Baine P. and Mildred C. Kerr v. Commissioner , 113 T.C. No. 30 ( 1999 )

113 T.C. No. 30
UNITED STATES TAX COURT
BAINE P. AND MILDRED C. KERR, DONORS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14449-98. Filed December 23, 1999.
In 1993, Ps and their children formed two family
limited partnerships (KFLP and KILP). The KFLP and KILP
partnership agreements contain identical restrictions on
liquidation of the partnerships. In June 1994, Ps
transferred limited partnership interests in KFLP and
KILP to the University of Texas (the university).
On Dec. 28, 1994, Ps created separate grantor
retained annuity trusts (GRAT’s). Ps each transferred a
44.535-percent class B limited partnership interest in
KFLP to their GRAT’s. The GRAT’s remainder interests
were intended to benefit Ps grandchildren through
generation-skipping trusts.
On Dec. 30, 1994, the university was admitted as a
limited partner of KILP. On Dec. 31, 1994 and 1995, Ps
transferred limited partnership interests in KILP to
their children.
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Ps filed Federal gift tax returns for 1994 and 1995.
Ps computed the value of the limited partnership
interests in KFLP that they transferred to the GRAT’s by
applying discounts for lack of liquidity and minority
interest. Ps computed the value of the limited
partnership interests in KILP that they transferred to
their children by applying a discount for lack of
liquidity. R determined that sec. 2704(b), I.R.C., bars
Ps from applying a discount for lack of liquidity in
computing the value of the partnership interests that Ps
transferred to the GRAT’s and to their children.
Ps filed a motion for partial summary judgment
arguing that sec. 2704(b), I.R.C. is not applicable
alternatively because: (1) The GRAT’s trustees received
only assignee interests, as opposed to limited
partnership interests; (2) the disputed transfers must be
valued as assignee interests under sec. 25.2512-1, Gift
Tax Regs.; and (3) the restrictions on liquidation set
forth in the partnership agreements do not constitute
“applicable restrictions” within the meaning of sec.
2704(b), I.R.C.
Held: Ps transferred limited partnership interests
to the GRAT’s in both form and substance.
Held further: Pursuant to sec. 25.2512-1, Gift Tax
Regs., the value of the limited partnership interests is
equal to the price that a hypothetical willing buyer
would pay to a willing seller for the limited partnership
interests.
Held further: The restrictions on liquidation in
dispute do not constitute “applicable restrictions”
within the meaning of sec. 2704(b), I.R.C.
John W. Porter, for petitioners.
Lillian D. Brigman and John D. Maceachen, for respondent.
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OPINION
JACOBS, Judge: This matter is before the Court on
petitioners' motion for partial summary judgment, filed pursuant to
Rule 121.1 Petitioners contend that they are entitled to partial
summary judgment that section 2704(b) is not applicable in valuing
the limited partnership interests that they transferred to their
grantor retained annuity trusts and to their children during 1994
and 1995.2 For the reasons set forth below, we will grant
petitioners' motion.
Background3
Baine P. Kerr and Mildred C. Kerr were married in 1942 and
have four adult children, Baine P. Kerr, Jr., John Caldwell Kerr,
James Robinson Kerr, and Mary Kerr Winters (the Kerr children). The
1
All Rule references are to the Tax Court Rules of
Practice and Procedure. Unless otherwise indicated, all section
references are to the Internal Revenue Code, as amended.
2
Petitioners also moved for partial summary judgment
that their interests in the grantor retained annuity trusts were
“qualified interests” within the meaning of sec. 2702(b).
Respondent subsequently conceded the point, and we issued an
order granting so much of petitioners' motion for partial summary
judgment as pertained to that issue.
3
The following summary of the relevant facts is based on
the parties' stipulations with attached exhibits and other
pertinent materials in the record. They are stated solely for
the purpose of deciding the pending motion and are not findings
of fact for this case. See Rule 1(a); Fed. R. Civ. P. 52(a).
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Kerr children are financially independent. Petitioners have 13
grandchildren.
Petitioners both graduated from the University of Texas.
Baine P. Kerr (petitioner) also graduated from the University of
Texas Law School.
After serving in World War II, petitioner joined the law firm
of Baker & Botts in Houston, Texas, subsequently was admitted as a
partner, and ultimately managed the firm's corporate law
department.
Petitioner left Baker & Botts to serve in various executive
positions at Pennzoil Co. Between 1964 and 1994, petitioner served
on Pennzoil's board of directors and as president. In 1989, he
received a $10 million bonus for work that he had performed in a
lawsuit that Pennzoil had filed against Texaco.
S. Stacey Eastland (Eastland), an attorney at Baker & Botts,
advised petitioners on estate planning matters for many years.
Eastland has written extensively on the use of family limited
partnerships (and particularly transfers of assignee interests) as
an estate planning tool.4 In September 1993, Eastland proposed
that petitioners create two limited partnerships. Eastland advised
petitioners that the limited partnerships could be used as a source
4
See Eastland, Family Limited Partnerships: Non-Transfer
Tax Benefits, 10 Probate and Property (Mar./Apr. 1993); Eastland,
“The Art of Making Uncle Sam Your Assignee Instead Of Your Senior
Partner: The Use of Partnerships In Estate Planning”, SD 63 ALI-
ABA 1153 (May 1999).
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for making gifts to their children. Eastland further advised
petitioners that the partnerships should include a charity as a
partner in light of the recent enactment of section 2704 and to
“make sure that traditional valuation rules apply to the
partnerships.”5
Kerr Issue GST Trust
On December 29, 1993, petitioners, as grantors, and their
children, as trustees, executed a document entitled “Agreement
Creating the Kerr Issue GST Trusts”. The agreement provided that
each of the Kerr children would act as the trustee of a separate
trust under which he or she would be the primary beneficiary. The
agreement further provided that each trust would terminate upon the
death of the primary beneficiary and that any remaining trust
property would pass to the living issue of the primary beneficiary;
i.e., the Kerr grandchildren. On December 29, 1993, petitioners
executed separate wills, which included “pour over” provisions to
the Kerr Issue GST Trusts in an amount equal to the available
generation-skipping tax exemption.
