Accuracy Related Penalty Under Section 6662 Imposed on Joint Return Despite Claimed Reliance on Tax Return Preparer. Prudhomme et us v. Commissioner, Fifth Circuit, July 16, 2009

 

 

The Fifth Circuit Court of Appeals, in a per curiam decision, affirmed the findings and holding of the Tax Court and upheld the imposition of an accuracy related penalty on a husband and wife based on the record before the court. The testimony proferred by each side was conflicting, which is frequently if not generally true in tax litigation proceedings, but the Tax Court found that the taxpayer had not met its burden of production that it acted in good faith and reasonable cause in relying on their accountant who prepared their returns. See §6664(c)(1). Tax Court held that the Prudhommes did not meet this standard because they provided their accountants with insufficient information to prepare the tax return accurately and did not make a reasonable effort to assess their proper tax liability.

After operating a family business for a period of years, the taxpayers sold the business for approximately $11M with approximately one half or $5.5M received in cash, the acquiring company’s stock, valued at $2M and a promissory note for $3.5M. The sale took place in 2003 and the Prudhommes long-standing accounting firm prepared the return which was timely filed after extensions were applied for. The tax return omitted substantial amount of the sales proceeds resulting in additional taxes that were assessed by the Service in the amount of $576,728 which was paid in November, 2005. The accounting firm admitted during the audit  that the error was its error. The taxpayers challenged a 20 percent underpayment (accuracy related) penalty and small penalty for failure to pay the correct amount of estimate taxes. The IRS contended that the taxpayers failed to properly notify the accounting firm of the total amount of sales proceeds it received in the transaction, including a $3.2M dividend they received from the sale. A Tax Court petition subsequently followed on the issue of the penalties..

On appeal to the Fifth Circuit, the Prudhommes asserted that the lower court’s findings of a lack of reasonable cause or acting in good faith on the part of the taxpayers was clearly erroneous. The Fifth Circuit was faced, under its applicable standard of review under §7482(a)(1), as to whether the Tax Court’s fact findings were clearly erroneous.

The Treasury regulations provide that "[t]he determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances." Treas. Reg. § 1.6664-4(b). "Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Id. The regulations also state that a court must consider whether the taxpayer made "an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Id. That is, even if a taxpayer relies on an expert, the court still must take into account "[a]ll facts and circumstances" regarding whether that reliance was reasonable and in good faith, including the "taxpayer's education, sophistication and business experience."Treas. Reg. § 1.6664-4(c)(1). Case law reveals that the most important factor is "'the extent of the taxpayer's effort to assess [his] proper tax liability' is '[g]enerally[] the most important factor' in determining reasonable cause and good faith." Stanford v. Comm'r, 152 F.3d 450, 460-61 (5th Cir. 1998) (quoting Treas. Reg. § 1.6664-4(b)). In other words, reliance on a tax professional, however, must be reasonable, and simply relying on a professional is not dispositive. While a taxpayer in avoiding the penalty based on reliance on a tax professional does not require obtaining a second opinion, there is no good faith reliance wheref the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item." Treas. Reg. § 1.6664-4(c)(i); see Srivastava v. Comm'r, 220 F.3d 353, 367 (5th Cir. 2000) (rejecting argument that the taxpayers reasonably relied upon a professional because, inter alia, they never gave their accountant a copy of the settlement agreement subject to the tax)..

The record established at trial, in the view of the Fifth Circuit, supported the Tax Court’s holding on the imposition of the penalties. First, the taxpayers did not fully reveal the details of the sale to the accounting firm. This included bank records, a large dividend distribution and other documents of the sale. Second, the court concluded that the Prudhommes did not make a good faith effort to assess their correct tax liability. The court noted that Richard Prudhomme did not even read or sign the return, that Cathy Prudhomme did not verify that all income from the sale of the company was on the return, and that both Prudhommes were not unsophisticated taxpayers but were successful business people.

Southern District of New York Bankruptcy Court Issues Final Order Restricting Transfers of Shares in General Motors Corp. In Order to Preserve GM's Tax Attributes

On June 25, the U.S. Bankruptcy Court for the Southern District of New York, Bankr. S.D. N.Y. No. 09-50026 (REG) June 25, 2009, issued a final order under §§105(a) and 362 of the Bankruptcy Act setting forth notification procedures and transfer restrictions pertaining to the transfer of GM stock retroactive to the filing of the petition before the court. It also scheduled a final hearing on open issues under the Chapter 11 proceeding.

