t c no united_states tax_court baine p and mildred c kerr donors petitioners v commissioner of internal revenue respondent docket no filed date in ps and their children formed two family limited_partnerships kflp and kilp the kflp and kilp partnership agreements contain identical restrictions on liguidation of the partnerships in date ps transferred limited_partnership interests in kflp and kilp to the university of texas the university on date ps created separate grantor retained annuity trusts grat’s ps each transferred a 535-percent class b limited_partnership_interest in kflp to their grat’s the grat’s remainder interests were intended to benefit ps grandchildren through generation-skipping trusts on date the university was admitted as a limited_partner of kilp on date and ps transferred limited_partnership interests in kilp to their children ps filed federal gift_tax returns for and ps computed the value of the limited_partnership interests in kflp that they transferred to the grat’s by applying discounts for lack of liquidity and minority interest ps computed the value of the limited_partnership interests in kilp that they transferred to their children by applying a discount for lack of liguidity r determined that sec_2704 i r c bars ps from applying a discount for lack of liquidity in computing the value of the partnership interests that ps transferred to the grat’s and to their children ps filed a motion for partial summary_judgment arguing that sec_2704 i r c is not applicable alternatively because the grat’s trustees received only assignee interests as opposed to limited_partnership interests the disputed transfers must be valued as assignee interests under sec_25_2512-1 gift_tax regs and the restrictions on liquidation set forth in the partnership agreements do not constitute applicable restrictions within the meaning of sec_2704 i r c held ps transferred limited_partnership interests to the grat’s in both form and substance held further pursuant to sec_25_2512-1 gift_tax regs the value of the limited_partnership interests is equal to the price that a hypothetical willing buyer would pay to a willing seller for the limited_partnership interests held further the restrictions on liquidation in dispute do not constitute applicable restrictions within the meaning of sec_2704 i r c john w porter for petitioners lillian d brigman and john d maceachen for respondent - - opinion jacobs judge this matter is before the court on petitioners' motion for partial summary_judgment filed pursuant to rule petitioners contend that they are entitled to partial summary_judgment that sec_2704 is not applicable in valuing the limited_partnership interests that they transferred to their grantor retained annuity trusts and to their children during and for the reasons set forth below we will grant petitioners' motion background baine p kerr and mildred c kerr were married in and have four adult children baine p kerr jr john caldwell kerr james robinson kerr and mary kerr winters the kerr children the all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated all section references are to the internal_revenue_code as amended petitioners also moved for partial summary_judgment that their interests in the grantor retained annuity trusts were qualified interests within the meaning of sec_2702 respondent subsequently conceded the point and we issued an order granting so much of petitioners' motion for partial summary_judgment as pertained to that issue the following summary of the relevant facts is based on the parties' stipulations with attached exhibits and other pertinent materials in the record they are stated solely for the purpose of deciding the pending motion and are not findings_of_fact for this case see rule a fed r civ p a - kerr children are financially independent petitioners have grandchildren petitioners both graduated from the university of texas baine p kerr petitioner also graduated from the university of texas law school after serving in world war ii petitioner joined the law firm of baker botts in houston texas subsequently was admitted as a partner and ultimately managed the firm's corporate law department petitioner left baker botts to serve in various executive positions at pennzoil co between and petitioner served on pennzoil's board_of directors and as president in he received a dollar_figure million bonus for work that he had performed in a lawsuit that pennzoil had filed against texaco s stacey eastland hastland an attorney at baker botts advised petitioners on estate_planning matters for many years rastland has written extensively on the use of family limited_partnerships and particularly transfers of assignee interests as an estate_planning tool ’ in date eastland proposed that petitioners create two limited_partnerships eastland advised petitioners that the limited_partnerships could be used as a source see eastland family limited_partnerships non-transfer tax benefits probate and property mar date eastland the art of making uncle sam your assignee instead of your senior partner the use of partnerships in estate_planning sd ali- aba date - - for making gifts to their children eastland further advised petitioners that the partnerships should include a charity as a partner in light of the recent enactment of sec_2704 and to make sure that traditional valuation rules apply to the partnerships kerr issue gst_trust on date petitioners as grantors and their children as trustees executed a document entitled agreement creating the kerr issue gst trusts the agreement provided that each of the kerr children would act as the trustee of a separate trust under which he or she would be the primary beneficiary the agreement further provided that each trust would terminate upon the death of the primary beneficiary and that any remaining trust property would pass to the living issue of the primary beneficiary ie the kerr grandchildren on date petitioners executed separate wills which included pour over provisions to the kerr issue gst trusts in an amount equal to the available generation-skipping tax exemption sec_2704 quoted infra pp generally provides that restrictions on the liquidation of a family_partnership will not be considered in valuing a gift of a partnership_interest from one family_member to another if the family has control of the partnership before the transfer and the family can remove the restriction on liquidation after the transfer kerr family limited_partnership on date petitioners and the kerr children executed an agreement forming the kerr family limited_partnership kflp under the texas revised limited_partnership act trlpa tex rev civ stat ann art 6132a-1 west supp petitioners made all capital contributions to kflp in the form of three life_insurance policies on their lives with a face_amount totaling approximately dollar_figure million the kerr children did not make any capital contributions to kflp at the time kflp was formed petitioners were the sole general partners however petitioners immediately assigned a portion of their general_partnership interest to each of the kerr children in particular each of the kerr children received a 2325-percent kflp general_partnership interest there is no evidence in the record that petitioners executed a written consent admitting the kerr children as general partners of kflp following the transfers described above petitioners retained the following partnership interests in kflp a combined percent class a limited_partnership_interest a combined pursuant to sec dollar_figure of the kflp partnership_agreement class a limited partners were entitled to an annual guaranteed_payment percent general_partnership interest and a combined percent class b limited_partnership_interest kerr interests limited_partnership on date petitioners their children and kflp executed an agreement forming the kerr interests limited_partnership kilp under trlpa petitioners made all capital contributions to kilp in the form of stocks bonds and real_estate with an aggregate fair_market_value of approximately dollar_figure million the kerr children did not make any capital contributions to kilp at the time kilp was formed petitioners were the sole general partners however petitioners immediately assigned all of their general_partnership interest in kilp to kflp and a portion of their class b limited_partnership_interest in kilp to kflp and the kerr children in particular kflp received a 2-percent general_partnership interest and an 18-percent class b limited_partnership_interest in kilp while the kerr children each received a percent class b limited_partnership_interest in kilp there is no evidence in the record that petitioners executed a written consent admitting kflp as a general_partner of kilp following the transfers described above petitioners retained a combined 100-percent class a limited_partnership_interest in kilp’ and a combined 686-percent class b limited_partnership_interest ’ pursuant to sec dollar_figure of the kilp partnership_agreement class a limited partners were entitled to an annual guaranteed_payment --- - in petitioners transferred additional assets to kilp with an aggregate fair_market_value of approximately dollar_figure million partnership agreements the kflp and kilp partnership agreements are identical in all material respects they include a number of provisions pertinent to the pending motion section dollar_figure of the partnership agreements states that the general partners shall appoint petitioners to serve jointly as the managing partner that if either petitioner fails or ceases to serve as managing partner then the other shall continue to serve as managing partner and if both petitioners cease or fail to serve as managing partner then mary kerr winters shall serve as managing partner sec_3_10 states the general_rule that no limited_partner shall have any control_over the management of the partnerships however sec_3 e states that the partnership shall not take action with respect to certain enumerated major decisions without prior written consent of a majority of the limited partners sec_3_10 identifies major decisions as extraordinary events such as the partnership's filing a petition in bankruptcy any act that would make it impossible to carry on the partnership's business and any act in contravention of the partnership_agreement --- - section dollar_figure states that no person shall be admitted as a general or limited_partner without the consent of all general partners except as provided in article viii of the agreements sec_3_10 states that no other person may become a limited_partner of the partnerships except by way of a transfer permitted under and effected in compliance with the partnership agreements sec_3_10 states that limited partners shall not be entitled to the withdrawal or return of their contributions to the partnerships except to the extent if any that distributions are made pursuant to the partnership agreements or upon termination of the partnerships section dollar_figure states the general_rule that no limited_partner or spouse of a limited_partner shall make a disposition of an interest in the partnership owned or held by him except with the consent of the partnership and all other partners the term disposition is defined in section dollar_figure as any sale assignment gift exchange transfer change in beneficial_interest of any trust or estate distribution from any trust or estate change in ownership of a corporate or partnership partner or any other_disposition of a limited_partnership_interest whether voluntary or involuntary direct or indirect however section dollar_figure states that the pertinent sections of article viii of