JOURNAL - American College of Trust and Estate Counsel · 2018-06-21 · by the entirety ownership...

Table of ContentsVolume 34, No. 4, Spring 2009

Asset Protection and Tenancy by the Entirety . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 Fred Franke

A thorough discussion of tenancy by the entirety and its asset protection attributes.

A Letter About Investing to a New Foundation Trustee,with Some Focus on Socially Responsible Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 Joel C. Dobris

Sage investment advice provided to private foundation board members.

Business Succession Planning, Profits Interests and § 2701 . . . . . . . . . . . . . . . . . . . . . . . . . . 243 Richard B. Robinson

An analysis of use a partnership profits interest in estate planning.

McCord to Holman—Five Years of Value Judgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 Cynthia A. Duncan, John R. Jones, Jr., and James D. Spratt, Jr.

A detailed examination of expert determination of lack control and lack of marketabilitydiscounts in litigation.

Family Offices: Securities and Commodities Law Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284 Audrey C. Talley

Securities and commodities law issues affecting the design and implementation of afamily office.

Comparison of the Twelve Domestic Asset Protection Statutes . . . . . . . . . . . . . . . . . . . . . . . 293 David G. Shaftel

An up-to-date chart on domestic asset protection trust legislation.

THE AMERICAN COLLEGE OF TRUST AND ESTATE COUNSEL

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Marc A. Chorney, Editor / Charles A. Redd, Associate Editor / Turney Berry, Assistant Editor

34 ACTEC Journal 209 (2009)

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Editors’ Synopsis: This article first discusses thehistory and development of tenancy by the entirety, aform of concurrent ownership of property by spouses.The article then considers state variations of that formof ownership and treatment with respect to bankruptcylaw and federal tax liens. The article concludes withrecommendations for planning with tenancies by theentirety. The appendix to the article provides a usefulstate by state summary of asset protection aspects ofthe form of ownership.

I. The Historic Roots and Development ofTenancy by the Entirety

And therefore, if an estate in fee begiven to a man and his wife, they areneither properly joint-tenants, nortenants in common: for husband andwife are considered one person in law,they cannot take the estate by moi-eties, but both are seized of the entire-ty, per tout et non per my; the conse-quences of which is, that neither thehusband nor the wife can dispose ofany part without the assent of theother, but the whole must remain tothe survivor.1

Under Blackstone’s classic formulation, tenancyby the entirety ownership did not track other forms ofconcurrent ownership like joint tenancies or tenanciesin common. Rather, entirety property was ownershipwithout equal parts or shares (“moieties”). One mightassume that the absence of divisible shares meant thatneither husband nor wife had a separate, alienable

share. One might also assume that if “the whole mustremain to the survivor,” then the alienation of a sepa-rate interest would defeat the right of each spouse tothe survivorship of the whole.

The classic formulation of the tenancy is rootedin the theory that husband and wife constitute anindivisible unit: “An estate by the entireties is analmost metaphysical concept which developed at thecommon law from the Biblical declaration that a manand his wife are one.”2 In practice, however, thismetaphysical oneness collided with the restrictionsplaced on women, particularly married women, bythe common law:

A species of common-law concurrentownership, tenancy by the entiretiesdeveloped as part of the English feu-dal system of land tenures. The exi-gencies of feudalism demanded thatthe functions of ownership be vestedin males presumably capable of bear-ing arms in war. Women were lightlyregarded legally, especially marriedwomen—whose very identifies, inmost respects, were consideredmerged and lost in the personalities oftheir husbands. For purposes of prop-erty and contract, the married womanwas under a complete legal blackouttermed coverture. Man and wife wereone and the one was male.3

The husband’s dominance at common law was exten-sive. He, and he alone, had sweeping powers over theentireties property. He exclusively:

* Copyright 2009 by Fred Franke. All rights reserved. Theauthor wishes to acknowledge his daughter, Mimi Murray DigbyFranke, Esq., for her generous editorial assistance.

1 WILLIAM BLACKSTONE, COMMENTARIES ON THE LAWS OF

ENGLAND 182 (9th ed. 1783), quoted in Peter M. Carrozzo, Tenan-cies in Antiquity: A Transformation of Concurrent Ownership forModern Relationships, 85 MARQ. L. REV. 423, 437 (Winter 2001).The 9th edition, published posthumously, contained the first discus-sion of a husband and wife owning an estate by its entirety byBlackstone. Its editor justified the addition: “The editor judges itindispensible to preserve the author’s text intire. The alterationswhich will be found therein, since the publication of the last edition,

were made by the author himself, as may appear from a correctedcopy in his own handwriting.” Id. at 437 n.154. In his article, Mr.Carrozzo traces the tenancy by the entirety to as early as the thir-teenth century and characterizes Blackstone’s description of entitiesas “the first modern pronouncement.” Id. at 435-37. For anotherdescription of the evolution of the tenancy by the entirety, see alsoJohn V. Orth, Tenancy by the Entirety: The Strange Career of theCommon-Law Marital Estate, 1997 B.Y.U. L. REV. 35 (1997).

2 United States v. Gurley, 415 F.2d 144, 149 (5th Cir. 1969)(interpreting Florida law).

3 Oval A. Phipps, Tenancy by Entireties, 25 TEMP. L. Q. 24,24 (1951) (emphasis added).

Asset Protection and Tenancy by the Entiretyby Fred Franke

Annapolis, Maryland*


(1) had the privilege and power tooccupy the principal and to consumethe income of the entire asset; (2) hadpower to manage, control, and exter-nally dispose of possession and ofincome during the marriage; (3) hadthe benefit alone of all the assets for theuse as a basis of credit, his possessoryand his contingent survivorship inter-ests being subject to attachment for hisdebts while not for those of the wife;(4) was alone entitled to represent theasset or any part thereof in litigation.4

The husband’s control over the property was a con-trol over its economic value during his lifetime. Thispower did not extend, however, to alienating the sur-vivorship interest. The tenancy by the entireties wasinseparable from the married unit even though it wasdominated by the husband during his lifetime. This sit-uation generally continued until the middle of the nine-teenth century when the women’s rights movementgained hold.5 As a consequence, Married Women’sProperty Acts were enacted by the various States.

Married Women’s Property Acts abrogated thedominance of a husband over his wife’s property, thusreversing the common law and bringing parity ofproperty rights to both spouses. These statutes forcedentireties tenancy to be re-examined: “The questionthen necessarily arose whether the husband’s powersand the wife’s disabilities, now abrogated, had beenincidents of the co-tenancy status or merely attributesof the marital status.”6

If the dominance/disability matrix was an essentialelement of the tenancy, then the various MarriedWomen’s Property Acts may be seen as being incompat-ible with, and therefore sweeping away, the tenancy

itself. “This view of the effect of the Married Women’sProperty Act—as abrogating entireties altogether—hasbeen expressly followed in at least nine states: Alabama,Colorado, Illinois, Iowa, Maine, Minnesota, New Hamp-shire, South Carolina, and Wisconsin.”7

Aside from the position that these acts effectivelyabolished tenancy by the entirety, two other generalresponses to the Married Women’s Property Acts arose:(1) to reinterpret the tenancy without the husband’sdominance and the wife’s disability; or (2) to deny thatthe new acts had any impact on the old form of the ten-ancy. Most states reinterpreted the tenancy by eitherprohibiting control or alienation of the property by onespouse through unilateral action or by giving eachspouse separate rights to control or alienate specificattributes of the property. The few jurisdictions thatinitially took the position that the Married Women’sProperty Acts did not impact the ancient attributes oftenancy by the entirety have now fallen into line withthose states adopting the tenancy to reflect the equalrights of married women to exercise property rights.8

It remains to be seen how entireties will develop inresponse to domestic partnership legislation and/ordeveloping case law recognizing same-sex civilunions. Entireties requires, of course, marriage as the“fifth unity” of the tenancy:

[C]ommon law requires five ‘unities’ tobe present: marriage—the joint ownersmust be married to each other; title—theowners must both have title to the prop-erty; time—they both must havereceived title from the same con-veyance; interest—they must have anequal interest in the whole property; andcontrol or possession—they both musthave the right to use the entire property.9

4 Id. at 25. Although this male control was sweeping, “Eng-lish equity courts early developed an institution of separate proper-ty for married women, which somewhat alleviated in specificinstances the harsh results of the common law dominance by thehusband—‘admitting the doctrine that a married woman is capableof taking real and personally estate to her own separate and exclu-sive use, and that she has also an incidental power to dispose of it.’”Id. at 26 quoting JOSEPH STORY, EQUITY JURISPRUDENCE §§ 1378,1402 (3d. ed. 1843).

5 See Carrozzo, supra note 2, at 439-40. The Seneca FallsDeclaration, for example, was published in 1848.

6 Phipps, supra note 4, at 28.7 Id. at 29. Interestingly, England abolished tenancy by the

entirety in 1925 by the Laws of Property Act in 1925. RICHARD R.POWELL, POWELL ON REAL PROPERTY, 52-54 (Michael A. Wolf, ed.2008). A limited form of entireties tenancy was re-established for“homestead property” by statute in Illinois after the initial aboli-tion. See Appendix.

8 Massachusetts, for example, followed the rule that the“husband was the one” for lifetime control of the entireties proper-ty until reversed by statute in 1980. See D’Ercole v. D’Ercole, 407F.Supp. 1377, 1382 (D. Mass. 1976). (“As was conceded [in anearlier case], the common law concept of tenancy by the entirety ismale oriented. It is true that the only Massachusetts tenancy tai-lored exclusively for married persons appears to be balanced infavor of males.”). See also Janet D. Ritsko, Lien Times in Massa-chusetts: Tenancy by the Entirety after Coraccio v. Lowell FiveCents Savings Bank, 30 NEW ENG. L. REV. 85 (1995) for a histori-cal prospective on the late-developing acknowledgement of equalproperty rights for women in Massachusetts. Compare the Com-ment in the Appendix regarding a similar late statutory reversal ofthe male domination of entireties in Michigan.

9 United States v. One Single Family Residence With OutBuildings Located at 15621 S.W. 209th Ave., Miami, Fla., 894 F.2d1511, 1514 (11th Cir. 1990) (interpreting Florida law).


Under Vermont’s civil union statute, parties to acivil union are able “to hold real and personal propertyas tenants by the entirety (parties to a civil union meetthe common law unity of person qualification for thepurposes of a tenancy by the entirety).”10 The New Jer-sey Tax Court recently held, however, that a valid Ver-mont civil union did not qualify a New Jersey same-sex couple to hold New Jersey property by theentireties.11 How, or whether, the various states willaccommodate entireties to the changing concepts ofdomestic relationships is uncertain. The earlyresponse appears to have similarities with the accom-modation of the Married Woman’s Property Acts andentireties a century and one-half ago.12

II. State Variations13

Those states reinterpreting tenancy by the entiretyto accommodate the Married Women’s Property Actsfollow one of two basic patterns: (1) re-establishingthe “oneness” of the tenancy so that neither spouse canact unilaterally; or (2) giving parity to the wife so thatshe also can alienate part of the tenancy during herlifetime. The survivorship element is generally main-tained, even in the latter model. From an asset protec-tion viewpoint, these states may be characterized aseither “full bar” jurisdictions or “modified bar” juris-dictions. In full bar jurisdictions, a creditor of onespouse does not acquire an attachable interest in theentireties property. Conversely, in a modified barjurisdiction, a creditor of one spouse enjoys somerights in the entireties property, but those rights mustaccommodate the non-debtor spouse’s interest.

Most states retaining the tenancy are full bar juris-dictions, holding that both spouses must act togetherto alienate the property.14 Hawaii was the last jurisdic-tion to examine the nature of the tenancy after theMarried Women’s Property Act, and it adopted a fullbar approach in Sawada v. Endo:

The effect of the Married Women’sProperty Acts was to abrogate thehusband’s common law dominance

over the marital estate and to placethe wife on a level of equality withhim as regards the exercise of owner-ship over the whole estate. The tenan-cy was and still is predicated uponthe legal unity of husband and wife,but the Acts converted it into a unityof equals and not of unequals as atcommon law. No longer could thehusband convey, lease, mortgage orotherwise encumber the propertywithout her consent. The Acts con-firmed her right to the use and enjoy-ment of the whole estate, and all theprivileges that ownership of propertyconfers, including the right to conveythe property in its entirety, jointlywith her husband, during the mar-riage relation. They also had theeffect of insulating the wife’s interestin the estate from the separate debtsof her husband.... Neither husbandnor wife has a separate divisibleinterest in the property held by theentirety that can be conveyed orreached by execution.15

The Sawada court held that the husband and wifecould convey their residence to their child free fromthe husband’s judgment creditor. After enactment ofthe Hawaii Married Women’s Property Act of 1888,therefore, the husband no longer had separate rightsthat could be subject to his sole debts.

Modified bar jurisdictions, on the other hand, per-mit a degree of creditor attachment of a debtorspouse’s interest. In Oregon, for example, the tenancyis viewed as a tenancy in common with an indestruc-tible right of survivorship. Thus, a creditor will havean interest in the rents and profits attributable to thedebtor spouse but no right of partition. If the non-debtor spouse is the survivor, the lien is extinguished.If the debtor spouse is the survivor, the property can besold to satisfy the lien.16

10 15 VT. STAT. ANN. § 1204(e)(1) (West 2008).11 Hennefeld v. Township of Montclair, 22 N.J. Tax 166, 188-

90 (2005). This decision was based, in part, on the more restrictiveNew Jersey Domestic Partnership Act.

12 For example, Carrozzo, supra note 2, sets out various possi-ble responses (abolition of the tenancy, altering the fifth unity toencompass civil unions, modification of the tenancy) which bear astriking resemblance to the responses of the various states to theMarried Woman’s Property Acts of the late 1800’s. Id. at 455-65.

13 This article’s Appendix includes a comparative chart ofthose states that recognize tenancy by the entirety.

14 See Appendix.15 Sawada v. Endo, 561 P.2d 1291, 1295 (Haw. 1977) (cita-

tions omitted). 16 Brownley v. Lincoln County, 343 P.2d 529, 531 (Or. 1959);

see also Hoyt v. American Traders, Inc., 725 P.2d 336, 337 n. 1 (Or.1986).


In addition to the full bar/modified bar distinction,those jurisdictions recognizing tenancy by the entiretydiffer as to whether the tenancy may be established forholding personal property. Most jurisdictions permitpersonal property to be held tenants by the entirety:

There has always been a controversyas to whether entireties doctrines hadany proper application to mere per-sonal property, which always could bedisposed of absolutely by the husband[under common law]; but there can beno doubt that in a majority of theUnited States [entireties doctrines]were early and consistently applied inappropriate cases to marital co-own-ership of any types of assets.17

Interestingly, even in full bar jurisdictions where theentireties doctrine applies to personal property, theentireties nature of a joint account is not necessarilydestroyed if one spouse may draw unilaterally fromthat account.18

Although the various entireties jurisdictions fol-low two clear patterns, the variations jurisdiction byjurisdiction are pronounced enough to require thatestate and/or asset protection planning involvingentireties property be rooted in the law of the appropri-ate jurisdiction.19 Given that many clients may ownproperties in multiple jurisdictions, the practitioner’stask can be complicated. In sum, estate and asset pro-tection planning involving entireties property must bejurisdiction specific.

III. Tenants by the Entirety and Bankruptcy

Generally, a debtor in bankruptcy can use statelaw creditor protection exemptions. As explained bythe Third Circuit Court of Appeals:

The Bankruptcy Code provides twoalternative plans of exemption. Under §522(b)(2), a debtor may elect the specif-ic federal exemption listed in § 522(d)

(“federal exemptions”) or, under §522(b)(3), may choose the exemptionspermitted, inter alia, under state law andgeneral (non-bankruptcy) federal law(“general exemptions”).... Debtors mayselect either alternative, unless a statehas “opted out” of the federal exemp-tions category.20

If the debtor uses the general exemptions, theentirety property is exempt to the extent permitted bythe non-bankruptcy law; the entireties shield is respect-ed “to the extent that such [entireties] interest… isexempt from process under applicable non-bankruptcylaw.”21 The applicable non-bankruptcy law appears tobe determined by the situs of real estate, not the domi-cile of the debtor. In In re Holland,22 for example, thebankruptcy court used Florida law to fully exempt non-residential property located in Florida when thedebtor’s home state of Illinois would have deniedexemption because the property was not a homestead.

In full bar states, of course, the property held bythe entireties is immune from process and fullyexempt if only one spouse is the debtor. Where, underapplicable state law, the creditors of one spouse canreach the property, it is not exempt. The nature ofapplicable state law restrictions thus determines thedegree of protection offered in bankruptcy:

“[In Massachusetts] [t]he debtor’sinterest in her [statutory] tenancy-by-the-entirety is subject to attachmentbut not subject to levy or execution atthis time and, so, the debtor’s right topossession cannot be interfered withunless and until the property is sold, ordebtor and her present spouse aredivorced, or she survives her spouse,in which event the trustee will be freeto enforce his interest in the debtor’sreal estate. The trustee has a real albeitcontingent interest in the real estate,while the debtor has an exemptionlimited by the trustee’s expectancy.”23

17 Phipps, supra note 4, at 25; see also Appendix. 18 See, e.g., Beal Bank, SSB v. Almond & Associates, 780

So.2d 45, 62 (Fla. 2001) (“[T]he ability of one spouse to make anindividual withdrawal from the account does not defeat the unity ofpossession so long as the account agreement contains a statementgiving each spouse permission to act for the other.”).

19 Some even argue that the dissimilarities between thosestates that continue to recognize entireties are so pronounced thatgeneralization is impossible. See POWELL, supra note 8, at 52-54.

20 In re Brannon, 476 F.3d 170, 174 (3d Cir. 2007). If a state

has opted out, the debtor must use the state exemptions. 21 Bankruptcy Code, 11 U.S.C. § 522(3)(B) (West 2008). 22 366 B.R. 825 (Bankr. N.D. Ill. 2007). 23 The Honorable Alan M. Ahart, The Liability of Property

Exempted in Bankruptcy for Pre-Petition Domestic Support Oblig-ations After BAPCPA: Debtors Beware, 81 AM. BANKR. L. J. 233,243-244 (2007), quoting In re McConchie, 94 B.R. 245, 247(Bankr. D. Mass. 1988). The discussion of Massachusetts lawinvolves law as applied to a principal residence.


Similarly, in Rhode Island a tenancyby the entirety is subject to attach-ment but not to levy and sale, whichmeans that a debtor who chooses stateexemptions can exempt entiretiesproperty to the extent that the debtorremains married or survives the non-debtor spouse. In Illinois, to theextent that a judgment creditor has ajudicial lien against a debtor’s contin-gent interests in tenancy by entiretyproperty arising out of a judgmentagainst the debtor, these interests maynot be immune from process andtherefore may not be exempt under §522(b)(3)(b). Similarly, in Tennesseebecause a debtor’s survivorship inter-est is not immune to execution, itremains in the bankruptcy estate eventhough the debtor’s interest in tenancyby entirety property is otherwiseexempt under Code § 522(b)(2)(3).24

Any exemption removes property from the bank-ruptcy estate: “An exemption is an interest withdrawnfrom the estate (and hence from the creditors) for thebenefit of the debtor.”25 First, however, all propertyinterests of the debtor come into such an estate,including a debtor’s interest in property held as a ten-ant by the entirety.26 Accordingly, a pre-petition trans-fer can cause financial disaster. The bankruptcy courtsin a majority of jurisdictions have held that the trusteecan avoid any pre-petition transfer of otherwiseexempt property.27 The fraudulent conveyance provi-sion of the Bankruptcy Code28 permits the debtor’s

interest in otherwise exempt entireties property thatwas transferred within two years of a bankruptcy peti-tion to be returned to the bankruptcy estate. Ifreturned, the property is likely no longer consideredentireties property.29

If the debtor is not filing for bankruptcy voluntari-ly, the debtor is at risk of the creditor forcing involun-tary bankruptcy within the avoidance period. Involun-tary bankruptcy unravels an intra-spousal or thirdparty transfer of entireties property. Involuntary peti-tioners, however, are not common:

Congress has made it quite difficultfor creditors to bring a successfulinvoluntary bankruptcy petition....Courts have been quite reluctant togrant involuntary bankruptcy peti-tions, interpreting the already strictstatutory requirements of involuntarybankruptcy “in a manner which vastlycomplicates creditors’ difficulties ofproof and, therefore, increases thecosts and risks associated with seek-ing bankruptcy relief....” Such deci-sions have made involuntary bank-ruptcy virtually useless to creditorsseeking to collect from opportunisticdebtors.30

Assuming a pre-petition transfer was not made,entireties property in a full bar jurisdiction will beexempted if none of the debts are joint debts: “Adebtor’s individual creditors [can] neither levy nor sella debtor’s undivided interest in the entireties propertyto satisfy debts owed solely by the debtor, because a

24 Id. (citations omitted). 25 Owen v. Owen, 500 U.S. 305, 308 (1991). 26 Brannon, 476 F.3d at 174 (quoting Napotnik v. Equibank &

Parkvale Savings Assoc., 679 F.2d 316, 318 (3d Cir.1982)); In reFord, 3 B.R. 559, 568 (Bankr. D. Md. 1980) aff’d, 638 F.2d 14 (4thCir. 1981) (“[E]ven property held to be exempt will initiallybecome property of the estate and will remain in the estate untilsuch time as the exemption is taken.”).

27 “The majority includes the Fourth, Sixth, Ninth, TenthCircuits, lower courts in the Seventh and Eighth Circuits, andsome lower courts in the First, Second, and Eleventh Circuits …The minority includes some lower courts in the First, Second andEleventh Circuits.” Dana Yankowitz, “I Could Have Exempted ItAnyway”: Can a Trustee Avoid a Debtor’s Prepetition Transfer ofExemptible Property?, 23 EMORY BANKR. DEV. J. 217, 227 n.54,55 (2006); see also Thomas E. Ray, Avoidance of Transfers ofEntireties Property—No Harm No Foul?, 25 ABI J., Sept. 2006,at 12.

28 11 U.S.C. § 548. There are also additional provisions per-mitting avoidance by the trustee.

29 See 11 U.S.C. § 522(g)(1)(A) (only involuntary transferscan be exempted); In re Swiontek, 376 B.R. 851, 865 (Bankr.N.D. Ill. 2007) (“A small number of courts that have analyzed thisissue within the context of property transferred pre-petition out ofa tenancy by the entirety estate, have permitted the trustee toavoid the transfer and have held that the property does not revertback into a tenancy by the entirety estate.”); In re Paulding, 370B.R. 11, 17-20 (Bankr. D. Mass. 2007) (holding that Chapter 7discharge can be denied when the debtor spouse transfersentireties property to the non-debtor spouse and then reversestransfer before filing the petition); In re Goldman, 111 B.R. 230,233 (Bankr. E.D. Mo. 1990) (“The parties are mistaken when theyassume that the property is conveyed back to the Debtor and hiswife as tenants by the entireties.”); In re Rotunda, 55 B.R. 386,388 (Bankr. W.D.Pa. 1985).

30 Elijah M. Alper, Opportunistic Informal Bankruptcy: HowBAPCPA May Fail to Make Wealthy Debtors Pay Up, 107 COLUM.L. REV. 1908, 1932 (2007), quoting Lawrence Ponoroff, Involun-tary Bankruptcy and the Bona Fides of a Bona Fide Dispute, 65IND. L.J. 315, 351 (1990) (other citations omitted).


debtor’s interest in tenancy by the entireties property isexempt from process under [the applicable statelaw].”31 Exemption may be available even if bothspouses file a petition jointly; the determinative factoris the nature of the debts.32

However, if the individual debtor-spouse files forbankruptcy and he or she has a joint debt with the non-filing spouse, the rule is markedly different. Remem-ber: entireties property is exempt to the extent that“such interest … is exempt from process under applic-able non-bankruptcy law.”33 If one spouse files forbankruptcy and there are joint debts, the entiretiesproperty is not exempt to the extent of those joint debts.

The existence of joint debt permits the trustee tosell the entireties property under the Bankruptcy Code,section 363(h).34 The power of sale permits the trusteeto use the entireties property’s equity to satisfy thejoint creditors.35 To the extent that entireties propertyexceeds the joint debt in value, however, such equitycontinues to be exempt.36

In modified bar jurisdictions that permit creditorattachment of one debtor-spouse’s interest, the proper-ty may be in jeopardy of sale. The Code’s power-of-sale provision gives the co-tenant who has not filed forbankruptcy procedural rights to object.37 Typically, ifthe creditor would not be prejudiced, courts will notpermit sale of entireties property.38

IV. Drye and Craft: Federal Tax Liens TrumpState-law Rights

A. A Close Look at Drye and CraftIn Drye v. United States,39 a unanimous U.S.

Supreme Court held that federal tax liens against anheir attached to the inheritance regardless of any dis-

claimer filed by the heir. Drye later became the basisfor United States v. Craft,40 where the Court breachedan entireties interest to satisfy a federal tax lien leviedagainst one of the spouses.

Drye resolved the question of whether dis-claiming an inheritance under state law prevents feder-al tax liens from attaching to that interest. In Drye, aninsolvent heir validly disclaimed his inheritance underArkansas state law.41 The Government argued that,because a lien is imposed on any and all “property” or“rights to property” belonging to the taxpayer to satis-fy tax debts owed, it was entitled to a lien on the heir’sinheritance, disclaimer notwithstanding.42

In deciding the controversy, the Court looked“initially to state law to determine what rights the tax-payer has in the property the Government seeks toreach, then to federal law to determine whether thetaxpayer’s state-delineated rights qualify as “property”or “rights to property” within the compass of the fed-eral tax lien legislation.”43 Justice Ginsburg expound-ed upon this “division of competence” between stateand federal law: state law determines whether the tax-payer has a legally protected property right; federallaw determines whether a lien can attach.44 She usedtwo telling examples, both dealing with insurance, tomake her point. In the first situation, the taxpayer’sright to the cash surrender value was exposed to thefederal tax lien because the taxpayer (but not his ordi-nary creditors) could compel payment of the cash sur-render value.45 That right to the cash surrender valuewas “property” or a “right to property” created understate law. For federal tax lien purposes, the taxpayer’sright to receive that value meant that the tax lienattached regardless of the state law that shielded thecash surrender value from creditors’ liens. In the other

31 In re Greathouse, 295 B.R. 562, 564 (Bankr. D. Md. 2003)(quoting In re Bell-Breslin, 283 B.R. 834, 837 (Bankr. D. Md.2002)).

32 Bunker v. Peyton, 312 F.3d 145, 152 (4th Cir. 2002).33 11 U.S.C. § 522(3)(B). 34 See 11 U.S.C. § 363(h). 35 Greathouse, 295 B.R. at 565. 36 In re Maloney, 146 B.R. 168, 171-72 (Bankr. W.D. Pa. 1992).

