for no one else to make any other contribution to RLP, for decedent to give limited partner interests in RLP to each of her sons, and for decedent to value the gifts at significantly less than the proportionate value of RLP's assets. In order to structure the partnership and draft the agreement (RLP agreement), John Rector met with the attorneys in person, Frederic Rector conversed with the attorneys by telephone, and decedent corresponded with the attorneys. The attorneys believed that they represented decedent in this process, but neither of decedent's sons had separate counsel as to the formation of RLP or as to the structuring and drafting of the RLP agreement. 6. Formation of RLP and Gifts of Partnership Interests The RLP agreement was executed on December 17, 1998.4 Under the terms of the agreement, decedent was a 2-percent general partner in RLP and the 1991 revocable trust was a 98-percent limited partner in RLP. John Rector was listed in the RLP agreement as a 0-percent general partner, but he was not in fact a general partner.5 *** On March 9, 1999, approximately 3 months after RLP's formation, RLP was funded by decedent's transfer from the 1991 revocable trust of $174,259.38 in cash and $8,635,082.77 in marketable securities. By virtue of this transfer, the 1991 revocable trust was left with no significant asset other than the 98-percent limited partner interest received in exchange for the transfer of the cash and marketable securities. At the time of the transfer, the Trust B assets were worth approximately $2.5 million. Decedent's entitlement to income from Trust B was $47,439.12 for 1999. In March 1999, decedent gave each of her sons, through her revocable trust, an 11.11-percent limited partner interest in RLP. Approximately 2 years later, on January 2, 2001, decedent assigned to the 1991 revocable trust her 2-percent general partner interest in RLP. On January 4, 2002, decedent's trust transferred a 2.754-percent limited partner interest in RLP to each of her sons. When she died, decedent (through the 1991 revocable trust) owned a 70.272-percent limited partner interest in RLP and a 2-percent general partner interest in RLP. 7. Operation of RLP A-104 RLP operated without a business plan or an investment strategy, and it did not trade or acquire investments. RLP also issued no balance sheets, income statements, or other financial statements. RLP's partners did not hold formal meetings. RLP functioned to own investment accounts, to make distributions to partners, and to pay decedent's personal expenses (directly during 1999 and indirectly in later years). RLP maintained monthly statements of investment account activity, including distributions, and a handwritten check register for payments. Statements of activity and capital accounts were not regularly maintained. The court had no difficulty concluding section 2036(a) would apply: The estate contends that there was neither an express nor an implied agreement for decedent to retain possession, enjoyment, or the right to income from the assets that she transferred to RLP. We disagree. We find on the basis of the credible evidence at hand that decedent and her sons had an implied understanding that decedent would retain enjoyment and the right to income from the transferred assets.8 The RLP agreement reflects an understanding among decedent and her sons that decedent would retain her interest in the transferred assets by virtue of her ability to control those assets, including the management and disposition thereof. Initially, as the direct general partner of RLP, decedent was given the right by the RLP partnership agreement to cause a distribution of RLP's net cashflow to RLP's partners in proportion to their partnership interests, and she was given the power "to do anything reasonably connected" with RLP's assets. Later, as an indirect (through the 1991 revocable trust) general partner of RLP, decedent continued to retain that right and power directly in that she was a cotrustee of the 1991 revocable trust and, most importantly, she had the absolute power to revoke the trust as if it had never been created in the first place. Thus, at all relevant times, decedent held both a majority interest in RLP and the powers incident to serving as RLP's general partner. We also find as a fact that decedent and her sons agreed impliedly that the transferred assets and the income earned therefrom would continue to be used for decedent's pecuniary benefit. The transfer of practically all of decedent's wealth to RLP left decedent with insufficient liquid assets with which to pay her living expenses. The estate asserts that decedent's assets were sufficient because Trust B had a corpus of $2.5 million at the time of the transfer and decedent's sons, as cotrustees, could distribute Trust B's corpus to pay decedent's expenses. The estate's argument is unavailing. When RLP was formed, decedent and her sons knew that decedent's annual income from Trust B, which for 1998 was $44,481, would be insufficient to cover decedent's annual expenses of approximately three times as much. Decedent had just become a full-time resident at the Hospital, where her residence resulted in medical costs totaling $71,788 for 1999, $78,114 for 2000, and $94,822 for 2001. Decedent and John Rector also directly drew over $77,000 in funds from RLP during 1999 to pay decedent's personal expenses. The estate attempts to downplay the significance of the direct use of RLP funds to pay decedent's personal expenses by attributing A-105 that use to "errors". In the light of John Rector's extensive financial expertise and his testimony that it never occurred to him that RLP should be reimbursed for such "errors" after they were discovered, we find that this argument lacks credibility. We also note that the Trust B agreement allowed the cotrustees to pay to decedent amounts of trust principal necessary for her "care and comfortable support in * * * her accustomed manner of living". The implied understanding among decedent and her sons was that the assets of RLP would be readily used to meet decedent's expenses and that the corpus of Trust B would not be invaded. We conclude that the principal of Trust B was not available in any significant sense to decedent to pay her living expenses. In fact, decedent never even asked her sons to distribute Trust B principal to her when her monthly income was insufficient to cover her expenses; rather, decedent relied heavily on the assets she had transferred to RLP and the income earned therefrom.9 In sum, we conclude that decedent impliedly retained enjoyment of and the right to income from the assets that she transferred to RLP. Decedent derived economic benefit from using RLP's assets to pay her living expenses, to meet her tax obligations, and to make gifts to her family members. Such use of RLP's assets shows an agreement among decedent and her sons that decedent would retain the enjoyment of and the right to income from the transferred assets by withdrawing those assets and/or income from RLP at will. Similarly, the court held that the funding of the partnership was not a bona fide sale for adequate and full consideration: First, the formation of RLP entailed no change in the underlying pool of assets or the likelihood of profit. Without such a change or a potential for profit, decedent's receipt of the partnership interests does not constitute the receipt of full and adequate consideration. See Estate of Bongard v. Commissioner, 124 T.C. 95, 128-129 (2005); see also Estate of Bigelow v. Commissioner, 503 F.3d 955 (9th Cir. 2007). Second, to constitute a bona fide sale for adequate and full consideration, decedent's transfer of the assets to RLP must have been made in good faith. See sec. 20.2043-1(a), Estate Tax Regs. For this purpose, good faith requires that the transfer be made for a legitimate and significant nontax business purpose. See Estate of Bongard v. Commissioner, supra at 118; Estate of Rosen v. Commissioner, T.C. Memo. 2006-115. A transaction between family members is subject to heightened scrutiny to ensure that the transaction is not a disguised gift. See Estate of Bigelow v. Commissioner, supra at 969; Harwood v. Commissioner, 82 T.C. 239, 258 (1984), affd. without published opinion 786 F.2d 1174 (9th Cir. 1986). With respect to good faith in transactions between family members, this Court has considered whether "the terms of the transaction differed from those of two unrelated parties negotiating at arm's length." Estate of Bongard v. Commissioner, supra at 123. The parties' actions during the formation of RLP contrast starkly with those that would be anticipated from unrelated parties A-106 forming a limited partnership. Decedent and her sons did not negotiate the terms of the RLP agreement, and they did not retain independent counsel. Decedent (through her revocable trust) made all contributions to RLP, and her contributions constituted the vast bulk of her wealth. RLP was formed with decedent and her revocable trust as the only partners. RLP was not actually funded until nearly 3 months after it was formed. We also note that the RLP partnership agreement contemplated that more than one partner would contribute property to RLP but that decedent and her sons never intended that anyone other than her (or her, through her revocable trust) would actually contribute property to RLP. As to the need for a significant nontax business purpose, we inquire whether the transfer of assets to RLP was reasonably likely to serve such a purpose at its inception. See Strangi v. Commissioner, 417 F.3d 468, 480 (5th Cir. 2005), affg. T.C. Memo. 2003-145. The estate asserts that the motivation behind the formation of RLP was the desire to benefit from estate tax savings, the ability to give away partnership interests, the need to protect decedent's assets from her creditors, and the desire to diversify decedent's assets. We disagree with the estate that decedent had the requisite purpose when she transferred her assets to RLP. The estate's stated goal of gift-giving is a testamentary purpose and is not a significant nontax business purpose. See Estate of Bigelow v. Commissioner, supra; see also Estate of Schauerhamer v. Commissioner, T.C. Memo. 1997-242. Nor is the estate's stated goal of efficiently managing assets such a purpose, given the lack of evidence that RLP required any special kind of active management. See Estate of Bigelow v. Commissioner, supra. The protection of assets against creditors also is not such a purpose in that the record does not establish any legitimate concern about the liabilities of decedent, nor did decedent's transfer of her assets to RLP actually protect the assets from her creditors in that she or her trust was at all times an RLP general partner. See id. The estate's stated claim to a diversification of assets also is not such a purpose in that RLP's ownership and management of the transferred assets was essentially identical to the 1991 revocable trust's pretransfer ownership and management of those assets. We also note that RLP had no investment strategy or business plan of providing added diversification of investments; rather, RLP held the securities transferred by decedent without any substantial change in investment strategy and did not engage in business transactions with anyone outside of the family.10 See Estate of Thompson v. Commissioner, 382 F.3d at 378 (partnership lacked substantial nontax purpose under similar facts). Given these findings and conclusions, and our additional findings as to decedent's age and health at the time of RLP's formation, as well as the fact that only decedent's cash and marketable securities were contributed to RLP, we conclude that the formation of RLP was more consistent with an estate plan than an investment in a legitimate business. Id. at 377; see also Estate of Rosen v. Commissioner, supra. Estate of Mirowski v. Commissioner, T. C. Memo 2008-74, decided by Judge Chiechi, is similar to Schutt in that once the court determined that the family limited liability company had a bona fide business purpose a favorable decision for the taxpayer was easy to reach. Mrs. Mirowski s husband had invented the automatic implantable cardioverter defibrillator - - a pacemaker. He died in 1990 leaving the patents from the pacemaker to Mrs. Mirowski. In 1992 she gave 7% of the patents to irrevocable trusts for her daughters and in 2001, after A-107 considering the plan for a year or so, she formed Mirowski Family Ventures L.L.C. (MFV), funding it with the patents and $62,000,000 in marketable securities. Immediately thereafter, on September 7, 2001, she gave 16% of MFV to the irrevocable trusts for her daughters leaving Mrs. Mirowski with 52%. On September 11, 2001 she died unexpectedly at the age of 73 from sepsis caused by a foot ulcer. The IRS argued for inclusion of all MFV assets in the estate. The opinion states: It is the position of decedent's estate that Ms. Mirowski's transfers to MFV were bona fide sales for adequate and full consideration in money or money's worth under section 2036(a). In support of that position, decedent's estate contends that Ms. Mirowski had legitimate and substantial nontax purposes for forming, and transferring assets to, MFV, that Ms. Mirowski received an interest in MFV proportionate to the value of the assets that she transferred to it, that Ms. Mirowski's capital account was properly credited with those assets, and that, in the event of a liquidation and dissolution of MFV, Ms. Mirowski had the right to a distribution of property from MFV in accordance with her capital account. Respondent counters that the exception under section 2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth does not apply to Ms. Mirowski's transfers to MFV. In support of that position, respondent contends that there was no legitimate, significant nontax reason for Ms. Mirowski's forming, and transferring assets to, MFV. In advancing that contention, respondent asks the Court to disregard the respective testimonies of Ginat Mirowski and Ariella Rosengard, two of decedent's three daughters and the personal representatives of decedent's estate, regarding the nontax reasons Ms. Mirowski decided to form and fund MFV. According to respondent, the relationship of those witnesses to decedent and to decedent's estate colored their respective testimonies.42 As the trier of fact, we disagree. We evaluated the respective testimonies of Ginat Mirowski and Ariella Rosengard by observing each of those witnesses' candor, sincerity, and demeanor. We also evaluated the reasonableness of the respective testimonies of those witnesses. We found Ginat Mirowski and Ariella Rosengard to be completely candid, sincere, and credible and their respective testimonies to be reasonable. We accorded controlling weight to the respective testimonies of Ginat Mirowski and Ariella Rosengard, which we concluded was appropriate on the record before us. We relied on those testimonies in making our findings of fact, including our findings that Ms. Mirowski had the following legitimate and significant nontax reasons for forming, and transferring certain assets to, MFV:43 (1) Joint management of the family's assets by her daughters and eventually her grandchildren;44 (2) maintenance of the bulk of the family's assets in a single pool of assets in order to allow for investment opportunities that would not be available if Ms. Mirowski were to make a separate gift of a portion of her assets to each of her daughters or to each of her daughters' trusts; and (3) providing for each of her daughters and eventually each of her grandchildren on an equal basis.45 A-108 In support of respondent's position that the exception under section 2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth does not apply to Ms. Mirowski's transfers to MFV, respondent advances certain other contentions, including the following: (1) Ms. Mirowski failed to retain sufficient assets outside of MFV for her anticipated financial obligations (respondent's contention (1)); (2) MFV lacked any valid functioning business operation (respondent's contention (2)); (3) Ms. Mirowski delayed forming and funding MFV until shortly before her death and her health had begun to fail (respondent's contention (3)); (4) Ms. Mirowski sat on both sides of Ms. Mirowski's transfers to MFV (respondent's contention (4)); and (5) after Ms. Mirowski died, MFV made distributions totaling $36,415,810 to decedent's estate that that estate used to pay Federal and State transfer taxes, legal fees, and other estate obligations (respondent's contention (5)).46 According to respondent, certain caselaw47 supports respondent's view that the presence of the foregoing types of factors necessarily establishes in the instant case the absence of a bona fide sale for an adequate and full consideration in money or money's worth under section 2036(a). With respect to respondent's contentions (1), (2), and (3), those contentions are not supported by the record in this case and/or ignore material facts that we have found on the basis of that record. We reject those contentions. With respect to respondent's contention (1), we have found that the only anticipated significant financial obligation of Ms. Mirowski when she formed and funded MFV was the substantial gift tax for which she would be liable with respect to her contemplated respective gifts of 16-percent interests in MFV to her daughters' trusts. We have also found that at no time before Ms. Mirowski's death did the members of MFV have any express or unwritten agreement or understanding to distribute assets of MFV in order to pay that gift tax liability. In order to pay the anticipated gift tax liability with respect to her contemplated respective gifts of 16-percent interests in MFV to her daughters' trusts, Ms. Mirowski could have (1) used a portion of the over $7.5 million of personal assets that she retained and did not transfer to MFV, including cash and cash equivalents of over $3.3 million, (2) used a portion or all of the distributions that she expected to receive as a 52-percent interest holder in MFV of the millions of dollars of royalty payments under the ICD patents license agreement that she expected MFV to receive, and (3) borrowed against (a) the personal assets that she retained and did not transfer to MFV and (b) her 52-percent interest in MFV,48 see Md. Code Ann., Corps. & Assns. sec. 4A-602 (West 2008); Md. Code Ann., Com. Law sec. 1-201(37) (West 2008). With respect to respondent's contention (1), we have also found that at no time before September 10, 2001, when Ms. Mirowski's condition unexpectedly deteriorated significantly, did Ms. Mirowski, her daughters, or her physicians expect her to die and that consequently at no time did Ms. Mirowski and her daughters discuss or anticipate the estate tax and similar transfer taxes and the other estate obligations that would arise only as a result of Ms. Mirowski's death.49 With respect to respondent's contention (2), we have found that at all relevant times, including after Ms. Mirowski's death, MFV has been a valid functioning A-109 investment operation and has been managing the business matters relating to the ICD patents and the ICD patents license agreement, including related litigation. Moreover, we reject the suggestion in respondent's contention (2) that the activities of MFV had to rise to the level of a "business" under the Federal income tax laws in order for the exception under section 2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth to apply.50 With respect to respondent's contention (3), as discussed above with respect to respondent's contention (1), we have found that at no time before September 10, 2001, when Ms. Mirowski's condition unexpectedly deteriorated significantly, did Ms. Mirowski, her daughters, or her physicians expect her to die and that consequently at no time did Ms. Mirowski and her daughters discuss or anticipate the estate tax and similar transfer taxes and the other estate obligations that would arise only as a result of Ms. Mirowski's death. We have also found that Ms. Mirowski was being treated since January 2001 both at home and at Johns Hopkins Hospital for a diabetic foot ulcer and that she was admitted to Johns Hopkins Hospital on August 31, 2001, for further treatment of that ulcer. In addition, we have found that at all times throughout the course of her treatment from January 2001 until September 10, 2001, when Ms. Mirowski's condition unexpectedly deteriorated significantly, the expectations of the members of the medical staff at that hospital who were responsible for treating Ms. Mirowski and the expectations of Ms. Mirowski and her daughters were that the treatment of her foot ulcer would allow her to recover. With respect to respondent's contention (4), that contention reads out of section 2036(a) in the case of any single-member LLC the exception for a bona fide sale for an adequate and full consideration in money or money's worth that Congress expressly prescribed when it enacted that statute. Respondent's contention (4) also ignores that Ms. Mirowski fully funded MFV; her daughters' trusts did not contribute any assets to that company. Instead, each of those trusts was the recipient of a gift from Ms. Mirowski consisting of a 16-percent interest in MFV. We reject respondent's contention (4). With respect to respondent's contention (5), that contention ignores our findings that at no time before September 10, 2001, when Ms. Mirowski's condition unexpectedly deteriorated significantly, did Ms. Mirowski, her family, or her physicians expect her to die and that consequently at no time did Ms. Mirowski and her daughters discuss or anticipate the estate tax and similar transfer taxes and the other estate obligations that would arise only as a result of Ms. Mirowski's death.51 Moreover, we reject the suggestion of respondent that respondent's contention (5) is determinative in the instant case of whether Ms. Mirowski's transfers to MFV were bona fide sales for adequate and full consideration in money or money's worth under section 2036(a). With respect to respondent's reliance on certain caselaw to support respondent's view that the existence of the various alleged contentions advanced by respondent necessarily establishes in the instant case the absence of a bona fide sale for an adequate and full consideration in money or money's worth under section 2036(a), we find the cases on which respondent relies to be factually A-110 distinguishable from the instant case and respondent's reliance on them to be misplaced.52 In support of respondent's position that the exception under section 2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth does not apply to Ms. Mirowski's transfers to MFV, respondent also contends that, because Ms. Mirowski did not at any time contemplate forming and funding MFV without making respective gifts of 16-percent interests in MFV to her daughters' trusts, Ms. Mirowski, "in substance, * * * received only a 52% MFV interest" in exchange for Ms. Mirowski's transfers to MFV of 100 percent of its assets. As a result, according to respondent, Ms. Mirowski "did not receive adequate and full consideration in the form of a proportionate MFV interest." On the record before us, we reject respondent's contention. Ms. Mirowski made two separate, albeit integrally related, transfers of property that are at issue in this case, namely, Ms. Mirowski's transfers to MFV of certain assets on September 1, 5, 6, and 7, 2001, and Ms. Mirowski's respective gifts of 16-percent interests in MFV to her daughters' trusts on September 7, 2001. In return for Ms. Mirowski's transfers to MFV, Ms. Mirowski received and held 100 percent of the interests in MFV. In return for Ms. Mirowski's respective gifts to her daughters' trusts, Ms. Mirowski received and held nothing.53 On the record before us, we find that Ms. Mirowski received an interest in MFV proportionate to the value of the assets that she transferred to it on September 1, 5, 6, and 7, 2001. On that record, we also find that Ms. Mirowski's capital account was properly credited with the assets that she transferred to it on September 1, 5, 6, and 7, 2001, and that, in the event of a liquidation and dissolution of MFV, Ms. Mirowski had the right to a distribution of property from MFV in accordance with her capital account. Based upon our examination of the entire record before us, we find that Ms. Mirowski's transfers to MFV were bona fide sales for adequate and full consideration in money or money's worth under section 2036(a). Based upon that examination, we further find that the exception under section 2036(a) for a bona fide sale for an adequate and full consideration in money or money's worth applies to Ms. Mirowski's transfers to MFV. The opinion also rejected the contention that Mrs. Mirowski retained any sort of 2036(a)(1) right over MFV: We turn now to the linchpin in respondent's contention that at the time of Ms. Mirowski's gifts and at the time of her death there was an express agreement in section 4.5.1 of MFV's operating agreement that Ms. Mirowski retain an interest or a right described in section 2036(a)(1) with respect to the respective 16percent interests in MFV that she gave to her daughters' trusts. According to respondent, under section 4.5.1 of MFV's operating agreement, as MFV's general manager, Ms. Mirowski's "authority included the authority to decide the timing and amounts of distributions from MFV."58 That section of MFV's operating agreement provides: "Except as otherwise provided in this Agreement, the timing and amount of all distributions shall be determined by the Members holding a majority of the Percentages then outstanding." A-111 Contrary to respondent's contention, section 4.5.1 of MFV's operating agreement did not give Ms. Mirowski as MFV's general manager the authority to determine the timing and the amount of all distributions from MFV. Any authority that Ms. Mirowski had under that section was in her capacity as the member of MFV who owned a majority of the outstanding percentage interests in MFV (majority percentage member of MFV). Moreover, any authority that section 4.5.1 of MFV's operating agreement gave Ms. Mirowski as the majority percentage member of MFV did not include the authority to determine the timing and the amount of distributions from MFV where that agreement "otherwise provided". That agreement otherwise provided in, inter alia, section 4.1 and 4.2. Pursuant to section 4.1 of MFV's operating agreement, Ms. Mirowski had no authority as the majority percentage member of MFV (or as MFV's general manager) to determine for each taxable year the distribution of MFV's cash flow (i.e., cash funds derived in the ordinary course of MFV's operations) or the allocation of MFV's profit or loss from the ordinary course of MFV's operations. With respect to the distribution of MFV's cash flow, section 4.1.2 of MFV's operating agreement provided that "Cash Flow for each taxable year * * * shall be distributed to the Interest Holders * * * no later than seventy-five (75) days after the end of the taxable year."59 Section 4.1.2 of MFV's operating agreement is unequivocal in mandating the distribution of MFV's cash flow no later than 75 days after the end of a taxable year. Pursuant to section 4.2 of MFV's operating agreement, Ms. Mirowski had no authority as the majority percentage member of MFV (or as MFV's general manager) to determine the distribution of MFV's capital proceeds (i.e., gross receipts from a capital transaction, namely, a transaction not in the ordinary course of MFV's operations) or the allocation of profit or loss from any capital transaction.60 With respect to the distribution of MFV's capital proceeds, section 4.2.3 of MFV's operating agreement provided that "Capital Proceeds shall be distributed and applied by the Company" as specified in that section.61 Section 4.2.3 of MFV's operating agreement is unequivocal in mandating the distribution (and application) of MFV's capital proceeds as specified in that section. In an attempt to qualify the unequivocal words of section 4.2.3 of MFV's operating agreement mandating the distribution of MFV's capital proceeds, respondent attempts to inflate the significance of the language "no later than seventy-five (75) days after the end of the taxable year" appearing in section 4.1.2 of MFV's operating agreement that mandates the distribution of MFV's cash flow. We reject respondent's reliance on that language to change the unequivocal words of section 4.2.3 of MFV's operating agreement mandating the distribution of MFV's capital proceeds. Section 4.1.2 of MFV's operating agreement governs the distribution of MFV's cash flow "for each taxable year" of MFV. Thus, that section cannot be implemented until a taxable year of MFV has ended. It is only after the end of a taxable year that cash flow and profit or loss from the ordinary course of MFV's operations for the taxable year may be computed, allocated, and distributed as required by section 4.1 of MFV's operating agreement. Section 4.1.2 of MFV's operating agreement ensures that there will be enough time after the end of each taxable year, but no more than 75 days after the end of each such year, within A-112 which to make the computations, allocations, and distributions for each such taxable year required by section 4.1 of MFV's operating agreement. There was no reason to add similar language to section 4.2 of MFV's operating agreement. That is because the term "capital proceeds" is defined in section I of MFV's operating agreement as "the gross receipts received by the Company from a Capital Transaction." As soon as each capital transaction of MFV is undertaken, section 4.2 of MFV's operating agreement requires the allocation of profit or loss and the distribution and the application of capital proceeds from that capital transaction as specified in that section. On the record before us, we find that section 4.5.1 of MFV's operating agreement did not give Ms. Mirowski as the majority percentage member of MFV (or as MFV's general manager) the authority to determine the timing and the amount of distributions of MFV's cash flow and MFV's capital proceeds.62 On that record, we further find that section 4.5.1 of MFV's operating agreement did not give Ms. Mirowski as the majority percentage member of MFV (or as MFV's general manager) the authority to determine the timing and the amount of distributions upon the liquidation and dissolution of MFV.63 On the record before us, we find that at the time of Ms. Mirowski's gifts and at the time of her death there was no express agreement in MFV's operating agreement (or elsewhere) that Ms. Mirowski retain the possession or the enjoyment of, or the right to the income from, the respective 16-percent interests in MFV that she gave to her daughters' trusts. The IRS also argued that 2036(a)(2) should apply, a contention also rejected by the court: It is the position of decedent's estate that Ms. Mirowski did not retain a right described in section 2036(a)(2) with respect to the respective 16-percent interests in MFV that she gave to her daughters' trusts. Respondent counters: With the approval of the daughters (now the other interest holders), decedent had the authority to dispose of assets in other than the ordinary course of business. [MFV's operating agreement] Section 5.1.3.1. As the holder of a majority of the MFV interests, decedent alone held the power to determine the timing of the distribution of the capital transaction proceeds. [MFV's operating agreement] Section 4.5.1. Thus, after the transfer of the three 16 percent interests, decedent held the right, in conjunction with her daughters, to designate the person or persons who shall possess or enjoy the proceeds of the transferred property, within the meaning of section 2036(a)(2), with the result that the assets transferred to MFV are includible in the gross estate. * * * Before addressing the linchpin in respondent's argument under section 2036(a)(2), we reject respondent's contention that Ms. Mirowski's daughters A-113 were members of MFV after Ms. Mirowski's gifts. After those gifts, the daughters' trusts, and not Ms. Mirowski's daughters, were members of MFV.69 We turn now to the linchpin in respondent's argument under section 2036(a)(2), namely, under section 4.5.1 of MFV's operating agreement Ms. Mirowski "alone held the power to determine the timing of the distribution of the capital transaction proceeds." We have considered and rejected that contention when we addressed respondent's argument under section 2036(a)(1) with respect to Ms. Mirowski's gifts. For the reasons stated above, we reject respondent's contention here in determining whether at the time of Ms. Mirowski's gifts and at the time of her death Ms. Mirowski retained a right described in section 2036(a)(2) with respect to the respective 16-percent interests in MFV that she gave to her daughters' trusts. Based upon our examination of the entire record before us, we find that at the time of Ms. Mirowski's gifts and at the time of her death Ms. Mirowski did not retain, either alone or in conjunction with any person, the right to designate the persons who shall possess or enjoy the respective 16-percent interests in MFV that she gave to her daughters' trusts or the income from such interests within the meaning of section 2036(a)(2). Based upon our examination of the entire record before us, we hold that section 2036(a) does not apply to Ms. Mirowski's respective gifts of 16-percent interests in MFV to her daughters' trusts. The court rejected the application of section 2038 on the same grounds as it rejected the application of 2306(a)(2). In support of respondent's argument under section 2038(a)(1), respondent relies on essentially the same contentions on which respondent relies in support of respondent's argument under section 2036(a)(2). We considered and rejected those contentions when we addressed respondent's argument under section 2036(a)(2). For the reasons stated