the partnership agreements are summarized infra pp -- - a disposition does not include a transfer to a permitted assignee the term permitted assignee is defined in section dollar_figure to include among others each existing partner any person who is a lineal descendant of both petitioners a trustee of any trust that 1s more than percent actuarially held for permitted assignees any partnership owned exclusively by permitted assignees or a charity section dollar_figure states that any limited_partner desiring to make a disposition of all or any part of his or her limited_partnership_interest shall first submit a written offer to sell the limited_partnership_interest to the partnership and the remaining partners sections dollar_figure and dollar_figure set forth a formula for determining the amount that the partnership or partners will pay for such limited_partnership interests section dollar_figure states that any disposition of a limited_partnership_interest shall be effective only to give the assignee the right to receive the share of profits to which his assignor would otherwise be entitled section dollar_figure states in pertinent part that upon the transfer of a general_partnership interest to a permitted assignee the general partners shall admit the transferee into the partnership as a class b limited_partner section dollar_figure states that no person not already a partner shall become a partner or acquire any rights to participate in the management of the partnership except with the unanimous consent of the partners however the provision further states that the terms of article viii shall apply to an assignee as if he were a substituted partner section dollar_figure states that no limited_partner shall have the right to withdraw from the partnerships before the partnerships dissolve and liguidate however class b limited partners have a put right e the right to require the partnership to purchase part or all of a class b limited_partnership_interest at fair_market_value as defined in section the latter section defines fair_market_value under the so-called willing buyer willing seller standard with the caveat that the hypothetical willing buyer of the limited_partnership_interest will have no withdrawal or put rights section dollar_figure sets forth the liquidation provisions at the center of the present controversy section dollar_figure states that the partnerships will dissolve and liquidate on the earlier of december by agreement of all the partners or on the occurrence of certain narrowly defined acts of dissolution transfers to university of texas petitioners donated approximately dollar_figure to the university of texas the university between and between and petitioners donated dollar_figure to the university to establish the mildred caldwell and baine perkins kerr centennial professorship in english history and culture in petitioners donated pennzoil co stock valued at dollar_figure to the university to enhance the aforementioned endowment and to redesignate the professorship as a chair--the mildred caldwell and baine perkins kerr centennial chair in english history and culture on date petitioners and a representative of the university executed two documents entitled assignment of partnership_interest which state that petitioners were transferring to the university one value unit of a class a limited_partnership_interest in kflp and nine value units of a class a limited_partnership_interest in kilp the assignments state that petitioners desired to assign a portion of their interests in kflp and kilp as more particularly described in schedule i thereto schedule i to the assignments states in pertinent part the assigned partnership_interest constituted a class a limited_partnership_interest in the partnerships when owned by assignors and when owned by assignee shall constitute a class a limited_partnership_interest in said partnership on date the kilp partnership_agreement was amended to state that the university would be admitted as a class a limited_partner transfers to grantor retained annuity trusts on date petitioner baine p kerr created the baine p kerr retained annuity_trust under which he served as the sole initial trustee on the same date petitioner mildred c kerr created the mildred caldwell kerr retained annuity_trust under which she served as the sole initial trustee the above- described trusts will hereinafter be referred to as the grat’s the grat’s were structured to provide petitioners with two annuity payments---the first payment was due_date and the second payment was due_date the grat’s were each set to terminate on the earlier of date or the date of the grantor's death on date petitioners each executed a document entitled assignment of partnership_interest stating that they were each transferring to the grat’s trustees a 535-percent class b limited_partnership_interest in kflp as more particularly described in schedule i thereto the parties agree that the grat’s trustees were permitted assignees within the meaning of section dollar_figure of the kflp partnership_agreement schedule i to the assignments states in pertinent part the assigned partnership_interest constituted a class b limited_partnership_interest in kflp when owned by assignor and when owned by assignee shall constitute a class b limited_partnership_interest in said partnership on date and date petitioners each executed documents entitled assignment of annuity in which they sold the rights to their annual grat’s annuity payments in exchange for promissory notes from the grat’s on date and date the grat’s transferred demand notes to petitioners as required under the assignments described above the original principal amounts due on the date grat’s demand notes held by petitioners baine p kerr and mildred c kerr were dollar_figure and dollar_figure respectively on date petitioners in their individual capacities and as grat’ss trustees executed documents entitled security agreement-assignment of partnership_interest under which the grat’s assigned to petitioners as security for the grat’s demand notes the grat’s class b limited_partnership interests in kelp during petitioners received interest payments on the grat’s demand notes totaling dollar_figure the grat’ss were terminated on date and the remaining assets and liabilities of the grat’s were transferred to the kerr issue gst trusts by separate agreements dated date petitioners agreed that the remaining principal and interest payments due on the date grat’s demand notes--then the liabilities of the various kerr issue gst trusts----would be forgiven subject_to the condition that the trustees agree to pay any federal and state gift estate inheritance transfer succession and generation-- skipping transfer_tax associated with the transfer -- - additional transfers to the kerr children on date petitioners each transferred a percent class b limited_partnership_interest in kilp to each of the kerr children on date petitioners each transferred a 09375-percent class b limited_partnership_interest in kilp to each of the kerr children petitioners' federal gift_tax returns petitioners filed federal gifts tax returns for in which they reported gift_tax liabilities attributable to the transfers that they made to the grat’s trustees and to their children in an appraisal report attached to the returns prepared by howard frazier barker elliott inc petitioners determined the fair_market_value of the kflp class b limited_partnership interests that they transferred to the grat’s trustees by applying a 25-percent discount for lack of liquidity or marketability to the value of the kilp interests held by kflp and a 5-percent minority-interest discount and a 35-percent discount for lack of liquidity or marketability on the net asset value of kflp's assets petitioners computed the fair_market_value of a 535-percent limited_partnership_interest in kflp as follows total net asset value kflp dollar_figure less class a capital_account big_number limited_partnership percentage nav of the interest big_number minority-interest discount marketable minority interest value big_number discount for lack of marketability big_number fair_market_value big_number -- - petitioners further reported that percent of the fair_market_value of the kflp class b limited_partnership interests that they transferred to the grat’s trustees was attributable to their retained annuities while the remaining percent or dollar_figure rounded represented the amount of their taxable_gifts to the remainder beneficiaries of the grat’s petitioners computed the fair_market_value of the kilp class b limited_partnership interests that they transferred to their children in and by applying a 25-percent discount for lack of liquidity or marketability respondent's determinations respondent issued a notice_of_deficiency to petitioner baine p kerr determining deficiencies of dollar_figure and dollar_figure in his federal gift_taxes for and respectively respondent issued a notice_of_deficiency to petitioner mildred c kerr determining deficiencies of dollar_figure and dollar_figure in her federal gift_taxes for and respectively respondent determined among other things that petitioners had understated the values of both the kflp interests that they had transferred to the grat’s trustees in and the values of the kilp interests that they had transferred to their children in and as follows partnership reported respondent's year interest value determination kf lp dollar_figure 1dollar_figure kilp big_number big_number kilp big_number big_number a substantial portion of the difference between the value that petitioners reported for this item and the value that respondent determined is attributable to the sec_2702 issue that respondent subsequently conceded respondent determined in pertinent part that the restrictions on liguidation set forth in section dollar_figure of the kflp and kilp partnership agreements constitute applicable restrictions within the meaning of sec_2704 and that these restrictions should have been disregarded in valuing the limited_partnership interests procedural history after petitioners filed a timely joint petition for redetermination and respondent filed an answer to the petition petitioners filed the motion for partial summary_judgment currently pending before the court petitioners raise several alternative arguments in support of their position that respondent erred in applying sec_2704 in this case petitioners' primary contention is that the interests that they transferred to the grat’s trustees were merely assignee interests in connection with this argument petitioners maintain that sec_2704 does not apply to the valuation of the transferred interests because the limited rights of assignees under the partnership agreements are no -- - more restrictive than the restrictions imposed on assignees under trlpa see sec_2704 b b respondent filed an objection to petitioners' motion for partial summary_judgment asserting in part that petitioners had not properly raised the assignment issue in their petition petitioners filed a response to respondent's objection and a motion for leave to file an amendment to petition and lodged an amendment to petition with the court raising the assignee issue the court granted petitioners' motion for leave and filed petitioners’ amendment to petition respondent subsequently filed an amended answer to the amendment to petition respondent also filed a supplemental objection to petitioners’ motion asserting that facts remained in dispute regarding petitioners' intent in making the disputed transfers initially this matter was called for hearing in washington d c during the hearing counsel for petitioners