Allowing the debtor-spouse’s share of the entireties property to beavailable to joint creditors only once that interest becomes subject to §363(h) has been criticized. See, e.g., Lawrence Kalevich, SomeThoughts on Entireties in Bankruptcy, 60 AM. BANKR. L. J. 141 (1986)(arguing that the debtor-spouses’ entire interest in the entireties prop-erty should be generally available for creditors). Some courts haveapplied the excess funds to individual creditors. Steven Chaneles, Ten-ancy by the Entireties: Has the Bankruptcy Court Found a Chink inthe Armor?, 71 FLA. B. J., Feb. 1997, at 22, 24 & n.16.

37 See In re Wickham, 127 B.R. 9, 10-11 (Bankr. E.D. Va. 1990).38 See In re Monzon, 214 B.R. 38, 48 (Bankr. S.D. Fla. 1997)

(“[A] single oversecured joint debt will not trigger administration

of [the entireties property]. However, the presence of an unsecuredor undersecured joint debt will subject entireties property toadministration by a Trustee…”); Gary Norton, Sales and Co-own-ers: Cautionary Tales from the Cases, 24 ABI J., Nov. 2005, at 22(discussing the balancing test employed by the courts in determin-ing whether to permit a sale under § 363(h)). In one case high-lighted in Norton’s article, In re Marks, the court found that §363(h) could not apply without eviscerating the entire notion of atenancy by the entirety. No. Civ. A. 00-524, 2001 WL 868667, at*3 (E.D. Pa. June 14, 2001). Other cases have been less protectiveof the notion of entireties or of the non-filing spouse.

39 528 U.S. 49 (1999). 40 535 U.S. 274 (2002). 41 See 528 U.S. at 52. 42 Internal Revenue Code (“I.R.C.”), 26 U.S.C. § 6321(West

2008); see also id. at 54. 43 Id. at 58.44 Id. at 58-59. 45 Id., discussing United States v. Bess, 357 U.S. 51, 56-57

(1958).


situation (the death benefit), the tax lien did not attachbecause the taxpayer did not have access to thosefunds: “By contrast, we also concluded, again as amatter of federal law, that no federal tax lien couldattached to policy proceeds unavailable to the insuredin his lifetime.”46

In Drye, the heir had a “valuable, transferable,legally protected” property right to the inheritance atthe time of his mother’s death.47 Rather than personal-ly take this interest, the heir chose to channel his inter-est to close family members through the act of dis-claiming. The state law “relation back” which pro-duces the creditor protection does not inhibit the fed-eral taxing authority:

In sum, in determining whether a fed-eral taxpayer’s state-law rights consti-tute “property” or “rights to property,”“the important consideration is thebreadth of the control the taxpayercould exercise over the property.”Drye had the unqualified right toreceive the entire value of his mother’sestate (less administrative expenses)...or to channel that value to his daugh-ter. The control rein he held understate law, we hold, rendered the inher-itance “property” or “rights to proper-ty” belonging to him within the mean-ing of [the IRC], and hence subject tothe federal tax liens that sparked thiscontroversy.48

The pivotal factor was the heir’s control over effectiveenjoyment of the inheritance:

The disclaiming heir or devisee, incontrast [to someone merely declin-ing an offered inter vivos gift], doesnot restore the status quo, for thedecedent cannot be revived. Thus theheir inevitably exercises dominionover the property. He determines whowill receive the property—himself if

he does not disclaim, a known other ifhe does. This power to channel theestate’s assets warrants the conclusionthat Drye held “property” or a “rightto property” subject to the Govern-ment’s liens.49

Craft held that property held as tenants by theentirety is subject to a federal tax lien against onespouse. Craft may be seen as an extension of Dryebut, unlike Drye, it was a split decision with JusticesStevens, Scalia and Thomas dissenting. According toJustice O’Connor’s opinion for the Court, whether thelien attaches to one spouse’s interest in an entiretiestenancy is ultimately a question of federal law. In ana-lyzing this question, the Court followed the Dryeapproach: it looked first to state law to determine whatrights a taxpayer had in the specific property the gov-ernment sought; then it decided whether the taxpayer’srights qualified as property or rights to property underfederal law.50 Justice O’Connor concluded that thedebtor-taxpayer had a sufficient number of presently-existing “sticks” in the “bundle” comprising the ten-ants by the entirety property right to give rise to anattachable interest.51 Among others, these rightsincluded rights of possession, of income, and of saleproceeds if the non-debtor spouse agreed to the sale.52

Blackstone’s legal fiction, ingrained by state law, thatneither tenant had an interest separable from the otherdid not control the scope of the federal tax lien: “[I]fneither of them had a property interest in the entiretiesproperty, who did? This result not only seems absurd,but would also allow spouses to shield their propertyfrom federal taxation by classifying it as entiretiesproperty, facilitating abuse of the federal tax system.”53

Justices Stevens, Scalia and Thomas dissent-ed. Justice Thomas objected to what he saw as a fed-eralization of the law governing rights to property:

Before today, no one disputed that theIRS, by operation of § 6321, stepsinto the taxpayer’s shoes, and has thesame rights as the taxpayer in proper-ty or rights to property subject to the

46 Id.47 Id. at 60. 48 Id. at 61, quoting Morgan v. Commissioner, 309 U.S. 78, 83

(1940) (other citations omitted). 49 Id. at 61, citing Adam J. Hirsch, The Problem of the Insol-

vent Heir, 74 CORNELL L. REV. 587, 607-608 (1989). Two ACTECAcademic Fellows are cited in Drye: Adam Hirsch and Jeffrey Pen-nell. Adam Hirsch is cited generally to support the Court’s holding

(as seen above). Jeffrey Pennell is quoted for the basic propositionthat a “qualified” disclaimer under I.R.C. § 2518 does not precludethe federal tax lien from attaching because the statute only appliesfor gift or estate transfer tax purposes. See id. at 57 n.3.

50 535 U.S. at 278. 51 Id. at 285. 52 Id. at 282, 283. 53 Id. at 286.


lien. I would not expand the nature ofthe legal interest the taxpayer has inthe property beyond those interestsrecognized under state law.54

Justice Scalia added:

[A] State’s decision to treat the mari-tal partnership as a separate legal enti-ty, whose property cannot be encum-bered by the debts of its individualmembers, is no more novel and nomore “artificial” than a State’s deci-sion to treat the commercial partner-ship as a separate legal entity, whoseproperty cannot be encumbered bythe debts of its individual members.55

Drye turned on a determination of whether Mr.Drye could unilaterally elect to receive what wouldotherwise be a property right. A single co-tenant by theentireties, of course, is not in an analogous positionbecause one co-tenant does not unilaterally control theenjoyment of that property right. Justice Thomasargued that federal tax liens should only be attachableto rights that a taxpayer actually personally possesses:

That the Grand Rapids property doesnot belong to Mr. Craft under Michi-gan law does not end the inquiry,however, since the federal tax lienattaches not only to “property” butalso to any “rights to property”belonging to the taxpayer. While theCourt concludes that a laundry list of“rights to property” belonged to Mr.Craft as a tenant by the entirety, itdoes not suggest that the tax lienattached to any of these particularrights. Instead, the Court gathersthese rights together and opines thatthere were sufficient sticks to form abundle, so that “respondent’s hus-band’s interest in the entireties prop-erty constituted ‘property’ or ‘rightsto property’ for the purposes of thefederal tax lien statute.

But the Court’s “sticks in a bundle”metaphor collapses precisely becauseof the distinction expressly drawn by

the statute, which distinguishesbetween “property” and “rights toproperty.” The Court refrains fromever stating whether this case involves“property” or “rights to property”even though § 6321 specifically pro-vides that the federal tax lien attachesto “property” and “rights to property”“belonging to” the delinquent taxpay-er, and not to an imprecise constructof individual rights in the estate suffi-cient to constitute “property” or“rights to property” for the purposesof the lien.

Rather than adopt the majority’sapproach, I would ask specifically, asthe statute does, whether Mr. Crafthad any particular “rights to property”to which the federal tax lien couldattach. He did not. Such “rights toproperty” that have been subject tothe § 6321 lien are valuable and“pecuniary,” i.e., they can be attached,and levied upon or sold by the Gov-ernment. With such rights subject tolien, the taxpayer’s interest has ripeninto a present estate of some form andis more than a mere expectancy, andthus the taxpayer has an apparentright to channel that value to another. In contrast, a tenant in a tenancy bythe entirety not only lacks a presentdivisible vested interest in the proper-ty and control with respect to the sale,encumbrance, and transfer of theproperty, but also does not possess theability to devise any portion of theproperty because it is subject to theother’s indestructible right of sur-vivorship. This latter fact makes theproperty significantly different fromcommunity property, where eachspouse has a present one-half vestedinterest in the whole, which may bedevised by will or otherwise to a per-son other than the spouse.56

B. The Craft Aftermath That the tax lien attaches to the debtor-tax

payer’s entireties interest does not sever the tenancy

54 Id. at 291-92 (quotations and citations omitted). 55 Id. at 289.

56 Id. at 294-98 (quotations and citations omitted).


automatically. It permits the Internal Revenue Service(“IRS”) to either (i) administratively seize and sell thetaxpayer’s interest or (ii) foreclose the federal tax lienagainst the entireties property. The administrativeoption is problematic for the IRS:

Because of the nature of the entiretiesproperty, it would be difficult togauge what market there would be forthe taxpayer’s interest in the property.The amount of any bid would in alllikelihood be depressed to the extentthat the prospective purchaser, giventhe rights of survivorship, would takethe risk that the taxpayer may not out-live his or her spouse. In addition, aprospective purchaser would notknow with any certainty if, how, andto the extent to which the rightsacquired in an administrative salecould be enforced … Levying on cashand cash equivalents held as entiretiesproperty does not present the sameimpediments as seizing and sellingentireties property.57

The most likely lien enforcement procedure isforeclosure.58 Foreclosure is supervised by a courtunder Internal Revenue Code (“IRC”) section 7403 andany individual with an interest in the property must bejoined and given an opportunity to be heard. The courtmay order sale of the whole property and then distributethe sale’s proceeds as it sees fit, considering the parties’interests and that of the Government.59 The value ofeach spouse’s interest is an issue of fact. This exchangefrom Craft’s oral argument is illustrative:

Question (by the Court): “But in yourreview, you always value the taxpay-er’s interest at 50 percent?”

Answer (by Mr. Jones): “No, I thinkin the Rodgers—well, if the proper-ty’s been sold, yes. If the propertyhasn’t been sold, and we’re talking

about in a foreclosure context, Ibelieve the Rodgers court goesthrough the example of the varyinglife expectancies of the two tenants,and which one—and I believe whatthe Court in Rodgers said was thateach of them should be treated as ifthey have a life estate plus a right ofsurvivorship, and the Court explainshow that could well—I think in thefacts of Rodgers resulted in only 10percent of the proceeds being appliedto the husband’s interest and 90 per-cent being retained on behalf of thespouse, but—”60

Craft did not address specifically how thedebtor spouse’s interest should be valued. Rodgers,the case referenced above, involved the judicial sale toenforce federal tax liens against a homestead propertywhere a non-debtor spouse also held an interest.61 Inthat case, the court ran calculations “only for the sakeof illustration” that assumed the protected interest wasthe same as a life estate interest. Based upon calcula-tions of the terminated interest (the life interest)amount, a substantial part of the sales proceeds shouldbe allocated to the non-debtor spouse (89% for a 50year old). This “illustration,” of course, focused onfully compensating the non-delinquent spouse for hisor her potential loss without regard to a full valuationof the delinquent spouse’s property interest.

Courts have not followed the Rodgersapproach when applying Craft. A few courts haveendorsed the use of comparable life expectancies.62

Most courts, however, simply split the proceeds inhalf. In Popky v. United States,63 the Third CircuitCourt of Appeals relied upon the equal rights eachspouse has to the “bundle of sticks” that constitutesentireties property to support a fifty percent-fifty per-cent split. It also relied upon “sound policy” for suchan approach to valuation, finding that “an equal valua-tion is far simpler and less speculative” than the valua-tion based on life expectancies.64

By its terms, Craft is limited to federal taxcases. To quote one case, “Craft gives no indication

57 I.R.S. Notice 2003-60, 2003-39 I.R.B. (Sept. 29, 2003),available at http://www.irs.gov/irb/2003-39_IRB/ar13.html.

58 See Steve R. Johnson, Why Craft Isn’t Scary, 37 REAL PROP.PROB. & TR. J. 439, 473-77 (2002).

59 I.R.C. § 7403(c). 60 Transcript of Craft Oral Argument 15. “Rodgers” refers to

United States v. Rodgers, 649 F.2d 1117 (5th Cir. 1981), rev’d, 461U.S. 677 (1983) and Ingram v. Dallas Dep’t of Hous. & UrbanRehab, 649 F.2d 1128 (5th Cir. 1981), vacated, 461 U.S. 677

(1983).61 461 U.S. at 698-99. 62 See In re Murray, 318 B.R. 211, 214 (Bankr. M.D. Fla.

2004). 63 419 F.3d 242, 245 (3d. Cir. 2005). 64 See also In re Estate of Johnson, 355 F. Supp.2d 866, 870

(E.D. Mich. 2004); In re Gallivan, 312 B.R. 662, 666 (Bankr. W.D.Mo. 2004).


that the reasoning therein should be extended beyondfederal tax law.”65 Although section 544 of the Bank-ruptcy Code accords a trustee the rights and powers ofa hypothetical “creditor that extends credit to thedebtor at the time of the commencement of the case,”66

courts have declined to extend such rights and powersto a trustee based on the Government being such ahypothetical creditor.67 In refusing to extend Craft,courts reject empowering bankruptcy trustees to usethe Bankruptcy Code’s “strong arm clause” to get atentireties property in non-tax cases. Craft has beenextended, however, to fines and forfeitures arisingfrom federal criminal cases: “Although Craft onlydealt with tax liens, Congress has unequivocally statedthat criminal fines are to be treated in the same fashionas federal tax liabilities.”68

If the federal tax lien is not acted upon, and onespouse dies, the property goes to the survivor either freeof the lien or not, depending on who is the survivor:

When a taxpayer dies, the survivingnon-liable spouse takes the propertyunencumbered by the federal tax lien.When a non-liable spouse predeceas-es the taxpayer, the property ceases tobe held in a tenancy by the entirety,the taxpayer takes the entire propertyin fee simple, and the federal tax lienattaches to the entire property.69

In Craft, the property was quitclaimed to thenon-debtor spouse after the debtor spouse incurred thetax lien. The lower courts held that no fraudulent con-veyance was involved because no lien could attach.This point was not preserved on appeal. JusticeO’Connor makes clear, however, that this issue will bepresent in future entireties tenancy cases involving fed-eral tax liens: “Since the District Court’s judgment was

based on the notion that, because the federal tax liencould not attach to the property, transferring it couldnot constitute an attempt to evade the Governmentcreditor, in future cases the fraudulent conveyancequestion will no doubt be answered differently.”70

V. Planning in Full Bar Jurisdictions:Post Judgment Transfers and/or Disclaimersin Full Bar Jurisdictions

Generally, except in Craft situations, the full barjurisdictions permit a debtor spouse to convey theentirety property to the non-debtor spouse or for bothspouses to transfer the property to third persons withoutrunning afoul of the fraudulent conveyance statute.71

The planning implication is obvious: Married individu-als with exposure to liability should hold as much oftheir property as possible by the entireties.72 Once lia-bility against one spouse is triggered, the at-risk spousemay transfer the property to the non-debtor spouse.73 InWatterson v. Edgerly,74 for example, a husband had ajudgment lien filed against him but not against his wife.The husband transferred his interest in their entiretyproperty to his wife for no consideration.75 The wifethereupon signed a will containing a testamentaryspendthrift trust for the benefit of her husband, and diedshortly thereafter.76 The Maryland Court of SpecialAppeals upheld the conveyance of the real estatedespite the judgment lien against the husband:

When, as here, a husband and wifehold title as tenants by the entireties,the judgment creditor of the husbandor of the wife has no lien against theproperty held as entireties, and nostanding to complain of a conveyancewhich prevents the property fromfalling into his grasp.77

65 In re Ryan, 282 B.R. 742, 750 (Bankr. D.R.I. 2002); seealso Musolina v. Sinnreich, 391 F.3d 1295, 1298 (11th Cir. 2004);In re Kelly, 289 B.R. 38, 43-44 (Bankr. D. Del. 2003).

66 11 U.S.C. § 544(a)(1). 67 Schlossberg v. Barney, 380 F.3d 174, 180-82 (4th Cir.

2004); In re Greathouse, 295 B.R. 562, 565-67 (Bankr. D. Md.2003).

68 In re Hutchins, 306 B.R. 82, 91 (Bankr. D. Vt. 2004) (drugtrafficking); see also United States v. Fleet, 498 F.3d 1225 (11thCir. Fla. 2007) (wire fraud, money laundering, etc.); United Statesv. Godwin, 446 F. Supp. 2d 425 (E.D.N.C. 2006) (embezzlementfrom federally insured bank). In Maryland, by contrast, the courthas refused to permit the sale of a truck used in drug traffickingwhen the vehicle was held tenants by the entirety. This was underthe state forfeiture statute and it was pre-Craft. Maryland v. One1984 Toyota Truck, 533 A.2d 659 (Md. 1987).

69 I.R.S. Notice 2003-60.

70 Craft, 535 U.S. at 289 (citations omitted). 71 See Martin J. McMahon, Annotation, Validity and Effect of

One Spouse’s Conveyance to Other Spouse of Interest in PropertyHeld as Estate by the Entireties, 18 A.L.R. 23, § 8 (5th ed. 1994).

72 Individuals who typically have liability exposure includephysicians, lawyers, public accountants, and business executiveswith Sarbanes-Oxley exposure.

73 See above, however, for the danger of making such a con-veyance before the filing of a voluntary or involuntary petition inbankruptcy.

74 388 A.2d 934 (Md. 1978). 75 Id. at 937. 76 Id.77 Id. at 939 (citation omitted); see also Donvito v. Criswell,

439 N.E.2d 467, 473-74 (Ohio 1982); L&M Gas Co. v. Leggett,161 S.E.2d 23, 27-28 (N.C. 1968).


This technique is not restricted to intra-spousaltransfers. In Sawada v. Endo,78 a judgment was ren-dered against a husband for an automobile tort. He andhis wife conveyed their entireties property to their chil-dren. The Supreme Court of Hawaii found that theconveyance could not be a fraudulent one because thecreditors had no attachable interest.79

Thus, as illustrated above, as long as bankruptcycan be postponed or avoided, transferring an entiretiestenancy with only a single debtor-spouse can move theproperty free of the debt. This is clearly an importantbenefit of the entireties form of ownership. From anasset protection point of view, entireties ownership is avaluable tool that ought to be preserved.

Using the flexibility afforded by the Internal Rev-enue Code section 2518, an estate plan can be craftedanticipating that a qualified disclaimer will be used bya surviving spouse to fund a credit shelter or qualifiedterminable interest property (“QTIP”) trust.80 Underthe Internal Revenue Service’s 1997 regulations, dis-claimer of the “survivorship interest” in entirety prop-erty is permitted within nine months of death (not thecreation of the interest).81 This provides an opportuni-ty to preserve the asset protection qualities of entiretieswithout unduly compromising estate planning.82

A creditor problem may exist at the first spouse’sdeath. If the debtor spouse predeceases the non-debtorspouse, no action is necessary to have the propertypass to the survivor lien free if the property is held as

entireties. If the debtor spouse survives, however, adisclaimer may be useful to avoid the lien on thatspouse’s portion of the entirety property.

Other than for federal tax liens, a disclaimer is typ-ically not a transfer for fraudulent conveyance purpos-es in most jurisdictions.83 As explained by one state’shighest court:

A review of the jurisprudence of otherstates shows that it is the majority viewthat a renunciation under the applica-ble state probate code is not treated asa fraudulent transfer of assets underthe UFTA [Uniform Fraudulent Trans-fers Act], and creditors of the personmaking a renunciation cannot claimany rights to the renounced property inthe absence of an express statutoryprovision to the contrary.84

In Pauw v. Agee,85 a federal district court permitted adebtor to disclaim his inheritance but then rent theproperty back from his brother who received the prop-erty through operation of the disclaimer: “This view[that a disclaimer will defeat the judgment against thedebtor-disclaimant] corresponds with the majorityview that a creditor cannot prevent a debtor from dis-claiming an inheritance.”86 New York also follows themajority rule. In Estate of Oot,87 the court upheld the

78 561 P.2d 1291 (Haw. 1977). This case is quoted at lengthabove in section II on state variations.

79 Id. at 1295-97. 80 I.R.C. § 2518(b)(4). 81 I.R.S. Treas. Reg. § 25.2518-2(c)(4)(i) (West 2008). A spe-

cial rule, however, applies to joint bank accounts between spouses“if a transferor may unilaterally regain the transferor’s own contri-butions without the consent of the other cotenant…”. Id. at(c)(4)(iii). For such joint tenancies, the surviving joint tenant maynot disclaim any portion of the account attributable to considera-tion furnished by that surviving joint tenant. As noted in Section IIon state variations, above, a joint account subject to the order ofeither spouse may nevertheless be an entireties account. Presum-ably such an account would fail the definition of “joint account”contained in these regulations.

82 To backstop the plan, each spouse should create a durablepower of attorney authorizing another person to disclaim on his orher behalf in the case that he or she is incompetent at the time oftheir spouse’s death. Also, of course, the trust receiving the dis-claimed property cannot permit a power of appointment to the dis-claiming spouse. The retention of entireties property until thedeath of one spouse necessarily involves a high degree of trustbetween spouses; each spouse must be certain that the survivor willtrigger the creditor shelter or QTIP trust if appropriate. Increasing-ly estate plans are being designed to give the surviving spouse suchcontrol over his or her destiny. See Jeffrey N. Pennell, Estate Plan-

ning for the Next Generation(s) of Clients: It’s Not Your Father’sBuick, Anymore, 34 ACTEC J., SUMMER 2008, at 2; see also HenryM. Ordower, Trusting Our Partners: An Essay on Resetting theEstate Planning Defaults for an Adult World, 31 REAL PROP. PROB.& TR. J. 313 (1996).

83 Neither the 2002 Uniform Disclaimer Property Interest Act(“UDPIA”) nor the earlier uniform acts directly address the issueof a disclaimer by an insolvent disclaimant. All of the uniform actsrelied on the law of each jurisdiction to sort out the issue. SeeAdam J. Hirsch, Revisions In Need of Revising: The Uniform Dis-claimer of Property Interests Act, 29 FLA. ST. U.L. REV. 109(2001). Separate considerations are also involved in Medicaidplanning. See UNIF. DISCLAIMER OF PROP. INTERESTS ACT § 13 cmt(amended 2006). Nothing in the general discussion herein on dis-claimers is meant to address Medicaid planning issues.

84 Essen v. Gilmore, 607 N.W.2d 829, 835 (Neb. 2000). For asummary of the treatment of disclaimers in other states, see alsoIn re Bright, 241 B.R. 664, 671-72 (B.A.P. 9th Cir. 1999) (uphold-ing a pre-petition disclaimer). In contrast, post-petition dis-claimers will not work. In re Schmidt, 362 B.R. 318 (Bankr. W.D.Tex. 2007).

85 No. 2:98-2318-23, 2000 U.S. Dist. LEXIS 22323 (D.S.C.2000).

86 Id. at *19. 87 408 N.Y.S.2d 303 (1978).


renunciation of a legacy regardless of the dis-claimant’s creditors’ claims: “It is with no smalldegree of reluctance that the court arrives at this deci-sion. However, until the legislature in its wisdom pro-vides some statutory vehicle for protecting creditorsagainst frustration of their claims, unfortunate resultsmay again occur.”88

A minority of states hold that a disclaimer is afraudulent transfer. Pennsylvania courts, for example,have held a disclaimer to be a fraudulent transfer.“While a solvent legatee may freely renounce andrefuse a gift or legacy, an insolvent legatee may not doso since his renunciation would constitute a fraudulentconveyance, void as to creditors under section 4 of theUniform Fraudulent Conveyance Act of May 21,1921.”89 Several states have statutes that prohibit dis-claimers by insolvent heirs. Disclaimers are prohibitedin Florida, for example, when “the disclaimant is insol-vent when the disclaimer becomes irrevocable.”90

The 2002 rendition of the Uniform Disclaimer ofProperty Interests Act (“UDPIA”) bars disclaimers if,before the disclaimer becomes effective, the dis-claimant “voluntarily assigns, conveys, encumbers,pledges or transfers the interest sought to be dis-claimed.”91 Earlier versions of the uniform acts hadsimilar language barring disclaimers after an encum-brance but without the “voluntary” element. Interpret-ing a disclaimer act without the “voluntarily” aspect,one state court barred a disclaimer when the dis-claimant was subject to a prior lien. After decidingthat the act’s encumbrance provision trumped its“relation back”92 provision, the Alabama SupremeCourt held that a creditor’s lien against the disclaimantrendered the disclaimer ineffective.93 The courtfocused on the heir’s direct interest in estate property:

When John Thomas Bigham diedintestate on June 25, 1984, the legaltitle to a one-half interest in his real

property vested eo instante in BobbyBigham; however, it vested subject tothe statutory power of the administra-trix to take possession of it and obtainan order to have it sold for payment ofthe debts of his father’s estate.94

In Pennington, a judgment creditor had perfected herlien against all of the disclaimant’s property before thedisclaimant’s father died; therefore, the lien acted as anencumbrance of the disclaimant’s share. Under the cir-cumstances of that case, a disclaimer after the attach-ment of the lien constituted a fraudulent conveyance.95

Similarly, In re Kalt’s Estate,96 the CaliforniaSupreme Court found a disclaimer to violate the fraud-ulent conveyance act. Kalt’s Estate is importantbecause it served as the basis of many other decisionsconstituting the minority view. California, however,subsequently legislatively reversed Kalt’s Estate:

The few states which appear to followthe minority view that a disclaimer canconstitute a fraudulent conveyancebase their holdings on the Californiacase of In re Kalt’s Estate…The hold-ing of In re Kalt’s Estate, however,was overruled by the California legis-lature when it enacted a statute provid-ing specifically that a disclaimer is nota fraudulent transfer. See Cal. Prob.Code § 283 (West 1991).97

In sum, given the variations among the states, nouniversal default planning rule can be applied. Never-theless, in full bar states that do not treat a disclaimeras a fraudulent conveyance, preserving, or indeed cre-ating, entireties ownership coupled with estate plan-ning to be triggered by a disclaimer at the first death,should become a default recommendation.

88 Id. at 306. 89 Est. of Centrella, 20 Pa. D.&C.2d 486, 490 (1960) (cita-

tions omitted). 90 FLA. STAT. ANN. 739.402(2)(d) (West 2008); see also MINN.

