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Best Practices Related to IRC Section 2036, Annual Exclusion Transfers and Graegin Loans

Best Practices Related to IRC Section 2036, Annual Exclusion Transfers and Graegin Loans

The Tax Court’s decision in Purdue delivered a late Christmas present to the estate-planning community

It isn’t every day that a Tax Court decision addresses three common estate-planning and administration techniques in a single case and even less common for there to be nothing but good news. However, Dec. 28, 2015, was one of those days as the Tax Court delivered a late Christmas present to the estate planning community—the memorandum decision in the case Estate of Purdue v. Commissioner.1 The court concluded that the decedent’s gifts of family limited liability company (LLC) interests to a trust for her children weren’t includible in her estate under Internal Revenue Code Section 2036, the gifts were of present interests, which qualified for the annual gift tax exclusion, and related party loans made to the estate by the children were properly deducted.  On each of these issues, the result demonstrates that good facts make good law. Even more important for clients and planners alike, the case makes clear that estate planning isn’t a “set it and forget it” proposition. Careful planning and careful administration created the good facts and gave the taxpayers a good result. Let’s review each of the issues and highlight what actions the taxpayer took in this matter that planners can replicate in their practice, which will hopefully lead to a replication of the positive results in Purdue.

Decedent’s Estate Plan

In this case, the decedent died in 2007 as a resident of the State of Washington, survived by her five children.  Within the last decade of her life, the decedent and her husband, who ultimately predeceased her, (the parents) engaged the husband’s law firm for estate and gift tax planning advice.  Their net worth when they began planning was approximately $28 million.  The parents’ assets consisted primarily of $24 million in marketable securities held at three management firms with no coordination among them.  The parents also owned a rental commercial property that was subject to a long-term lease. The planning began by consolidating the management of many of their assets into a single family LLC (the Family LLC). Interests of the company were transferred over time into a family trust they created, which had withdrawal rights (that is, Crummey powers), so that the decedent could transfer interests in the partnership using the annual exclusion allowed for each beneficiary of the trust.  On death, there were insufficient liquid assets available to the estate to pay estate taxes, so children of the decedent provided loans to the estate, and the interest on the loan was deducted as an administration expense under IRC Section 2053. The Internal Revenue Service attacked the partnership transaction under Section 2036, challenged whether the transfers of the entity's interest qualified as a gift of a present interest and argued that the interest deduction should be disallowed because the loan taken wasn’t necessary. 

Attack Under Section 2036(a)

The first issue the court addressed was whether gifts of interests in the Family LLC to a family trust were includible in the decedent’s estate under Section 2036(a), applying the test set forth in Estate of Bongard v. Comm’r.2  Under the Bongard framework, Section 2036(a) applies to an interest in property if three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent’s transfer wasn’t a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest in the property that’s enumerated in Section 2036(a)(1) or (2) or (b) that isn't  relinquished before death.  The IRS and the estate agreed the first condition had been met, however, the IRS argued all three conditions were satisfied, while the estate contended the latter two conditions weren’t.

A bona fide sale for adequate and full consideration occurs when the record establishes the existence of a “legitimate and significant nontax reason for creating the family limited partnership and the transferor received partnership interests proportional to the value of the property received.”3 The IRS argued that the transfers were a testamentary substitute, motivated primarily by tax savings. The estate, however, presented several nontax motives for the transfers to the Family LLC.

Of these, the most convincing to the court appeared to be the consolidation and change of management of the investments.  The parents established the Family LLC in August of 2000, and it was funded with $22 million of their marketable securities, the commercial real estate, a demand promissory note to one of the children that was secured by a mortgage and an $865,523 certificate of deposit.  In 2001, the parents entered into an agreement with an advisory company to provide investment and management services to the Family LLC.  The result was that the bulk of the parents’ marketable securities were consolidated into the Family LLC and subject to a coordinated professional investment strategy at the children’s direction, as opposed to spread across multiple investment firms under the parents’ direction.  The court found that the desire to have the marketable securities and other assets held and managed as a family asset constituted a legitimate nontax motive for the transfer of the property.4  Further, the fact that the children ran the Family LLC like a business that was achieving the stated nontax aims strongly propped up the estate’s argument. For example, they followed the formalities of the operating agreement, had regular meetings and kept minutes of these meetings.  Ultimately, the estate’s statement of a legitimate nontax purpose that was supported by the facts at the time the entity was established and consistently through its administration was sufficient to show a bona fide sale.5