5
Sec. 2704(b), quoted infra pp. 20-21, generally provides
that restrictions on the liquidation of a family partnership will
not be considered in valuing a gift of a partnership interest
from one family member to another if the family has control of
the partnership before the transfer and the family can remove the
restriction on liquidation after the transfer.
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Kerr Family Limited Partnership
On December 31, 1993, petitioners and the Kerr children
executed an agreement forming the Kerr Family Limited Partnership
(KFLP) under the Texas Revised Limited Partnership Act (TRLPA),
Tex. Rev. Civ. Stat. Ann. art. 6132a-1 (West Supp. 1993).
Petitioners made all capital contributions to KFLP in the form of
three life insurance policies on their lives with a face amount
totaling approximately $7 million. The Kerr children did not make
any capital contributions to KFLP.
At the time KFLP was formed, petitioners were the sole general
partners. However, petitioners immediately assigned a portion of
their general partnership interest to each of the Kerr children.
In particular, each of the Kerr children received a .2325-percent
KFLP general partnership interest. There is no evidence in the
record that petitioners executed a written consent admitting the
Kerr children as general partners of KFLP.
Following the transfers described above, petitioners retained
the following partnership interests in KFLP: (1) A combined 100-
percent class A limited partnership interest;6 (2) a combined 2-
6
Pursuant to sec. 5.01 of the KFLP partnership agreement,
class A limited partners were entitled to an annual guaranteed
payment.
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percent general partnership interest; and (3) a combined 97.07-
percent class B limited partnership interest.
Kerr Interests Limited Partnership
On December 31, 1993, petitioners, their children, and KFLP
executed an agreement forming the Kerr Interests Limited
Partnership (KILP) under TRLPA. Petitioners made all capital
contributions to KILP in the form of stocks, bonds, and real estate
with an aggregate fair market value of approximately $11 million.
The Kerr children did not make any capital contributions to KILP.
At the time KILP was formed, petitioners were the sole general
partners. However, petitioners immediately assigned all of their
general partnership interest in KILP to KFLP and a portion of their
class B limited partnership interest in KILP to KFLP and the Kerr
children. In particular, KFLP received a 2-percent general
partnership interest and an 18-percent class B limited partnership
interest in KILP, while the Kerr children each received a .0785-
percent class B limited partnership interest in KILP. There is no
evidence in the record that petitioners executed a written consent
admitting KFLP as a general partner of KILP.
Following the transfers described above, petitioners retained
a combined 100-percent class A limited partnership interest in
KILP7 and a combined 76.686-percent class B limited partnership
interest.
7
Pursuant to sec. 5.01 of the KILP partnership agreement,
class A limited partners were entitled to an annual guaranteed
payment.
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In 1995, petitioners transferred additional assets to KILP
with an aggregate fair market value of approximately $9.9 million.
Partnership Agreements
The KFLP and KILP partnership agreements are identical in all
material respects. They include a number of provisions pertinent
to the pending motion.
Section 3.03 of the partnership agreements states that the
general partners shall appoint petitioners to serve jointly as the
managing partner, that if either petitioner fails or ceases to
serve as managing partner, then the other shall continue to serve
as managing partner, and, if both petitioners cease or fail to
serve as managing partner, then Mary Kerr Winters shall serve as
managing partner. Section 3.10(b) states the general rule that no
limited partner shall have any control over the management of the
partnerships. However, section 3.09(e) states that the partnership
shall not take action with respect to certain enumerated “Major
Decisions” without prior written consent of a majority of the
limited partners. Section 3.10(e) identifies “Major Decisions” as
extraordinary events such as the partnership's filing a petition in
bankruptcy, any act that would make it impossible to carry on the
partnership's business, and any act in contravention of the
partnership agreement.
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Section 3.06 states that no person shall be admitted as a
general or limited partner without the consent of all general
partners, except as provided in article VIII of the agreements.8
Section 3.10(a) states that no other person may become a limited
partner of the partnerships except by way of a transfer permitted
under and effected in compliance with the partnership agreements.
Section 3.10(c) states that limited partners shall not be
entitled to the withdrawal or return of their contributions to the
partnerships except to the extent, if any, that distributions are
made pursuant to the partnership agreements or upon termination of
the partnerships.
Section 8.01 states the general rule that no limited partner
or spouse of a limited partner shall make a “disposition” of an
interest in the partnership owned or held by him except with the
consent of the partnership and all other partners. The term
“disposition” is defined in section 8.02 as any sale, assignment,
gift, exchange, transfer, change in beneficial interest of any
trust or estate, distribution from any trust or estate, change in
ownership of a corporate or partnership partner, or any other
disposition of a limited partnership interest, whether voluntary or
involuntary, direct or indirect. However, section 8.02 states that
8
The pertinent sections of article VIII of the partnership
agreements are summarized infra pp. 9-10.
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a “disposition” does not include a transfer to a “permitted
assignee”. The term “permitted assignee” is defined in section
8.03 to include, among others, each existing partner, any person
who is a lineal descendant of both petitioners, a trustee of any
trust that is more than 75 percent actuarially held for permitted
assignees, any partnership owned exclusively by permitted
assignees, or a charity.
Section 8.04 states that any limited partner desiring to make
a disposition of all or any part of his or her limited partnership
interest shall first submit a written offer to sell the limited
partnership interest to the partnership and the remaining partners.
Sections 8.11 and 8.12 set forth a formula for determining the
amount that the partnership or partners will pay for such limited
partnership interests.
Section 8.19 states that any disposition of a limited
partnership interest shall be effective only to give the assignee
the right to receive the share of profits to which his assignor
would otherwise be entitled. Section 8.20 states, in pertinent
part, that upon the transfer of a general partnership interest to
a permitted assignee, the general partners shall admit the
transferee into the partnership as a class B limited partner.
Section 8.21 states that no person not already a partner shall
become a partner or acquire any rights to participate in the
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management of the partnership except with the unanimous consent of
the partners. However, the provision further states that the terms
of article VIII shall apply to an assignee as if he were a
substituted partner.
Section 9.02 states that no limited partner shall have the
right to withdraw from the partnerships before the partnerships
dissolve and liquidate. However, class B limited partners have a
“put right”; i.e., the right to require the partnership to purchase
part or all of a class B limited partnership interest at “fair
market value” as defined in section 8.12. The latter section
defines fair market value under the so-called willing buyer/willing
seller standard, with the caveat that the hypothetical willing
buyer of the limited partnership interest will have no withdrawal
or put rights.