STAT. ANN. § 525.532(6) (West 2008).91 UNIF. DISCLAIMER OF PROP. INTERESTS ACT § 13(b)(2). 92 The “relation back” doctrine of earlier versions of the

UDPIA has been replaced in the new Act. “The disclaimer takeseffect as of the time the instrument creating the interest becomesirrevocable, or, if the interest arose under the law of intestate suc-cession, as of the time of the intestate’s death.” UNIF. DISCLAIMER

OF PROP. INTERESTS ACT § 6(b)(1). The Comment to that sectionstates: “This Act continues the effect of the relation back doctrine,not by using the specific words, but by directly stating what therelation back doctrine has been interpreted to mean.” The term

“relation back” is used in the Article as short-hand for the revisedsection.

93 Pennington v. Bigham, 512 So.2d 1344 (Ala. 1987). 94 Id. at 1345-46.95 Id. at 1347. The 2002 amendments to the UDPIA, of

course, adds “voluntary” to the list of actions barring a disclaimer.This addition “reflects the numerous cases holding that onlyactions by the disclaimant taken after the right to disclaim hasarisen will act as a bar.” UNIF. DISCLAIMER OF PROP. INTERESTS ACT

§ 13 cmt. Maryland, for example, adopted this provision of theUDPIA and added that “Creditors of the disclaimant have no inter-est in the property disclaimed.” MD. CODE ANN., EST. & TRUSTS §9-202(f)(2) (West 2008).

96 108 P.2d 401 (Cal. 1940).97 Pauw, 2000 U.S. Dist. LEXIS 22323 at *20.


Alaska Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Levy and sale permitted. Partition may beforced.

Type of Property: Real and personal property. Alaska Stat. § 34.15.140 recognizes ten-ants by the entirety in real property. See Faulk v. Est. of Haskins, 714 P.2d 354 (Alaska1986), recognizing tenants in the entirety in personal property.

Comment: Alaska Stat. § 09.38.100(a) provides that a creditor of one spouse “may obtaina levy on and sale of the interest” of the debtor spouse. The creditor may force partitionor severance of the non-debtor spouse’s interest. This is subject, however, to otherexemptions such as the homestead exemption. Alaska Sta. §§ 09.38.100(a)-(b).

Arkansas Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Creditor may execute but may not defeatnon-debtor spouse’s right of survivorship interest. Creditor gets one-half of rents andprofits but cannot displace non-debtor spouse.

Type of Property: Real and personal property. “[O]nce property, whether personal or realis placed in the names of persons who are husband and wife, without specifying the man-ner in which they take, there is a presumption that they own the property as tenants by theentireties …” Sieb’s Hatcheries, Inc. v. Lindley, 111 F.Supp. 705, 716 (W.D. Ark. 1953).Ark. Code § 23-47-204 lists entireties as one of the accounts banks shall offer under themultiple party account rules.

Comment: “Execution against a spouse’s interest in a tenancy by the entirety has longbeen permitted even though partition has not. [Earlier cases have] affirmed the principlethat property owned as husband and wife as tenants by the entirety may be sold underexecution to satisfy a judgment against the husband, subject to the wife’s right of sur-vivorship … [A] purchaser of the interest of one tenant by the entirety cannot oust theother tenant from possession, and can only claim one-half of the rents and profits. Theremaining tenant is not only entitled to possession plus one-half of the rents and profits,but the right of survivorship is not destroyed or in anywise affected.” Morris v. Solesbee,892 S.W.2d 281, 282 (Ark. Ct. App. 1995) (citations omitted).

Delaware Type of Bar: Full.

Effect of Judgment Creditor of One Spouse: Not subject to attachment.

Type of Property: Real and personal property. See Rigby v. Rigby, 88 A.2d 126 (Del. Ch.1952), on cattle, and Widder v. Leeds, 317 A.2d 32 (Del. Ch. 1974), on partnership inter-est. “It has likewise been held that, in the absence of proof to the contrary, a joint bankaccount opened in the conjunctive form in the name of a husband and wife may create atenancy by the entireties, and this status is not altered by the fact that either may withdrawthe funds therefrom.” Widder, 317 A.2d at 35 (citations omitted).

Comment: Delaware courts have stated, at various times, that a judgment against onespouse does not create a lien on entireties property under Delaware law: “It is settled in

APPENDIXAsset Protection Variations Among Jurisdictions Recognizing Tenancy by the Entirety


Delaware that a creditor of one spouse, such as Ms. Johnson, may not place a lien on realproperty held as tenants by the entireties. See Steigler v. Insurance Co. of North America,384 A.2d 398 (1978) ( “interest of neither [husband nor wife] can be sold, attached orliened ‘except by [their] joint act’”); Citizens Savings Bank, Inc. for the Use of Govatos v.Astrin, 61 A.2d 419 (1948)… so the creditors of one spouse cannot reach the interest thedebtor holds in the estate.” Johnson v. Smith, No. Civ. A. 13585, 1994 WL 643131, *2(Del. Ch. Oct. 31, 1994).

In Mitchell v. Wilmington Trust Co., 449 A.2d 1055 (Del. Ch. 1982), aff’d 461 A.2d 696(Del. 1983), a husband obtained a mortgage from a bank by fraudulently bringing awoman to execute loan settlement documents that, in fact, was not his wife. The courtheld that the forgery failed to operate to bind the tenant by entirety property. Before thewife received notice of the forgery, the husband transferred the title to the wife as a mar-ital settlement. The transfer was not held a fraudulent transfer because the wife lackedknowledge of the fraudulent transfer (being then unaware of the purported lien) and paidvalid consideration (the release of her husband’s marital obligations). The court held thatthe bank acquired an inchoate lien in the property which became extinguished upon thehusband’s transfer of the property to his wife without knowledge and for valid considera-tion. Given that no lien attaches in any event, there should have been no reason for thecourt to reach the fraudulent conveyance aspect of the case. In Wilmington Savings FundSociety v. Kaczmarczyk, No. Civ. A. 1769-N, 2007 WL 704937 (Del. Ch. March 1, 2007),the Chancery Court found that a post-judgment transfer by the debtor husband to his non-debtor wife violated the fraudulent conveyance act. As opposed to Mitchell, the Kacz-marczyk court held that the transfer, while purportedly made pursuant to the divorce dis-cussions, did not include fair consideration because the parties reconciled. Arguably, nei-ther case should have involved an examination of the fraudulent conveyance statute.These cases necessarily raise a cautionary note as to whether a lien attaches.

District of Columbia Type of Bar: Full.

Effect of Judgment Creditor of One Spouse: Not subject to attachment.

Type of Property: Real and personal property. See Morrison v. Potter, 764 A.2d 234(D.C. 2000), where a joint checking account was presumed to be held by tenants by theentirety despite the right, under the account agreement, of either spouse to withdraw:“[C]ourts have not interpreted the unilateral right of a spouse to withdraw funds as analienation of the marital property. Instead, ‘[w]here a deposit is made payable to eitherspouse, agency or authority exists by implication … Indeed, with respect to a joint bankaccount held by a husband and wife, each spouse acts as the other spouse’s agent, andboth have properly consented to the other spouse’s withdrawals in advance, thus satisfy-ing the non-alienation requirement of a tenancy by the entireties” (citations omitted).

Comment: In Est. of Wall, 440 F.2d 215 (D.C. 1971), the husband died holding a tenantby the entirety interest in a fund. The husband’s creditors unsuccessfully sought theestate’s “interest” in the fund: “[T]he full complement of common law characteristicsof co-tenancy by the entireties is preserved. A unilaterally indestructible right of sur-vivorship, an inability of one spouse to alienate his interest, and, importantly for thiscase, a broad immunity from claims of separate creditors remain among its vital inci-dents.” Id. at 219. In American Wholesale Corp. v. Aronstein, 10 F.2d 991 (1926), thehusband’s transfer of his interest in entireties property to his wife was held not to be afraudulent conveyance because the entireties property was not subject to a lien by hisjudgment creditors.

Florida Type of Bar: Full.

Delawarecontinued


Florida continued Effect of Judgment Creditor of One Spouse: No attachment.

Type of Property: Real and personal property. See Beal Bank, SSB v. Almand & Assoc.,780 So.2d 45 (Fla. 2001), announcing a presumption in favor of entireties of joint bankaccount unless the signature card specifically disclaims a tenancy by the entireties: “[A]swe have explained, the ability of one spouse to make an individual withdrawal from theaccount does not defeat the unity of possession so long as the account agreement containsa statement giving each spouse permission to act for the other.” This presumption, thatjointly owned property held by a married couple is entireties, is rebuttable. In re Hinton,378 B.R. 371 (Bankr. M.D. Fla. 2007).

Comment: In Passalino v. Protective Group Securities, 886 So.2d 295 (Fla. 2004), hus-band and wife owned rental property as tenants by the entirety. They sold the property andthe proceeds were held by their attorney intended as a deposit on another tenants by theentirety property. The fund retained its tenant by the entirety characteristics and was notsubject to the judgment solely against the husband. In Hunt v. Covington, 200 So. 76 (Fla.1941), the Florida Supreme Court described the attributes of tenant by the entirety: “It isnot subject to execution for the debt of the husband. It is not subject to partition; it is notsubject to devise by will; neither is it subject to the laws of descent and distribution.”

Hawaii Type of Bar: Full.

Effect of Judgment Creditor of One Spouse: No attachment.

Type of Property: Real and personal property. Haw. Rev. Stat. § 509-2 provides that land “orany other type of property” may be held tenants by the entirety. See Traders Travel Interna-tional, Inc. v. Howser, 753 P.2d 244 (Haw. 1988), holding that the clear and unambiguouslanguage of the signature card of “joint account” did not suggest entireties. That childrenwere additional joint owners further rebutted any indication of entireties ownership.

Comment: In Sawada v. Endo, 561 P.2d 1291 (Haw. 1977), the husband was a judgmentdebtor due to a motor tort award against him. He and his wife subsequently transferredtenant by the entirety property to their sons. The Hawaii Supreme Court found that nolien attached to husband’s interest because he had no separate property interest in theproperty. Thus, the estate was not subject to the husband’s sole debt.

Illinois Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: No attachment to “homestead” entireties property.

Type of Property: Homestead real property only; see comment below for further explanation.

Comment: The tenancy was re-established in Illinois by statute and limited to homesteadproperty. 765 ILCS § 1005/1c. By statute, 735 Ill. Comp. Stat. § 5/12-112, the debtor ofone spouse cannot act against homestead entireties property. “Illinois stopped recogniz-ing common law tenancy by the entirety in 1861 when married women’s law were firstadopted. These laws recognized that women enjoyed rights independent of their hus-bands. In 1989, the Illinois General Assembly enacted a statute creating a tenancy by theentirety applicable only to ‘homestead property’ held by husbands and wives ‘duringcoverture.’” E.J. McKernan co. v. Gregory, 643 N.E.2d 1370, 1373 (Ill. App. 1994).

Indiana Type of Bar: Full.



Indiana continued Type of Property: Real property and personal property “directly derived from real estateheld by [tenants by the entirety], as crops produced by cultivation of lands owned byentireties or proceeds arising from sale of property (i.e., real estate) so held.” Rhodes v.Indiana Nat’l Bank, 544 N.E.2d 179, 180 (Ind. 1989) (holding that the personal propertyexception is very narrow so that rents are not subject to tenants by the entireties protec-tion). The limitation to real property or to personal property directly derived from it pro-duces fine distinctions. In Diss v. Agri Business Int’l, 670 N.E.2d 97 (Ind. 1996), thedebtor husband transferred rental property to the wife and the transfer was set aside as afraudulent conveyance because the rental income was not “personal property directlyderived” from the realty. By statute, Ind. Code § 34-55-10-2(c)(5), entireties real estate isexempt from sale for the debt of one spouse.

Comment: In Myler v. Myler, 210 N.E.2d 446 (Ind. App. 1965), the husband owed childsupport arrearage from his first marriage. The husband’s mother subsequently trans-ferred real estate to the husband and his second wife. The court held that the husband’sinterest was not subject to his individual debts. There was no showing that he transferredhis sole funds to acquire the property so no fraudulent conveyance was involved.

Kentucky Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Attachment only on the contingent survivor-ship interest.

Type of Property: Real and personal property. “It is recognized in this state that a personmay by depositing his own money in the names of himself and another create the equiva-lent of a tenancy in common or a tenancy by the entirety, depending upon his intent.” Say-lor v. Saylor, 389 S.W.2d 904, 905 (Ky. 1965). Saylor held that the conjunctive “and” ispresumed to create tenancy in common while the disjunctive “or” created a presumptionof entireties.

Comment: In Hoffmann v. Newell, 60 S.W.2d 607, 613 (Ky. 1932) the court permitted thesale of the husband’s contingent survivorship interest subject, however, to the wife’s rightof life time enjoyment and her survivorship right: “We are of the opinion that, as thestatute declares this contingent interest of the husband to be subject to sale for the judg-ment creditor’s debt, he takes the interest acquired upon its sale, subject only to the defea-sance its very contingent nature demands, or its destruction through the wife’s survivor-ship of his judgment debtor.”

In Peyton v. Young, 659 S.W.2d 205 (Ky. 1983), a husband, but not the wife, mortgagedthe entirety property. He subsequently transferred his interest to his wife. The court heldthat one-half interest carried with it the mortgage. He subsequently murdered his wifethen committed suicide. The court treated the deaths as simultaneous and permitted themortgage to be satisfied out of his one-half interest. If she had indeed survived him, how-ever, the debt would have effectively extinguished because the right of the survivorship isseen as a core element of tenants by the entirety.

Maryland Type of Bar: Full.


Type of Property: Real and personal property. Bruce v. Dyer, 524 A.2d 777 (Md. 1987),evidences that entireties are favored by the law. See also Diamond v. Diamond, 467 A.2d510 (Md. 1983) (“It is well established that this Court recognizes that a tenancy by theentireties may be created in personal property.”)


Comment: Watterson v. Edgerly, 388 A.2d 934 (Md. App. 1978) held that a creditor “hasno standing to complain” when the debtor husband transferred all of his interest in a resi-dence to his wife because it was held tenants by the entirety. In that case, the wife thenprovided that the residence go by Will to a spendthrift trust for husband’s benefit. Thewife died 61 days after the transfer of the real estate to her. The intent to create entiretiesproperty, coupled with the four unities, causes the tenancy to be created. Cruickshank-Wallace v. Co. Banking & Trust Co., 885 A.2d 403 (Md. App. 2005). See, however, In rePernia, 165 B.R. 581 (Bankr. D. Md. 1994), where the Bankruptcy Court held that theaccount designation trumped intent. In that case, proceeds from the sale of entireties prop-erty was used to acquire U.S. Treasury EE Bonds. The bonds were titled as held husband“or” wife. Treasury regulations stated that holding the bonds as such made them subject tothe order of either spouse. The court found that the EE Bonds were not entirety propertyunder Maryland law: “Both husband and wife are essential parties to an effective transferof property held as tenants by the entirety.” Id. at 582. The federal regulations governingthe account holdings were found to preempt “all laws and court decisions” because of fed-eral preemption. Pernia was wrongly decided to the extent it claims to make a general pro-nouncement of Maryland law. Indeed, in In re Breslin, 283 B.R. 834 (Bankr. D. Md.2002), the court stated that the Pernia result was “only because” the federal regulationsdetermined ownership and referred to Brewer v. Bowersox, 48 A. 1060 (Md. 1901), for theproposition that when an account is held disjunctively but only payable to the two spouses,but subject to the order of either, an entireties account is created. Entireties exists if thecouple so intends and the unities coincide, regardless of the nature of the account. SeeCruickshank-Wallace, 885 A.2d at 413, Diamond, 467 A.2d 510; M. Lit, Inc. v. Berger, 170A.2d 303 (Md. 1961). There is also a presumption that property purchased from the pro-ceeds of entireties property retains its character. Tait v. Safe Deposit & Trust Co. of Balti-more, 70 F.2d 79 (4th Cir. 1934) (interpreting Maryland law).

Massachusetts Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Lien attaches but no execution if principalresidence, otherwise may sell debtor’s share.

Type of Property: Real and personal property. After entireties property was condemned inRonan v. Ronan, 159 N.E.2d 653 (Mass. 1959), the court held that the proceeds belongedto both the husband and wife. Under pre-1980 law, the husband was entitled to the incomeduring their joint lives, and upon the death of either, the survivor was entitled to all of it.

Comment: Before a statutory fix, Massachusetts held to the “husband was the one” ruleunder common law. Therefore, the husband’s creditors could take possession of the prop-erty as long as the husband debtor lived, subject to the wife’s right of survivorship. Pray v.Stebbins, 4 N.E. 824 (Mass. 1886); Raptes v. Pappas, 155 N.E. 787 (1927). The statereversed this rule by statute, Mass. Gen. Laws ch. 209, § 1, providing that both “shall beequally entitled to the rents, products, income or profits and to the control, managementand possession of property held by them as tenants by the entirety.” The statute also pro-vided that a debtor spouse’s interest was not subject to seizure or execution “so long assuch property is the principal residence of the nondebtor spouse.” Other than propertyserving as the principal residence of the non-debtor spouse, creditors may execute and sellentireties property after adjusting for the non-debtor spouse’s interest. Coraccio v. LowellFive Cents Savings Bank, 612 N.E.2d 650 (Mass. 1993); In re Snyder, 249 B.R. 40 (B.A.P.1st Cir. 2000).

Michigan Type of Bar: Full

Effect of Judgment Creditor of One Spouse: No Attachment

Marylandcontinued


Type of Property: Real property and its proceeds as well as certain enumerated personalproperty.

Comment: As with Massachusetts, Michigan was late in enacting a statute holding thatboth spouses “shall be equally entitled to the rents, products, income or profits, and to thecontrol and management of real or personal property held by them as tenants by theentirety.” Mich. Comp. Laws § 557.71 (adopted in 1975). In SNB Bank & Trust v.Kensey, 378 N.W.2d 594 (Mich. 1985), the court held that rents from entirety propertycannot be attached to satisfy the debts of one spouse’s creditors. In that case, the courtheld that the statute simply equalized the rights of both spouses to control the propertyand that the entireties property and its rents continued to be the property of the maritalunit. Also by statute, certain jointly held debt instruments and stock certificates areexempt from attachment by one spouse’s creditors. Mich. Comp. Laws §§ 557.151,600.6023a. These statutes, in effect, recognized entireties in those enumerated debt andstock accounts. Zavradinos v. JTRB, Inc., 753 N.W.2d 60 (Mich. 2008); DeYoung v.Mesler, 130 N.W.2d 38 (Mich. 1964).

Mississippi Type of Bar: Full.


Type of Property: Real property.

Comment: Mississippi recognizes entireties in real property: “An estate by entirety mayexist only in a husband and wife and may not be terminated by the unilateral action of oneof them because they take by the entireties and not by moieties. While the marriageexists, neither husband nor wife can sever this title so as to defeat or prejudice the right ofsurvivorship in the other, and a conveyance executed by only one of them does not passtitle.” Ayers v. Petro, 417 So.2d 912, 914 (Miss. 1982). Thus, in Cuevas v. McCallum, 191So.2d 843 (Miss. 1966), a husband purportedly conveyed his interest in tenant by theentirety property to his girlfriend in an attempt to lower his asset profile anticipating adivorce. The Mississippi Supreme Court held the transaction void because neither spousecould unilaterally alienate tenant by the entirety property. There are no cases, however,that discuss the rights of creditors of one of the spouse and whether the lack of moietiesprecludes attachment or merely means that a creditor takes subject to the survivorshipinterest of the non-debtor spouse. See Note, Rodger A. Heaton, Administration ofEntireties Property in Bankruptcy, 60 Ind. L.J. 305, 309 n.24 (1985). Given the descrip-tions of entireties in the Mississippi cases, however, there is no reason to doubt that it is afull bar jurisdiction.

Missouri Type of Bar: Full.


Type of Property: Real and personal property. “It has been held in Missouri for sometime that where a husband and wife hold personal property as joint owners they are pre-sumed to be tenants by the entirety. Each is presumed to have an undivided interest in thewhole of the property.” Hanebrink v. Tower Grove Bank & Trust Co., 321 S.W.2d 524,527 (Mo. Ct. App. 1959); see also Hallmark v. Stallings, 648 S.W.2d 230 (Mo. Ct. App.1983) (recognizing entireties ownership in livestock).

Comment: In Hanebrink v. Tower Grove Bank & Trust Co., 321 S.W.2d 524 (Mo. Ct.App. 1959), a bank paid a garnishment against the husband alone from a tenant by theentirety account. The court held the bank liable to wife for the amount paid: “It is also the

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law in this state that where a judgment and execution are against the husband alone suchjudgment cannot in any way affect property held by the husband and wife in the entirety.”Id. at 527. That either spouse can draw on an account does not defeat the entireties: “Nei-ther does the fact that either Dr. Coleman or his wife could draw checks on the accountdestroy their relationship as tenants by the entirety in the balance left in the bank. Thedrawing of the checks was by mutual consent.” State Bank of Poplar Bluff v. Coleman,240 S.W.2d 188, 191 (Mo. Ct. App. 1951).

New Jersey Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Execution on judgment permitted subject toequity determination.

Type of Property: Real and personal property by statute, N.J. Stat. Ann. § 46:3-17.2. Thisstatute, however, is found under the “Property” title (title 46), and “Real Property Only”subtitle (subtitle 2). Furthermore, state courts have questioned the existence of entiretiesownership in personal property. For example, Fort Lee Savings & Loan Association v.LiButti, 254 A.2d 804, 807 (N.J. Super. App. Div. 1969), suggests that entireties ownershiponly exists in real property: “The estate by the entirety has been described as a ‘remnant ofother times’ which rests upon ‘fiction of oneness of husband and wife’… But whateversocial purpose this tenancy was designed to serve in the interest of married parties andwhatever the reasons for its continued existence in this State, there is no justifiable basis forextending it to the personal property which replaces it. To indulge in the further fiction nec-essary to achieve such a result serves no useful purpose and acts to frustrate justice. Fur-thermore, it runs counter to the policy of this State against recognizing the existence of ten-ancies by the entirety in personalty.” (dissent by Judge Carton, adopted by the New JerseySupreme Court on reversal, 264 A.2d 33 (N.J. 1970)). The Fort Lee holding was reaffirmedin High v. Balun, 943 F.2d 323, 325 (3d. Cir. 1991), when the court recognized that NewJersey law does not permit married couples to own personal property by the entireties.

Comment: The execution by the judgment creditor of one spouse acquires the survivor-ship interest of the debtor spouse and a tenant in common life interest without the auto-matic right of partition. Newman v. Chase, 359 A.2d 474 (N.J. 1976). In Newman, thecourt weighed the creditor’s interest against the “cost of dispossessing the family of itshome.” Id. at 480. The court granted the creditor one-half the imputed net rental value ofthe house. Ultimately, the issue of partition is one within the equity court’s determina-tion. “In the usual case involving residential property, the purchaser at the sale may causeneither a physical partition of the property nor a partition by sale of the life estate. Thecreditor may, however, collect from the non-debtor spouse one-half of the imputed rentalvalue of the property, but must give credit to the non-debtor spouse for his share of certaincharges against the property such as mortgage payments, taxes, insurance and repairs.”In re Jordan, 5 B.R. 59, 62 (Bankr. D.N.J. 1980).

New York Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Attachment permitted and sale allowed sub-ject to equity determination.

Type of Property: Real property or co-op apartments only under statute, N.Y. Est. Powers &Trusts Law §§ 6-2.1, 6-2.2. In Hawthorne v. Hawthorne, 192 N.E.2d 20 (N.Y. 1963), the NewYork Court of Appeals held that fire insurance proceeds from entireties property was personalproperty not held by the entireties. The court in Nat’l Bank & Trust Co. of Norwich v. Rickard,393 N.Y.S.2d 801 (N.Y. App. Div. 1977), reached a similar result, finding that excess fore-closure proceeds were personalty held as tenants in common rather than as entireties.

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Comment: A creditor may reach the debtor spouse’s interest and, under certain circum-stances, may sell the interest: “[U]nder the authorities, the sale of the husband’s interestin the real property would convey a hybrid tenancy in common, with survivorship but nopartition rights, to a third party stranger who then could have some conceivable right touse immediately an undivided one-half share of the property … It is, of course, unques-tioned that the creditor has legitimate considerations in its favor … However, as a practi-cal matter, its real interest is in asserting its lien in the event of a voluntary sale of theproperty, or in the husband’s possibility of surviving the wife. The creditor’s legitimatesecurity interest is really protected by its judgment lien. This Court cannot visualize inthis case any substantive value in immediate occupancy rights to anyone outside the closefamily.” Hammond v. Econo-Car of North Shore, 336 N.Y.S.2d 493, 494-95 (N.Y. Sup.Ct. 1972) (citations omitted). “As a practical matter, if this were the marital residence,petitioner-wife’s right to exclusively occupy the whole of the property unaffected by anyattempted sale of her debtor-spouse’s interest therein goes without questions.” BNYFinancial Corp. v. Moran, 584 N.Y.S.2d 261, 262 (N.Y. Sup. Ct. 1992) (staying collec-tion activity on Hamptons vacation home to permit non-debtor spouse time to attemptprivate sale). In In re Levehar, 30 B.R. 976 (Bankr. E.D.N.Y. 1983), the BankruptcyCourt reviewed a proposed sale under Bankruptcy Code § 363 which permits such a saleif the Court finds the benefit to the estate outweighs the detriment of such sale to the co-owner. Levehar assumed that the co-owner non-debtor would be entitled to a sharegreater than 50% of the net proceeds based on her greater life expectancy, suggesting thatsuch a sale would not be appropriate. Id. at 981. Implicit in Levehar, of course, is thatthe balancing test of § 363 might yield a different result under other fact situations. In rePersky, 134 B.R. 81 (Bankr. E.D.N.Y. 1991), after deciding that under no circumstancecan the undivided right to survivorship be severed by such a sale, held the power to sellfree of the non-debtor spouse’s survivorship interest unenforceable. This case is not fol-lowed generally. See Sapir v. Sartorius, 230 B.R. 650 (Bankr. S.D.N.Y. 1999).

North Carolina Type of Bar: Full.


Type of Property: Real estate only. “Although North Carolina recognizes the right of hus-band and wife to hold real property as tenants by the entirety, it does not in general rec-ognize the tenancy by the entirety in personal property. When husband and wife volun-tarily sell and convey real property owned by them as tenants by the entirety, the proceedsof such are considered personal property … held by husband and wife as tenants in com-mon.” In re Foreclosure of Deed of Trust Recorded at Book 911, at Page 512, CatawbaCo. Registry, 272 S.E.2d 893, 896 (N.C. Ct. App. 1980) (citations omitted).

