Respondent determined a $52,878,785 Federal estate tax deficiency against the Estate of Wayne C. Bongard (the estate). After concessions and stipulations, two issues remain for decision: First, whether the shares of Empak, Inc. (Empak), decedent transferred to WCB Holdings, LLC. (WCB Holdings), are included in his gross estate pursuant to sections 2035(a)1 and 2036(a) and (b); and second, whether the WCB Holdings membership units decedent transferred to the Bongard Family Limited Partnership (BFLP) are included in his gross estate under sections 2035(a) and 2036(a). The resolution of these issues depends on the applicability of section 2036(a) to decedent’s respective transfers of Empak stock to WCB Holdings and of WCB Holdings membership units to BFLP.
FINDINGS OF FACT
Many of the facts have been stipulated. The stipulation of facts, stipulation of settled issues, and attached exhibits are incorporated herein by this reference.
Decedent resided in Minnesota on November 16, 1998, the date of his death. On December 9, 1998, the First Judicial District Court, Probate Court Division, Carver County, Minnesota, appointed James A. Bernards (Mr. Bernards) personal representative of decedent’s estate. At the time the petition was filed, Mr. Bernards resided in Minnesota. On February 4, 2003, respondent issued a notice of deficiency to the estate with respect to its timely filed Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.
I. General Background and Time Line
Decedent was a skilled and experienced businessman. In 1966, decedent was a founding employee of Fluoroware, Inc. (Fluoroware), a Minnesota corporation that produced packaging materials for the semiconductor, data storage, and microelectronic industries. In 1980, decedent left Fluoroware to start his own corporation, Empak.
On November 9, 1984, decedent married Cynthia Bongard. Decedent entered into this marriage with four children from a prior marriage: Beth Akerberg, Mark Bongard, Rhonda Notermann, and Lynn Zupan. Cynthia Bongard also entered the marriage with a child from a previous marriage, Terra Saxe.2 Decedent and Cynthia Bongard never had any children together, nor did decedent adopt Terra Saxe.
On May 23, 1986, decedent formed the Wayne C. Bongard Irrevocable Stock Accumulation Trust (isa Trust) for the benefit of his children and Terra Saxe, and funded it with shares of Empak stock. ISA Trust is described in further detail infra pp. 105-106.
On January 17, 1991, Empak incorporated Empak International, Inc. (Empak International), as a wholly owned subsidiary. Pursuant to a joint venture agreement, Empak sold an interest in Empak International to an unrelated foreign corporation. See infra pp. 99-100 for greater details of this joint venture.
Between April 22, 1991, and December 30, 1994, ISA Trust made six distributions of shares of Empak stock to specific beneficiaries. After each distribution, Empak redeemed the shares from the distributee for cash. See infra pp. 105-106 for specific details of these distributions/redemptions.
On January 30, 1996, WCB Holdings, LLC (WCB Holdings), was established, but was not capitalized until December 28, 1996. Before WCB Holdings was capitalized, two significant events occurred. First, on April 18, 1996, Empak had a stock split of 223 to 1, significantly increasing the number of shares decedent and ISA Trust owned. See infra pp. 101-102 and p. 105 for details regarding the stock split and its effect on the Empak shareholders. Second, in February 1996, Empak incorporated Emplast, Inc. (Emplast), and capitalized it with some of Empak’s noncore assets. On July 31, 1996, Empak distributed its Emplast shares to decedent in exchange for some of his Empak shares, which were canceled. This transaction and its effects are discussed further infra pp. 101-102 and p. 105.
On December 28, 1996, decedent and ISA Trust transferred their respective shares of Empak stock to WCB Holdings in exchange for WCB Holdings membership units, which were divided into class A governance, class A financial, class B governance, and class B financial units. For a greater discussion of this transaction, see infra pp. 101-103.
On December 29, 1996, decedent and ISA Trust created the Bongard Family Limited Partnership (BFLP). Decedent transferred all of his WCB Holdings class B membership units to BFLP in exchange for a 99-percent limited partnership interest, and ISA Trust transferred a portion of its WCB Holdings class B membership units to BFLP in exchange for a 1-percent general partnership interest. BFLP is discussed in further detail infra pp. 106-107.
On March 7, 1997, Empak International merged into Empak, which resulted in the foreign corporation’s receiving an ownership interest in Empak and the cancellation of Empak’s shares in Empak International. Facts regarding this transaction are set forth infra pp. 103-104.
On March 15, 1997, decedent transferred WCB Holdings class A membership units to three trusts that he had previously established. Each of these trusts was established to benefit different members of his family. See infra pp. 107-109 for further details regarding these trusts. On December 10, 1997, decedent gave Cynthia Bongard a 7.72-percent limited partnership interest in BFLP. That same day, Cynthia Bongard and decedent entered into a postmarital agreement. See infra p. 109 for details of the postmarital agreement.
Decedent died unexpectedly on November 16, 1998, while on a business/hunting trip in Austria. Decedent was 58 years of age and appeared to be in good health before his death.
11. Decedents Business Interests
A. Empak
On July 14, 1980, decedent founded Empak as a Minnesota corporation. Decedent was assisted by Mr. Bernards, who was one of Fluoroware’s outside accounting consultants, in incorporating Empak. Empak is an acronym for "electronic materials packaging”. Empak engaged in the design, development, manufacture, and marketing of plastic products used in the semiconductor and data storage industries. Some of Empak’s and Fluoroware’s businesses directly competed with each other.
Decedent was Empak’s sole shareholder upon incorporation. Empak had only one class of stock, common voting stock. When decedent funded the ISA Trust with shares of Empak stock in 1986, decedent’s ownership percentage decreased to 85 percent. Decedent was also one of three directors on Empak’s board of directors. In the mid-1980s, decedent became the sole member of Empak’s board of directors and remained in that position until his death, except for a 28-day period from December 30, 1996, to January 24, 1997.
Empak grew into a successful business through decedent’s leadership. Empak’s growth was attributable to selling a greater number and variety of products, expanding its markets, reinvesting its earnings, and borrowing funds. Empak, however, never declared a dividend.
B. Empak, Marubeni Corp., and Marubeni America Corp. Joint Venture
In the 1980s, Empak, Marubeni Corp. (MC), and Marubeni America Corp. (mac) engaged in a joint venture to produce plastic compact disk containers (a.k.a. jewel boxes). MC was a Japanese trading entity with over 700 subsidiaries and was listed on numerous international stock exchanges. MAC was the U.S. sales and marketing subsidiary of MC. Basically, MC financed and provided materials for the joint venture and Empak manufactured the jewel boxes.
C. Empak’s Incorporation of Empak International
On January 17, 1991, Empak incorporated Empak International, Inc., a wholly owned Minnesota subsidiary organized to distribute, sell, and manufacture a proprietary line of computer disk and semiconductor packaging products outside the United States and Canada. The formation of Empak International was a function of the joint venture agreement between Empak and MC. Pursuant to Empak International’s shareholder agreement, Empak sold 49 percent of Empak International’s common stock to MC for $3,765,000 but remained the majority shareholder with a 51-percent interest. During 1992 and 1993, Mark Bongard was employed by Empak International as vice president of sales and marketing.
D. Planning for Corporate Liquidity
At a meeting in 1995, decedent, Robert Boyle (Mr. Boyle), Mr. Bernards, and Chuck Eitel (Mr. Eitel), then president of Empak, discussed various business plans for Empak to remain competitive in the market. Mr. Boyle began representing decedent’s various business interests while he was an attorney at Larkin, Hoffman, Daly & Lindgren, Ltd. (Larkin Hoffman). Mr. Boyle left Larkin Hoffman in 1995 but continued his professional relationship with decedent. As part of these discussions, Mr. Boyle envisioned the necessary steps to position Empak for a corporate liquidity event, which the discussants agreed would provide Empak with the necessary capital to remain competitive. A corporate liquidity event included either a public or private offering of Empak stock. Mr. Boyle handwrote notes during this meeting. These contemporaneous handwritten notes indicate that a single holding company, to hold all the Empak stock owned by the Bongard family, was going to be established as part of this business plan. As explained hereinafter, the formation of BFLP was part of decedent’s estate plan and not contemplated as a necessary step in positioning Empak for a corporate liquidity event. On December 22, 1995, Mr. Boyle provided decedent with a letter memorializing the steps associated with obtaining corporate liquidity. Many of these integrated steps were completed before decedent’s death.
1. Empak’s Incorporation and Spinoff3 of Emplast
On February 21, 1996, Empak incorporated a wholly owned subsidiary, Emplast. Emplast was incorporated and capitalized with noncore assets of Empak to streamline Empak in preparation for a corporate liquidity event. The noncore assets consisted of assets outside of Empak’s semiconductor business. The net book value of these assets was $5,752,854, which represented 5 percent of Empak’s net book value. Mark Bongard was appointed the chief executive officer of Emplast and remained in that position until decedent’s death.