Section 10.01 sets forth the liquidation provisions at the
center of the present controversy. Section 10.01 states that the
partnerships will dissolve and liquidate on the earlier of (1)
December 31, 2043, (2) by agreement of all the partners, or (3) on
the occurrence of certain narrowly defined acts of dissolution.
Transfers to University of Texas
Petitioners donated approximately $750,000 to the university
of Texas (the university) between 1975 and 1999. Between 1981 and
1983, petitioners donated $100,000 to the university to establish
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the Mildred Caldwell and Baine Perkins Kerr Centennial
Professorship in English History and Culture. In 1988, petitioners
donated Pennzoil Co. stock valued at $433,687 to the university to
enhance the aforementioned endowment and to redesignate the
professorship as a chair--the Mildred Caldwell and Baine Perkins
Kerr Centennial Chair in English History and Culture.
On June 24, 1994, petitioners and a representative of the
university executed two documents entitled “Assignment of
Partnership Interest”, which state that petitioners were
transferring to the university one value unit of a class A limited
partnership interest in KFLP and nine value units of a class A
limited partnership interest in KILP. The assignments state that
petitioners desired to assign a portion of their interests in KFLP
and KILP as more particularly described in schedule I thereto.
Schedule I to the assignments states in pertinent part: “The
Assigned Partnership Interest constituted a Class A Limited
Partnership Interest in * * * [the partnerships] when owned by
Assignors, and when owned by Assignee shall constitute a Class A
Limited Partnership Interest in said partnership.”
On December 30, 1994, the KILP partnership agreement was
amended to state that the university would be admitted as a class
A limited partner.
Transfers to Grantor Retained Annuity Trusts
On December 28, 1994, petitioner Baine P. Kerr created the
Baine P. Kerr 1994 Retained Annuity Trust under which he served as
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the sole initial trustee. On the same date, petitioner Mildred C.
Kerr created the Mildred Caldwell Kerr 1994 Retained Annuity Trust
under which she served as the sole initial trustee. (The above-
described trusts will hereinafter be referred to as the GRAT’s.)
The GRAT’s were structured to provide petitioners with two annuity
payments--the first payment was due December 29, 1994, and the
second payment was due December 30, 1995. The GRAT’s were each set
to terminate on the earlier of December 30, 1995, or the date of
the grantor's death.
On December 28, 1994, petitioners each executed a document
entitled “Assignment of Partnership Interest”, stating that they
were each transferring to the GRAT’s trustees a 44.535-percent
class B limited partnership interest in KFLP as more particularly
described in Schedule I thereto. The parties agree that the GRAT’s
trustees were permitted assignees within the meaning of section
8.03 of the KFLP partnership agreement. Schedule I to the
assignments states in pertinent part: “The Assigned Partnership
Interest constituted a Class B Limited Partnership Interest in
[KFLP] when owned by Assignor and, when owned by Assignee, shall
constitute a Class B Limited Partnership Interest in said
partnership.”
On December 29, 1994, and December 30, 1995, petitioners each
executed documents entitled “Assignment of Annuity” in which they
sold the rights to their annual GRAT’s annuity payments in exchange
for promissory notes from the GRAT’s. On December 29, 1994, and
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December 30, 1995, the GRAT’s transferred demand notes to
petitioners as required under the assignments described above. The
original principal amounts due on the December 30, 1995, GRAT’s
demand notes held by petitioners Baine P. Kerr and Mildred C. Kerr
were $795,148.76 and $795,716.99, respectively.
On December 29, 1994, petitioners (in their individual
capacities and as GRAT’s trustees) executed documents entitled
“Security Agreement-Assignment of Partnership Interest” under which
the GRAT’s assigned to petitioners, as security for the GRAT’s
demand notes, the GRAT’s class B limited partnership interests in
KFLP.
During 1995, petitioners received interest payments on the
GRAT’s demand notes totaling $18,792.47. The GRAT’s were
terminated on December 30, 1995, and the remaining assets and
liabilities of the GRAT’s were transferred to the Kerr Issue GST
Trusts.
By separate agreements dated February 28, 1998, petitioners
agreed that the remaining principal and interest payments due on
the December 30, 1995, GRAT’s demand notes--then the liabilities of
the various Kerr Issue GST Trusts--would be forgiven subject to the
condition that the trustees agree to pay any Federal and State
gift, estate, inheritance, transfer, succession, and generation-
skipping transfer tax associated with the transfer.
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Additional Transfers to the Kerr Children
On December 31, 1994, petitioners each transferred a .085-
percent class B limited partnership interest in KILP to each of the
Kerr children. On December 31, 1995, petitioners each transferred
a .09375-percent class B limited partnership interest in KILP to
each of the Kerr children.
Petitioners' Federal Gift Tax Returns
Petitioners filed Federal gifts tax returns for 1994 in which
they reported gift tax liabilities attributable to the transfers
that they made to the GRAT’s trustees and to their children. In an
appraisal report (attached to the returns) prepared by Howard
Frazier Barker Elliott, Inc., petitioners determined the fair
market value of the KFLP class B limited partnership interests that
they transferred to the GRAT’s trustees by applying a 25-percent
discount for lack of liquidity or marketability to the value of the
KILP interests held by KFLP, and a 17.5-percent minority-interest
discount and a 35-percent discount for lack of liquidity or
marketability on the net asset value of KFLP's assets. Petitioners
computed the fair market value of a 44.535-percent limited
partnership interest in KFLP as follows:
Total net asset value (KFLP) $3,196,366
Less class A capital account 10,000
3,186,366
Limited partnership percentage 44.535%
NAV of the interest 1,419,048
Minority-interest discount 17.5% 248,333
Marketable minority interest value 1,170,715
Discount for lack of marketability 35.0% 409,750
Fair market value 760,965
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Petitioners further reported that 95 percent of the fair market
value of the KFLP class B limited partnership interests that they
transferred to the GRAT’s trustees was attributable to their
retained annuities, while the remaining 5 percent (or $38,050
(rounded)) represented the amount of their taxable gifts to the
remainder beneficiaries of the GRAT’s.