Next the court considered whether the decedent received full and adequate consideration.  Receipt of a partnership interest isn’t part of a bona fide sale for full and adequate consideration when an intrafamily transaction merely attempts to change the form in which the decedent holds property.6 The mere recycling of value doesn’t rise to the level of payment of consideration,7  however, when a decedent employs capital to achieve a legitimate nontax purpose, the court can’t conclude that there was a mere recycling of the shareholdings.8  The court’s previous finding of a legitimate nontax purpose also established that the decedent’s receipt of a partnership interest wasn’t a mere change in the form of ownership and that the partnership interest received by the decedent constituted full and adequate consideration.  Due to the finding of a bona fide sale for full and adequate consideration, the court found that Section 2036(a) was inapplicable and the Family LLC interests weren’t includible in the decedent’s estate.

Annual Exclusion Transfers

The court next turned to the IRS argument that the gifts of the LLC interests to the trust, which gave the beneficiaries Crummey rights, qualified for the annual exclusion.  As in Hackl v. Comm’r, the court looked to “whether the donees in fact received rights differing in any meaningful way from those that would have flowed from a traditional trust arrangement.”9   To satisfy Section 2503(b) the estate needed to show that, at the time of each gift, the donees obtained the use, possession or enjoyment of: (1) the Family LLC interest, or (2) the income from those interests.10 The operating agreement of the Family LLC required unanimous consent of the members to transfer membership interests.  As in prior cases, the court found that the beneficiaries who held the withdrawal rights didn’t receive immediate use, possession or enjoyment of the Family LLC interest itself, given the restrictive agreement.  Therefore, if the transfers were to qualify as a gift of a present interest, the taxpayer would need to show the beneficiaries received a present interest in the income of the LLC. 

To show a present interest in the income of the Family LLC, the estate was required to show that: (1) the Family LLC would generate income; (2) that portion of income could be readily ascertained; and (3) some portion of that income would flow steadily to the donees.  As with the Section 2036 argument, the facts surrounding how the LLC operated gave the taxpayer credibility and the evidence necessary to prove that there was a present interest in the entity’s income.  The first two factors were easily met as the LLC held publically traded marketable securities and real property subject to a long term lease, meaning that it was known that income would be generated and, due to the nature of the assets, could be reasonably ascertained. The third factor was also met as both the operating agreement and the fiduciary duties under state law on the members would result in income being distributed, but even more important, the entity did distribute income during the time period for which the IRS was challenging whether the beneficiaries had a present interest in the income.  These facts can be compared to cases in which the Tax Court ruled against the taxpayer based on the facts, such as in Price, in which the court found that the beneficiaries didn’t have a right to income given it was at the sole discretion of a general manager, which the taxpayer couldn’t show had a clear fiduciary duty to make distributions and, in fact, didn’t make distributions for a period of time.11  Again, as with the Section 2036 issue, the court’s analysis shows the ruling is very much a fact specific one, and the taxpayer prevailed because the facts in this case showed the entity wasn’t only properly set up but operated in a way that supported the taxpayer’s position.

Deductibility of Graegin Loan

At the time of the decedent’s death, her gross estate for tax purposes consisted primarily of interests in the Family LLC held by her directly and by a qualified terminable interest property (QTIP) trust established under her husband’s estate plan.  To pay the estate tax liability, the estate would need assets from the Family LLC.  The parents’ attorney recommended obtaining liquid assets by compelling a dividend from the Family LLC, or, alternatively, obtaining a loan from the Family LLC.  While the four personal representatives of the estate, who were four of the five children of the decedent, sought to compel a dividend, the Family LLC required unanimous consent of the members to transfer interests.  The fifth child refused to approve dividends to pay the estate tax in hopes that this would induce the remaining siblings to approve a larger lump sum dividend that had been previously opposed.  Ultimately, the estate and the QTIP trust were forced to take loans from the Family LLC totaling $1,233,897 to cover estate tax liabilities in excess of the liquid assets, and the IRS challenged the estate tax deduction. The estate claimed the $20,891 of interest that accrued under the terms of the loan as a deduction as an administrative expense under Section 2053.