Comment: Dealer Supply Co. v. Greene, 422 S.E. 2d 350 (N.C. Ct. App. 1992), reviewdenied 426 S.E.2d 704 (1993), involved a pre-divorce transfer by husband and wife tohusband’s parents in exchange for a cash-out of the wife. “In North Carolina, it is wellestablished that an individual creditor of either husband or wife has no right to levy uponproperty held by the couple as tenants by the entirety. It follows therefore that a‘[h]usband and wife [can] by joint voluntary conveyance transfer the [entirety held] prop-erty to anyone of their choice, free of lien or claims of [one spouse’s] individual credi-tors.’ Further, as a debtor can only commit a fraudulent conveyance by disposing of prop-erty to which the creditor has a legal right to take in satisfaction of his claim, a husband’sconveyance of his interest in entirety held property cannot come within the prohibitionagainst fraudulent conveyances.” Id. at 352 (citations omitted, alterations in original); seealso L&M Gas Co. v. Leggett, 161 S.E.2d 23 (N.C. 1968). In Martin v. Roberts, 628S.E.2d 812 (N.C. Ct. App. 2006), on the other hand, a transfer incident to divorce butmade after the date of the divorce decree was held attachable because the entireties was

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severed by the time of the conveyance. N.C. Gen. Stat. § 39-13.6, enacted in the early1980s, reversed the husband’s right to control the property during coverture.

Ohio Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: No attachment provided that the deed wascreated during a certain period.

Type of Property: Real property only under deeds created after February 9, 1972 andbefore April 4, 1985 pursuant to the former Ohio Rev. Stat. § 5302.17.

Comment: Prior to 1972, Ohio did not recognize entireties. By statute in 1972 it permit-ted husbands and wives to hold real estate as tenants by the entirety. Cases held that suchtenancy precluded attachment by the creditor of one spouse: “[W]e unequivocally followthe majority of jurisdictions and hold that a judgment creditor of a married individual isprecluded from enforcing that judgment by an action in foreclosure against real propertythat an individual debtor holds with his/her spouse in an estate by the entireties…” Kosterv. Boucheaux, 463 N.E.2d 39, 47 (Ohio Ct. App. 1982). Likewise, in Donvitov v.Criswell, 439 N.E.2d 467 (Ohio Ct. App. 1982), a post-judgment transfer to the non-debtor spouse was not a fraudulent conveyance because the creditor had no attachableinterest. As of 1984, a “survivorship tenancy” replaced tenants by the entirety which doesnot enjoy the entireties protection. Central Benefits Mutual Insurance Co. v. Ris Admin-istrators Agency, 637 N.E.2d 291 (Ohio 1994). Although a co-tenant of a survivorshiptenancy may not unilaterally defeat another’s right to the survivorship share, a judgmentlien against one tenant converts the tenancy to tenancy in common. Ohio Rev. Stat. §5302.20(c)(4). Tenancies by the entirety created while the 1972 statute was effective,however, shall be respected. Ohio Rev. Stat. § 5302.21.

Oklahoma Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Attachment permitted.

Type of Property: Real and personal property. Okla. Stat. Ann. tit. 60, § 74.

Comment: By statute, Oklahoma recognizes entireties. Okla. Stat. Ann. tit. 60, § 74.However, the statute provides: “Nothing herein contained shall prevent execution, levyand sale of the interest of the judgment debtor in such entireties and such sale shall con-stitute a severance.” A sale, not the attachment of a lien, severs the tenancy. Thus, if thedebtor spouse dies prior to sale, the property passes to the survivor free of the debt. Tomav. Toma, 163 P.3d 540 (Okla. 2007). It appears that the Oklahoma version of entiretiesprecludes voluntary transfer of an interest during coverture. See Note, Tom R. Russell,Title 60, Section 74 of the Oklahoma Statutes: A Unique Form of Tenancy by the Entirety,58 Okla. L. Rev. 317 (2005).

Oregon Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Attachment subject to non-debtor’s right topossession and survivorship.

Type of Property: Real property only. Panushka v. Panushka, 349 P.2d 450 (Or. 1960),involved an executory contract on real property executed by husband and wife. The hus-band died before settlement and his interest went to his probate estate because the con-tract converted the holding to a right to the purchase price. The court refused to recognizeentireties in personal property. But see Bedortha v. Sunridge Land Co., 822 P.2d 694 (Or.

North Carolinacontinued


1991), for a cautionary note on the conversion of real estate to personal property upon anexecuting contract of sale.

Comment: Tenancy by the entirety is seen as a tenancy in common with an indestructibleright of survivorship. Therefore the interest that a judgment creditor takes is an interestthat may be defeated if the non-debtor spouse survivors the debtor. If the tenancy is termi-nated by divorce, however, the lien remains attached and the creditor may enforce its lienregardless of a divorce decree awarding the property to the non-debtor spouse. Brownleyv. Lincoln Co., 343 P.2d 529 (Or. 1959). A creditor of one has an interest in the rents andprofits and partition is not permitted. Stanley v. Mueller, 350 P.2d 880 (Or. 1960). InWilde v. Mounts, 769 P.2d 802 (Or. Ct. App. 1989), the couple deeded the property to afamily member after a judgment lien attached due to the debt of the husband alone. Thecourt held that this out conveyance terminated the wife’s right of survivorship. Becausethe judgment lien attached to the husband’s interest, and because the interest was an inter-est in the whole (subject to the wife’s interest), the judgment lien thereupon attached to thewhole. A later case, involving the allocation of a property damage award to the two co-tenants, held that each owns one-half of such proceeds in keeping with the view thatentireties is a form of in common ownership. This ruling calls into questions the earlierholding in Wilde. McCormick v. City of Portland, 82 P.3d 1043 (Or. Ct. App. 2004).

Pennsylvania Type of Bar: Full.


Type of Property: Real and personal property. “The authorities thus cited would seem toshow that either spouse presumptively has the power to act for both, as long as the mar-riage subsists, in matters of entireties, without specific authorization, provided that fruitsor proceeds of such action inures to the benefit of both and the estate is not terminated.But neither may be such action destroy the true purpose of the estate by attempting toconvert it or a part of it, in bad faith, into one in severalty.” Madden v. Gosztonyi Savings& Trust Co., 200 A. 624, 630-631 (Pa. 1938) (discussing a joint bank account).

Comment: In Sterrett v. Sterrett, 166 A.2d 1, 2 (Pa. 1960), the Supreme Court likened ten-ancy by the entirety property to a living tree “whose fruits they share together. To splitthe tree in two would be to kill it and then it would not be what it was before when eithercould enjoy its shelter, shade and fruit as much as the other.” It is not subject to the cred-itors of one spouse. There is some question as to whether an unenforceable lien attachesto the debtor spouse’s interest, subject to divestment. See In re Hope, 77 B.R. 470(Bankr. E.D.Pa. 1987). In C.I.T. Corp. v. Flint, 5 A.2d 126 (Pa. 1939) a transfer by thedebtor husband and non-debtor wife to a spendthrift trust for their benefit was found notto be a fraudulent conveyance because the creditor had no attachable interest in the prop-erty. The court’s holding was narrow however; it only decided the issue of the fraudulentconveyance and not whether, or to what extent, a creditor could reach the debtor’s inter-ests in the self-settled spendthrift trust. Id. at 129.

Rhode Island Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Attachment permitted but not sale.

Type of Property: Real property. Applicability to personal property is uncertain, as thereare no cases regarding personalty and entireties ownership.

Comment: In Broomfield v. Brown, 25 A.2d 354 (R.I. 1942), the Rhode Island SupremeCourt held that the state’s married woman’s act merely permitted women to own proper-

Oregoncontinued


ty in any manner permitted by law, including as tenants by the entirety. Therefore, thejudgment creditor of husband could not force the sale of the property. The courts, how-ever, made a distinction between attachment and sale. It permitted the attachment to berecorded. Knobb v. Security Ins. Co., 399 A.2d 1214 (R.I. 1979). In Cull v. Vadnais, 406A.2d 1241 (R.I. 1979), the court held that the lien attaches but no levy and sale permitted.In re Gibbons, 459 A.2d 938 (R.I. 1983), the court held that once the lien attaches, a thirdparty will not be free of the debt. The death of the debtor spouse before the non-debtorspouse, however, permits survivorship free of the lien. The Bankruptcy Court in In reFurkes, 65 B.R. 232, 236 (Bankr. D.R.I. 1986), explained that the lien attaches “to a con-tingent future expectancy interest, and that said interest may be sold by the attachingcreditor, if anyone can be persuaded to buy it.”

Tennessee Type of Bar: Modified.

Effect of Judgment Creditor of One Spouse: Lien attaches to debtor spouse’s survivorshipinterest.

Type of Property: Real and personal property. Joint bank accounts subject to the order ofeither spouse may be entireties property. Grahl v. Davis, 971 S.W.2d 373 (Tenn. 1998);Sloan v. Jones, 241 S.W.2d 506 (Tenn. 1951) (relying on the reasoning in Madden v.Gosztonyi Savings & Trust Co., 200 A. 624 (Pa. 1938)).

Comment: The lien attaches to the survivorship interest only and it does not affect thepresent possessory interest. In re Arango, 992 F.2d 611 (6th Cir. 1993) (applying Ten-nessee law). In Citizens v. Southern Nat’l Bank, 640 F.2d 837 (6th Cir. 1981), the courtfound that the transfer of the tenants by the entirety property from the debtor spouse tothe non-debtor spouse involved the transfer of the debtor spouse’s survivorship interest.This interest, explained the court, has “substantial value to the recipient spouse” so prej-udice to the creditor is inferred. Id. at 839. The court therefore remanded the fraudulentconveyance issue.

U.S. Virgin Islands Type of Bar: Full.

Effect of Judgment Creditor of One Spouse: No levy and execution.

Type of Property: Real property only. V.I. Code Ann. tit. 28 § 7.

Comment: In Masonry Products, Inc. v. Tees, 280 F.Supp. 654 (D.V.I. 1968), the courtapplied the majority rule that a creditor of one spouse may not “reach” that spouse’s inter-est in property held by the entireties during the joint lives of the spouses. Therefore, itpasses free from the debt if the non-debtor spouse survives. The estate by the entiretieswas introduced by statute in 1957 with few interpretative cases so it cannot be determinedif a lien attaches.

Vermont Type of Bar: Full.


Type of Property: Real and personal property. See Beacon Milling Co. v. Larose, 418A.2d 32 (Vt. 1990), finding that a joint bank account could be held as entireties, notwith-standing the ability of either to unilaterally withdraw from the account.

Comment: Entireties property is not subject to the debts of one spouse. In re Pauquette,38 B.R. 170 (Bankr. Vt. 1984). In Lowell v. Lowell, 419 A.2d 321 (Vt. 1980), an ex-wife

Rhode Islandcontinued


could not use part of the value of the husband’s tenant by the entirety interest with his cur-rent wife to support an alimony claim because such property could not be available tocover his sole debts. See also Rose v. Morrell, 259 A.2d 8 (Vt. 1969). Under Vermont’scivil union statute, entireties ownership is extended to parties of a civil union. Vt. Stat.Ann. tit. 15 § 1204(e).

Virginia Type of Bar: Full.


Type of Property: Real and personal property. In Oliver v. Givens, 129 S.E.2d 661 (Va.1963), the court found that the sale proceeds of entirety property continue to be held bythe entireties and therefore the debtor spouse transferring his interest in the proceeds tohis spouse was not a fraudulent transfer. “This is so for the obvious reason that creditorsare not prejudiced by a gift of property which is exempt from their claims.” Id. at 664.

Comment: In Rogers v. Rogers, 512 S.E.2d 821 (Va. 1999), the Virginia Supreme Courtheld that tenancy by the entirety property could not be sold by a creditor who had twoseparate judgments (one against husband and one against wife). In that case, the judg-ments were separate but related. Judgment against the wife was entered because she par-ticipated with her husband in a scheme to hinder and delay the collection of the judgmentagainst her husband. See also Bunker v. Peyton, 312 F.3d 145 (4th Cir. 2002), where theCourt of Appeals in a consolidated bankruptcy case held that the separate creditors ofhusband and wife were not entitled to satisfy debts against the tenancy by the entiretyproperty regardless of the generally commingling of their finances. Virginia has a statutethat extends entirety protection to spouses holding property in revocable trusts under cer-tain circumstances. Such property held in trust “shall have the same immunity from theclaims of their separate creditors as it would had it remained a tenancy by the entirety, solong as (i) they remain husband and wife, (ii) it continues to be held in the trust or trusts,and (iii) it continues to be their property.” Va. Code Ann. § 55-20.2. The property had tobe held, before the transfer into trust, as tenants by the entirety.

Wyoming Type of Bar: Full.


Type of Property: Real and personal property. Wyo. Stat. Ann. § 34-1-140. However, the“existence of a tenancy by the entirety will not be presumed by this court in the absenceof an express intent to create the right of survivorship.” In re Anselmi, 52 B.R. 479, 487(Bankr. D. Wyo. 1985).

Comment: In Colorado Nat’l Bank v. Miles, 711 P.2d 390 (Wyo. 1985), the court heldthat one spouse alone cannot subject tenant by the entirety property to a mortgage.“Entirety in this connection means indivisibility. The estate is owned not by one butby both as an indivisible entity …” Ward Terry & Co. v. Hensen, 297 P.2d 213, 215(Wyo. 1956).

Vermontcontinued


A Letter About Investing to a New Foundation Trustee, with Some Focus

on Socially Responsible Investingby Joel C. Dobris Davis, California*

Editors’ Synopsis: Cast in the form of an e-mail,this article provides investment guidance to a newboard member of a private foundation. Included in theadvice offered is a discussion of socially responsibleinvesting and its various subcategories.

Dear Amy:

Congratulations on your appointment to the Boardof the Black Swan Foundation. I saw it in the paper theother day.

I’m guessing you’re wondering about your invest-ment responsibilities. So, I thought I’d try to composea “short” e-mail about investing endowment funds andtrust funds. I’m not functioning as a lawyer here and Idon’t know a lot about the Foundation, but I did pickup some information from the Web. I know the endow-ment is humongous and that it’s a private foundation. Iassume it’s a (nonprofit) corporation.

So, here goes.

BASICS OF FIDUCIARY INVESTING

All the law in the world1 requires that the Founda-tion, let me say the Board, let me say you, invest pru-dently.

I’m going to pretend you, or the whole board, aregoing to do the investing yourself(selves). But, intruth, organizations are likely to turn to knowledgeableindividuals and institutions. Individuals may be a partof the organization (volunteers, employees, officers orboard members) or individuals or institutions may be

vendors of investment advisory services.So, what does prudent mean? Well, all things

being equal, and, oversimplifying, it means that youinvest for the risk-adjusted return best suited to theorganization’s goals.

What does that mean? Simply put, it means that youfollow the tenets of modern portfolio theory (MPT), theefficient market hypothesis (EMH), the capital assetpricing model (CAPM) and similar, academically root-ed and robed, theories of investment (all of themcousins, if not siblings), as they evolve. I say “as theyevolve” because they are currently being attacked, ques-tioned, improved, tested, however you want to put it.2

“Crikey, Joel, I don’t know what you just said.”Neither do I. Let me try to put it at the level of cocktailparty chatter (more realistically at the level of a lectureover the top of a glass to a bored “student”). Whycocktail chatter? Because I know you ain’t gonna do alot of studying.

So, here are some simple rules on how to invest:(1) set reasonable and obtainable objectives, (2) keepan eye on potential risks as well as potential returns,(3) establish and communicate an investment policy(which may well involve bench-marking your differentportfolios3), (4) keep transaction costs low,4 (5) investin a core of passive indexes,5 or the equivalent, (6)hyper-diversify,6 (7) worry about inflation, (8) under-stand that assets return to a mean or equilibrium value(what goes up comes down, what goes down oftenbounces back), (9) understand that ultimately portfo-lios over the long term, on average, cannot outperformtheir underlying earnings,7 (10) delegate to profession-

* Copyright 2009 by Joel C. Dobris. All rights reserved.1 THE RESTATEMENTS OF TRUSTS, THE UNIFORM PRUDENT

INVESTOR ACT (UPIA) and the UNIFORM PRUDENT MANAGEMENT OF

INSTITUTIONAL FUNDS ACT (UPMIFA).2 I first started to try to understand this stuff on my first sab-

batical in 1983-84 in London, where I spent endless days readingand failing to understand the dozens of articles in financial journalsin the library of the London Business School. That’ll teach me tomajor in English.

3 A benchmark is an accepted norm against which to mea-sure performance. It should be transparent and will likely take intoaccount a manager’s investment style, broad market movements

and her ability to successfully make active investment decisions(add alpha as the big girls put it).

4 Transaction costs are advisors’ fees, brokers’ commissions,and the like.

5 Passive is discussed below.6 Try to own a piece of everything.7 More specifically, over very long periods of time equity

cannot outperform earnings per share (EPS). As Warren Buffett putit in his 2005 Berkshire Report: “With unimportant exceptions, ...,the most that owners in aggregate can earn between now and Judg-ment Day is what their businesses in aggregate earn.”


als when it makes sense, (11) err decisively on the sideof investing in equity, as opposed to debt,8 (12) stayaway from alternative/exotic/arcane investments andtechniques, with their very high fees, unless your port-folio is large enough to justify using the fancy stuffand you are absolutely convinced you have access tothe rare advisers capable of successfully using suchproducts and techniques (and earning their fees andyour profit), and that you understand and can super-vise their investing or, even rarer, that you are one ofthose investors yourself,9 (13) stay away from invest-ment fashion and fads. You should be very skepticalabout alternate and fashionable investments and theassociated high fees.10 Eventually, the exotic willbecome the ordinary, I do admit, but we ain’t thereyet.11

Very briefly why are the rules in the precedingparagraph useful? Here goes.

(1) Setting reasonable and obtainable objectivesis a good idea because investing is the art of the possi-ble, or as Charlie Ellis has put it, winning the loser’sgame.12 In the absence of clearly stated objectives thatare comprehensible, reasonable, and achievable, theprobability of actually achieving those objectives issmall. Written objectives help focus the mind. Forexample, “maximize returns” is not reasonable (it saysnothing about risks). “Maximize returns at a prudentlevel of risk” is incomprehensible, because it doesn’texplain where the prudent level of risk lies. “Earn astable 5% real return” may not be achievable, especial-ly by plain-vanilla perpetual endowments, because(among other reasons) stable returns and high realreturns usually don’t come from the same assets.

(2) Keeping an eye on potential risks as well aspotential returns is a good idea because we are so eas-ily seduced by the prospect of return and because cal-culating risk is so much a part of modern financial the-ory. Avoiding pitfalls can be just as useful as earninggood returns. For example, Cambridge Universityand Oxford University had similar sized endowmentsin the 17th century. During the English Civil War inthe 1640s, Oxford backed the loser (Charles I) by

lending him part of its endowment. Even now, 360years later, Oxford’s endowment is smaller. Success-ful long term investors keep an eye on risks as theyseek returns. One of the simplest ways to reduce risk,by the way, is to diversify.

(3) Establishing and communicating an invest-ment policy is a good idea (indeed, a must) becauseeveryone knows where they stand and your profes-sionals will do a better job.

(4) Keeping transaction costs low speaks foritself. More money for you and less for “them.” A keypoint of low transaction costs is that the money youdon’t pay to the folks in suits “goes to your bottomline” as they say—i.e. you get to keep it and the suitsdon’t. In other words, the spielers and the Music Menaren’t in the game for low transaction costs. Thatmeans that a constant commitment to low transactioncosts not only keeps you from chasing rainbows, butalso keeps the wisenheimers out of your life. You getto say, “That sounds like a lovely idea, but we don’tpay umpty ump percent of profits to our advisers. It’sone of our silly little rules.”

(5) Let’s talk about passive investing. Amongother things, passive investing reduces transactioncosts, and in taxable portfolios (which is not yours)reduces capital gains. Passive investing is, oversimpli-fying, directly or indirectly replicating the holdings ina particular stock index. For instance, it might meanmaking an asset allocation to large-cap American cor-porate equity, and then seeking to make that invest-ment by buying an S&P 500 fund. To invest passivelyis to accept a so-called market return.

Or, one can engage in active investing by havingadvisers who point you in the direction of assets cho-sen to provide a return superior to an index return, or,using fashionable lingo, to provide Alpha.

But the Alpha men better be good. (6) There are several reasons to hyper-diversify.

My two favorites are these: first, you do it to get asomewhat uncorrelated portfolio. Huh? Well, whensome of your holdings are down others will be up, andwith any luck, overall, you’ll have a nice smooth posi-

8 Seriously oversimplifying, there are only two kinds ofinvestments—equity and debt. Equity means you own the stuff anddebt means you are loaning, or renting, your money to somebodyelse. Classic examples of equity are common stock and real estateand a classic example of debt is a bond.

9 There is a ritzy hierarchy of folks who can successfullyadvise regarding alternative investments. Most investors have noaccess to these people.

10 Every con man knows the promise that ‘always’ works:“Give me all your money, and I’ll solve all your problems.”

11 You can see that I buy into the so-called bar bell theory ofinvesting today and that I’m talking about plain foundations invest-

ing in only one end of the bar bell. Huh? Read this quote fromPauline Skypala in her article, The Barbell Rings True for Tradi-tionals, FINANCIAL TIMES, Sept. 7, 2008: “Things are looking goodfor the asset management barbell thesis Morgan Stanley first putforward five years ago. This suggested traditional asset managerswould lose out as money increasingly shifted to cheap passivestrategies on the one hand and alternative investments and highreturn specialists on the other.”

12 CHARLES D. ELLIS, WINNING THE LOSER’S GAME: TIMELESS

STRATEGIES FOR SUCCESSFUL INVESTING (4th ed. 2002). He is aleading investment commentator and author. See http://mba.yale.edu/why/advisors/profiles/ellisc.shtml.


tive return, sorta. That’s an eighth grade definition ofuncorrelated. Kind of like those physics vector dia-grams from high school. One arrow to the left, onearrow to the right and the third arrow goes down themiddle. Or, the pistons in a car engine—when someare up some are down, but the car keeps moving for-ward. Or something like that.

Another reason to hyper diversify is behavioral—when you hear about some hot new stock, you don’thave to chase it because chances are you’ve got some.

(7) Fearing inflation explains itself. And, bythe way, if you don’t believe me, the cigar that I usedto buy when I was in practice for a $1.80 is now$18.95.

(8) Reversion to the mean (simplifying, return-ing to the average, if you will) explains itself, too. Ifyou like, it’s called gravity.

(9) That shares of stock, ultimately, can’t out-perform corporate earnings is clear, too. Again, it’scalled gravity. If the company can’t make moneythere’s no reason to own it.

(10) Delegation is easy, too. We can’t do every-thing by ourselves. And, certainly, not well.

(11) Over very long periods of time, studies sug-gest that the more equity you have the more moneyyou make. And, if that’s not enough, if you own stock,the dividends give you a nice steady stream of spend-able income.

(12) As to alternate investments, for whatever it’sworth, I am dead set against run of the mill, smallerfoundations getting into alternate investments and I amdead set against any organization using alternate invest-ments unless they are absolutely certain they are dealingwith Mr. or Ms. Right. Get it tattooed on your wrist.13

(13) Why stay away from fads and fashions?Because you, or your advisers, have to be awfullygood at exploiting them or you’re going to lose money.And because fads and fashions will inevitably attract“Music Men” who won’t know what they’re doing, butwho can be awfully convincing.

So, those are my rules. About eight too many. Soshoot me.

Getting yourself sorted. Realistically, as a newtrustee, I’m sure you will find that the board has a sys-tem in place for investing foundation funds, for invest-ing the foundation’s portfolio of assets. And, just tomake you miserable, they might be considering chang-ing the way they invest from System A to System B.

What kind of system are you going to find? Well, Idon’t know, but most charities are likely to have a so-called “policy portfolio” of more or less traditional, orconventional, asset classes.

So, what’s a “policy portfolio?” It’s a portfolioinvested according to a policy.

Duh. Of course. Remember, I said to establish and communicate a

policy to your advisers. Typically, the policy will bean asset allocation policy. That policy was, hopefully,prudently adopted, and was, and will be, periodicallyrevisited, again prudently. And the establishment andrevisiting/review of the policy was and will be ade-quately documented. Under such a policy the organi-zation allocates assets, likely on a percentage basis, tovarious, likely traditional, asset classes, e.g., domesticequity, domestic debt (say bonds), emerging marketequity, and the like.

I just said traditional. “Traditional” lies in the eyeof the beholder. Simplifying, “traditional” in this para-graph means, to many folks, liquid assets such as listedsecurities, traded bonds and real estate investment trusts(REITs). Coming up with the “right” policy portfolio ismore than enough of a task for most fiduciary investors.To give you an ultra simple example, a lot of individualinvestors hold a 60/40 portfolio—60% American stocksand 40% American bonds. That is a policy portfolio.“What’s your policy?” “I’m a 60/40 investor.”

Your tasks. I would suggest, for starters, that yougive yourself two tasks—figuring out what best invest-ing practices are for a foundation like yours and figur-ing out just what it is that your foundation is doingabout investments. Once you have educated yourselfon both scores, which is not trivial, then you candecide if you are satisfied with the organization’sinvestment strategy and operation, or if you would liketo take on the daunting task of trying to change thegroup’s investment goals and operations. Realistically,the typical new trustee is not likely to try to change theinvestment system, and even if she tries, query if shewill succeed. And, even if she succeeds it can take along time, like turning a battleship.

And now for something completely different.Nontraditional investments. OK, so, I discussed tra-ditional investing. Having said all I’ve said, I suspectthat questions of nontraditional, or nonstandard,investments will quickly arise in your life as a boardmember. You may find, one of these days, that youhave to decide whether to depart from a standard, runof the mill, finance-theory-based, policy. By nonstan-dard I mean investments other than those designed toget the best risk adjusted return on capital in a tradi-tional, straightforward fashion—the up-to-the-minute,modern, large foundation version of a 60/40 policyportfolio. Not surprisingly, the definition of conven-tional in this context is a moving target, with smallerinvestors participating in markets once reserved for theultra sophisticated. To make a (stale) joke of it, evenbarbers are investing in hedge funds these days.13 Textual tattoos are very fashionable these days.


Nontraditional comes in two forms: Spicy andSaintly.

Spicy: “C’mon over and meet David Swensen.He’s the one talking to Jane Mendillo.” Nonstandardinvestments could be offered, let me say to your board,with the goal of making more money for your charita-ble purposes—for what folks call profit maximizing.“Let’s take some of our money out of the S&P 500 andinvest it in a hedge fund, some private equity, someventure capital and in some Carpathian timberland.We’ll make a bloody fortune.” That is, let’s invest likeDavid Swensen at Yale, not like a retired New Englandtrust banker acting as the trustee for an ancient widow.