Petitioners computed the fair market value of the KILP class
B limited partnership interests that they transferred to their
children in 1994 and 1995 by applying a 25-percent discount for
lack of liquidity or marketability.
Respondent's Determinations
Respondent issued a notice of deficiency to petitioner Baine
P. Kerr determining deficiencies of $698,401 and $10,024 in his
Federal gift taxes for 1994 and 1995, respectively. Respondent
issued a notice of deficiency to petitioner Mildred C. Kerr
determining deficiencies of $698,401 and $10,024 in her Federal
gift taxes for 1994 and 1995, respectively. Respondent determined,
among other things, that petitioners had understated the values of
both the KFLP interests that they had transferred to the GRAT’s
trustees in 1994 and the values of the KILP interests that they had
transferred to their children in 1994 and 1995, as follows:
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Partnership Reported Respondent's
Year Interest Value Determination
1
1994 KFLP $38,050 $1,636,420
1994 KILP 12,411 16,547
1995 KILP 17,440 13,080
1
A substantial portion of the difference between the value
that petitioners reported for this item and the value that
respondent determined is attributable to the sec. 2702(b) issue
that respondent subsequently conceded.
Respondent determined in pertinent part that the restrictions on
liquidation set forth in section 10.01 of the KFLP and KILP
partnership agreements constitute “applicable restrictions” within
the meaning of section 2704(b), and that these restrictions should
have been disregarded in valuing the limited partnership interests.
Procedural History
After petitioners filed a timely joint petition for
redetermination, and respondent filed an answer to the petition,
petitioners filed the motion for partial summary judgment currently
pending before the Court. Petitioners raise several alternative
arguments in support of their position that respondent erred in
applying section 2704(b) in this case. Petitioners' primary
contention is that the interests that they transferred to the
GRAT’s trustees were merely assignee interests. In connection with
this argument, petitioners maintain that section 2704(b) does not
apply to the valuation of the transferred interests because the
limited rights of assignees under the partnership agreements are no
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more restrictive than the restrictions imposed on assignees under
TRLPA. See sec. 2704(b)(3)(B).
Respondent filed an objection to petitioners' motion for
partial summary judgment asserting in part that petitioners had not
properly raised the assignment issue in their petition.
Petitioners filed a response to respondent's objection and a
motion for leave to file an amendment to petition and lodged an
amendment to petition with the Court raising the assignee issue.
The Court granted petitioners' motion for leave and filed
petitioners' amendment to petition.
Respondent subsequently filed an amended answer to the
amendment to petition. Respondent also filed a supplemental
objection to petitioners' motion asserting that facts remained in
dispute regarding petitioners' intent in making the disputed
transfers.
Initially, this matter was called for hearing in Washington,
D.C. During the hearing, counsel for petitioners conceded that,
because the Kerr children were already limited partners of KILP
when petitioners transferred additional KILP interests to them in
1994 and 1995, the Kerr children received limited partnership
interests, as opposed to assignee interests. However, petitioners
argued that these property interests should be valued for Federal
gift tax purposes as assignee interests under the willing
buyer/willing seller standard set forth in section 25.2512-1, Gift
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Tax Regs. While accepting petitioners' concession regarding the
transfers to the Kerr children, counsel for respondent argued that
additional discovery was needed to determine the nature of the
property interests that petitioners transferred to the GRAT’s
trustees. In response to these developments, the Court informed
the parties that it intended to define the property interests that
petitioners had transferred to the GRAT’s trustees, and decide the
legal question of the applicability of section 2704(b) before
conducting a trial on valuation issues. In this regard, the Court
directed the parties to proceed with informal discovery, submit a
stipulation of facts to the Court, and prepare for a partial trial,
if necessary, on the issue of the nature of the property interests
that petitioners had transferred to the GRAT’s trustees.
This matter was subsequently called for a partial trial in
Houston, Texas. The parties filed a stipulation of facts, and the
Court received testimony from Eastland, petitioner, Mary Kerr
Winters, and James Robinson Kerr. Following the aforementioned
hearings, the parties filed additional memoranda.
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Discussion
Summary judgment is intended to expedite litigation and avoid
unnecessary and expensive trials. See Florida Peach Corp. v.
Commissioner, 90 T.C. 678, 681 (1988). Summary judgment may be
granted with respect to all or any part of the legal issues in
controversy “if the pleadings, answers to interrogatories,
depositions, admissions, and any other acceptable materials,
together with the affidavits, if any, show that there is no genuine
issue as to any material fact and that a decision may be rendered
as a matter of law.” Rule 121(b). The party opposing the motion
cannot rest upon the allegations or denials in the pleadings but
must “set forth specific facts showing that there is a genuine
issue for trial.” Rule 121(d). The moving party, however, bears
the burden of proving that there is no genuine issue of material
fact, and factual inferences will be read in a manner most
favorable to the party opposing summary judgment. See Marshall v.
Commissioner, 85 T.C. 267, 271 (1985).
On the basis of the record presented, we are satisfied that
there are no material facts in dispute with regard to the issues
raised in petitioners' motion for partial summary judgment.
Section 2501 imposes a tax for each calendar year on the
transfer of property by gift by any individual. Section 2512
provides that if a gift is made in property, “the value thereof at
the date of the gift shall be considered the amount of the gift.”
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Pursuant to section 25.2512-1, Gift Tax Regs., the value of the
gift is the price at which such property would change hands between
a willing buyer and a willing seller, neither being under any
compulsion to buy or sell, and both having reasonable knowledge of
relevant facts. See United States v. Cartwright, 411 U.S. 546, 551
(1973).
In the Omnibus Budget Reconciliation Act of 1990 (OBRA 1990),
Pub. L. 101-508, sec. 11602(a), 104 Stat. 1388-491, Congress
enacted a series of special valuation rules applicable to transfers
of interests in corporations, partnerships, and trusts. One of
these provisions, section 2704(b), provides:
SEC. 2704(b). Certain Restrictions on Liquidation
Disregarded.--
(1) In general.--For purposes of this subtitle, if–
(A) there is a transfer of an interest
in a corporation or partnership to (or for the
benefit of) a member of the transferor's
family, and
(B) the transferor and members of the
transferor's family hold, immediately before
the transfer, control of the entity,
any applicable restriction shall be disregarded in
determining the value of the transferred interest.