Empak had a stock split on April 18, 1996, which was approved by a vote of the outstanding Empak stockholders. Empak shareholders received 223 shares for each Empak share held, which increased decedent’s number of shares to 5,686,500. The stock split also increased ISA Trust’s number of shares. See infra p. 106. The day following Empak’s stock split, decedent in his capacity as Empak’s sole member on its board of directors adopted a resolution authorizing grants of incentive stock options and nonqualified stock options. It does not appear that any of these stock options were exercised before decedent’s death.
On July 31, 1996, Empak distributed the stock of Emplast to decedent. In exchange for receiving 100 percent ownership of Emplast, 551,871 of decedent’s shares in Empak were canceled. This decreased decedent’s ownership interest in Empak to 5,134,629 shares, or 86.39 percent. Because some of decedent’s shares were canceled and ISA Trust did not participate in the distribution, ISA Trust’s ownership percentage in Empak increased to 13.61 percent. ISA Trust’s percentage holding of Empak had decreased after 1986 due to the redemptions of some of the Empak stocks held by the trust.
2. WCB Holdings
In view of market conditions in 1996, Mr. Boyle determined that investors would be more likely to invest in Empak if the Bongard family members’ ownership interests were placed in a holding company. As of December 1996, decedent and ISA Trust held all of the Empak stock. Decedent had established the ISA Trust on May 23, 1986, with the assistance of John Fullmer (Mr. Fullmer) and Mr. Boyle. When ISA Trust was established, Messrs. Fullmer and Boyle were both attorneys with Larkin Hoffman, but in 1996 only Mr. Fullmer was with Larkin Hoffman. In 1996, Mr. Boyle, who continued to represent decedent’s business interests after leaving Larkin Hoffman, informed Mr. Fullmer, decedent’s estate planning attorney, that decedent’s Empak stock was going to be transferred to a holding company as part of the overall plan to achieve corporate liquidity.
On January 30, 1996, Mr. Boyle, on behalf of decedent, organized WCB Holdings as a Minnesota limited liability company (WCB Holdings). Its articles of organization (articles), as amended, authorized the issuance of class A governance, class A financial, class B governance, and class B financial units. The class A governance units were the sole membership units with voting rights except as provided under State law.4
On December 28, 1996, decedent contributed his 5,134,629 shares of Empak stock to WCB Holdings. Decedent received in exchange 513,463 class A governance, 513,463 class A financial, 4,621,166 class B governance, and 4,621,166 class B financial membership units in WCB Holdings. This gave decedent an 86.39-percent ownership interest in each subclass of WCB Holdings membership units. ISA Trust also contributed its 808,598 shares of Empak stock to WCB Holdings and received 80,860 class A governance, 80,860 class A financial, 727,738 class B governance, and 727,738 class B financial units. This gave ISA Trust a 13.61-percent ownership interest in each subclass of WCB Holdings membership units. Decedent and ISA Trust received WCB Holdings class A governance, class A financial, class B governance, and class B financial membership units in proportion to the number of Empak shares each contributed.5
On December 28, 1996, Mark Bongard was elected chief manager, secretary, and treasurer of WCB Holdings. According to the Member Control Agreement, the chief manager is the person “duly elected or appointed pursuant to the terms of this Agreement to manage the business of the Company.” Some of the chief manager’s duties include general management, presiding at meetings, overseeing that orders and resolutions are carried out, maintaining records and certifying proceedings, and signing and delivering WCB Holdings documents.
Limitations were placed on the chief manager’s powers. For instance, the Member Control Agreement provided that the chief manager was not granted sole decisionmaking authority over the allocation of distributions. If a distribution were authorized, it would be allocated according to the number of class A financial and class B financial units owned. The chief manager was also charged with the decisionmaking for accounting matters, except if the members representing a majority of class A governance units disagreed. The members by a majority vote of the class A governance units could take any action the chief manager himself could take and could remove the chief manager. Lastly, the chief manager needed the approval of the members representing the majority of the class A governance units before he could issue additional membership units, lend, borrow, or commit WCB Holdings’s funds in excess of $25,000, authorize capital expenditures in excess of $10,000, sell any of WCB Holdings’s assets, including its Empak stock, worth over $10,000 in any 12-month period, or vote any securities, including its Empak stock, owned by WCB Holdings.
On December 30, 1996, 2 days after WCB Holdings was capitalized, a vote was held to increase the number of Empak directors to two. The WCB Holdings chief manager did not vote on this change, even though WCB Holdings was the sole shareholder of Empak stock. Rather, decedent and Mr. Boyle, as trustees for the ISA Trust, voted for this change.
3. Empak International’s Merger Into Empak
On March 7, 1997, Empak International merged into Empak. As part of the merger, MC’s stock in Empak International was canceled and MC received, among other things, 660,359 shares of Empak common stock and an option to purchase 58,667 additional shares of Empak common stock. Empak’s stock in Empak International was canceled.
Pursuant to the merger, Empak assumed responsibility for the foreign distribution of Empak products with the exception of Japan. Empak appointed MAC as the exclusive exporter of Empak products to Japan and MC as the exclusive distributor of Empak products in Japan. Empak’s ownership was altered as a result of the merger of Empak International into Empak as follows:
Empak shareholder No. of shares Percentage of total
WCB Holdings 5,943,227 90%
MC 396,215 6
MAC 264,144 4
Total 6,603,586 100
E. Consolidation of Empak and Fluoroware
In the summer of 1998, Empak and Fluoroware began consolidation discussions. Decedent engaged in the discussions in his capacity as chairman of the board and chief executive officer of Empak. Before November 1998, decedent had sketched out potential organizational structures in the event the corporations consolidated, but Empak and Fluoroware did not agree to specific details regarding the consolidation before decedent’s death. Following decedent’s unexpected death on November 16, 1998, consolidation discussions were renewed.
On February 5, 1999, Mr. Bernards, who assisted in representing Empak in the discussions, recommended the approval of a consolidation between Empak and Fluoroware. On March 15, 1999, Empak and Fluoroware signed a letter of intent to consummate the general terms of the consolidation. Between April 13 and 14, 1999, Mr. Boyle, as corporate secretary of Empak, prepared and filed Federal Trade Commission (ftc) Form 4 (a.k.a. Hart-Scott-Rodino filing), with the FTC indicating the parties’ intended consolidation. Mark Bongard, as chief manager of WCB Holdings, gave notice of a special meeting to its members to consider the proposed consolidation, which was approved by the members. On June 1, 1999, Empak and Fluoroware entered into a consolidation agreement which provided for the formation of a new corporation, Entegris, Inc. (Entegris). Pursuant to the new consolidation agreement, Empak shareholders received 10,250,789 Entegris shares, which represented a 40-percent ownership interest.
On March 31, 2000, Entegris filed a registration statement with the Securities and Exchange Commission in anticipation of its initial public offering (ipo). On July 11, 2000, Entegris had a 2-for-l stock split, resulting in WCB Holdings’s owning 21,580,6086 shares of Entegris stock. Also on July II, 2000, Entegris completed its IPO. WCB Holdings sold 1,925,000 shares of Entegris as part of the Entegris IPO.
III. Decedent’s Estate Planning
Decedent sought counsel, considered advice, and worked on his estate planning from at least 1984. In 1984, decedent did not want either his children or Cynthia Bongard to directly own Empak stock. Decedent engaged Larkin Hoffman for estate and business planning purposes.
A. ISA Trust
On May 23, 1986, decedent established ISA Trust with the assistance of Larkin Hoffman. ISA Trust was initially funded by decedent’s transfer of 4,500 of Empak’s 30,000 outstanding shares, which represented a 15-percent ownership interest in Empak. The beneficiaries of ISA Trust were decedent’s four children and Terra Saxe. The initial trustees of ISA Trust were Mr. Bernards and Larry Welter, an employee of Empak. The trustees were granted the power to distribute the trust’s income or principal to any beneficiary acquiring a home or establishing and maintaining a trade or business. On February 14, 1988, Mr. Bernards resigned as trustee of ISA Trust, leaving Mr. Welter as sole trustee.
ISA Trust made six distributions between April 22, 1991, and December 30, 1994. Each distribution was preceded by decedent’s requesting the trustee or trustees to consider making the distribution. After each distribution, an entry was made in Empak’s stock register recording ISA Trust’s distribution of Empak shares to a particular beneficiary. Empak and the named distributee would enter into a stock redemption agreement at approximately the same time as the distribution. The stock redemption agreements provided for Empak to redeem the distributed shares if the distributee was willing.