As part of its final order the Court held: (i) that the Debtors’ net operating loss carryforwards "NOLs", foreign tax credits and other excess credit carryforwards, inotherwords the Debtors’ aggregate tax attributes, were property of the Debtors’ estates and are protected by section 362(a) of the Bankruptcy Code; (ii) unrestricted trading in GM stock could, before the Debtors' emergence from chapter 11 could severely limit the Debtors' ability to use the tax attributes for purposes of the Internal Revenue Code of 1986, as amended (i.e., by application of section 382 ownership change of the Code and related provisions); and (iii) with a view to preserving the maximium benefit or use of such tax attributes, set out detailed share transfer notification procedures and restrictions viewed as necessary and proper to preserve the tax attributes and in the best interests of the Debtors, their estates, and their creditors.

As background, where a corporation possessed with carryovers, i.e., NOLs, excess business or foreign tax losses, etc., undergoes an ownership change, section 382(a) imposes prospective use of such tax attributes. More specifically, an ownership change occurs if, for example, the percentage of stock owned by one or more of the corporation's 5% shareholders increases by more than 50% points over 3 year "testing period" on the day of any owner shift involving a "5% shareholder" as defined. As is true with public companies, section 382(g)(4) provides that stock owned by all shareholders who are not 5% shareholders is generally treated as owned by one 5% shareholder group n determining whether an ownership change has occurred. However, unless the corporation elects otherwise, the section 382(a) limitation does not apply to an ownership change if the old loss corporation is under the jurisdiction of a court in a Title 11 or similar case and the shareholders and qualified creditors, as defined, of the old loss corporation (determined immediately before the ownership change) own, as a result of being shareholders or creditors immediately before the change, stock of the new loss corporation constituting at least 50% of the total voting power and 50% of the total value of stock of the new loss corporation. See also Treas. Reg. §1.382-9(d)(3)(i)(debt "as always" equity rule). This paragraph is an oversimplification of the breadth and depth of section 382 to a corporation with tax attributes both in bankruptcy and non-bankrupcty contexts.

 

Chief Counsel Announces Standard of Review Under Innocent Spouse Equitable Relief Provision

Chief Counsel’s Office Announces Standard of Review for Litigating Cases Involving Innocent Spouse Relief Under Section 6015(f). (CC-2009-021)(June 30, 2009), supplementing CC-2004-26 (July 12, 2004).

The subject of "innocent spouse" relief is not new to tax practitioners and to many individuals who have had to endure the situation where signing a joint income tax return exposed the "non-liable" spouse, so to speak, with the spectre of joint and several liability. Section 6015(a) provides three avenues for a spouse filing a joint return to obtain relief. Under § 6015(b) , innocent spouse relief is available if the understatement of tax is attributable to erroneous items of one individual and the other individual did not know, or have reason to know, of the understatement and, taking into account all the facts and circumstances, it would be inequitable to hold that spouse liable. Section 6015(c) provides, for taxpayers who are no longer married, are legally separated, or not living together, for the liability of each spouse to be computed separately as if the spouses had filed separate returns for the taxable year if certain pre-requisites can be met. Finally, § 6015(f) is a general equity or "catch-all" rule that taking into account all the facts and circumstances, it would be inequitable to hold the spouse claiming innocent spouse status liable.

Chief Counsel’s Office sets forth a short history of recent case law under the general equitable relief rule, §6015(f). In Porter v. Comm’r, 130 T.C. 115 (2008) ("Porter I"), the Tax Court, following its prior opinion in Ewing, 122 T.C. 32 (2004), vacated, 439 F.3d 1009 (9th Cir. 2006), held that in determining whether the Commissioner abused his discretion in denying the petitioner relief under section 6015(f), the court conducts a trial de novo and may consider evidence introduced at trial that was not included in the administrative record developed during the administrative consideration of the claim. In Porter v. Commissioner, 132 T.C. No. 11 (April 23, 2009) ("Porter II"), the court reconsidered the standard of review in section 6015(f) cases and concluded that a de novo standard of review is proper. Thus, the Tax Court now will make its own de novo determination regarding whether a requesting spouse is entitled to relief under §6015(f) and will not be limited to evidence in the administrative record. The proper standard for review if that of "abuse of discretion". The Chief Counsel’s Advisory directs that attorneys should, therefore, continue to argue that, under an abuse of discretion standard of review, the scope of the Tax Court's review is limited to issues and evidence presented before Appeals or Examination. Attorneys should raise the scope and standard of review arguments whenever appropriate (e.g., in the pre-trial memo, at trial, and on brief), noting the Service's disagreement with the holding in the Porter I and II opinions.