conceded that because the kerr children were already limited partners of kilp when petitioners transferred additional kilp interests to them in and the kerr children received limited_partnership interests as opposed to assignee interests however petitioners argued that these property interests should be valued for federal gift_tax purposes as asssignee interests under the willing buyer willing seller standard set forth in sec_25_2512-1 gift_tax regs while accepting petitioners concession regarding the transfers to the kerr children counsel for respondent argued that additional discovery was needed to determine the nature of the property interests that petitioners transferred to the grat’s trustees in response to these developments the court informed the parties that it intended to define the property interests that petitioners had transferred to the grat’s trustees and decide the legal question of the applicability of sec_2704 before conducting a trial on valuation issues in this regard the court directed the parties to proceed with informal_discovery submit a stipulation of facts to the court and prepare for a partial trial if necessary on the issue of the nature of the property interests that petitioners had transferred to the grat’s trustees this matter was subseguently called for a partial trial in houston texas the parties filed a stipulation of facts and the court received testimony from eastland petitioner mary kerr winters and james robinson kerr following the aforementioned hearings the parties filed additional memoranda discussion summary_judgment is intended to expedite litigation and avoid unnecessary and expensive trials see 90_tc_678 summary_judgment may be granted with respect to all or any part of the legal issues in controversy if the pleadings answers to interrogatories depositions admissions and any other acceptable materials together with the affidavits if any show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law rule b the party opposing the motion cannot rest upon the allegations or denials in the pleadings but must set forth specific facts showing that there is a genuine issue for trial rule d the moving party however bears the burden of proving that there is no genuine issue of material fact and factual inferences will be read in a manner most favorable to the party opposing summary_judgment see 85_tc_267 on the basis of the record presented we are satisfied that there are no material facts in dispute with regard to the issues raised in petitioners' motion for partial summary_judgment sec_2501 imposes a tax for each calendar_year on the transfer of property by gift by any individual sec_2512 provides that if a gift is made in property the value thereof at the date of the gift shall be considered the amount_of_the_gift - pursuant to sec_25_2512-1 gift_tax regs the value_of_the_gift is the price at which such property would change hands between a willing buyer and a willing seller neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts see 411_us_546 in the omnibus budget reconciliation act of obra publaw_101_508 sec a stat congress enacted a series of special valuation rules applicable to transfers of interests in corporations partnerships and trusts one of these provisions sec_2704 provides sec_2704 b certain restrictions on liquidation disregarded --- in general --for purposes of this subtitle if- a there is a transfer of an interest in a corporation or partnership to or for the benefit of a member_of_the_transferor's_family and b the transferor and members of the transferor's family hold immediately before the transfer control of the entity any applicable_restriction shall be disregarded in determining the value of the transferred interest applicable_restriction ---for purposes of this subsection the term applicable_restriction means any restriction-- a which effectively limits the ability of the corporation or partnership to liquidate and -- - b with respect to which either of the following applies the restriction lapses in whole or in part after the transfer referred to in paragraph the transferor or any member_of_the_transferor's_family either alone or collectively has the right after such transfer to remove in whole or in part the restriction exceptions ----the term applicable_restriction shall not include-- b any restriction imposed or required to be imposed by any federal or state law sec_25_2704-2 gift_tax regs provides that an applicable_restriction is a restriction on the ability to liquidate the entity in whole or in part that is more restrictive than the limitations that would apply under the state law generally applicable to the entity in the absence of the restriction in sum sec_2704 generally provides that where a transferor and his family control a corporation or partnership a restriction on the right to liquidate the corporation or partnership shall be disregarded in determining the value of an interest that has been transferred from the transferor to a family_member if after the transfer the restriction on liquidation either lapses or can be removed by the family - - sec_2704 grants the secretary the authority to promulgate regulations providing that restrictions other than restrictions on liquidation shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership among family members if the restriction has the effect of reducing the value of the transferred interest for transfer_tax purposes but does not ultimately reduce the value of the interest to the transferee to date the secretary has promulgated regulations concerning only restrictions on the liguidation of partnerships as previously mentioned respondent determined that section dollar_figure of the kflp and kilp partnership agreements which states that the partnerships shall liguidate upon the earlier of december or the consent of all the partners contains restrictions on the liquidation of the partnerships that constitute applicable restrictions within the meaning of sec_2704 respondent maintains that these restrictions must be disregarded in valuing the interests petitioners transferred to the grat’s trustees and to their children petitioners contend that sec_2704 is not applicable on a number of alternative grounds t petitioners' argument that interests transferred to grat’s trustees were assignee interests petitioners contend that sec_2704 does not apply to the kflp interests that they transferred to the grat’s trustees because -- - those interests were merely assignee interests under state law trlpa section a provides that an assignment of a partnership_interest does not dissolve a limited_partnership or entitle the assignee to become or exercise the rights or powers of a partner trlpa section a and provides that an assignee is allocated the income gain loss deduction or credit to which the assignor was entitled and until the assignee becomes a partner the assignor continues to be a partner and to have the power to exercise any rightss or powers of a partner trlpa section a provides that an assignee of a partnership_interest may become a limited_partner if and to the extent that the partnership_agreement provides for such a transition or on the consent of all partners relying on the definition of an applicable_restriction contained in sec_25_2704-2 gift_tax regs petitioners maintain that an assignee’s inability to force kflp to liquidate under the kflp partnership_agreement imposes no greater restriction than those imposed upon assignees under trlpa petitioners’ contention that the partnership interests they transferred to the grat’ss trustees were assignee interests as opposed to limited_partnership interests is based on a strict construction of the kflp partnership_agreement in particular although petitioners made the transfers to themselves as grat’s trustees petitioners nonetheless maintain that their children as kflp general partners had to consent to the admission of the - - grat’s trustees as limited partners pursuant to section dollar_figure of the kflp partnership_agreement taxpayers generally are free to structure a business transaction as they please even if motivated by tax_avoidance considerations see 293_us_465 861_f2d_494 7th cir affg 87_tc_1087 86_f2d_710 2d cir affg 33_bta_1003 however the tax effects of a particular transaction are informed by the substance of the transaction rather than its form in 435_us_561 the supreme court has articulated the principle as follows in applying this doctrine_of substance over form the court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed the court has never regarded the simple expedient of drawing up papers 327_us_280 as controlling for tax purposes when the objective economic realities are to the contrary in the field of taxation administrators of the laws and the courts are concerned with substance and realities and formal written documents are not rigidly binding helvering v lazarus co u s the doctrine that the substance of a transaction will prevail over its form has been applied in federal estate and gift_tax cases see 945_f2d_359 10th cir estate of murphy v commissioner tcmemo_1990_472 see - - also 493_f2d_1225 4th cir johnson v commissioner supra on the basis of our review of the record we are persuaded by a number of factors that petitioners in substance as in form transferred limited_partnership interests to the grat’s trustees as discussed below the factors that we have relied upon in support of our holding on this point include petitioners' failure to respect the literal terms of the partnership_agreement the form of the transfers and the economic realities and tax motivation underlying the transfers a failure to comply with the partnership_agreement petitioners failed to adhere strictly to the literal terms of the kflp partnership_agreement governing transfers of general_partnership interests specifically when kflp was’ formed petitioners transferred three life_insurance policies on their lives to the partnership the kerr children did not contribute any assets to the partnership consistent with the terms of the partnership_agreement petitioners admit that they initially were the sole general partners of kflp pursuant to section dollar_figure of the partnership_agreement petitioners subsequently assigned a portion of their general_partnership interests in kflp to each of their children significantly under the plain language of section dollar_figure of the kflp partnership_agreement petitioners' inter_vivos transfers of -- p7 - general_partnership interests to their children who were permitted assignees within the meaning of section should have resulted in the admission of the kerr children as class b limited partners of kflp petitioners were free of course to override section dollar_figure of the partnership_agreement and admit the kerr children as general partners of kflp nevertheless considering the unambiguous terms of section it would have been reasonable to expect that petitioners would clearly document the admission of the kerr children as general partners of kflp by way of written consents given the lack of formality surrounding the admission of the kerr children as general partners of kflp we are left with the impression that petitioners either did not fully appreciate the terms of the kflp partnership_agreement or deemed formal consents to the admission of the kerr children as general partners to be unnecessary in either case petitioners' failure to take any formal steps in regard to the admission of the kerr children as general partners of kflp belies petitioners’ contention that the kerr childrens' formal consent was necessary to admit the grat’s trustees as limited partners of kflp b the form of the transfers petitioners