(2) Applicable restriction.--For purposes of
this subsection, the term “applicable restriction”
means any restriction–-
(A) which effectively limits the ability
of the corporation or partnership to
liquidate; and
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(B) with respect to which either of the
following applies:
(i) The restriction lapses, in
whole or in part, after the transfer
referred to in paragraph (1).
(ii) The transferor or any
member of the transferor's family,
either alone or collectively, has
the right after such transfer to
remove, in whole or in part, the
restriction.
(3) Exceptions.--The term “applicable restriction”
shall not include--
* * * * * * *
(B) any restriction imposed, or required to be
imposed, by any Federal or State law.
Section 25.2704-2(b), Gift Tax Regs., provides that an applicable
restriction is a restriction on “the ability to liquidate the
entity (in whole or in part) that is more restrictive than the
limitations that would apply under the State law generally
applicable to the entity in the absence of the restriction.”
In sum, section 2704(b) generally provides that, where a
transferor and his family control a corporation or partnership, a
restriction on the right to liquidate the corporation or
partnership shall be disregarded in determining the value of an
interest that has been transferred from the transferor to a family
member if, after the transfer, the restriction on liquidation
either lapses or can be removed by the family.
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Section 2704(b)(4) grants the Secretary the authority to
promulgate regulations providing that restrictions other than
restrictions on liquidation shall be disregarded in determining the
value of the transfer of any interest in a corporation or
partnership among family members if the restriction has the effect
of reducing the value of the transferred interest for transfer tax
purposes but does not ultimately reduce the value of the interest
to the transferee. To date, the Secretary has promulgated
regulations concerning only restrictions on the liquidation of
partnerships.
As previously mentioned, respondent determined that section
10.01 of the KFLP and KILP partnership agreements, which states
that the partnerships shall liquidate upon the earlier of December
31, 2043, or the consent of all the partners, contains restrictions
on the liquidation of the partnerships that constitute “applicable
restrictions” within the meaning of section 2704(b). Respondent
maintains that these restrictions must be disregarded in valuing
the interests petitioners transferred to the GRAT’s trustees and to
their children. Petitioners contend that section 2704(b) is not
applicable on a number of alternative grounds.
I. Petitioners' Argument That Interests Transferred to GRAT’s
Trustees Were Assignee Interests
Petitioners contend that section 2704(b) does not apply to the
KFLP interests that they transferred to the GRAT’s trustees because
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those interests were merely assignee interests under State law.
TRLPA section 7.02(a)(2) provides that an assignment of a
partnership interest does not dissolve a limited partnership or
entitle the assignee to become or exercise the rights or powers of
a partner. TRLPA section 7.02(a)(3) and (4) provides that an
assignee is allocated the income, gain, loss, deduction, or credit
to which the assignor was entitled, and, until the assignee becomes
a partner, the assignor continues to be a partner and to have the
power to exercise any rights or powers of a partner. TRLPA section
7.04(a) provides that an assignee of a partnership interest may
become a limited partner if and to the extent that the partnership
agreement provides for such a transition or on the consent of all
partners. Relying on the definition of an applicable restriction
contained in section 25.2704-2(b), Gift Tax Regs., petitioners
maintain that an assignee’s inability to force KFLP to liquidate
under the KFLP partnership agreement imposes no greater restriction
than those imposed upon assignees under TRLPA.
Petitioners’ contention that the partnership interests they
transferred to the GRAT’s trustees were assignee interests as
opposed to limited partnership interests is based on a strict
construction of the KFLP partnership agreement. In particular,
although petitioners made the transfers to themselves as GRAT’s
trustees, petitioners nonetheless maintain that their children, as
KFLP general partners, had to consent to the admission of the
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GRAT’s trustees as limited partners pursuant to section 3.06 of the
KFLP partnership agreement.
Taxpayers generally are free to structure a business
transaction as they please, even if motivated by tax avoidance
considerations. See Gregory v. Helvering, 293 U.S. 465, 469
(1935); Yosha v. Commissioner, 861 F.2d 494, 497 (7th Cir. 1988),
affg. Glass v. Commissioner, 87 T.C. 1087 (1986); Johnson v.
Commissioner 86 F.2d 710, 712 (2d Cir. 1936), affg. 33 B.T.A. 1003
(1936). However, the tax effects of a particular transaction are
informed by the substance of the transaction rather than its form.
In Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978), the
Supreme Court has articulated the principle as follows:
In applying this doctrine of substance over form, the
Court has looked to the objective economic realities of
a transaction rather than to the particular form the
parties employed. The Court has never regarded “the
simple expedient of drawing up papers,” Commissioner v.
Tower, 327 U.S. 280, 291 (1946), as controlling for tax
purposes when the objective economic realities are to the
contrary. “In the field of taxation, administrators of
the laws, and the courts, are concerned with substance
and realities, and formal written documents are not
rigidly binding.” Helvering v. Lazarus & Co., 308 U.S.
[252, 255 (1939).] * * *
The doctrine that the substance of a transaction will prevail
over its form has been applied in Federal estate and gift tax
cases. See Heyen v. United States, 945 F.2d 359, 363 (10th Cir.
1991); Estate of Murphy v. Commissioner, T.C. Memo. 1990-472; see
- 26 -
also Schultz v. United States, 493 F.2d 1225 (4th Cir. 1974);
Johnson v. Commissioner, supra.
On the basis of our review of the record, we are persuaded by
a number of factors that petitioners, in substance, as in form,
transferred limited partnership interests to the GRAT’s trustees.
As discussed below, the factors that we have relied upon in support
of our holding on this point include petitioners' failure to
respect the literal terms of the partnership agreement, the form of
the transfers, and the economic realities and tax motivation
underlying the transfers.
A. Failure To Comply With The Partnership Agreement
Petitioners failed to adhere strictly to the literal terms of
the KFLP partnership agreement governing transfers of general
partnership interests. Specifically, when KFLP was formed,
petitioners transferred three life insurance policies on their
lives to the partnership. The Kerr children did not contribute any
assets to the partnership. Consistent with the terms of the
partnership agreement, petitioners admit that they initially were
the sole general partners of KFLP. Pursuant to section 4.01 of the
partnership agreement, petitioners subsequently assigned a portion
of their general partnership interests in KFLP to each of their
children.
