RC section 2501 imposes a tax on the transfer of property by gift during a taxable year. IRC section 2511 says this tax applies whether the gift is direct or indirect or the transfer is in trust or otherwise. The gifted property is valued as of the date of transfer under IRC section 2512(a). The step transaction doctrine, which determines whether separate transactions, regardless of their overall purpose, should be treated as an integrated set of transactions for tax purposes, also applies to such transfers.
During 1998 and 1999 Mark and Michele Senda formed two family limited partnerships to which they transferred a total of 46,977 shares of MCI WorldCom stock worth approximately $3.5 million. The Sendas then gave substantial interests (90% and 67.2%, respectively) in the limited partnerships as gifts to their three children. The IRS contended that, based on the step transaction doctrine, the Sendas had made indirect gifts of stock to their children; the Sendas claimed they had made gifts of the partnership interests. The IRS valued the stock at its fair market value of $2.75 million. The Sendas valued the partnership interests at $0.7 million after subtracting discounts for lack of marketability and minority interests and the annual gift tax exclusion for each child. The Tax Court agreed with the IRS, and the Sendas appealed to the Eighth Circuit Court of Appeals.
Result . For the IRS. The Sendas made five different arguments to the Eighth Circuit, but the appeals court spent time only on the second, quickly disposing of the other four. The couple’s second argument was that the court had erred in determining the timing of the stock and partnership interest transfers. The Sendas claimed they had transferred the stock to the partnerships before they transferred the partnership interests to the children. As evidence they pointed to various documents: gift-tax returns, the partnerships’ income-tax returns and certificates of ownership and two letters faxed to their tax advisers concerning what were the most tax-advantageous percentages of partnership interests that could be given to the children. With the exception of faxed letters, all the documents were executed after the transfer dates listed on the tax returns. Both the Tax Court and the Eighth Circuit ruled that these after-the-fact documents were unreliable in establishing the sequence of events.
The courts next looked at the faxed letters, one dated the same day as the transfer of stock to the first partnership and the other dated two days after the transfer to the second. The second letter was not helpful to the Sendas’ argument as on their return they said they had transferred the partnership interest the same day as the second stock transfer. In his testimony Mark Senda undermined his own argument by acknowledging his business practice was to execute documents and transactions as of a certain date, not necessarily the actual date of the transaction.
The appeals court agreed with the Tax Court that “at best, the transactions were integrated (as asserted by the IRS) and simultaneous.” This is a classic application of the step transaction doctrine.
Both courts expressed concern that the Sendas’ primary focus as seen in the evidence was what were the most tax-advantaged percentages they could give the children. No purpose was presented for the family limited partnerships other than tax minimization.
Family limited partnerships have been used both successfully and unsuccessfully in the gift and estate tax area to transfer property among family members. The decision in this case illustrates that tax avoidance strategies that have no nontax purpose are likely to be ignored by both the IRS and the courts. Family limited partnerships, in and of themselves, are not a sanctioned loophole in the tax code and should not be treated as such by taxpayers or tax advisers.
Mark W. and Michele Senda v. Commissioner, 97 AFTR2d 2006–419.
Prepared by Sharon Burnett, CPA, PhD, associate professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of the College of Business, West Texas A&M University, Canyon.