transferred limited_partnership interests to themselves as grat’s trustees although it is agreed that the grat’s trustees were permitted assignees under section dollar_figure of the kflp partnership_agreement petitioners contend that the grat’s - - trustees could not be admitted to the partnership as limited partners without the consent of all the kflp general partners including the kerr children petitioner testified that he never considered whether he was transferring a limited_partnership_interest or an assignee interest to himself as a grat’s trustee further two of petitioners’ children testified that they were never asked to consent to the admission of the grat’s trustees as limited partners although petitioners argue that the absence of formal consents by the kerr children to the admission of the grat’s trustees as limited partners suggests that petitioners technically transferred assignee interests to themselves as the grat’ss trustees it is difficult to reconcile that position with the language petitioners used to document the transfers as noted earlier petitioners each signed a document entitled assignment of partnership_interest stating that assignor and assignee desire that assignor assign to assignee a portion of the partnership_interest of assignor in kflp such assigned partnership_interest being more particularly described in schedule i hereto in each case the assignment of partnership_interest further stated that all consents required to effect the conveyance of the assigned partnership_interest have been duly obtained further schedule i which identified the transferred interests as a class b limited_partnership_interest stated that the assigned - - partnership_interest constituted a class b limited_partnership_interest in kflp when owned by assignor and when owned by assignee shall constitute a class b limited_partnership_interest in said partnership read as a whole the language used in the assignment of partnership_interest establishes that petitioners transferred limited_partnership interests to themselves as the grat’s trustees although the documents refer to the grat’s trustees as assignees the description of the assigned interests contained in schedule i clearly states that the assignees will hold class b_ limited_partnership interests in kflp equally important the assignment of partnership_interest states that petitioners had obtained all necessary consents to effect the conveyance because the grat’s trustees qualified as permitted assignees within the meaning of section dollar_figure of the partnership_agreement and petitioners were not required to obtain any consents to transfer an assignee interest to a permitted assignee the inclusion of the statement that all necessary consents had been obtained also indicates that petitioners were transferring limited_partnership interests to the grat’s trustees further the statement that all necessary consents had been obtained contradicts the testimony of the kerr children that petitioners never requested that they consent to the transfers to the grat’s trustees -- - c objective economic analysis the objective economic realities underlying the transfers to the grat’s trustees do not support petitioners' position that the transferred interests should be considered assignee interests first and perhaps most importantly there were no significant differences under the kflp partnership_agreement between the rights of limited partners and assignees petitioners were vested with managerial responsibilities for kflp neither limited partners nor assignees had any managerial rights in addition limited partners and assignees enjoyed equivalent rights to information concerning the partnership's business affairs and they shared the same interests in the partnership's distributable cash finally while limited partners were permitted to put or sell their interests to the partnership under section dollar_figure of the partnership_agreement assignees were given a substantially equivalent right to offer their interests to the partnership under sections dollar_figure and dollar_figure of the partnership_agreement the only relevant difference between the rights of limited partners and assignees relates to a limited partner's right to vote on major decisions---a right not extended to assignees however given the rare and extraordinary nature of the matters gualifying as a major decision such as the filing of a bankruptcy petition or approving an act in contravention of the partnership_agreement we --- - do not consider a limited partner's right to vote on such matters to be significant for purposes of deciding the question presented we further note that petitioners retained the right to vote the limited_partnership interests and petitioners and the kerr children had the ability to convert the purported assignee interests to full limited_partnership interests or liquidate the partnership at will to characterize the interests’ that petitioners transferred to the grat’s trustees as assignee interests ignores the objective economic reality that there was no meaningful difference between the transfer of an assignee interest as opposed to a limited_partnership_interest d tax motivation the record shows that eastland structured petitioners' transfers to the grat’s trustees primarily to avoid the special valuation rules set forth in sec_2704 eastland's writings on the subject of family limited_partnerships disclose his belief that the transfer of an assignee interest from one family_member to another would serve to circumvent sec_2704 accepting petitioner's testimony that he did not consider whether he was transferring a limited_partnership_interest as opposed to an assignee interest to his grat’s it appears that eastland made a conscious decision not to raise the subject with his clients - - consistent with the foregoing we conclude that petitioners transferred limited_partnership interests to the grat’s trustees in substance as in form il petitioners' argument that the disputed transfers must be valued as assignee interests under sec_25_2512-1 gift_tax regs petitioners contend in the alternative that the limited_partnership interests in kflp they transferred to the grat’s trustees and the limited_partnership interests in kilp they transferred to the kerr children must be valued as assignee interests under the willing buyer willing seller standard prescribed in sec_25_2512-1 gift_tax regs specifically petitioners contend that the hypothetical willing buyer is assumed to be an outsider who would approach the purchase of a kflp or kilp limited_partnership_interest with the understanding that he could buy only an assignee interest and that there would be no guaranty of admission as a limited_partner petitioners’ position is based on a misunderstanding of the proper application of the willing buyer willing seller standard the nature of the property interest to be valued for federal gift_tax purposes generally is determined under state law see 309_us_78 8o 658_f2d_999 5th cir once the court has determined the nature or character of the property interest in - - question federal_law applies to determine how the property interest will be taxed see 357_us_51 the valuation standard under sec_25_2512-1 gift_tax regs is objective--the standard is based on a purely hypothetical willing buyer and willing seller each of whom seeks to maximize his or her profit from any transaction involving the property see 112_tc_130 and cases cited thereat the hypothetical willing buyer and willing seller are not specific individuals or entities and their characteristics are not necessarily the same as the personal characteristics of the actual seller or a particular buyer see estate of bright v united_states supra pincite6 estate of simplot v commissioner supra pincite petitioners attempt to expand sec_25_2512-1 gift_tax regs beyond its intended scope by using the provision to redefine the character of the property interests in question as assignee interests see eg estate of nowell v commissioner tcmemo_1999_15 however as explained above we have already determined that petitioners transferred limited_partnership interests to the grat’s trustees further petitioners admit that they transferred limited_partnership interests to their children accordingly sec_25_2512-1 gift_tax regs is properly applied by determining the price that a hypothetical willing buyer would pay - - a willing seller for limited_partnership interests in kflp and kilp tit sec_2704 b ---applicable restriction petitioners contend that sec_2704 is not applicable in this case even if the court concludes as we have that petitioners transferred limited_partnership interests to the grat’s and to their children petitioners argue that the provisions of section dollar_figure of the partnership agreements do not constitute applicable restrictions because the provisions do not restrict liguidation of the partnerships within the meaning of sec_2704 b a and the university's interests in kflp and kilp demonstrate that the kerr family did not have the ability unilaterally to lift any restrictions on liguidation within the meaning of sec_2704 b in the alternative petitioners assert that any restrictions on liguidation in the partnership agreements are excepted from the definition of an applicable_restriction pursuant to sec_2704 b and sec_25_2704-2 gift_tax regs because we agree with petitioners' contention that restrictions on liquidation in the partnership agreements are excepted from the definition of an applicable_restriction pursuant to sec_2704 b and sec_25_2704-2 gift_tax regs we need not consider petitioners' remaining arguments - - before proceeding with our analysis we will briefly review the legislative_history underlying sec_2704 the special valuation rules of which sec_2704 is a part were enacted in obra section a in conjunction with the repeal of sec_2036 the latter provision enacted as part of the omnibus budget reconciliation act of publaw_100_203 sec a 101_stat_1330 represented congress' attempt to discourage taxpayers' use of estate_freeze transactions for the purpose of reducing or avoiding federal transfer_taxes see h conf rept pincite 1987_3_cb_193 by congress felt compelled to repeal sec_2036 on the ground that the statute's complexity breadth and vagueness posed an unreasonable impediment to the transfer of family businesses informal s rept on s cong rec s15679-s15680 daily ed date although the special valuation rules were enacted as a more targeted substitute for sec_2036 there is little in the way of direct legislative_history relating to the enactment of sec_2704 in particular there was no provision for the special sec_2036 generally provided that if a person transferred property having a disproportionately large share of the potential appreciation in an enterprise while retaining an interest or right in the enterprise then the transferred property would be included in the transferor's gross_estate or upon the disposition of either the transferred property or the retained_interest the transferor would be deemed to have made a gift - - valuation rules in h_r 101st cong 2d sess --the house bill underlying obra provisions for special valuation rules first appeared in s 101lst cong 2d sess --the text of which the senate adopted in lieu of the language passed by the house in h_r s sec_7210 included new sec_2704 which provided in pertinent part as follows treatment of certain restrictions and lapsing rights -- for purposes of this subtitle the value of any property shall be determined--- without regard to any restriction other than a restriction which by its terms will never lapse the broad language of the senate version of sec_2704 did