To preserve the Porter issues for appeal, attorneys should continue to work with the petitioner to stipulate to the administrative record and should continue to raise a continuing evidentiary objection if the petitioner attempts to testify or otherwise enter evidence into the record that was not made available to the Service's examiner or Appeals Officer. If the court denies the evidentiary motion, additional evidence outside of the administrative record that may strengthen the Commissioner's case should be introduced into evidence . Other information and guidance is set forth in the Advisory.

 

Seventh Circuit Limits Scope of Federal Tax Practitioner Privilege

There is no accountant-client privilege recognized by the common law. U.S.v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999); FREV 501. In 1998, Congress provided a limited shield of confidentiality between a federally authorized tax practitioner and his client. This privilege is no broader than the existing attorney-client privilege. This is set forth in §7525, and in particular §7525(a)(1), which provides that "…with respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney. This federally recognized privilege can only be asserted in any noncriminal tax matter before the Internal Revenue Service; and any noncriminal tax proceeding in Federal court brought by or against the United States. §7525(a)(2). Moreover, the relatively new privilege does not apply to the rendering of business advice, accounting advice or tax return preparation advice. On the other hand, communications on legal matters raised in litigation or in anticipation of litigation are privileged by application of the work product doctrine. See FRCP 26(b). On the other side of the spectrum, communications about legal questions raised in litigation (or in anticipation of litigation) are privileged. The policy rationales under the attorney client privilege and the work product doctrine are distinctly different. As to the former, the courts give a narrow construction to the scope of the attorney client privilege inasmuch as such privilege runs contra to the search for truth. See U.S. v. Evans, 113 F.3d 1457, 1461 (7th Cir. 1997).

The Seventh Circuit, in Valero Energy Corp. v U.S., affirmed the U.S. District Court’s for the Northern District of Illinois, Eastern Division, order partially granting enforcement of an IRS summons issued to a company's tax advisers and directing the company to produce documents previously withheld under the tax practitioner privilege, upholding the court's finding that the tax shelter exception to the privilege applies. The tax issue pertained to a merger of Valero Energy and a Canadian company in 2001. Arthur Andersen LLP rendered tax and accounting advice on the transaction, including structure a purchase and disposition of certain financial instruments or positions which would generate large foreign source tax losses to offset gain realized in the acquisition. After finding out about the strategy in the financial press reporting the strategy saved Valero approximately $46M in taxes, the IRS issued a third party administrative summons on Arthur Andersen under §7609. Valero moved to quash the enforcement of the summons.

The lower court held that the tax practitioner privilege applied to some documents and the government had failed to meet its burden of showing that the tax shelter exception to the privilege applied. In a second ruling, the same district court found the government had established that some documents were discoverable under the "promotion" of tax shelter exception. Valero appealed to the Seventh Circuit.

The Seventh Circuit affirmed the district court's ruling. First, it agreed that certain documents were not privileged on the grounds that such documents were in the nature of business or accounting advice. Moving to the more noteworthy aspect of its opinion, the Appeals Court found that the exception under §7525(b)(2) did apply to certain materials sought to be produced. The appellant-Valero argued that to apply §7525(b)(2) there had to be a finding that the documents pertained to the "promotion of the direct or indirect participation of the person in a tax shelter". Here, Valero argued, there was no promotion since Arthur Andersen presented the tax strategy to it alone in order to reduce the tax impact of the merger and not as part of a pre-packaged promotion to various persons.

The appeals court rejected Valero’s argument which it found to create a conflict as far as Congress’ intent in defining tax shelter in §6662(d)(2)(C)(ii). "Nothing in this definition limits tax shelters to cookie-cutter products peddled by shady practitioners or distinguishes tax shelters from individualized tax advice," the court wrote. "Instead, the language is broad and encompasses any plan or arrangement whose significant purpose is to avoid or evade federal taxes." It also distinguished the case from Textron, 507 F. Supp. 2d 138 (2007), on the basis that the tax accrual workpapers involved in that case were not to be evaluated in the same light as pre-transactional documents and written advises rendered by a tax practitioner in the case before it. The Seventh Circuit added additional ingredients to its holding by stating in its opinion that the summons power held by the IRS goes to the "flip side of [the] coin" of our country’s self-reporting system. The section 7525 privilege "chips away at the IRS's summons power: we will not broaden it by narrowly interpreting exceptions without clear direction from Congress," the court stated.