Significantly, under the plain language of section 8.20 of the
KFLP partnership agreement, petitioners' inter vivos transfers of
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general partnership interests to their children, who were permitted
assignees within the meaning of section 8.03, should have resulted
in the admission of the Kerr children as class B limited partners
of KFLP. Petitioners were free, of course, to override section
8.20 of the partnership agreement and admit the Kerr children as
general partners of KFLP. Nevertheless, considering the
unambiguous terms of section 8.20, it would have been reasonable to
expect that petitioners would clearly document the admission of the
Kerr children as general partners of KFLP by way of written
consents. Given the lack of formality surrounding the admission of
the Kerr children as general partners of KFLP, we are left with the
impression that petitioners either did not fully appreciate the
terms of the KFLP partnership agreement or deemed formal consents
to the admission of the Kerr children as general partners to be
unnecessary. In either case, petitioners' failure to take any
formal steps in regard to the admission of the Kerr children as
general partners of KFLP belies petitioners' contention that the
Kerr childrens' formal consent was necessary to admit the GRAT’s
trustees as limited partners of KFLP.
B. The Form of the Transfers
Petitioners transferred limited partnership interests to
themselves as GRAT’s trustees. Although it is agreed that the
GRAT’s trustees were permitted assignees under section 8.03 of the
KFLP partnership agreement, petitioners contend that the GRAT’s
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trustees could not be admitted to the partnership as limited
partners without the consent of all the KFLP general partners,
including the Kerr children. Petitioner testified that he never
considered whether he was transferring a limited partnership
interest or an assignee interest to himself as a GRAT’s trustee.
Further, two of petitioners' children testified that they were
never asked to consent to the admission of the GRAT’s trustees as
limited partners.
Although petitioners argue that the absence of formal consents
by the Kerr children to the admission of the GRAT’s trustees as
limited partners suggests that petitioners technically transferred
assignee interests to themselves as the GRAT’s trustees, it is
difficult to reconcile that position with the language petitioners
used to document the transfers. As noted earlier, petitioners each
signed a document entitled “Assignment of Partnership Interest”
stating that “Assignor and Assignee desire that Assignor assign to
Assignee a portion of the Partnership Interest of Assignor in
[KFLP] * * * such assigned partnership interest being more
particularly described in Schedule I hereto.” In each case, the
“Assignment of Partnership Interest” further stated that “all
consents required to effect the conveyance of the Assigned
Partnership Interest have been duly obtained.” Further, Schedule
I, which identified the transferred interests as a “44.535% Class
B Limited Partnership Interest”, stated that “The Assigned
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Partnership Interest constituted a Class B Limited Partnership
Interest in [KFLP] when owned by Assignor, and when owned by
Assignee, shall constitute a Class B Limited Partnership Interest
in said partnership.”
Read as a whole, the language used in the “Assignment of
Partnership Interest” establishes that petitioners transferred
limited partnership interests to themselves as the GRAT’s trustees.
Although the documents refer to the GRAT’s trustees as assignees,
the description of the assigned interests contained in Schedule I
clearly states that the assignees will hold class B limited
partnership interests in KFLP. Equally important, the “Assignment
of Partnership Interest” states that petitioners had obtained all
necessary consents to effect the conveyance. Because the GRAT’s
trustees qualified as permitted assignees within the meaning of
section 8.03 of the partnership agreement, and petitioners were not
required to obtain any consents to transfer an assignee interest to
a permitted assignee, the inclusion of the statement that all
necessary consents had been obtained also indicates that
petitioners were transferring limited partnership interests to the
GRAT’s trustees. Further, the statement that all necessary
consents had been obtained contradicts the testimony of the Kerr
children that petitioners never requested that they consent to the
transfers to the GRAT’s trustees.
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C. Objective Economic Analysis
The objective economic realities underlying the transfers to
the GRAT’s trustees do not support petitioners' position that the
transferred interests should be considered assignee interests.
First, and perhaps most importantly, there were no significant
differences under the KFLP partnership agreement between the rights
of limited partners and assignees. Petitioners were vested with
managerial responsibilities for KFLP; neither limited partners nor
assignees had any managerial rights. In addition, limited partners
and assignees enjoyed equivalent rights to information concerning
the partnership's business affairs, and they shared the same
interests in the partnership's distributable cash. Finally, while
limited partners were permitted to put or sell their interests to
the partnership under section 9.02 of the partnership agreement,
assignees were given a substantially equivalent right to offer
their interests to the partnership under sections 8.04 and 8.21 of
the partnership agreement.
The only relevant difference between the rights of limited
partners and assignees relates to a limited partner's right to vote
on major decisions--a right not extended to assignees. However,
given the rare and extraordinary nature of the matters qualifying
as a major decision, such as the filing of a bankruptcy petition or
approving an act in contravention of the partnership agreement, we
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do not consider a limited partner's right to vote on such matters
to be significant for purposes of deciding the question presented.
We further note that petitioners retained the right to vote
the limited partnership interests and petitioners and the Kerr
children had the ability to convert the purported assignee
interests to full limited partnership interests or liquidate the
partnership at will. To characterize the interests that
petitioners transferred to the GRAT’s trustees as assignee
interests ignores the objective economic reality that there was no
meaningful difference between the transfer of an assignee interest
as opposed to a limited partnership interest.
D. Tax Motivation
The record shows that Eastland structured petitioners'
transfers to the GRAT’s trustees primarily to avoid the special
valuation rules set forth in section 2704(b). Eastland's writings
on the subject of family limited partnerships disclose his belief
that the transfer of an assignee interest from one family member to
another would serve to circumvent section 2704(b). Accepting
petitioner's testimony that he did not consider whether he was
transferring a limited partnership interest as opposed to an
assignee interest to his GRAT’s, it appears that Eastland made a
conscious decision not to raise the subject with his clients.
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Consistent with the foregoing, we conclude that petitioners
transferred limited partnership interests to the GRAT’s trustees in
substance as in form.
II. Petitioners' Argument That the Disputed Transfers Must Be
Valued as Assignee Interests Under Section 25.2512-1, Gift Tax
Regs.
