Valuation Benefits with Leveraged Co-Ownerships May Exceed Entity-Related Valuation Adjustments for Minority Interests [1]
Executive Summary
Limited partnerships and limited liability companies attract IRS audit attention while becoming more disfavored with the Tax Court. While these strategies remain viable (albeit with significant planning and maintenance expense and oversight), the ownership at death of interests in these pass-through entities impose significant valuation and income tax disadvantages when compared to tenancies in common (“TIC”), particularly when debt exists in the ownership of the real property. In fact, the greater the debt the more favored will be TIC ownership. This article reviews the favorable bias with estate tax valuation in the determination of the taxable value attributable to real estate held by a TIC on which recourse debt exists, the enhanced overall estate tax savings with TIC ownership once debt exceeds roughly 33-40% of the property value, and the advantageous income tax basis treatment extended to leveraged co-owned property compared to partnership or LLC interests. In summary, many planners may find TICs preferable for bottom line tax savings regardless of whether or not the client is risk averse.
FACTS
- Valuation discounts are greater generally when the decedent owns a non-controlling interest in a limited partnership (LP) or limited liability company (LLC) than in the situation in which the decedent owns a fractional interest in same real property.
- There are no fractional interest discounts on the death of a joint tenant when the decedent’s interest passes to the other owner by right of survivorship. The same principle applies to community property with right of survivorship and tenancy by the entirety.
- Net asset value (NAV) is a common approach taken in the valuation of a decedent’s interest in an LP or LLC in which real estate is the principal asset. While net income and distribution history and capacity may play significant roles with the valuation of some holding company interests, the NAV method is most commonly applied.
- Under the NAV method of value, the debt that is owed by the entity is subtracted from the value of the other entity assets (most particularly the real property), and, against which valuation discounts for lack of marketability and minority interest may be applied in determining the value of the decedent’s interests. As a result, the lack of marketability and minority interest discounts apply to the entity’ net value .
- The Instructions to the preparation of the Estate Tax Return, the regulations, and several court cases support the reporting of the gross value of the decedent’s interest in the gross estate, without reduction for recourse debt, with the reporting of the debt on Schedule K.
- Fractional interest discounts apply against the value of the property reported in the gross estate (such as on Schedule A, F or G) so that the fractional interest discount is not reduced with respect to the recourse debt. The full recourse debt is deductible against estate tax. The interplay of the fractional interest discount against the gross value and not against the net asset value, increases the percentage discount when compared to the net asset value of the property. This can achieve comparable taxable value, or even reduced taxable value, with leveraged real property than with entity-owned real estate. This result is described and illustrated below.
- From the income tax perspective, the step-up in basis on death with the leveraged TIC will often even exceed the basis adjustment available on partnership property (“inside basis”) with the leveraged LP or LLC interest unless a Sec. 754 election is made. When a Sec. 754 election by the LP or LLC, the inside basis adjustment allowance for partnership property will equal the additional value that is estate taxed on the decedent’s interest in the LP or LLC. However, when the entity owns ordinary income assets, this income tax benefit for the LP or LLC may be significantly reduced. This result is described and illustrated below.
- The ownership of tenancy in common property with the co-owners borrowing money and investing through a limited partnership or LLC may provide the best results for discounting assets for estate taxes while maximizing income tax basis. Significant business purpose must exist.
- Given the IRS challenges to LLCs and LPs, many taxpayers may find the TIC to not only be less expensive from the standpoint of tax compliance, but produce greater overall taxes when compared to real estate ownership by an entity.
COMMENT
LLCs and partnerships serve important tax and non-tax purposes. The purpose of this article is not to suggest that the use of such entities is passé or inappropriate. To the contrary, the use of entities can promote creditor protection, ease transfers within families, provide centralized management, restrict transfer of interests to the unwanted and provide some tax savings. Similarly, the IRS has not challenged (at least not to the point of taking the case to an opinion) family partnerships that conduct a business or rental activity. In fact, the recent Rev. Rul. 2006-34 liberalized the 6166 election to the ownership of limited partnership interests when the entity provides meaningful service consistent with the active, closely-held business requirements of that section.