The Seventh Circuit’s decision in Valero Energy reaches an opposite conclusion from the Tax Court’s recent decision in Countryside Limited Partnership et al.,132 T.C. No. 17 (June 8, 2009). In Countryside, Tax Court Judge James Halpern held that the section 7525(b) privilege exception for tax shelter promotion while not clear perhaps on its face did find support for the thought that it was not intended to apply to "routine relationships" between advisers and taxpayers as present before the Court.

In short, Valero Energy Corp. provides the government with a clear victory in its continued efforts to obtain tax opinions and related materials issued to clients by federal tax practitioners through the use of its summons power. Since the various courts that have looked at this issue previously gave the §7525(b)(2) exception a more narrow read, it will be interesting to follow how the issue continues to be received by the courts.

 

VALUATION: Section 7520 Applied to Lottery Winnings

The Sixth Circuit in Negron v. U.S., 103 A.F.T.R. 2d 1009-634 reversed 502 F.Supp. 2d 682 (D.C. OH) and held, following the Fifth Circuit in Cook, that lottering winnings should be valued pursuant to section 7520. As the Court noted, “A marketability factor is not necessary to determine the value of a guaranteed income stream…”

 

Discussion of Kohler Case

The discussion of the Kohler case, posted on March 4, 2008, requires an update.  The Internal Revenue Service has issued Proposed Regulations, Section 20.2032-1(f) which provide that the election to use the alternate valuation can be utilized only to the extent that the change in value during the six-month period is a result of "market conditions."  For this purpose, "market conditions" means events outside of the control of the decedent or his executors.  When adopted as final regulations, the rules will be made applicable to estates of decedents dying on or after April 25, 2008.  Thus, the result in Kohler is reversed.

VALUATION: WHEN CAN SECTION 7520 BE AVOIDED?

The Fifth Circuit in Taylor v. United States, ___F.3d___, 2008 WL 57081 (5th Cir. 2008) faced the issue of how to value payments made pursuant to a structured settlement arising from tort claims, which payments could not be anticipated, sold, assigned or encumbered. The issue is whether the annuities should have been valued under the customary willing buyer-willing seller test (presumably at a discount because of the restrictions on transferability), or using the Section 7520 tables. The estate had argued that the provisions of Reg. Section 20.7520-3(b)(1)(i) of a “restricted beneficial intent” meant that the Section 7520 approach should not be used. The cited regulations preclude the use of section 7520 tables for “an annuity…that is subject to any contingency power, or restriction…” The court explained that the use of the tables did not produce a result so unrealistic that the table should be ignored. As the Tax Court noted:

the enactment of a statutory mandate in section 7520 reflects a strong policy in favor of standardized actuarial valuation of these interests which would be largely vitiated by the estate’s advocated approach. A necessity to probe in each instance the nuances of a payee’s contractual rights, when those rights neither alter or jeopardize the essential entitlement to a stream of fixed payments, would unjustifiably weaken the law.” Gribauskas, 116 T.C. at 163-64.

The Fifth Circuit relied on its earlier opinion in Cook v. United States, 349 F.3d 850 (5th Cir. 2003) affirming T. C. Memo 2001-170 which valued lottery payments as suitable for valuation by using the Section 7520 approach rather than general valuation principles which remains the Fifth Circuit’s view.

The Ninth Circuit (Estate of Shackleford v. United States, 262 F.3d 1028 (9th Cir. 2001)), and the Second Circuit (Estate of Gribauskas, 342 F.3d 85 (2nd Circuit, 2003) are to the contrary. The result in Taylor does not seem unreasonable because the factor accounting for the disparity between the expert valuation testimony and the table valuation is not properly applied to the lottery winnings. After all, non-marketability of a private annuity is an assumption underlying the section 7520 table.

From a planning point of view, until the Supreme Court resolves the conflict in the circuits, any private annuity arrangement should have strong non-assignability clauses.

NONACQUIESCENCE AND FAILURE TO APPEAL

Once again the Internal Revenue Service in AOD 2008-1 announced its nonacquiescence in Herbert V. Kohler, Jr., v. Commissioner, T.C. Memo 2006-152(2006), but did not appeal the adverse result in the Tax Court.

In Kohler, a shareholder died and two months later the corporation reorganized tax-free under § 368 and the new stock received by the shareholder’s estate was subject to transfer restrictions, and a purchase option designed to insure that family members would continue to own all of the stock.