Petitioners contend, in the alternative, that the limited
partnership interests in KFLP they transferred to the GRAT’s
trustees and the limited partnership interests in KILP they
transferred to the Kerr children must be valued as assignee
interests under the willing buyer/willing seller standard
prescribed in section 25.2512-1, Gift Tax Regs. Specifically,
petitioners contend that the hypothetical willing buyer is assumed
to be an outsider who would approach the purchase of a KFLP or KILP
limited partnership interest with the understanding that he could
buy only an assignee interest and that there would be no guaranty
of admission as a limited partner.
Petitioners’ position is based on a misunderstanding of the
proper application of the willing buyer/willing seller standard.
The nature of the property interest to be valued for Federal gift
tax purposes generally is determined under State law. See Morgan
v. Commissioner, 309 U.S. 78, 80 (1940); Estate of Bright v. United
States, 658 F.2d 999, 1001 (5th Cir. 1981). Once the Court has
determined the nature or character of the property interest in
- 33 -
question, Federal law applies to determine how the property
interest will be taxed. See United States v. Bess, 357 U.S. 51, 55
(1958).
The valuation standard under section 25.2512-1, Gift Tax
Regs., is objective--the standard is based on a purely hypothetical
willing buyer and willing seller, each of whom seeks to maximize
his or her profit from any transaction involving the property. See
Estate of Simplot v. Commissioner, 112 T.C. 130, 151-152 (1999),
and cases cited thereat. The hypothetical willing buyer and
willing seller are not specific individuals or entities, and their
characteristics are not necessarily the same as the personal
characteristics of the actual seller or a particular buyer. See
Estate of Bright v. United States, supra at 1005-1006; Estate of
Simplot v. Commissioner, supra at 152.
Petitioners attempt to expand section 25.2512-1, Gift Tax
Regs., beyond its intended scope by using the provision to redefine
the character of the property interests in question as assignee
interests. See, e.g., Estate of Nowell v. Commissioner, T.C. Memo.
1999-15. However, as explained above, we have already determined
that petitioners transferred limited partnership interests to the
GRAT’s trustees. Further, petitioners admit that they transferred
limited partnership interests to their children. Accordingly,
section 25.2512-1, Gift Tax Regs., is properly applied by
determining the price that a hypothetical willing buyer would pay
- 34 -
a willing seller for limited partnership interests in KFLP and
KILP.
III. Section 2704(b)--Applicable Restriction
Petitioners contend that section 2704(b) is not applicable in
this case even if the Court concludes (as we have) that petitioners
transferred limited partnership interests to the GRAT’s and to
their children. Petitioners argue that the provisions of section
10.01 of the partnership agreements do not constitute “applicable
restrictions” because: (1) The provisions do not restrict
liquidation of the partnerships within the meaning of section
2704(b)(2)(A); and (2) the university's interests in KFLP and KILP
demonstrate that the Kerr family did not have the ability
unilaterally to lift any restrictions on liquidation within the
meaning of section 2704(b)(2)(B)(ii). In the alternative,
petitioners assert that any restrictions on liquidation in the
partnership agreements are excepted from the definition of an
“applicable restriction” pursuant to section 2704(b)(3)(B) and
section 25.2704-2(b), Gift Tax Regs. Because we agree with
petitioners' contention that restrictions on liquidation in the
partnership agreements are excepted from the definition of an
“applicable restriction” pursuant to section 2704(b)(3)(B) and
section 25.2704-2(b), Gift Tax Regs., we need not consider
petitioners' remaining arguments.
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Before proceeding with our analysis, we will briefly review
the legislative history underlying section 2704. The special
valuation rules, of which section 2704 is a part, were enacted in
OBRA 1990 section 11602(a), in conjunction with the repeal of
section 2036(c).9 The latter provision, enacted as part of the
Omnibus Budget Reconciliation Act of 1987, Pub. L. 100-203, sec.
10402(a), 101 Stat. 1330, 1330-431, represented Congress' attempt
to discourage taxpayers' use of “estate freeze” transactions for
the purpose of reducing or avoiding Federal transfer taxes. See H.
Conf. Rept. 100-495, at 994 (1987), 1987-3 C.B. 193, 274. By 1990,
Congress felt compelled to repeal section 2036(c) on the ground
that “the statute's complexity, breadth, and vagueness posed an
unreasonable impediment to the transfer of family businesses.”
Informal S. Rept. on S. 3209, 136 Cong. Rec. S15629, S15679-S15680
(daily ed. Oct. 18, 1990).
Although the special valuation rules were enacted as a more
targeted substitute for section 2036(c), there is little in the way
of direct legislative history relating to the enactment of section
2704. In particular, there was no provision for the special
9
Sec. 2036(c) generally provided that if a person
transferred property having a disproportionately large share of
the potential appreciation in an enterprise while retaining an
interest or right in the enterprise, then the transferred
property would be included in the transferor's gross estate, or
upon the disposition of either the transferred property or the
retained interest, the transferor would be deemed to have made a
gift.
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valuation rules in H.R. 5835, 101st Cong., 2d Sess. (1990)--the
House bill underlying OBRA 1990. Provisions for special valuation
rules first appeared in S. 3209, 101st Cong., 2d Sess. (1990)--the
text of which the Senate adopted in lieu of the language passed by
the House in H.R. 5835. S. 3209, section 7210(a), included new
section 2704, which provided in pertinent part as follows:
Treatment of Certain Restrictions and Lapsing Rights.–-
For purposes of this subtitle, the value of any
property shall be determined–-
(1) without regard to any restriction other than a
restriction which by its terms will never lapse * * *
The broad language of the Senate version of section 2704 did
not survive the ensuing conference between the House and Senate
managers of the legislation. Unfortunately, there is no meaningful
explanation of the detailed language or concepts that were made a
part of section 2704 as finally enacted. H. Conf. Rept. 101-964,
at 1137 (1990), 1991-2 C.B. 560, 606, states in pertinent part:
Treatment of certain restrictions and lapsing rights
In general
The conference agreement modifies the provision in
the Senate amendment regarding the effect of certain
restrictions and lapsing rights upon the value of an
interest in a partnership or corporation. These rules
are intended to prevent results similar to that of Estate
of Harrison v. Commissioner, 52 T.C.M. 1306 (1987).