Rather, this article addresses the bottom-line differences in tax savings given the interplay of valuation principles, debt and basis rules between TICs and partnership or LLC interests. By focusing on thebottom line, the exuberance of proclaiming a large entity discount when the property is subject to substantial debt may be greatly muted, if not dulled to regret.
Reference in this article to co-owned or fractional ownership of real property is directed solely to tenancy in common and not to joint tenancy or community property with right of survivorship. No fractional interest discount applies to either of these means of joint ownership in which the survivor receives the decedent’s interest by right of survivorship.
Recourse Versus Non-Recourse Debt
The debtor is not personally liable with non-recourse debt. Such debt can arise under the terms of the loan (i.e., personal liability is waived) or under state law. For example, in California debt incurred to purchase residential property of four units or less and all seller-carryback financing that is secured by a deed of trust or mortgage is non-recourse. Cal. Code of Civil Proc. Sec. 580(b). However, judicial foreclosures, generally, allow for recourse against the debtor when the creditor goes to court rather than utilizing the power of sale under the deed of trust. State law will determine whether or not a particular loan is recourse or non-recourse. That determination has important estate tax implications.
The Instructions to the federal Estate Tax Return direct that non-recourse debt be deducted from the gross value of the property and reported as a net-value amount in the gross estate schedules. Accordingly, the benefits discussed below in this article are not applicable to non-recourse debt under the Instructions. This treatment for non-recourse debt can have adverse effects, particularly when the real property is needed to qualify for an estate tax benefit and the value reported must exceed a fixed percentage of the adjusted gross estate. For example, section 6166 requires that greater than 35% of the adjusted gross estate consist of closely-held business property. When real estate is subject to non-recourse debt, the numerator in fraction of closely-held property will be reduced because the net value reported is less. However, with recourse debt, the denominator is not reduced in determining the amount of the adjusted gross estate.
Recourse debt, on the other hand, is reflected on Schedule K of the Estate Tax Return. The Instructions to Schedule A, p. 5 of the Form 706, and to Schedule K at p. 17 of the Instructions to Form 706 direct this reporting. This treatment is supported by Estate of Stevens T.C. Memo. 2000-53, Propstra v. U.S. (1982, CA9) 82‑2 USTC ¶13475; and Estate of Fung v. Comr. 117 T.C. 21 (2001).
These Instructions are consistent with Reg. Sec.2053-7, which provides in relevant part:
“A deduction is allowed from a decedent's gross estate of the full unpaid amount of a mortgage upon, or of any other indebtedness in respect of, any property of the gross estate, including interest which had accrued thereon to the date of death, provided the value of the property, undiminished by the amount of the mortgage or indebtedness, is included in the value of the gross estate. If the decedent's estate is liable for the amount of the mortgage or indebtedness, the full value of the property subject to the mortgage or indebtedness must be included as part of the value of the gross estate; the amount of the mortgage or indebtedness being in such case allowed as a deduction. But if the decedent's estate is not so liable, only the value of the equity of redemption (or the value of the property, less the mortgage or indebtedness) need be returned as part of the value of the gross estate.”
This regulation was applied by the IRS in PLR 8423007 to uphold the full deduction for the recourse debt even though the interest rate was below the market rate. However, the fact that the rate was below market and the mortgage was assumable were facts that the Service concluded could be considered in the value of the decedent’s interest under fair market value principles per Code Sec. 20.2031-1(b).
The following is an example with real property having a $2 million fair market value and debt of $800,000, which property is wholly owned by the decedent:
| Recourse Debt | Non-Recourse Debt | ||
| Schedule A | $2,000,000 | Schedule A | $1,200,000 |
| Schedule K | (800,000) | ($2M — $800K) | |
| Effective net value | $1,200,000 | Effective net value | $1,200,000 |
Thus, in the example of the 100%-decedent-owned property, the net taxable result to the estate is the same.
Estate Tax Rule, Not Gift Tax Rule
The unique treatment afforded recourse versus non-recourse debt is an estate tax principle. Gift tax transfers are based on the valued transferred, which would generally be reduced by the liability that is attached to the property. In the ordinary case, there should be no gift tax difference between the recourse and non-recourse debt. (It would likely require the unusual case of a donee assuming personal liability in excess of the value of the property to achieve a different result in the gift context.)