The first distribution occurred on April 22, 1991. ISA Trust distributed 150 shares of Empak stock to Mark Bongard, who then caused Empak to redeem the shares on May 1, 1991, for $40,000, which he used to purchase a home. The second distribution of 180 shares of Empak stock occurred on August 31, 1992. Beth Akerberg was the recipient of this distribution, which was shortly followed by a redemption of the shares by Empak in exchange for a 90-day note. On February 1, 1994, ISA Trust distributed 250 shares of Empak stock to Lynn Zupan. On the same day, Empak redeemed the 250 shares from Lynn Zupan. Empak paid a portion of the redemption proceeds directly to a third party who had performed home improvement work on Lynn Zupan’s home. The fourth, fifth, and sixth distributions all occurred on December 30, 1994. Mark Bongard, Rhonda Notermann, and Beth Akerberg were the recipients of 85, 151, and 58 shares of Empak stock, respectively, all of which were apparently redeemed by Empak. Following these six distributions, ISA Trust held 3,626 shares of Empak stock which represented a 12.45-percent ownership interest.
On January 5, 1995, Mr. Welter appointed Mark Bongard and Mr. Boyle as cotrustees of ISA Trust; he then resigned as trustee. Mark Bongard and Mr. Boyle accepted their appointments on January 10 and 18, 1995, respectively. Mr. Boyle and Mark Bongard later reappointed Mr. Bernards as an additional ISA Trust trustee on October 1, 1997.
When Empak’s stock was split 223 to 1 on April 18, 1996, ISA Trust’s number of Empak shares increased to 808,598. When Empak distributed to decedent its Emplast stock on July 31, 1996, ISA Trust continued to hold 808,598 shares of Empak. ISA Trust’s ownership percentage of Empak was 13.61 percent at that time.
B. Bongard Family Limited Partnership
On December 28, 1996, decedent signed a letter that was written by Mr. Fullmer and addressed to decedent’s children. The letter expressed some reasons for forming WCB Holdings and BFLP. The letter explained that the entities provided, among other things, a method for giving assets to decedent’s family members without deterring them from working hard and becoming educated, protection of his estate from frivolous lawsuits and creditors, greater flexibility than trusts, a means to limit expenses if any lawsuits should arise, tutelage with respect to managing the family’s assets, and tax benefits with respect to transfer taxes. On December 29, 1996, decedent contributed all of his 4,621,166 WCB Holdings class B governance and 4,621,166 WCB Holdings class B financial units to bflp in exchange for a 99-percent limited partnership interest in bflp. ISA Trust contributed 46,678 WCB Holdings class B governance and 46,678 WCB Holdings class B financial units to bflp and received a 1-percent general partnership interest in exchange. Mr. Boyle (as trustee of ISA Trust), decedent, and Mr. Fullmer (as decedent’s estate planning counsel) negotiated the terms of the partnership, and explained the partnership to Mark Bongard (cotrustee of ISA Trust) before the partnership agreement was executed. Pursuant to the partnership agreement, either decedent, as limited partner, or ISA Trust, as general partner, could propose amendments to the partnership. For a proposed amendment to be adopted, both the general partner, ISA Trust, and 60 percent of the limited partnership interests needed to vote in favor of the amendment, bflp was validly created and existing under Minnesota law until decedent’s death.
In the event bflp liquidated, its assets were first to be allocated to satisfy its creditors, other than the general partner, limited partners, or assignees; second, to satisfy any liabilities owed to the interest holders;7 and third, to satisfy any liabilities owed to the general partner. Any remaining assets were to be allocated among the general partner, limited partners, and assignees in accordance with their respective capital accounts.
C. Additional Trusts Created by Decedent
On December 28, 1996, decedent created the Wayne C. Bongard Children’s Trust (CH Trust), and appointed Mark Bongard and Mr. Bernards as trustees. Decedent initially funded the CH Trust on March 15, 1997, with 77,262 class A governance and 77,262 class A financial units in WCB Holdings.
On December 30, 1996, decedent created the Wayne C. Bongard Grandchildren’s Trust (GC Trust). The trust agreement was drafted by Mr. Fullmer. Decedent appointed Del Jensen and Mr. Eitel, both of whom were employed by Empak, as trustees. Decedent funded GC Trust on March 15, 1997, by transferring 77,262 class A governance and 77,262 class A financial units in WCB Holdings. Decedent’s children and issue were the named beneficiaries of GC Trust.
On December 30, 1996, decedent created the Cynthia F. Bongard Qualified Terminable Interest Property Trust (qtip Trust). The QTIP Trust agreement was drafted by Mr. Fullmer. Gary Bongard (decedent’s brother) and Gary Brown (decedent’s friend) were appointed trustees of this trust. The named beneficiaries of qtip Trust were Cynthia Bongard, decedent’s children, and their issue. On March 15, 1997, QTIP Trust was funded by decedent with 71,319 class A governance and 71,319 class A financial units in WCB Holdings.
Decedent formed the Wayne C. Bongard Revocable Trust (Revocable Trust) on December 28, 1996. Decedent appointed himself trustee, Mr. Bernards successor trustee, and Mark Bongard second successor trustee. According to decedent’s last will and testament dated December 28, 1996, all of his property was to go to the Revocable Trust, except his personal property was to go to Cynthia Bongard.
Decedent’s funding of GC Trust, CH Trust, and QTIP Trust changed the ownership interests in WCB Holdings so that they were held as follows:
WCB Class A Class A Class B Class B
Holdings member governance unitst percent financial units/ percent governance units/ percent financial units/ percent
Decedent 287,620/48.39% 287,620/48.39% 0/0 0/0
ISA Trust 80,860/13.61 80,860/13.61 681,060/12.73% 681,060/12.73%
BFLP 0/0 0/0 4,667,844/87.27 4,667,844/87.27
CH Trust 77,262/13 77,262/13 0/0 0/0
GC Trust 77,262/13 77,262/13 0/0 0/0
QTIP Trust 71,319/12 71,319/12 0/0 • 0/0
Total 594,323/100 594,323/100 5,348,904/100 5,348,904/100
Decedent reported the funding of CH Trust, GC Trust, and QTIP trust on a Federal gift tax return for 1997. The values reported on the gift tax return were consistent with a valuation report prepared as of December 15, 1996, before WCB Holdings’s formation.
D.Decedent’s Transfer of BFLP Interest to Cynthia Bongard
On December 10, 1997, decedent made a gift representing a 7.72-percent ownership interest in BFLP to Cynthia Bongard. bflp’s ownership was then as follows:
BFLP partner Partnership interest and type
ISA Trust . 1% general partner
Decedent . 91.28% limited partner1
Cynthia . 7.72% limited partner
Decedent did not report this gift on his gift tax return filed for taxable year 1997, as the marital gift tax exclusion was applicable. Cynthia Bongard and decedent entered into a postmarital agreement contemporaneously with the transfer. This agreement was “in full discharge, settlement, and satisfaction of all such rights and claims [either spouse may have possessed against the other], in the event of the termination of their marital relationship or after the death of the first of them to die”.
E. Purpose and Function of BFLP
From its inception until decedent’s death, BFLP did not perform any activities, never acted to diversify its assets, or make any distributions. The WCB Holdings membership units in BFLP were nonvoting, and decedent determined whether the Empak shares held by WCB Holdings would be redeemed. WCB Holdings did not redeem any of its class B membership units held by BFLP before decedent’s death.
F. 1998 ISA Trust Distribution
In early 1998, decedent suggested that ISA Trust make distributions to each of his children to see how maturely they would handle the funds. A series of transactions occurred in which Empak redeemed 52,924 of its outstanding shares from WCB Holdings, and WCB Holdings then redeemed 21,345 of its class A and class B financial units from ISA Trust. This redemption generated $747,816.12. After covering tax liabilities of all WCB Holdings members, WCB Holdings and in turn ISA Trust distributed $400,000 in four equal shares to decedent’s four children. The ownership interests in WCB Holdings were changed so that they were held as follows:
WCB Class A Class A Class B Class B
Holdings member governance units/ percent financial units/ percent governance units/ percent financial units / percent
Decedent 287,620/48.39% 287,620/50.2% 0/0 0/0
ISA Trust 80,860/13.61 59,515/10.39 681,060/12.73% 659,715/12.38%
BFLP 0/0 0/0 4,667,884/87.27 4,667,864/87.62
CH Trust 77,262/13 77,262/13.48 0/0 0/0
GC Trust 77,262/13 77,262/13.48 0/0 0/0
QTIP Trust 71,319/12 71,319/12.45 0/0 0/0
Total 594,323/100 572,978/100 5,348,944/100 5,327,579/100
IV. The Estate of Wayne C. Bongard
The estate filed a Federal estate tax return on February 15, 2000. For Federal estate tax purposes, the estate elected the alternate valuation date of May 16, 1999. On February 15, 2000, the estate completed a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, which reported that the Federal estate tax owed was $17,004,363. The estate attached Schedule F, Other Miscellaneous Property Not Reportable Under Any Other Schedule, to its Form 706. Schedule F showed the alternate values of decedent’s WCB Holdings class A membership units and his 91.28-percent limited partnership interest in BFLP to be $4,193,000 and $41,329,838, respectively. On February 4, 2003, respondent issued to the estate a notice of deficiency, that determined a Federal estate tax deficiency of $52,878,785. In the notice of deficiency, respondent adjusted the values attached by the estate to many assets in decedent’s gross estate. In addition, respondent determined that the 5,134,629 shares of Empak stock decedent transferred to WCB Holdings were includable in decedent’s gross estate because decedent had retained sections 2035(a) and 2036(a) and/or (b) rights and interests in the transferred property. On the estate tax return, the estate reported values of the WCB Holdings class A units and BFLP interest held by decedent at his death totaling $45,523,338. Respondent in the notice of deficiency included in the gross estate a value for decedent’s Empak shares that had been transferred to WCB Holdings totaling $141,621,428.8 This resulted in an adjustment increasing the gross estate by $96,098,120.