The Tax Court interestingly didn’t cite to Graegin or its progeny, but applied the traditional three-prong analysis under Graegin to determine whether the loan qualified for a deduction.12  Under the traditional Graegin analysis, to satisfy the requirements to receive a deduction under Section 2053 for the interest on the loan, it must be demonstrated that: (1) the loan was a bona fide debt, (2) the amount of the interest was readily ascertainable, and (3) the loan was actually and necessarily incurred.  The IRS only challenged, and the court only considered, the last factor.  Another positive factor for the taxpayer is that the Tax Court didn’t seem to consider the “indirect use” argument that the IRS had prevailed on in recent years to disallow the interest deduction in other cases.13

Again, it was the clear evidence and good facts that carried the day.  The facts showed that the parents’ attorney recommended taking a distribution from the Family LLC, however, because the distribution required unanimous consent and one of the children refused to grant consent the loan was necessary, and therefore it was actually and necessarily incurred.  This case shows three best practices in setting up a family structure and loan to ensure that the interest deduction will be respected.  First, if the estate holds an interest in the lending entity, the operating agreement should have sufficiently restrictive terms to prevent a distribution being made.14 Second, it’s helpful if the individuals taking the loan or making the loan aren’t identical.  In this case, it was very useful that the one child who wasn’t a personal representative was the party that blocked the distribution from the Family LLC.  Although the IRS should respect that the same individual can have differing fiduciary duties if on both the borrower and lender side of a loan, it hasn’t always done so and has had success ignoring the distinction such as in the Black case.15  Third, the terms of the loan were reasonable and appeared to be for the purpose of paying the estate tax liability as opposed to generating an estate tax deduction.16

Useful Reminders

As estate planning practitioners and advisors head into 2016, Purdue offers useful reminders that the defense against common IRS attacks doesn’t just rest on what was done at the time of the transaction, but also on what happens in the years following the transaction.  By diligently setting up, maintaining and stress testing structures over time, the taxpayer can build a factual record that not only gives the good facts that make good law, but also gives the taxpayer credibility. Don't just look ahead to the planning to be done and the best practices in doing a specific planning technique, but look back on what’s been done and fine tune it so that the planning will continue to serve the client's non-tax and tax objectives.


1. Estate of Purdue v. Commissioner,T.C. Memo. 2015-249.

2. Estate of Bongard v. Comm’r, 124 T.C. 95, 112 (2005).

3. Ibid., at 118.

4. The court considered several other factors, noting receiving advice about transfer tax savings and the children not retaining an independent advisor weighed against the taxpayer.  It further noted that several additional factors weighed in favor of the estate, specifically the parents not being financially dependent on the assets of the Family LLC, the lack of any significant commingling of the decedent's funds with the Family LLC, the adherence to the formalities of the Family LLC (including documented annual meetings), the transfer of the property to the Family LLC and the fact that the parents were in good health at the time of the transfer all weighed in favor of the estate. 

5. For thorough discussions on how to properly administer family limited partnerships with Internal Revenue Code Section 2036 considerations in mind see Todd Angkatavanich and Stephanie Loomis-Price, “Set It, But Don't Forget It:  Practical tips to avoid the devil in the details after a transaction has closed,” Trusts & Estates (September 2011); Stephanie Loomis-Price, “FLPing The Cards:  Dealing with the IRS,” 18 ALI CLE Est. Plan. C. Mat'ls J. 5 (2012)

6. Estate of Gore v. Comm’r, T.C. Memo. 2007-169.

7. Estate of Harper v. Comm’r, T.C. Memo. 2002-121.

8. Estate of Schutt v. Comm’r, T.C. Memo. 2005-126.

9. Hackl v. Comm’r 118 T.C. 279, 292 (2002).

10. Treasury Regulations Section 20.2053-3(b).

11. Price v. Comm'r, T.C. Memo. 2010-2.

12. Estate of Cecil Graegin, T.C. Memo 1988-477.

13. See Estate of Black v. Comm'r 133 T.C.C 340 (2009); Estate of Koons v. Comm’r, T.C. Memo. 2013-94. See also James I. Dougherty and Marissa Dungey, “Intra-Family Loans to Provide Liquidity for Estates 25 Years After Graegin,” Connecticut Bar Association Estates & Probate Newsletter, Issue No. 73 (2014) (discussion of the evolution of the Graegin analysis).

14. Compare with Koons, ibid.  (disallowing interest deduction when LLC could have been compelled to distribute property to pay estate tax).

15. Estate of Black, 133 T.C. 340 (disallowing interest deduction where an FLP owning liquid assets held the only significant assets of the estate and the executor in his capacity as managing partner could ultimately compel distributions to pay the estate tax).

16. Compare with, Koons, supra note 14 (disallowing interest deduction when a loan for $10.75 million was structured in such a way that it would generate a $71,419,497 interest deduction, which the Court found was “high”).








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