not survive the ensuing conference between the house and senate managers of the legislation unfortunately there is no meaningful explanation of the detailed language or concepts that were made a part of sec_2704 as finally enacted h conf rept pincite 1991_2_cb_560 states in pertinent part treatment of certain restrictions and lapsing rights in general the conference agreement modifies the provision in the senate amendment regarding the effect of certain restrictions and lapsing rights upon the value of an interest in a partnership or corporation these rules are intended to prevent results similar to that of estate of harrison v commissioner 52_tcm_1306 these rules do not affect minority discounts or other discounts available under present law the conferees intend that no inference be drawn regarding the transfer_tax effect of restrictions and lapsing rights under present law with restrictions under the conference agreement any restriction that effectively limits the ability of a corporation or partnership to liquidate is ignored in valuing a transfer among family members if the transferor and family members control the corporation or partnership and the restriction either lapses after the transfer or can be removed by the transferor or members of his family either alone or collectively example ---mother and son are partners in a two- person partnership the partnership_agreement provides that the partnership cannot be terminated mother dies and leaves her partnership_interest to daughter as the sole partners daughter and son acting together could remove the restriction on partnership_termination under the conference agreement the value of mother's partnership_interest in her estate is determined without regard to the restriction such value would be adjusted to reflect any appropriate fragmentation discount this rule does not apply to a commercially reasonable restriction which arises as part of a financing with an unrelated party or a restriction required under state or federal_law the provision also grants to the treasury secretary regulatory authority to disregard other restrictions which reduce the value of the transferred interest for transfer_tax purposes but which do not ultimately reduce the value of the interest to the transferee the foregoing as background we return to our analysis sec_2704 b a broadly defines an applicable_restriction as any restriction which effectively limits ability of the corporation or partnership to liquidate sec_2704 b b excepts from the definition of an applicable_restriction any restriction on liquidation imposed or required to be imposed by any federal or state law however -- - in what we view as an expansion of the exception contained in sec_2704 b b the secretary promulgated sec_25 b gift_tax regs which states in pertinent part an applicable_restriction is a limitation on the ability to liquidate the entity in whole or in part that is more restrictive than the limitations that would apply under the state law generally applicable to the entity in the absence of the restriction thus the question arises whether the partnership agreements involved herein impose greater restrictions on the liquidation of kflp and kilp than the limitations that generally would apply to the partnerships under state law section dollar_figure of the partnership agreements states in pertinent part that the partnerships shall dissolve and liquidate upon the earlier of december or by agreement of all the partners petitioners direct our attention to trlpa section which provides that a texas limited_partnership shall be dissolved on the earlier of the occurrence of events specified in the partnership_agreement to cause dissolution the written consent of all partners to dissolution the withdrawal of a general_partner or entry of a decree of judicial dissolution trlpa section dollar_figure provides that following the dissolution of a limited_partnership the partnership's affairs shall be wound up including the liquidation of partnership assets as soon as reasonably practicable -- -- on the basis of a comparison of section dollar_figure of the partnership agreements and trlpa section we conclude that section dollar_figure of the partnership agreements does not contain restrictions on liquidation that constitute applicable restrictions within the meaning of sec_2704 we reach this conclusion because texas law provides for the dissolution and liquidation of a limited_partnership pursuant to the occurrence of events specified in the partnership_agreement or upon the written consent of all the partners and the restrictions contained in section dollar_figure of the partnership agreements are no more restrictive than the limitations that generally would apply to the partnerships under texas law consequently these provisions are excepted from the definition of an applicable_restriction pursuant to sec_2704 b b and sec_25_2704-2 gift_tax regs respondent counters that we should compare the restrictions contained in section dollar_figure of the partnership agreements with trlpa section which provides a limited_partner may withdraw from a limited_partnership at the time or on the occurrence of events specified in a written partnership_agreement and in accordance with that written partnership_agreement if the partnership_agreement does not specify such a time or event or a definite time for the dissolution and winding up of the limited_partnership a limited_partner may withdraw on giving written notice not less than six months before the date of withdrawal to each general_partner respondent's reliance on trlpa section dollar_figure is misplaced trlpa section dollar_figure governs the withdrawal of a limited_partner from the -- - partnership----not the liquidation of the partnership trlpa section dollar_figure sets forth limitations on a limited partner's withdrawal from a partnership however a limited_partner may withdraw from a partnership without requiring the dissolution and liquidation of the partnership in this regard we conclude that trlpa section dollar_figure is not a limitation on the ability to liquidate the entity within the meaning of sec_25_2704-2 gift_tax regs respondent's position herein is inconsistent with sec_25_2704-2 example gift_tax regs which states in pertinent part d owns a percent interest and each of d's children a and b owns a percent interest in general_partnership x the partnership_agreement requires the consent of all the partners to liquidate the partnership under the state law that would apply in the absence of the restriction in the partnership_agreement the consent of partners owning percent of the total partnership interests would be required to liquidate xx x the requirement that all the partners consent to the liquidation is an applicable_restriction significantly the restriction on liquidation in the partnership_agreement described in the example was not compared with a state law provision such as trlpa section pertaining to withdrawal from a partnership rather the terms of the partnership_agreement are compared with a partnership_liquidation provision similar to trlpa section with these points in mind we reject respondent's argument regarding trlpa section we are mindful that the secretary has been vested with broad regulatory authority under sec_2704 however the - al --- regulations in place do not support a conclusion that the disputed provisions in the kflp and kilp partnership agreements constitute applicable restrictions conclusion in sum we hold that petitioners transferred limited_partnership interests to the grat’s trustees however consistent with the preceding discussion we conclude that section dollar_figure of the partnership agreements does not contain an applicable_restriction within the meaning of sec_2704 accordingly we will grant petitioners' motion for partial summary_judgment as it pertains to this issue to reflect the foregoing an order granting petitioners’ motion for partial summary_judgment will be issued as it relates to the sec_2704 b issue


internal_revenue_service number release date index number --------------------------------- ------------------------------- ---------------------------- ----------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ----------------------- id no ------------- telephone number --------------------- refer reply to cc psi b03 plr-149695-08 date february legend legend company ------------------------------------------------------------------------------------------- ------------------------- shareholder1 ------------------------------------------------------------------------------------------- ------------------------ shareholder2 ------------------------------------------------------------------------------------------- --------------------------- individual date1 state ------------------------------------------------------------------------------------------- --------------------------- ------------------ --------------- dear -------------- this letter responds to a letter dated date and subsequent correspondence submitted on behalf of company requesting a ruling under sec_1362 of the internal_revenue_code facts company was incorporated under the laws of state on date1 company elected to be treated as an s_corporation effective date1 upon incorporation company had two shareholders shareholder1 and shareholder2 shareholder1 is a corporation that elected to be treated as an s_corporation and thus is not an eligible s_corporation shareholder under sec_1361 upon discovery of the ineffective s_corporation plr-149695-08 election shareholder1’s shares in company were distributed to individual shareholder1’s sole shareholder company represents that company and its shareholders have at all times intended company to be an s_corporation and have treated company consistent with this intent company also represents that company and its shareholders have reported their income consistent with company being an s_corporation company represents that other than the ineligibility of shareholder1 to be a shareholder of company company has met the definition of an s_corporation under sec_1361 company and all of its shareholders consent and agree to make any adjustments consistent with the treatment of company as an s_corporation as may be required by the secretary under sec_1362 law and analysis sec_1361 provides that the term s_corporation means with respect to any taxable_year a small_business_corporation for which an election under sec_1362 is in effect for such year sec_1361 provides that a small_business_corporation cannot have as a shareholder a person other than an estate a_trust described in sec_1361 or an organization described in sec_1361 who is not an individual sec_1362 provides in part that a small_business_corporation may elect to be an s_corporation sec_1362 provides that an election under sec_1362 shall be terminated whenever at any time on or after the 1st day of the 1st taxable_year for which the corporation is an s_corporation such corporation ceases to be a small_business_corporation sec_1362 provides in part that if an election under sec_1362 by any corporation was not effective for the taxable_year for which made determined without regard to sec_1362 by reason of a failure to meet the requirements of sec_1361 or to obtain shareholder consents the secretary determines that the circumstances resulting in such ineffectiveness were inadvertent no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness steps were taken so that the corporation is a small_business_corporation and the corporation and each person who was a shareholder in the corporation at any time during the period specified pursuant to sec_1362 agrees to make such adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary with respect to such ineffective period then notwithstanding the circumstances resulting in the ineffectiveness the corporation shall be treated as an s_corporation during the period specified by the secretary plr-149695-08 conclusion based on the information submitted and representations made we conclude that company’s s_corporation_election was ineffective because shareholder1 was an ineligible s_corporation shareholder under sec_1361 we further conclude that the invalid election was inadvertent within the meaning of sec_1362 under sec_1362 company will be treated as if it were an s_corporation from date1 and thereafter provided that individual is treated as being the owner of shareholder1’s stock in company from date1 and thereafter accordingly company’s shareholders in determining their respective income_tax liabilities during the termination period and thereafter must include their pro_rata share of the separately and non- separately_computed_items of company as provided in sec_1366 make any adjustments to stock basis as provided in sec_1367 and take into account any distributions made by company as provided by sec_1368 if company or any of the shareholders fail to treat company as described above this ruling shall be void except as expressly provided herein no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter specifically no opinion is expressed or implied concerning whether company otherwise qualifies an s_corporation this ruling is directed only to the taxpayer requesting it sec_6110 of the code provides that it may not be used or cited as precedent pursuant to a power_of_attorney on file with this office we are sending a copy of this letter to your authorized representative sincerely s leslie h finlow senior technician reviewer branch office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes cc


t c memo united_states tax_court james t and tiffany a manning petitioners v commissioner of internal revenue respondent docket no filed date farley p katz and charles j muller iii for petitioners daniel n price for respondent memorandum findings_of_fact and opinion kroupa judge respondent determined a dollar_figure deficiency in petitioners’ federal_income_tax for and a dollar_figure accuracy-related_penalty under sec_6662 1all section references are to the internal_revenue_code in effect for the year at issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated after concessions we are left to decide three issues the first issue is whether payments james manning petitioner made to warrior fund llc warrior are deductible under sec_162 we hold the payments are deductible because they are ordinary and necessary business_expenses in so holding we also hold that the payments are not illegal payments under sec_162 nor are they barred from deductibility under the economic_substance_doctrine the second issue is whether petitioner generated taxable gains as a trading agent of a warrior subaccount we hold he did not because the gains belonged to warrior not petitioner the third issue is whether petitioners are liable for the accuracy-related_penalty under sec_6662 we hold that petitioners are not liable for an accuracy-related_penalty findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts supplemental stipulation of facts second supplemental stipulation of facts and their accompanying exhibits are incorporated by this reference petitioners are husband and wife who resided in texas at the time they filed the petition petitioners timely filed a joint federal_income_tax return for 2respondent concedes that petitioners are not taxable on dollar_figure in unreported gross_receipts or sales and that petitioners are entitled to deduct dollar_figure in professional fees petitioners concede they mistakenly deducted dollar_figure in commission rate adjustments in that were actually paid in petitioner’s career as a day trader petitioner received a bachelor’s degree in business management from southwest texas state university in shortly thereafter he entered the high-paced day trading industry day traders use software to track stock values and may trade hundreds of thousands of shares per day trying to profit from minute-to-minute changes in their value day trading is extremely risky and often results in substantial financial losses in a short time in fact many day traders buy on borrowed money increasing their risk beyond their invested capital the securities_and_exchange_commission sec warns that day traders should be prepared to lose their entire investment because of the risk of large and immediate financial losses petitioner however beat the odds and consistently made money as a day trader despite his success petitioner began to desire a more stable and less stressful job when his first child was born he began to coach other traders in while continuing to trade his own account petitioner mastered how the day trading business operates during this time petitioner then decided to open his own business and began negotiations with assent llc assent the largest national broker-dealer that provided direct-access electronic trading and other services to day traders petitioner became the initial branch manager and general securities principal gsp of assent’s office in austin texas branch office petitioner operated the branch office through a wholly owned entity james t manning llc a disregarded_entity for federal_income_tax purposes petitioner leased the offices and provided computers monitors and extremely fast t-1 lines for internet connection at the branch office petitioner’s duties as branch manager included handling compliance matters for the branch office and supervising the traders petitioner was also a class b member of assent class b members act as group leaders and recruit business to assent assent compensated petitioner for his work as a class b member by permitting him to share in the commissions generated by branch office customers petitioner was not separately compensated for serving as branch manager assent’s commission arrangement with petitioner assent charged its customers for various services including commissions on executed trades petitioner negotiated the commission rates with the customers and the customers paid the commissions directly to assent assent charged commissions as an amount per big_number shares of stock purchased or sold ie dollar_figure per big_number shares assent kept a portion of the customers’ commissions and paid the rest to petitioner assent’s commission rate was tied to the volume of shares traded through the branch office assent lowered its commission rate when the branch office reached certain tiers in the volume of shares traded all shares traded through the branch office were charged the lower rate once the share volume reached the next volume tier petitioner’s business model focused on increasing the branch office’s trading volume thereby lowering assent’s commission rate and allowing petitioner more flexibility to negotiate commissions with branch office customers accordingly petitioner actively recruited customers who were group leaders with multiple traders trading under them for example petitioner recruited mike kestler and jonathan kirkland group leaders affiliated with a different branch office of assent other group leaders were organized as limited_liability companies llcs petitioner recruited vantage capital llc vantage and warrior two high-volume llcs to trade through the branch office these llcs opened a main account with assent individual traders who were members of the llcs acted as designated trading agents and traded the funds in the main account their trading activity was tracked through individual subaccounts for accounting purposes petitioner negotiated with group leaders to determine the commission rates for each of their trading agents and these rates were assigned to the trader’s subaccount when a designated trading agent executed a trade assent would charge the llc the negotiated commission rate for that subaccount in addition petitioner brought in many individual accounts commission rate adjustments the llcs and the group leaders sought the lowest possible commission rates because they traded huge volumes of shares the branch office competed against firms nationwide to attract and keep these customers petitioner could request that assent make a commission rebate to a customer who demanded lower commissions assent routinely made commission rebates where the customer exceeded certain target levels set by a gsp or a branch manager assent required gsps and branch managers to process requests for commission rebates on an assent form petitioner requested that assent make rebates to customers on a number of occasions but they were not happy with the time it took assent to process the requests petitioner began to make payments directly to customers from his share of the commissions commission rate adjustments to keep them happy assent would have made any rebates petitioner requested provided they did not affect assent’s share of the branch office income accordingly the economics were identical for all parties whether assent processed a commission rebate or petitioner made a commission rate adjustment petitioner made commission rate adjustments for warrior vantage mr kirkland and mr kestler that depended on their trading volume warrior was the branch office’s largest customer and generated most of the branch office’s trading volume assent charged warrior an average commission of dollar_figure to dollar_figure per thousand shares traded assent kept dollar_figure as profit and paid petitioner the remaining amount petitioner agreed to make commission rate adjustments so that warrior’s net commission rate would be about dollar_figure per thousand shares traded accordingly petitioner’s net_earnings were about cents per thousand shares traded after commission rate adjustments petitioner reported the commission rate adjustments as commission adjustments on forms 1099-b proceeds from broker and barter_exchange transactions issued to each customer petitioner then deducted dollar_figure as commissions on the schedule c profit or loss from business for warrior reported all the commission rate adjustments it received as income for tax purposes petitioner maintained his books_and_records for on quickbooks petitioner wife’s mother vicki mcgee entered all the source data including checks ms mcgee mistakenly recorded two commission rate adjustments as paid on date even though petitioner actually paid them on date richard springer a certified_public_accountant prepared petitioners’ tax_return for petitioner believed that the records he provided to mr springer were accurate and they were accurate with the exception of the two commission rate adjustments that were paid in john manning and warrior john manning petitioner’s brother was a day trader with the midas touch he partnered with several day traders who desired to work with him because of his success he formed warrior in to consolidate his multiple trading partnerships under one common entity petitioner’s brother provided most of warrior’s capital from his own funds and various loans petitioner lent his brother dollar_figure to help fund the initial trading partnerships and warrior took over this debt petitioner became a preferred member of warrior giving him a priority right to repayment of the dollar_figure loan principal at a 5-percent interest rate petitioner had no right of control or management as a result of his interest warrior’s books reflected that petitioner did not share in its profits or losses petitioner received dollar_figure in interest from