Prior to trial, respondent amended the answer to assert an increased deficiency based upon the parties’ agreement that the starting price of Empak shares before any discounts was $32.24. Using this value, respondent’s counsel estimated the revised adjustment to decedent’s gross estate could be as high as $160 million.
OPINION
A Federal estate tax is imposed “on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States.” Sec. 2001(a). The estate tax is imposed on the value of the taxable estate with specified adjustments made. Sec. 2001(b). A decedent’s taxable estate is determined by the value of the decedent’s gross estate less enumerated deductions. Sec. 2051. The value of a gross estate includes all of a decedent’s property to the extent provided under sections 2033 through 2045. Sec. 2033. At issue here is whether certain property decedent transferred during his lifetime is included in his gross estate under sections 2035(a) and 2036(a) and (b).
I. Burden of Proof
The estate argues that under section 7491(a) the burden of proof has shifted to respondent. Conversely, respondent contends the burden has not shifted because the estate was not cooperative within the meaning of section 7491(a), and because the estate failed to introduce credible evidence necessary for the burden to shift. It is unnecessary for us to address the parties’ disagreements and to determine whether the burden of proof has shifted because the outcome of this case is determined on the preponderance of the evidence and is unaffected by section 7491. See Blodgett v. Commissioner, 394 F.3d 1030, 1035 (8th Cir. 2005), affg. T.C. Memo. 2003-212; Estate of Stone v. Commissioner, T.C. Memo. 2003-309.
II. Sections 2035(a) and 2036(a)
The purpose of section 2036 is to include in a deceased taxpayer’s gross estate inter vivos transfers that were testamentary in nature. United States v. Estate of Grace, 395 U.S. 316 (1969). Section 2036(a)9 generally provides that if a decedent makes an inter vivos transfer of property, other than a bona fide sale for adequate and full consideration, and retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property will be included in the decedent’s gross estate. Section 2036(a) is applicable when three conditions are met: (1) The decedent made an inter vivos transfer of property; (2) the decedent’s transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b)10 in the transferred property which he did not relinquish before his death.
Additionally, pursuant to section 2035(a) a decedent’s gross estate includes the value of any property in respect of which the decedent made a transfer or relinquished a power within 3 years of his death if the value of such property would have been included in the decedent’s gross estate under section 2036 but for the decedent’s transfer of an interest in the property or the decedent’s relinquishment of a power with respect to the property.
This case focuses on each aspect of section 2036(a). The estate argues that decedent’s transfer of Empak stock to WCB Holdings and decedent’s transfer of WCB Holdings class B membership units to BFLP: (1) Did not constitute “transfers” under section 2036, (2) satisfied the bona fide sale exemption, and (3) did not include the retention of section 2036 interests.
A. “Transfer” and Section 2036(a)
The first question is whether decedent, in fact, made a lifetime transfer. See United States v. O’Malley, 383 U.S. 627, 631 (1966) (stating the purpose behind the predecessor to section 2036(a) was to tax all property that had been the “subject of an incomplete inter vivos transfer”).
The term “transfer”, as used in section 2036, is broadly defined. See Helvering v. Hallock, 309 U.S. 106, n.7 (1940); Estate of Shafer v. Commissioner, 749 F.2d 1216, 1221-1222 (6th Cir. 1984), affg. 80 T.C. 1145 (1983); Guynn v. United States, 437 F.2d 1148, 1150 (4th Cir. 1971) (stating that section 2036 “describes a broad scheme of inclusion in the gross estate, not limited by the form of the transaction, but concerned with all inter vivos transfers where outright disposition of the property is delayed until the transferor’s death”). The interpretation of the term “transfer” must reflect the purpose of section 2036(a), which is to include in a decedent’s gross estate all property he transferred but retained an interest therein during his lifetime. See United States v. Estate of Grace, supra at 322; Ray v. United States, 762 F.2d 1361, 1362 (9th Cir. 1985) (citing United States v. Estate of Grace, supra at 320); Estate of Shafer v. Commissioner, supra (citing Foster v. United States, 303 U.S. 118, 120 (1938)). Thus, the caselaw does not support a narrow definition of the term “transfer” but instead indicates a section 2036 analysis should begin by determining whether the decedent made an inter vivos voluntary act of transferring property. Estate of DiMarco v. Commissioner, 87 T.C. 653, 662-663 (1986). Any such act, including decedent’s transfer of his Empak shares to WCB Holdings and decedent’s transfer of his WCB Holdings class B financial and class B governance units, is included in a broad interpretation of the term “transfer”.
B. The Bona Fide Sale Exception
As previously stated, Congress excepted from section 2036(a) any transfer made in a “bona fide sale for an adequate and full consideration” (the bona fide sale exception). Respondent argues that decedent’s inter vivos transfers to WCB Holdings and BFLP should not be allowed to deplete the gross estate because sections 2035(a) and 2036(a) and (b) are applicable. The estate urges us to respect the transfers, arguing each satisfied the bona fide sale exception. This exception has frequently been the grist of judicial interpretation.
In Estate of Harrison v. Commissioner, T.C. Memo. 1987-8, we determined that a partnership agreement was not a substitute for a testamentary disposition since the decedent received “adequate consideration for his transfer to the partnership.” On June 10, 1975, the decedent was in poor health and executed a power of attorney appointing his son as his attorney-in-fact. On August 1, 1979, the decedent’s son, acting individually and under the power of attorney, organized a family limited partnership for purposes of consolidating and preserving the decedent’s assets. Some of the assets the decedent contributed included oil and gas assets, which required active management. The decedent’s 77.8-percent limited partnership interest and 1-percent general partnership interest were proportionate to the value of the property he transferred. The decedent’s sons each received 10.6-per-cent general partnership interests. The decedent died on January 14, 1980. We held that the formation of the partnership was not a testamentary disposition for two reasons significant to this discussion. First, the decedent received adequate and full consideration for his transfer. Second, because the estate was able to show that the partnership was created for the business purpose of providing the necessary and proper management of the decedent’s properties.
In Estate of Harper v. Commissioner, T.C. Memo. 2002-121, the Court held the bona fide sale exception was not satisfied. On December 18, 1990, the decedent created a revocable trust. The trust instrument named the decedent the initial trustee. The decedent formed a limited partnership in which his two children received a combined 1-percent general partnership interest and the trust received a 99-percent limited partnership interest. The decedent never consulted with his children regarding how the partnership was going to be operated or structured.
As part of the analysis the Court stated that the applicability of the bona fide sale exception depends on two requirements: “(1) A bona fide sale, meaning an arm’s-length transaction, and (2) adequate and full consideration.” The alleged nontax purpose for creating the partnership was to manage and invest the assets contributed. However, the facts revealed that no new investment strategies were employed by the partnership, nor did any of the assets constitute working assets as in Estate of Harrison v. Commissioner, supra. Moreover, the estate failed to identify the property, if any, the decedent’s children transferred to him or the partnership in exchange for their partnership interests. See Estate of Reichardt v. Commissioner, 114 T.C. 144, 155 (2000) (holding that there was no adequate and full consideration where, among other things, the decedent’s children transferred nothing to him or the partnership). A circuitous recycling of value occurred because the pooled assets were significantly composed of the same property contributed by the trust to the partnership.
In Estate of Thompson v. Commissioner, T.C. Memo. 2002-246, affd. 382 F.3d 367 (3d Cir. 2004), we again held the bona fide sale exception was not applicable. On January 16, 1969, the decedent established a revocable trust. The trust agreement was amended, and the trust was funded with securities and cash on March 17, 1993. The decedent received income from the securities held in the trust. In early 1993, the decedent’s children and the decedent met with a financial adviser and an attorney who described for the decedent an estate plan that used family limited partnerships. The decedent agreed to form two limited partnerships to benefit his two children. Two new corporations were incorporated, each serving as general partner to one of the partnerships. The decedent received shares of stock that represented a 49-percent ownership interest in each newly formed corporation. Before forming the partnerships and corporations, the decedent and his two children agreed that he would be taken care of financially. Additionally, they wanted decedent to have access to money in each partnership in order to continue making gifts to his family. With respect to the adequate and full consideration prong, the substance of the transaction revealed that there was not a true pooling of assets. The income from some of the properties each partner contributed was allocated to that partner. The partnerships also failed to change the investment strategy of their principal assets — the stocks and bonds contributed by the decedent. The lack of nontax business reasons for the transfer further supported the conclusion that the decedent did not receive adequate and full consideration within the meaning of section 2036(a). Finally, the Court determined that the partnership was conducted in a testamentary manner, rather than in a businesslike manner, because the decedent’s money was used to finance the needs of individual family members including himself. On these findings, we held that the bona fide sale exception was not applicable.