above, we reject respondent's contentions here in determining whether at the time of Ms. Mirowski's death Ms. Mirowski held the power to alter, amend, revoke, or terminate the enjoyment of the respective 16-percent interests in MFV that she gave to her daughters' trusts. Based upon our examination of the entire record before us, we find that at no time, including at the time of Ms. Mirowski's death, was the enjoyment of the respective 16-percent interests in MFV that Ms. Mirowski gave to her daughters' trusts subject to any change through the exercise of a power by her, alone or in conjunction with any other person, to alter, amend, revoke, or terminate within the meaning of section 2038(a)(1). Mirowski is difficult to reconcile with Rector and other previous cases except by concluding that the factual findings made all the difference. In Mirowski a legitimate, nontax reason did not include a business reason, the lack of arms-length negotiations did not matter nor did the lack of outside contributors to the entity. Most strikingly perhaps was the determination that an implied agreement could not be found from the payment of estate taxes and A-114 other estate obligations from the entity. The court put particular emphasis on the unexpected timing of Mrs. Murowski s death. In pertinent part the opinion states: We shall, however, address again what respondent considers to be of "particular significance" in our determining whether at the time of Ms. Mirowski's gifts and at the time of her death there was an implied agreement that she retain an interest or a right described in section 2036(a)(1) with respect to the respective 16percent interests in MFV that she gave to her daughters' trusts, namely, during 2002, MFV distributed $36,415,810 to decedent's estate which that estate used to pay Federal and State transfer taxes, legal fees, and other estate obligations.64 As discussed above, we have found that the only anticipated significant financial obligation of Ms. Mirowski when she formed and funded MFV and when she made the respective gifts to her daughters' trusts was the substantial gift tax for which she would be liable with respect to those gifts. We have also found that at no time before Ms. Mirowski's death did the members of MFV have any express or unwritten agreement or understanding to distribute assets of MFV in order to pay that gift tax liability. In order to pay the anticipated gift tax liability with respect to her contemplated respective gifts of 16-percent interests in MFV to her daughters' trusts, Ms. Mirowski could have (1) used a portion of the over $7.5 million of personal assets that she retained and did not transfer to MFV, including cash and cash equivalents of over $3.3 million, (2) used a portion or all of the distributions that she expected to receive as an interest holder in MFV of the millions of dollars of royalty payments under the ICD patents license agreement that she expected MFV to receive, and (3) borrowed against (a) the personal assets that she retained and did not transfer to MFV and (b) her 52percent interest in MFV,65 see Md. Code Ann., Corps. & Assns. sec. 4A-602 (West 2008); Md. Code Ann., Com. Law sec. 1-201(37) (West 2008). In addition, as also discussed above, we have found that at no time before September 10, 2001, when Ms. Mirowski's condition unexpectedly deteriorated significantly, did Ms. Mirowski, her daughters, or her physicians expect her to die and that consequently at no time did Ms. Mirowski and her daughters discuss or anticipate the estate tax and similar transfer taxes and the other estate obligations that would arise only as a result of Ms. Mirowski's death.66 In 2002, after Ms. Mirowski died, MFV distributed over $36 million to decedent's estate in order for the estate to pay Federal and State transfer taxes, legal fees, and other estate obligations. At the time in 2002 when MFV made those distributions to decedent's estate, MFV's members (i.e., the daughters' trusts),67 through their respective trustees (i.e., Ms. Mirowski's daughters), agreed and decided that MFV should not make distributions to them.68 In making that decision, MFV's members had in mind that those members will own collectively 100 percent of MFV, in three equal shares, after decedent's estate is closed. On the record before us, we conclude that the decision by MFV's members after Ms. Mirowski died to have MFV distribute during 2002 over $36 million to decedent's estate, which the estate used to pay Federal and State transfer taxes, legal fees, and other estate obligations, is not determinative in the instant case of whether at the time of Ms. Mirowski's gifts and at the time of her death there was A-115 an implied agreement that Ms. Mirowski retain an interest or a right described in section 2036(a)(1) with respect to the respective 16-percent interests in MFV that she gave to her daughters' trusts. The case of Jane Z. Astleford v. Commissioner, T. C. Memo. 2008-128, involved the valuation of a gift of limited partnership interests and then a gift of assets to the partnership itself. In 1996 Mrs. Astleford formed Astleford Family Limited Partnership (AFLP) and funded it with an interest in an assisted living facility valued at $871,000. On August 1, 1996 she gave a 30% limited partnership interest to each of her three children and retained a 10% general partnership interest. The opinion describes certain features of the partnership agreement as follows: Under provisions of the AFLP agreement, AFLP's net cashflow was to be distributed annually among the partners. The limited partners were not entitled to vote on matters relating to management of AFLP, no outside party could become a partner in AFLP without consent of petitioner as general partner, a limited partner could not sell or transfer any part of his or her AFLP limited partnership interest without consent of petitioner, and no real property interest held by AFLP could be partitioned without consent of petitioner. On December 1, 1997 Mrs. Astleford gave a 50% general partnership interest in Pine Bend partnership to AFLP, as well as her interest in 14 other properties. Simultaneously, she gave her children additional limited partnership interests so that after the transfers she continued to own 10% and her children 30% each in AFLP. The court rejected the taxpayer s argument that the 50% general partnership interest should be discounted 5% because it was really an assignee interest applying the substance over form doctrine: The substance over form doctrine has been applied to Federal gift and estate taxes. See Heyen v. United States, 945 F.2d 359, 363 (10th Cir. 1991); Estate of Murphy v. Commissioner, T.C. Memo. 1990-472. In particular, we have applied the substance over form doctrine in valuation cases to treat transfers of alleged assignee interests as, in substance, transfers of partnership interests. See Kerr v. Commissioner, 113 T.C. 449, 464-68 (1999), affd. on another issue 292 F.3d 490 (5th Cir. 2002). The facts in this case establish that in substance the Pine Bend interest transferred by petitioner to AFLP should be treated as a general partnership interest, not as a Pine Bend assignee interest. Because petitioner was AFLP's sole general partner, petitioner was essentially in the same management position relative to the 50-percent Pine Bend interest whether she is to be viewed as having transferred to AFLP a Pine Bend assignee interest (and thereby retaining Pine Bend management rights) or as having transferred those management rights to AFLP via the transfer of a Pine Bend general partnership interest (in which case she reacquired those same management rights as sole general partner of AFLP). Either way, after December 1, 1997, petitioner continued to have and to control the management rights associated with the 50-percent Pine Bend general partnership interest. A-116 We note that the November 2, 1997, AFLP partnership resolution treats petitioner's Pine Bend transfer as a transfer of all of petitioner's rights and interests in Pine Bend, suggesting the transfer of a general partnership interest, not the transfer of an assignee interest. See Estate of Jones v. Commissioner, 116 T.C. 121, 133 (2001) (interests not assignee interests where documents referred to interests as "partnership" interests); Kerr v. Commissioner, supra at 466-467 (interests not assignee interests where language used to document transfers demonstrated "partnership" interests were transferred); Estate of Dailey v. Commissioner, T.C. Memo. 2001-263 (interests not assignee interests where documents referred to "partnership" interests); cf. Estate of Nowell v. Commissioner, T.C. Memo. 1999-15 (interests assignee interests where documents did not indicate partnership interests were transferred). The court applied a combined 30% discount for lack of control and marketability in valuing the 50% interest in Pine Bend. The court went on to value the AFLP interests and there allowed a 16.17% discount for lack of control and a 21.23% discount for lack of marketability for the 1996 gifts and a 17.47% discount for lack of control and 22% discount for lack of marketability. With respect to the stacking of discounts, footnote 5 states: We note that this Court, as well as respondent, has applied two layers of lack of control and lack of marketability discounts where a taxpayer held a minority interest in an entity that in turn held a minority interest in another entity. See Estate of Piper v. Commissioner, 72 T.C. 1062, 1085 (1979); Janda v. Commissioner, T.C. Memo. 2001-24; Gow v. Commissioner, T.C. Memo. 200093, affd. 19 Fed. Appx. 90 (4th Cir. 2001); Gallun v. Commissioner, T.C. Memo. 1974-284. However, we also have rejected multiple discounts to tiered entities where the lower level interest constituted a significant portion of the parent entity's assets, see Martin v. Commissioner, T.C. Memo. 1985-424 (minority interests in subsidiaries comprised 75 percent of parent entity's assets), or where the lower level interest was the parent entity's "principal operating subsidiary", see Estate of O'Connell v. Commissioner, T.C. Memo. 1978-191, affd. on this point, revd. on other issues 640 F.2d 249 (9th Cir. 1981). The 50-percent Pine Bend interest constituted less than 16 percent of AFLP's NAV and was only 1 of 15 real estate investments that on Dec. 1, 1997, were held by AFLP, and lack of control and lack of marketability discounts at both the Pine Bend level and the AFLP parent level are appropriate. Judge Halpern applied section 2703 in Thomas H. Holman, Jr. v. Commissioner, 130 T. C. No. 12 (2008) when valuing gifts of limited partnership interests. Nonetheless, overall the opinion was a partial victory for the taxpayers. Tom and Kim Holman formed a partnership and funded it with 70,000 shares of Dell. In addition, a trust for the benefit of the Holman s four children contributed 100 Dell shares. Tom and Kim were each 0.89% general partners and 49.04% limited partners. The trust was a 0.14% limited partner. In November, 1999 Tom and Kim made substantial gifts to the trust for their children and to a custodian account for one of the children. In December, A-117 1999 custodian accounts for the four children each contributed to the partnership additional Dell stock that had been given by the Holman s before the partnership was formed. Tom s mother, Janelle was trustee of the trust and custodian under the Minnesota Uniform Transfers to Minors Act. Further gifts were made of limited partnership interests in 2000 and 2001, as well as additional gifts of Dell stock to the partnership, with the end result being that Tom and Kim each had a 0.56% general interest and a 5.04% limited interest, each custodian account having a 11.13% limited interest and the trust a 44.29% limited interest. The IRS advanced five arguments on audit: (1) It is determined that the transfer of assets to the Holman Limited Partnership, [sic] is in substance an indirect gift within the meaning of I.R.C. Section 2511 of the assets to the other partners. (2) Alternatively, it is determined that in substance and effect the taxpayer's interest in Holman Limited Partnership is more analogous to an interest in a trust than to an interest in an operating business, and should be valued as such for federal transfer tax purposes. (3) Alternatively, it is determined that the transferred interest in the Holman Limited Partnership should be valued without regard to any restriction on the right to sell or use the partnership interest within the meaning of I.R.C. Section 2703(a)(2). (4) Alternatively, it is determined that certain restrictions on liquidation of the Holman Limited Partnership interests contained in the articles of organization and operating agreement should be disregarded for valuation purposes pursuant to I.R.C. Section 2704(b). (5) Alternatively, it is determined that the fair market value of such gifts is $871,971.00, after allowance of a discount for lack of marketability or minority interest of 28%. The court rejected the first two arguments, finding that the Shepherd and Senda cases did not apply: Respondent's first alternative indirect gift argument invokes the illustration in section 25.2511-1(h)(1), Gift Tax Regs., of an indirect gift made by a shareholder of a corporation to the other shareholders of the corporation. The regulation concludes that, generally, where a shareholder transfers property to a corporation for less than adequate consideration, the transfer represents gifts by the shareholder to the other shareholders to the extent of their proportionate interests in the corporation. Respondent asks us to compare the facts at hand to the facts in Shepherd and in Senda v. Commissioner, T.C. Memo. 2004-160, affd. 433 F.3d 1044 (8th Cir. 2006), in both of which we concluded that transfers by a partner to a partnership were indirect transfers to the other partners. In Shepherd v. Commissioner, 115 T.C. at 380-381, the taxpayer transferred real property and shares of stock to a newly formed family partnership in which he A-118 was a 50-percent owner and his two sons were each 25-percent owners. Rather than allocating contributions to the capital account of the contributing partner, the partnership agreement provided that any contributions would be allocated pro rata to the capital accounts of each partner according to ownership. Id. at 380. Because the contributions were reflected partially in the capital accounts of the noncontributing partners, the values of the noncontributing partners' interests were enhanced by the contributions of the taxpayer. Accordingly, we held that the transfers to the partnership were indirect gifts by the taxpayer to his sons of undivided 25-percent interests in the real property and shares of stock. Id. at 389. In Senda v. Commissioner, supra, the Commissioner contended that the taxpayers' transfers of shares of stock to two family limited partnerships, coupled with their transfers of limited partner interests to their children, were indirect gifts of the shares to those children. In both instances, the stock transfers and the transfers of the partnership interests occurred on the same day. We said that the taxpayers' transfers of shares were similar to the transfer of property in the Shepherd case: "In both cases, the value of the children's partnership interests was enhanced by their parents' contributions to the partnership." We rejected the taxpayers' attempt to distinguish the Shepherd case on the ground that they first funded the partnership and then transferred the partnership interests to their children. We found: "At best, the transactions were integrated (as asserted by respondent) and, in effect, simultaneous." We held that the taxpayers' transfers of the shares of stock to the two partnerships were indirect gifts of the shares to their children. The facts in the instant case are distinguishable from those of both the Shepherd and Senda cases. On November 3, 1999, the partnership was formed, petitioners transferred 70,000 Dell shares to the partnership, and Janelle, as trustee, transferred 100 Dell shares to the partnership. On account of those transfers, petitioners and Janelle received partnership interests proportional to the number of shares each transferred to the partnership. It was not until November 8, 1999, that petitioners are deemed to have made (and, on that date, they did make)5 a gift of LP units to Janelle, both as custodian for I. under the Minnesota UTMA and as trustee. Petitioners did not first transfer LP units to Janelle and then transfer Dell shares to the partnership, nor did they simultaneously transfer Dell shares to the partnership and LP units to Janelle. The facts of the Shepherd and Senda cases are materially different from those of the instant case, and we cannot rely on those cases to find that petitioners made an indirect gift of Dell shares to Janelle, either as custodian for I. under the Minnesota UTMA or as trustee. We shall proceed to respondent's alternative argument. *** The nub of respondent's argument is that petitioners' formation and funding of the partnership should be treated as occurring simultaneously with their 1999 gift of LP units since the events were interdependent and the separation in time between the first two steps (formation and funding) and the third (the gift) served no purpose other than to avoid making an indirect gift under section 25.25111(h), Gift Tax Regs. While we have no doubt that petitioners' purposes in forming the partnership included making gifts of LP units indirectly to the children, we cannot say that the legal relations created by the partnership A-119 agreement would have been fruitless had petitioners not also made the 1999 gift. Indeed, respondent does not ask that we consider either the 2000 gift (made approximately 2 months after formation of the partnership) or the 2001 gift (made approximately 15 months after formation of the partnership) to be indirect gifts of Dell shares. We must determine whether the fact that less than 1 week passed between petitioners' formation and funding of the partnership and the 1999 gift requires a different result. Respondent relies heavily on the opinion of the Court of Appeals for the Eighth Circuit in Senda v. Commissioner, 433 F.3d 1044 (8th Cir. 2006).6 In affirming our decision in the Senda case, the Court of Appeals concluded that we did not clearly err in finding that the taxpayers' transfers of shares of stock to two family limited partnerships, coupled with their transfers on the same days of limited partner interests to their children, were in each case integrated steps in a single transaction. Id., at 1049. The taxpayers argued that the order of transfers did not matter since, pursuant to the partnership agreements in question, their contributions of the shares of stock were credited to their partnership capital accounts before being credited to the children's accounts. Id. at 1047. Invoking the step transaction doctrine, the Court of Appeals rejected that step-dependent argument. Id. at 1048. It said: "In some situations, formally distinct steps are considered as an integrated whole, rather than in isolation, so federal tax liability is based on a realistic view of the entire transaction." Id. This case is distinguishable from Senda because petitioners did not contribute the Dell shares to the partnership on the same day they made the 1999 gift; indeed, almost 1 week passed between petitioners' formation and funding of the partnership and the 1999 gift. Nevertheless, the Court of Appeals in Senda did not say that, under the step transaction doctrine, no indirect gift to a partner can occur unless, on the day property is transferred to the partnership, the partner is (or becomes) a member of the partnership. As respondent's failure to argue indirect gifts on account of the 2000 and 2001 gifts suggests, however, the passage of time may be indicative of a change in circumstances that gives independent significance to a partner's transfer of property to a partnership and the subsequent gift of an interest in that partnership to another. The court applied section 2703 to ignore certain transfer restrictions imposed by the partnership agreement. The opinion discusses this issue as follows: Indeed, we have held that buy-sell agreements serve a legitimate purpose in maintaining control of a closely held business. E.g., Estate of Bischoff v. Commissioner, supra; Estate of Reynolds v. Commissioner, 55 T.C. 172 (1970); Estate of Fiorito v. Commissioner, 33 T.C. 440 (1959).8 Here, however, we do not have a closely held business. From its formation through the date of the 2001 gift, the partnership carried on little activity other than holding shares of Dell stock. Dell was not a closely held business either before or after petitioners contributed their Dell shares to the partnership. While we grant that paragraphs 9.1 through 9.3 (and paragraph 9.3 in particular) aid in control of the transfer of LP units, the stated purposes of the partnership, viewed in the light of petitioners' testimony as to their reasons for forming the A-120 partnership and including paragraphs 9.1 through 9.3 in the partnership agreement, lead us to conclude that those paragraphs do not serve bona fide business purposes. Paragraph 3.1 of the partnership agreement includes among the stated purposes of the partnership: "to * * * provide a means for the Family to gain knowledge of, manage, and preserve Family Assets." Tom testified at some length as to his understanding of the term "preservation" and his reasons for making asset preservation a purpose of the partnership. On the basis of that testimony, we find that his reason for making asset preservation a purpose of the partnership was to protect family assets from dissipation by the children. Tom also testified that paragraph 9.1 "lays out pretty strong limitations on what the limited partners can do in assigning or giving away their interests to other people." He viewed the buy-in provisions of paragraph 9.3 as a "safety net" if an impermissible person obtained an assignment of a limited partner interest from one of the girls. He considered the provisions of paragraphs 9.1, 9.2, and 9.3, together, as important in accomplishing his goal of keeping the partnership a closely held partnership of family members: "If there are ways for the family [the children] to wiggle out of that and bring other people in, then it will prevent us from accomplishing our goals, so we wanted a couple of levels here of restriction that would prevent that from happening." Kim testified that the purpose of organizing the partnership was to establish a tool for Tom and her "to be able to teach * * * [the] children about wealth and the responsibility of that wealth." We believe that paragraphs 9.1 through 9.3 were designed principally to discourage dissipation by the children of the wealth that Tom and Kim had transferred to them by way of the gifts. The meaning of the term "bona fide business arrangement" in section 2703(b)(1) is not self apparent. As discussed supra, in Estate of Amlie v. Commissioner, T.C. Memo. 2006-76, we interpreted the term "bona fide business arrangement" to encompass value-fixing arrangements made by a conservator seeking to exercise prudent management of his ward's minority stock investment in a bank consistent with his fiduciary obligations to the ward and to provide for the expected liquidity needs of her estate. Those are not the purposes of paragraphs 9.1 through 9.3. There was no closely held business here to protect, nor are the reasons set forth in the Committee on Finance report as justifying buy-sell agreements consistent with petitioners' goals of educating their children as to wealth management and "disincentivizing" them from getting rid of Dell shares, spending the wealth represented by the Dell shares, or feeling entitled to the Dell shares. *** The second requirement of section 2703(b) is that the restriction not be a device to transfer the encumbered property to members of the decedent's family for less than full and adequate consideration in money or money's worth (hereafter, simply adequate consideration). Sec. 2703(b)(2). The Secretary's regulations interpreting section 2703 substitute the term "the natural objects of the transferor's bounty" for the term "members of the decedent's family", apparently because he interprets section 2703 to apply to both transfers at death and inter vivos transfers. Sec. 25.2703-1(b)(1)(ii), Gift Tax Regs.9 Clearly, the gifts of the LP units were both (1) to natural objects of petitioners' bounty and (2) for less than adequate consideration. They were not, however, a "device" to transfer the LP units to the children for less than adequate consideration. The question we A-121 must answer is whether paragraphs 9.1 through 9.3, which restrict the children's rights to enjoy the LP units, constitute such a device. We believe that they do. Those paragraphs serve the purposes of Tom and Kim to discourage the children from dissipating the wealth that Tom and Kim had transferred to them by way of the gifts. They discourage dissipation by depriving a child desirous of making an impermissible transfer of the ability to realize the difference in value between the fair market value of his LP units and the units' proportionate share of the partnership's NAV. If a child persists in making an impermissible transfer, paragraph 9.3 allows the general partners (currently Tom and Kim) to redistribute that difference among the remaining partners. Thus, if the provisions of paragraph 9.3 are triggered and the partnership redeems the interest of an impermissible transferee for less than the share of the partnership's net asset value proportionate to the impermissible transferee's interest in the partnership (which is likely, given the agreement of the parties' valuation experts as to how the valuation discounts appropriate to an LP unit are applied; see infra section IV.A. of this report), the values of the remaining partners' interests in the partnership will increase on account of that redemption. See infra note 17 and the accompanying paragraph. The partners benefiting from the redemption could (indeed, almost certainly, would) include one or more of the children, natural objects of petitioners' bounty. Tom participated in the drafting of the partnership agreement to ensure, in part, that "asset preservation" as he understood that term (i.e., to discourage the children from dissipating their wealth) was addressed. Tom impressed us with his intelligence and understanding of the partnership agreement, and we have no doubt that he understood the redistributive nature of paragraph 9.3. and his and Kim's authority as general partners to redistribute wealth from a child pursuing an impermissible transfer to his other children. We assume, and find, that he intended paragraph 9.3 to operate in that manner, and this intention leads us to conclude, and find, that paragraph 9.3 is a device to transfer LP units to the natural objects of petitioners' bounty for less than adequate consideration. Because the court found that the partnership was not a bona fide business arrangement and was a device it did not need to consider the comparability test of section 2703. Nonetheless the court did hear evidence and the opinion contains the following discussion: Respondent called Daniel S. Kleinberger, professor of law at William Mitchell College of Law, St. Paul, Minnesota. Professor Kleinberger was accepted as an expert on arm's-length limited partnerships. In his direct testimony, he expressed the opinion that the overall circumstances of the partnership arrangement made it unlikely that a person in an arm's-length arrangement with the general partners would accept any of the "salient" restrictions on sale or use contained in the partnership agreement. He explained: In virtually every material respect, the * * * [partnership] agreement blocks for 50 years the limited partners' ability to sell or use their respective limited partner interests. In an arm's length transaction, a reasonable investor faced with such a prospect would ask, "What is so special about this opportunity, A-122 what do I get out of this arrangement that justified so restricting and enfeebling my rights?" The answer, in an arm's length context, is nothing. On cross-examination, he agreed with counsel for petitioners that transfer restrictions similar to those found in paragraphs 9.1 through 9.3 are common in agreements entered into at arm's length. That, however, he concluded, was beside the point since "The owners of a closely held business at arm's length would never get into this deal with the Holmans, period, so the issue [transfer restrictions] wouldn't come up." In response to petitioner's counsel's expression of doubt as to what he meant, he answered: What I mean is that when you look at the overall context, when you look at the nature of the assets, when you look at the expertise or non-expertise of the general partner, when you look at the 50-year term, when you look at the inability to get out, when you look at the susceptibility of this single asset, * * *the issue [transfer restrictions] wouldn't arise, because nobody at arm's length would get into this deal." Using a colorful expression, he summed up his view as follows: [B]ased on my experience and based on conversations with more than a dozen practitioners who do this stuff, I couldn't find anybody would do this deal, who would let their client into a deal like this as a limited partner without writing a very large CYA memo, saying: "We advise against this." Petitioners called William D. Klein (Mr. Klein), a shareholder in the Minnesota law firm of Gray, Plant, Mooty, Mooty & Bennett, P.A. Mr. Klein has "practiced, written, and lectured about" partnership taxation and law for more than 20 years. He has participated in the drafting of, or reviewed drafts of, more than 300 limited partnership agreements. He was accepted as an expert with respect to the comparability of the provisions of the partnership agreement to provisions in other partnership agreements entered into by parties at arm's length. He was asked by petitioners to express his opinion as to whether various provisions of the partnership agreement are "'comparable to similar arrangements entered into by persons in an arm's length transaction'". With respect to paragraphs 9.1 and 9.2, Mr. Klein is of the opinion that the paragraphs "are comparable to provisions one most often finds in limited partnership agreements among unrelated partners." As to paragraph 9.3, he is of the opinion that the paragraph "is not out of the mainstream of what one typically finds in arm's length limited partnership agreements." Petitioners must show that paragraph 9.3 is "comparable to similar arrangements entered into by persons in an arm's length transaction." See sec. 2703(b)(3). The experts agree that transfer restrictions comparable to those found in paragraphs 9.1 through 9.3 are common in agreements entered into at arm's length. That would seem to be all that petitioners need to show to satisfy section 2703(b)(3). Nevertheless, respondent relies on one of his expert's, Professor Kleinberger's, testimony "that the overall circumstances of the * * * [partnership] arrangement A-123 make it unlikely that arm's length third parties would agree to any one of its restrictions on sale or use." Even were we to find that paragraph 9.3 is comparable to similar arrangements entered into by persons in arm's-length transactions (thus satisfying section 2703(b)(3)), we would still disregard it because it fails to constitute a bona fide business arrangement, as required by section 2703(b)(1), and is a prohibited device within the meaning of section 2703(b)(2). Therefore, we need not (and do not) decide today whether respondent is correct in applying the arm's-length standard found in section 2703(b)(3) to the transaction as a whole. With respect to valuation, the court did apply discounts for lack of control and lack of marketability. In general, the court found the IRS expert to be more helpful and credible than the taxpayer s expert. The lack of marketability discount was 12.5% and the lack of control discount was 11.32% for the 1999 gifts, 14.34% for the 2000 gifts, and 4.63% for the 2001 gifts. Helpful information about the court s approach may be drawn from footnotes 17 and 18: 17 Thus, for instance, assume that a hypothetical limited partnership organized under an agreement identical to the partnership's has one general and four limited partners, all sharing equally in profits and losses, an NAV of $100, and, because of minority interest and marketability discounts, no impermissible assignment of a limited partner interest could be made for a price greater than 60 percent of the interest's share of NAV. If a limited partner with bargaining power and wishing to dispose of her 20-percent interest and the limited partnership were to settle on a redemption price of $14 for her interest, she would receive $2 more than she could receive on an impermissible assignment, the limited partnership's remaining NAV would be $86, and each of the four remaining partners' share of that NAV would increase by $1.50, from $20 to $21.50. Of course, we cannot say where between $12 and $20 the redemption price would settle, but, putting transaction costs aside, it would be in the economic interest of both the withdrawing partner and the remaining partners to have it settle somewhere in between. 