Pursuant to § 2032, the Tax Court held that the new stock received within six months after death, is the stock to be valued. In other words, the court accepted the estate’s argument that (i) the stock should be valued at six months post-death and (ii) that the stock to be valued has the restrictions which depress the value. As the court noted, the regulations (Reg Sec. 20.2032-1(c)(1)) provide that a tax-free organization is not a disposition. 

If the Service disagrees with a decision, it has a simple remedy: Appeal. Sound tax policy is not found here. 


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EQUITABLE RECOUPMENT

The Supreme Court first approved an application of the doctrine of equitable recoupment in Bull v. United States, 295 U.S. 247 (1935). In a case of first impression, the Tax Court (Menard, Inc. v. Commissioner, 130 T.C. No. 4 (2008)) held that under the doctrine of equitable recoupment, it had jurisdiction to offset an income tax deficiency with a tax paid even if the court lacks subject matter jurisdiction over the tax so paid.

Section 6214(b) was amended by the Pension Protection Act of 2006 by adding the last sentence to subsection (b) authorizing the Tax Court to apply the doctrine of equitable recoupment to the same extent as it is available in the district courts and Claims Court. (This amendment confirms the jurisdiction of the court to apply equitable recoupment which had split the courts of appeal. See conflict between the Sixth and Ninth Circuits). The Commissioner had argued that the Tax Court cannot apply the doctrine unless it has jurisdiction over the tax, i.e. income, estate and gifts, and excise tax. The Commissioner argued that this group does not include the “hospital tax” imposed by sections 3101 and 31111, 

Rejecting this argument, the Tax Court stated as a matter of policy, that the 2006 Amendment should be read in such a manner so as to eliminate confusion and to provide “simplification benefits to both taxpayers and the IRS.”

FORMULA DISCLAIMERS

In a fully reviewed opinion, the United States Tax Court in the Estate of Christiansen v. Commissioner, 130 TC No.1 (2008) rendered what may become a landmark case dealing with “formula disclaimers.”

The decedent’s daughter made a formula disclaimer of everything in the estate in excess of $6,350,000.00. The excess passed to a charitable lead trust and a foundation. (As to the part passing to the trust, the charitable deduction was disallowed by the court on the ground that the disclaimant had an interest in the trust which itself was not disclaimed, violating Reg. § 25.2518-2(c) and  §25.2518-3(a)(b)).

The specific formula disclaimer clause provided “intending to disclaim a fraction or portion of the Gift, … hereby disclaims that portion of the Gift determined by reference to a fraction, the numerator of which is the Fair Market Value of the Gift … less $6,350,000.00, and the denominator of which is the Fair Market Value of the Gift….” Fair Market Value was defined as the value as finally determined for Federal Estate Tax purposes. The disclaimer clause also had a savings clause in which the disclaimant “…hereby takes such actions to the extent necessary to make the disclaimer…a qualified disclaimer.”

The Commissioner challenged the disclaimer as not being effective to pass the property to the foundation on two grounds: (1) The amount was subject to a contingency - as a conditioned subsequent and (2) the clause was void as contrary to public policy. As to the condition subsequent argument, the court held that the regulation (§ 20.2055-2(b)(1) which disallows a charitable deduction if the Gift is dependent upon the performance of an act precedent) does not apply. As the court noted, the transfer to the foundation occurred at the time of the disclaimer and was not contingent upon any event that occurred after the decedent’s death. 

As to the public policy discussion, the Commissioner cited the often-cited case of Commmissioner. V. Procter, 142 F.2d 824 (4th Cir. 1944). In Procter, the court voided a clause as contrary to public policy in that the clause would discourage collection of tax, would render the court’s own decision as moot by undoing the gift, and would upset a final judgment. Here, the Tax Court stated “This case is not Procter. The contested phrase would not undo a transfer, but only reallocate the value of the property transferred…” The court concluded that an increase in the charitable deduction to reflect the increase of the property passing to the charity “violates no public policy.”

ARE TAX-ACCRUAL WORKPAPERS GENERATED BY CORPORATION AND ITS INDEPENDENT AUDITOR SO THAT CORPORATION COULD COMPLY WITH SEC FILING REQUIREMENTS SUBJECT TO AN IRS SUMMONS??? ---STAY TUNED!