In Estate of Strangi v. Commissioner, T.C. Memo. 2003-145, the decedent executed a power of attorney in 1988 that named his son-in-law, Mr. Gulig, his attorney-in-fact. In 1993, the decedent’s health began to deteriorate, and Mr. Gulig took over the decedent’s personal affairs. On August 12, 1994, Mr. Gulig, as the decedent’s attorney-in-fact, independently created the Strangi Family Limited Partnership (SFLP) and Stranco, Inc. (Stranco), the corporate general partner of SFLP. Mr. Gulig singlehandedly determined how the SFLP would be structured and operated. Mr. Gulig assigned 98 percent of the decedent’s wealth to the SFLP in exchange for a 99-percent limited partnership interest. The assets contributed by the decedent included, among other things, his personal residence, securities, and insurance policies. The decedent and Mrs. Gulig (the decedent’s daughter and Mr. Gulig’s wife), purchased Stranco shares for cash. The decedent purchased a 47-percent interest in Stranco. Stranco contributed the cash to SFLP for a 1-percent general partnership interest. The Stranco shareholders acting in concert delegated its managing powers to Mr. Gulig. The decedent died on October 14, 1994.
We determined that the formation of the SFLP was not an arm’s-length transaction because Mr. Gulig, as the decedent’s attorney-in-fact, established and operated SFLP without any meaningful negotiations, essentially standing on both sides of the transaction. Moreover, the Court determined that Mr. Gulig recycled the value of the decedent’s assets through the partnership or corporate solution since the decedent contributed more than 99 percent of the total combined property in SFLP and Stranco and received an interest with a value derived “almost exclusively” from the assets he contributed rather than from a true pooling of assets. None of the contributed assets were found to be of the sort qualifying as a “functioning business enterprise” as discussed in Estate of Harrison v. Commissioner, T.C. Memo. 1987-8. Accordingly, in Estate of Strangi we held that the bona fide sale exception was not satisfied.
Shortly thereafter, the Court in Estate of Stone v. Commissioner, T.C. Memo. 2003-309, held that the bona fide sale exception in section 2036(a) was satisfied. In Estate of Stone, the decedent spouses (the Stones) had operated a successful closely held business for a number of years and created five family limited partnerships. We rejected the Commissioner’s argument that the formation of each of the family limited partnerships was not “motivated primarily by legitimate business concerns”. A reason for employing the limited partnership concept was to resolve the Stones’ children’s concerns. There were significant intrafamily disputes with regard to the Stones’ assets which led to litigation.
The Court found that the future management of the Stones’ assets by the children qualified as a legitimate business concern since they were going to succeed their parents in operating the business. The children actively managed the assets that were contributed to the partnership in which they had their respective interests. These facts supported a finding that each partnership had economic substance and was not merely a circuitous recycling of value. Additionally, the Stones were both in good health for most of the time the negotiations concerning the formation of the partnerships were taking place, and they retained sufficient assets outside of the partnerships to meet their personal needs. We also concluded that the terms of the transactions reflected arm’s-length dealing. The Stones determined which assets would be contributed to the partnerships, and Mr. Stone’s attorney drafted the partnership agreements, but the children each had counsel representing their individual interests.
The adequate and full consideration prong was also deemed satisfied. All partners in each partnership received interests proportionate to the fair market value of the assets they each transferred, and partnership legal formalities were respected. We rejected the Commissioner’s argument that valuation discounts attached to the partnership interest the decedent received precluded the adequate and full consideration prong from being satisfied. We reasoned that the Commissioner’s argument effectively read “out of section 2036(a) the exception that Congress expressly prescribed when it enacted that statute”. We found that the partnerships had economic substance as a joint venture for profit in which there was a genuine pooling of property and services.
This Court had another opportunity to consider the application of section 2036(a) and the bona fide sale exception in Estate of Hillgren v. Commissioner, T.C. Memo. 2004-46. The decedent’s estate argued that the creation of the limited partnership was motivated by a business purpose and premarital protection of the decedent’s assets. The Court rejected the estate’s contention that the partnership served as a means of premarital asset protection. On that point, the Court determined that because title to the properties remained in the decedent’s name until after her death, and she was financially dependent on the distributions from the partnership, the transaction was not a bona fide sale, but rather was a paper transaction. The estate was unable to establish a credible nontax reason for engaging in the transaction, nor was it able to explain how the decedent’s relationship to the properties allegedly transferred to the partnership was altered.
In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership, and the transferors received partnership interests proportionate to the value of the property transferred. See, e.g., Estate of Stone v. Commissioner, supra; Estate of Harrison v. Commissioner, supra. The objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership’s creation. See Estate of Harper v. Commissioner, T.C. Memo. 2002-121; Estate of Harrison v. Commissioner, supra. A significant purpose must be an actual motivation, not a theoretical justification.
By contrast, the bona fide sale exception is not applicable where the facts fail to establish that the transaction was motivated by a legitimate and significant nontax purpose. See Estate of Hillgren v. Commissioner, supra; Estate of Thompson v. Commissioner, supra; Estate of Harper v. Commissioner, supra; see also Estate of Reichardt v. Commissioner, 114 T.C. 144 (2000). A list of factors that support such a finding includes the taxpayer’s standing on both sides of the transaction, Estate of Hillgren v. Commissioner, supra; the taxpayer’s financial dependence on distributions from the partnership, Estate of Thompson v. Commissioner, supra; Estate of Harper v. Commissioner, supra; the partners’ commingling of partnership funds with their own, Estate of Harper v. Commissioner, supra, and the taxpayer’s actual failure to transfer the property to the partnership, Estate of Hillgren v. Commissioner, supra.
The Court of Appeals for the Fifth Circuit recently decided a case in this area, Kimbell v. United States, 371 F.3d 257, 258 (5th Cir. 2004). In Kimbell, the decedent transferred assets including $2.5 million in cash, an active oil and gas business, and royalties to a trust. The trust contributed the property to a family limited partnership and received a 99-percent pro rata partnership interest in return. The other partner was a limited liability company (the llc) owned by the decedent, her son, and his wife. The LLC contributed $25,500 in exchange for a 1-percent general partnership interest. The oil and gas working assets constituted 11 percent of the partnership’s assets. The decedent retained over $450,000 in assets for her personal expenses.
The court separated the bona fide sale exception into two prongs: (1) Whether the transaction qualifies as a bona fide sale; and (2) whether the decedent received adequate and full consideration. The court first examined the adequate and full consideration language and set forth an objective inquiry. Id. at 262. The court stated that the proper question in examining the adequate and full consideration prong was whether the sale depleted the gross estate. Id. (citing Wheeler v. United States, 116 F.3d 749, 759 (5th Cir. 1997)); see Estate of Frothingham v. Commissioner, 60 T.C. 211, 215-216 (1973).
The Court of Appeals disagreed with the District Court’s determination that a sale between members of the same family cannot be a bona fide one. Kimbell v. United States, supra at 267. A transaction between family members is, however, subjected to heightened scrutiny to ensure that it is not a sham or disguised gift. Applying its test to the facts, the Court of Appeals held in Kimbell that the pro rata partnership interest the decedent received was adequate and full consideration. The court also found that the decedent’s transfer met the bona fide sale exception because the partnership was in actual possession of the assets transferred, partnership formalities were satisfied, she retained sufficient assets outside of the partnership to meet her personal needs, some of the assets contributed were active business assets, and she had nontax business reasons for creating the partnership. Id. The nontax business reasons included, among others, the protection of the taxpayer from personal liability with regard to the oil and gas properties contributed, the pooling of all of the decedent’s assets to provide greater financial growth than splitting the assets up, and the establishment of a centralized management structure. Additionally, the court rejected the Commissioner’s argument that the LLC’s interest was de minimis since it found no principle in partnership law that required partners to own “a minimum percentage interest in the partnership for the entity to be legitimate”. Id. at 268.
