• In two separate cases, Tax Court determines whether transfers were gifts or loans—Under Internal Revenue Code Section 102(a), gifts aren’t included in a recipient’s gross income. In Kroner v. Commissioner (T.C. Memo. 2020-73 (June 1, 2020)), the Tax Court analyzed whether certain transfers made to Burt Kroner constituted gifts or should have been included in his taxable income. The total amount of the gifts at issue exceeded $24 million, made over the course of three years: 2005, 2006 and 2007.
Burt had a business relationship with David Haring, which developed into a friendship. Throughout the early 1990s, Burt and David had been co-investors and business partners at various times. However, at the time of the transfers in 2005-2007, they had no direct business ventures together. Burt’s lawyer, Robert Bernstein (who was also David’s lawyer) advised Burt that the transfers were gifts and excludable from his income under IRC Section 102. Burt’s accountant didn’t report the transfers as income. Robert prepared Forms 3520 for the years at issue because David was a British citizen, and Robert advised Burt to report the transfers as foreign gifts.
The Internal Revenue Service audited Burt’s income tax returns and, in a notice of deficiency dated July 10, 2014, determined that the transfers should have been reported as income. The IRS also proposed accuracy-related penalties under IRC Section 6662.
Under Section 102, a transfer must be made with detached and disinterested generosity to be a gift excluded from income. Accordingly, the court had to determine David’s intent when making the transfers. However, David didn’t testify, so the court only had Burt’s testimony and that of Robert and his associate. The court didn’t find Burt’s or Robert’s testimony credible—instead, it found the testimony to be self-serving, unsubstantiated and unconvincing. The court found that David and Burt only had a business relationship, and the friendship didn’t explain the large transfers. In addition, the timing of the gifts correlated with liquidity events for David, which the court suggested could indicate that David was acting as a nominee for Burt, making investments for him (because Burt was barred by a non-compete agreement from investing in some of the companies that had these liquidity events). In sum, Burt failed to convince the court that the transfers were gifts.
The court did hold for Burt, however, that the accuracy-related penalties didn’t apply because the IRS’ initial determination that asserted the penalties hadn’t been approved by the proper supervisor at the IRS.
In another case, Estate of Mary P. Bolles v. U.S. (T.C. Memo. 2020-71 (June 1, 2020)), as in Kroner, the court had to determine if transfers were gifts or loans. This time, however, the transfers were between family members. The taxpayer, Mary, had died in 2010. The IRS reviewed her estate tax return and asserted that Mary had made loans to her son Peter and that the full amount of the loan, including interest, should be an asset of her estate under IRC Section 2031.
Over the course of 20 years, Mary had transferred more than $1.063 million to Peter, whose architecture business initially showed great promise. None of the transfers were subject to a written loan agreement. There were no attempts or requests for payment. Mary did record the amounts given to Peter and kept track of interest. In intrafamily transfers, there are many factors to consider when determining the nature of the transaction, but an actual expectation of repayment and intent to enforce the debt is critical to characterizing a loan. The court found that Mary initially expected repayment because she thought Peter’s business would be successful. However, after 1989, it became clear to Mary that his business was in significant trouble. The court held that Mary had no expectation of repayment after 1989, and from that point forward, the transfers were no longer loans, but instead were gift advances.
• Formula gift held to be fixed without adjustment—The Tax Court analyzed a formula gift of limited partnership (LP) interests in Mary P. Nelson v. Comm’r (T.C. Memo. 2020-81 (June 10, 2020)) and narrowly construed the language of the transfer instrument, causing the taxpayer to be deemed to be making additional gifts on the redetermination of value of the partnership interests.
Mary Nelson owned interests in a family-owned holding company (WEC) that was a Delaware corporation that owned 100% of each of seven operating subsidiaries. The subsidiary companies owned, rented and serviced equipment for the oil and gas industry. Interests in WEC were subject to a shareholders’ agreement that restricted the transfer of the stock. Mary also owned interests in a second family-owned company, Longspar Partners, Ltd. (Longspar) that was formed as a Texas LP. Longspar owned interests in WEC, along with other investment assets. Similar to WEC, Longspar was subject to a partnership agreement that restricted the transferability of partnership interests and the ability of limited partners to control the company.
In December 2008, Mary transferred interests in Longspar to a family trust as a gift. The language in the gift assignment provided that the transfer was of Longspar interests having a value of $2.096 million “as determined by a qualified appraiser within 90 days of the effective date of this Assignment.”
Then, a few days later, in January 2009, Mary transferred additional interests in Longspar to the family trust, as a sale. The transfer document provided that the sale was of Longspar interests having a value of $20 million “as determined by a qualified appraiser within 180 days of the effective date of this Assignment.”
Neither the gift or sale assignment contained a clause defining the fair market value or providing for reallocation after the valuation date. Mary retained an appraiser who concluded that a 1% interest in Longspar was worth $341,000. This resulted in a gift of a 6.14% LP interest in Longspar in December and a sale of a 58.65% LP interest in Longspar in January. Mary and her spouse reported the gift on a Form 709, and they elected to split gifts (so each reported a gift of $1.048 million). The sale wasn’t reported on the Form 709.
The IRS determined that the LP interests were undervalued, finding a value of $1,761,009 for the December gift and an additional gift of $6,803,519 for each of Mary and her spouse, to account for the value transferred in excess of the sales price of $20 million.
The Tax Court looked to the transfer documents to determine the LP interests that were transferred. The taxpayers argued that the formula clauses in the transfer documents were intended to transfer fixed dollar amounts, so that on redetermination, if Longspar were revalued, the corresponding percentage interest conveyed would be adjusted downward. Formula clauses that adjust the property transferred have been approved in prior well-known cases such as Wandry v. Comm’r and McCord v. Comm’r.
However, the court held for the IRS and distinguished the prior cases upholding formula adjustments. It explained that the gift and sale assignment documents expressed the transfer of interests as dependent on the appraiser’s valuation, not on the value as being finally determined for gift or estate tax purposes. The court understood that although that may have been the intent, those critical words “as determined for federal gift and estate tax purposes” weren’t included in the documents, and therefore, the percentage transferred didn’t adjust with redetermination. It was fixed on the appraiser’s determination.
The court went on to analyze the valuation of Longspar and evaluate the work of the appraisers hired by both parties and applied discounts for lack of control and marketability. The redetermined value of a 1% LP interest was $411,235, causing Mary and her spouse to be treated as making total additional gifts of over $4.5 million.