Saintly: “C’mon over and meet Mother Teresa.”Or, nonstandard investments could be offered to yourboard with the goal of making more than money, ofserving nonfinancial interests and purposes of thecharity, or some of its stakeholders, or the world. Sim-plifying, the thoughts behind these money’s-not-everything offerings might include: [a] let’s cast someof our grants in the form of investments in our grantees(that’s PRI—more later); [b] let’s make our money dotwo jobs—earn a financial return and also advance ourcharitable goal (that’s MRI—more later); [c] let’s notearn dirty money (let me say earned via the labor ofThird World orphans14)—let’s do some good for theworld at large with our money (that’s nonspecific SRI,or sub-SRI).15

I think I’d better fully label and briefly definesome of this stuff. What I’m talking about, in broadterms is social investing, or socially responsibleinvesting, or SRI. Think of SRI as a Big Tent thatincorporates all the approaches. There are labeling dis-putes about what SRI means, plus there are labels forsubcategories. And, you will find that I am using thelabel SRI twice—(1) to describe any do-some-goodinvesting conduct other than trying to make money,and (2) to describe general, soft focus, save-the-world,we-are-nice-people investing—my category [c].Dang. As I’ve said, maybe we can call this second kindof socially responsible investing “nonspecific SRI” or“sub-SRI.”

Let’s get rid of a distraction. “C’mon over andmeet Al Gore.” Let me make an important point. Any-one who says “we can make more money by investingonly in do-good companies” is not talking aboutengaging in SRI. Rather, she is engaging in activeinvesting according to a theory. One might argue thisbelongs in my category, “C’mon over and meet DavidSwensen,” but let’s give it its own cubby hole. The

famous Kleiner venture capital firm is basicallyswitching to all green investments—to make money,not to make nice. Ditto Al Gore and David Blood withtheir heralded firm in London.

“You really are mean-spirited, Joel.” You may, ormay not, be sad to know that I believe, given our cur-rent state of knowledge, that, theoretically, any con-straint of an investment portfolio for noninvestmentpurposes (let me say SRI) will reduce return, orincrease risk, over extended periods of time. That’s abig gulp, so let try to make it simple. I believe, if youronly goal is to get the best risk-adjusted return for yourendowment, you should not engage in socially respon-sible investing (SRI). Sorry. Maybe, you better notinvite me to the foundation Christmas party. This viewis a popular one among quantitative investors (andmany investment advisers) and it is an unpopular viewin the foundation world and the world of SRI invest-ment advisers.

In other words, I am not a crook.I hasten to add that this may change in the future,

and I hasten to add that you may decide that makingevery last dime is not the be-all and end-all when itcomes to endowment investing. And, you may discov-er that events that appear to be about investing, actual-ly are about something else like implementing pro-grams of the foundation or carrying out its charitablemission (PRI and MRI, respectively), which, I wouldsay, removes them from the path of my dreary dictum.

“Why should I listen to you, Joel?” Two questionsimmediately arise—who says I can’t invest any way Iwant; and do I have to invest every dollar in a way thatallows me to earn every dime? Is that what the lawrequires of me? Oversimplifying, my answer to thefirst question is that trust law says you can’t invest anyway you want and my answer to the second questionis: I don’t think so—I think you don’t have to makeevery dime as long as you have a good story.

You can do anything you want with your ownmoney. You can “invest” it all in lottery tickets if youlike. You can swing for the fences with startups orbunt with Treasury Bills—it’s up to you. That’s not thecase when you’re talking about money you are invest-ing on behalf of someone else—the foundation’s ben-eficiaries. In other words, fiduciaries cannot do what-ever they want with OPM—other people’s money.They are supposed to come up with an investment pol-icy, execute it (directly or indirectly) and review boththe policy and the execution periodically. And that pol-icy has to be focused on the other people—the benefi-

14 TESTED ON ORPHANS, CARTOONS BY DAVID MAMET (2006).15 Some foundations become corporate activists for social

benefit and seek to engage corporate management in order to reach

either mission goals or make-the-world-a-better-place goals. Thismight be done with the goal of making more money, but is likelierdone for a public benefit purpose.


ciaries of the dedicated money in the foundationendowment or the trust.

It’s okay to invest only for financial return. As Ihave kind of indicated, one approach to endowmentinvesting is to conclude, as a fiduciary, after due con-sideration, that the appropriate investment policy foryour organization is to focus on your financial, orpecuniary, return and then spend that return, wisely, onthe organization’s programs and mission.16 “First weearn it, then we give it away.” That is a legitimatedecision, and one that the trustees of many organiza-tions will make. Put another way, they are saying wewill not sacrifice financial profit for any non-financialpurpose, no matter how noble.

Put differently, many fiduciaries will focus solelyon pecuniary return. Focusing solely on pecuniaryreturn, does not, however, license you to take unduerisks. Risk is calculable and is a function of circum-stances. And, I bet you don’t want to do any calcula-tions and that’s why you delegate.

SIRENS’ SONGS

Another way of putting much of what I’ve said sofar about deviating from standard investing is as fol-lows: The crew of the good ship prudent endowmentare gonna hear some sirens’ songs as they sail on theirjourney.

Let’s talk about making more money (i.e., let’stalk about meeting David Swensen). Staying focusedon financial gain, I note, oversimplifying, some chari-ties hearing a sirens’ song will be looking for ratio-nales for investing for dramatic pecuniary gain, step-ping out beyond the world of traditional, often liquid,fiduciary investments. I am guessing that your boardis thinking about buying some exotic investments, alot of which, I bet will be illiquid by their nature.Oversimplifying, if you turn to the more unusualinvestments available to large foundations, your boardwill be looking to rationalize those more exotic invest-ments as prudent. Why rationalize? I would say to be

sure you’re doing a good job, to maintain self-esteemin the event of loss, and to create a defense in theunlikely event you are sued for breach of duty byvirtue of over-adventurous, loss making investing.One way of rationalizing it will be to say, “We’re notbeing greedy, we’re just diversifying. We’re good littlegirls and boys.” One defense might be, “We took cal-culated risks, appropriate to our situation. They shoul-da worked. They coulda worked. It woulda been niceif they did work. ”

So, that is one sirens’ song your board may hear—“Board members, Amy, vote to buy Carpathian timberfutures. They’ve got nowhere to go but up.”

Let’s talk about making less money (i.e., let’s talkabout meeting Mother Teresa). There’s another sirens’song out there. SRI.

What’s that? We’ve kind of been talking about itand, hopefully, what follows will enhance understand-ing. I am certain that your board has at the leastbumped up against, and perhaps engages in sociallyresponsible investing, or SRI. Simply put, the songyou will hear is, “Amy, vote to sacrifice financial prof-it for this or that good reason. Vote for SRI.”17

As I mentioned, SRI is a Big Tent. Let’s say it’s“managing money according to ethical criteria”18 justto have a definition.19 Let’s say it covers all our cate-gories. And, let’s distinguish the label SRI from whatI’m calling “nonspecific or sub SRI” or general, soft-focus, save-the-world, we-are-good-people investing.

Oversimplifying, some charities are looking forrationales for investing for other purposes besides maxi-mum financial return. Obviously, then it is not enoughto say that directors have the fiduciary duty to maximizeendowment returns, one must go on and ask if returnsare to be measured only pecuniarily or financially.

Here are some rationales for going beyond finan-cial returns: [a] we must engage in SRI to carry out ourprogram (that’s PRI), [b] we must engage in SRI tocarry out our mission (that’s MRI), [c] we mustengage in SRI to be good people (that’s nonspecific orsub SRI). As I’ve already said, “We must engage in

16 What’s the difference between a program and a mission?The mission might be to aid children and the program might be toprovide nourishing snacks at after school activities.

17 Or, even better, or worse, some folks will say you can soinvest without sacrificing profit.

18 Michael S. Knoll, ETHICAL SCREENING IN MODERN FINAN-CIAL MARKETS: THE CONFLICTING CLAIMS UNDERLYING SOCIALLY

RESPONSIBLE INVESTMENT, 57 BUS. LAW. 681 (2002). SRI is alsocalled Ethical Investing and ESG investing (Environmental, Socialand Governance). See CAPGEMINI & MERRILL LYNCH, WORLD

WEALTH REPORT 2007. SRI is to be distinguished from CSR—cor-porate social responsibility. See N. Craig Smith & Halina Ward,

Corporate Social Responsibility At a Crossroads?, 18 BUSINESS

STRATEGY REVIEW 1 (2007) (Summary and analysis of currentthinking about CSR in Britain via interviews with business insiderswhich inter alia suggest the term CSR may be too vague to be use-ful.) Of course, what’s ethical and what are the criteria are deter-mined by the investor.

19 I have a friend who says SRI is whatever the loudest personin the room says it is. There surely are disputes. See The InformedReader, When Gastronomy and Morality Collide, WALL ST. J.August 17, 2007 at B6; Vanessa O’Connell, The New Politics ofPurses, WALL ST. J., Aug. 4-5, 2007 at 3 (whether a good personuses/buys anaconda rather than python.).


SRI to make more money” has no place in this sectionof my email. This section is about not making money.20

Let me try to define [a] program related invest-ments, or PRI, and [b] mission related investments, orMRI, and [c] nonspecific, or sub, SRI.

PRI is just a grant in the form of an investment.You may engage in PRI. It’s kosher. It’s a term fromthe Internal Revenue Code21 that applies to privatefoundations.22 The I.R.C. blesses PRI as a form of SRI.A PRI has to advance the charity’s objectives and nothave a true financial purpose. In other words, it has tobe a really lousy investment, but a rational good deed.

Private foundations don’t mind PRIs. PRIs counttowards the 5% of the endowment that a private foun-dation must spend to maintain its tax-exempt status.PRIs are another arrow in the charitable warrior’squiver. A grant in the form of an investment can bemore dignifying for the recipient than a plain grantand PRIs offer some chance of getting some of themoney back as opposed to grants, where the moneyis gone for good. They can, however, be administra-tively complex.

An example of a PRI might be a direct loan to acharity that helps poor people get better jobs. SincePRIs aren’t supposed to be real investments, the loanwould have to be at a bargain rate, have a high risk thatit won’t be paid back, or a combination of both.

A mission related investment, or MRI, is one madein pursuit of the entity’s mission, but with a goal ofmaking an investment return23 (oversimplified, think ofit as an investment that aims to make both a meaning-ful, if not ideal, risk adjusted pecuniary return and asocial return related to the mission of the organiza-

tion). I think MRIs offer one rationale for engaging inSRI that overcomes legal barriers in the way of SRI.24

To recap, so-called mission investing involves invest-ing endowment funds to advance the organization’snonprofit goals.

For example, folks may want to avoid securitiesthat appear to undermine the mission of the organiza-tion. A cancer charity might want to avoid tobaccostock. Or, entities might want to invest in the securi-ties of corporations that seem to advance the missionof the organization. A charity chartered to advancethe cause of housing lower income individuals mightinvest in the stock of a for-profit developer whodevelops small, bare-bones condominiums, locatedon brown fields, positioned in the market for sale tolower income individuals. A university that is para-lyzed by a student strike demanding the divestment ofparticular securities might legitimately conclude thatif it wants to get on with the mission of teaching it hasto end the strike by selling the securities. A founda-tion whose staff is demoralized by holding the stockof a gross polluter might divest to get on with thebusiness of carrying out the foundation’s mission offeeding the poor. A fund for the city of Cincinnatimight invest a portion of its portfolio in Cincinnati-based corporations.

Nonspecific SRI, or sub-SRI, involves an organi-zation investing endowment “to be good people.” Itisn’t related to the program or mission of the organiza-tion and it serves imperfectly in the risk-adjusted,financially modern portfolio of the organization.25

Why all this fussing? Because, somebody is goingto worry about being sued. Sued for what? Sued for

20 I’d say so-called community investing is PRI, MRI or sub-SRI investing depending on the circumstances. I’d say so-called ESGinvesting is likely MRI, sub-SRI or active investing according to atheory, depending on the circumstances. It’s less likely to be PRI.

21 Since it’s legally defined, you want to get it right if you areclaiming a transaction for PRI purposes. See I.R.C. § 4944(c)(2006); Treas. Reg. § 53.4944-3 (1972).

22 I would be comfortable applying a quasi-PRI analysis tocharities that are not private foundations, but that is a story foranother day. Then I’d speak of pri not PRI.

23 SARAH COOCH & MARK KRAMER, COMPOUNDING IMPACT:MISSION INVESTING BY U.S. FOUNDATIONS 6 (2007); Jed Emerson,Where MONEY meets MISSION, Stan. Soc. Innovation Rev., 38(Summer 2003); Jed Emerson & Mark Kramer, Maximizing OurMissions, CHRON. PHILANTHROPY (Jan. 25, 2007). The Gates Foun-dation was scolded for investing against their mission. They choseto ignore the fuss. See Charles Piller, Berkshire Wealth Clasheswith Gates Mission in Sudan, LA TIMES, May 4, 2007, available athttp://www.latimes.com/news/nationworld/nation/la-na-berkshire4may04,0,07433631,full.story?coll=la-home-headlines; CharlesPiller, Buffett Rebuffs Efforts to Rate Corporate Conduct, LA

TIMES, May 7, 2007, available at http://www.latimes.com/news/nationworld/nation/la-na-berkshire7May07,1,2180048.story?coll=la-headlines-business; Charles Piller, Money Clashes with Mission,LA TIMES, Jan. 8, 2007, available at http://www.latimes.com/news/nationworld/nation/la-na-gates8jan08,0,7911824.story?coll=la-home-headlines; Charles Piller, et. al., Dark Cloud Over GoodWorks of Gates Foundation, LA TIMES, Jan. 7, 2007, available athttp://www.latimes.com/news/nationworld/nation/la-na-gatesx07jan07,0,6827615.story.

24 MRI is a very attractive rationale for accepting a lesserreturn. Why? The Uniform Prudent Investor Act (UPIA), adoptedin most states, in § 2(c)(8), says that a trustee can consider “anasset’s special relationship or special value, if any, to the purposesof the trust or to one or more of the beneficiaries” in making aninvestment decision. This section suggests that a mission relatedinvestment may well be prudent. The Uniform Prudent Manage-ment of Institutional Funds Act (UPMIFA), which applies to non-profit corporations, has a parallel section.

25 If the investment is trivial and/or is buried in the portfoliothen realistically it will likely not generate litigation, or gounmarked in any litigation about something else.


not pursuing the maximum risk-adjusted financialreturn appropriate for the foundation. Or, perhaps suedfor not earning every last dollar.

An unspeakable truth.26 Let me ask again, why docharities (or more precisely, the people who run them)look for rationales—why don’t they just invest as theywish? They seek rationales to conduct their affairs inan orderly and structured fashion. And, perhaps moreimportantly, they do it because they don’t want to be(successfully) sued for breach of fiduciary duty forinvesting for purposes other than prudently maximiz-ing financial gain for the charity. That is all to thegood, and I would encourage every board member tofully understand and discharge her fiduciary duties, butthe great truth is that if a charity, after due and rationalconsideration, prudently decides to forgo some finan-cial gain for legitimate organizational purposes, then Ibelieve there will ordinarily be no such successful law-suit. The likeliest plaintiff is the attorney general andshe is looking to pluck the low-hanging fruit. And,well-lawyered, mildly adventurous investing by chari-table boards ain’t low hanging fruit.

Let’s talk about lawsuits. What kind of a lawsuitmight a foundation trustee theoretically face? Thelikeliest trigger for such a lawsuit would be dramaticfinancial loss. A less likely trigger might be bad pub-licity for the organization or one of its principals.Whatever the trigger, once somebody decides a lawsuitis a good idea, a litigator will look for a theory. Thelikeliest theories include: failure to properly dischargethe duty of care (i.e., failure to invest properly/prudent-ly); and breach of the duty of loyalty to the charity andits beneficiaries.

Let’s talk about plaintiffs. Who might be theplaintiffs in such a hypothetical lawsuit? The mostobvious possible plaintiff is the Attorney General ofthe state where the charity was created (let me sayincorporated) and the Attorney General in any statewhere the charity conducts its affairs. The AttorneyGeneral is always a proper plaintiff and has had, forcenturies, the authority to enforce the interests of soci-ety, or, as lawyers put it, the interests of the charity’sultimate beneficiaries. Much less likely are suits begunby fellow members of the board27 or members of the

corporation if the organization is a so-called member-ship corporation. There might be a suit by someonewith “a special interest.” In a small number of jurisdic-tions, suits by the creator of the foundation or her suc-cessors are possible, too.28

If your goal is to make money and you follow myadvice you won’t be successfully sued. If the board’sgoal was simply to get a good financial return for theorganization the group’s likely, and best, defense willbe that they invested for the risk-adjusted return bestsuited to the organization’s goals; established, commu-nicated and periodically reviewed an investment policycompetently established in pursuit of that return; andfollowed the tenets of theoretical finance as set forthabove. All things being equal, this would likely proveto be an adequate defense. It’s not whether you win orlose, it’s how you play the game.

Recap: What about lawsuits because you pursuednonfinancial goals when investing? If the organizationhad nonfinancial goals when the investments were madeand there was financial loss, or the plaintiffs fear a lossin the future, then a different analysis is called for.

Once again, it is important to distinguish activeinvesting strategies designed to maximize financialgain, from goody two-shoes attempts to make theworld a better place. The business pages tell us thatCostco is good to its employees and a great place towork. If a fiduciary adds Costco to her portfoliobecause she thinks that companies that are kind to theiremployees make more profits than those that aren’tkind, then this is not social investing. Rather, it is theactive investing for profit pursuant to a theory-thatcompanies with best practices vis-à-vis their employ-ees make the best stock market investments.

If a foundation with the charitable purpose of reha-bilitating ex-convicts buys the below market interestrate, poor credit risk bonds of a non-profit traininginstitute that seeks to rehabilitate ex-cons to qualify forwork at Costco, that is a program related investment,or PRI. If the foundation invests in Costco because thefoundation has a charitable purpose of improving thelives of working people in the retail trade, then thismay be mission related investing, or MRI. If the foun-dation invests in Costco because Costco employee

26 Inconvenient? No. Unspeakable? Yes.27 Some foundations are run by family members. Will they

sue? There are as many answers as there are families. “Happy fam-ilies are all alike; every unhappy family is unhappy in its own way.”LEO TOLSTOY, ANNA KARENINA.

28 Cases of interest include: Smithers v. St. Luke’s-RooseveltHosp. Ctr., 723 N.Y. S.2d 426 (App. Div. 2001); L.B. Research &Education Foundation v. UCLA Foundation, 130 Cal. App. 4th 171(Cal. Ct. App. 2005); Robertson v. Princeton, No. C-9902 (N.J.

Super. Ct. Ch. Div. filed Jul. 17, 2002); In re Milton Hershey Sch.Trust, 911 A.2d 1258 (Pa. 2006); In re Barnes Found., 871 A.2d792 (Pa. 2005); 582 Pa. 370 (2005); Estate of Buck, No. 23259(Cal. Super. Ct., Marin County Aug. 15, 1986), reprinted in Sympo-sium: Nonprofit Organizations, 21 U.S.F. L. REV. 691 (1987); Doev. Kamehameha Sch./Bernice Pauahi Bishop Estate, 295 F. Supp.2d 1141 (D. Haw. 2003), aff’d in part and rev’d in part, 470 F.3d827 (9th Cir. 2006) (en banc).


practices make the world a better place, that is nonspe-cific or sub SRI, as far as I am concerned, and it theo-retically might be actionable.

There are those who would argue that any pur-poseful forgoing of financial return when investingfiduciary assets is an actionable breach of trust. I amnot one of them. There are those, and I am one ofthem, who would argue there are credible rationalesfor forgoing some financial investment return.

Hybrids and the fourth sector. This e-mail wouldnot be complete without a bit of talk about so-calledfourth sector, or hybrid entities.

What the heck is that about? It kind of goes likethis. There are several relatively new ideas floatingaround in the world of nonprofits. They have to dowith organizing and running do-good operations.One big one is that we need more business-like oper-ations in the nonprofit world. Another one is that thetax rules that bind and restrict charities have gottenso bad that it may be smarter to organize “charities”as business corporations—give up the exemption andthe deductions, but gain freedom from the rules thatbind tax-favored charities. Another one is that youngentrepreneurs bring new, especially useful approach-es to entity problems and that they can make special,synergistic contributions. There are some very cre-ative combinations of foundation, corporations, andLLCs out there.29 Yet another idea is to focus on theperceived synergy available in joint venturesbetween nonprofit and for profit corporations. Not tomention charities that run serious “businesses” likemuseums with giant cafes, catalogs, websites andmuseum stores.

Let’s talk about the hybrid label. It’s easy to seewhere the term “hybrid” comes from—if you organizea charity as a profit-making business, but run it like acharity, it’s kind of a hybrid. What about “fourth sec-tor?” Well, that’s a little bit harder to explain.

We used to say that there were three sectors in oureconomic world: profit, nonprofit, and government.Well now, we’re talking about adding a fourth sector—hybrids, a mix of profit and nonprofit. The easiestproof of the existence of the sector is Google.org,

which is a funny mix of a charitable foundation and afor profit corporate entity.

Sometimes the hybrid nature lies in the entityorganization and sometimes it lies in the operationaltools used by a standard type of entity. As to the first,an example would be a charity organized under thelocal business corporation statute, which would meanthat its income would be subject to tax and transfers toit would not be deductible for income, gift, estate, orgeneration skipping transfer tax purposes. An exampleof the second would be a large foundation that tried tooperate in an entrepreneurial fashion or that appliesMBA type metrics to its internal operations and tograntees.30

Hybrids are almost certainly going to be or involvesome kind of corporate entity, using that term verybroadly. They will involve some form of nonprofit cor-poration organized under the law of some state or theywill be some kind of business entity organized underthe law of some state, likely a business corporation or alimited liability corporation (LLC) organized underlocal law. Whatever the form, or forms, it seems safeto say that the organization will be operated in a non-traditional fashion, perhaps with some traditional ben-efits of the form chosen being given up by the opera-tors. For instance, if there is an entity that is a for-prof-it corporation there may not be that much interest inmaking a profit. Or, if the entity is a nonprofit corpo-ration, there may be a very strong interest in returns ora willingness to use methods ordinarily reserved, in thetraditionalist’s mind, for a profit-making organization.One way or another something in the picture would notlook right to a traditional observer.

Booking an “investment” in a hybrid could be adaunting chore for a charity. Might it be a grant?Might it be a program related investment? Might it bea mission related investment? Might it be a nonspecif-ic socially responsible investment? Might it be aninvestment pure and simple? Stay tuned. If this were apaper I would insert a footnote that said the questionwas beyond the scope of the paper.

To summarize this section, it seems fair to say thatFourth Sector/Hybrid-investing/Venture Philanthropy31

29 The Omidyar network comes to mind.30 Nonprofit managers are more and more expected to have

MBAs.31 One definition of venture philanthropy is foundations

investing in experimental drugs both for profit and to insure thedrug comes to market, when normal methods for funding experi-mental drugs fail. See Kai Ryssdal & Janet Babin, A Different Sortof Venture (American Public Media Broadcast transcript, LEXIS,June 8, 2007). Broader definitions exist. New forms of philan-thropy are fashionable. “The new generation … philanthropists is

looking to give back to society through a much broader range ofactivities than was previously the case.” CAPGEMINI & MERRILL

LYNCH, WORLD WEALTH REPORT (2007). Another definition of ven-ture philanthropy is applying business metrics to purely charitabledonations. Is the soup kitchen getting the best deal on carrots? Seegenerally Rachel Emma Silverman, A New Generation ReinventsPhilanthropy, WALL ST. J., Aug. 21, 2007, at D1 (“Blogs, Social-Networking Sites Give 20-Somethings a Means To Push, FundFavorite Causes.”) Julie Hudson, THE SOCIAL RESPONSIBILITY OF

THE INVESTMENT PROFESSION (2006) is a worthwhile resource.


is in vogue and that it bangs up against SRI.32 Combin-ing structures, methods, metrics and attitudes of theprofit and nonprofit corporate worlds, it’s rung a bigbell in the world of philanthropy. It’s a loose amalgamof ideas, notions, outlooks and the like that include:charities are sleepy and need a good kick in the buttfrom folks who understand modern business methods;well run businesses produce so much excess profit thatsome of the excess profit (or the ability to make profit)can be shared; the new generation of technocrat entre-preneurs are somehow better people and better man-agers than the J.P. Morgans of the world (and even theAndrew Carnegies and John Rockefellers of theworld); this new generation wants to, and can easilyshare, their human capital and a bit of their cash in newand exciting ways with those less fortunate throughinvesting in the so-called fourth sector via hybrid enti-ties and bespoke venture capitalism,33 that managingrisk and adapting to new markets can be enhanced byphilanthropic and partner activities with NGOs andnonprofits34 creative combinations of entities offersplendid opportunities, tax advantages are not the be-all and the end-all and that business corporations cangrow and renew themselves by better understanding

the nonprofit world.35 There, in a paragraph, is thefourth sector. Whew.

Any organization with an endowment has to facethe question of how much to spend each year out ofendowment—what is the spending rate to be? Becauseyou are a private foundation the question is answeredfor you—you have to spend 5%, with certain non-obvious expenditures counting toward this 5% figure.Beyond that I am gonna punt.

And so it goes.

Best,

Joel

PS. You know I’m a magpie. That means thatsome of these ideas are mine and some aren’t. I guar-antee I have taken some thoughts from Jim Garland,Susan Gary, Harvey Goldschmidt, Mark Kritzman andDavid Levine. And I learned a lot at two conferencessponsored by the NYU Law School National Center onPhilanthropy and the Law and The Investment Fundfor Foundations (TIFF). Thanks to Harvey Dale andDavid Salem.