Recently, the Court of Appeals for the Third Circuit affirmed Estate of Thompson v. Commissioner, supra, in Estate of Thompson v. Commissioner, 382 F.3d 367 (3d Cir. 2004). Focusing on the adequate and full consideration language, the court stated an inter vivos transfer in exchange for assets of a lesser value should trigger heightened scrutiny into the substance of the transaction. Id. at 381. The Court of Appeals found that neither partnership engaged in transactions rising to the level of legitimate business operations that provided the decedent with a substantive nontax benefit. Id. at 379. This determination was supported by the partnerships’ allocating income produced by certain assets to the contributing partner, and the testamentary nature of one of the partnership’s lending practices. Even though the estate presented evidence that one of the partnerships engaged in a real estate investment, the testamentary nature of the transfer and the subsequent operation of the partnership outweighed any legitimizing effect of that investment. In addition, the Court of Appeals found that the decedent contributed marketable securities to the partnerships, but the partnerships failed to sell or diversify them. Other than favorable estate tax treatment resulting from this change in form, the court was unable to identify a legitimate and significant nontax reason for the transfer. See id. at 380. The court therefore held that there was no adequate consideration within the meaning of section 2036(a).
The Court of Appeals also concluded that the decedent’s transfers, to the family limited partnerships did not constitute bona fide sales within the meaning of section 2036(a). The Third Circuit noted that it is important to scrutinize the substance of an intrafamily transaction because “‘the family relationship often makes it possible for one to shift tax incidence by surface changes of ownership without disturbing in the least his dominion and control over the subject of the gift or the purposes for which the income from the property is used.’” Id. at 382 (quoting Commissioner v. Culbertson, 337 U.S. 733 (1949)).
C. Decedent’s Transfer of Empak Stock to WCB Holdings
Respondent contends that decedent’s transfer of Empak stock to WCB Holdings was not a bona fide sale for adequate and full consideration in money or money’s worth. The estate’s position is that decedent’s transfer of Empak stock to WCB Holdings was a bona fide sale for adequate and full consideration. As stated above, a finding to that effect would preclude the application of section 2036; thus, the Empak stock decedent transferred to WCB Holdings would not be included in his gross estate under section 2036(a). Moreover, if section 2036(a) does not apply to decedent’s transfer, section 2035(a) cannot apply to the gifts he made of WCB Holdings class A governance units to CH Trust, GC Trust, and QTIP Trust. Essentially, the question is whether decedent’s gross estate includes, via the application of section 2036(a), the Empak stock decedent transferred to WCB Holdings.
In order to answer this question, we must separate the true nontax reasons for the entity’s formation from those that merely clothe transfer tax savings motives. Legitimate nontax purposes are often inextricably interwoven with testamentary objectives. See, e.g., Bommer Revocable Trust v. Commissioner, T.C. Memo. 1997-380.
In 1995, decedent, while in good health, met with his advisers, Messrs. Boyle, Bernards, and Eitel, to discuss how Empak could remain successful and competitive. These discussions determined that Empak needed to develop additional means for acquiring capital to remain successful and competitive. Mr. Bernards testified that for Empak to grow, “additional capital other than through bank debt and through [reinvesting its] earnings” was needed. It was believed that positioning Empak for either a public or private offering (a corporate liquidity event) would accomplish this goal. Decedent and his advisers discussed how to facilitate a corporate liquidity event for Empak. Mr. Boyle drafted a memo and a checklist detailing the specific steps of the plan to position Empak for a corporate liquidity event.
Many of the steps in the checklist were completed. First, Empak formed Emplast, and Empak distributed its stock to decedent. Second, incentive stock options were established. Third, decedent and ISA Trust transferred their stock in Empak to WCB Holdings, and in exchange each received interests in WCB Holdings proportionate to the number of Empak shares they had contributed. Fourth, Empak International merged into Empak. Decedent was in good health until his sudden death in 1998; never was his health a reason to accelerate the completion of these steps.
The positioning and structuring of Empak to facilitate a corporate liquidity event was also beneficial for decedent and ISA Trust. ISA Trust held a single asset, Empak stock. The value of the shares held by both decedent and ISA Trust was maximized by positioning Empak to attract potential investors. Moreover, the potential market for the Empak shares was increased. These facts together support that positioning Empak for a corporate liquidity event was a legitimate and significant nontax reason that motivated the Empak shareholders to create WCB Holdings.
1. Bona Fide Sale
Respondent argues that the creation of WCB Holdings did not occur as the result of an arm’s-length transaction, and consequently, was not a bona fide sale. In Estate of Harper v. Commissioner, T.C. Memo. 2002-121, relying partially on Estate of Goetchius v. Commissioner, 17 T.C. 495, 503 (1951), we determined that the bona fide sale exception in section 2036(a) is applicable only where there was an arm’s-length transaction.
Respondent appears to assert that an arm’s-length transaction cannot occur between related parties. An arm’s-length transaction has been defined as “A transaction between two unrelated and unaffiliated parties”, or alternatively, a transaction “between two parties, however closely related they may be, conducted as if the parties were strangers, so that no conflict of interest arises.” Black’s Law Dictionary 1535 (8th ed. 2004). A previous edition of Black’s Law Dictionary stated that an arm’s-length transaction was the standard for testing whether the resulting terms and conditions of a transaction were the same as if unrelated parties had engaged in the same transaction. See Black’s Law Dictionary 100 (5th ed. 1979) (stating that “in testing whether $10,000 is an ‘arm’s length’ price [for the sale of property] it must be ascertained for how much the corporation could have sold the property to a disinterested third party in a bargained transaction”); see also Dauth v. Commissioner, 42 B.T.A. 1181, 1189 (1940) (stating “The test to determine whether a transaction is a bona fide transaction [for Federal income tax purposes] is described by the term ‘arm’s length’, or, in other words, Was the transaction carried out in the way that the ordinary parties to a business transaction would deal with each other?”). The bona fide sale exception has not been limited to transactions involving unrelated parties as respondent’s argument implies. See Estate of Stone v. Commissioner, T.C. Memo. 2003-309.
It is axiomatic that intrafamily transactions are subjected to a higher level of scrutiny, but this heightened scrutiny is not tantamount to an absolute bar. In that connection, we have already concluded that decedent and ISA Trust had mutual legitimate and significant nontax reasons for forming WCB Holdings. In addition, both decedent and ISA Trust received interests in WCB Holdings proportionate to the number of shares transferred. We believe that had this transaction occurred between two unrelated parties the majority interest holder in Empak would have received similar powers to those the decedent received via WCB Holdings’s member control agreement. An important purpose for creating WCB Holdings was to position Empak for a corporate liquidity event, and the record does not contain any credible evidence that unrelated parties would not have agreed to the same terms and conditions. Given these facts, we cannot hold that the terms of the transaction differed from those of two unrelated parties negotiating at arm’s length.
Respondent’s final argument is that the formation of WCB Holdings was not a bona fide sale because there was not a true pooling of assets. WCB Holdings’s purpose was to pool the Bongard family’s Empak stock within a single entity, which decedent and ISA Trust satisfied through their respective contributions. WCB Holdings’s creation was part of a much grander plan, to attract potential investors or to stimulate a corporate liquidity event to facilitate Empak’s growth. Moreover, when WCB Holdings was capitalized, the members’ capital accounts were properly credited and maintained, WCB Holdings’s funds were not commingled with decedent’s, and all distributions during decedent’s life were pro rata. The amalgamation of these facts evinces that this transaction resulted in a true pooling of assets.
2. Full and Adequate Consideration
The factual circumstances of this case further establish that decedent and ISA Trust each received an interest in WCB Holdings that represented adequate and full consideration reducible to money value. See Estate of Stone v. Commissioner, T.C. Memo. 2003-309; Estate of Higgins v. Commissioner, T.C. Memo. 1991-47; see also secs. 20.2036-1(a), 20.2043-1(a), Estate Tax Regs. Decedent and ISA Trust received interests in WCB Holdings proportionate to the number of Empak shares each contributed. Although by itself this may not be sufficient evidence to meet the adequate and full consideration requirement, two additional facts do support such a finding. We have determined that the respective assets contributed by the members were properly credited to the respective capital accounts of each contributing member, and distributions from WCB Holdings required a negative adjustment in the distributee member’s capital account. Most importantly, we have found the presence of a legitimate and significant nontax business reason for engaging in this transaction.
Respondent nonetheless argues that decedent did not receive adequate and full consideration since decedent contributed 86.31 percent of Empak’s outstanding stock without receiving a control premium for his contribution. Decedent did not need to receive a control premium because he retained effective control over Empak after he contributed his Empak stock to WCB Holdings. True, decedent was not the chief manager of WCB Holdings, but the 86.31-percent interest in the class A governance units he received in the exchange provided him with the power to remove the WCB Holdings chief manager and appoint himself as chief manager, to take any action the chief manager himself could take, and to approve any significant action the chief manager could take, including selling more than $10,000 worth of any security in any 12-month period and the voting of any security held by WCB Holdings. See also Estate of Thompson v. Commissioner, 382 F.3d at 381 (agreeing that the dissipated value resulting from a transfer to a closely held entity does not automatically constitute inadequate consideration for section 2036(a) purposes, but such dissipation triggers heightened scrutiny into the substance of the transaction and whether there was a true business purpose).