On January 25, 2008 the Justice Department submitted a brief for the First Circuit, arguing that a district court erred in U.S. v. Textron Inc. and Subsidiaries, 507 F. Supp. 2d 138 (D.R.I. 2007) by refusing to enforce an IRS summons and in holding that tax accrual workpapers prepared by a public corporation for a regular financial audit required by federal securities laws are protected by the work product doctrine. The District Court in Textron was able to conclude that the IRS was not entitled to the tax-accrual workpapers because the court ruled that those workpapers had “little to do” with the determination of Textron’s tax liability and that disclosure “would put Textron at an unfair disadvantage” in disputes regarding its tax liability. 

In its brief the United States argues that the District Court’s determination that Textron’s tax accrual workpapers are protected work product (i) misapplies the Supreme Court’s Arthur Young, 465 U.S. 805 (1984) (holding that accountants’ tax-accrual workpapers were “highly relevant” to an IRS audit and were not protected by an accountant’s work-paper doctrine) decision, (ii) conflicts with the First Circuit’s work-product test set out in Maine, 298 F.3d 60 (1st Cir. 2002)(“documents should be deemed prepared for litigation and within the scope of the [work product rule] if, ‘in light of the nature of the document and the factual situation in the particular case, the document can be fairly said to have been prepared or obtained because of the prospect of litigation’”), and (iii) unnecessarily creates a conflict with the Fifth Circuit’s El Paso, 682 F.2d 530 (5th Cir. 1982), cert. denied, 466 U.S. 944 (1984) (no work-product protection for documents “assembled in the ordinary course of business, or pursuant to public requirements unrelated to litigation”) decision which has held that a company’s tax-accrual workpapers are not protected work product.

Treasury Suggests Congress Cut Us a Break

On February 4, 2008 as part of President Bush's proposed fiscal 2009 budget, Treasury suggested that Congress give tax return preparers a break.  Realizing the potential conflict between the client taxpayer and the preparer the Treasury made the following proposal: “The standard applicable to preparers when taking a position not disclosed on a return would be the substantial authority standard. Because the determination as to whether a transaction has a significant purpose of tax avoidance or evasion is inherently subjective to the taxpayer, the preparer standard applicable to tax shelters would also be substantial authority. However, a preparer would be required to have a reasonable belief that the position would more likely than not be sustained on the merits when taking a position with respect to a transaction determined to have a potential for tax avoidance or evasion to which section 6662A applies. The standard applicable to preparers for disclosed positions would remain at reasonable basis. No penalty would be asserted against a preparer if the preparer has reasonable cause and good faith. The proposal would be effective for returns prepared after January 1, 2008.”

Family Limited Partnerships

       The most recent appellate case involving family limited partnerships, Estate of Bigelow v. Commissioner, 503 F.3d 955, 2007 WL 2684526 (9th Cir. 2007) deserves careful study for the discussion of the "bona-fide sale for adequate and full consideration," exception to section 2036.

       The Ninth Circuit held that if the consideration exception applies, section 2036 does not apply.  In determining the applicability of the exception, the inherent reduction (such as arises when an investor transfers a stock portfolio to a hedge fund in exchange for an interest therein) of the value of the property transferred cannot per se disqualify the property from failing the 2036(a) exception.  But, the court continues on to state:

"The validity of the adequate and full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in making the bona fide transfer inquiry."

         Estate planners should not assume that the inquiry of subjective motive is necessarily required in measuring the adequacy of the consideration.  In Bongard, 124 T.C. 95 (2005), Judge Halpern, in a concurring opinion, expressed his disagreement with the majority's interpretation of the bona-fide sale exception, as the Judge stated:"

"Therefore, to establish that the transfers were for full consideration, petitioner must, for each transfer, establish that the value of the property transferred by decedent did not exceed the cash value of the property received by him. Id. By the explicit terms of section 25, 2512-8, Gift Tax Regs., the resulting inquiry is limited to an economic calculus, and there is no room for any inquiry as to the transferor's (decedent's) state of mind.  Yet the majority makes his state of mind critical..."

         A more recent Tax Court decision, Estate of Rector, T.C. Memo 2007 367 (2007) involved the creation of an FLP, by a 92-year old woman who was living in a nursing home.  She was the only general partner and her revocable trust held the remaining 98% interest as a limited partner.  Before death, the decedent transferred by a gift a 30% interest of FLP.  Judge Laro had no difficulty in concluding that section 2036 applied and no discount was available.  See also, Estate of Hilde E. Erickson, 2007 T.C. Memo 107 (2007).