32 James Mackintosh, The New Philanthropy: Feared FundTurns to Business of Charity, 4 FIN. TIMES, July 2, 2007 (“…bring-ing business rigour and a private sector approach into develop-ment.”). Kate Burgess, Companies Buy Into the Notion of GivingSomething Back, FIN. TIMES, July 2, 2007, at 4; Stephanie Strom,Make Money, Save the World, N.Y. TIMES SUNDAY § 3, at 1; MONEY

AND BUSINESS/FINANCIAL DESK, May 6, 2007, at 1. One vague def-inition is “a hybrid organizational form—part nonprofit, part for-profit—what some are calling ‘the fourth sector,’ a social-benefitenterprise.” Clint Wilkins, A Nonprofit Leader Builds His EncoreCareer, THE CHRONICLE OF PHILANTHROPY, September 14, 2006, at44. See Briefcase, BRISBANE CITY NEWS (Australia) October 6,2005, speaking of a particular enterprise: “... [the founder’s]philosophies are imbedded in the fairly new “fourth sector” con-cept and its ultimate aim is to produce entrepreneurs with business-es that are not only profitable but which also operate in a socially,culturally and environmentally responsible way.” For a contraryview see, N.Y. TIMES, Section 3; Column 5; MONEY AND BUSI-NESS/FINANCIAL DESK, May 7, 2007, at 7, Salve for the Conscience:“To the Editor: The corporate/nonprofit hybrids of the “fourth sec-tor” (“Make Money, Save the World,” May 6) are a sure-fire formu-la for confusion, conflict of interest, deception and outright fraud.They join “eco-friendly tourism’’ and “carbon credits’’ for guilt-stricken, environmentally conscious travelers. Such feel-good sub-stitutes for meaningful government action are themselves inade-quately regulated, and merely lull people into the mistaken beliefthat they are making a significant contribution to curing social illsthat can be dealt with effectively only through legislative, regulato-ry and judicial means.” John S. Koppel Bethesda, Md. Further dis-cussion is to be found in Kathryn Tully, Charity That Offers FairProfit, FIN. TIMES, July 28/July 29, 2007, at 4. See also Stephanie

Strom, Ex-Wall St. Executives Go to Bat to Help Nonprofits, N.Y.TIMES, August 3, 2007, at C3 (Using Wall Street ways to raisefunds for charity.).

33 See Richard C. Morais, Charity Made Efficient, FORBES,June 25, 2007; see also Face Value: Book Value, The Economist,July 21, 2007, at 66 (“He also happens to believe, rather asGoogle’s young founders do, that he can, and should, change theworld.”); James Flanigan, Community Investment in San Jose,N.Y. Times, July 19, 2007, at C9; Face Value: Leader of theSwarm, The Economist, July 14, 2007, at 74.

34 For an intriguing story on a Proctor and Gamble’s ventureinto hybridicity see Claudia H. Deutsch, A Reverse Profit StrategyFaces a Commercial Test, N.Y. TIMES, July 24, 2007, at C7.

35 Google.org and General Electric’s Ecomagination come tomind. The following extract from a help wanted ad for a job atGoogle.org might help: “Investments Researcher - … Google.orgis looking for an Investments Researcher to assist with evaluating“triple bottom line” investments in companies and projects, the pri-mary goal of which will be positive and scalable impact on globalpublic health, economic development and climate change. …[Y]ouwill work … identifying and evaluating partnership and investmentopportunities consistent with Google.org’s mission. ….Responsi-bilities: Play an integral role in evaluating investment opportunitiesand projects consistent with Google.org’s philanthropic mission.… [Assist] with decisions relating to investments in the areas ofpublic health, economic development and climate change….Strong knowledge of issues surrounding climate change, globaleconomic development and/or public health ….” For a fascinatingtale of an ad agency founded pitch for nonprofits that found a muchlarger clientele among profit clients see Stephanie King, Agency’sSocial Responsibility Focus, WALL ST. J. 3B (August 17, 2007).


Editors’ Synopsis: This article analyzes the cre-ation and implementation of a type of business succes-sion vehicle that rarely garners the attention itdeserves: a profits interest in a partnership—some-times referred to as a “carried interest.” The articleexamines the income tax and gift tax minefields that canarise in connection with partnership profits interests,particularly the troublesome IRC Section 2701 issues.Embedded in the article are several helpful examples.

Business succession planning focuses on transi-tioning the ownership of a business from one genera-tion of owners to the next generation. Traditionalstrategies for business succession planning includebuy-sell agreements, purchase and sale agreements,stock options, restricted stock programs, deferredcompensation, stock redemptions, leveraged buy-outs,employee stock ownership plans, grantor retainedannuity trusts, and installment sales to grantor defec-

tive trusts. This article will examine an often over-looked strategy in the planning process: the use ofpartnership profits interests.

A profits interest is a partnership interest that enti-tles its owner to a share of the partnership’s future earn-ings and appreciation but not to any share of the fairmarket value of its capital on the date the profits interestis issued.2 One of its principal tax benefits is that gener-ally the receipt of a profits interest is not a taxable event.3

In addition, the profits partner can report an allocableshare of any capital gains recognized by the partnershipand may be entitled to capital gains treatment upon thesale or liquidation of the profits interest.4 If a profitsinterest is issued to an unrelated employee, the risk of agift tax in connection with the transaction is remote.5 Ifthe profits interest is issued to an employee who is relat-ed to the retiring owner, there is a risk that the transac-tion may be treated as a gift, even if the transaction isotherwise for full and adequate consideration.6

Business Succession Planning,Profits Interests and § 27011

by Richard B. Robinson Denver, Colorado*

* Copyright 2009 by Richard B. Robinson. All rightsreserved.

1 References to “§,” unless otherwise specified, are refer-ences to the Internal Revenue Code of 1986, as amended, (the“Code”) or the accompanying Treasury Regulations.

2 See Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43,2001-2 C.B. 191 and Treas. Reg. § 1.704-1(e).

3 The no-tax regime applies only for income tax purposesand is conditioned on satisfaction of the requirements of Rev. Proc.93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191.See the discussion in footnote 14. This result is the principal taxadvantage of a profits interest as compared to stock options or § 83restricted stock programs.

4 A heated debate has erupted about the use of profits inter-ests (sometimes referred to as “carried interests”) as part of a com-pensation strategy for managers of hedge funds and private equityfunds. This strategy has permitted those hedge fund managers toreport what is, arguably, compensation for services at capital gainstax rates instead of ordinary income rates. See Victor Fleischer,Two and Twenty: Taxing Partnership Profits in Private EquityFunds, UNIVERSITY LEGAL STUDIES RESEARCH PAPER SERIES (Mar.2006, rev. Mar. 11, 2007), forthcoming N.Y.U. L. REV. (2008);Howard E. Abrams, Taxation of Carried Interests, TAX NOTES, July16, 2007, p. 183, Doc. 2007-15317, 2007 TNT 137-43; reprinted in23 TAX MGMT. REAL ESTATE J. 199 (2007); Michael L. Schler, Tax-ing Partnership Profits Interests as Compensation Income, TAX

NOTES, May 26, 2008, at 829; and Letter to the House Ways andMeans Committee and Senate Finance Committee, the State Bar of

Texas, Section of Taxation, Doc. 2008-8193, 2008 TNT 72-58.Legislation was proposed in 2007, but has not been enacted, thatwould have caused compensation treatment for the holders of car-ried interests that constitute “investment services partnership inter-ests.” Specifically, under such proposed legislation, all K-1income and gain allocable to an investment services partnershipinterest and all gain from the sales of an investment services part-nership interest would be taxed as compensation income. In addi-tion, property distributions attributable to an investment servicespartnership interest would be treated as compensation and not as aproperty distribution subject to the rules of § 731(a). An invest-ment services partnership interest is a partnership interest if thepartner provides substantial services in connection with advisingon, investing in, purchasing or selling, managing, or arrangingfinancing with respect to securities, real estate, commodities andoptions, or derivatives with respect to these assets. Any partnerwho provides a substantial quantity of the specified services withrespect to those assets would have been subject to this rule. A rea-sonable allocation of income and gain to “invested capital” wouldnot have been subject to re-characterization as compensation. SeeH.R. 3996, 110th Cong., § 611 (2007), which would have added anew § 710 to the Code. However, § 611 was deleted from H.R.3996 when it was finally enacted as the Tax Increase PreventionAct of 2007.

5 See James A. Nitsche, Intra-Family Transfers of Interests inthe Family Business: Gift, Compensation or Both? 86 TAXES 19(2008), and discussion in Section III.

6 See discussion in Sections II and V.


I. CREATING A PROFITS INTEREST.

A profits interest is created when the partnershipissues an ownership interest to a partner (or to a personin anticipation of becoming a partner) in exchange forservices provided to the partnership.7 In order to consti-tute a profits interest (as opposed to a capital interest),the partnership interest must give the partner a share ofthe future earnings and appreciation from the partner-ship assets but not any share of its existing capital value.The determination of whether a partnership interest is aprofits interest or a capital interest is made by assuminga hypothetical liquidation of the partnership on the datethe interest is created.8 If the partnership assets are soldon that date at fair market value and the net sales pro-ceeds distributed in complete liquidation of the partner-ship, the interest is a capital interest if the partner wouldreceive a share of the liquidation proceeds.9 If thishypothetical sale and liquidation will result in no liqui-dating distribution to the partner, then the interest is aprofits interest.10 The holder of a profits interest willacquire a share of partnership capital as profits areearned and credited to the partner’s capital account andas the partnership assets appreciate in value.

If the partnership agreement satisfies the substan-tial economic effect test under the § 704(b) regulationsand the partnership business is correctly valued uponthe issuance of the profits interest, then it is relativelyeasy to insure that the transaction involves a profits

interest and not a capital interest.11 The § 704(b) regu-lations require the partnership to adjust the capitalaccounts of the existing partners to reflect the fair mar-ket value of partnership property upon this issue of theprofits interests.12 The regulations also require that liq-uidation distributions must be made in accordancewith positive capital account balances.13 Therefore, ifthe fair market value of the partnership business iscredited to the capital account of the current partnersand the beginning capital account of the profits partneris zero, the profits partner will receive no liquidatingdistribution in the hypothetical sale and liquidation.The profits partner is only entitled to future earningsand appreciation, and the partnership interest will betreated as a profits interest.

The distinction between a capital interest and aprofits interest can be illustrated by the followingexample. Sam and Beth own 100% of Business/Invest-ment Entity LLC (“BIE”). BIE is treated as a partner-ship for federal income tax purposes. Ann is BIE’s keyemployee. BIE will issue a 20% ownership interest toAnn on January 1, 2009, when the fair market value ofthe BIE assets is $8mm. Ann’s 20% profits interest willbe subject to a vesting requirement. If her employmentis terminated prior to January 1, 2013, her ownershipinterest will be reduced to zero. The provisions of theBIE operating agreement comply with the substantialeconomic effect test in the § 704(b) regulations. (SeeFigure 1 on page 275.)

7 It is crucial that the profits interest partner is treated as apartner for federal income tax purposes, and not as an employee orindependent contactor. See Richard O. Wheeler, 37 T.C.M. 883(1978); Dorman v. United States, 296 F.2d 27 (9th Cir. 1961); Unit-ed States v. Frazell, 335 F.2d 487 (5th Cir. 1964); Estate of Smith,313 F.2d 724 (8th Cir. 1963); cf. Pounds v. United States, 372 F.2d342 (5th Cir. 1967); Vestal v. United States, 498 F.2d 487 (8th Cir.1974); Harry Burglass, 38 T.C.M. 979 (1979); Estate of R. D.McDaniel, 20 T.C.M. 1551 (1961), and TAM 199922014 (Feb. 12,1999) (a service arrangement was not a partnership despite a shareof profits and business and management collaboration).

8 Rev. Proc. 93-27, 1993-2 C.B. 343, Section 2.01. See alsoTreas. Reg. § 1.704-1(e) (for purposes of § 704(e), a capital inter-est in a partnership means an interest in the assets of the partner-ship, which is distributable to the owner of the capital interestupon his withdrawal from the partnership or upon liquidation ofthe partnership).

9 See Rev. Proc. 93-27, 1993-2 C.B. 343, Section 2.01;MarkIV Pictures, Inc., 60 T.C.M. 1171, 1176 (1990) aff’d 969 F.2d 669,674 (8th Cir. 1991); Robert Johnston, 69 T.C.M. 2282, 2286, n.5(1995); and Hensel Phelps Constr. Co. v. Comm’r., 51 AFTR2d 83-1006, aff’d, 831 USTC ¶ 9270, (10th Cir. 1983).

10 Rev. Proc. 93-27, 1993-2 C.B. 343, Section 2.02. See, also,Herman M. Hale, 24 T.C.M. 1497 (1965); Sol Diamond, 56 T.C.530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974); St. John v. U.S.,

84-1 USTC ¶ 9158 (C.D. Ill. 1983); Kenroy, Inc., T.C.M. 1749(1984); National Oil, 52 T.C.M. 1223 (1986); and Campbell, 59T.C.M. 236 (1990), rev’d on the issue of taxability, 943 F.2d 815(8th Cir. 1991); Prop. Treas. Reg. §§ 1.83-1 and 1.721-1.

11 The primary economic effect test requires that, throughoutthe term of a partnership, the partnership agreement requires that:(1) the partners’ capital accounts must be maintained and deter-mined in accordance with the capital account maintenance rules inthe regulations; (2) liquidation proceeds must be distributed inaccordance with positive capital account balances; and (3) eachpartner has an obligation to restore a deficit capital account balancewithin 90 days after his interest is liquidated. See Treas. Reg. §§1.704-1(b)(2)(ii)(b)(1), (2), and (3). The alternate economic effecttest requires satisfaction of (1) and (2) above, but doesn’t require anunlimited deficit restoration obligation. This test does require aprohibition on deficit producing allocations the partner is not oblig-ated to restore and a qualified income offset provision (“QIO”). AQIO requires a partnership to allocate gross income to a partnerwhose capital account becomes negative as a result of certain unex-pected events such as a distribution. See Treas. Reg. § 1.704-1(b)(2)(ii)(d).

12 Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5); Treas. Reg. § 1.704-1(b)(2)(iv)(g).

13 Treas. Reg. § 1.704-1(b)(2)(ii)(b)(2).


If Ann is issued an ownership interest entitling herto receive 20% of BIE’s future profits and apprecia-tion, and under the BIE operating agreement she willreceive 20% of BIE’s existing capital if the assets weresold and the partnership liquidated immediately aftershe received her interest, she will have received a part-nership capital interest, as illustrated by the capitalaccounts set forth below.

Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $6.4mm $1.2mm $1.6mm $.3mm

Ann has received a capital interest in this examplebecause the partnership agreement provides that liqui-dating distributions will be made in accordance withpositive capital account balance and her § 704(b) cap-ital account was credited with 20% of the value of thepartnership’s assets. Upon the hypothetical sale andliquidation of BIE immediately after Ann received her20% interest, she will be entitled to receive 20% of the$8mm fair market value of the partnership capital, or$1.6mm. The receipt of a capital interest for services

rendered to or on behalf of a partnership is a taxableevent. Taxation occurs when the capital interest issubstantially vested.14

On the other hand, if Ann is issued an ownershipinterest entitling her to receive 20% of BIE’s futureprofits and appreciation, but not a share of the existingcapital, she will be treated as receiving a partnershipprofits interest. In this case, Ann’s initial § 704(b)capital account should be $0, as shown below.

Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $8.0mm $1.5mm $0 $0

If the partnership assets are sold and the partnershipliquidated in accordance with the § 704(b) capitalaccounts immediately after Ann received her interest,her share of the liquidating distribution will be $0. AsBIE’s income is allocated to Ann and retained by thepartnership, she will acquire a capital account and ashare of BIE capital. The receipt of a profits interest forservices rendered to or on behalf of a partnership is gen-erally not a taxable event.15 No tax occurs regardless of

14 Property received in connection with the performance ofservices is taxable as compensation to the service provider whenthe property is substantially vested, i.e., when the serviceprovider’s rights become transferable and/or are not subject to asubstantial risk of forfeiture. The amount of compensation incomeis equal to the fair market value of the property received. See §§83(a) and (b); Treas. Reg. §§ 1.83-1(a), 1.83-2(a), and 1.83-3(b);Alves v. Comm’r., 84-2 USTC ¶ 9546, and MacNaughton v. Com-m’r., 64 AFTR2d 89-5807 (6th Cir. 1989). If the property is notsubstantially vested, recognition of income is delayed until it isvested. If the service provider makes a § 83(b) election within 30days of receipt of the property, it will be taxed as if the propertywas substantially vested upon receipt. See Treas. Reg. § 1.83-2(a).When the nonvested property becomes fully vested, the fair marketvalue of the property on that date is reported as compensationincome. See Treas. Reg. § 1.83-1(a), 1.83-2(a), and 1.83-3(b). TheMay 24, 2005 proposed regulations do not provide a definition fora capital interest and/or for a profits interest. These proposed regu-lations provide that all partnership interests (whether a capitalinterest or a profits interest) transferred in connection with the per-formance of services are subject to the rules of § 83. According tothe preamble, “the proposed regulations apply § 83 to all partner-

ship interests without distinguishing between partnership capitalinterests and partnership profits interests.” Prop. Reg. § 1.721-1(b)(1) (2005) and Prop. Reg. § 1.83-3(e) (2005). For valuationpurposes, the proposed regulations contain an elective safe harborthat permits a partnership and the service partner to use the liquida-tion method for purposes of valuing a partnership interest (capitaland profits) received for services. Liquidation value is defined asthe amount of cash the recipient of a partnership interest wouldreceive if, immediately after the transfer, the partnership sold all ofits assets including goodwill, going concern value (and any otherintangible assets associated with the partnership’s operation) forcash equal to the fair market value of those assets and liquidated.See Notice 2005-43, 2005-1 C.B. 1221.

15 Receipt of a partnership profits interest in exchange for ser-vices provided to the partnership by a partner, or in anticipation ofbecoming a partner, is generally not a taxable event regardless ofwhether it is vested upon receipt, subject to compliance with Rev.Proc. 93-27, 1993-2 C.B. 343, and 2001-43, 2001-2 C.B. 191. Theno-tax treatment provided for in Rev. Proc. 93-27, 1993-2 C.B. 343,requires that the profits interest: (1) must not relate to a substantiallypredictable stream of income from partnership assets such as incomefrom high quality debt securities or a high quality net lease; (2) must

Figure 1


whether or not the profits interest is substantially vestedupon receipt, and, if it is not substantially vested, notaxable event occurs when it becomes vested.16

If the parties do not accurately value the partner-ship assets upon Ann’s admission as a partner, therecould be a disguised capital shift to her, even thoughher initial capital account balance is zero. Suppose theparties valued the BIE assets at $4mm when they wereactually worth $8mm and that Sam/Beth’s § 704(b)capital is shown as $4mm while Ann’s is shown as $0.Upon the hypothetical sale and liquidation of the BIEassets for their true value of $8mm, Ann will receive20% of the $4mm that was not properly taken intoaccount. Based on these facts, Ann should be taxableupon receipt of her ownership interest to the extent ofthe $800,000 of capital transferred to her, as if she hadreceived a capital interest in BIE.

If the LLC Operating Agreement does not com-ply with the substantial economic effect test in the §704(b) regulations, it will be more difficult, but notimpossible, to determine if Ann has received a capi-tal interest or a profits interest. In that case, theterms of the partnership agreement must be carefullyreviewed to determine whether she will receive anydistribution upon a hypothetical sale and liquidationof BIE immediately after the receipt of her partner-ship interest.

II. ALLOCATING APPRECIATION TO THEPROFITS PARTNER.

Partnership earnings and appreciation are allocat-ed among the partners in accordance with the provi-sions of the partnership agreement. As long as the

partnership agreement does not contain any specialallocation provisions, the profits partner will be allo-cated a share of the earnings and appreciation in accor-dance with his or her percentage interest, as illustratedin the example below.

Sam and Beth own 100% of Business/InvestmentEntity LLC (“BIE”). Ann is BIE’s key employee. BIEwill issue a 20% ownership interest (a profits interest)to Ann on January 1, 2009, when the fair market valueof the BIE assets is $8mm. Ann’s 20% ownershipinterest will be subject to a vesting requirement. If heremployment terminates prior to January 1, 2013, herownership interest will be reduced to zero. On Janu-ary 1, 2013, BIE sells all of its assets and liquidates.The LLC Operating Agreement satisfies the provisionsof the substantial economic effect test under the §704(b) regulations. For purposes of this example,assume zero taxable income and no operating cashflow. (See Figure 2.)

If the assets are sold for $8mm, there is no appre-ciation and Ann is not entitled to any portion of thesales proceeds.

Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $8.0 $1.50 $0 $0704(b) Gain .0 .0 0 0704(c) Gain17 0 6.50 0 0Ending $8mm $8.0mm $0 $0

If the assets are sold for $12mm, Ann will be enti-tled to 20% of the $4mm appreciation ($12mm -$8mm) for the period January 1, 2009 through Decem-ber 31, 2012.

not be disposed of within two years of receipt; and (3) must not be alimited partnership interest in a publicly traded partnership within themeaning of § 7704(b). See, also, Herman M. Hale, 24 T.C.M. 1497(1965); St. John v. U.S., 84-1 USTC ¶ 9158 (C.D. Ill. 1983); Kenroy,Inc., T.C.M. 1749 (1984); National Oil, 52 T.C.M. 1223 (1986); andCampbell, 59 T.C.M. 236 (1990), rev’d on the issue of taxability, 943F.2d 815 (8th Cir. 1991). The 2005 proposed regulations treat thereceipt of a profits interest as a taxable event under the provisions of§ 83; however, the parties may use the liquidation method to deter-mine the value of the profits interest. See Prop. Treas. Reg. § 1.83-6(b); Prop. Treas. Reg. § 1.721-1(b)(2), and Notice 2005-43, 2005-1

C.B. 1221. See PLR 200329001 (Feb. 21, 2003) where the IRS ruledthat the receipt of partnership units constituted the receipt of a profitsinterest and, therefore, were not taxable under Rev. Proc. 93-27,1993-2 C.B. 343, and 2001-43, 2001-2 C.B. 191. Cf. Diamond v.Comm’r, 492 F.2d 286 (7th Cir. 1974), where the profits interest wastaxable because it was disposed of shortly after receipt.

16 Rev. Proc. 2001-43, 2001-2 C.B. 191. 17 The § 704(c) gain is the built-in gain allocated under Treas.

Reg. § 1.704-3 representing the difference between the fair marketvalue and the tax basis of the BIE property upon Ann’s admissionas a partner. See Treas. Reg. §§ 1.704-1(b)(2)(iv)(g) and 1.704-3.

Figure 2


Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $8.0 $1.50 $0 $0704(c) Gain .0 6.50 0 0704(b) Gain18 3.2 3.2 .8 .8Ending $11.2mm $11.2mm $.8mm $.8mm

(93.32%) (93.32%) (6.68%) (6.68%)

Since Ann is entitled to only 20% of the appreciationoccurring after her admission as a partner, she willreceive $800,000 (20% x $4,000,000, or 6.68% of the$12mm sales proceeds).

If there is sufficient appreciation in the BIE assets,it is possible to put Ann in the same economic positionas if she has received a 20% capital interest by using a“catch-up allocation.” A catch-up allocation is a spe-cial allocation of future partnership income and/orgain in the amount required to cause Ann’s capitalaccount percentage to be in parity with her percentageinterest. Once Ann’s capital account has achieved par-ity, she shares any subsequent increases or declines inthe value of partnership property proportionately withthe other partners. In this example, a catch-up alloca-tion will give her 100% of the first $2mm of apprecia-tion, i.e., the amount required so her capital account is20% of the aggregate capital accounts for all of thepartners. The balance of appreciation is allocated inthe basic 80%/20% ratio. The results of the catch-upallocation are set forth below, assuming BIE sells allof its assets for $12mm on January 1, 2013.

Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $8.0 $1.50 $0 $0704(c) Gain 0 6.50 0 0Catch Up Gain19 0 0 2.0 2.0Balance of Gain19 1.6 1.6 .4 .4Ending $9.6mm $9.6mm $2.4mm $2.4mm

(80%) (80%) (20%) (20%)

Catch-up allocations can be made from partner-ship operating income, gain from the sale of partner-

ship property, or gain from the hypothetical sale ofpartnership property upon the occurrence of a book-upevent.20 If the catch-up allocation is made from part-nership income, Ann may be specially allocated ordi-nary income to fill up her capital account. If the allo-cation is gain from the sale of partnership property,she may be taxed at capital gains rates on the incomeused to fill up her capital account. If the catch-up allo-cation results from a book-up transaction, then Ann’scapital account is filled up without any current recog-nition of gain. The gain will be deferred until the part-nership actually sells the booked-up property and thenAnn will recognize gain in accordance with the rulesgoverning reverse § 704(c) allocations.21

III. COMBINATION ENTITIES.

If a business is operated as an S corporation, theyounger generation cannot receive a profits interest inthe corporation, because it would violate the secondclass of stock rule. An S corporation has more than oneclass of stock if there are different rights to liquidatingdistributions determined on a per share basis.22 Howev-er, the profits interest strategy can be structured as a part-nership between the corporation and the key employee.The S corporation will contribute all or a portion of itsassets to a newly formed partnership, and the partner-ship will issue a profits interest to the key employee.The corporation’s contribution of the business to thepartnership is generally not a taxable event.23

These principles can be illustrated by the follow-ing example. Sam and Beth own 100% of Sam Co., anS corporation. Ann is Sam Co.’s key employee. SamCo. wants to issue Ann a 20% ownership interest, butSam Co. doesn’t want Ann to pay income taxes uponreceipt of the ownership interest. Sam Co. contributesall of its business and employees to Business/Invest-ment Entity LLC (“BIE”) in exchange for an 80%share of profits and losses and an $8mm beginningcapital account. BIE will issue a 20% ownershipinterest (a profits interest) to Ann effective January 1,2009. Ann’s 20% ownership interest will be subject to

18 The § 704(b) regulations require gain to be computed by ref-erence to the book value rather than the tax basis of the partnershipproperty. The BIE assets will be booked up to their $8mm fair mar-ket value upon Ann’s admission to the partnership. The § 704(b)gain is the excess of the $12mm sale price over the $8mm bookvalue of the property. See Treas. Reg. § 1.704-1(b)(2)(iv)(f) and (g).

19 Once the book-tax differences are taken into accounts asrequired by § 704 and Treas. Reg. § 1.704-1(b)(2)(iv)(g), the bookgain and the tax gain will be the same.

20 Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5) permits the readjustmentof § 704(b) capital accounts to fair market value under the admissionof a partner for capital or services, or the retirement of a partner.

21 See Treas. Reg. § 1.704-3; Treas. Reg. § 1.704-1(b)(2)(iv)(g).22 See § 1361 and 1.1361-1(l ).23 See §§ 707, 721 and 752. § 721 provides that no gain or

loss is recognized to a partnership or to any of its partners uponthe contribution of property to the partnership in exchange for aninterest in the partnership. §§ 752(a) and (b) treat increases anddecreases in a partner’s share of liabilities as constructive contri-bution and distribution from the partnership. See Treas. Reg. §§1.7523(a) and (b). § 731(a) provides that, in case of a distributionby a partner to a partnership, gain will not be recognized to thedistributee partner except to the extent that any money distrib-uted exceeds the adjusted basis of such partner’s interest in the


a vesting requirement. If Ann’s employment termi-nates prior to January 1, 2013, her profits interest willbe reduced to zero. The provisions of the BIE Operat-ing Agreement comply with the § 704(b) regulations.On January 1, 2013, BIE sells its assets and liquidates.(See Figure 3.)

Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $8.0 $1.5 0. 0.704(c) Gain 0. 6.5 0. 0Balance 3.2 3.2 .8 .8Ending $11.2mm $11.2mm $.8mm $.8mm

The result for Sam, Beth and Ann is the same as ifSam Co. had been a partnership from inception.BIE could also provide for a catch-up allocation forAnn that gives her a $2.4mm share of the liquidationproceeds.

IV. Can the Issuance of a Profits Interest Result ina Taxable Gift?

The no-income-tax regime found in Rev. Proc. 93-27 and Rev. Proc. 2001-43 does not require any corre-lation between the value of the services provided andthe value of the profits interest received.24 The onlyrequirement is that the profits interest must be issuedin connection with the performance of service to or onbehalf of the partnership by a person who is a partneror in anticipation of becoming a partner. Treas. Reg. §25.2512-8 appears to apply a similar no gift tax rulefor the issuance of profits interests to unrelatedemployees in the ordinary course of business.25

If the issuance of the profits interest involvesan intra-family transaction, then a comparison ofthe value of the services provided and the value ofthe profits interest received may be required todetermine if the transaction results in a taxablegift.26 For profits interests issued in an intra-fami-ly context, several courts have found a taxable giftbased on the present value of the future earningsattributable to the profits interest.27 Even if thevalue of the services provided is equal to the valueof the profits interest received and, therefore, nogift results under the full and adequate considera-

partnership immediately before the distribution, except as pro-vided in § 751(b) relating to unrealized receivables and invento-ry items. Care must also be taken to avoid treating the transfer asa disguised sale transaction. See Treas. Reg. §§ 1.707-3(b), (c),and (d). This type of transaction was approved in PLR200123035 (Mar. 8, 2001). In that ruling, an S corporationowned several automobile dealerships. The corporation wantedto give a manager direct ownership in some, but not all, of thedealerships. It transferred three dealerships to Newco LLC inexchange for a majority interest in capital and profits. The man-ager contributed cash. Included in the assets were LIFO invento-ry with a fair market value in excess of basis. The IRS ruled: (1)no gain to the manager because his capital interest was equal tothe cash contributed; (2) LIFO inventory was § 704(c) property,so built-in gain/loss for LIFO will be allocated to S corporationwhen recognized by LLC; and (3) LLC will elect, under Treas.Reg. § 1.704-3(e)(2)(iii), to aggregate each item of inventory forpurposes of § 704(c).

24 The question of reasonable compensation has not beenraised in any of the cases that litigated whether or not the receipt ofa profits interest was a taxable event. See the cases cited in foot-note 9.

25 See Treas. Reg. § 25.2518-8. “However, a sale, exchange,

or other transfer of property made in the ordinary course of busi-ness (a transaction which is bona fide, at arm’s length and free fromany donative intent) will be considered as made for an adequateand full consideration in money or money’s worth.”; M.D. Ander-son Est., 8 T.C. 706 (1947) (transfers of stock at a bargain pricefrom senior executives to unrelated junior executives as part of abusiness succession plan were not taxable gifts); and Rev. Rul. 80-196, 1980-2 C.B. 32 (transfers of stock from existing shareholdersto key employees for no consideration as part of a business succes-sion plan did not result in taxable gifts). In both the Anderson caseand Rev. Rul. 80-196, 1980-2 C.B. 32, the employees’ receipt ofthe stock was an income taxable event. However, the receipt of aprofits interest is not a taxable event.

26 Treas. Reg. § 25.2512-8’s no-gift rule only applies if thetransaction is bona fide, at arm’s length, and free from any donativeintent. The fact that the profits interest partner is also an employeedoes not automatically preclude a finding of donative intent. See E.B. Williams Est., 75 T.C.M. 1758 (1998); J.B. Hitchon Est., 45 T.C.96 (1965), and V. Z. Harwood, 82 T.C. 239.

27 See W. H. Gross, 7 T.C. 837 (1946) (the value of the servicesto be provided by the related profits interest partners was found tobe less than their share of the profits interests received; and Knots v.Comm’r, 55 T.C.M. 424 (1988) (gift of a subordinated profits inter-

Figure 3


tion rule of Treas. Reg. § 25.2512-8, the specialvaluation rules of § 2701 may, nonetheless, causethe transaction to be treated as a taxable gift.28

To understand the substantial benefits that may beobtained by issuing a large profits interest as part of abusiness succession plan, consider the following exam-ple. Sam and Beth own 100% of Business/InvestmentEntity LLC (“BIE”). Ann is BIE’s key employee. BIEwill issue a 99% ownership interest (a profits interest)to Ann effective January 1, 2009, when BIE’s asset areworth $8mm. Ann’s 99% ownership interest is subjectto a vesting requirement. If her employment terminatesprior to January 1, 2013, her ownership interest will bereduced to zero. The Company is sold for $12mm onJanuary 1, 2013. The provisions of the LLC operatingagreement comply with the substantial economic effecttest in the § 704(b) regulations. For purposes of thisexample, assume zero taxable income and no operatingcash flow. (See Figure 4.)

When the BIE assets are sold for $12mm, Annwill be allocated 99% of the $4mm gain ($12mmminus $8mm), or $3.96mm. In addition, Sam andBeth’s share of BIE will be essentially frozen at itsJanuary 1, 2009 fair market value. Of course, the par-ties still need a plan to monetize Sam and Beth’sremaining interest in BIE; however, the earnings fromSam and Beth’s capital have effectively been shifted toAnn, and she can use those earnings to purchase theirremaining interest. In this scenario, the retiring part-

ners should maintain some share of profits, losses, dis-tributions, and appreciation prior to the commence-ment of the purchase of their remaining interest inorder to maintain their status as partners.29 The alloca-tions to Sam, Beth and Ann under this scenario are setforth below.

Sam/Beth AnnCapital Accounts 704(b) Tax 704(b) TaxBeginning $8.0 $1.50 $0. $0 .704(c) Gain 0 6.50 0. .0Balance .04 .04 3.96 3.96Ending $8.04mm $8.04mm $3.96mm $3.96mm

(67%) (67%) (33%) (33%)

V. PARTNERSHIP PROFITS INTERESTS FORSERVICES AND § 2701.

Does § 2701 drive a stake into the heart of thisplanning strategy? Well, like so many questions oflaw, the answer depends on the facts, i.e., the terms ofthe partnership agreement being examined. The spe-cial problem created for intra-family transfers by §2701 is that the determination of the existence and theamount of any gift under § 2701 is made independent-ly of the rules for identifying a gift under Chapter 12of the Internal Revenue Code. Even if a transaction isfor full and adequate consideration it can, nonetheless,be treated as a gift under these special rules.30

est was valued for gift tax purposes applying a 10% discount rate tothe projected future income stream of the partnership.)

28 See the discussion of § 2701 in Section V. § 704(e) does notapply to the transaction if no capital interest in the partnership istransferred. See Treas. Reg. § 1.704-1(e)(1). For purposes of §704(e), a capital interest in a partnership means an interest in theassets of the partnership which is distributable to the owner of thecapital interest upon his withdrawal from the partnership or uponliquidation of the partnership. The mere right to participate in theearnings and profits of the partnership is not a capital interest in thepartnership. Treas. Reg. § 1.704-1(e)(1)(v).

29 See Paul D. Carman and Colleen A Kushner, The UncertainCertainty of Being A Partner: Partner Classification for Tax Pur-poses, 109 J. TAX’N 165 (2008).

30 See Treas. Reg. § 25.2701-1(b)(1). The legislative historyindicates that the Senate Finance Committee was concerned aboutthe potential transfer of wealth through the use of discretionaryrights in a partnership or corporation. Accordingly, the Committeeadopted certain rules designed to eliminate the potential for trans-ferring wealth through the non-exercise of discretionary rights.See 136 CONG. REC. S15681 (daily ed., Oct. 18, 1990).

Figure 4


§ 2701 rears its ugly head whenever an equityinterest in a corporation or a partnership is transferredto a member of the transferor’s family and either thetransferor or an applicable family member holds an“applicable retained interest.”31 An applicableretained interest is any equity interest in a corporationor partnership with respect to which there is either anextraordinary payment right or, in the case of a con-trolled entity, a distribution right.32 The risk posed bythese rules for an intra-family profits interest isderived from the method used to compute the amountof any gift. The gift is computed using a subtractionmethod and by treating any distribution right or extra-ordinary payment right as having a value of zero.33 If

the older generation of partners hold applicableretained interests that are valued at zero, the issuanceof a profits interest to the younger generation couldresult in a taxable gift equal to the entire value of thepartnership’s assets.

Fortunately for the profits interest technique, thereare two important exceptions to these draconianresults. First, § 2701 does not apply to an intra-familytransfer if the retained interest is of the same class ofequity as is (or is proportional to) the profits interest.34

Second, § 2701 does not apply to the issuance of aprofits interest to the extent it results in a proportionatereduction of each class of equity interests held by thetransferor and all applicable family members.35

31 Treas. Reg. § 25.2701-1(a)(1). For purposes of § 2701, atransfer includes the following transactions: (1) a capital contribu-tion to a new or an existing entity; (2) a redemption, recapitaliza-tion, or other change in the capital structure of an entity (a “capitalstructure transaction”) if: (a) the transferor or an applicable familymember receives an applicable retained interest in the capital struc-ture transaction; (b) the transferor or an applicable family memberholding an applicable retained interest before the capital structuretransaction, surrenders an equity interest that is junior to the applic-able retained interest (a “subordinate interest”) and receives proper-ty other than an applicable retained interest; or (c) the transferor oran applicable family member holding an applicable retained interestbefore the capital structure transaction, surrenders an equity interestin the entity (other than a subordinate interest) and the fair marketvalue of the applicable retained interest is increased. Treas. Reg. §25.2701-1(b)(2)(A) and (B). For purposes of § 2701, a familymember is the transferor’s spouse, any lineal descendant of thetransferor or the transferor’s spouse, and the spouse of any such lin-eal descendant. Treas. Reg. § 25.2701-1(d)(1). For purposes of §2701, an applicable family member is the transferor’s spouse, anyancestor of the transferor or the transferor’s spouse, and the spouseof any such ancestor. Treas. Reg. § 25.2701-1(d)(2).

32 An extraordinary payment right is any put, call, or conver-sion right, any right to compel liquidation, or any similar right, theexercise or nonexercise of which affects the value of the transferredinterest. A call right includes any warrant, option, or other right toacquire one or more equity interests. Treas. Reg. § 25.2701-2(b)(2). A distribution right is the right to receive distributionswith respect to an equity interest. Treas. Reg. § 25.2701-2(b)(3).A distribution right does not include: (1) any right to receive dis-tributions with respect to an interest that is of the same class as, ora class that is subordinate to, the transferred interest; (2) any extra-ordinary payment right; or (3) any mandatory payment right, anyliquidation participation right, any right to guaranteed payments ofa fixed amount under § 707(c), or any non-lapsing conversionright. Treas. Reg. § 25.2701-2(b)(3) and (4). If the transferor,members of the transferor’s family, or applicable family membershave the ability to compel liquidation, the liquidation participationright is valued as if the ability to compel liquidation did not existor, if the lower of rule applies, is exercised in a manner that is con-sistent with that rule. Treas. Reg. § 25.2701-2(b)(4)(ii).

33 Treas. Reg. §§ 25.2701-1(a)(2). The subtraction valuationmethodology requires four steps: (1) determine the fair market

value of all family held equity interests in the entity immediatelyafter the transfer (Treas. Reg. § 25.2701-3(b)(1)); (2) subtract thefair market value of all family held senior equity interests (otherthan applicable retained interests held by the transferor or applica-ble family members) and the fair market value of any family heldequity interest of the same class or a subordinate class to the trans-ferred interest held by persons other than the transferor, membersof the transferor’s family and applicable family members of thetransferor (Treas. Reg. § 25.2701-3(b)(2)(A)) as well as the valueof all applicable retained interests held by the transferor or applic-able family members (other than an interest received as considera-tion for the transfer) (Treas. Reg. § 25.2701-3(b)(2)(B)); (3) allo-cate the remaining value among the transferred interests and otherfamily held subordinate equity interests (Treas. Reg. § 25.2701-3(b)(3)); and (4) determine the amount of the gift (the amountallocated to the transferred interests, reduced by applicable valua-tion discounts). Treas. Reg. § 25.2701-3(b)(4). If § 2701 appliesto a transfer, the value of a junior equity interest is not less than itspro rata portion of 10% of the sum of the total value of all equityinterests in the entity and the total debt owed to applicable familymembers. Treas. Reg. § 25.2701-3(c)(1). A senior equity interestis an equity interest in the entity that carries a right to distributionsof income or capital that is preferred to rights of the transferredinterest. Treas. Reg. § 25.2701-3(a)(2)(ii). A subordinate equityinterest is an equity interest in the entity as to which an applicableretained interest is a senior equity interest. Treas. Reg. § 25.2701-3(a)(2)(iii). A junior equity interest means any partnership inter-est under which the rights to income and capital are junior to therights of all other classes of partnership interest. Treas. Reg. §25.2701-3(c)(2).

34 A class of equity is the same class as is (or is proportionalto the class of) the transferred interest if the rights are identical (orproportional) to the rights of the transferred interest, except fornon-lapsing differences in voting rights (or, for a partnership, non-lapsing differences with respect to management and limitations onliability). For these purposes, non-lapsing provisions necessary tocomply with partnership allocation requirements of the InternalRevenue Code (e.g., § 704(b)) are non-lapsing differences withrespect to limitations on liability. An interest in a partnership is notan interest in the same class as the transferred interest if the trans-feror or applicable family members have the right to alter the lia-bility of the transferee. Treas. Reg. § 25.2701-1(c)(3).

35 See Treas. Reg. § 25.2701-1(c)(4).


A class partnership interests is the same as is (or isproportional to the class of) the transferred interests ifthe rights are identical (or proportional) except for non-lapsing differences with respect to management and lim-itations on liability.36 For these purposes, the § 2701 reg-ulations state that non-lapsing provisions necessary tocomply with partnership allocation requirements in the §704(b) regulations are non-lapsing differences withrespect to limitations on liability.37 Therefore, a require-ment in a partnership agreement that liquidation distrib-utions will be made in accordance with positive capitalaccount balances (which is an allocation requirement setforth in the § 704(b) regulations) is disregarded for pur-poses of the same or proportional class test.38

The application of these rules to an intra-familyprofits interest transaction can be illustrated by the fol-lowing example. Sam and Beth own 100% of Busi-ness/Investment Entity LLC (“BIE”). Ann (Sam andBeth’s daughter) is BIE’s key employee. BIE willissue a 20% ownership interest (a profits interest) toAnn on January 1, 2009, when the BIE assets are worth$8mm. Ann’s 20% ownership interest will be subjectto a vesting requirement. If her employment terminatesprior to January 1, 2013, her ownership interest will bereduced to zero. The provisions of the LLC OperatingAgreement satisfy the substantial economic effect testas set forth in the § 704(b) regulations. (See Figure 5.)

A comparison of the rights attributable to Ann,Sam, and Beth’s ownership interests is set forth below.

Ann Sam BethProfits/losses 20% 40% 40%Distributions 20% 40% 40%Liquidation Capital Capital Capital

Account Account AccountVoting rights 20% 40% 40%

Based on the facts presented, Sam, Beth, and Ann allhave the same (or proportional) rights to profits, loss-es, current distributions and liquidating distributions.In the case of liquidating distributions, each of themhas the right to receive a liquidating distribution inaccordance with his or her positive capital accountbalance. The fact that Sam and Beth could receive aliquidating distribution of $8mm more than Ann is dis-regarded for purposes of determining whether the part-ners have identical rights to distributions. This differ-ence is the result of a non-lapsing difference withrespect to limitations on liability and is not taken intoaccount for purposes of determining whether the part-ners’ rights are identical under Treas. Reg. § 25.2701-1(c)(3). This result is correct because Ann hasreceived a profits interest and not a capital interest.No portion of Sam and Beth’s capital was transferredto Ann when her profits interest was issued and there-fore she should not receive any distribution of the ini-tial $8mm of BIE capital.

This analysis is also supported by the legislativehistory of § 2701. This provision was not designed toaffect the valuation of a partnership interest if all inter-ests in the partnership share proportionately in all itemsof income, deduction, loss, and gain (i.e., a straight-upallocation).39 On the other hand, the same or propor-tional class exception is not intended apply if one part-ner has a preference with respect to distributions.40 Inthis context, the term “preference” means a right of onepartner to a return of his or her capital before anotherpartner’s return of their capital. The provision requir-ing liquidating distributions in accordance with posi-tive capital accounts doesn’t give any partner a prefer-ential return of capital. Each partner is only entitled toreceive his or her share of partnership capital propor-tionately when the partnership is liquidated.

36 See Treas. Reg. § 25.2701-1(c)(3).37 Id.38 Treas. Reg. § 1.704-1(b)(2)(ii)(b)(2) states that the partner-

ship agreement must provide that liquidating distributions must bein accordance with positive capital account balances in order for

profits and loss allocations to comply with the § 704(b) substantialeconomic effect test.

39 See 136 CONG. REC. S15681 (daily ed., Oct. 18, 1990).40 See H.R. Rep. No. 101-964 at 1133 (1990), reprinted in

1990 U.S.C.C.A.N. 2374, 2838.

Figure 5


A distribution in accordance with positive capitalaccount balances is not the same as the typical prefer-ence given to preferred stock as compared to commonstock in a corporate context. If preferred stock is enti-tled to receive a return of its par value before any liq-uidating distributions are made to the common stock,the common stock bears all declines in value of thecorporation’s assets before the preferred stock. In theabove example, once earnings and appreciation arecredited to Ann’s capital account, all three partnerswill all bear any declines in value of the partnershipassets in proportion to the value of their share of part-nership capital. Sam and Beth will not receive a pref-erential return of capital.

The IRS has applied this same analysis when exam-ining whether a particular capital structure falls withinthe same or proportional class exception for purposes of§ 2701. For example, in TAM 199933992 (Aug. 23,1999), the partnership agreement provided that the pro-ceeds from capital transactions would be distributedfirst to the limited partners until their adjusted capitalcontributions were reduced to zero and then to the gen-eral partner until its adjusted capital contributions werereduced to zero. The balance, if any, would be distrib-uted to the partners in proportion to their partnershipinterests. The Service held that the limited partnershipinterests and the general partnership interest were not ofthe same class because the limited partnership interestshad a preference with respect to distributions. On theother hand, in PLR 9710021 (Mar. 7, 1997), the part-nership agreement provided that, upon termination andliquidation, all debts would be paid or reserved for, andthe remaining partnership property distributed in accor-dance with, the capital accounts of the owners. In con-cluding that the partnership interests were all of thesame class, the ruling states that, when the partnershipis dissolved, the assets will be distributed on a pro ratabasis in accordance with the partners’ respective owner-ship interests.41

If Sam and Beth’s ownership interests are not thesame class (or proportionately the same) as Ann’sownership (because, for example, their capital is

returned before any of Ann’s capital in a liquidatingdistribution), then § 2701 will probably apply to thetransaction.42

VI. REPORTING THE INTRA-FAMILYPROFITS INTEREST TRANSACTION.

In order to start the running of the statute of limi-tations for gift tax purposes, a transaction must be ade-quately disclosed. The adequate disclosure regula-tions provide that completed transfers to members ofthe transferor’s family (see § 2032A(e)(2)) that aremade in the ordinary course of operating a businessare deemed to be adequately disclosed under Treas.Reg. § 301.6501(c)-1(f)(2)), even if the transfer is notreported on a gift tax return, provided the transfer isproperly reported by all parties for income tax purpos-es.43 For example, in the case of salary paid to a fami-ly member employed in a family owned business, thetransfer will be treated as adequately disclosed for gifttax purposes if the item is properly reported by thebusiness and the family member on their income taxreturns.44 Any other completed transfer that is report-ed, in its entirety, as not constituting a transfer by giftwill be considered adequately disclosed only if the fol-lowing information is provided on, or attached to, thereturn: (a) the information required for adequate dis-closure; and (b) an explanation as to why the transferis not a transfer by gift under Chapter 12 of the Inter-nal Revenue Code.45

The tax planner must also consider whether ade-quate disclosure for purposes of Treas. Reg. §301.6501(c)-1(f)(2) satisfies the new preparer penaltyrules for the return preparer under § 6694. Generally ataxable gift doesn’t occur if there is full and adequateconsideration for the transfer.46 A transfer ostensiblyas compensation for services can result in a partially orwholly disguised gift or a gift under the special valua-tion rules of § 2701.47 The new preparer penalty rulesrequire disclosure unless the preparer reasonablybelieves there is substantial authority for the positiontaken in the return.48

41 See, also, PLR 9451051 (Dec. 23, 1994). In that ruling, a cor-poration’s Class A Preferred Stock was entitled to a $10 liquidationpreference. Any remaining assets would be distributed to the holdersof the common stock (Class A and Class B) and the Class A PreferredStock. The distribution to the Class A Preferred shareholders will bereduced by the $10 distribution preference. The ruling found that thepreferred and common stock were of the same class because therights of the preferred holders were only slightly different. The divi-dend distribution rights were identical, and the liquidation rights werethe same except for the $10 per share preference.

42 “Probably,” because there is an argument that the issuanceof a profits interest is not a “transfer” within the meaning of Treas.Reg. §§ 25.2701-1(b)(1) and (2).

43 Treas. Reg. § 301.6501(c)-1(f)(4).44 Id.45 Id.46 See Treas. Reg. § 25.2512-8. 47 See footnote 31. 48 § 6694(a)(2); Notice 2009-5, 2009-3 IRB (12/15/08).


VII. CONCLUSION.

A partnership profits interest can be an incredi-bly powerful business succession planning tool. Ifproperly structured, it provides significant advan-tages over more traditional techniques. One chal-lenge to this technique may be the carried interestlegislation being considered but not enacted by Con-gress. Three versions of this legislation have been

introduced, and two remain pending as of this writ-ing.49 The version with the potentially most damag-ing consequences for profits interests is H.R. 2834.The language in this bill could apply to a family-owned business even if its principal activity is notfinancial services or real estate management services.The progress of this legislation should be closelymonitored by anyone considering this technique aspart of a business succession plan.50

49 Cf. proposed new § 710 contained in H.R. 2834, 110thCong., § 1 (2007), H.R. 3970, 110th Cong., § 1270 (2007), andH.R. 3996, 110th Cong., § 611 (2007).

50 See Carol K. Harvey and Eric Lee, A Technical WalkThrough the Carried Interest Provisions in Chairman Rangel’s TaxReform Proposal, 86 TAXES 77 (2008).


Editors’ Synopsis: This article provides an in-depth and detailed analysis of the principles advancedby taxpayer and I.R.S. experts in twelve cases valuingfamily limited partnerships and closely-held corpora-tions. Also considered are the Tax Court’s and onedistrict court’s approaches in utilizing or disregardingthe analyses of the litigants’experts in determining thevalue of partnership interests and corporate stock.

I. Introduction.

McCord,1 Lappo,2 Peracchio,3 Green,4 Thompson,5

Kelley,6 Temple,7 Kohler,8 Gimbel,9 Jelke,10 Astleford11

and Holman12 are recent valuation cases, principallyaddressing the valuation of interests in family limitedpartnerships, family limited liability companies orclosely held corporations (except that Gimbel dealtwith the valuation of restricted shares of a publicly-traded company). Most of these cases originated in theTax Court, except for Temple which was a U.S. DistrictCourt case. These decisions clearly illustrate thatcourts, while willing to consider the testimony of eachparty’s valuation expert, are not bound to adopt the val-uation of either party’s expert; rather, courts ultimatelybase their conclusions on their own analysis of the evi-dence. The following discussion summarizes the valu-ation issues in each case. Specifically, the analysisfocuses on the valuation method-ologies used by the variousexperts, the experts’ applications ofthose methodologies, the conclu-sions drawn by the experts andfinally, the court’s response to, andcriticism of, the experts’ analyses.We discuss primarily discountissues, particularly the discounts

for lack of control and lack of marketability. TheMcCord and Jelke cases, however, are also significantfor their treatment of other issues with important impli-cations in the valuation area, such as the effect to begiven to “defined value” provisions and how to accountfor built-in capital gain tax, and those issues are alsodiscussed here to some degree, particularly from thestandpoint of the appellate decisions that reversed orvacated the Tax Court’s determinations.

II. McCord.

A. Facts.13

The relevant facts are as follows. Charles andMary McCord, their four sons and an existing partner-ship formed McCord Interests, Ltd., L.L.P. in 1995(“MIL”). The four sons were the general partners ofMIL. Each son owned a 0.268% general partner inter-est. The separate, preexisting partnership, ownedequally by the four sons, owned a 16.594% limited part-ner interest in MIL. Charles and Mary owned theremaining limited partner interests. On January 12,1996, Charles and Mary entered into an assignmentagreement covering their entire limited partner interestswith their sons and two charities. As of the valuationdate, MIL’s net asset value (“NAV”) was $17,673,760.The various asset classes of MIL were as follows:

* Copyright 2009 by the authors. All rights reserved.1 McCord v. Commissioner, 120 T.C. 358 (2003), reversed

and remanded, 461 F.3d 614 (5th Cir. 2006).2 Lappo v. Commissioner, 86 T.C.M. 333 (2003).3 Peracchio v. Commissioner, 86 T.C.M. 412 (2003).4 Estate of Green v. Commissioner, 86 T.C.M. 758 (2003).5 Estate of Thompson v. Commissioner, 88 T.C.M. 48

(2004), vacated and remanded, 499 F. 3d 129 (2d Cir. 2007), cert.denied, 128 S. Ct. 2932 (2008).

6 Estate of Kelley v. Commissioner, 90 T.C.M. 369 (2005).

7 Temple v. United States, 423 F. Supp. 2d 605 (E.D. Tex. 2006)8 Kohler v. Commissioner, 92 T.C.M. 48 (2006).9 Estate of Gimbel v. Commissioner, 92 T.C.M. 504 (2006).10 Estate of Jelke v. Commissioner, 89 T.C.M. 1397 (2005),

vacated and remanded, 507 F. 3d 1317 (11th Cir. 2007), cert.denied, 129 S. Ct. 168 (2008).

11 Astleford v. Commissioner, 95 T.C.M. 1497 (2008).12 Holman v. Commissioner, 130 T.C. No. 12 (2008).13 Judge Halpern wrote the opinion in McCord.

McCord to Holman—Five Years of Value Judgments

by Cynthia A. Duncan, John R. Jones, Jr. and James D. Spratt, Jr. Atlanta, Georgia*

• Asset Type: Equities portfolio Value: $3,641,956 % of Total: 20.6• Asset Type: Bond portfolio Value: $8,040,220 % of Total: 45.5• Asset Type: Real estate Value: $ 5,194,933 % of Total: 29.4

partnership• Asset Type: Real estate Value: $581,553 % of Total: 3.3• Asset Type: Oil and gas interest Value: $215,098 % of Total: 1.2

Total: $17,673,760 100.0


There were several issues in the case, includ-ing what effect, if any, should be given for gift tax pur-poses to a post-gift “confirmation agreement” amongthe donees (discussed further below in conjunctionwith the Fifth Circuit’s reversal of the Tax Court), butthe focus of our discussion here is on the discountsapplicable in determining the federal gift tax values ofthe January 12, 1996 gifts.