3. Conclusion
We hold that decedent’s transfer of Empak stock to WCB Holdings satisfies the bona fide sale exception of section 2036(a). Therefore, we need not determine whether decedent retained a section 2036(a) or (b) interest in the transferred property. This holding further precludes the application of section 2035(a) to decedent’s gifts of WCB Holdings class A membership units to CH Trust, GC Trust, and qtip Trust as they were outright gifts, not gifts of retained section 2036(a) interests. See Kisling v. Commissioner, 32 F.3d 1222, 1225 (8th Cir. 1994), revg. T.C. Memo. 1993-262; Estate of Jalkut v. Commissioner, 96 T.C. 675, 679 (1991); Estate of Frank v. Commissioner, T.C. Memo. 1995-132.
D. BFLP
The estate argues that section 2036(a) is not applicable to decedent’s transfer of WCB Holdings class B membership units to BFLP since that transfer was also a bona fide sale for adequate and full consideration. The estate contends that the creation of BFLP was motivated by nontax reasons. The BFLP agreement provides that BFLP was established to “acquire, own and sell from time to time stocks (including closely held stocks), bonds, options, mutual funds and other securities.” At trial, Mr. Fullmer testified that BFLP was established to provide another layer of credit protection for decedent. Additionally, the estate asserts that BFLP facilitated decedent’s and Cynthia Bongard’s postmarital agreement. Messrs. Bernards and Fullmer both also testified that BFLP was established, in part, to make gifts. On December 10, 1997, decedent made a gift of a 7.72-percent ownership interest in BFLP to Cynthia Bongard. This gift was the sole transfer of a BFLP partnership interest by decedent during his life. BFLP also never diversified its assets during decedent’s life, never had an investment plan, and never functioned as a business enterprise or otherwise engaged in any meaningful economic activity.
E. The Bona Fide Sale Exception
In determining whether the bona fide sale exception in section 2036(a) applies to an intrafamily transaction, the substance of the transaction is subject to a higher level of scrutiny. See Estate of Thompson v. Commissioner, supra at 383. Both parties set forth facts supporting their respective positions regarding decedent’s transfer of WCB Holdings class B membership units to BFLP.
In support of its contention that decedent’s transfer to BFLP satisfied the bona fide sale exception, the estate asserts that ISA Trust was adequately and independently represented in negotiating the terms of the BFLP transaction. Mr. Boyle explained to Mark Bongard, the other trustee of ISA Trust, the terms and reasons for engaging in the partnership. In addition, after BFLP was formed, partnership formalities were complied with.
Conversely, respondent asserts that BFLP was “simply a paper transaction designed to facilitate the distribution of family wealth both before and after death while leaving decedent’s lifetime control of Empak unimpaired.”11 In support of his position, respondent asserts that decedent’s and ISA Trust’s contributions to BFLP were not a true pooling of assets because decedent’s relationship to the contributed assets remained the same before and after the contribution. Following decedent’s contribution to BFLP and until his death, BFLP never engaged in any investment transactions or decisions. BFLP had neither an investment plan nor a diversification strategy.
Estate tax savings did play an important role in motivating the transfer to BFLP. The record does not support that the nontax reasons for BFLP’s existence were significant motivating factors. The formation of WCB Holdings eliminated direct stock ownership in Empak and allowed decedent to make gifts without diversifying the direct ownership of Empak. Messrs. Fullmer and Bernards testified that an impetus for forming BFLP was to continue decedent’s gift giving. Decedent, in fact, made numerous gifts after the formation of BFLP, but not of his BFLP interest. All of the gifts decedent made were of WCB Holdings class A membership units, except for the 7.72-percent limited partnership interest he gave to Cynthia Bongard in 1997. At the time of BFLP’s formation and at the time of his death, any additional gifts decedent had contemplated were speculative and indefinite at best. There was no immediate or definite plan for such gifts. Such intent is not sufficient to establish that the transfer of membership units to BFLP was motivated by a significant nontax reason.
Decedent and Cynthia Bongard entered into a postmarital agreement on December 10, 1997. For a postmarital agreement to be valid under Minnesota Statutes section 519.11 (West 1990 & Supp. 2004), in effect at the time the agreement was entered into, each spouse needed to have titled in that spouse’s name property with a total net value exceeding $1,200,000. Attached to the postmarital agreement was Cynthia Bongard’s financial statement, which included the value of her interest in BFLP and QTIP Trust. QTIP Trust was funded by decedent’s giving it WCB Holdings class A membership units on March 15, 1997. Decedent’s gift of a small portion of his BFLP interest to his wife does not establish that his prior transfer of all of his class B membership units to BFLP had a significant nontax motive. Decedent’s gift of the 7.72-percent BFLP interest to Cynthia Bongard does not establish a significant nontax reason for decedent to transfer all 4,621,166 WCB Holdings class B membership units he owned to BFLP. The motive for the transfer of all of decedent’s class B membership units to BFLP was not to fund the postmarital agreement. Rather, decedent used part of his BFLP interest to fund the postmarital agreement simply because that was where the assets rested when the agreement was completed. The vast majority of decedent’s BFLP interest was never transferred in the almost 2 years before his death.
The estate’s credit protection argument is also unpersuasive because WCB Holdings served this function for decedent. In fact, decedent via letter stated that “by holding a majority of my assets in the limited liability company or the limited partnership, I will be providing a greater amount of protection for those assets from both creditors and lawsuits.” Decedent contributed his Empak stock to WCB Holdings in exchange for WCB Holdings membership units, which he then contributed to BFLP in exchange for his limited partnership interest. Decedent’s initial transfer of his Empak shares to WCB Holdings accorded him the credit protection he sought. Any additional benefit provided by BFLP was not significant to the transfer to BFLP because decedent’s class A membership units, with their voting power, remained in WCB Holdings with only the protection provided by that entity.
Moreover, we find unpersuasive the estate’s argument that decedent wanted to create BFLP because of the greater flexibility it would provide him as compared to the trusts he had previously created. Decedent in fact established three trusts within days of BFLP’s creation. These trusts were funded months after BFLP was created with very large gifts. Clearly, decedent was not adverse to establishing trusts, nor is there evidence that would establish how a limited partnership interest in BFLP provided decedent with greater flexibility than he already possessed by holding WCB Holdings membership units outright.
Additionally, BFLP did not perform a management function for the assets it received. BFLP never engaged in any businesslike transactions, either before or after decedent contributed his WCB Holdings class B membership units to BFLP. Until decedent’s death, BFLP’s only ownership interest was in WCB Holdings, and 99 percent of that interest was contributed by decedent. Similarly, BFLP never attempted to invest or diversify its assets. As a practical matter, decedent did not receive any benefit beyond transfer tax savings from placing his WCB Holdings class B membership units in BFLP. In Estate of Harper v. Commissioner, T.C. Memo. 2002-121, we found that the decedent only recycled the value of the property he transferred to the partnership. A recycling of value has occurred if “all decedent did was to change the form in which he held his beneficial interest in the contributed property.” Id. The partnership in Estate of Harper, like the partnership here, did not establish a different investment plan with respect to its assets. In this case, decedent recycled the value of his WCB Holdings class B membership units by contributing them to BFLP.
Under these facts, decedent’s transfer of WCB Holdings class B membership units to BFLP did not satisfy the bona fide sale exception.
III. Whether Decedent Retained a Section 2036(a) Interest in BFLP
Our determination that the bona fide sale exception does not apply to decedent’s transfer to BFLP does not end the inquiry. As pertinent here, section 2036(a) includes in a decedent’s gross estate “all property to the extent of any interest therein” of which the decedent has made a transfer wherein he “has retained for his life” either “(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.” Section 7701(a)(1) defines “person” to include “an individual, a trust, estate, partnership, association, company or corporation.”
A. Section 2036(a)
“An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred.” Sec. 20.2036-l(a), Estate Tax Regs. “The existence of formal legal structures which prevent de jure retention of benefits of the transferred property does not preclude an implicit retention of such benefits.” Estate of Thompson v. Commissioner, 382 F.3d at 375; Estate of McNichol v. Commissioner, 265 F.2d 667, 671 (3d Cir. 1959). The existence of an implied agreement is a question of fact that can be inferred from the circumstances surrounding a transfer of property and the subsequent use of the transferred property. See Estate of Thompson v. Commissioner, supra at 376; Estate of Reichardt v. Commissioner, 114 T.C. 144, 151 (2000).