18 We are mindful of one of respondent's expert's, Professor Kleinberger's, testimony that "nobody at arm's length would get into this deal" (meaning the partnership), and the implication to be drawn from that testimony that it would be hard to market an interest in the partnership. Professor Kleinberger, however, was not called as an expert on valuation; he did not offer any opinion as to the value of an existing LP unit, and, although we are unpersuaded by one of petitioners' expert's, Mr. Ingham's, opinion as to an appropriate marketability discount, he stopped at 35 percent. Where does that leave us with respect to family partnerships? Five general rules stand out. First, the form of the partnership (or LLC) must be respected and the senior generation (the primary transferor) should retain no, or as little as possible, income from the partnership. If income flow is necessary requiring the payment of an annuity from the partnership, not related to the amount of income, should be considered. Loaning money to the decedent is not likely to be respected A-124 unless the decedent has an independent source of repayment and there is a repayment plan. Second, if possible, family members should pool assets rather than having the senior generation make substantially all the contributions. Family trusts should be considered as contributors in this regard. Nonetheless, the partnership income tax rules relating to investment companies cannot be disregarded. Third, if possible, assets other than or in addition to marketable securities should be used. If a client has both marketable securities and other assets (e.g. actively managed real estate interests), the investment company rules suggest keeping the assets in separate entities for income tax purposes. May simultaneous creation of two or more entities allow those entities to be treated, by the taxpayer, as if they were akin to one entity for transfer tax purposes while maintaining separate tax status for income tax purposes? Fourth, because the Tax Court majority seems to have rejected a gift on formation argument, the primary transferor should not have control of the entity even at the beginning. An exception may be if the primary transferor is a QTIP trust; will section 2519 apply if the surviving spouse consents to the transfer of liquid assets into an illiquid investment, especially if there is no guaranteed income flow from the entity? If that is a concern, may it be mitigated by leaving sufficient assets in the QTIP after the entity is funded to allow the trustee to make distributions (using principal) equivalent to the amount of income the trust would have if the entity distributed all of its income? Regardless, the primary transferor should not have any voting interests. Fifth, because section 2036 (a) (2) is a concern (based on the broad conclusions of Judge Cohen in Strangi) ideally the primary transferor should retain no partnership interests at all. Instead, the limited interests should be owned by a trust over which a testamentary special power of appointment is retained. Ideally the primary transferor would retain no significant rights over such a trust, including no right to receive income. Alternatively, the limited partnership interests should be given or sold before death. 2. Power of Substitution in a Fiduciary Capacity. PLR 200603040 states that the power to substitute assets for assets of equivalent value, and the actual exercise of the power, does not implicate sections 2036 or 2038. PLR 200606006 is to the same effect. This determination follows Estate of Jordahl v. Commissioner, 65 T. C. 92 (1975), acq. 1977-1 C. B. 1. The Service did not rule on a power held in a non-fiduciary capacity, as a section 675(4)(C) power must be if the purpose of such a power is to make the trust a grantor trust for income tax purposes. Some commentators have argued that whether it is a fiduciary or non-fiduciary power is irrelevant for sections 2036 and 2038, because those sections do not normally turn on fiduciary limits. In Rev. Rul. 2008-22, 2008-16 IRB 796, the IRS determined that neither section 2036 nor section 2038 would apply to a trust merely because the grantor retained the power, exercisable in a nonfiduciary capacity, to acquire trust property by substituting other property of equivalent value. The Ruling states: A-125 In situations where the grantor of a trust holds a nonfiduciary power to replace trust assets with assets of equivalent value, the trustee has a duty to ensure that the value of the assets being replaced is equivalent to the value of the assets being substituted. If the trustee knows or has reason to believe that the exercise of the substitution power does not satisfy the terms of the trust instrument because the assets being substituted have a lesser value than the trust assets being replaced, the trustee has a fiduciary duty to prevent the exercise of the power. See Restatement (Third) of Trusts § 75 (2007) and Uniform Trust Code §§ 801 and 802 (2005). In the instant case, unlike the situation presented in Estate of Jordahl, the trust instrument expressly prohibits D from serving as trustee and states that D's power to substitute assets of equivalent value is held in a nonfiduciary capacity. Thus, D is not subject to the rigorous standards attendant to a power held in a fiduciary capacity. However, under the terms of the trust, the assets D transfers into the trust must be equivalent in value to the assets D receives in exchange. In addition, T has a fiduciary obligation to ensure that the assets exchanged are of equivalent value. Thus, D cannot exercise the power to substitute assets in a manner that will reduce the value of the trust corpus or increase D 's net worth. Further, in view of T's ability to reinvest the assets and T's duty of impartiality regarding the trust beneficiaries, T must prevent any shifting of benefits between or among the beneficiaries that could otherwise result from a substitution of property by D. Under these circumstances, D's retained power will not cause the value of the trust corpus to be included in D's gross estate under § 2036 or 2038. HOLDING A grantor's retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor's gross estate under § 2036 or 2038, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor's compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. A substitution power cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or (b) the nature of the trust's investments or the level of income produced by any or all of the trust's investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income. Read literally the Ruling applies only when a trustee has a fiduciary obligation to ensure that the substituted property is of equivalent value and that it is not exercised in a manner that will shift benefits among the trust benefits. The first requirement is uncontroversial. The Ruling seems to assume that under normal state law a trustee will have the power to prohibit substitutions that might shift benefits - - for instance, the substitution of illiquid, non- A-126 income producing assets for liquid, income producing ones. Such a conclusion is not obvious. In order to ensure compliance with the Ruling, consideration should be given to providing trustee with the supervisory power clearly given. Alternatively, the Ruling provides that if the trustee has a power to reinvest trust corpus and a duty of impartiality towards the beneficiaries, powers which a trustee will normally have, then the requirements of the Ruling are met. Similarly, if the trust is administered in such a way that income production is largely irrelevant, as in a unitrust or a discretionary trust as to income and principal, the requirements of the Ruling are met. The Ruling does not consider the basis of the property substituted for or substituted in determining value, unless the substitution could be considered to change the benefits of the various parties to the trust. The grantor with the substitution power should not be trustee unless it is clear under state law that the power of substitution can be exercised in a nonfiduciary capacity even if the powerholder is also a fiduciary. Rev. Rul. 2004-64 held: When the grantor of a trust, who is treated as the owner of the trust under subpart E, pays the income tax attributable to the inclusion of the trust's income in the grantor's taxable income, the grantor is not treated as making a gift of the amount of the tax to the trust beneficiaries. If, pursuant to the trust's governing instrument or applicable local law, the grantor must be reimbursed by the trust for the income tax payable by the grantor that is attributable to the trust's income, the full value of the trust's assets is includible in the grantor's gross estate under § 2036(a)(1). If, however, the trust's governing instrument or applicable local law gives the trustee the discretion to reimburse the grantor for that portion of the grantor's income tax liability, the existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust's assets to be includible in the grantor's gross estate. In PLR 200816008 the following self-explanatory rulings were granted: 1. The inadvertent payment by Granddaughter of income taxes on mineral receipts that were, in fact, allocated to principal and not distributed to her does not constitute an addition to the Trust for generation-skipping transfer (GST) tax purposes where Granddaughter has a right of recovery from the Trust, has exercised her right, and the Trustee, in fact, reimburses Granddaughter in the amount of the overpayment, plus interest. 2. The inadvertent payment by Granddaughter of income taxes on mineral receipts that were, in fact, allocated to principal and not distributed to her does not constitute a gift to the Trust for gift tax purposes where Granddaughter has a right of recovery from the Trust, has exercised her right, and the Trustee, in fact, reimburses Granddaughter in the amount of the overpayment, plus interest. A-127 J. K. SECTIONS 2041 AND 2514 GENERAL POWERS OF APPOINTMENT SECTIONS 61, 83, 409A, 2042 AND 7872 - LIFE INSURANCE 1. Transfer Between Grantor Trusts Not a Transfer for Value. Section 101 provides that if an insurance policy is transferred for a valuable consideration prior to the death of the insured the usual rule that the insurance proceeds are income tax free does not apply. A transfer of value that is nonetheless to the insured is not a transfer for value. The IRS ruling position is that a transfer of a policy to a trust of which the insured is the grantor, and the trust is a wholly grantor trust, is a transfer to the insured and hence there is no transfer for value. See PLRs 200606027, 200518061, 200514001, 200514002, 200247006, 200228019, 200120007. A transfer from one life insurance to another, where the trusts are grantor trusts, is a useful way to avoid the three-year inclusion rule of sections 2042 and 2035. Care must be taken to ensure that the recipient trust, in particular, is a grantor trust for all purposes. Rev. Rul. 2007-13, IRB 2007-11 at 684, confirms the holdings of the private letter rulings above. In Situation 1, two trusts were grantor trusts with respect to grantor. The second trust owned an insurance policy on grantor s life and transferred the policy to the first trust for cash. In Situation 2, the second trust (the transferring trust) was not a grantor trust. The Ruling states that for transfer for value purposes under section 101 the grantor of a grantor trust is treated as the owner of the policy. Thus, in both situations, the buyer of the policy is considered to be the insured. L. SECTION 2053 and 2054 - DEBTS AND ADMINISTRATION EXPENSES 1. Proposed Regulations under Section 2053. The IRS has issued new Proposed Regulations under section 2053, principally dealing with the value of claims deductible for estate tax purposes. REG-143316-03; 72 F.R. 20080-20087. In general, the approach of the Proposed Regulations is to allow a deduction for amounts actually paid, as they are paid, rather than a valuation of the claim approach. In addition, there is a special rule for claims by family members intended to create a presumption against the validity of such claims. The Proposed Regulations are controversial not only for the approach taken but also because of perceived difficulties implementing them in connection with the marital (and charitable) deduction. The Supplementary information discusses the case-law background of the Proposed Regulations and states: Section 2001 of the Code imposes a tax on the transfer of the taxable estate, determined as provided in section 2051, of every decedent, citizen, or resident of the United States. Section 2031(a) generally provides that the value of the decedent's gross estate shall include the value at the time of decedent's death of all property, real or personal, tangible or intangible, wherever situated. Section 2051 provides that the value of the taxable estate is determined by deducting from the value of the gross estate the deductions provided for in sections 2051 A-128 through 2058. Pursuant to section 2053(a), "the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts -(1) for funeral expenses, (2) for administration expenses, (3) for claims against the estate, and (4) for unpaid mortgages on, or any indebtedness in respect of, property where the value of the decedent's interest therein, undiminished by such mortgage or indebtedness, is included in the value of the gross estate, as are allowable by the laws of the jurisdiction, whether within or without the United States, under which the estate is being administered." The deductions allowable under sections 2051 through 2058 operate to eliminate from estate taxation those portions of the gross estate that are necessarily expended in paying certain claims and expenses of the estate. The rationale for those deductions is that those expended portions of the gross estate are not transferred to the decedent's legatees, beneficiaries, or heirs and, therefore, are not subject to the transfer tax. The amount an estate may deduct for claims against the estate has been a highly litigious issue. Unlike section 2031, section 2053(a) does not contain a specific directive to value a deductible claim at its date of death value. Section 2053, in fact, specifically contemplates expenses such as funeral and administration expenses, which are only determinable after the decedent's date of death. Although numerous courts have addressed section 2053(a)(3), there is little or no consistency among the conclusions of those courts with regard to the extent (if any) to which post-death events are to be considered in valuing such claims. One line of cases follows the decision in Ithaca Trust v. Commissioner, 279 U.S. 151 (1929), holding that the estate tax charitable deduction for a charitable remainder interest was to be determined as of date of death. In Federal judicial circuits where the Ithaca Trust date-of-death valuation approach is applied to a claim against a decedent's estate under section 2053(a)(3), courts generally hold that post-death events may not be considered when determining the amount deductible for that claim. At the opposite end of the spectrum, there is a line of cases that follows the Eighth Circuit's opinion in Jacobs v. Commissioner, 34 F.2d 233 (8th Cir. 1929), cert. denied, 280 U.S. 603 (1929), in which the court considered but rejected the date-of-death valuation approach in determining the deductible amount of a claim against the estate. The court in Jacobs distinguished Ithaca Trust, stating that, unlike charitable deductions, ". . . the claims which Congress intended to be deducted were actual claims, not theoretical ones." The court therefore held that only claims presented and determined as valid against the estate and actually paid could be deducted as claims against the estate. Jacobs, 34 F.2d at 235. The courts that follow Jacobs generally restrict the amount deductible under section 2053(a)(3) to amounts actually paid by the estate in satisfaction of the claim. Even in the circuits where the date-of-death valuation approach has been applied in determining the amount that may be deducted for a claim against the decedent's estate, courts have recognized exceptions that necessitate taking into account events that occur after the decedent's death. For example, courts have deviated from the date-of-death valuation approach in favor of the actual payment approach when a claim is contested, contingent, unenforceable, becomes unenforceable after the decedent's death, or is not in fact presented for payment. The application and extent of these exceptions are inconsistent from A-129 circuit to circuit, however, and cannot be reconciled to form a conclusive rule applicable to all estates. The result of this lack of consistency in the case law is that similarly situated estates are being treated differently for Federal estate tax purposes, depending only upon the jurisdiction in which the executor resides. The Treasury Department and the IRS believe that similarly situated estates should be treated consistently by having section 2053(a)(3) construed and applied in the same way in all jurisdictions. One possible approach would be to value claims against a decedent's estate on the basis of the facts existing on the date of the decedent's death. The Treasury Department and the IRS believe, however, that this date-of-death valuation approach, when applied, has required an inefficient use of resources for taxpayers, the IRS, and the courts. Determining a date-of-death value requires the taxpayer and the IRS to retry the substantive issues underlying the claims against the estate in a tax controversy setting. In most cases, the tax controversy is addressed after the issue either has been settled by or has been argued by parties with adverse interests in a court of competent jurisdiction that is more familiar with the nuances of the underlying applicable law. Furthermore, this approach has proven to be expensive, both in terms of appraisal and litigation costs. In addition, this approach generally results in a deduction that is different from the amount actually paid on disputed claims. Finally, the date-of-death valuation approach often forces the taxpayer involved in actively defending against a claim to take contradictory positions on the estate tax return and in the substantive court pleadings, and may actually increase the taxpayer's potential liability. After carefully considering the numerous judicial decisions and the analysis and conclusion in each, the legislative history of section 2053 and its predecessors, and the various possible alternatives, and in order to further the goal of the effective and fair administration of the tax laws, the proposed regulations adopt rules based on the premise that an estate may deduct under section 2053(a)(3) only amounts actually paid in settlement of claims against the estate. If the resolution of a contested or contingent claim cannot be reached prior to the expiration of the period of limitations for claims for refund, the estate may file a protective claim for refund to preserve its right to claim a deduction under section 2053(a). Explanation of Provisions The proposed regulations will amend the regulations under section 2053 to clarify that events occurring after a decedent's death are to be considered when determining the amount deductible under all provisions of section 2053 and that deductions under section 2053 are limited to amounts actually paid by the estate in satisfaction of deductible expenses and claims. Final court decisions as to the amount and enforceability of the claim or expense are accepted in determining the amount deductible if the court passes upon the facts upon which deductibility depends. Settlements are accepted if they are reached in bona fide negotiations between adverse parties with valid claims recognizable under applicable law, and if they are not inconsistent with the applicable law. A protective claim for A-130 refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund if the amount of a liability will not be ascertainable by the time of the expiration of the period of limitations for claims of refund. A deduction is not allowed to the extent the expense or claim is compensated for by insurance or is otherwise reimbursed. The proposed regulations further provide that no deduction may be taken on an estate tax return for a claim that is potential, unmatured, or contested at the time the return is filed. A protective claim for refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund by reason of the deduction of a claim against the estate to the extent that claim is ultimately paid by the estate. Additional provisions in the proposed regulations provide guidance for other particular circumstances. When a claim against an estate lists multiple defendants, the estate may only deduct the decedent's portion of the liability. Claims by family members or beneficiaries of a decedent's estate will be strictly scrutinized to ensure that they are legitimate claims. If a claim becomes unenforceable after the decedent's death, the estate may not take a section 2053(a)(3) deduction with respect to the claim. If a claim represents a decedent's obligation to make recurring payments that will likely continue for a period extending beyond the final determination of the estate tax liability, a deduction is allowed only as each payment is made, provided the period of limitations for claims for refund has not expired or the estate has properly preserved the claim for refund. Alternatively, a deduction is allowed for the cost of a commercial annuity purchased by the estate from an unrelated dealer in commercial annuities in satisfaction of that obligation. Finally, the proposed regulations reflect changes made to section 2053(d) and the enactment of section 2058 in 2001 and clarify that the rules in section 20.2053-9 apply only to the estates of decedents dying on or before December 31, 2004. Proposed Effective Date The regulations, as proposed, apply to the estate of any decedent dying on or after the date final regulations are published in the Federal Register. The Proposed Regulations also deal with deductions for administration expenses. That section reads as follows: § 20.2053-1 Deductions for expenses, indebtedness, and taxes; in general. (a) General rule. In determining the taxable estate of a decedent who was a citizen or resident of the United States at death, there are allowed as deductions under section 2053(a) and (b) amounts falling within the following two categories (subject to the limitations contained in this section and in §§ 20.2053-2 through 20.2053-10): A-131 ***** (b) * * * (1) * * * In order to properly take into account events occurring after the date of a decedent's death when determining the amount deductible against a decedent's estate, the deduction for any item described in paragraph (a) of this section is limited to the total amount actually paid (subject to any time requirement under paragraph (a) of this section) in settlement or satisfaction of that item. (See however, § 20.2053-1(b)(4) for a special rule for deducting certain estimated amounts.) (2) Effect of court decree -- (i) In general. If the court with appropriate jurisdiction over the administration of the estate reviews and approves expenditures for funeral expenses, administration expenses, claims against the estate, or unpaid mortgages as allowable estate expenditures under local law, the executor may rely on the final judicial decision in that matter to determine the amount deductible for estate tax purposes if the following conditions are satisfied: the expenditures are otherwise deductible under section 2053 and the corresponding regulations; the expenditures have been paid by the estate or meet the requirements for estimated expenses; the court reviewed the facts relating to the expenditures; and the court's decision is consistent with local law. See § 20.2053-2 for additional rules regarding the deductibility of funeral expenses. See § 20.2053-3 for additional rules regarding the deductibility of administration expenses. See § 20.2053-4 for additional rules regarding the deductibility of claims against the estate. See § 20.2053-7 for additional rules regarding the deductibility of unpaid mortgages. If the decision reached by the court is inconsistent with local law, the estate may not rely on the court's decree to establish the amount deductible for estate tax purposes. For example, a local court decree approving an allowance made to an executor in excess of the amount or limit prescribed by statute may not be relied upon to establish the amount deductible under section 2053. An estate will not be denied an otherwise allowable deduction under section 2053 solely because a local court decree has not been entered with respect to that amount if the amount would be allowable under local law and if no court decree is required under applicable law for payment. (ii) Consent decree. An executor may rely on a local court decree rendered by consent to establish the amount deductible under section 2053 for amounts paid (or meeting the requirements for estimated expenses) if the consent was a bona fide recognition of the validity of the claim and was accepted by the court as satisfactory evidence upon the merits. Consent given by all parties having interests adverse to that of the claimant will be presumed to be recognition of the claim's validity. See § 20.2053-4(b)(4) for special rules to determine the amount deductible for claims by decedent's family members, related entities, or beneficiaries of the decedent's estate or revocable trust. (3) Settlements. An executor may rely on a settlement to establish the amount deductible under section 2053 for amounts paid (or meeting the A-132 requirements for estimated expenses) (subject to any applicable time limitation under paragraph (a) of this section) if the following conditions are satisfied: the settlement resolves a bona fide issue in an active and genuine contest; the settlement is the product of arm's length negotiations by parties having adverse interests with respect to the claim; and the settlement is within the range of reasonable outcomes under applicable state law governing the issues resolved by the settlement. A settlement that results in a compromise between the positions of such adverse parties and reflects the parties' assessments of the relative strengths of their respective positions is a settlement that is within the range of reasonable outcomes. However, a deduction for amounts paid in settlement of a claim against the decedent's estate will not be allowed if the terms of the settlement are inconsistent with applicable local law. No deduction will be allowed for amounts paid in settlement of an unenforceable claim. See § 20.2053-4(b)(4) for special rules to determine the amount deductible for claims by decedent's family members, related entities, or beneficiaries of the decedent's estate or revocable trust. For settlements structured using recurring payments, see § 20.2053-4(b)(7). (4) Estimated amounts. A deduction will be allowed for a claim that satisfies all applicable requirements even though its exact amount is not then known, provided that the amount is ascertainable with reasonable certainty, and will be paid. Under this exception to the rule set forth in paragraph (b)(1) of this section, no deduction may be taken upon the basis of a vague or uncertain estimate. If a deduction is allowed in advance of payment and the payment is thereafter waived or otherwise left unpaid, it shall be the duty of the executor to notify the Commissioner and to pay the resulting tax, together with interest. To the extent that the amount of a liability otherwise deductible under section 2053 is not ascertainable with reasonable certainty at the time of examination of the return by the Commissioner, or to the extent that it is not then clear that the amount will be paid, that amount will not be allowed as a deduction by the Commissioner. If the deduction is disallowed in whole or in part on examination of the return and the amount of the liability is subsequently ascertained and paid, relief may be sought by a timely claim for refund as provided by section 6511. A protective claim for refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund if the amount of a liability was or will not be paid before the expiration of the period of limitations for claims for refund. Although the protective claim need not state a particular dollar amount or demand an immediate refund, the protective claim must identify the outstanding liability or claim that would have been deductible under section 2053(a) had it already been paid. The protective claim must also describe the reasons and contingencies delaying the determination of the liability or the actual payment of the claim. Action on protective claims will proceed after the executor has notified the Commissioner that the contingency has been resolved. A-133 (5) Reimbursements. A deduction is not allowed to the extent that the expense or claim is or could be compensated for by insurance or otherwise reimbursed. (6) Examples. The following examples illustrate the application of this section. Assume that the amounts are payable out of property subject to claims and are allowable by the law of the jurisdiction governing the administration of the estate, whether the applicable jurisdiction is within or without the United States. Example 1. Estimated amounts, deduction ascertainable. Decedent's (D's) estate was probated in state. State law provides that the personal representative shall receive compensation equal to 2.5 percent of the value of the probate estate. The executor (E) may claim a deduction for estimated fees equal to 2.5 percent of D's probate estate on the estate tax return filed for D's estate as an estimated amount, provided the amount will be paid to E after the estate tax return is filed. To the extent that, at the time of the examination of the return, the amount has not been paid and E cannot satisfy the conditions listed in paragraph (b)(4) of this section and § 20.2053-3(b)(1), the deduction will be disallowed, but the executor may file a timely protective claim for refund to protect the estate's right to a refund once the amount has been paid or satisfies the applicable conditions. If the deduction is allowed in advance of payment and the payment is thereafter waived or otherwise left unpaid, it shall be the duty of the executor to notify the Commissioner and to pay the resulting tax, together with interest. Example 2. Estimated amounts, deduction not ascertainable. Prior to death, Decedent (D) is sued by Claimant (C) for $100x in a tort proceeding and responds asserting affirmative defenses available to D under applicable local law. C and D are unrelated. D subsequently dies and D's Form 706 is due before a final judgment is entered in the case. The executor (E) of D's estate may not take a deduction for $100x on D's estate tax return as an estimated amount because the deductible amount cannot be ascertained with reasonable certainty in accordance with § 20.2053-4(b)(2). If the amount of the actual liability will not be paid or cannot be ascertained with reasonable certainty before the expiration of the period of limitations for claims for refund, E may file a protective claim before that date in order to preserve the estate's right subsequently to claim a refund. *** § 20.2053-3 Deductions for expenses of administering estate. ***** (b) Executor's commissions. (1) The executor, in filing the estate tax return, may deduct executor's commissions in such an amount as has actually been paid, or in an amount which at the time of filing the estate A-134 tax return may reasonably be expected to be paid, but no deduction may be taken if no commissions are to be collected. If the amount of the commissions has not been fixed by decree of the proper court, the deduction will be allowed on the examination of the return, to the extent that all three of the following conditions are satisfied: (i) The Commissioner is reasonably satisfied that the commissions claimed will be paid. (ii) The amount claimed as a deduction is within the amount allowable by the laws of the jurisdiction in which the estate is being administered. (iii) It is in accordance with the usually accepted practice in the jurisdiction to allow such an amount in estates of similar size and character. (2) If the conditions described in paragraph (b)(1) of this section are not met, a protective claim for refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund for future amounts paid as described in § 20.2053-1(b)(4). (3) If the deduction is disallowed in whole or in part on the examination of the return and a protective claim was timely filed, the disallowance will be subject to modification once the requirements for deductibility are met. If the deduction is allowed in advance of payment and payment is thereafter waived or otherwise left unpaid, it shall be the duty of the executor to notify the Commissioner and to pay the resulting tax, together with interest. ***** (c) Attorney's fees. (1) The executor, in filing the estate tax return, may deduct such an amount of attorney's fees as has actually been paid, or an amount which at the time of filing may reasonably be expected to be paid. If on the examination of the return, the fees claimed have not been awarded by the proper court and paid, the deduction will, nevertheless, be allowed, if the Commissioner is reasonably satisfied that the amount claimed will be paid and that it does not exceed a reasonable remuneration for the services rendered, taking into account the size and character of the estate and the local law and practice. If the amount does not satisfy these requirements, a protective claim for refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund for future amounts paid as described in § 20.2053-1(b)(4). If the deduction is disallowed in whole or in part on the examination of the return and a protective claim was timely filed, the disallowance will be subject to modification once the requirements for deductibility are met. ***** A-135 (d) * * * (3) Expenses incurred in defending the estate against claims described in section 2053(a)(3) are deductible as provided in § 20.2053-1 if the expenses are incurred incident to the assertion of defenses to the claim available under the applicable law, even if the estate is not ultimately victorious. For purposes of this section, "expenses incurred in defending the estate