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How to Avoid Indirect-Gift Treatment Under the Step Transaction Doctrine

Gross v. Commissioner

(T.C. Memo. 2008-221,

September 29, 2008)

Ms. Gross formed a limited partnership (Dimar) in July and contributed marketable securities from early October to early December.  She then made limited partnership gifts to her two daughters in mid-December. The gifts were reported with a 35 percent discount.  The IRS claimed the formation, funding, and gifting all occurred on the same day. Accordingly, the IRS considered the gifts to be gifts of the marketable securities, not the entity, with no valuation discounts.  They assessed a gift tax deficiency of over $120,000.

Judge Halpern, who decided Holman v. Commissioner (130 T.C. No. 12, May 27, 2008), a similar case, stated that, despite a mix of good and bad facts on both sides, he was respecting the entity and discount.

The Court analyzed four prior cases: Jones, Shepherd, Senda and Holman, and then looked first at whether Dimar was properly formed.

According to the taxpayer, the facts were as follows:

  1. After several discussions, on or before July 15, 1998, Ms. Gross and her daughters agreed to form a family limited partnership with initial funding of $100 from Ms. Gross and $10 each from her two daughters.  The terms were negotiated and certain terms were agreed to, including control by Ms. Gross and restrictions on transfer and dissolution.
  2. On July 15, 1998, Ms. Gross caused the Dimar certificate of limited partnership to be filed with the New York Department of State. Certain other steps were subsequently taken to address formation requirements, such as publishing notices of the formation in New York newspapers.
  3. On July 31, 1998, Ms. Gross and her daughters wrote checks payable to Dimar in the amount of $100, $10 and $10, respectively.
  4. From early October through December 4, 1998, Ms. Gross transferred ownership of the marketable securities from her name to Dimar’s name, and maintained records of the transfers in a notebook.
  5. On December 15, 1998, Ms. Gross and her daughters executed the Dimar partnership and executed a “Deed of Gift”, transferring to each daughter a 22.25 percent limited partner interest in Dimar.
  6. Dimar filed a Form 1065 partnership tax return showing that Dimar commenced business on July 15, 1998.
  7. Ms. Gross filed a gift tax return that included capital account calculations showing the initial contributions, an increase in Ms. Gross’s capital account for the entire amount of the securities, a decrease in Ms. Gross’s account for the gifts, and an equal increase in the daughters’ accounts.

In contrast, the Service’s version of events was as follows:

  1. Dimar was formed on December 15, 1998, when the limited partnership agreement was signed.
  2. Each daughter acquired a 22.25 percent interest in Dimar on the same day.
  3. On the same day, Ms. Gross contributed the securities to Dimar, with 22.25 percent of the value of the contribution being credited to each daughter’s capital account.

Both sides agreed that the limited partnership agreement was not signed until December 15, 1998, which prevented Dimar from being properly formed as a limited partnership prior to the date of the gifts.  The Court did not believe that either party made a compelling argument on their interpretation of New York partnership law.  Since no persuasive authority exists, the Court turned to the taxpayer’s back-up position, that Dimar had been formed as of July 15, 1998, as a general partnership.  Under New York law, when parties seeking to form a limited partnership do not satisfy the requirements necessary to form a limited partnership, they may be deemed to have formed a general partnership if their conduct indicates that they have agreed, whether orally and whether expressly or impliedly, on all the essential terms and conditions of their partnership arrangement. The Court found sufficient evidence existed to conclude that, at the time petitioner caused the Dimar certificate to be filed on July 15, 1998, she and her daughters had agreed to form a partnership essentially on the terms set forth in the Dimar agreement.

In spite of the fact that the limited partnership agreement was not signed until December 15th, the taxpayer still had to establish that the funding was completed by December 4th.  The taxpayer’s gift tax return included a list of Dimar’s securities in a schedule titled “Securities Contributed to Partnership on 12/15/98.”  The Court noted in a footnote that Dimar’s capital account calculations did not allocate any of the $41,107 of net portfolio appreciation up to December 15th to the daughters’ accounts.  Despite this, Dimar was considered by the Court to have been formed and funded by December 4, 1998.

The Court then focused on the step transaction doctrine using the Holman analysis.  This doctrine will not be applied where “the taxpayers bore a real economic risk of a change in value of the partnership” between the funding and the gift. Fortunately for the taxpayer, with the formation and funding issues decided favorably, the facts of the case were now very similar to Holman, which had gone in the taxpayer’s favor. The Court concluded: “We reach the same result as in Holman, here, where (1) 11 days passed between petitioner’s conclusion of her transfer of the Dimar securities to the partnership and her gifts of interests in the partnership to her daughters, and (2) the Dimar securities were mostly, if not all, common shares of well-known companies.”

Also, Ms. Gross seems to have been very careful in outlining her estate planning.  For example, she documented the fact that, “because she deemed one of her daughters extravagant, she considered a trust arrangement, but she rejected that because her other daughter declined to serve as a trustee.”  She kept careful records of such things as the transfer of the securities from her name to Dimar’s name in a notebook titled “Dimar.”

Since the partnership agreement was not signed until the date of the gift; and the reference in the gift tax return to the securities being contributed on December 15, 1998, ___?___ no allocation of gains to the daughters’ accounts, this could have caused a major problem for the taxpayer.  Even though they ultimately prevailed, the mistakes landed Ms. Gross in Tax Court.

The parties stipulated that the 35 percent valuation discounts would apply if the gifts were upheld as limited partnership interests.  Even though they were not, the Court upheld the 35 percent discount.

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