warrior in and he reported it petitioner continued to receive interest until the full principal was repaid the trading partners became designated trading agents of warrior each designated by a separate subaccount the trading agents were authorized to act as agents on warrior’s behalf all gains or losses on the warrior account belonged to the entity itself subject_to negotiated subaccount profit splits warrior entered into written agreements with the trading agents setting out the terms of the profit splits these terms depended on the amount of capital contributed by the individual trader if any and the trader’s experience warrior issued schedules k-1 member’s share of income credits deductions etc to its members reporting their income from profit-splitting agreements petitioner occasionally traded a warrior subaccount during his downtime to keep a presence in and check the pulse of the market his trading activity generated gains of dollar_figure during warrior was entitled to all profits generated in the subaccount petitioner invested no money in the main warrior account had no interest in the subaccount gains and never received any of those gains events after losing significant customers to better commission rates including vantage mr kirkland and mr kestler petitioner decided to reevaluate his business model petitioner had also lost individual customers who left to trade through llcs like vantage or warrior petitioner discussed changing his business structure with his brother in petitioner had found two new scanning software programs which he believed could substantially increase warrior’s trading profits petitioner advised his brother to purchase all rights to both programs and warrior did for dollar_figure each by purchasing all rights to that software warrior completely controlled it and no competitors could use it warrior’s profitability and volume increased as a result of the new software and its retention of traders improved petitioner agreed to supervise and maintain the new software for a split of warrior’s profits petitioner received no interest in warrior’s capital however assent’s compliance since assent has been subject_to numerous reviews by self-regulatory organizations sros like the national association of securities dealers nasd and various exchanges and has an excellent compliance record no complaints were ever filed by customers against the branch office or against petitioner assent’s director of compliance periodically conducted compliance reviews of the branch office and concluded that the office was generally in compliance with assent’s requirements assent has never sanctioned petitioner nor has petitioner been sanctioned by or had adverse determinations from the sec or the texas securities board genesis of respondent’s investigation despite petitioner’s excellent compliance record respondent challenges the commission rate adjustments petitioner paid to warrior respondent questioned the commission rate adjustments after investigating petitioner’s brother concerning his tax reporting position that he was a resident_of_the_united_states virgin islands usvi from through petitioner’s brother established residency in the usvi because he was persuaded that he could obtain significant tax benefits by moving there and participating in a statutory economic development program he entered into various agreements with the march group lllp a virgin islands limited_liability partnership to facilitate obtaining these tax benefits petitioner’s brother received all warrior’s income from his trading gains shares of the gains generated by other warrior traders and commission rate adjustments from petitioner he reported on the usvi returns all warrior’s income that flowed through to him through various entities except for some payments that went to the march group in addition petitioner’s brother claimed a 90-percent economic development tax_credit he stopped claiming usvi residency in when guidance was released that challenged the tax benefits he was receiving respondent issued petitioners a deficiency_notice for as a result of the investigation into his brother’s alleged tax sheltering activities in the usvi respondent’s determinations treat the commission rate adjustments paid to warrior differently from those paid to other customers because petitioner’s brother ultimately received the payments and reported them as income in the usvi petitioners timely filed a petition i introduction opinion we must now determine whether petitioner took part in his brother’s alleged tax sheltering activities in the manner alleged by respondent respondent’s determinations depend on the premise that petitioner made commission rate adjustments to warrior only to lower petitioner’s taxable_income and that these payments were funneled back to petitioner in later years we ultimately conclude that the record does not support respondent’s determinations we first address the burden_of_proof we then determine whether petitioner’s commission rate adjustments to warrior are deductible by petitioner as ordinary and necessary business_expenses under sec_162 in doing so we decide whether the commission rate adjustments were illegal payments under sec_162 or lacked economic_substance we then turn to whether petitioners must include warrior subaccount gains in gross_income we finally address whether petitioners are liable for an accuracy-related_penalty under sec_6662 ii burden_of_proof the parties disagree as to whether the burden_of_proof shifted to respondent under sec_7491 the commissioner’s determinations in the deficiency_notice are generally presumed correct and the taxpayer has the burden of proving that the commissioner’s determinations are in error rule a 290_us_111 at trial we granted petitioners’ motion to shift the burden_of_proof to respondent under sec_7491 because we found that they introduced credible_evidence substantiated items maintained required records and fully cooperated with respondent’s reasonable requests see sec_7491 and b we stand by our ruling accordingly respondent bears the burden_of_proof as to all issues relevant to petitioners’ liability for the deficiency 3the parties agree that respondent bears the burden_of_proof concerning new issues under rule and whether the commission rate adjustments were illegal payments under sec_162 respondent also bears the burden of production concerning the accuracy-related_penalty see sec_7491 4the court invited the parties to address this issue on brief we have carefully reviewed the parties’ arguments and stand by our ruling that petitioners’ challenge of a summons in federal district_court and motion for protective_order in the tax_court reflected petitioners’ legitimate discovery concerns see kohler v commissioner tcmemo_2006_152 iii deductibility of petitioner’s payments to warrior we now address whether petitioner’s commission rate adjustments to warrior are deductible under sec_162 initially we note that respondent allowed deductions to petitioner for similar payments to vantage mr kirkland and mr kestler respondent disallowed deductions for the payments to warrior under several theories involving the relationship between petitioner and his brother respondent’s primary argument is that petitioner’s payments to warrior are not deductible under sec_162 because the payments were not ordinary and necessary business_expenses respondent also makes two alternative arguments against deductibility respondent first argues that petitioner is barred from deducting the payments because they are illegal payments under sec_162 respondent then argues that the payments are not deductible because the transactions lack economic_substance we address each of respondent’s arguments in turn a ordinary and necessary business_expenses tax deductions are a matter of legislative grace and taxpayers must satisfy the specific statutory requirements for the item claimed rule a 503_us_79 292_us_435 a taxpayer is generally permitted to deduct all ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business sec_162 the determination of whether an expenditure satisfies the requirements for deductibility under sec_162 is a question of fact see 320_us_467 in general an expense is ordinary if it is considered normal usual or customary in the context of the particular business out of which it arose see 308_us_488 generally an expense is necessary if it is appropriate and helpful to the operation of the taxpayer’s trade_or_business see 383_us_687 83_tc_356 affd 777_f2d_662 11th cir respondent argues that petitioner’s commission rate adjustments to warrior were not ordinary because the payments ran contrary to assent’s written policies and the regulatory framework in which assent operated we disagree it is common in the day trading industry to lower commissions to attract and retain customers assent a large nationwide broker-dealer servicing day traders routinely made commission rebates when requested by a gsp or a branch manager petitioner began making direct commission rate adjustments for several customers when they complained of the untimeliness of assent’s commission rebates whether petitioner or assent paid the commission rebates did not change the economics customers demanded that their commissions be lowered and petitioner 5the parties agree that three-cornered transactions between assent petitioner and assent’s customers are not rebates for tax purposes and are subject_to the rules of deductibility negotiated the commission rate adjustments at arm’s length to keep them respondent does not challenge the ordinary nature of payments made to vantage mr kirkland or mr kestler only those made to warrior warrior was the branch office’s biggest customer and generated significant trading volume petitioner was aware that warrior could demand a very low commission rate elsewhere in addition petitioner hoped warrior’s trading would cause the branch office to meet certain volume tiers lowering assent’s commission rate petitioner could then have the flexibility to lower commissions and attract more traders the commission rate adjustments are expenses that would be expected of someone trying to increase and maintain business in the highly competitive world of day trading this is true regardless of whether the customer is warrior mr kirkland mr kestler or vantage accordingly we hold petitioner’s payments to warrior were ordinary expenses for sec_162 purposes see corrigan v commissioner tcmemo_2005_119 respondent further argues that the payments were not necessary because customers chose assent for reasons beyond the commission rates including assent’s software and because petitioner could have processed commission rate adjustments through assent again we disagree petitioner has satisfied the court that commission rates were the most critical element to customers petitioner eventually lost mr kirkland mr kestler and vantage as customers when they found better commission rates elsewhere further petitioner did not use the assent form to process volume rebate credits because his customers were dissatisfied by the untimeliness of these payments an expense may be necessary even where the taxpayer could have avoided it by pursuing a different course of conduct 708_f2d_1043 6th cir petitioner’s payments were appropriate and helpful to keep customers trading through the branch office given the highly competitive nature of the day trading industry accordingly we hold that petitioner’s payments to warrior were necessary for sec_162 purposes b illegal payments under sec_162 we now turn to whether petitioner’s commission rate adjustments to warrior while ordinary and necessary are not deductible because they are illegal payments