against claims" include costs relating to the arbitration and mediation of contested issues, costs associated with defending the estate against claims (whether or not enforceable), and costs associated with reaching a negotiated settlement of the issues. Expenses incurred merely for the purpose of unreasonably extending the time for payment, or incurred other than in good faith, are not deductible. As indicated above, the new Proposed Regulation dealing with a deduction for claims against an estate is more controversial: § 20.2053-4 Deduction for claims against the estate. (a) In general. (1) For purposes of this section, liabilities imposed by law or arising out of contracts or torts are deductible if they meet the requirements set forth in § 20.2053-1 and this section. Except as provided in paragraph (b) of this section, the amounts that may be deducted as claims against a decedent's estate are limited to amounts for legitimate and bona fide claims that -(i) Represent personal obligations of the decedent existing at the time of the decedent's death; (ii) Are enforceable against the decedent's estate at the time of payment; and (iii) Are actually paid by the estate in settlement of the claim. (2) Events occurring after the date of a decedent's death shall be considered when determining the amount deductible against a decedent's estate. (b) Special rules--(1) Potential and unmatured claims. Claims that are unmatured on the date of the decedent's death and that later mature and are paid are deductible by the estate. However, no deduction may be taken on an estate tax return for a potential or unmatured claim. If the claim matures and is paid prior to the expiration of the period of limitations for filing a claim for refund, the estate may file a claim for refund as provided by section 6511. A protective claim for refund may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund once the claim against the decedent's estate is matured and is paid or may be estimated as provided in § 20.2053-1(b)(4). Although the protective claim need not state a particular dollar amount or demand an immediate refund, the protective claim must identify the outstanding liability or claim that would have been deductible under section 2053(a) had it already been paid, and must describe the reasons A-136 and contingencies delaying actual payment of the liability or claim. Action on protective claims will proceed after the executor has notified the Commissioner that the contingency has been resolved. (2) Contested claims. No deduction may be taken on an estate tax return for a claim against the decedent's estate to the extent the estate is contesting the decedent's liability. However, see § 20.2053-1(b)(4) relating to estimated amounts. (3) Claims against multiple parties. If the decedent or the decedent's estate is one of two or more parties against whom the claim is being asserted, the estate may only deduct the portion of the total claim due from and paid by the estate, reduced by the total of any reimbursement received from another party, insurance, or otherwise. The estate's deductible portion will also be reduced by the amount or contribution the estate could have collected from another party or an insurer but which the estate declines or fails to attempt to collect. If, however, the estate establishes that the burden of necessary collection efforts would have outweighed the benefit from those efforts, the potential reimbursement will not reduce the estate's deductible portion of the total claim. If the estate establishes that the party from whom a potential reimbursement could be collected could only pay a portion of the potential reimbursement, then only that portion that could reasonably have been expected to be collected will reduce the estate's deductible portion of the total claim. (4) Claims by family members, related entities, or beneficiaries. Relationships with and among a decedent and the decedent's family members, related entities, and beneficiaries may create the potential for collusion in asserting invalid or exaggerated claims in order to reduce the decedent's taxable estate. Thus, notwithstanding § 20.2053-1 and paragraph (a) of this section, there will be a rebuttable presumption that claims by a family member of the decedent, a related entity, or a beneficiary of the decedent's estate or revocable trust are not legitimate and bona fide and therefore are not deductible. Evidence sufficient to rebut the presumption may include evidence that the claim arises from circumstances that would reasonably support a similar claim by unrelated persons or non-beneficiaries. Similarly, a settlement between a decedent's estate or revocable trust and a family member, a related entity, or a beneficiary of the decedent's estate or revocable trust will be presumed to not be deductible absent evidence of the legitimacy and bona fide nature of the claim. For purposes of this section, family members include the spouse of the decedent; the grandparents, parents, siblings, and lineal descendants of the decedent or of the decedent's spouse; and the spouse and lineal descendants of any such grandparent, parent, and sibling. Family members include adopted individuals. For purposes of this section, a related entity is an entity in which the decedent, either directly or indirectly, had a beneficial ownership interest at the time of the decedent's death or at any time during the three-year period ending on the decedent's date of death. Such an entity, however, shall not include a publicly-traded entity nor shall it include a closely-held entity in which the combined beneficial interest, either direct or indirect, of the decedent and the decedent's family members, collectively, is less than thirty percent of the beneficial ownership interests (whether voting or non-voting). A-137 (5) Unenforceable claims. Claims that are unenforceable prior to or at the decedent's death are not deductible, even if they are actually paid. Claims that become unenforceable during the administration of the estate are not deductible to the extent that they are paid after they become unenforceable. To the extent that enforceability of a claim is at issue, see paragraph (b)(2) of this section relating to contested claims. (6) Claims founded upon a promise. Except with regard to pledges or subscriptions, (see § 20.2053-5), section 2053(c)(1)(A) provides that the deduction for a claim founded upon a promise or agreement is limited to the extent that the promise or agreement was bona fide and in exchange for adequate and full consideration in money or money's worth. For this purpose, bona fide and for adequate and full consideration in money or money's worth requires that the promise or agreement must have been made in good faith, and that the price must have been an adequate and full equivalent reducible to a money value. (7) Recurring payments -- (i) Non-Contingent obligations. If a decedent is obligated to make recurring payments on an enforceable and certain claim that are not subject to a contingency and if the payments will continue for a period that will likely extend beyond the final determination of the estate tax liability, the obligation may be deducted as an estimated amount using the rules in § 20.2053-1. The amount deductible is the present value of the payments on the decedent's date of death as determined under § 20.2031-7(d). See § § 20.7520-1 through 20.7520-4. If there is a reasonable likelihood that full satisfaction of the liability will not be made, then the obligation will be deemed to be subject to a contingency for purposes of this section. (ii) Contingent obligations. If a decedent has a recurring obligation to pay an enforceable and certain claim, but the decedent's obligation is subject to a contingency or is otherwise not described in paragraph (b)(7)(i) of this section, the estate's deduction is limited to amounts actually paid by the estate in satisfaction of the claim. (iii) Purchase of commercial annuity to satisfy recurring obligation to pay. If a decedent has a recurring obligation (whether or not contingent) to pay an enforceable and certain claim and the estate purchases a commercial annuity from an unrelated dealer in commercial annuities in an arms-length transaction to satisfy the obligation, the amount deductible by the estate is the sum of -(A) The amount paid for the commercial annuity; and (B) Any amount actually paid to the claimant by the estate prior to the purchase of the commercial annuity. (c) Interest on claims. The interest on a deductible claim is itself deductible as a claim under section 2053, but only to the extent of the amount of interest accrued at the date of the decedent's death and actually paid, even if the executor elects the alternate valuation method under section 2032. (Post-death accrued interest may be deductible in appropriate circumstances either as an estate tax administration expense under section 2053 or as an income tax deduction.) A-138 (d) Examples. The following examples illustrate the application of paragraphs (a) through (c) of this section. Except as is otherwise provided in the examples, assume that the claimant (C) is not a family member, related entity or beneficiary of the decedent (D) and is not the executor (E). Assume that a claim represents a personal obligation of D existing at the time of D's death and is enforceable against D's estate. Assume that the payment of the claim, where applicable, is made out of property subject to claims (as defined in section 2053(c)(2) and § 20.2053-1(c)(2)) and is allowable by the law of the jurisdiction under which the decedent's estate is being administered, or is paid prior to the filing of the estate tax return (including any extension granted under section 6081) from property not subject to claims. Assume that any court decree is based upon the facts upon which deductibility depends and is consistent with applicable local law. Assume that any settlement is reached in bona fide negotiations between or among parties having adverse interests with respect to the claim and that the terms of the settlement are not inconsistent with applicable local law. Example 1. Contested claim, single defendant, no decision. D is sued by C for $100x in a tort proceeding and responds asserting affirmative defenses available to D under applicable local law. D dies and E is substituted as defendant in the suit. D's estate tax return is due before a judgment is reached in the case. D's gross estate includes only property subject to claims and exceeds $100x. E may not take a deduction on the return for the claim under section 2053(a)(3). A deduction may be claimed on the return, however, for expenses incurred prior to the filing of the estate tax return in defending the estate against the claim if the expenses have been paid in accordance with § 20.2053-3(c) or (d)(3) or as an estimate under § 20.2053-1(b)(4). E may file a protective claim for refund before the expiration of the period of limitations for claims for refund of the estate tax in order to preserve the estate's right to claim a refund if the amount of the liability will not be paid or cannot be ascertained with reasonable certainty by the expiration of that period of limitations. If payment is subsequently made pursuant to a court decision or a settlement, a deduction for the payment, as well as expenses incurred incident to the claim and not previously deducted, may be taken and relief may be sought by supplementing a previously filed protective claim or by filing a claim for refund as provided by section 6511. Example 2. Contested claim, single defendant, final court decree and payment. The facts are the same as in Example 1 except that, before the return is timely filed, the court enters a decision in favor of C, no timely appeal is filed, and payment is made. A deduction is allowed for the amount paid in satisfaction of the claim pursuant to the final decision of the local court, including any interest accrued prior to D's death, under section 2053(a)(3). In addition, a deduction may be available under § 20.2053-3(d)(3) for expenses incurred prior to the filing of the estate tax return in defending the estate against the claim and in processing payment of the claim. Example 3. Contested claim, single defendant, settlement and payment. The facts are the same as in Example 1 except that, before the return is timely filed, a settlement is reached between D's estate and C for $80x and payment is made. A deduction is allowed for the amount of the settlement paid to C ($80x) under section 2053(a)(3). In addition, a deduction may be available under § 20.2053- A-139 3(d)(3) for expenses incurred prior to the filing of the estate tax return in defending the estate, reaching a settlement, and processing payment of the claim. Example 4. Contested claim, multiple defendants. The facts are the same as in Example 1 except that the suit filed by C lists D and K, an unrelated third-party, as defendants. If the claim is not resolved prior to the time the estate tax return is filed, E may not take a deduction for the claim under section 2053(a)(3) on the return. If payment is subsequently made of D's share of the claim pursuant to a court decision or a settlement holding D liable for 40 percent of the amount due and K liable for 60 percent of the amount due, then the estate may take a deduction for the amount paid in satisfaction of the claim representing D's share of the liability as assigned by the court decree ($40x), plus any interest on that share accrued prior to D's death, under section 2053(a)(3). If the court decision finds D and K jointly and severally liable for the entire $100x and D's estate pays the entire $100x but could have reasonably collected $50x from K in reimbursement, the estate may take a deduction under section 2053(a)(3) and paragraph (b)(3) of this section for only $50x and the interest on $50x accrued prior to D's death. In both instances, a deduction may also be available under § 20.2053-3(d)(3) for expenses incurred and not previously deducted in defending the estate against the claim and processing payment of the amount due from D. Example 5. Contested claim, multiple defendants, settlement and payment. The facts are the same as in Example 1 except that the suit filed by C lists D and K, an unrelated third-party, as defendants. D's estate settles with C for $10x and payment is made before the return is timely filed. E may take a deduction for the amount paid to C in satisfaction of the claim. In addition, a deduction may be available under § 20.2053-3(d)(3) for expenses incurred prior to the filing of the estate tax return in defending the estate, reaching a settlement, and processing payment of the claim. Example 6. Mixed claims. During life, D contracts with C to perform specific work on D's home for $75x. Under the contract, additional work must be approved in advance by D. C performs additional work and sues D for $100x for work completed including the $75x agreed to in the contract. D dies and D's estate tax return is due before a judgment is reached in the case. E contests liability for $25x. E may take a deduction on the return for $75x if it has been paid or if it meets the requirements of an estimated amount. In addition, a deduction may be claimed on the return for expenses incurred in defending the estate against the claim if they have been paid under § 20.2053-3(c) or (d)(3) or as an estimate under § 20.2053-1(b)(4). E may file a protective claim for refund before the expiration of the period of limitations on claims for refund of the estate tax in order to preserve the estate's right to claim a refund if payment on any amount in excess of $75x is subsequently made in resolution of a claim that would qualify for a deduction under section 2053. To the extent that the expenses incurred in defending the estate against the claim are not deducted as an estimate, they may be included in the protective claim for refund. Example 7. Unenforceable claims. D is sued by C for $100x in a tort proceeding but the claim is barred by the applicable period of limitations and there is no other recourse available to C. A deduction is not allowed for the claim under section 2053(a)(3) whether or not the estate actually pays money in satisfaction A-140 of the claim. A deduction may be available, however, under § 20.2053-3(d)(3) for expenses incurred in defending the estate against the claim. Example 8. Non-contingent and recurring obligation to pay, binding on estate. D's property settlement agreement incident to D's divorce, signed three years prior to D's death, obligates D or D's estate to pay to S, D's former spouse, $20x per year for 10 years. The payments are not conditioned on whether or not S remarries. If S dies prior to the last payment, the terms of the agreement state that the remaining payments are to be made to S's estate or as S may appoint in S's will. Prior to filing D's estate tax return, D's estate pays the first of the 7 payments remaining as of D's death. The estate may take a deduction for the present value of these payments. See § § 20.7520-1 through 20.7520-4. Example 9. Contingent recurring obligation to pay, binding on estate. D's property settlement agreement incident to D's divorce, signed three years prior to D's death, obligates D or D's estate to pay to S, D's former spouse, $20x per year for 10 years. The obligation to make the annual payments ceases upon S's remarriage or S's death prior to the due date of the last payment. Prior to filing D's estate tax return, D's estate pays the first of the 7 payments remaining as of D's death. E may take as a deduction on the return the amount of the 1 payment made prior to the filing of D's estate tax return. Additional payments become deductible as they are paid. E may file a protective claim for refund before the expiration of the period of limitations for claims for refund of the estate tax in order to preserve the estate's right to claim a refund if the amount of the liability will not be paid or is not ascertainable with reasonable certainty by the expiration of the applicable period of limitations. If the total amount to be paid in satisfaction of the liability is not ascertainable with reasonable certainty at the time of examination of the return, relief may be sought by a claim for refund (either actual or protective) as provided by section 6511. Example 10. Recurring obligation to pay, estate purchases a commercial annuity in satisfaction. D's property settlement agreement incident to D's divorce, signed three years prior to D's death, obligates D or D's estate to pay to S, D's former spouse, $20x per year for 10 years. D's estate purchases a commercial annuity from an unrelated dealer in commercial annuities, XYZ, in a bona fide sale to satisfy the obligation to S. E may deduct the entire amount paid to XYZ to obtain the annuity, regardless of whether or not the obligation to S was contingent. The deduction for taxes is also discussed: § 20.2053-6 Deduction for taxes. (a) In general. Taxes are deductible in computing a decedent's gross estate only as claims against the estate (except to the extent that excise taxes may be allowable as administration expenses), and only to the extent not disallowed by section 2053(c)(1)(B) (see the remaining paragraphs of this section). However, see §§ 20.2053-9 and 20.2053-10 with respect to the deduction allowed for certain state and foreign death taxes. A-141 ***** (c) Death taxes. (1) For the estates of decedents dying on or before December 31, 2004, no estate, succession, legacy or inheritance tax payable by reason of the decedent's death is deductible, except as provided in § 20.2053-9 and § 20.2053-10 with respect to certain state and foreign death taxes on transfers for charitable, etc., uses. However, see sections 2011 and 2014 and these regulations with respect to credits for death taxes. (2) For the estates of decedents dying after December 31, 2004, see section 2058 to determine the deductibility of state death taxes. ***** (g) Post-death adjustments of deductible tax liability. Post-death adjustments increasing a tax liability accrued prior to the decedent's death, including increases of taxes deducted under this section, will increase the amount of the deduction taken under section 2053(a)(3) for that tax liability. Similarly, any refund subsequently determined to be due to and received by the estate with respect to taxes deducted by the estate under this section reduces the amount of the deduction taken for that tax liability under section 2053(a)(3). Expenses associated with defending the estate against the increase in tax liability or with obtaining the refund may be deductible under § 20.2053-3(d)(3). A protective claim for refund of estate taxes may be filed before the expiration of the period of limitations for claims for refund in order to preserve the estate's right to claim a refund if the amount of a deductible tax liability may be affected by such an adjustment or refund. The application of this section may be illustrated by the following examples: Example 1. Increase in tax due. After the decedent's death, the Internal Revenue Service examines the gift tax return filed by the decedent in the year before the decedent's death and asserts a deficiency of $100x. The estate spends $30x in a non-frivolous defense against the increased deficiency. The final determination of the deficiency, in the amount of $90x, is paid by the estate. The estate may deduct $90x under section 2053(a)(3) and $30x under § 20.2053-3(c)(2) or (d)(3). Example 2. Refund of taxes paid. Decedent's estate timely files D's individual income tax return for the year in which the decedent died. The estate timely pays the entire amount of the tax due, $50x, as shown on that return. The entire $50x was attributable to income received prior to the decedent's death. Decedent's estate subsequently discovers an error on the income tax return and files a timely claim for refund. Decedent's estate receives a refund of $10x. The estate is only allowed a deduction of $40x under section 2053(a)(3) for the income tax liability accrued prior to the decedent's death. If a deduction for $50x was allowed on the estate tax return prior to the receipt of the refund, it shall be the duty of the executor to notify the Commissioner of the change and to pay the resulting tax, with interest. *** A-142 § 20.2053-9 Deduction for certain state death taxes. (a) General rules for the estates of decedents dying on or before December 31, 2004. * * * For the estates of decedents dying after December 31, 2004, see section 2058 to determine the deductibility of state death taxes. ***** (c) Exercise of election. The election to take a deduction for a state death tax imposed upon a transfer for charitable, etc., uses shall be exercised by the executor by the filing of a written notification to that effect with the Commissioner. * * * The election may be revoked by the executor by the filing of a written notification to that effect with the Commissioner at any time before the expiration of such period. ***** *** § 20.2053-10 Deduction for certain foreign death taxes. ***** (c) Exercise of election. The election to take a deduction for a foreign death tax imposed upon a transfer for charitable, etc., uses shall be exercised by the executor by the filing of a written notification to that effect with the Commissioner. An election to take the deduction for foreign death taxes is deemed to be a waiver of the right to claim a credit under a treaty with any foreign country for any tax or portion thereof claimed as a deduction under this section. The notification shall be filed before the expiration of the period of limitations for assessment provided in section 6501 (usually 3 years from the last day for filing the return). The election may be revoked by the executor by the filing of a written notification to that effect with the Commissioner at any time before the expiration of such period. ***** Treasury personnel have stated that the new Proposed Regulations specifically do not address interest on money borrowed to pay estate taxes. Substantial criticism has been made of the Proposed Regulations. Treas. Reg. § 20.2956(b)-4 requires that the marital deduction be calculated as of the date of death. Consider an estate in which the residue passes entirely to the surviving spouse. If section 2053 does not allow a deduction for a claim on the Form 706, because it is unmatured, but the claim reduces the value of the estate on the date of death, the value of the marital deduction is reduced. The mismatch in approaches snapshot under section 2056 and deduct when paid under section 2053 is A-143 not easily rectified. Other issues are the difference in valuing a claim by an estate (snapshot) versus a claim against an estate (deduct when paid) even if in the same action, and the time value of money calculations. Another question about the Proposed Regulations that may be raised is their constitutionality. As the Background information states several courts have previously held that the claims should be handled differently than the approach mandated by the Proposed Regulations. In this regard, the discussion in Gerson , which deals with a GST regulation, should be considered. 2. Attorneys Fees. In John Kessler v. United States, (N.D. Cal. 2007) the court denied summary judgment to the government, in part, on the question of allowing attorneys fees as a deduction. The executrix probated a 2000 Will that after a two week trial was determined to be invalid because the testator lacked testamentary capacity. The parties subsequently settled the remaining issues about distribution of the estate, including payment of all parties attorneys fees. The opinion states:The fees were incurred by, (1) Robert, the executor under the 1994 will; (2) Margaret, the executor under the 2000 will that was tentatively declared invalid, and; (3) Herbert and the grandchildren, who were only beneficiaries under both wills. The IRS argues that California law permits attorney fees to be charged to an estate only when incurred by an executor or personal representative, and even then only under certain circumstances.2 The IRS is correct that the California Probate Code expressly provides only for payment by the estate of attorney fees incurred by a personal representative. See Cal. Prob. Code §§ 10810 et seq.3 Although the Code allows for the recovery of fees in excess of the statutory schedule when "extraordinary services" have been provided, those fees also are only such fees as have been incurred "by the attorney for the personal representative." Cal. Prob. Code §§ 10811. The IRS acknowledges that California cases have sometimes permitted beneficiaries to recover attorney fees from the estate under the "common fund doctrine." See In re Marre's Estate, 18 Cal.2d 191, 192 (1941) ("[P]laintiffs who have succeeded in protecting, preserving or increasing a fund for the benefit of themselves and others may be awarded compensation from the fund for the services of their attorneys.") The IRS, however, rejects the applicability of doctrine here because the litigation did not involve preserving or increasing estate assets, and Kessler does not argue to the contrary.4 Thus, neither the statutory scheme nor common fund doctrine serves as a basis under California law to permit the fees of Herbert and the grandchildren to be charged to the estate, as they undisputedly were not personal representatives under either will. Kessler suggests those fees (and those of Margaret and Robert) were nonetheless appropriately charged to the estate because the entire litigation was "essential to the proper administration of the estate." The condition that the fees be essential to the estate administration is an additional requirement of Federal law that applies in determining deductibility, it is not a substitute for the threshold requirement that the fees be allowable as estate expenses under state law. See Rev. Rul. 74-509, 4-5. Thus, as persuasive a case as Kessler may make A-144 that it was necessary to resolve issues such as which will governed before the estate could be administered, those arguments would serve only to support deductibility of the fees if they were properly allowable as administrative expenses of the estate under California law in the first instance. For a similar reason, Kessler's reliance on cases such as Dulles v. Johnson, 273 F.2d 362 (2nd Cir. 1959) and Estate of Swayne, 43 T.C. 190 (1964) is unavailing. In those cases, there was no question that the underlying state statutes (non-California) expressly permitted recovery from the estate of the kind of attorney fees in issue. See Swayne 43 T.C. at 197-198 (holding that the executor under a will that ultimately was not admitted to probate was entitled to recover his fees from the estate given Sec. 45-185 of the General Statutes of Connecticut that provided, in relevant part, "[t]he court of probate . . . shall allow to the executor his just and reasonable expenses in defending the will . . . whether or not the will is admitted to probate."); Dulles, 273 F. 2d at 369 (holding beneficiaries entitled to recover fees from estate under N.Y. Surrogate's Court Act, § 278.5) Putting aside for a moment the question of fees incurred by Robert and Margaret, all Kessler is left with in support of his contention that the fees of Herbert and the grandchildren were allowable as expenses of the estate under California law is the declaration of Michael Desmarais (counsel to Robert in the underlying proceedings) that payment of beneficiaries' fees by an estate is "customary" and that it is "authorized by the laws of the State of California." Desmarais Decl. ¶ 6. Although attorney Desmarais likely is qualified to testify as to what is "customary" in local practice, the question of what is "authorized" under state law presents a question for the Court, not an evidentiary issue to be resolved by declarations. Accordingly, based on the present record and briefing, the Court concludes that the fees incurred by Herbert and the grandchildren were not properly charged to the estate as administrative expenses and that, therefore those expenses are not deductible.6 The Court has weighed whether that conclusion warrants an order granting partial summary judgment, as provided in subdivision (d) of Rule 56 of the Federal Rules of Civil Procedure. Although the IRS did not move for partial summary judgment in the alternative, the rules authorize courts to issue orders that specify, "the facts that appear without substantial controversy." Fed. R. Civ. P. 56(d). Here, however, the issue of whether Herbert and the grandchildren's fees are properly charged to the estate appears to turn more on conclusions of law than on factual issues. Given that, and given that the IRS did not identify the dollar amount of the claimed refund that would be affected by a conclusion that Herbert and the grandchildren's fees are not deductible, the Court declines to issue partial summary judgment. Whether Margaret's fees were properly claimed as administrative expenses presents more difficult questions. As the IRS acknowledges, Margaret was the named executor under the 2000 will. As such, she had a duty to offer it for probate unless, perhaps, she knew it to be invalid. The probate court's tentative conclusion was that Margaret did not offer the will in bad faith. Thus, although neither party has cited California law clearly on point, there is at least some basis for arguing that her fees were properly charged to the estate.7 A-145 Robert's fees present the strongest case for Kessler's position. There is no dispute that he was the executor under the 1994 will that was validated by the stipulated order that followed the settlement. The IRS contends Robert was nonetheless not entitled to recover his fees from the estate because, (1) only he stood to benefit by admission of the 1994 will to probate rather than the 2000 will, and (2) in the only part of the litigation that went to trial, he technically was contesting the 2000 will, not defending the 1994 will. As to the first point, there is some authority that where only the executor stands to benefit from defending a will, the fees incurred in doing so cannot be charged to the estate. See, e.g. In re Higgins Estate, 158 Cal. 355 (1910). The situation here, however, appears to have been more complex. The estate could not have been administered absent a determination as to which will governed. There were, apparently, reasons to believe there had been undue influence, although the probate court ultimately noted that it had not been egregious in any event. In this regard, Sussman v. United States, 236 F.Supp. 507 (D.C.N.Y. 1962) is instructive, even though it applied New York rather than California law. "If the test is benefit to the estate, the test ought not to be incapable of embracing the idea that achieving a correct result is beneficial to the estate." Id. at 509. Robert had a duty as executor under the 1994 will to offer it for probate and to defend it, absent reason to believe that it had been superceded by a valid will or otherwise revoked. In doing so, he was giving effect to Hawkins' last expression of her intent made with testamentary capacity, according to the probate court's tentative decision. Under these circumstances, the IRS has failed to show that the mere fact that Robert stood to benefit under the 1994 will precluded him from charging his fees to the estate. The IRS's second point elevates form over substance. It may be true that the only portion of the underlying litigation that went to trial was technically a contest of the 2000 will, but that appears to be more a matter of procedural happenstance than otherwise. There is little doubt that the substance of the dispute from the outset through the trial and the settlement was the same: which will would be probated? The challenge to the validity of the 2000 will was part and parcel of the effort to defend the 1994 will. As such, the IRS has not established the impropriety of charging those fees to the estate.8 Finally, the IRS also argues that Robert's fees were unreasonable in amount and that the parties and the probate court failed to comply strictly with the statutory provisions governing the approval of fees based on a contingency agreement. The reasonableness of the fees claimed by Robert presents a factual issue not subject to determination in a motion for summary judgment. The apparent failure to comply with the letter of the procedural requirements applicable to contingency-based fees does not, on this record, warrant a finding that the fees were therefore not allowable under California law as estate administrative expenses. 