These rules do not affect minority discounts or other
discounts available under present law. The conferees
intend that no inference be drawn regarding the transfer
tax effect of restrictions and lapsing rights under
present law.
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* * * * * * *
Restrictions
Under the conference agreement, any restriction that
effectively limits the ability of a corporation or
partnership to liquidate is ignored in valuing a transfer
among family members if (1) the transferor and family
members control the corporation or partnership, and (2)
the restriction either lapses after the transfer or can
be removed by the transferor or members of his family,
either alone or collectively.
Example 8.–-Mother and Son are partners in a two-
person partnership. The partnership agreement provides
that the partnership cannot be terminated. Mother dies
and leaves her partnership interest to Daughter. As the
sole partners, Daughter and Son acting together could
remove the restriction on partnership termination. Under
the conference agreement, the value of Mother's
partnership interest in her estate is determined without
regard to the restriction. Such value would be adjusted
to reflect any appropriate fragmentation discount.
This rule does not apply to a commercially
reasonable restriction which arises as part of a
financing with an unrelated party or a restriction
required under State or Federal law. The provision also
grants to the Treasury Secretary regulatory authority to
disregard other restrictions which reduce the value of
the transferred interest for transfer tax purposes but
which do not ultimately reduce the value of the interest
to the transferee.
With the foregoing as background, we return to our analysis.
Section 2704(b)(2)(A) broadly defines an applicable
restriction as “any restriction which effectively limits the
ability of the corporation or partnership to liquidate”. However,
section 2704(b)(3)(B) excepts from the definition of an applicable
restriction “any restriction on liquidation imposed, or required to
be imposed, by any Federal or State law”.
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In what we view as an expansion of the exception contained in
section 2704(b)(3)(B), the Secretary promulgated section 25.2704-
2(b), Gift Tax Regs., which states in pertinent part: “An
applicable restriction is a limitation on the ability to liquidate
the entity (in whole or in part) that is more restrictive than the
limitations that would apply under the State law generally
applicable to the entity in the absence of the restriction.” Thus,
the question arises whether the partnership agreements involved
herein impose greater restrictions on the liquidation of KFLP and
KILP than the limitations that generally would apply to the
partnerships under State law.
Section 10.01 of the partnership agreements states in
pertinent part that the partnerships shall dissolve and liquidate
upon the earlier of December 31, 2043, or by agreement of all the
partners. Petitioners direct our attention to TRLPA section 8.01,
which provides that a Texas limited partnership shall be dissolved
on the earlier of: (1) The occurrence of events specified in the
partnership agreement to cause dissolution; (2) the written consent
of all partners to dissolution; (3) the withdrawal of a general
partner; or (4) entry of a decree of judicial dissolution. TRLPA
section 8.04 provides that, following the dissolution of a limited
partnership, the partnership's affairs shall be wound up (including
the liquidation of partnership assets) as soon as reasonably
practicable.
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On the basis of a comparison of section 10.01 of the
partnership agreements and TRLPA section 8.01, we conclude that
section 10.01 of the partnership agreements does not contain
restrictions on liquidation that constitute applicable restrictions
within the meaning of section 2704(b). We reach this conclusion
because Texas law provides for the dissolution and liquidation of
a limited partnership pursuant to the occurrence of events
specified in the partnership agreement or upon the written consent
of all the partners, and the restrictions contained in section
10.01 of the partnership agreements are no more restrictive than
the limitations that generally would apply to the partnerships
under Texas law. Consequently, these provisions are excepted from
the definition of an applicable restriction pursuant to section
2704(b)(3)(B) and section 25.2704-2(b), Gift Tax Regs.
Respondent counters that we should compare the restrictions
contained in section 10.01 of the partnership agreements with TRLPA
section 6.03, which provides:
A limited partner may withdraw from a limited
partnership at the time or on the occurrence of events
specified in a written partnership agreement and in
accordance with that written partnership agreement. If
the partnership agreement does not specify such a time or
event or a definite time for the dissolution and winding
up of the limited partnership, a limited partner may
withdraw on giving written notice not less than six
months before the date of withdrawal to each general
partner * * *.
Respondent's reliance on TRLPA section 6.03 is misplaced. TRLPA
section 6.03 governs the withdrawal of a limited partner from the
- 40 -
partnership--not the liquidation of the partnership. TRLPA section
6.03 sets forth limitations on a limited partner's withdrawal from
a partnership. However, a limited partner may withdraw from a
partnership without requiring the dissolution and liquidation of
the partnership. In this regard, we conclude that TRLPA section
6.03 is not a “limitation on the ability to liquidate the entity”
within the meaning of section 25.2704-2(b), Gift Tax Regs.
Respondent's position herein is inconsistent with section
25.2704-2(d) (Example 1), Gift Tax Regs., which states in pertinent
part:
D owns a 76 percent interest and each of D's
children, A and B, owns a 12 percent interest in General
Partnership X. The partnership agreement requires the
consent of all the partners to liquidate the partnership.
Under the State law that would apply in the absence of
the restriction in the partnership agreement, the consent
of partners owning 70 percent of the total partnership
interests would be required to liquidate X. * * * The
requirement that all the partners consent to the
liquidation is an applicable restriction. * * *
Significantly, the restriction on liquidation in the partnership
agreement described in the example was not compared with a State
law provision (such as TRLPA section 6.03) pertaining to withdrawal
from a partnership. Rather, the terms of the partnership agreement
are compared with a partnership liquidation provision similar to
TRLPA section 8.01. With these points in mind, we reject
respondent's argument regarding TRLPA section 6.03.
We are mindful that the Secretary has been vested with broad
regulatory authority under section 2704(b)(4). However, the
- 41 -
regulations in place do not support a conclusion that the disputed
provisions in the KFLP and KILP partnership agreements constitute
applicable restrictions.
Conclusion
In sum, we hold that petitioners transferred limited
partnership interests to the GRAT’s trustees. However, consistent
with the preceding discussion, we conclude that section 10.01 of
the partnership agreements does not contain “an applicable
restriction” within the meaning of section 2704(b). Accordingly,
we will grant petitioners' motion for partial summary judgment as
it pertains to this issue.
To reflect the foregoing,
An order granting
petitioners’ Motion for
Partial Summary Judgment
will be issued as it
relates to the section
2704(b) issue.