under sec_162 respondent argues that petitioner’s payments to warrior are illegal payments under sec_162 because they were made in violation of federal_law implemented by nasd rule deductions are not allowed for payments that constitute an illegal_bribe an illegal kickback or other illegal payment under any law of the united_states the term laws of the united_states includes only federal statutes including state laws which are assimilated into federal_law by federal statute and 6we do not address whether an nasd rule can properly be considered a law of the united_states as it is unnecessary to our holding legislative and interpretive regulations thereunder sec_1 a income_tax regs the term is further limited to statutes that prohibit some act or acts for the violation of which there is a civil or criminal_penalty sec_1_162-18 income_tax regs respondent bears the burden of establishing by clear_and_convincing evidence that the commission rate adjustments constitute illegal payments see sec_162 sec_7454 rule b the nasd is a nonprofit delaware corporation registered with the sec as a national securities association the nasd serves as an sro subject_to extensive oversight supervision and control by the sec on an ongoing basis see u s c sec_78s nasd conduct rule provides a member in the conduct of its business shall observe high standards of commercial honor and just and equitable principles of trade respondent argues that petitioner’s payments to warrior were commission-sharing payments that violated nasd rule and subjected him to sanction or suspension by the nasd see dept of enforcement v ryerson complaint no c9b040033 n a s d r date holding that an nasd member violated rule when the member shared commissions with an unlicensed person who directed customers to him 7an organization’s bylaws and rules must conform to the securities exchange act of as amended to become a registered securities association u s c sec_78o-3 b respondent’s argument is misplaced first petitioner returned commissions paid_by warrior a customer to ensure that warrior continued trading through the branch office these payments were not commission-sharing payments made in return for referrals of business as in dept of enforcement v ryerson supra respondent has not otherwise met his burden of showing by clear_and_convincing evidence that petitioner’s commission rate adjustments would be classified by the nasd as commission-sharing payments or that these payments would result in petitioner’s being subject_to a civil or criminal_penalty or losing his license in fact no adverse compliance determinations were made against petitioner by assent the nasd or the sec regarding these payments further deductions are barred under sec_162 for payments that are illegal in and of themselves 41_fedclaims_134 there must be a federal or state law that the payment specifically violates id pincite the relevant statute or regulation must prohibit some act or acts sec_1_162-18 income_tax regs respondent cites no statute or regulation specifically prohibiting petitioner’s payments but relies only on a general_rule requiring ethical conduct we conclude that the payments to warrior are not illegal per se accordingly we hold that respondent has not proven by clear_and_convincing evidence that petitioner’s commission rate adjustments were illegal within the meaning of sec_162 c economic_substance we now turn to respondent’s argument that petitioner’s payments to warrior are not deductible because they lacked economic_substance the effect of disregarding a transaction for lack of economic_substance is that for taxation purposes the transaction is viewed to have never occurred at all klamath strategic inv fund llc v united_states __ f 3d __ __ 5th cir date slip op pincite see also 113_tc_254 affd 254_f3d_1313 11th cir accordingly deductions are generally prohibited for expenditures in furtherance of a transaction that is disregarded for lack of economic_substance klamath strategic inv fund llc v united_states supra at __ slip op pincite winn-dixie stores inc v commissioner supra pincite respondent argues that petitioner and john manning entered into a symbiotic business relationship intended to produce mutual tax benefits in he contends petitioner’s payments to warrior were returned to petitioner in later years that are not before the court and argues that we should use the economic_substance_doctrine to disregard petitioner’s payments to warrior we have fully examined the evidence and find that it does not support respondent’s contention petitioner has produced credible_evidence and testimony accounting for all payments he received from warrior in and later years petitioner received a return of all principal plus interest on his dollar_figure loan by the end of petitioner also received a share of warrior’s profits in later years when he became responsible for operating and maintaining new trading software he convinced warrior to purchase we conclude that the profit-splitting arrangement was attributable to petitioner’s new responsibilities at warrior and not devised for tax_avoidance purposes petitioner properly reported his portion of warrior profits reflected on schedules k-1 for and later years and was taxed on these amounts respondent also argues that petitioner’s arrangement with warrior lacked economic_substance because it was not an arm’s- length arrangement he contends that low initial commissions rather than high initial commissions with the prospect of rebates would reflect an arm’s-length arrangement we have found however that these arrangements were common practice at assent petitioner has satisfied the court that the commission rate adjustments paid to warrior were necessary and legitimate business_expenses indistinguishable from those paid to unrelated parties these payments resulted in net commissions to warrior comparable to those warrior could have negotiated directly with assent or other broker-dealers there were no strings attached accordingly we hold that the deductibility of petitioner’s payments is not barred by the economic_substance_doctrine iv subaccount trading gains we now decide whether petitioner must include gains from a warrior subaccount in gross_income for gross_income includes all income from whatever source derived unless specifically excluded from gross_income sec_61 348_us_426 respondent argues that the subaccount gains are includable in petitioner’s gross_income because other warrior traders included gains generated in their respective subaccounts respondent ignores the facts the other warrior traders included their portions of subaccount gains in gross_income because they received these gains petitioner was not entitled to the gains nor did he receive them traders who were entitled to subaccount gains had written agreements with warrior setting the terms of the profit splits they also received schedules k-1 reflecting their portions of the subaccount gains petitioner had no agreement with warrior giving him rights to a share of the subaccount gains respondent has presented no evidence to the contrary and we find petitioner’s testimony credible as to this issue in fact respondent acknowledges that the subaccount belonged to warrior and that all gains generated in the subaccount were passed through a series of entities and ultimately to petitioner’s brother we conclude that petitioner had no ownership_interest in or rights to the subaccount and never received any funds from the subaccount accordingly we hold that petitioner is not required to include the subaccount trading gains in gross_income for v accuracy-related_penalty we finally consider whether petitioners are liable for an accuracy-related_penalty under sec_6662 petitioners are liable for an accuracy-related_penalty for any portion of an underpayment attributable to negligence or disregard of rules and regulations sec_6662 and b negligence includes any failure to make a reasonable attempt to comply with the provisions of this title and the term disregard includes any careless reckless or intentional disregard sec_6662 negligence also includes any failure by the taxpayer to keep adequate books_and_records or to substantiate items properly sec_1_6662-3 income_tax regs we have found for petitioners on all issues petitioners mistakenly deducted two commission rate adjustments in even though they were not in fact paid until the following year all of petitioners’ records were accurate and thorough except for this mistake in fact respondent conceded more than dollar_figure in alleged unreported deposits after considering the accuracy of petitioners’ records we find after considering all the facts and circumstances that petitioners are not liable for the accuracy-related_penalty under sec_6662 for 8respondent first raised the issue of whether the subaccount gains were includable in petitioner’s gross_income in the answer respondent therefore has the burden_of_proof as to this issue which we find respondent has not met in reaching our holdings we have considered all arguments made and to the extent not mentioned we conclude that they are moot irrelevant or without merit to reflect the foregoing and the concessions of the parties decision will be entered under rule


internal_revenue_service number release date index number ------------------------- --------------------------------------- ----------------------------- ----------------------------- - - department of the treasury washington dc third party communication none date of communication not applicable_person to contact --------------------- id no ------------- telephone number --------------------- refer reply to cc psi b02 plr-119895-05 date june this responds to a letter dated date submitted on behalf of x by its x -------------------------------------- ------------------------------ a -------------------- -------------------------------- d1 ------------------ dear ------------------ authorized representatives requesting a ruling under ' b of the internal_revenue_code to be an s_corporation effective d1 however no form_2553 election by a small_business_corporation was timely filed for x is made for any taxable_year after the date prescribed by ' b for making such election for such taxable_year or no such election is made for any taxable_year and b the secretary determines that there was reasonable_cause for the failure to timely make such election the secretary may treat such an election as timely made for such taxable_year sec_1362 of the code provides that if -- a an election under ' a a as president of x represents that x was incorporated on d1 and was intended except as specifically set forth above no opinion is expressed concerning the based solely on the facts and the representations submitted we conclude that x has established reasonable_cause for failing to make a timely election to be an s_corporation effective d1 accordingly provided that x makes an election to be an s_corporation by filing a completed form_2553 effective d1 along with a copy of this letter with the appropriate service_center within days from the date of this letter then such election will be treated as timely made for d1 federal tax consequences of the facts described above under any other provision of the code including whether x was or is a small_business_corporation under ' b of the code of the code provides that it may not be used or cited as precedent being forwarded to x’s authorized representative this ruling is directed only to the taxpayer who requested it sec_6110 pursuant to a power_of_attorney on file with this office a copy of this letter is sincerely j thomas hines chief branch associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes