Anna was the mother of three children and the widow of the man who invented the heart defibrillator implant. In 1992, she created a trust for each of her daughters and gave a portion of her substantial interests in patent licenses to the trusts. In 2001, she created a limited liability company (LLC), to which she made some large transfers. She then gave a 16% interest in the LLC to each of the trusts, keeping a 52% interest to herself. Only four days later, Anna died suddenly and unexpectedly.
The IRS claimed a deficiency of millions of dollars in estate taxes. It pointed to a part of the Internal Revenue Code that provides that all property is to be included in a decedent’s estate to the extent that the decedent has transferred an interest in the property while retaining for life the possession or enjoyment of, or income from, the property. There is an exception to this general rule in cases of a bona fide sale for full and adequate consideration in money, but the IRS argued that the exception did not apply in the case of Anna’s estate.
In a somewhat surprising decision, given a recent trend favoring the IRS in such disputes, the United States Tax Court sided with the estate and kept the LLC assets out of the gross estate for estate tax purposes. The court ruled that the bona fide sale exception applied, notwithstanding that the LLC activities were not in the nature of a “business.” It was sufficient that Anna had “legitimate and significant nontax reasons” for creating and funding the LLC, including joint management of family assets, pooling family assets to maximize investment opportunities, and providing for each of her daughters on an equal basis.
Some practical lessons for minimizing estate tax liability while using family LLCs emerge from the case of Anna’s estate. They include the following: (1) document the legitimate and significant motivations, unrelated to estate taxes, for forming such an entity; (2) continue the entity after the decedent’s death, to avoid the appearance of an ordinary trust; (3) if, as in Anna’s case, the donor dies unexpectedly a short time after the gifts, be prepared to demonstrate that the death was unexpected; and (4) keep sufficient assets outside of the entity to cover the donor’s living expenses, to avoid the possibility that the donor will treat the assets of the entity as her own. The planning, drafting, and advice associated with a family LLC entails resolution of complex issues and requires the guiding hand of a knowledgeable professional.