The decedent did not need the membership interest in WCB Holdings class B shares to continue his lifestyle. However, decedent retained ownership of more than 91 percent of his BFLP interest and did not make gifts of such interest prior to his death. More importantly, decedent controlled whether BFLP could transform its sole asset, the class B WCB Holdings membership units, into a liquid asset. Decedent as CEO and sole member of Empak’s board of directors determined when Empak redeemed its stock in each of the seven instances of redemptions prior to his death, including the last redemption of about $750,000 worth of Empak stock in 1998 after WCB Holdings was formed. None of the seven redemptions reduced the membership units owned by bflp. In order for bflp to be able to diversify or take any steps other than simply holding the class B membership units, decedent would have had to cause the membership units and the underlying Empak stock to be redeemed. He chose not to do this. By not redeeming the WCB membership units held by BFLP, decedent ensured that BFLP would not engage in asset management. Thereby, decedent exercised practical control over bflp and limited its function to simply holding title to the class B membership units. Whether decedent caused the WCB membership units held by bflp and the underlying Empak stock to be redeemed or not, his ability to decide whether that event would occur demonstrates the understanding of the parties involved that decedent retained the right to control the units transferred to BFLP.
The estate’s argument that the general partner’s fiduciary duties prevent a finding of an implied agreement is overcome by the lack of activity following bflp’s formation and bflp’s failure to perform any meaningful functions as an entity.12 We conclude that decedent’s transfer to BFLP for a 99-percent ownership interest in the partnership did not alter his control of the wcb Holdings class B membership units transferred to BFLP. See Estate of Thompson v. Commissioner, 382 F.3d at 376-377 (finding “nothing beyond formal title changed in decedent’s relationship to his assets” where the practical effect on his relationship to the transferred assets during decedent’s life was minimal).
B. Conclusion
Under the circumstances of this case, an implied agreement existed that allowed decedent to retain the enjoyment of the property held by BFLP. Therefore, under section 2036(a)(1), decedent’s gross estate includes the value of the WCB Holdings class B membership units held by BFLP on decedent’s death that is proportionate to decedent’s 91.28-percent limited partnership interest. Given this finding, it is unnecessary to determine whether the terms of the BFLP agreement provided decedent explicit rights to control the property.
IV. Section 2035(a) and Decedent’s Gift to Cynthia Bongard
As pertinent here, section 2035(a) provides that a decedent’s gross estate includes the value of any property or interest therein if “(1) the decedent made a transfer * * * [of an interest in such property] during the 3-year period ending on the date of the decedent’s death, and (2) the value of such property (or an interest therein) would have been included in the decedent’s gross estate under section 2036 * * * if such transferred interest * * * had been retained by the decedent on the date of his death”. In this case, decedent transferred a 7.72-percent partnership interest in BFLP to Cynthia Bongard within 3 years of his death. The issue is whether the value of the partnership interest decedent gave to Cynthia Bongard would have been included in his gross estate had he retained it until his death.
As stated previously, decedent retained a section 2036(a)(1) interest in the WCB Holdings class B membership units he transferred to BFLP because we found the existence of an implied agreement between decedent and ISA Trust. Decedent’s gift of a limited partnership interest to Cynthia Bongard decreased his ownership interest in BFLP. Because the partnership interest decedent gave to Cynthia Bongard consisted of a portion of the property that triggered the application of section 2036(a)(1), we find that section 2035(a) is applicable to decedent’s transfer of the 7.72-percent limited partnership interest in BFLP. Thus, decedent’s gross estate includes the value of the WCB Holdings class B membership units held by BFLP on decedent’s death that is proportionate to the 7.72-percent limited partnership interest.
V. Discounts Applicable to Decedent’s Membership Units in WCB Holdings
The relevant part of section 2031 provides that any property included in a decedent’s gross estate is included at its fair market value. See also sec. 20.2031-l(b), Estate Tax Regs. The parties stipulated that on the alternate valuation date, May 16, 1999, Empak’s stock per-share value was $32.24. This was used as the starting point by the parties to determine the value of the decedent’s interests in WCB Holdings and BFLP and was then decreased by stipulated discounts depending upon this Court’s determinations regarding the application of section 2036.
We apply the discounts provided by the parties in their stipulation of settled issues with respect to the WCB Holdings membership units. If section 2036 was not applied to the transfers to WCB Holdings, the parties stipulated a 13-per-cent lack of control discount and a 17.5-percent lack of marketability discount. We are left to apply the stipulation to the value . of decedent’s 287,620 WCB Holdings class A membership units and 4,621,166 WCB Holdings class B membership units.
The stipulation provides that the value of decedent’s WCB Holdings class A membership units is equal to $32.24 less the stipulated discounts for lack of control and lack of marketability, multiplied by 287,620 (the total number of class A governance and financial membership units decedent owned on the alternate valuation date). As such, the value of decedent’s WCB Holdings class A membership units was $6,655,527, as calculated below.
[{$32.24 - ($32.24 x .13)} - {($32.24 - ($32.24 x .13)) x .175}] = $23.14 x 287,620 = $6,655,527
We read the stipulation to further provide the WCB Holdings class B membership units an additional 5-percent lack-of-voting-rights discount. Given the stipulation and our holdings herein, we find that the value of decedent’s WCB Holdings class B membership units on the alternate valuation date was $101,573,229,13 as calculated below.
[$23.14 - ($23.14 x .05)] = $21.98 x 4,621,166 = $101,573,229
To reflect the foregoing and give effect to the parties’ stipulations,
Decision will be entered under Rule 155.
Reviewed by the Court.
Gerber, Swift, Colvin, Vasquez, Thornton, Haines, Wherry, Kroupa, and Holmes, JJ., agree with this majority opinion. Gale, J., concurs in result only.Unless otherwise indicated, all section references are to the Internal Revenue Code, and all Rule references are to the Tax Court Rules of Practice and Procedure. Dollar amounts are generally rounded to the nearest dollar.
The parties stipulated that Terra is the correct spelling, but the Wayne C. Bongard Irrevocable Stock Accumulation Trust Agreement spells her name Tara.
The parties’ stipulation terms this transaction as a “spinoff”. However, it appears that the distribution was a splitoff.
Minn. Stat. Ann. sec. 322B.155 in effect in 1996 generally provided voting rights for any class of membership units, whether or not the articles of organization provided such units voting rights, only if the rights or interests attached to that class could be affected by a proposed change.
It appears the number of class A governance units and class A financial units issued to each member was determined by multiplying the number of Empak shares the respective shareholder contributed by 10 percent, rounded to the nearest share. The number of class B governance units and class B financial units issued to each member was then calculated by decreasing the number of Empak shares contributed by 10 percent of the number of Empak shares contributed, rounded to the nearest share.
It appears the Empak shareholders received an additional 539,5X5 shares of Entegris stock pursuant to the consolidation agreement on the first anniversary of the closing date (June 7, 1999).
Pursuant to the partnership agreement, an interest holder is a holder of an “interest”. An “interest” is “an ownership interest in the Partnership [held] by a Limited Partner (or an as-signee)”.
Decedent owned this interest until his death.
This adjustment would include in the gross estate the value of the Empak shares previously held by decedent and transferred to WCB Holdings, including the Empak share value related to the WCB Holdings class B membership units that were transferred to BFLP.
SEC. 2036. TRANSFERS WITH RETAINED LIFE ESTATE.
(a) General Rule. — The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
Sec. 2036(b) instructs that the retention of the right to vote shares of a controlled corporation that were transferred by a decedent is the retention of the enjoyment of the transferred property.
Respondent has not challenged whether BFLP is a partnership that should be recognized for tax purposes under sec. 761(a) or 7701(a)(2), so we do not reach that issue in this case.
Under Minnesota law, the relationship of partners is fiduciary in character, and each partner owes the other partners the highest degree of integrity, loyalty, and good faith. Prince v. Sonnesyn, 222 Minn. 528, 535 (1946); Margeson v. Margeson, 376 N.W.2d 269 (Minn. Ct. App. 1985). In a limited partnership, a general partner can be liable to the limited partners for breach of fiduciary duty. Minn. Stat. Ann. sec. 322A.33 (West 2004); see also Minn. Stat. Ann. sec. 323.20 (West 1995), repealed by Laws 1997, ch. 174, art. 12, sec. 68, effective Jan. 1, 2002, but replaced by Minn. Stat. Ann. secs. 323A.4-04 and 323A.4-05, effective Jan. 1, 1999 (West 2004). In addition, the ISA trust trustees owed fiduciary duties to its beneficiaries. See Minn. Stat. Ann. sec. 501B.10 (West. Supp. 1990), repealed by Laws 1996, ch. 314, sec. 8, eff. Jan. 1, 1997, replaced by Minn. Stat. Ann. sec. 501B.151, effective Jan. 1, 1997 (West 2002 & Supp. 2004); Minn. Stat. Ann. sec. 501B.60 (West 1990).
We note that decedent’s estate may be entitled to a deduction under sec. 2056 for his inter vivos gift of WCB Holdings class B membership units to Cynthia Bongard that was pulled back into his gross estate under sec. 2035(a).