3. Bona Fide Loan. The Tax Court found that a loan from a decedent s parents to the decedent was bona fide and allowed a section 2053 deduction in Estate of Kimberly A. Hicks et al. v. Commissioner, T.C. Memo. 2007-182. The court summarized the issue: A-146 HOLMES, Judge: Kimberly Hicks, while still a toddler, was severely disabled in a collision at a railroad crossing. Litigation followed, and the largest part of the ultimate settlement was a lump sum to be allocated between Kimberly and her father. The Ohio court that allocated that lump sum gave over $1.4 million to her father, but with the full expectation that he would immediately lend $1 million to a special trust for Kimberly's benefit. Kimberly died before she needed the money, and the major question presented in this case is whether the $1 million is deductible from the taxable value of her estate as a debt incurred on a bona fide loan. The opinion further states: The Commissioner's first attack on the bona fides of the loan is an argument that Clyde never had control over the $1 million to begin with. He claims that the settlement really provided Clyde with only $415,000 in damages, and that the probate judge's allocation of damages effectively transferred the $1 million straight from the guardian's interim financial holding account to the Management Trust without Clyde's ever having control. We think the Commissioner is underestimating the importance of the Probate Court in deciding to whom the $1 million belonged. The Hickses' lawyers were very careful in leaving the unallocated settlement funds with Society National until the beneficiaries were determined. This acknowledged the Probate Court's broad discretionary authority as "superior guardian" of a minor under Ohio law. That status means that the Probate Court has the power and authority to control the actions of the minor's guardian and act directly to ensure that the minor's best interests are being considered. Ohio Rev. Code Ann. sec. 2111.50 (Anderson 2002). It also means that the Probate Court has to approve any settlement which the minor's guardian reaches before it can take effect. See Ohio Rev. Code Ann. sec. 2111.18 (2007). Because of this essential role the Probate Court plays under Ohio law, we hold that the $1 million in question didn't belong to anyone until the Probate Court said it did. The Commissioner's attack doesn't end with that quibble about possession of the settlement proceeds under Ohio law. He also argues that the allocation was a sham. This is itself a problem because the statute and regulation don't tell us to review the allocation. They tell us to review the bona fides of the loan. Decades ago, we held that the "bona fides of a loan are primarily established by the intention of the parties that repayment will be made pursuant to the terms of the agreement." Estate of Ribblesdale v. Commissioner, T.C. Memo. 1964-177. The Commissioner isn't really contesting the existence of that intention -- it is uncontroverted that Kimberly's trust was paying interest to Clyde. We also specifically find that all the parties to the trust arrangement intended that the loan would be repaid if either of the stated conditions -- Kimberly's death or need to get on Medicaid -- were met. In Estate of Labombarde v. Commissioner, 58 T.C. 745, 753 (1972), affd. 502 F.2d 1158 (1st Cir. 1973), we held that the children's support payments to their mother were not a loan because there was no note evidencing the supposed debt and no interest was ever paid. Here, the facts are in complete contrast: The note was executed and admitted into the record, and Clyde was paid interest every month on the principal amount of the loan. A-147 The Commissioner does make a good point by noting that the Probate Court specifically mentioned at the settlement hearing only $415,000 as compensation to Clyde. He concludes from this that the extra $1 million allocated to Clyde in the papers approved by the Probate Court transformed the allocation into nothing more than an "uncontested, nonadversarial, and entirely tax-motivated" proceeding of the sort we condemned in Robinson v. Commissioner, 102 T.C. 116, 129 (1994), affd. in part and revd. in part 70 F.3d 34 (5th Cir. 1995). In the Commissioner's view, the Probate Court's review is colored by the undisputed fact the Hickses themselves proposed the allocations, and Kimberly and her father did not have adverse interests in how the settlement proceeds were distributed. The Commissioner reasonably suspects that this might mean the form of the allocations has little relation to economic reality, and that the disputed $1 million was Kimberly's at all times. We disagree at the outset with the Commissioner's unlinking of the $1 million repayment feature of the loan from its associated income stream. That income stream was Clyde's from the start, and it is plain error as a matter of economics to say in effect that it was valueless. Because the note was callable at Kimberly's death, we can estimate its present value as of the Probate Court's allocation by using her life expectancy at that time. That was the subject of considerable dispute, and the Commissioner argues that it ranged between 4 and 50 years. The annual payment to Clyde was fixed at $60,000. If one uses a discount rate of 10% to this income stream (at the time, longterm prime interest rates were between 7% and 8%),7 and applies it to the range of Kimberly's life expectancy, Clyde's income interest in the note was likely worth between $190,000 and $590,000 on the day it was created; if one discounts at 8%, that worth jumps to a range of $200,000 to $730,000. These values only increase if one adds in the prospect of payment of the principal, or computes some nonzero probability of that payment being accelerated by Kimberly's need to qualify for Medicaid. (They also admittedly decrease with the probability that Kimberly would use the money before then.) This means that the allocation approved by the Probate Court is not simply an allocation of $1 million to Kimberly. As the Hickses suggest, there was a real risk that Clyde would predecease Kimberly. If he did, the present value of the note would become part of his taxable estate, and these rough calculations strongly hint that that value would not be negligible. This strongly suggests that there was real economic substance here even if we look at the entirety of the allocation, including the loan. We do agree with the Commissioner that it's reasonable to assume that Kimberly's injuries would shorten her life, but we find as a fact she was in no danger of imminent death at the time of the settlement, and so do not see the loan as an attempt to dodge the imminent imposition of the estate tax. Cf. Robinson, 102 T.C. at 129 (even State-court-approved allocations are disregarded if done "solely with a view to Federal income taxes"). We also find that Clyde had plenty of motivation to seek a large portion of the settlement for himself. Remember that under Ohio law parents have a statutory obligation to provide continuing support to their minor children. Ohio Rev. Code Ann. sec. 3103.03(A) (Anderson 2003). And medical care for Kimberly was expected to cost around $30,000 a month. Given Clyde's obligation to support Kimberly until she was an adult, and in the face of Kimberly's enormously A-148 expensive round-the-clock care, it seems quite reasonable for Clyde to have sought a large payout and then to have provided part of it as a loan to a trust to ensure money would be available. The allocation-plus-loan of $1 million can be seen as fulfillment of the parental duty that he owed his daughter. Should the Hicks lose their health insurance, or if Kimberly turned out not to qualify for Medicaid coverage, the trusts and the Hickses would shoulder the financial burden. But the Hickses' lawyers foresaw a sea of troubles if that happened. If there was too much money in the Management Trust, Medicaid might swallow it all before Kimberly would become eligible; but if too much money went to Clyde, it might end up with unforeseen future creditors of his own if he met with bad luck. The loan was a way to tack between these two dangers. It ensured that the money would be there during Kimberly's minority, but with a towline attached so that if Kimberly were ever forced to rely on Medicaid, the money could be taken out of the Management Trust and she could qualify after spending down only $450,000 rather than nearly $1.5 million. Her parents would then have the resources from which they could continue to meet her needs that were unmet by Medicaid. In deciding whether the allocation as a whole lacked substance, we return again to the important role of the Probate Court under Ohio law. Probate courts' decisions in this area are discretionary -- as the Hickses' personal injury lawyer credibly testified: "Some judges don't like special-needs trusts, because some judges think that that money should go to the state, and that's just a strong philosophical belief. Some judges don't mind the loss-of-society claims; some judges do." And unless there is an abuse of discretion, an Ohio appellate court "will not substitute its judgment for that of the trial court." In re Estate of Steigerwald, 2004-Ohio-3834, at par. 17 (Ohio Ct. App. 2004) (discussing allocation of wrongful death suit). Ohio is, moreover, wonderfully blunt about why it gives Probate Courts this degree of deference: to "protect minors against others whose interests may be adverse to theirs, especially their parents." In re Guardianship of Matyaszek, 824 N.E.2d 132, 143 n.7 (Ohio Ct. App. 2004) (emphasis added). This makes us especially disinclined to second-guess, in the guise of economic-substance review, their specialized expertise in the appropriate allocation under Ohio family law of the lump-sum settlement of a state tort claim. In upholding the allocation of the settlement made by the State court in this case as having economic substance, we are not invoking a bright-line rule that our Court must always defer to settlement allocations reviewed by State courts -- we plainly don't in circumstances like those we faced in Robinson, where a statecourt judge late one night accepted a settlement that grossly rewrote a jury's allocation in a way plainly aimed at reducing the taxability of the award. In a case like that, there is no incentive by the state-court judge to closely review the settlement -- as we pointed out there, since Texas has no income tax of its own, there was no state interest that would be affected by a different allocation. The Hickses' case -- though superficially similar in that the settling tortfeasor had no interest in the allocation of the settlement -- is different in important ways. The first, of course, is that states themselves have an interest (represented by state-court judges) in considering the impact of allocations in personal injury cases on the state's own Medicaid system. The field of long-term health-care A-149 planning, both for the disabled and the elderly, is rapidly growing and changing with a frequency that seems to rival tax law's. The policy decisions already made by Congress and the states in that area -- acknowledging the use of trusts and asset transfers in preparing to qualify for Medicaid benefits, but limiting them and, in cases like this, subjecting them to state-court review -- strongly counsel us to not second-guess those courts in the guise of reallocating settlements years later in estate-tax cases. A second factor making us reluctant to upset the allocation here is that the initial allocation of the settlement was not between taxable and nontaxable amounts. Unlike Robinson, the allocation here was entirely among various causes of action all of which produced nontaxable transfers to the Hickses. That reduces the probability that tax avoidance was driving the allocation -- to be sure, there would be foreseeable tax consequences, but those consequences depended on questions that couldn't be answered with much certainty: Would Clyde and Theresa die before Kimberly? How much money would the trusts have to spend on her? Would the Blue Cross/Blue Shield insurance lapse sooner or later or not at all? And we finally return to Ohio's law expressly giving probate courts the authority to review intrafamily allocations of tort settlements when minors are involved. This reflects the all-toohuman likelihood that not all families will respond to the type of tragedy that the Hickses endured the way the Hickses endured it, by drawing together to do the best for all the members of the family. Some families will be rent asunder in dividing large amounts of money, and some parents will inevitably be tempted to cheat their own children. But Ohio foresaw that threat and created courts to forestall it. Due regard for them again counsels us against upsetting the allocation of the settlement here. Our hesitation echoes the Supreme Court's, which recently noted the potential importance of State-court approval in similar circumstances. Ark. Dept. of Health & Human Servs. v. Ahlborn, 547 U.S. 268, 126 S. Ct. 1752, 1765 (2006). Ahlborn involved a statutory lien that Arkansas imposed on settlement proceeds received by accident victims. The lien's purpose was to reimburse the State for its Medicaid expenses in caring for the victim, but the lien was limited to "medical expenses" that were recovered. Arkansas wanted to extend the lien to the entire amount of any settlement proceeds, suspecting that the parties' allocation of the settlement among various categories of damage was done with an eye to minimizing the reach of the lien. To be sure, Ahlborn is not directly on point either, because the Supreme Court did not actually rule on the argument that court approval should shield an allocation from subsequent second-guessing. But it did hint strongly in that direction: [T]he risk that parties to a tort suit will allocate away the State's interest can be avoided either by obtaining the State's advance agreement to an allocation or, if necessary, by submitting the matter to a court for decision. Id. at ___, 126 S. Ct. at 1765 & n.17 (emphasis added). A-150 We view with some skepticism the Commissioner's fear that upholding the deductibility of the loan repayment here will trigger a massive recharacterization of settlement proceeds as intrafamily loans in the future. But we take cases one at a time, and here the facts persuade us that Clyde's loan had real substance -- it was concededly valid under Ohio law, and resulted in the creation of real interest income on which he really did pay tax. We are particularly persuaded by the evidence that the Hickses were trying very hard to comply with the complex Medicaid-eligibility rules in settling the trusts. As the Supreme Court said in a leading opinion on substance-over-form, where, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties * * *. Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978). We therefore honor the allocation disputed here, and find that the $1 million loan was bona fide and for adequate and full consideration under section 2053(c)(1)(A). It is not a sham, and we hold that it is deductible from Kimberly's gross estate. M. SECTIONS 2056, 2056A AND 2519- MARITAL DEDUCTION 1. Obtaining Step-Up In Basis. PLR 200403094 is interesting. Husband created a trust and funded it with his own assets. The trust allowed him to revoke or amend it during his lifetime and to withdraw income and principal. The trust also gave his wife a testamentary general power of appointment if she died first: At my wife's death, if I am still living, I give to my wife a testamentary general power of appointment, exercisable alone and in all events to appoint part of the assets of the Trust Estate, having a value equal to (i) the amount of my wife's remaining applicable exclusion amount less (ii) the value of my wife's taxable estate determined by excluding the amount of those assets subject to this power, free of trust to my deceased wife's estate or to or for the benefit of one or more persons or entities, in such proportions, outright, in trust, or otherwise as my wife may direct in her Will. If husband died first a traditional marital/exemption equivalent plan would be implemented with the marital share passing outright to wife, and the exemption equivalent share being held in a Family Trust for wife and for husband s descendants, subject to ascertainable standards. appointment among husband s descendants. The ruling states that wife intends to execute a Will that was described as follows: Wife also had a testamentary special power of A-151 Wife plans to execute Will. Article 2.1 of Will makes gifts of Wife's tangible personality. Article 2.2 of Will provides: I exercise in favor of my estate the power of appointment given to me by Section 4.5 of the Trust created by [Husband] dated [__], and direct that assets having a value equal to (i) the amount of my remaining applicable exclusion amount less (ii) the value of my taxable estate, determined by excluding the amount of those assets subject to this power, be distributed to my estate as soon after my death as possible. Article 2.3 of Will provides that if Husband survives Wife, Husband will receive a fraction of Wife's residuary estate, after the payment of estate taxes, debts, and expenses, determined as follows: The numerator of the fraction will be the smallest pecuniary amount that, if given outright to [Husband], would eliminate or reduce to the lowest possible sum the state and federal estate tax liability of [Wife's] estate. This amount will be calculated by taking into account [Wife's] applicable exclusion amount and all other tax credits, deductions, and other preferences allowed to [Wife's] estate. The balance of the residuary estate will be held as a separate trust (Wife's Family Trust). If Husband does not survive Wife, the entire residuary estate will be held as the Family Trust. Under Article 3 of Will, any part of the gift to Husband that he disclaims will become part of Wife's Family Trust. The Family Trust is parallel to the Family Trust described above. The Service granted four rulings: 1. On the death of Wife during Husband's lifetime, if Wife exercises the power of appointment granted her under article 4.5 of Trust, Husband will be treated as making a gift that qualifies for the federal gift tax marital deduction to Wife with respect to that portion of Trust appointed by Wife. 2. If Wife predeceases Husband, of the assets in Trust, the value of Trust assets over which Wife holds a power of appointment under article 4.5 of Trust will be included in Wife's gross estate. 3. Any assets that originated in Trust and that pass to or from Wife's Family Trust established under Will will not constitute a gift from Husband to the other beneficiaries of Wife's Family Trust. 4. Any assets that originated in Trust and that pass to Wife's Family Trust established under Will will not be included in Husband's gross estate. A-152 Presumably the point of this exercise was for the assets in the trust passing into the Family Trust at the first death to receive a step-up in bases by reason of being included in the estate of the first to die. No income tax ruling is mentioned suggesting the Service was not prepared to rule (or to rule favorably) on the basis issue. Assets that pass back to a donee surviving spouse from a donor deceased spouse where the gift occurred within one year are denied a basis step-up. Thus, the question is, would these assets pass from husband to wife to husband if wife died first and, of course, that depends on the status of husband and the Family Trust. Also see PLR 200413011 where husband retained a special power of appointment over assets in an irrevocable trust that would pass into a QTIP if the power were released. PLR 200604028 is to the same effect. In Estate of Lee v. Commissioner, T.C. Memo 2007-371, the court refused to allow an estate tax marital deduction in similar circumstances. Guidance from the IRS has been requested. 2. Division of QTIP on Non-Pro-Rata Basis Followed by Renunciation Approved. In PLR 200717016 the IRS approved the division of a QTIP trust into sub-trusts on a non-pro-rata basis, followed by the spouse s renunciation of her interest in one of the trusts (creating a gift under section 2519, but only with respect to that trust). N. O. SECTIONS 2501 TO 2524 - GIFTS SECTION 2518 1. DISCLAIMERS Disclaimer to Charitable Lead Annuity Trust. At issue in Estate of Helen Christiansen v. Commissioner, 130 T. C. No. 1 (2008), was the disclaimer of assets to a private foundation (see the discussion of Charitable Allocation Clauses above) and to a charitable lead trust. Helen Christiansen died leaving everything to her only child, Christine Hamilton. Any amounts Christine Hamilton disclaimed would go 75% to a charitable lead annuity trust and 25% to a private foundation. Ms. Hamilton disclaimed a fraction of the estate the numerator of which was the fair market value of the estate, before payment of debts, expenses, and taxes, less $6,350,000, and the denominator of which was the fair market value of the estate, before payment of debts, expenses, and taxes. Fair market value was defined using the willing buyer, willing seller formula and referencing the value as finally determined for Federal estate tax purposes. The estate included some cash and real estate but also 99% interests in two limited partnerships. The estate tax return reported a total value of $6,512,223.20; in the litigation the parties agreed that the value of the estate was $9,578,895.93. The lead trust would pay an annuity equal to 7% of the fair market value of the trust as of Ms. Christiansen s date of death for 20 years to the private foundation with the remainder passing to Ms. Hamilton the A-153 disclaimant. A majority of the Tax Court found the disclaimer invalid because the disclaimant received an interest in the disclaimed property, the remainder of the CLAT. The opinion states: The applicable regulation is section 25.2518-2(e)(3), Gift Tax Regs., and the key provision is this one: (3) Partial failure of disclaimer. If a disclaimer made by a person other than the surviving spouse is not effective to pass completely an interest in property to a erson other than the disclaimant because: (i) The disclaimant also has a right to receive such property as an heir at law, residuary beneficiary, or by any other means; and (ii) The disclaimant does not effectively disclaim these rights, the disclaimer is not a qualified disclaimer with respect to the portion of the disclaimed property which the disclaimant has a right to receive * * *. If the regulation stopped here, the estate would win-- everyone agrees that the partial disclaimer s carveout of a contingent remainder means that the estate can t deduct the value of that remainder interest. But the regulation doesn t stop there. Instead, it continues: If the portion of the disclaimed interest in property which the disclaimant has a right to receive is not severable property or an undivided portion of the property, then the disclaimer is not a qualified disclaimer with respect to any portion of the property. Thus, for example, if a disclaimant who is not a surviving spouse receives a specific bequest of a fee simple interest in property and as a result of the disclaimer of the entire interest, the property passes to a trust in which the disclaimant has a remainder interest, then the disclaimer will not be a qualified disclaimer unless the remainder interest in the property is also disclaimed. It s the language we ve italicized that seems to resolve this issue. Hamilton: (a) is not a surviving spouse, (b) received a specific bequest of a fee simple interest in her mother s property under the will, (c) as a result of the disclaimer that property passed to a trust in which Hamilton had a remainder interest, and (d) Hamilton did not disclaim that remainder interest. The majority further determined that the remainder interest was neither severable property nor an undivided portion of the property. Severable property is defined by Treas. Reg. § 25.2518-3(a)(1)(ii) as property that can be divided into separate parts each of which has a complete and independent existence, e.g. shares of stock. The majority concluded that a remainder interest and annuity interest were not severable. A concurrence (eight judges) elaborated on the point, concluding that although an annuity interest and remainder interest may be A-154 ascertained and valued separately, they do not maintain a complete an independent existence apart because the remainder is dependent (more than is an income interest) on an annuity (which may include corpus). Treas. Reg. § 25.2518 3(b) defines an undivided portion of property as a vertical slice - - a fraction of each and every substantial interest or right owned by the disclaimant, extending over the entire term of the disclaimant s interest in the property. Specifically, the regulation provides that where a devisee receives a fee simple interest the devisee may not disclaim a remainder interest but retain a life estate. The majority rejected the estate s argument (accepted by the dissent, a total of three judges) that an annuity interest is severable property: But for Hamilton s retaining a remainder interest and giving up present enjoyment instead of the reverse, the example describes this case. The Court of Appeals for the Eighth Circuit explained the distinction by comparing it to horizontal and vertical slices. Disclaiming a vertical slice--from meringue to crust--qualifies; disclaiming a horizontal slice--taking all the meringue, but leaving the crust--does not Walshire, 288 F.3d at 347 The only difference that we can see between Walshire and this case is that Walshire disclaimed a remainder interest and kept the income, while Hamilton tried to do the reverse-but no matter how you slice it, the cases are indistinguishable. We are left with the conclusion that her disclaimer is not a qualified disclaimer with respect to any portion of the property. Sec. 25.2518-2(e)(3), Gift Tax Regs. The dissent reaches a different result by focusing on a different sort of property-the annuity interest created under the Trust agreement--and asking whether it is severable property. We agree that section 20.2055-2(e)(2)(vi), Estate Tax Regs., allows the severance of a guaranteed annuity interest from a remainder interest, and would allow a deduction for (a transfer of) the value of the annuity interest that the Trust would pay to the Foundation. But the problem for the estate is that this section of the regulations applies only to interests passing from the decedent directly. See sec. 20.2055-2(e)(1), Estate Tax Regs. When the interest is created by operation of a disclaimer,13 as it was in this case, section 20.20552(c)(1) of the estate tax regulations tells us to look to the disclaimer rules: The amount of a * * * transfer for which a deduction is allowable under section 2055 includes an interest which falls into the bequest, devise or transfer as the result of * * * (i) A qualified disclaimer (see section 2518 and the corresponding regulations for rules relating to a qualified disclaimer). Because Hamilton s disclaimer is not, under that regulation, a qualified disclaimer as to any portion of the property passing to the Trust, none of the property transferred to the Trust generates a charitable deduction. The majority opinion would have allowed the disclaimer had Ms. Christiansen specifically bequeathed the annuity interest to Ms. Hamilton. P. SECTIONS 2601-2654 - GENERATION-SKIPPING TRANSFER TAX 1. Final Regulations Regarding Qualified Severances. On August 2, 2007, the IRS published Final Regulation T.D. 9348. A-155 The Supplementary information states: In response to these comments, the final regulations do not supersede § 26.26541(b). Rather, § 26.2654-1(b) is retained, but, as explained hereafter, is proposed to be amended as described in a notice of proposed rulemaking issued contemporaneously with these final regulations. Subject to those proposed changes, § 26.2654-1(b) will continue to provide rules for mandatory and discretionary severances of trusts includible in the transferor's gross estate, effective retroactively to the transferor's date of death. The final regulations under § 26.2642-6 generally provide rules for the qualified severance of a trust (whether or not includible in the transferor's gross estate) if the severance will be effective only prospectively from the date of severance. One commentator requested that the regulations provide that separate trusts, created as the result of a mandated division of a single trust that is effective under state law, be recognized prospectively as separate trusts for certain GST tax purposes, even if the severance does not satisfy the requirements of a qualified severance. This comment will be addressed in the proposed regulations under section 2642, issued contemporaneously with these final regulations. One commentator requested that the regulations provide additional flexibility in severing a trust that has an inclusion ratio between zero and one. Specifically, the commentator requested that the final regulations permit the qualified severance of a trust into one or more separate resulting trusts, as long as one or more of the resulting trusts, in the aggregate, would receive a fractional share of the total value of the original trust's assets that equals the applicable fraction of the original trust. In such a qualified severance, the resulting trust or trusts receiving this fractional share would each have an inclusion ratio of zero, and each of the other resulting trusts would have an inclusion ratio of one. This comment will be addressed in the proposed regulations under section 2642, issued contemporaneously with these final regulations. In response to comments, the final regulations continue to require that, in notifying the IRS of the severance of a trust, the words "Qualified Severance" should appear at the top of Form 706-GS(T), "Generation-Skipping Transfer Tax Return for Terminations," but the use of red ink for that purpose is not required. One commentator questioned the requirement in the proposed regulations that any non-pro rata funding of trusts resulting from a qualified severance must be based on the value of the trust assets as of the date of funding. The commentator pointed out that, in many cases, the funding of trusts resulting from a qualified severance will take place over a period of time, rather than on one specific date. Accordingly, under the final regulations, the non-pro rata funding of trusts resulting from a qualified severance must be achieved by applying the appropriate fraction or percentage to the total value of the trust assets as of the "date of severance." The term "date of severance" is defined as the date selected for determining the value of the trust assets (whether selected on a discretionary basis or by a court order), provided that funding is commenced immediately and occurs within a reasonable time before or after the selected date of severance. A-156 For this purpose, a reasonable time may differ depending upon the type of asset involved, but in no event may be more than 90 days. Several commentators requested that the regulations address the severance of a trust that was irrevocable on September 25, 1985, but with respect to which an addition was made to the trust after September 25, 1985. For purposes of determining the inclusion ratio with respect to such a trust, § 26.26011(b)(1)(iv)(A) provides that the trust is deemed to consist of two portions, one portion not subject to GST tax (the non-chapter 13 portion) with an inclusion ratio of zero, and one portion subject to GST tax (the chapter 13 portion) with an inclusion ratio determined under section 2642. In response to these comments, the final regulations provide guidance regarding a qualified severance of the chapter 13 portion of these trusts. The proposed regulations include a mandatory reporting requirement, without which a severance would not constitute a qualified severance. One commentator noted that, in some situations, it may be advantageous to sever a trust but to avoid qualification under section 2642(a)(3) as a qualified severance. The Treasury Department and the IRS believe that the qualified severance rules were not intended to be optional; that is, able to be employed or avoided depending upon the tax consequences of a particular severance. Therefore, under the final regulations, the reporting provisions do not constitute a requirement for qualified severance status, but each severance should be reported to ensure that the provisions of Chapter 13 of the Code may be properly applied with regard to the trusts. One commentator noted that § 1.1001-1(h)(1) of the proposed regulations provides favorable income tax treatment only with respect to a qualified severance. The commentator requested that the regulations also address the income tax treatment of all other trust modifications and severances. The commentator noted that the failure to address, for example, the income tax consequences of severances that are not qualified severances for GST tax purposes implies that such severances are taxable events for income tax purposes. In response to these comments, the category of severances to which § 1.1001-1(h)(1) will apply has