Discounts Create Significant Differences in Treatment
Application of the Instructions, Reg. Sec. 20.2057-1, the mathematics and result of the Propstra and Stevens decisions and the distinction drawn in Fung support applying a fractional interest discount to determine the value of the decedent’s interest when reporting the gross estate value while deducting the pro-rata share of the debt in calculating the taxable estate. The following illustrates the effective taxable value, less debt, in the recourse liability setting.
Each of the foregoing examples continues our illustration of the $2 million parcel of real property, $800,000 in debt, two equal owners and a 20% fractional interest discount.
| Recourse Debt | |
|
Schedule A
| $ 800,000
($ 400,000 ) $ 400,000 |
The guidance for the treatment of non-recourse debt within the fractional interest discount setting is not as extensive. However, the foregoing regulation provides some assistance, wherein it provides that the “equity of redemption” is the returned value. This equity is parenthetically equated to the value of the decedent’s interest less the non-recourse mortgage. This reference could lead to three possible results: (1) that the fractional interest discount is applied to the net asset value (i.e., after the debt); (2) that the fractional interest discount is applied before the debt (i.e., similar to the recourse debt situation) and to which the proportionate deduction of the debt is then applied; or (3) that fair market value of the partial interest is considered, including the effect that the debt may have on the decedent’s interest.
(1) Approach 1: Net Asset Value for Non-Recourse Debt
|
Schedule A
| $ 480,000
$ 480,000 |
This result lessens the benefit of the fractional interest discount by applying the discount against the after-debt value of the property. In our illustration, the taxable estate is $80,000 less with the recourse debt than when applying approach (1). This is the approach urged by the IRS.
(2) Approach 2: Value of Partial Interest and Reduce Estate’s Share of Debt
This approach would achieve the same example as in the recourse debt illustration (i.e., as $400,000 reported value), but would include the gross value, fractional interest discount and non-recourse debt in the gross estate reporting schedule (A, F or G). This approach reaches the most favorable result. It also follows the direction of the Regulation by determining the fair market value of the decedent’s interest and then reducing the pro-rata share of the debt against that interest. The significant difference between the non-recourse debt and the recourse debt situations with this approach would be that the net value in the non-recourse debt setting could not be less than zero. However, in the recourse debt situation, it may be possible to have a debt exceed the value of the interest in the gross estate because of the personal liability that would remain with the estate.
(3) Approach 3: Determine Fair Market Value of the Interest with Debt
The third approach would be to determine the fair market value of the non-recourse interest with debt being a factor in that determination. This approach draws upon fair market value principles. Does the debt influence fair market value? Can the debt be assumed? Is the rate below or above market? Are there limitations against prepayment?
If this approach was applied, the result may equal neither of the results of approaches (1) or (2), although the result would likely be more consistent with approach (1) because the reasonable buyer and reasonable seller are focused upon the net value (or equity) of the decedent’s interest. PLR 8423007 implies that this result should apply in the recourse debt situation when the terms of the promissory note may influence value. For example, if the promissory note has an interest rate that is below market and the loan is assumable, this factor may increase value. Following this reasoning, a due-on-sale provision at times of higher interest rates could depress value.
The application of the fair market value to the partial interest in the context of debt presents the most intriguing issues in the context of recourse debt. This would be the case in situations in which the discounted value of the gross interest was close to, or even less than the amount of the estate’s pro-rata share of the debt. Would a willing seller sell the property if the sale could achieve little or no net proceeds when a full fractional interest discount applied? Where would the bargain be struck between the willing buyer and willing seller?
Recourse Debt Achieves the Best Discount Result
As we have seen, the recourse debt achieves the best result. The non-recourse debt approach may achieve a result equal in the fractional interest discount although the estate may receive resistance from the Service using approach (2). Nevertheless, the taxpayer has substantial authority, particularly the language of the regulation on how to determine the taxable value of the non-recourse debt.
The actual amount of the fractional interest discount may vary from property to property, or perhaps even within the area or custom of a particular area. The total value of the property, percentage interest, nature of the property, debt, number of co-owners, duration of court calendars, income and unique characteristics of a given property can influence the amount of the discount. Twenty percent was selected as reflective of a moderate discount concluded in tax litigation with rental property during the past several years.
Finally, in the event that the IRS implements staff reductions that significantly reduce the likelihood of audits, the amount of discounts that taxpayer will want to assert will likely increase in this arena of professional judgment. No prediction is made as to whether or not increases in discounts will more likely apply to tenancy in common or entity-ownership situations, or in a same or similar matter in each instance.
Discounts for Partial Entity Interests Owning Leveraged Real Estate Achieve Worse Estate Tax Valuation Results than Do Fractional Interest Discounts
Net asset value (NAV) is not the exclusive means of determining the value of a limited partnership or LLC that owns real property. However, it is a very important factor, and often the primary factor in the valuation of interests in entities that own real estate. Income and distributions will be particularly important to the minority interest owner in an entity, which factors may result in value less than the net asset value. Yet, NAV remains the primary approach for valuation of the real estate holding company (including partnerships, corporations and LLCs), including the ownership of minority interests therein.
While this article applies NAV as the most significant factor in the valuation of the real estate entity, the extent to which this approach will be more or less significant can vary in a particular case. Weinberg Estate v. Comr . is an excellent example of this principle, wherein the weighting assigned to distributions and income achieved an inherent discount when compared to a straight NAV approach. This weighting of factors achieved valuation reductions in excess of 50% when compared to NAV, even with a lack of marketability discount of only 20%.
To the extent that net asset value is applied in the valuation of an entity, or the decedent’s interest in the entity, the effect of debt owned by the entity more closely resembles non-recourse debt. After all, the debt reduces NAV.
The following is an example of the net taxable value in a decedent’s estate, comparing real property with a $2 million value, $800,000 recourse debt and 50% ownership by each of the partners in the partnership that owns the property or the two co-owners in a TIC. We apply this illustration with a 20%, then a 25%, fractional interest discount on the TIC against a 40%, then a 33.33% discount, for the minority interest.
| Recourse Debt (Co-Ownership) | FLP/FLLC Valuation | ||
| Schedule A
(½ of $2 M x .8) | $800,000 | Schedule F
(Net Asset Value: $2 M - $800 K= $1.2 million) | $1,200,000 |
| Schedule K
(½ of $800K) | ( 400,000 ) | Times ownership interest ( x.5)
Less even 40% combined discounts (x .4) | 600,000
( 240,000 ) |
| Effective net value | $ 400,000 | Effective net value | $360,000 |
| At a 25% FID, effective value = | $ 350,000 | If the discount was 33.33% the
effective value (rounded) = | $400,000 |
In the above instance, with a 40:60 debt to equity ratio, the effective taxable estate from co-ownership rivals the minority value in the entity. Some may find that the difference is sufficiently small to suggest the co-ownership approach rather than use of an entity, even if estate tax value is a significant factor. In fact, a 20% fractional interest discount applied to a 40% debt to equity ratio generates a 331/3% discount when compared to the net asset value.
The greater the debt to equity ratio, the higher will be the net taxable benefit from leveraging the real property in the co-ownership setting. For example, had the debt been $1,200,000 (60% debt ratio), the gross estate value would have remained at $800,000 (with a 20% discount) against debt of $600,000, for an effective taxable amount of $200,000. The entity value (40% discount to NAV) would equal $240,000. In that setting, the fractional interest discount is greater than the combined entity discounts! In fact, entity level discounts of 50% would be required to achieve an effective taxable amount equal to the 20% fractional interest discount at this level of debt.
The net estate tax savings garnered with the moderately leveraged TIC is only part of the story. The loss of estate tax savings with higher leveraging of the TIC is only part of the woe. Even greater tax-savings nuggets rest with income tax basis.
Sec. 754 Election May Offset Some of the Estate Tax Disadvantage of Leveraged Entities, but not Always
Income tax basis on death is generally the fair market value of the decedent’s interest, with the exception of income in respect to a decedent. Reg. §1.1014‑3(a). An additional exception to this rule arises with respect to the so-called “inside basis” for partnership property when a basis adjustment election is made under Code §§754/743(b).
The basis adjustment election allows the successor to the decedent’s interest to receive a basis other than the carryover basis that normally applies to the share of partnership property attributed to the decedent’s/successor’s interest.
Under Reg. § 1.742-1, the basis to a transferee partner of an interest in a partnership shall be determined under the general basis rules for property provided by Code §1011 and following. As a result, the basis of a partnership interest acquired from a decedent is the fair market value of the interest at the date of his death or at the alternate valuation date, increased by his estate's or other successor's share of partnership liabilities, if any, on that date, and reduced to the extent that such value is attributable to items constituting income in respect of a decedent. Therefore, debt that is allocable to the deceased partner’s interest is added to the fair market value of the interest. On the other hand, the 754 election adjusts inside basis for partnership property.
The following compares the tenancy in common income tax basis on death to the inside basis on death in the limited partnership example when the 25% fractional interest discount is compared to 40% combined discounts for the minority interest in the limited partnership:
| Effectively Estate Taxed | Income Tax Basis | |
| Tenancy in Common | $ 350,000 | $ 750,000 |
| Limited Partnership | $ 360,000 | $ 760,000 |
The inside basis for the limited partnership property equals the fair market value of the interest ($360,000) plus the one-half share of the debt ($400,000) attributable to the decedent as of the date of death. In summary, the estate tax value with the leveraged TIC is less than the estate tax value of the entity interest while the adjusted income tax basis is slightly better for the survivor’s interest in the partnership by the same amount at this level of debt. This result continues with even more debt and even with a reduced fractional interest discount on highly leveraged property.
To illustrate, we next assume a $2 million real property holding with debt of $1.4 million and two equal owners. This property has a NAV of $700,000. We will apply a conservative 20% TIC discount against an un-conservative 50% minority ownership interest discount:
| Effectively Estate Taxed | Income Tax Basis | |
| Tenancy in Common | $ 100,000 | $ 800,000 |
| Limited Partnership | $ 175,000 | $ 875,000 |
This results in an estate tax savings value of $75,000 for the TIC with a corresponding $75,000 increased inside basis with the LP or LLC. Of course, the estate tax requires the immediate payment of money, not a deferred tax liability, and the estate tax rate is greater than the capital gains rate on sale. However, even the relative income tax benefit with the 754 election is minimized, if not lost, when the partnership owns significant ordinary income assets.
Finally, if the leveraged real estate is owned in an entity to which the 754 election is not available, such as a corporation or a partnership or LLC in which the election is not made, the result will be the worse of both worlds. Not only will the estate tax value be greater (depending on the extent of the debt), but the favorable basis adjustment which may offset this disadvantage will be lost as well.
Allocation of Basis Adjustment Generally Divided Between Asset Classes
The inside basis of the surviving partner, even following a favorable election to adjust basis under Code §754 will produce a lower basis for the real property and other capital assets than owned directly (i.e., no entity ownership). This negative income tax result is counteracted, in part, because the ordinary assets (such as cash or publicly traded securities) do not receive discounts when owned directly. As noted below, the best result occurs when the leveraged real property is owned in a TIC and the liquid assets are owned through an entity.
This result occurs because the basis adjustment is allocated between the two classes of property…the §1245 property [depreciable personal property-ordinary]) and the §1250 property (depreciable real property-capital gain) in proportion to value. The allocation between these classes is based upon the assumption that the assets are sold at fair market value. Therefore, some basis adjustment applies to assets that may allow for a faster depreciation deduction. For transactions occurring after December 14, 1999, the method of allocations changed substantially as a result of regulations that were finalized in 1999. As a result of these regulations, the bases of assets that have declined in value can be decreased even if the overall section 743(b) adjustment is an increase. An adjustment that would cause the basis of capital gain assets to be reduced below zero must be applied to lower the basis of ordinary income property. Code §755.
Consider the following examples:
Example #1 : C and D (decedent) were 50/50 partners in CD Partnership. Immediately prior to the death of D, the basis for each of C and D was: §1245 property ($30,000) and §1250 property ($50,000), for total basis to each of them of $80,000. The partnership real estate (§1250 property) with a fair market value of $240,000, and §1245 property with a $60,000 fair market value and no liabilities. Assume that D’s partnership interest at death is valued at $90,000 (½ of $300,000= $150,000, less applicable discounts of 40% [$150,000 x .6= $90,000]). With a §754 election, the D’s inside basis will increase, by $10,000, with none of that adjustment allocated to the basis to ordinary income property because estate’s pre-death basis and the fair are the same for the §1245 property. All $10,000 of the adjustment allocated to the §1250 property. This creates an adjusted basis of $60,000 for the real property (§1250 property) and retains the $30,000 for the §1245 property. This basis adjustment for the real property is considerably less than the fair market value of one-half the real estate before discount (i.e., $120,000 versus $60,000). D will have a basis of $90,000 for his/her partnership interest. See, Appendix 1 to this article, Example 1, for a summary of: (1) the pre-death basis in partnership property to each partner, (2) the pre-death basis for the partnership interest of each partner; (3) the post-death basis for the partnership property; and, (4) the post-death basis for C and D in their respective partnership interests.
Example #2: The same as the above example, except that the basis in the §1245 property for D is $10,000 and the basis for D on the §1250 property is $70,000, for total basis of $80,000. The total basis adjustment will continue to be $10,000, with all of that adjustment being allocated to the §1245 property. See, Appendix 1, Example 2.
Example #3: C and D (decedent) were 50/50 partners in DC Partnership. Each of C and D has a total basis of $110,000 comprised of $20,000 for the §1245 property and a basis of $90,000 for the §1250 property (real estate) immediately prior to the death of D. The partnership owns real property with a value of $340,000 and debt of $100,000, plus the $60,000 in §1245 property, at the time of the death of D. Assume that D’s partnership interest at death is valued for $90,000 (½ of $300,000= $150,000, less applicable discounts of 40% [$150,000 x .6= $90,000]. No section 754 election would be made because the basis at the time of death ($110,000) is greater than the new basis that would be available ($90,000) through the election, if made. However, if a previous section 754 election had been made, then the transfer would cause a decreased in the basis of the partnership interest. As a result of the debt on the property, D’s one-half share of the debt ($50,000) is allocated to the basis for his interest, resulting in a new basis of $140,000 for D’s interest. See, Appendix 1, Example 3.
In the third example, D’s estate (assuming a 20% fractional interest discount) would have a gross estate value of $136,000 for the real estate ($340,000 times .5= $170,000 x .80= $136,000) with a $50,000 deduction for debt on Schedule K, leaving a net taxable value of $86,000 for the real property. In addition, D’s estate would have $30,000 in ordinary income assets, for a total taxable value of $116,000, which is $26,000 more than the estate-taxed value of the limited partnership interest. D’s estate will also have an income tax basis of $136,000 for the real estate in the tenancy in common situation compared to the inside partnership basis of $110,000 for the §1250 property, $30,000 for the §1245 property, and a $140,000 basis for D’s partnership interest. The $140,000 basis that D will have for his partnership interest is $26,000 less than the combined basis that would exist if the real estate was in tenancy in common and the non-real property had no discount. From the standpoint of the basis on the real property, the difference is $136,000 (TIC) versus $110,000 (LP).
| Effectively Estate Taxed | Income Tax Basis | |
| Tenancy in Common | $ 116,000 | $ 166,000 |
| Limited Partnership | $ 90,000 | $ 140,000 |
This illustration is consistent with the common perception that entity owner reduces estate tax when compared to direct ownership. However, this perception is not correct when debt becomes more significant.
Finally, the step-up has the effect of adjusting the basis of ordinary income assets to fair market value with the remainder adjusting the basis of capital gain property. Allocation of basis to ordinary income assets can reduce the payment of tax at higher, non-capital-gain rates.
Entities Do Not Necessarily Achieve the Best Discounts
The immediate conclusion to the above examples is that a greater attention to the net impact of discounts for both the taxable estate on death and income tax basis results needs to be made when planning entities or tenancy in common ownership. With leveraged real estate, the tenancy in common is greatly favored. When publicly traded stock or cash are blended into the leveraged real estate entity, the entity may still achieve some overall greater estate tax benefit, but that benefit may be significantly reduced when debt is significant or when considerable ordinary income assets are present.
Optimum Results with Leveraged Tenancy in Common with Entities Funded through Borrowing
The best overall results arise when the decedent dies with leveraged tenancy in common interests and investment assets (securities and cash) held in a limited partnership or LLC. If the funding of the entity arises from money borrowed on the tenancy in common property, the entity could be established without gifting and with contributions being made from several family investors. Should this approach be undertaken, be mindful of all of the pre-death planning (health of the partners, documentation of business purpose, following ownership and operational technical steps, and maintaining liquidity and income outside of the entity) plus post-death actions (including avoiding use of the entity to pay estate taxes and liabilities) that have been discussed in great depth in articles and cases in the context of IRC Sec. 2036.
Real estate co-ownership is more easily restricted through tenancy in common agreements, which can be recorded in full or by abstract. However, liquid assets cannot be protected against transfers to third parties without some type of entity or trust. In the business context, the entity makes the most sense and is best adapted to transactions, to the avoidance of probate rules, and to fiduciary limitations that plague trustees.
Recourse Debt Analysis in the Sec. 2036 Case
The foregoing analysis regarding recourse debt may be of assistance to taxpayers and their advisors when facing IRS audits of entities raising Sec. 2036 arguments. The effect of IRS success with a 2036 audit may be to disregardthe entity for valuation purposes. As we have seen, that may not be such a bad result when there debt exists against the real estate. Whether this analysis saves the day or merely reduces the downside to an IRS success in this arena will vary from real estate related case to case. In any event, it is a factor.
Conclusion
With estate taxes becoming less important for more taxpayers as a result of the increase in the estate tax exemption allowance, the increased focus on income tax consequences suggests that many clients for whom the use of a partnership or LLC has a significant estate tax planning component may wish to review their planning. Even the estate-tax concerned taxpayer may find that TICs with real property offer greater savings when compared to the ownership of entity interests in the overall mix of estate and income tax results, or even with each regime separately considered.
Citations
IRC Code Secs. 754, 755, 2031, 2053, and 6166; Estate of Young v. Comr . 110 TC 297 (1998); Fratini v. Comr . T.C. Memo. 1998-308; Estate of Kelley v. Comr. TC Memo. 2005-235 (32.2% discount in investment limited partnership); Estate of Shutt v, Comr. TC Memo. 2005-126 (32.5% stock-to-hold limited partnership); Estate of Dailey v. Comr . TC Memo 2001-263 (40% discount investment limited partnership). See, Lappo v. Comr. TC Memo. 2003-258, which is a gift tax case without IRC Sec. 2036 issues; Regarding Sec. 2036: Bongard v. Comr. 124 TC 8 (2005); Mulligan, Current Status of Use of Limited Partnerships in Estate Planning , Estates, Gifts and Trusts Journal , Vol. 30, No. 4, P. 199 (7/14/05); Est. of Bigelow v. Comr . TC Memo. 2005-65; Estate of Korby v. Comr . TC Memo. 2005-103; Estate of Disbrow v. Comr . T.C. Memo. 2006-34; Estate of Abraham v. Comr . TC Memo. 2004-39, aff’d 2005-1 USTC Par. 60,502 (1st Cir.); and Senda v. Comr. TC Memo 2004-160, aff’d 2006-1 USTC Par. 60515 (8th Cir.). Bryle Aubin authored an excellent checklist with reference to court cases in Steve Leimberg's Estate Planning Newsletter # 900 (December 4, 2005) at http://www.leimbergservices.com ; Reg. §1.1014‑3(a); Moore v. Comr . T.C. Memo 1991-546; Weinberg Estate v. Comr . T.C. Memo. 2000-53 (factors weighted); California Code of Civil Procedure Secs. 580(b) and 580(f).
[1] KEITH SCHILLER, of the SCHILLER LAW GROUP, a Prof. Law Corp., Orinda, CA. Copyright Keith Schiller, November, 2006. The author thanks John Feyche, CPA of Los Angeles, California, for raising a question during a Real Estate Conference which suggested portions of this article. The author also wishes to extend his appreciation to Carol Raimondo, CPA, Torrance, California, Neil H. Siegel, Esq., of the Schiller Law Group, and especially to Michael Fredlender, CPA, Woodland Hills, California, for their review. The author wrote on portions of this subject in the May, 2006, issue of BNA’s Estates, Gifts and Trusts Journal .