been broadened. No inference should be drawn with respect to the income tax consequences under section 1001 of any severance that is not described in § 1.1001-1(h)(1). Commentators noted that some qualified severances may result in a taxable termination or taxable distribution, for example, if after the severance, one of the resulting trusts is a skip person. The final regulations clarify that, if the qualified severance itself results in a GST taxable event, the taxable event is treated as occurring immediately after the severance. As a result, if the resulting trust that is a skip person is also the trust that has a zero inclusion ratio after the severance, then no GST tax will result from the taxable event that is deemed to occur after the severance. An example was added illustrating this rule. Finally, in response to comments, an example has been added addressing the qualified severance rules in the case of a trust where the beneficiary is granted a contingent testamentary general power of appointment that is dependent upon the trust's inclusion ratio. A-157 New Section 26.2642-6 is added to read as follows: § 26.2642-6 Qualified severance. (a) In general. If a trust is divided in a qualified severance into two or more trusts, the separate trusts resulting from the severance will be treated as separate trusts for generation-skipping transfer (GST) tax purposes and the inclusion ratio of each new resulting trust may differ from the inclusion ratio of the original trust. Because the post-severance resulting trusts are treated as separate trusts for GST tax purposes, certain actions with respect to one resulting trust will generally have no GST tax impact with respect to the other resulting trust(s). For example, GST exemption allocated to one resulting trust will not impact on the inclusion ratio of the other resulting trust(s); a GST tax election made with respect to one resulting trust will not apply to the other resulting trust(s); the occurrence of a taxable distribution or termination with regard to a particular resulting trust will not have any GST tax impact on any other trust resulting from that severance. In general, the rules in this section are applicable only for purposes of the GST tax and are not applicable in determining, for example, whether the resulting trusts may file separate income tax returns or whether the severance may result in a gift subject to gift tax, may cause any trust to be included in the gross estate of a beneficiary, or may result in a realization of gain for purposes of section 1001. See § 1.1001-1(h) of this chapter for rules relating to whether a qualified severance will constitute an exchange of property for other property differing materially either in kind or in extent. (b) Qualified severance defined. A qualified severance is a division of a trust (other than a division described in § 26.2654-1(b)) into two or more separate trusts that meets each of the requirements in paragraph (d) of this section. (c) Effective date of qualified severance. A qualified severance is applicable as of the date of the severance, as defined in § 26.2642-6(d)(3), and the resulting trusts are treated as separate trusts for GST tax purposes as of that date. (d) Requirements for a qualified severance. For purposes of this section, a qualified severance must satisfy each of the following requirements: (1) The single trust is severed pursuant to the terms of the governing instrument, or pursuant to applicable local law. (2) The severance is effective under local law. (3) The date of severance is either the date selected by the trustee as of which the trust assets are to be valued in order to determine the funding of the resulting trusts, or the court-imposed date of funding in the case of an order of the local court with jurisdiction over the trust ordering the trustee to fund the resulting trusts on or as of a specific date. For a date to satisfy the definition in the preceding sentence, however, the funding must be commenced immediately upon, and funding must occur within a reasonable time (but in no event more than 90 days) after, the selected valuation date. A-158 (4) The single trust (original trust) is severed on a fractional basis, such that each new trust (resulting trust) is funded with a fraction or percentage of the original trust, and the sum of those fractions or percentages is one or one hundred percent, respectively. For this purpose, the fraction or percentage may be determined by means of a formula (for example, that fraction of the trust the numerator of which is equal to the transferor's unused GST tax exemption, and the denominator of which is the fair market value of the original trust's assets on the date of severance). The severance of a trust based on a pecuniary amount does not satisfy this requirement. For example, the severance of a trust is not a qualified severance if the trust is divided into two trusts, with one trust to be funded with $1,500,000 and the other trust to be funded with the balance of the original trust's assets. With respect to the particular assets to be distributed to each resulting trust, each resulting trust may be funded with the appropriate fraction or percentage (pro rata portion) of each asset held by the original trust. Alternatively, the assets may be divided among the resulting trusts on a non pro rata basis, based on the fair market value of the assets on the date of severance. However, if funded on a non pro rata basis, each resulting trust must be funded by applying the appropriate fraction or percentage to the total fair market value of the trust assets as of the date of severance. (5) The terms of the resulting trusts must provide, in the aggregate, for the same succession of interests of beneficiaries as are provided in the original trust. This requirement is satisfied if the beneficiaries of the separate resulting trusts and the interests of the beneficiaries with respect to the separate trusts, when the separate trusts are viewed collectively, are the same as the beneficiaries and their respective beneficial interests with respect to the original trust before severance. With respect to trusts from which discretionary distributions may be made to any one or more beneficiaries on a non-pro rata basis, this requirement is satisfied if (i) The terms of each of the resulting trusts are the same as the terms of the original trust (even though each permissible distributee of the original trust is not a beneficiary of all of the resulting trusts); (ii) Each beneficiary's interest in the resulting trusts (collectively) equals the beneficiary's interest in the original trust, determined by the terms of the trust instrument or, if none, on a per-capita basis. For example, in the case of the severance of a discretionary trust established for the benefit of A, B, and C and their descendants with the remainder to be divided equally among those three families, this requirement is satisfied if the trust is divided into three separate trusts of equal value with one trust established for the benefit of A and A's descendants, one trust for the benefit of B and B's descendants, and one trust for the benefit of C and C's descendants; (iii) The severance does not shift a beneficial interest in the trust to any beneficiary in a lower generation (as determined under section 2651) than the person or persons who held the beneficial interest in the original trust; and (iv) The severance does not extend the time for the vesting of any beneficial interest in the trust beyond the period provided for in (or applicable to) the original trust. A-159 (6) In the case of a qualified severance of a trust with an inclusion ratio as defined in § 26.2642-1 of either one or zero, each trust resulting from the severance will have an inclusion ratio equal to the inclusion ratio of the original trust. (7) In the case of a qualified severance occurring after GST tax exemption has been allocated to the trust (whether by an affirmative allocation, a deemed allocation, or an automatic allocation pursuant to the rules contained in section 2632), if the trust has an inclusion ratio as defined in § 26.2642-1 that is greater than zero and less than one, then the trust must be severed initially into two trusts. One resulting trust must receive that fractional share of the total value of the original trust as of the date of severance that is equal to the applicable fraction, as defined in § 26.2642-1(b) and (c), used to determine the inclusion ratio of the original trust immediately before the severance. The other resulting trust must receive that fractional share of the total value of the original trust as of the date of severance that is equal to the excess of one over the fractional share described in the preceding sentence. The trust receiving the fractional share equal to the applicable fraction shall have an inclusion ratio of zero, and the other trust shall have an inclusion ratio of one. If the applicable fraction with respect to the original trust is .50, then, with respect to the two equal trusts resulting from the severance, the Trustee may designate which of the resulting trusts will have an inclusion ratio of zero and which will have an inclusion ratio of one. Each separate trust resulting from the severance then may be further divided in accordance with the rules of this section. See paragraph (j), Example 7 of this section. The Regulations also discuss how to report a qualified severance on a Form 706-GS(T) by April 15 of the year following the severance. With respect to when a qualified severance may be made, the Regulations state: (f) Time for making a qualified severance. (1) A qualified severance of a trust may occur at any time prior to the termination of the trust. Thus, provided that the separate resulting trusts continue in existence after the severance, a qualified severance may occur either before or after -(i) GST tax exemption has been allocated to the trust; (ii) A taxable event has occurred with respect to the trust; or (iii) An addition has been made to the trust. (2) Because a qualified severance is effective as of the date of severance, a qualified severance has no effect on a taxable termination as defined in section 2612(a) or a taxable distribution as defined in section 2612(b) that occurred prior to the date of severance. A qualified severance shall be deemed to occur before a taxable termination or a taxable distribution that occurs by reason of the qualified severance. See paragraph (j) Example 8 of this section. A-160 (g) Trusts that were irrevocable on September 25, 1985 -- (1) In general. See § 26.2601-1(b)(4) for rules regarding severances and other actions with respect to trusts that were irrevocable on September 25, 1985. (2) Trusts in receipt of a post-September 25, 1985, addition. A trust described in § 26.2601-1(b)(1)(iv)(A) that is deemed for GST tax purposes to consist of one separate share not subject to GST tax (the non-chapter 13 portion) with an inclusion ratio of zero, and one separate share subject to GST tax (the chapter 13 portion) with an inclusion ratio determined under section 2642, may be severed into two trusts in accordance with § 26.2654-1(a)(3). One resulting trust will hold the non-chapter 13 portion of the original trust (the non-chapter 13 trust) and will not be subject to GST tax, and the other resulting trust will hold the chapter 13 portion of the original trust (the chapter 13 trust) and will have the same inclusion ratio as the chapter 13 portion immediately prior to the severance. The chapter 13 trust may be further divided in a qualified severance in accordance with the rules of this section. The non-chapter 13 trust may be further divided in accordance with the rules of § 26.2601-1(b)(4). REG-128843-05 contains the Proposed Regulations noted above. The Explanation of Provision states as follows: The proposed regulations amend the regulations under § 26.2642-6 to provide that trusts resulting from a severance that does not meet the requirements of a qualified severance nevertheless will be treated, after the severance, as separate trusts for GST tax purposes, provided that the resulting trusts are recognized as separate trusts under applicable state law. Because the severance is not a qualified severance, each such resulting trust will have the same inclusion ratio immediately after the severance as the original trust immediately before the severance. Nevertheless, GST tax exemption allocated after the severance may be separately allocated to one or more of the resulting trusts, and the trusts will otherwise be treated as separate trusts for GST tax purposes. An example of a nonqualified severance is added to the regulations. The proposed regulations also revise § 26.2654-1(a)(1)(i) and (a)(5), Example 8. In addition, pursuant to the authority granted in section 2642(a)(3)(B)(iii), these proposed regulations provide for an additional type of qualified severance. Specifically, the proposed regulations provide that a trust with an inclusion ratio between zero and one may be severed in a qualified severance into more than two resulting trusts. One or more of the resulting trusts in the aggregate must receive that fractional share of the total value of the original trust as of the date of severance that is equal to the applicable fraction used to determine the inclusion ratio of the original trust immediately before the severance. The trust or trusts receiving such fractional share shall have an inclusion ratio of zero, and each of the other resulting trust or trusts shall have an inclusion ratio of one. Further, the trustee may designate the beneficiary of each separate resulting trust, provided that the designation results in each beneficiary having the same beneficial interest (within the meaning of § 26.2642-6(d)(5)) after the severance as that beneficiary had in the original trust corpus. Guidance illustrating the A-161 application of this rule is included in § 26.2642-6(d)(7)(ii) and Example 9 of § 26.2642-6(j) of these proposed regulations. Finally, these proposed regulations clarify a provision of the final regulations issued contemporaneously with these proposed regulations. Specifically, § 26.26426(d)(4) requires that each resulting trust be funded with a fraction or percentage of the entire trust and that, although particular assets may be divided among the resulting trusts on a non pro rata basis based on the fair market value of the assets on the date of severance, the sum of those fractions or percentages must be one or one hundred percent, respectively. Thus, if the resulting trusts are funded on a non pro rata basis, the sum of the values distributed to the resulting trusts must equal the fair market value of the trust being severed. These proposed regulations clarify that no discounts or other reductions from the value of an asset owned by the original trust, arising by reason of the division of the original trust's interest in the asset between or among the resulting trusts, are permitted in funding the resulting trusts. Instead, solely for funding purposes, each resulting trust's interest in the stock of a closely held corporation, partnership interest, or other single asset must be valued by multiplying the fair market value of the asset held in the original trust as of the date of severance by the fractional or percentage interest in that asset being distributed to that resulting trust. This clarification is proposed to be effective with respect to severances occurring on or after the date these proposed regulations are published in the Federal Register. 2. Proposed Regulations Regarding Extensions of Time for GST Allocations. On April 16, 2008, the Service issued proposed regulations (REG-14775-06) on the circumstances and procedures under which the Service will grant an extension of time under section 2642(g)(1) to make a timely allocation of GST exemption under section 2632(a) or to make a timely election to opt in or to opt out of the deemed allocation rules under sections 2632(b)(3) or (c)(5). A major advantage of making a lifetime gift is the ability to exclude the future income and appreciation on the property from the donor s estate. For gifts made in trust, an allocation of GST exemption to the trust will also protect such income and appreciation from GST tax. Section 2632 provides automatic rules for the allocation of GST exemption for transfers made both during the transferor s lifetime and at death. For gifts which are direct skips, GST exemption is automatically allocated unless the donor elects otherwise under section 2632(b)(3). The same is true for bequests which are direct skips. For gifts in trusts that are not direct skips (or indirect skips as discussed below), an allocation of GST exemption to gifts is made on a timely filed gift tax return and is effective as of the date of the gift at the gift tax value (Treas. Reg. § 26.2632-1(b)(2)(ii)). If a timely allocation is not made, a late allocation may be made at a later date using the fair market value of the trust assets at that time. Prior to 2001, there was little flexibility in correcting erroneous allocations or unintentional failures to make an allocation. The latter typically occurred when a donor made gifts which qualified for the annual exclusion to a A-162 Crummey trust. Many tax preparers and advisors assumed that since the gifts qualified for the annual exclusion for gift tax purposes under section 2503(e), that they also qualified for the annual exclusion for GST under section 2642(c), so no gift tax return was filed and no timely GST allocation was made. More often than not, by the time this error was discovered, the only available remedy was to make a late allocation. In 2001, Congress approved, and the President signed, the Economic Growth and Tax Relief Reconciliation Act ( EGTRRA ). Although the most notable effect of EGTRRA was the repeal of the estate tax, it also made several modifications to the GST tax, including a new category of GST transfers called indirect skips as well as procedural relief for making a timely allocation of exemption. Beginning on January 1, 2001 or later, unless the donor elects otherwise, GST exemption will be allocated automatically to all gifts in trust that are indirect skips under section 2632(c)(1). An indirect skip is any gift (other than a direct skip) subject to GST tax that is made to a GST trust under section 2632(c)(3)(A). A GST trust is a trust that could have a generation-skipping transfer with respect to the donor unless it falls into one of six exceptions. Under section 2632(c)(5), a donor may elect not to have the automatic allocation rules apply to an indirect skip, may elect not to have the automatic allocation rules apply to any or all transfers made to a particular trust, and may also elect to treat any trust as a GST trust. All elections must be made on a timely filed gift tax return. Treasury Regulation § 26.2632-1, issued on June 28, 2005, sets forth additional procedural requirements for electing out of the automatic allocation rules. Another significant modification made by EGTRRA is the addition of section 2642(g)(1) which authorizes the Service to grant extensions of time to make a timely election to allocate GST exemption to a transfer to a trust. If such relief is granted, the allocation would be made using the gift tax or estate tax value of the transfer to the trust at the time of the transfer. On August 2, 2001, the Service issued Notice 2001-50 which provided that the request for such relief must follow the provisions of Treas. Reg. § 301.9100-3 and must take the form of a request for a private letter ruling. After being bombarded by thousands of such requests, on July 29, 2004, the Service issued Rev. Proc. 2004-46 which establishes a simplified alternate method to obtain an extension of time for taxpayers who meet certain requirements. If eligible, taxpayers may avoid the requirement of requesting a private letter ruling and may make a timely allocation of GST exemption by filing a new gift tax return. Once the proposed regulations become final, relief under Regulations §§ 301.9100-1 and 301.9100-3 will no longer be available. Relief under Regulation § 301.9100-2 (an automatic 6 month extension) will still be available for taxpayers who qualify for such relief, although generally, the six month period will have run before the A-163 taxpayer realizes that this relief is available. Also, Revenue Procedure 2004-46 will remain effective for taxpayers who satisfy the procedural requirements of the simplified method of obtaining an extension. Under the proposed regulations, if the Service grants an extension to allocate GST exemption, the allocation of GST exemption will be effective as of the date of the transfer, and the amount of exemption allocated will be the gift or estate tax value as of such date. If the Service grants an extension of time to elect out of the automatic allocation of GST exemption under section 2632(b)(3) or (c)(5), the election will be considered effective as of the date of the transfer. Likewise, if the Service grants an extension of time to elect to treat any trust as a GST trust, the election will be effective as of the date of the first (or each) transfer covered by that election. The amount of GST exemption that may be allocated to a transfer will be limited to the amount of the transferor's unused GST exemption under section 2631(c) as of the date of the transfer. As a result, if, the GST exemption has increased from the date of the transfer until the date that relief is granted, no portion of the increased amount may be applied to the earlier transfer. The Service will grant relief if the taxpayer can establish to the Service s satisfaction that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. The Service s determination will be based upon: (2) Reasonableness and good faith. The following is a nonexclusive list of factors that will be considered to determine whether the transferor or the executor of the transferor's estate acted reasonably and in good faith for purposes of this section: (i) The intent of the transferor to timely allocate GST exemption to a transfer or to timely make an election under section 2632(b)(3) or (c)(5), as evidenced in the trust instrument, the instrument of transfer, or other relevant documents contemporaneous with the transfer, such as Federal gift and estate tax returns and correspondence. This may include evidence of the intended GST tax status of the transfer or the trust (for example, exempt, non-exempt, or partially exempt), or more explicit evidence of intent with regard to the allocation of GST exemption or the election under section 2632(b)(3) or (c)(5). (ii) Intervening events beyond the control of the transferor or of the executor of the transferor's estate as the cause of the failure to allocate GST exemption to a transfer or the failure to make an election under section 2632(b)(3) or (c)(5). (iii) Lack of awareness by the transferor or the executor of the transferor's estate of the need to allocate GST exemption to the transfer, despite the exercise of reasonable diligence, taking into account the experience of the transferor or the executor of the transferor's estate and the complexity of the A-164 GST issue, as the cause of the failure to allocate GST exemption to a transfer or to make an election under section 2632(b)(3) or (c)(5). (iv) Consistency by the transferor with regard to the allocation of the transferor's GST exemption (for example, the transferor's consistent allocation of GST exemption to transfers to skip persons or to a particular trust, or the transferor's consistent election not to have the automatic allocation of GST exemption apply to transfers to one or more trusts or skip persons pursuant to section 2632(b)(3) or (c)(5)). Evidence of consistency may be less relevant if there has been a change of circumstances or change of trust beneficiaries that would otherwise explain a deviation from prior GST exemption allocation decisions. (v) Reasonable reliance by the transferor or the executor of the transferor's estate on the advice of a qualified tax professional retained or employed by one or both of them and, in reliance on or consistent with that advice, the failure of the transferor or the executor to allocate GST exemption to the transfer or to make an election described in section 2632(b)(3) or (c)(5). Reliance on a qualified tax professional will not be considered to have been reasonable if the transferor or the executor of the transferor's estate knew or should have known that the professional either (A) Was not competent to render advice on the GST exemption; or (B) Was not aware of all relevant facts. (3) Prejudice to the interests of the Government. The following is a nonexclusive list of factors that will be considered to determine whether the interests of the Government would be prejudiced for purposes of this section: (i) The interests of the Government would be prejudiced to the extent to which the request for relief is an effort to benefit from hindsight. The interests of the Government would be prejudiced if the IRS determines that the requested relief is an attempt to benefit from hindsight rather than to achieve the result the transferor or the executor of the transferor's estate intended at the time when the transfer was made. A factor relevant to this determination is whether the grant of the requested relief would permit an economic advantage or other benefit that would not have been available if the allocation or election had been timely made. Similarly, there would be prejudice if a grant of the requested relief would permit an economic advantage or other benefit that results from the selection of one out of a number of alternatives (other than whether or not to make an allocation or election) that were available at the time the allocation or election could have been timely made, if hindsight makes the selected alternative more beneficial than the other alternatives. Finally, in a situation where the only choices were whether or not to make a timely allocation or election, prejudice would exist if the transferor failed to make the allocation or election in order to wait to see (thus, with the benefit of hindsight) whether or not the making of the allocation of exemption or election would be more beneficial. A-165 (ii) The timing of the request for relief will be considered in determining whether the interests of the Government would be prejudiced by granting relief under this section. The interests of the Government would be prejudiced if the transferor or the executor of the transferor's estate delayed the filing of the request for relief with the intent to deprive the IRS of sufficient time to challenge the claimed identity of the transferor of the transferred property that is the subject of the request for relief, the value of that transferred property for Federal gift or estate tax purposes, or any other aspect of the transfer that is relevant for Federal gift or estate tax purposes. The fact that any period of limitations on the assessment or collection of transfer taxes has expired prior to the filing of a request for relief under this section, however, will not by itself prohibit a grant of relief under this section. Similarly, the combination of the expiration of any such period of limitations with the fact that the asset or interest was valued for transfer tax purposes with the use of a valuation discount will not by itself prohibit a grant of relief under this section. (iii) The occurrence and effect of an intervening taxable termination or taxable distribution will be considered in determining whether the interests of the Government would be prejudiced by granting relief under this section. The interests of the Government may be prejudiced if a taxable termination or taxable distribution occurred between the time for making a timely allocation of GST exemption or a timely election described in section 2632(b)(3) or (c)(5) and the time at which the request for relief under this section was filed. The impact of a grant of relief on (and the difficulty of adjusting) the GST tax consequences of that intervening termination or distribution will be considered in determining whether the occurrence of a taxable termination or taxable distribution constitutes prejudice. The Service will not grant relief under the following circumstances: (1) Timely allocations and elections. Relief will not be granted under this section to decrease or revoke a timely allocation of GST exemption as described in §26.2632-1(b)(4)(ii)(A)(1), or to revoke an election under section 2632(b)(3) or (c)(5) made on a timely filed Federal gift or estate tax return. (2) Timing. Relief will not be granted if the transferor or executor delayed the filing of the request for relief with the intent to deprive the IRS of sufficient time to challenge the claimed identity of the transferor or the valuation of the transferred property for Federal gift or estate tax purposes. (However, see paragraph (d)(3)(ii) of this section for examples of facts which alone do not constitute prejudice.) (3) Failure after being accurately informed. Relief will not be granted under this section if the decision made by the transferor or the executor of the transferor's estate (who had been accurately informed in all material respects by a qualified tax professional retained or employed by either (or both) of them with regard to the allocation of GST exemption or an election described in section 2632(b)(3) or (c)(5)) was reflected or implemented by the action or inaction that is the subject of the request for relief. A-166 (4) Hindsight. Relief under this section will not be granted if the IRS determines that the requested relief is an attempt to benefit from hindsight rather than an attempt to achieve the result the transferor or the executor of the transferor's estate intended when the transfer was made. One factor that will be relevant to this determination is whether the grant of relief will give the transferor the benefit of hindsight by providing an economic advantage that may not have been available if the allocation or election had been timely made. Thus, relief will not be granted if that relief will shift GST exemption from one trust to another trust unless the beneficiaries of the two trusts, and their respective interests in those trusts, are the same. Similarly, relief will not be granted if there is evidence that the transferor or executor had not made a timely allocation of the exemption in order to determine which of the various trusts achieved the greatest asset appreciation before selecting the trust that should have a zero inclusion ratio. The proposed regulations specifically state that a request for relief does not reopen, suspend, or extend the statute of limitations period on the assessment or collection of any estate, gift, or GST tax. The Service may request that the taxpayer consent to an extension of the limitation period on any or all taxes that are the subject of the requested relief although the taxpayer has the right to withhold such consent. The proposed regulations also point out that a request for relief does not constitute a claim for refund or credit of an overpayment and does not extend the statute of limitations period for filing a claim for refund or credit of an overpayment. However, if the Service and the taxpayer agree to extend the period for assessment of tax, the period for filing a claim for refund or credit will also be extended. A request for relief must take the form of a request for a private letter ruling and must satisfy all procedural requirements for the same, including affidavits regarding the following: (2) Affidavit and declaration of transferor or the executor of the transferor's estate. (i) The transferor or the executor of the transferor's estate must submit a detailed affidavit describing the events that led to the failure to timely allocate GST exemption to a transfer or the failure to timely elect under section 2632(b)(3) or (c)(5), and the events that led to the discovery of the failure. If the transferor or the executor of the transferor's estate relied on a tax professional for advice with respect to the allocation or election, the affidavit must describe (A) The scope of the engagement; (B) The responsibilities the transferor or the executor of the transferor's estate believed the professional had assumed, if any; and (C) The extent to which the transferor or the executor of the transferor's estate relied on the professional. A-167 (ii) Attached to each affidavit must be copies of any writing (including, without limitation, notes and e-mails) and other contemporaneous documents within the possession of the affiant relevant to the transferor's intent with regard to the application of GST tax to the transaction for which relief under this section is being requested. (iii) The affidavit must be accompanied by a dated declaration, signed by the transferor or the executor of the transferor's estate that states: Under penalties of perjury, I declare that I have examined this affidavit, including any attachments thereto, and to the best of my knowledge and belief, this affidavit, including any attachments thereto, is true, correct, and complete. In addition, under penalties of perjury, I declare that I have examined all the documents included as part of this request for relief, and, to the best of my knowledge and belief, these documents collectively contain all the relevant facts relating to the request for relief, and such facts are true, correct, and complete. (3) Affidavits and declarations from other parties. (i) The transferor or the executor of the transferor's estate must submit detailed affidavits from individuals who have knowledge or information about the events that led to the failure to allocate GST exemption or to elect under section 2632(b)(3) or (c)(5), and/or to the discovery of the failure. These individuals may include individuals whose knowledge or information is not within the personal knowledge of the transferor or the executor of the transferor's estate. The individuals described in paragraph (h)(3)(i) of this section must include (A) Each agent or legal representative of the transferor who participated in the transaction and/or the preparation of the return for which relief is being requested; (B) The preparer of the relevant Federal estate and/or gift tax return(s); (C) Each individual (including an employee of the transferor or the executor of the transferor's estate) who made a substantial contribution to the preparation of the relevant Federal estate and/or gift tax return(s); and (D) Each tax professional who advised or was consulted by the transferor or the executor of the transferor's estate with regard to any aspect of the transfer, the trust, the allocation of GST exemption, and/or the election under section 2632(b)(3) or (c)(5). (ii) Each affidavit must describe the scope of the engagement and the responsibilities of the individual as well as the advice or service(s) the individual provided to the transferor or the executor of the transferor's estate. (iii) Attached to each affidavit must be copies of any writing (including, without limitation, notes and e-mails) and other contemporaneous documents within the possession of the affiant relevant to the transferor's intent with regard A-168 to the application of GST tax to the transaction for which relief under this section is being requested. (iv) Each affidavit also must include the name, and current address of the individual, and be accompanied by a dated declaration, signed by the individual that states: Under penalties of perjury, I declare that I have personal knowledge of the information set forth in this affidavit, including any attachments thereto. In addition, under penalties of perjury, I declare that I have examined this affidavit, including any attachments thereto, and, to the best of my knowledge and belief, the affidavit contains all the relevant facts of which I am aware relating to the request for relief filed by or on behalf of [transferor or the executor of the transferor's estate], and such facts are true, correct, and complete. (v) If an individual who would be required to provide an affidavit under paragraph (h)(3)(i) of this section has died or is not competent, the affidavit required under paragraph (h)(2) of this section must include a statement to that effect, as well as a statement describing the relationship between that individual and the transferor or the executor of the transferor's estate and the information or knowledge the transferor or the executor of the transferor's estate believes that individual had about the transfer, the trust, the allocation of exemption, or the election. If an individual who would be required to provide an affidavit under paragraph (h)(3)(i) of this section refuses to provide the transferor or the executor of the transferor's estate with such an affidavit, the affidavit required under paragraph (h)(2) of this section must include a statement that the individual has refused to provide the affidavit, a description of the efforts made to obtain the affidavit from the individual, the information or knowledge the transferor or the executor of the transferor's estate believes the individual had about the transfer, and the relationship between the individual and the transferor or the executor of the transferor's estate. A public hearing on the proposed regulations is set for August 5, 2008. Q. SECTIONS 2701-2704 - SPECIAL VALUATION RULES 1. Joint Purchase. PLR 200728018 outlines an IRS approved technique for spouses to acquire the life interest in a residence with a trust for their descendants to acquire the remainder interest. This is a useful technique when a party has no gift tax exemption remaining because it does not require a gift assuming the purchasing generation has sufficient funds. However, in general, a QPRT is more efficient in leveraging gift tax exemption and the ability to pay rent after the QPRT term does not exist with the joint purchase. If a residence is owned by one spouse may it be sold to the other spouse and the children? The answer should be yes . R. SECTION 6166 1. EXTENSION OF TIME TO PAY TAX No Extension of Time to Make Election Available. IRS issues interim guidance for determining whether security is required for deferred estate tax installment payments. In Notice 2007-90, 2007-46 IRB 1, the A-169 IRS announced it is changing its policy and now will determine on a case-by-case basis whether security will be required when a qualifying estate elects under section 6166 to pay all or a part of the estate tax in installments. The factors set forth are: 1. Duration and stability of the business. This factor considers the nature of the closely held business on which the estate tax is deferred under section 6166 and of the assets of that business, the relevant market factors that will impact the business's future success, its recent financial history, and the experience of its management, in an effort to predict the likelihood of its success and survival through the deferred payment period. Facts relevant to this factor are likely to appear primarily in the appraisal and the financial statements that accompany the estate tax return. Information regarding any outstanding liens, judgments, or pending or anticipated lawsuits or other claims against the business, if any, that are not disclosed in that documentation should be provided by the estate with the election. The estate may be required to furnish such information in response to an inquiry by the IRS. 2. Ability to pay the installments of tax and interest timely. This factor considers how the estate expects to be able to make the annual payments of tax and interest as due, and the objective likelihood of realizing that expectation. Facts relevant to this factor may include the nature of the business's significant assets and liabilities, and the business's cash flow (both historical and anticipated). If not sufficiently disclosed in the documents attached to the estate tax return, the estate should submit relevant information with the election under section 6166. The estate may be required to furnish such information in response to an inquiry by the IRS. 3. Compliance history. This factor addresses the business's history regarding compliance with all federal tax payment and tax filing requirements, in an effort to determine whether the business and its management respect and comply with all tax requirements on a regular basis. This factor also addresses the estate's compliance history with respect to federal tax payment and filing requirements. The estate may use a sworn affidavit or other probative documents to provide this information. With respect to an effective date: This notice is applicable to each estate: (1) that timely elects to pay the estate tax in installments under section 6166 and that timely files a return on or after November 13, 2007; (2) whose return was being classified, surveyed or audited by the IRS as of April 12, 2007; or (3) that is currently in the deferred payment period but that has not yet provided a bond or special lien if (a) the general federal estate tax lien will expire within two years from November 13, 2007 or (b) the IRS reasonably believes that the government's interest in collecting the deferred estate tax and interest thereon in full is sufficiently at risk to require a bond or special lien. In ILM 200747019, the IRS addressed use of closely-held stock or LLC interests as collateral stating: A-170 Issue 1. Whether, and under what circumstances, stock in a closely held corporation meets the requirements of section 6324A as property which may be pledged in support of the election by the estate under section 6166(k)(2), and related Treas. Regs. §§ 20.6324A-1 and 301.6324A-1? Section 6324A(c)(1)(A) provides that the collateral offered to secure the lien may be an interest in "real and other property." Stock in a closely held corporation qualifies as "other property." Although stock in a closely held corporation may be offered as collateral to secure the section 6324A lien, the Service may accept the stock only when the three statutory requirements in section 6324A(b)(1) and (2) are met. First, the stock in a closely held corporation must be expected to survive the deferral period. This means that the corporation must survive the deferral period and retain value. To determine whether a corporation will survive the deferral period, the Service should first value the business, i.e., the closely held corporation, based on the relevant financial information provided by the estate. It is incumbent upon the estate to provide the Service with all relevant financial information, including appraisals, annual reports, and any other relevant financial document, in order for the Service to adequately value the closely held business. IRM § 4.48.4. provides guidelines for valuing a business. Professional judgment should be used to select the best valuation method. Using the results from its valuation, the Service must then judge whether the business can be expected to survive the deferral period. There is a risk that the Service may err in its conclusion, but Congress intended that the Service bear such a risk. Comm. On Ways and Means, 94th Cong., Background Materials on Federal Estate and Gift Taxation 302, (Comm. Print 1969) ("[t]he Government will not only permit the deferral of taxes, but will bear part of the risk that the illiquid asset may decline in value during the deferral period"). If Congress had intended that the Service be assured payment, Congress would have required that a bond be provided to the Service for deferred estate taxes. Second, the stock in the closely held corporation must be identified in the written agreement described under section 6324A(b)(1)(B). Specifically, the executor must file a written agreement showing that all of the persons having an interest in the collateral, agree to the creation of the special lien.3 I.R.C. § 6324A(c)(1). The agreement must be binding on all parties that have any interest on the collateral. Id. Further details concerning the specific requirements of the written agreement can be found in Treas. Reg. § 301.6324A-1(b). Third, the value of the stock as of the agreement date must be sufficient to pay the deferred taxes plus the required interest. Revenue Ruling 59-60, 1959-1 C.B. 237 provides guidance as to the valuation of stock of closely held corporations. Specifically, the valuation of stock of closely held corporations will require consideration of all available financial data that is provided by the estate, as well as all relevant factors affecting the fair market value. Because a determination of the fair market value depends upon the circumstances in each case, a general formula will not exist for the many different valuation situations arising in the valuation of such stock. A-171 If the three requirements under section 6324A are met, the section 6324A special lien arises and the collateral must be accepted by the Service. The Service does not have the authority to reject collateral proffered by the estate on the grounds that it would be burdensome for the Service to make the economic or business calculations to determine the value. Nor does the Service have the authority to reject collateral proffered by the estate because the Service would prefer other collateral. Congress gave the Service a very limited role in the creation of the section 6324A special lien: the Service determines whether the statutory requirements have been met. Even when the statutory requirements under section 6324A have been met, we understand that some Service employees would prefer not to take stock as collateral because of the risks: some of the concern stems from the fact that the stock may become worthless. For example, if the closely held business were to sell or transfer its assets and distribute all of the funds, the stock would have little value. In another instance, the business could encumber its assets and thereby reduce the value of the stock. The company could also become bankrupt or close down the business causing the stock to have no value. Furthermore, there is concern that the stock may become worthless due to bad management decisions, economic downturns, or shareholder/management chicanery. These concerns, as well as others are legitimate. Taking stock as collateral is a risky endeavor. Nevertheless, section 6324A and its legislative history, illustrate that Congress was aware of that risk. By enacting section 6324A(d)(5), and giving the Service the authority to demand additional collateral when the initial collateral declines in value, Congress chose to reduce, rather than eliminate the risks to the Service. Issue 2. What criteria should the Service use in determining the adequacy [of stock] as related to section 6324A(b)(1)(A)? Under section 6324A(b)(1)(A) the Service must determine whether the collateral can be expected to survive the deferral period. In making this determination, the Service may use any generally accepted business criteria. IRM 4.48.4.2.3 and Rev. Rul. 59-60 identify factors to be used in making the determination. The viability and net worth of the company is reflected in the value of the stock. Whether a stock will retain its value is a factor to be considered in determining whether the company will survive the deferral period.4 The Service should not assume that a stock's failure to retain its value automatically means that a company will not survive the deferral period. Indeed, stock accepted as collateral may decrease in value, requiring the Service to request additional collateral under section 6324A(d)(5). Issue 3. What requirements may the Service impose on an estate which has pledged stock as collateral in order to determine whether there has been a disposition of interest or withdrawal of funds from the business that would trigger the acceleration of payment under section 6166(g)(1)? A-172 The Service has statutory rights under section 6324A to determine whether there has been a disposition of interest or withdrawal of funds from the business that would trigger the acceleration of payment under section 6166(g)(1). These rights include requiring all relevant financial information from the estate to continue to monitor the value of the accepted stock as collateral during the deferral period. I.R.C. § 6324A(d)(5). Specifically, the Service could require the estate to provide annual reports or certified financial statements on or before April 15 of each year during the term of the deferral period. If the estate refuses the Service's request for information, the estate runs the risk that the Service may determine that additional collateral is required pursuant section 6324A(d)(5). If the estate refuses to provide additional collateral, the Service may declare an acceleration of all deferred payments under section 6166(g). This may be extremely burdensome to the estate, but it is a result that the estate may have prevented by timely complying with the Service's request for information. Issue 4 In what manner should the Service secure its interest in the stock pledged as collateral? Section 6324A(d)(1) provides that the special estate tax lien "shall not be valid as against any purchaser, holder of a security interest, mechanic's lien, or judgment lien creditor until notice thereof which meets the requirements of section 6323(f) has been filled by the Secretary." Thus, as a first step, the Service should file a Notice of Federal Tax Lien (NFTL), Form 668-J, for the special estate tax lien on the stock. I.R.C. § 6324A(d)(1). The lien arises at the time the executor is discharged from personal liability under section 2204 and continues until the liability for the deferred amount is satisfied or becomes unenforceable by reason of lapse of time. I.R.C. § 6324A(d)(2). Section 6323(f) states that a NFTL relating to interests in personal or real property must be filed in the office mandated by applicable state law. Stock, in most instances, will be considered personal property by most state law. With respect to personal property, whether tangible or intangible, a NFTL must be filed in the office designated by state law in which the property subject to the lien is situated. I.R.C. § 6323(f)(1)(A)(ii). Personal property, whether tangible or intangible, is situated at the residence of the taxpayer at the time the NFTL is filed. I.R.C. § 6323(f)(2). Since the taxpayer in this case is an estate, applicable state law will determine where the NFTL will be filed. In addition, if stock certificates exist, we recommend that the Service request that the certificates be given to the Service. This would prevent the sale of such certificates to third parties. If the Service fails to obtain possession of the certificates, there is the possibility that third parties may purchase such certificates, incorrectly believing that they have a superpriority in the certificates under section 6323(b)(1)(A).5 At first blush, this assumption seems reasonable. Congress enacted section 6323(b)(1)(A) to allow securities be traded freely on the open markets without purchasers carrying the burden of searching the public record to find previously filed NFTLs. Congress, however, limited the scope of the section 6323(b) superpriorities as against the section 6324A special lien. In section 6324A(d)(3), Congress provided that only three of the superpriorities listed in section 6324(b) would qualify as a superpriority against the special estate tax liens.6 Congress did not provide a superpriority for purchasers of a A-173 stock encumbered with the section 6324A special estate tax lien. Accordingly, Congress must have intended that, after the Service filed a NFTL, purchasers of such stock took it encumbered with the special estate tax lien. Nonetheless, to avoid potential litigation is this area, we recommend that the Service request the actual stock certificates. In ILM 200803016 the IRS accepted LLC interests as collateral if the 6324A requirements were met. S. TAX ADMINISTRATION 1. Penalties. Section 6694 was amended by the Small Business and Work Opportunity Act of 2007 (Small Business Act, P.L. 110-28). The section now applies to all tax returns, not just income tax returns. In addition, the amendment imposes a more likely than not standard. Thus, unless a return preparer believed that a position taken on a return is more likely than not correct, the preparer would be subject to penalty unless the position were adequately disclosed. The minimum standard for a position that must be disclosed is no longer not frivolous but rather reasonable basis. Thus, if a court were to conclude that a position taken by a return preparer were not reasonable, the preparer could be penalized even if the position were adequately disclosed The penalty is the greater of $1,000 or 50% of the income the preparer derives from the return or position. The new rules apply to returns filed in 2008. There is no allowance for factual issues that a return preparer cannot know. Further, giving advice as to a return may make a practitioner a non-signing preparer subject to the more likely than not standard. In Notice 2008-13, IR-2007-213 (December 31, 2007) the IRS announced that in 2008 the preparer penalty regulations would be overhauled. The Notice limits liability if a taxpayer has been advised to disclose positions and of potential penalties and allows preparers to rely on taxpayers and other representations unless the preparer knows them to be wrong. The IRS has issued proposed regulations that in most ways are more lenient than the Notice or that were expected based on the statute. REG 129243-07 (June 17, 2008). The most significant portion of the proposed regulations for estate planners is as follows: §1.6694-2 Penalty for understatement due to an unreasonable position. (a) In general-(1) Proscribed conduct. Except as otherwise provided in this section, a tax return preparer is liable for a penalty under section 6694(a) equal to A-174 the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer for any return or claim for refund that it prepares that results in an understatement of liability due to a position if the tax return preparer knew (or reasonably should have known) of the position and either-(i) The position was not disclosed as provided in this section and there was not a reasonable belief that the position would more likely than not be sustained on its merits; or (ii) The position was disclosed as provided in this section but there was no reasonable basis for the position. (2) Special rule for corporations, partnerships, and other firms. A firm that employs a tax return preparer subject to a penalty under section 6694(a) (or a firm of which the individual tax return preparer is a partner, member, shareholder or other equity holder) is also subject to penalty if, and only if-(i) One or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the conduct proscribed by section 6694(a); (ii) The corporation, partnership, or other firm entity failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed; or (iii) Such review procedures were disregarded by the corporation, partnership, or other firm entity through willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate or ascertain) in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed. (b) Reasonable belief that the position would more likely than not be sustained on its merits-- (1) In general. A tax return preparer may "reasonably believe that a position would more likely than not be sustained on its merits" if the tax return preparer analyzes the pertinent facts and authorities, and in reliance upon that analysis, reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits. In reaching this conclusion, the possibility that the position will not be challenged by the Internal Revenue Service (IRS) (for example, because the taxpayer's return may not be audited or because the issue may not be raised on audit) is not to be taken into account. The analysis prescribed by §1.6662-4(d)(3)(ii) (or any successor A-175 provision) for purposes of determining whether substantial authority is present applies for purposes of determining whether the more likely than not standard is satisfied. Whether a tax return preparer meets this standard will be determined based upon all facts and circumstances, including the tax return preparer's diligence. In determining the level of diligence in a particular situation, the tax return preparer's experience with the area of Federal tax law and familiarity with the taxpayer's affairs, as well as the complexity of the issues and facts, will be taken into account. A tax return preparer may reasonably believe that a position more likely than not would be sustained on its merits despite the absence of other types of authority if the position is supported by a well-reasoned construction of the applicable statutory provision. For purposes of determining whether the tax return preparer has a reasonable belief that the position would more likely than not be sustained on the merits, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer's firm), as provided in §1.6694-1(e). (2) No unreasonable assumptions. A position must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. For example, a position must not be based on a representation or assumption that the tax return preparer knows, or has reason to know, is inaccurate. (3) Authorities. The authorities considered in determining whether a position satisfies the more likely than not standard are those authorities provided in §1.6662-4(d)(3)(iii) (or any successor provision). (4) Examples. The provisions of paragraphs (b)(1) through (b)(3) of this section are illustrated by the following examples: Example 1. A new statute is silent as to whether the taxpayer may take advantage of certain tax benefits. The Treasury Department and the IRS have not issued any interpretative guidance for the newly enacted provision. A well-reasoned construction of the statutory text supports the position that a taxpayer may claim the tax benefits. Preparer M may avoid the section 6694(a) penalty by taking the position that M reasonably believed that the taxpayer's position would more likely than not be sustained on its merits. Example 2. After the passage of legislation containing a new statutory provision, a taxpayer engaged in a transaction that is adversely affected by the new provision. Prior law supported a position favorable to the taxpayer. Preparer N believes that the new statute is inequitable as applied to the taxpayer's situation. The statutory language, however, is unambiguous as applied to A-176 the transaction to deny the result claimed by the taxpayer previously. In considering the new statutory provision as applied to the taxpayer's position, N may not avoid the section 6694(a) penalty by taking the position that the tax return preparer reasonably believed that the position would more likely than not be sustained on its merits. Example 3. While preparing the taxpayer's return, Preparer O determines that a statute is silent as to whether the taxpayer may take a certain position on the taxpayer's 2007 Federal income tax return. Three private letter rulings issued to other taxpayers in 2002 and 2003 support the taxpayer's position. Temporary regulations issued in 2004, however, are clearly contrary to the taxpayer's position. After the issuance of the temporary regulations, the earlier private letter rulings cease to be authorities and are not taken into account in determining whether the taxpayer's position satisfies the reasonable belief that the position would more likely than not be sustained on its merits standard. Preparer O may not avoid the section 6694(a) penalty by taking the position that the tax return preparer reasonably believed that the taxpayer's position would more likely than not be sustained on its merits. Example 4. In the course of researching whether an interpretation of a phrase in the Internal Revenue Code (Code) is a position that more likely than not will be sustained on its merits, Preparer P discovers that the only relevant authorities include decisions of five U.S. courts of appeal. Three U.S. courts of appeal have construed the language as being taxpayer favorable. Two other U.S. courts of appeal, however, have construed the identical language as being favorable to the government's position. The U.S. court of appeals in the jurisdiction where the taxpayer is located has not addressed this issue. P reasonably believes that the taxpayer's facts more closely parallel the facts involved in the three U.S. courts of appeals' decisions that were taxpayer favorable. Under the analysis prescribed by §1.6662-4(d)(3)(ii), P may avoid the section 6694(a) penalty by taking the position that the tax return preparer reasonably believed that a well-reasoned position consistent with the taxpayer favorable interpretation would more likely than not be sustained on its merits. (5) Written determinations. The tax return preparer may avoid the section 6694(a) penalty by taking the position that the tax return preparer reasonably believed that the taxpayer's position satisfies the "more likely than not" standard if the taxpayer is the subject of a "written determination" as provided in §1.6662-4(d)(3)(iv)(A). (6) When "more likely than not" standard must be satisfied. For purposes of this section, the requirement that a position satisfies the A-177 "more likely than not" standard must be satisfied on the date the return is deemed prepared, as prescribed by §1.6694-1(a)(2). (c) Exception for adequate disclosure of positions with a reasonable basis-(1) In general. The section 6694(a) penalty will not be imposed on a tax return preparer if the position taken has a reasonable basis and is adequately disclosed within the meaning of paragraph (c)(3) of this section. For an exception to the section 6694(a) penalty for reasonable cause and good faith, see paragraph (d) of this section. (2) Reasonable basis. For purposes of this section, "reasonable basis" has the same meaning as in §1.6662-3(b)(3) or any successor provision of the accuracy-related penalty regulations. For purposes of determining whether the tax return preparer has a reasonable basis for a position, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer's firm), as provided in §1.6694-1(e). (3) Adequate disclosure--(i) Signing tax return preparers. In the case of a signing tax return preparer within the meaning of §301.7701-15(b)(1) of this chapter, disclosure of a position for which there is a reasonable basis but for which the tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits is adequate if the tax return preparer meets any of the following standards: (A) The position is disclosed in accordance with §1.6662-4(f) (which permits disclosure on a properly completed and filed Form 8275, "Disclosure Statement," or Form 8275-R, "Regulation Disclosure Statement," as appropriate, or on the tax return in accordance with the annual revenue procedure described in §1.6662-4(f)(2)). (B) For income tax returns, if the position would not meet the standard for the taxpayer to avoid a penalty under section 6662(d)(2)(B) without disclosure (no substantial authority), the tax return preparer provides the taxpayer with the prepared tax return that includes the disclosure in accordance with §1.6662-4(f). (C) For income tax returns, if the position would otherwise meet the standard for nondisclosure under section 6662(d)(2)(B)(i) (substantial authority), the tax return preparer advises the taxpayer of all the penalty standards applicable to the taxpayer under section 6662. The tax return preparer must also contemporaneously document the advice in the tax return preparer's files. A-178 (D) For income tax returns, if section 6662(d)(2)(B) does not apply because the position may be described in section 6662(d)(2)(C) or section 6662A (a tax shelter, reportable transaction with a significant purpose of tax avoidance or evasion, or a listed transaction), the tax return preparer advises the taxpayer that there needs to be at a minimum substantial authority for the position, that the taxpayer must possess a reasonable belief that the tax treatment was more likely than not the proper treatment in order to avoid a penalty under section 6662(d) or section 6662A as applicable, and that disclosure will not protect the taxpayer from assessment of an accuracy-related penalty if either section 6662(d)(2)(C) or 6662A applies to the position. The tax return preparer must also contemporaneously document the advice in the tax return preparer's files. (E) For returns or claims for refund that are subject to penalties pursuant to section 6662 other than the substantial understatement penalty under section 6662(b)(2) and (d), the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under sections 6662. The tax return preparer must also contemporaneously document the advice in the tax return preparer's files. (ii) Nonsigning tax return preparers. In the case of a nonsigning tax return preparer within the meaning of §301.7701-15(b)(2) of this chapter, disclosure of a position that satisfies the reasonable basis standard but does not satisfy the reasonable belief that a position would more likely than not be sustained on its merits standard is adequate if the position is disclosed in accordance with §1.6662-4(f) (which permits disclosure on a properly completed and filed Form 8275 or Form 8275-R, as appropriate, or on the return in accordance with an annual revenue procedure described in §1.6662-4(f)(2)). In addition, disclosure of a position is adequate in the case of a nonsigning tax return preparer if, with respect to that position, the tax return preparer complies with the provisions of paragraph (c)(3)(ii)(A) or (B) of this section, whichever is applicable. (A) Advice to taxpayers. If a nonsigning tax return preparer provides advice to the taxpayer with respect to a position for which there is a reasonable basis but for which the nonsigning tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits, disclosure of that position is adequate if the tax return preparer advises the taxpayer of any opportunity to avoid penalties under section 6662 that could apply to the position, if relevant, and of the standards for disclosure to the extent applicable. A-179 The tax return preparer must also contemporaneously document the advice in the tax return preparer's files. (B) Advice to another tax return preparer. If a nonsigning tax return preparer provides advice to another tax return preparer with respect to a position for which there is a reasonable basis but for which the nonsigning tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits, disclosure of that position is adequate if the tax return preparer advises the other tax return preparer that disclosure under section 6694(a) may be required. The tax return preparer must also contemporaneously document the advice in the tax return preparer's files. (iii) Requirements for advice. For purposes of satisfying the disclosure standards of paragraphs (c)(3)(i) and (ii) of this section, each return position for which there is a reasonable basis but for which the tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits must be addressed by the tax return preparer. The advice to the taxpayer with respect to each position, therefore, must be particular to the taxpayer and tailored to the taxpayer's facts and circumstances. The tax return preparer is required to contemporaneously document the fact that the advice was provided. There is no general pro forma language or special format required for a tax return preparer to comply with these rules. No form of a general boilerplate disclaimer, however, is sufficient to satisfy these standards. A tax return preparer may choose to comply with the documentation standard in one document covering each position, or in multiple documents covering all of the positions. (iv) Pass-through entities. Disclosure in the case of items attributable to a pass-through entity is adequate if made at the entity level in accordance with the rules in §1.6662-4(f)(5) or at the entity level in accordance with the rules in paragraphs (c)(3)(i) or (ii) of this section. (v) Examples. The provisions of paragraph (c)(3) of this section are illustrated by the following examples: Example 1. An individual taxpayer hires Accountant Q to prepare its income tax return. Q does not reasonably believe that a particular position taken on the tax return would more likely than not be sustained on A-180 its merits although there is substantial authority for the position. Q prepares and signs the tax return without disclosing the position taken on the tax return, but advises the individual taxpayer of the penalty standards applicable to the taxpayer under section 6662, and contemporaneously documents in Q's files that this advice was provided. The individual taxpayer signs and files the tax return without disclosing the position because the position meets the standards for nondisclosure under section 6662(d)(2)(B)(i). The IRS later challenges the position taken on the tax return, resulting in an understatement of liability. Q is not subject to a penalty under section 6694. Example 2. Attorney R advises a large corporate taxpayer concerning the proper treatment of complex entries on the corporate taxpayer's tax return. R has reason to know that the tax attributable to the entries is a substantial portion of the tax required to be shown on the tax return within the meaning of §301.7701-15(b)(3). When providing the advice, R concludes that one position with respect to these entries does not meet the reasonable belief that the position would more likely than not be sustained on the merits standard and also does not have substantial authority, although the position meets the reasonable basis standard. R, in good faith, advises the corporate taxpayer that the position lacks substantial authority and the taxpayer will be subject to an accuracy-related penalty under section 6662 unless the position is disclosed in a disclosure statement included in the return. R also documents the fact that this advice was contemporaneously provided to the corporate taxpayer at the time the advice was provided. Neither R nor any other attorney within R's firm signs the corporate taxpayer's return as a tax return preparer, but the advice by R constitutes preparation of a substantial portion of the tax return and R is the individual with overall supervisory responsibility for the position giving rise to the understatement. Thus, R is a tax return preparer for purposes of section 6694. R, A-181 however, will not be subject to a penalty under section 6694. (d) Exception for reasonable cause and good faith. The penalty under section 6694(a) will not be imposed if, considering all the facts and circumstances, it is determined that the understatement was due to reasonable cause and that the tax return preparer acted in good faith. Factors to consider include: (1) Nature of the error causing the understatement. The error resulted from a provision that was complex, uncommon, or highly technical and a competent tax return preparer of tax returns or claims for refund of the type at issue reasonably could have made the error. The reasonable cause and good faith exception, however, does not apply to an error that would have been apparent from a general review of the return or claim for refund by the tax return preparer. (2) Frequency of errors. The understatement was the result of an isolated error (such as an inadvertent mathematical or clerical error) rather than a number of errors. Although the reasonable cause and good faith exception generally applies to an isolated error, it does not apply if the isolated error is so obvious, flagrant, or material that it should have been discovered during a review of the return or claim for refund. Furthermore, the reasonable cause and good faith exception does not apply if there is a pattern of errors on a return or claim for refund even though any one error, in isolation, would have qualified for the reasonable cause and good faith exception. (3) Materiality of errors. The understatement was not material in relation to the correct tax liability. The reasonable cause and good faith exception generally applies if the understatement is of a relatively immaterial amount. Nevertheless, even an immaterial understatement may not qualify for the reasonable cause and good faith exception if the error or errors creating the understatement are sufficiently obvious or numerous. (4) Tax return preparer's normal office practice. The tax return preparer's normal office practice, when considered together with other facts and circumstances, such as the knowledge of the tax return preparer, indicates that the error in question would rarely occur and the normal office practice was followed in preparing the return or claim for refund in question. Such a normal office practice must be a system for promoting accuracy and consistency in the preparation of returns or claims for refund and generally would include, in the case of a signing tax return preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year's return, and review procedures. Notwithstanding these rules, the reasonable cause and good faith exception does not apply if there is a flagrant error on a return or claim for refund, a pattern of errors on a return or claim for refund, or a repetition of the same or similar errors on numerous returns or claims for refund. A-182 (5) Reliance on advice of others. For purposes of demonstrating reasonable cause and good faith, a tax return preparer may rely without verification upon advice and information furnished by the taxpayer or other party, as provided in §1.6694-1(e). The tax return preparer may reasonably rely in good faith on the advice of, or schedules or other documents prepared by, the taxpayer, another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer's firm), and who the tax return preparer had reason to believe was competent to render the advice or other information. The advice or information may be written or oral, but in either case the burden of establishing that the advice or information was received is on the tax return preparer. A tax return preparer is not considered to have relied in good faith if-(i) The advice or information is unreasonable on its face; (ii) The tax return preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or (iii) The tax return preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given. (6) Reliance on generally accepted administrative or industry practice. The tax return preparer reasonably relied in good faith on generally accepted administrative or industry practice in taking the position that resulted in the understatement. A tax return preparer is not considered to have relied in good faith if the tax return preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the return or claim for refund was prepared, that the administrative or industry practice was no longer reliable due to developments in the law or IRS administrative practice since the time the practice was developed. (e) Burden of proof. In any proceeding with respect to the penalty imposed by section 6694(a), the issues on which the tax return preparer bears the burden of proof include whether-(1) The tax return preparer knew or reasonably should have known that the questioned position was taken on the return; (2) There is reasonable cause and good faith with respect to such position; and (3) The position was disclosed adequately in accordance with paragraph (c) of this section. A-183 2. Gift Tax Declaratory Judgment Action. The IRS has issued proposed regulations under section 7477 dealing with declaratory judgments in Tax Court as to the valuation of gifts. REG-143716-04 (June 9, 2008). The Explanation of Provisions states: Under section 7477(a), the donor may contest an IRS determination of the amount of a gift. Specifically, the donor may petition the Tax Court for a declaratory judgment, provided that certain requirements are met. Section 7477(a) applies in the case of an actual controversy involving a determination by the IRS regarding the value of a gift that is shown on the gift tax return or disclosed on the gift tax return or in a statement attached to that return. These proposed regulations provide a procedure for pursuing a declaratory judgment in the Tax Court pursuant to section 7477 in situations where, prior to the enactment of that section, the taxpayer would have had no remedy to challenge the IRS determination. Specifically, the procedure provided by these proposed regulations applies only in those situations where an adjustment by the IRS does not result in a gift tax deficiency or refund. In situations where the IRS adjustment results in a proposed tax deficiency or a potential refund, taxpayers should not follow the procedures in these proposed regulations but should continue to follow the procedures already in place to dispute a deficiency or claim a refund. These procedures more efficiently address and resolve disputes involving a deficiency or refund. The first requirement for eligibility for relief under section 7477 is that the transfer must be shown or disclosed ``on the return of tax imposed by chapter 12,'' that is, a Federal gift tax return, or on a statement attached to the return. Under the proposed regulations, the return of tax imposed by chapter 12 is defined as the last gift tax return for the calendar year filed on or before the due date of the return, including extensions granted (if any), or if a timely return is not filed, the first gift tax return for the calendar year filed after the due date. If the transfer is not shown or disclosed on the gift tax return, or on a statement attached to the return, a declaratory judgment under section 7477 is not available. If, however, a transfer is disclosed on the return or on a statement attached to the return, this eligibility requirement for the section 7477 procedure is satisfied, even if the transfer is disclosed in a manner that does not satisfy the requirements of section 6501(c)(9) and Sec. 301.6501(c)-1(e) or (f) pertaining to adequate disclosure sufficient to commence the running of the period of limitations on assessment. There may be no compelling reason for the IRS to examine a transaction that is disclosed on the return but not in a manner sufficient to trigger the running of the statute of limitations, because the time period for adjusting the value of the gift is not limited by the statute of limitations for assessments. The Treasury Department and the IRS, however, recognize that in many cases the IRS may prefer to contemporaneously resolve the transfer tax treatment of that transaction, even though the standards for adequate disclosure with regard to that transaction have not been satisfied by the donor. Thus, the IRS in its discretion may make a determination regarding the transfer and place the transfer in controversy by mailing a notice of determination of value used in unagreed cases (Letter 3569) with regard to that A-184 transfer. The ability to place a transfer that is not adequately disclosed in controversy is consistent with the Congressional purpose in enacting the TRA provisions, noted previously, to promote the early resolution of gift tax controversies based on contemporaneous evidence. The IRS and Treasury Department emphasize that the issuance of a Letter 3569 with regard to such a transfer does not constitute a determination by the IRS that the transfer was adequately disclosed or otherwise cause the period of limitations on assessment to commence to run with respect to that transfer. Alternatively, the IRS may in its discretion decide not to put a transfer in controversy at that time (whether or not any other transfer reported on a gift tax return is then put into controversy). If the IRS decides not to put the transfer into controversy at that time, the IRS will not issue a Letter 3569 (described in this preamble) (or the Letter 3569 issued will not address that transfer), the declaratory judgment procedure will not be available for that transfer, and the limitations period applicable to that transfer will remain open. Section 7477 also requires an actual controversy with respect to a determination by the IRS of the value of the disclosed transfer. Thus, the donor is not permitted to bypass the examination process and unilaterally seek a declaratory judgment. Generally, the IRS must propose adjustments with which the donor disagrees. Accordingly, the proposed regulations provide that, in order for the section 7477 declaratory judgment procedure to be available to a donor, the IRS must first make a determination regarding the gift tax treatment of the transfer that results in an actual controversy in a situation where the adjustments do not result in a gift tax deficiency or refund. This IRS determination is deemed to be made by the mailing of a Letter 3569 to notify the taxpayer of the adjustments proposed by the IRS. The mailing of this letter to the donor is the prerequisite for filing a petition with the Tax Court requesting a declaratory judgment under section 7477. Section 7477 also requires that the donor's pleading seeking a declaratory judgment under section 7477 must be filed with the Tax Court before the 91st day after the mailing of the Letter 3569 by the IRS. The pleading must be in the form of a petition subject to Tax Court Rule 211(d). Finally, section 7477(b)(2) provides that the Tax Court may not issue a declaratory judgment under section 7477 unless it first determines that the donor has exhausted all administrative remedies available to the donor within the IRS with respect to the controversy. Tax Court Rule 211(d) requires that the petition in an action under section 7477 must contain a statement that the petitioner has exhausted all administrative remedies within the IRS. See also Tax Court Rule 210(c)(4). Accordingly, the proposed regulations set forth the administrative remedies available to the donor with respect to a determination by the IRS of the amount of a gift, and the circumstances in which the IRS will not contest the donor's allegation that administrative remedies have been exhausted. The administrative remedies are intended to parallel those applicable in the case of an asserted gift tax deficiency. A-185 Specifically, the proposed regulations provide that the IRS will not contest the donor's allegation that the donor's administrative remedies have been exhausted if: (1) The donor requests Appeals consideration in writing within 30 calendar days after the mailing date of a notice of preliminary determination of value (Preliminary Determination Letter) from the IRS, or by such later date for responding to the Preliminary Determination Letter as determined pursuant to IRS procedures; (2) the donor participates fully in the Appeals consideration process, including without limitation timely submitting all additional information related to the amount of the gift that is requested by the IRS in connection with (or as a follow-up to) the Appeals consideration process; and (3) the IRS mails to the donor the Letter 3569, which will notify the donor of the proposed adjustments and of the donor's right to contest the determination by filing a petition for declaratory judgment with the Tax Court before the 91st day after the date of mailing the Letter 3569. The Letter 3569 usually will be issued by the Appeals office. However, because section 7477 requires that the Tax Court, rather than the IRS, determines whether the donor has exhausted all administrative remedies, the donor generally will be sent a Letter 3569 in those situations where the donor does not respond to the Preliminary Determination Letter, or expressly declines to participate in the Appeals process. If a donor does not respond to a Preliminary Determination Letter, or if a donor does not participate in the Appeals process, the IRS will consider the donor to have failed to exhaust administrative remedies. In such cases, the IRS may challenge any allegation in the donor's petition for a section 7477 declaratory judgment that the donor has exhausted all administrative remedies. The proposed regulations also provide that the IRS will not contest the donor's allegation that all administrative remedies have been exhausted in certain circumstances where the above-described process is not followed by the IRS. (For example, the IRS might mail a Letter 3569 to the donor in the absence of these other preliminary steps where, because of the imminent expiration of the applicable statute of limitations, the IRS believes there is not sufficient time to issue a Preliminary Determination Letter to allow Appeals consideration.) If the IRS's decision not to issue a Preliminary Determination Letter is not due to the donor's actions or failure to act, the IRS will not contend that the donor failed to exhaust all administrative remedies, provided that the donor fully participates in the Appeals consideration process offered by the IRS during the pendancy of the Tax Court proceeding. In this regard, the IRS and Treasury Department do not view the reference to section 7477 contained in Sec. 601.106(a)(2)(iv) of the Statement of Procedural Rules as currently in effect and Rev. Proc. 87-24 (19871 CB 720) as prohibiting Appeals' jurisdiction to consider docketed cases under current section 7477. The version of section 7477 referenced in those items was repealed prior to the enactment of the current section 7477 as part of the TRA. The proposed regulations confirm that the donor is not required to consent to an extension of the time within which gift tax with respect to the transfer at issue may be assessed in order to exhaust the donor's administrative remedies, and that the failure to consent to such an extension will not be taken into account for this purpose. See section 7430(b)(1) and Minahan v. Commissioner, 88 T.C. 492 (1987), considering this issue in the context of section 7430(b)(1) prior to amendment by Public Law 104-168 (110 Stat. 1452). A-186 Under the proposed regulations, a donor may petition for a declaratory judgment with respect to disputes regarding valuation and/or other related issues. This is consistent with Sec. Sec. 20.2001-1(b) and 25.2504-2(b) providing that, once the gift tax statute of limitations has expired with respect to a transfer, the IRS is precluded from making any adjustments with respect to that transfer for purposes of determining prior taxable gifts or adjusted taxable gifts, regardless of whether the adjustment involves a valuation issue or a legal issue pertaining to the proper interpretation of the gift tax law. See also Sec. 301.6501(c)-1(f)(5) providing a similar rule regarding transfers that are incomplete gifts but are reported as completed gifts. Accordingly, even if a gift tax adjustment does not generate any additional gift tax liability, the IRS nevertheless is required to propose the adjustment (and to take all other necessary steps) in order to challenge the return as filed within the statutory limitations period, regardless of the nature of the issue presented. Sections 2001(f), 2504(c), 6501(c)(9) and 7477, as enacted or amended by TRA and the 1998 Acts, provide an integrated statutory regime pursuant to which taxpayers are accorded finality with respect to adequately disclosed transfers (except for transfers that are reported as incomplete gifts), while the IRS is afforded the reasonable opportunity to identify in a timely manner returns that present issues that merit further examination. The section 7477 declaratory judgment procedure is a necessary part of this regime because it provides a mechanism to finally resolve any disputed adjustments in circumstances where there is no tax assessment and thus the donor would otherwise be unable to satisfy the jurisdictional requirements for any judicial resolution. The IRS and Treasury Department believe it is appropriate for the declaratory judgment mechanism under section 7477, when available in circumstances where there is no deficiency or refund, to be available for all adjustments regardless of whether the basis for those adjustments is factual, legal, or both. Examples are provided as follows: (e) Examples. The following examples illustrate the provisions of this section. These examples, however, do not address any other situations that might affect the Tax Court's jurisdiction over the proceeding. The examples read as follows: Example 1. Exhaustion of administrative remedies. The donor (D) timely files a Form 709, ``United States Gift (and Generation-Skipping Transfer) Tax Return,'' on which D reports D's completed gift of closely held stock. After conducting an examination, the IRS concludes that the value of the stock on the date of the gift is greater than the value reported on the return. Because the amount of D's available applicable credit amount under section 2505 is sufficient to cover any resulting tax liability, no gift tax deficiency will result from the adjustment. D is unable to resolve the matter with the IRS examiner. The IRS sends a notice of preliminary determination of value (Preliminary Determination Letter) to D informing D of the proposed adjustment. D, within 30 calendar days after the mailing date of the letter, submits a written request for Appeals consideration. During the Appeals process, D provides to the Appeals office all additional information (if any) requested by Appeals relevant to the determination of the value of the stock in a timely fashion. The Appeals office and D are unable to A-187 reach an agreement regarding the value of the stock as of the date of the gift. The Appeals office sends D a notice of determination of value (Letter 3569). For purposes of section 7477, the IRS will consider D to have exhausted all available administrative remedies within the IRS, and thus will not contest the allegation in D's petition that D has exhausted all such administrative remedies. Example 2. Exhaustion of administrative remedies. Assume the same facts as in Example 1, except that D does not timely request consideration by Appeals after receiving the Preliminary Determination Letter. A Letter 3569 is mailed to D more than 30 days after the mailing of the Preliminary Determination Letter and prior to the expiration of the period of limitations for assessment of gift tax. D timely files a petition in Tax Court pursuant to section 7477. After the case is docketed, D requests Appeals consideration. In this situation, because D did not respond timely to the reliminary Determination Letter with a written request for Appeals consideration, the IRS will not consider D to have exhausted all administrative remedies available within the IRS for purposes of section 7477 prior to filing the petition in Tax Court, and thus may contest any allegation in D's petition that D has exhausted all such administrative remedies. Example 3. Exhaustion of administrative remedies. D timely files a Form 709 on which D reports D's completed gifts of interests in a family limited partnership. After conducting an examination, the IRS proposes to adjust the value of the gift as reported on the return. No gift tax deficiency will result from the adjustments, however, because D has a sufficient amount of available applicable credit amount under section 2505. D declines to consent to extend the time for the assessment of gift tax with respect to the gifts at issue. Because of the pending expiration of the period of limitation on assessment with respect to the gifts, the IRS determines that there is not adequate time for Appeals consideration. Accordingly, the IRS mails to D a Letter 3569, even though a Preliminary Determination Letter had not first been issued to D. D timely files a petition in Tax Court pursuant to section 7477. After the case is docketed in Tax Court, D is offered the opportunity for Appeals to consider any dispute regarding the determination and participates fully in the Appeals consideration process. However, the Appeals office and D are unable to resolve the issue. The IRS will consider D to have exhausted all administrative remedies available within the IRS, and thus will not assert that D has not exhausted all such administrative remedies. Example 4. Legal issue. In 2006, D transfers nonvested stock options to a trust for the benefit of D's child. D timely files a Form 709 reporting the transfer as a completed gift for Federal gift tax purposes and complies with the adequate disclosure requirements for purposes of triggering the commencement of the applicable statute of limitations. Pursuant to Sec. 301.6501(c)-1(f)(5), adequate disclosure of a transfer that is reported as a completed gift on the Form 709 will commence the running of the period of limitations for assessment of gift tax on D, even if the transfer is ultimately determined to be an incomplete gift for purposes of Sec. 25.2511-2 of this chapter. After conducting an examination, the IRS concurs with the reported valuation of the stock options, but concludes that the reported transfer is not a completed gift for Federal gift tax purposes. D is unable to resolve the matter with the IRS examiner. Assuming that the IRS mails to D a Letter 3569 with regard to this transfer, and that D complies with A-188 the administrative procedures set forth in this section, including the exhaustion of all administrative remedies available within the IRS, then D may file a petition for declaratory judgment with the Tax Court pursuant to section 7477. Example 5. Transfers in controversy. On April 16, 2007, D timely files a Form 709 on which D reports gifts made in 2006 of fractional interests in certain real property and of interests in a family limited partnership (FLP). However, although the gifts are disclosed on the return, the return does not contain information sufficient to constitute adequate disclosure under Sec. 301.6501(c)1(e) or (f) for purposes of the application of the statute of limitations on assessment of gift tax with respect to the reported gifts. The IRS conducts an examination and concludes that the value of both the interests in the real property and the FLP interests on the date(s) of the transfers are greater than the values reported on the return. No gift tax deficiency will result from the adjustments because D has a sufficient amount of remaining applicable credit amount under section 2505. However, D does not agree with the adjustments. The IRS sends a Preliminary Determination Letter to D informing D of the proposed adjustments in the value of the reported gifts. D, within 30 calendar days after the mailing date of the letter, submits a written request for Appeals consideration. The Appeals office and D are unable to reach an agreement regarding the value of any of the gifts. In the exercise of its discretion, the IRS decides to resolve currently only the value of the real property interests, and to defer the resolution of the value of the FLP interests. On May 28, 2009, the Appeals office sends D a Letter 3569 addressing only the value of the gifts of interests in the real property. Because none of the gifts reported on the return filed on April 16, 2007, were adequately disclosed for purposes of Sec. 301.6501(c)-1(e) or (f), the period of limitations during which the IRS may adjust the value of those gifts has not begun to run. Accordingly, the Letter 3569 is timely mailed. If D timely files a petition in Tax Court pursuant to section 7477 with regard to the value of the interests in the real property, then, assuming the other requirements of section 7477 are satisfied with regard to those interests, the Tax Court's declaratory judgment, once it becomes final, will determine the value of the gifts of the interests in the real property. Because the IRS has not yet put the gift tax value of the interests in the FLP into controversy, the procedure under section 7477 is not available with regard to those gifts. T. MISCELLANEOUS 1. Section 529 Plans. The Pension Protection Act of 2006 gives the IRS broad regulatory power to prevent abuses of section 529 plans. In general, the Congressional concern is that donors might manipulate plans for transfer tax purposes rather than educational purposes. The IRS has issued advance notice of future guidance. Reg127127-05 (January 17,2008). The Overview states: Section 529(f) authorizes the IRS and the Treasury Department to promulgate regulations as needed to protect against these and other types of abuse. Accordingly, the IRS and the Treasury Department intend to issue a notice of proposed rulemaking to address the potential for abuse of section 529 accounts. The notice of proposed rulemaking will provide a general anti-abuse rule that will apply when section 529 accounts are established or used for purposes of A-189 avoiding or evading transfer tax or for other purposes inconsistent with section 529. In addition, the notice of proposed rulemaking will include rules relating to the tax treatment of contributions to and participants in QTPs, including rules addressing the inconsistency between section 529 and the generally applicable income and transfer tax provisions of the Code. The notice of proposed rulemaking also will include rules relating to the function and operation of QTPs and section 529 accounts. With respect to the anti-abuse rule, the Notice states: As described above, the Technical Explanation accompanying new section 529(f) provides two examples in which present law creates the opportunity for abuse of section 529 accounts. Concern has also been raised as to the potential for abuse in other situations. For example, assume that in 2007, when the gift tax annual exclusion amount under section 2503(b) is $12,000, Grandparents wish to give more than $1 million to Child, free of transfer taxes. Grandparents open section 529 accounts for each of their 10 grandchildren, naming Child the AO [account owner] of each account. Grandparents use the 5-year spread rule of section 529(c)(2)(B) to contribute $120,000 ($60,000 from each Grandparent) to each grandchild's account without triggering any gift or generation-skipping transfer (GST) tax liability. The earnings then accumulate on a tax-deferred basis in the accounts and Child may withdraw the balances at any time. If Grandparents survive for 5 years, the account balances will not be included in their gross estates at death. In effect. Grandparents have transferred $1.2 million to Child while claiming that no transfer taxes are due and claiming to use none of their applicable credit amount (formerly the unified credit). As discussed more fully below, similar concerns have been raised where there is a change from one AO to a new AO, thus giving the new AO all rights to and control over the section 529 account, including the right to completely withdraw the entire account for the new AO's benefit. The forthcoming notice of proposed rulemaking will contain an anti-abuse rule designed to prevent opportunities for abuse of section 529 accounts such as those set forth above. The anti-abuse rule generally will deny the favorable transfer tax treatment under section 529 if contributions to those accounts are intended or used for purposes other than providing for the QHEEs of the DB [designated beneficiary](except to the extent otherwise allowable under section 529 or the corresponding regulations). The IRS and the Treasury Department anticipate that the anti-abuse rule will generally follow the steps in the overall transaction by focusing on the actual source of the funds for the contribution, the person who actually contributes the cash to the section 529 account, and the person who ultimately receives any distribution from the account. If it is determined that the transaction, in whole or in part, is inconsistent with the intent of section 529 and the regulations, taxpayers will not be able to rely on the favorable tax treatment provided in section 529. The anti-abuse rule will include examples such as those set forth above that provide clear guidance to taxpayers about the types of transactions considered abusive. Examples are provided: A-190 It is anticipated that the forthcoming notice of proposed rulemaking will provide the following rules regarding the tax consequences arising from the death of a DB. Rule 1. If the AO distributes the entire section 529 account to the estate of the deceased DB within 6 months of the death of the DB, the value of the account will be included in the deceased DB's gross estate for federal estate tax purposes. Rule 2. If a successor DB is named in the section 529 account contract or program and the successor DB is a member of the family of the deceased DB and is in the same or a higher generation (as determined under section 2651) as the deceased DB, the value of the account will not be included in the gross estate of the deceased DB for Federal estate tax purposes. Rule 3. If no successor DB is named in the section 529 account contract or program, but the AO names a successor DB who is a member of the family of the deceased DB and is in the same or a higher generation (as determined under section 2651) as the deceased DB, the value of the account will not be included in the gross estate of the deceased DB for Federal estate tax purposes. Rule 4. If no successor DB is named in the section 529 account contract or program, and the AO does not name a new DB but instead withdraws all or part of the value of the account, the AO will be liable for the income tax on the distribution, and the value of the account will not be included in the gross estate of the deceased DB for federal estate tax purposes. Rule 5. If, by the due date for filing the deceased DB's estate tax return, the AO has allowed funds to remain in the section 529 account without naming a new DB, the account will be deemed to terminate with a distribution to the AO, and the AO will be liable for the income tax on the distribution. The value of the account will not be included in the gross estate of the deceased DB for Federal estate tax purposes. A-191