B. Valuation Issues in the Case.1. Taxpayer’s Expert.

The taxpayers offered William H. Frazier(“Mr. Frazier”) as an expert witness to testify concern-ing the valuation of the limited partner interests thatwere the subject of the gifts.14 Mr. Frazier concludedthat a 22% lack of control discount was appropriate, a35% lack of marketability discount was appropriate,and based on such discounts the fair market value of a1% limited partner interest in MIL (on the valuationdate) was $89,505.

2. Service’s Expert.The Service offered Mukesh Bajaj, Ph. D.

(“Dr. Bajaj”) as an expert witness.15 Dr. Bajaj con-cluded that an 8.34% lack of control discount wasappropriate, a 7% lack of marketability discount wasappropriate, and based on such discounts that the fairmarket value of a 1% limited partner interest in MIL(on the valuation date) was $150,665.64.

3. Methodologies.The experts agreed that in the case of an

investment company, the lack of control discountshould equal the weighted average of the lack of con-trol discounts for each asset class (or each type ofinvestment) held by MIL. The use of closed-endinvestment company data as support for quantifyingminority interest discounts (for investment holdingentities funded chiefly with marketable securities) iswidely accepted and both experts analyzed data onpublicly traded closed-end funds.16

With respect to MIL’s equity portfolio,both experts determined the lack of control discountbased on publicly traded closed-end equity investmentfunds. Both experts derived a range of discounts by

determining for their sample of funds the discount atwhich a share of each fund traded relative to its prorata share of the NAV of such fund. With respect toMIL’s bond portfolio, both experts determined the lackof control discount by reference to publicly traded,closed-end municipal bond investment funds. Withrespect to MIL’s real estate partnership holdings, theexperts disagreed on the general type of publicly trad-ed entity from which to base their discount. Dr. Bajajused a diversified group of real estate investment trusts(“REITS”).17 The taxpayer’s expert argued that the useof REITS was inappropriate because REITS arerequired by law to pay out annually a large portion oftheir earnings to shareholders and are therefore pricedon a current yield basis. The taxpayer’s expert insteadused publicly traded real estate companies for his sam-ple group. The taxpayer’s expert was able to come upwith 5 comparable companies. He derived his rangeof discounts from 3 of those companies. Dr. Bajaj’ssample consisted of 62 companies. With respect toMIL’s direct real estate holdings, the IRS accepted thetaxpayer’s 40% lack of control discount. The IRSlikewise accepted the taxpayer’s 33.5% lack of controldiscount with respect to MIL’s oil and gas holdings.Within each of the other asset classes, the taxpayer’sexpert selected discounts at the upper end of the range,and the Service’s expert selected discounts at thelower end of the range.

Both experts agreed that a lack of mar-ketability discount was appropriate. Mr. Frazier utilizedfour restricted stock studies and pre-IPO studies.18 Dr.Bajaj used his own private placement study, the Wruckstudy, and the Hertzel and Smith study. Dr. Bajaj arguedthat private placement studies used to quantify discountsfor lack of marketability should include both registeredand unregistered private placements.

C. Tax Court’s Conclusions.The Tax Court rejected both experts’ proposed

discounts with respect to the equity, bond and realestate asset classes. As is typical in valuation cases, thepoints of contention were (1) the appropriate measure-ment date, (2) the appropriate sample funds, and (3) the

14 At the time of trial, Mr. Frazier was a principal of HowardFrazier Barker Elliott, Inc., a Houston based valuation consultingfirm. Judge Halpern noted that Mr. Frazier was a senior member ofthe American Society of Appraisers and had been involved in valu-ation and general investment banking activities since 1975.

15 At the time of trial, Dr. Bajaj was the managing director ofthe finance and damages practice of LECG, LLC. Judge Halpernnoted that Dr. Bajaj had experience as a university professor offinance and business economics, had lectured extensively on valua-tion issues, and had testified as an expert in several valuation cases.

16 Publicly traded closed-end funds typically trade at pricediscounts from their NAVs.

17 A real estate investment trust (“REIT”) is a tax-favoredvehicle through which numerous investors can invest in real estateby pooling their resources.

18 Including the SEC study, the Silber study, the StandardResearch Consultants study, and the Hertzel and Smith study. Thepre-IPO approach refers to studies which compare (i) the private mar-ket price of shares sold before a company goes public with (ii) thepublic market price obtained in the company’s initial public offering.


appropriate representative discount within the range ofthe sample fund discounts. With respect to the experts’analyses of MIL’s equity portfolio, the Tax Court sidedwith the Service’s expert as to the appropriate measure-ment date based on the fact that the Service’s expertselected data closer to the valuation date.19 As for sam-ple funds, the Tax Court again sided with the Service’sexpert based on the larger size of his sample.20 As pre-viously noted, the taxpayer’s expert argued for a dis-count at the higher end of his range, and the Service’sexpert argued for a discount at the lower end of hisrange.21 In determining the appropriate discount, theTax Court did not side with either expert. The TaxCourt used the Service’s expert’s measurement datesand sample funds (with one addition) and took theaverage of those funds’ discounts. In the end, the TaxCourt concluded a 10% lack of control discount wasappropriate for the equities portfolio.

The Tax Court found both experts’ analysesflawed with respect to MIL’s bond portfolio. The tax-payer’s expert derived his sample of closed-end munic-ipal bond funds from Morningstar’s Mutual FundsGuide. He then excluded funds with scheduled liqui-dation dates. The taxpayer’s expert also excluded sin-gle-state funds notwithstanding the fact that MIL’sbond portfolio consisted of 75% Louisiana bonds. TheTax Court agreed that funds with scheduled liquidationdates should be excluded but disagreed with the tax-payer’s expert’s exclusion of single-state funds. Basedon the actual holdings of the partnership, the Tax Courtreasoned that an appropriate sample group should con-sist entirely of single-state funds. The Service’s expertderived his sample funds from a list of 140 funds setforth in the 1/15/96 edition of the Wall Street Journal.He excluded 6 funds, leaving a sample of 134 funds(including funds that had scheduled liquidation dates).The Tax Court created its own sample consisting of 62single-state funds pulled from the Service’s expert’ssample (excluding those funds that had scheduled liq-uidation dates). Again, the Tax Court was unpersuadedby the arguments of both experts and concluded the

appropriate lack of control discount was 10%.22

With respect to the experts’ analyses of MIL’sreal estate partnership holdings, the Tax Court rejectedthe taxpayer’s expert’s argument regarding the use ofREITS (noted previously) because the funds the tax-payer’s expert used in his own equity and bond sampleswere likewise required to distribute substantially all oftheir earnings as regulated investment companies(“RIC’s”). In addition, the taxpayer’s expert relied on3 real estate investment companies which the TaxCourt considered insufficient. The Tax Court did agreewith the Service’s expert that the difference betweenthe trading price of a REIT and its NAV is attributableto (i) a positive amount for the liquidity premium (asecondary market exists for REITS), and (ii) a negativeamount reflecting a lack of control discount. However,the Tax Court did make adjustments to the numbersused by the Service’s expert and concluded a 23.3%lack of control discount was appropriate.

The Tax Court accepted (as did the Service) thetaxpayer’s expert’s 40% lack of control discount withrespect to MIL’s direct real estate holdings and alsoaccepted the taxpayer’s expert’s 33.5% lack of controldiscount with respect to MIL’s oil and gas holdings.

As for the lack of marketability discount, theTax Court rejected as unreliable those portions of thetaxpayer’s expert’s analysis based on the pre-IPOapproach. The Tax Court agreed with the Service’sexpert that private placement studies used to quantifydiscounts for lack of marketability should include bothregistered and unregistered private placements, but theTax Court saw no reason to choose a lack of marketabil-ity discount from the “low” category within the Ser-vice’s expert’s study. Instead, the Tax Court chose a dis-count from the “middle” group of private placements inthe Service’s expert’s sample. The average discount ofsuch group was 20.36%. The Tax Court concluded thata 20% lack of marketability discount was appropriate.23

McCord illustrates the Tax Court’s willing-ness to pick and choose portions of each side’sexperts’ opinions.

19 The taxpayer’s expert calculated the discounts for his sam-ple of closed-end funds using 1/11/96 trading prices and 1/12/96(the valuation date) NAVs. The Service’s expert used data from1/12/96.

20 The taxpayer’s expert derived his sample from a list ofdomestic equity funds from Morningstar’s Mutual Fund Guide. Hethen screened those funds, ending up with 14 funds. The Service’sexpert derived his sample funds from the list of general equityfunds set forth in the 1/12/96 edition of the Wall Street Journal. Heexcluded two, which left him with a sample of 20 funds. The courtultimately added one fund to the Service’s expert’s sample to createits own sample.

21 The taxpayer’s expert argued that MIL’s equity portfolio

would not compare favorably to an interest in an institutional fund.the Service’s expert argued that MIL was similar to a new investment,which traditionally trades at lower discounts than seasoned funds.

22 The Tax Court rejected the Service’s expert’s “new invest-ment” argument because MIL’s bond portfolio had been in place(in the hands of the contributing partners) for years. The Tax Courtcriticized the taxpayer’s expert for failing to provide data whichshowed a correlation between the variables he used (in determininga higher than median discount within his range) and the samplefund discounts.

23 Specifically, this number was derived from the average ofthe middle 29 discounts from a total of 88 private placementstaken, as previously noted, from Dr. Bajaj’s own study.


D. Fifth Circuit Decision on Appeal.The taxpayers appealed the Tax Court’s deci-

sion to the Fifth Circuit. The Court of Appeals held thatthe approach used by the Tax Court majority in deter-mining the taxable and nontaxable values of the variousgifts (relying in part on a post-gift “confirmation agree-ment” among the charitable and noncharitable donees)constituted legal error, and therefore that the results ofthe Tax Court’s valuation of the transferred interests inMIL were irrelevant to the amount of gift taxes owed bythe taxpayers. The assignment agreement had expressedthe noncharitable gifts and one of the charitable gifts asdollar amounts, i.e., interests in MIL having specifieddollar values, not percentage interests in MIL. In otherwords, the assignment agreement tookwhat practitioners often refer to as adefined value approach. The confirma-tion agreement, which was entered intotwo months after the gifts were made andto which the donees but not the taxpayers were parties,translated the transferred interests into percentage inter-ests in MIL so as to determine the relative interests ofthe donees among themselves. According to the FifthCircuit, the Tax Court was mistaken in using the after-the fact confirmation agreement to transform the dollarvalue gifts stated in the assignment agreement into giftsof percentage interests in MIL. The appeals court alsoheld that the Tax Court erred in not allowing a reductionin the taxable gifts for the actuarially determined presentvalue of the noncharitable donees’ assumption of liabili-ty for estate taxes that would come due under I.R.C.§2035(b) if the taxpayers failed to survive the gifts bythree years. Although McCord was an unusual casebecause of the defined value gift involved and the non-charitable donees’ assumption of the donors’ potentialI.R.C. §2035(b) estate tax liability, and the Tax Court’svaluation analysis ended up not being pertinent to thetaxpayers’ gift tax liability, the case is included in thisarticle because the Tax Court’s analysis of the lack ofcontrol and lack of marketability discounts is illustrativeof its approach in this area.

III. Lappo.

A. Facts.24

Lappo was a gift tax case. The relevant factsare as follows: In 1995, Clarissa Lappo (“Lappo”) and

Clarajane Middlecamp (“Middlecamp”) formed theLappo Family Limited Partnership (the “Lappo Part-nership”) which consisted of marketable securities(primarily municipal bonds) and real estate. Lappoowned a 1% general partner interest and a 98.7% lim-ited partner interest. Middlecamp owned a 0.2% gen-eral partner interest and a 0.1% limited partner inter-est. On April 19, 1996, Lappo made a gift of a 66.8%limited partner interest to Middlecamp as trustee of atrust and a 0.668% limited partner interest to each ofher four grandchildren. In July, Lappo gave herremaining limited partner interest to Middlecamp.The asset classes of the Lappo Partnership at the timeof the gifts were as follows:


The taxpayer offered Robert P. Oliver(“Mr. Oliver”) as an expert witness.25 Mr. Oliver con-cluded that a 7.5% lack of control discount was appro-priate with respect to the marketable securities. Heconcluded that a 35% lack of control discount wasappropriate with respect to the real estate componentfor the 4/19/96 gift. He concluded that a 30% lack ofcontrol discount was appropriate with respect to thereal estate component for the 7/02/96 gift. Mr. Oliverconcluded that a 35% lack of marketability discountwas appropriate for each gift.

2. Service’s Expert.The Service offered Dr. Alan C. Shapiro

(“Dr. Shapiro”) as an expert witness.26 Dr. Shapiroconcluded that an 8.5% lack of control discount wasappropriate and an 8.35% lack of marketability dis-count was appropriate.

3. Methodologies.The lack of control discount was again

determined by using a weighted average of the indi-vidual discount factors for each category of assetowned by the partnership. Both experts applied theclosed-end fund analysis in determining the lack ofcontrol discount with respect to the marketable securi-ties component. With respect to the real estate compo-

24 Judge Thornton wrote the opinion in Lappo.25 Mr. Oliver was an accredited appraiser and had been with

Management Planning, Inc. (“MPI”) since 1975 and had served asits president since 1996. The Tax Court noted that MPI had been inthe business of preparing financial analyses of closely held busi-nesses and in evaluating securities of such businesses since 1939.The court also noted that Mr. Oliver was an author and speaker on

valuation and related topics.26 At the time of trial, Dr. Shapiro was the Ivadelle and

Theodore Johnson Professor of Banking and Finance at the Univer-sity of Southern California. He was also an outside director ofLECG, LLC, an economic and financial consulting company. Hehad taught at a number of prestigious universities and was the authorof numerous academic articles and books on corporate finance.

• Asset Type: Marketable Securities Value on 4/19/96: $1,296,882Value on 7/02/96: $1,379,531

• Asset Type: Real Estate Value: $1,860,000


nent of the partnership, both experts agreed thatREITS were the appropriate starting point. As is typi-cal, they disagreed on which REITS should be usedfor comparison and on the appropriate analysis of theREITS data. Mr. Oliver started with 400 REITS andreal estate companies listed in Moody’s Bank andFinance Manual. He then eliminated all but 7 (leaving3 REITS and 4 companies). Dr. Shapiro started with62 companies provided by Green Street Advisors,Inc.27 Dr. Shapiro then eliminated 10 companiesbecause they were not REITS.

To determine the NAV of his 7 guidelinecompanies, Mr. Oliver started with book value andmade certain upward adjustments to reflect “appraisedvalues disclosed by management.” Mr. Oliver thencompared NAV to share price and determined themedian price-to-NAV discounts for his guideline com-panies. Mr. Oliver then reasoned that the partnership’sreal estate portfolio would likely trade at a deeper dis-count than the guideline median price-to-NAV dis-count because it was inferior in certain respects to theREITS used in his sample group (e.g., smaller size ofpartnership’s holdings, concentration in a few parcels,dependence on one tenant, untested entity, and unlikethe REITS had no performance track record).

Dr. Shapiro compared the market pricesof his Green Street REITS to their NAVs and found themedian price-to-NAV premium. He then lookedbelow the median (to the 15th percentile) because thepartnership unlike the REITS was not required to paylarge and regular distributions to its interest holders.Dr. Shapiro adjusted these percentages to remove aliquidity premium.28

To determine the lack of marketability dis-count, both experts used private placement studies astheir starting point. The experts disagreed on the appro-priate private placements to consider and what is mea-sured by such comparisons. Mr. Oliver used a “restrict-ed stock approach.” Specifically, Mr. Oliver used a pre-existing MPI study that analyzed 197 private transac-tions in common stocks of actively traded corporationsfrom 1980 through 1995. Mr. Oliver then determined aguideline group of 39 transactions in unregistered (i.e.,restricted) stock from which he determined the mediandiscount. Dr. Shapiro used a “private placement”approach. Dr. Shapiro relied on Dr. Bajaj’s privateplacement study (used by Dr. Bajaj in McCord). Asnoted previously, the Bajaj study analyzes discountsobserved in private placements of registered shares as

well as private placements of unregistered shares. Thisis a means of isolating that portion of the discountattributable solely to a lack of marketability.

C. Judge Thornton’s Conclusions.Judge Thornton reasoned that “fairness” dic-

tated the use of Dr. Sharpiro’s 8.5% lack of control dis-count rate (as opposed to Mr. Oliver’s 7.5% discountrate) for the marketable securities component of thepartnership since the parties had agreed to use theIRS’s higher NAV for such component. The opiniondid not further explore the experts’ approaches withrespect to this component. With respect to the realestate component of the partnership, Judge Thorntondetermined his own discount by reference to compara-ble publicly traded REITS coupled with the guidanceof several academic studies on private placement dis-counts. Judge Thornton concluded that a 19% lack ofcontrol discount was appropriate for this component.Applying the weighted averages of the two lack of con-trol discount factors, Judge Thornton held that an over-all lack of control discount of 15% was appropriate.

In determining the appropriate lack of mar-ketability discount, Judge Thornton relied on the rawdata of the private placement analyses prepared by Dr.Bajaj and Hertzel & Smith (as did the Tax Court inMcCord). The median discount of such studies was21%. Judge Thornton adjusted this number upward by3% resulting in a marketability discount of 24%.Judge Thornton stated that he was hesitant to rely sole-ly on a study which the expert had not participated inpreparing and was therefore unable to elaborate onfirst hand. Applying his own lack of control discountand lack of marketability discount sequentially, JudgeThornton held that a combined discount of approxi-mately 35.4% was appropriate.

Judge Thornton spent considerable time com-paring the characteristics of the guideline companiesused by the experts to the actual characteristics of thepartnership being valued. The opinion clearly illus-trates the Tax Court’s willingness to pick and choosethose portions of the experts’ reports which it likes anddiscard those portions which it dislikes. As inMcCord, one sees a retooling of the experts’ analyses.This is especially evident when the Judge Thornton“creates” his own ideal sample, picking and choosingamong experts’ guideline companies those which heconsiders the most comparable to the subject assetclass of the partnership.

27 Green Street Advisors, Inc. is an independent research andconsulting firm concentrating on REITS and other publicly tradedreal estate companies which make up 80% of the market capitaliza-tion of the overall market of about 200 REITS.

28 The liquidity premium exists because the REIT interests,unlike their underlying assets, are publicly traded in reasonably liq-uid markets.


IV. Peracchio.

A. Facts.29

Peracchio was a gift tax case. The relevantfacts are as follows: In November of 1997 (the valua-tion date), John R. Peracchio created the PeracchioFamily Trust (the “Trust”). On the same day, Mr. Per-acchio, the Trust, and Mr. Peracchio’s son created alimited partnership known as Peracchio Investors, L.P.Mr. Peracchio contributed cash and securities worth$2,013,765 in exchange for a 0.5% general partnerinterest and a 99.4% limited partner interest (collec-tively representing 2,013.765 partnership units). Mr.Peracchio’s son contributed $1,000 in cash to the part-nership in exchange for a .05% general partner inter-est. The Trust also contributed $1,000 in cash inexchange for a .05% limited partner interest. On thevaluation date, Mr. Peracchio made three transfers.He gave 9.0788 partnership units to his son (to be heldin his capacity as a general partner). He gave 916.667partnership units to the Trust (to be held in its capacityas a limited partner). He sold 1,077.9409 partnershipunits to the Trust in exchange for the Trust’s promisso-ry note in the amount of $646,764. The partnership’sassets consisted of cash and marketable securities.30

At issue in the case were the fair market values of (i)the interest gifted to the Trust, and (ii) the interest soldto the Trust. On the valuation date, the NAV of thepartnership was $2,010,370. The partnership’s securi-ties were held indirectly through investment funds,including open-end investment funds.31 Mr. Peracchioreported the amount of the gift after applying a com-bined 40% discount (for lack of control and lack ofmarketability).


The taxpayer offered Timothy R. Dankoff(“Mr. Dankoff”) and Charles H. Stryker (“Mr. Stryk-er”) as expert witnesses.32 Mr. Dankoff concluded thata 7.7% lack of control discount was appropriate and a35% lack of marketability discount was appropriate.Mr. Stryker concluded that a 5% lack of control dis-

count was appropriate and a 40% marketability dis-count was appropriate.

2. Service’s Expert.The IRS offered Francis X. Burns (“Mr.

Burns”) as an expert witness.33 Mr. Burns concludedthat a 4.4% lack of control discount and a 15% lack ofmarketability discount were appropriate.

3. Methodologies.Mr. Dankoff’s first mistake (in the eyes of

Judge Halpern) was that he determined the NAV of thepartnership based on brokerage account statementsissued 5 days after the valuation date. Both expertsdetermined a minority interest discount factor for eachtype of investment held by the partnership, based on dis-counts observed in shares of closed-end funds holdingsimilar assets. They then determined their respectiveminority interest discounts by calculating the weightedaverage of such factors, based on the partnership’s rela-tive holdings of each asset type (both Mr. Dankoff andMr. Burns divided the assets of the partnership into 5basic categories with Judge Halpern further dividing the“municipal bonds” category for a total of 6 asset class-es). Both experts used data from tables prepared by Lip-per Analytical Services and published in Barron’s.However, Mr. Burns used more contemporary data.

Interestingly, Mr. Dankoff calculated themean discount and the median discount with respect toeach of his fund samples. The median discount wasalways greater than the mean discount. Mr. Dankoffused the median rather than the mean for each sample(for purposes of determining the lack of control dis-count factor for each corresponding asset category ofthe partnership), but he conceded at trial that he didnot have a valid reason for doing so. The opinion doesnot address further the individual discounts assertedby the experts for each asset class. This might bebecause Judge Halpern (applying the general method-ology used by the experts) went on to calculate hisown lack of control discounts for each asset category.

With respect to the lack of marketabilitydiscounts, Mr. Dankoff started with a benchmark dis-count or range of discounts and then, based on fac-tors Judge Laro analyzed in Mandelbaum v. Commis-

29 Judge Halpern wrote the opinion in Peracchio.30 Judge Halpern noted that the partnership’s equity portfolio

consisted of 44 companies, with no apparent concentration in anyparticular industry.

31 Shares of open-end funds are not themselves publicly traded,however a shareholder can typically liquidate his or her investmentat any time simply by tendering his or her shares to the fund forrepurchase at a price equal to their pro rata share of the fund’s NAV.

32 At the time of trial, Mr. Dankoff was a partner at Plante &Morgan, LLP, an accounting and management consulting firm. He

was an accredited senior appraiser by the American Society ofAppraisers and had been involved in business valuation activitiessince 1986. At the time of trial, Mr. Stryker was a partner in thevaluation and appraisal group of BDO Seidman, LLP, an account-ing and consulting firm. He had been performing valuation ser-vices for approximately 25 years.

33 Mr. Burns was managing director of InteCap, Inc., a finan-cial consulting firm that specializes in valuation services. He hadbeen performing valuation services for approximately 15 years andhad testified as an expert in several valuation cases.


sioner,34 determined whether the marketability dis-count for the subject interest should be greater than, lessthan, or equal to the benchmark range.35 Mr. Strykerasserted that he used the “restricted stock” approach.However, as Judge Halpern noted, he failed to analyzethe data from the studies as they might have related tothe transferred interests. Mr. Burns briefly analyzed 6factors to come up with a discount range of 5-25%.

C. Judge Halpern’s Conclusions.Judge Halpern began with the now standard

observation that the Tax Court may be selective indetermining what portions of each expert’s opinion, ifany, to accept and that as long as the figure arrived at iswithin the range of values that may be properlyderived from consideration of all the evidence suchfigure need not be directly traceable to specific testi-mony. Judge Halpern agreed that the use of publiclytraded, closed-end mutual funds was an appropriatemethod by which to determine the lack of control dis-count. Judge Halpern summarily dismissed Mr. Stryk-er’s opinion because his methodology was both“imprecise and incomplete.”36 Judge Halpern used Mr.Burns’s price/NAV data because it was more contem-poraneous. Judge Halpern then began the process ofscrutinizing each sample of funds used by the expertsfor each asset category. In the end, Judge Halpern cre-ated his own fund samples. Judge Halpern then deter-mined the mean lack of control discount factor foreach asset category. Based on those discount factors,Judge Halpern determined the weighted average andheld that a 6.02% lack of control discount was appro-priate.

As for the lack of marketability discount,Judge Halpern concluded that a 25% discount waswarranted. With respect to the lack of marketabilitydiscount, Judge Halpern was dissatisfied with bothexperts’ analyses. Judge Halpern noted that Mr. Burnsstated in his written report that a lack of marketabilitydiscount above 25% would not be justified for an enti-ty with the characteristics of the partnership. JudgeHalpern treated this statement as a concession that amarketability discount up to 25 % would be appropri-

ate. However, because the taxpayer failed to meet hisburden of proof of persuading Judge Halpern that afigure in excess of 25% would be appropriate, JudgeHalpern utilized the 25% marketability discount.

The novel aspect of the opinion in Peracchiois the Tax Court’s willingness to treat the upper end ofan expert’s suggested range of discounts as essentiallya concession on the part of the expert that a discountup to that percentage would be appropriate. The TaxCourt appears especially willing to take this approachwhen the expert has failed to provide qualitative sup-port for a conclusion regarding the appropriate dis-count within a specified range.

V. Green.

A. Facts.37

Green was an estate tax case. The relevantfacts are as follows: Mildred Green died on Septem-ber 26, 1997 (the “Decedent”). At the time of herdeath, the Decedent owned 3,276 (the “Shares”) of the64,372 shares of issued and outstanding commonstock of Royal Bancshares, Inc. (“RBI”). The Dece-dent’s Shares represented 5.09% of the outstandingshares of RBI (the fifth largest holding of RBI sharesby any one shareholder). On September 26, 1997there were a total of 62 RBI shareholders. RBI’sshares had never been listed on any securitiesexchange. At the time, RBI had total assets of$172,613,000 and between 1993 and 1997, RBIdeclared cash dividends ranging from $1.68 to $4.06per share. Royal Banks of Missouri was a whollyowned subsidiary of RBI. In 1996, Royal Banksloaned $1.6 million to the Havrillas. A printing com-pany guaranteed the loan by a deed of trust grantingRoyal Banks a security interest in certain real propertyit owned. The Havrillas’ note was current through Julyof 1997. However, no payments were made on thenote in either August or September and on the Dece-dent’s date of death the note was in default. In Augustof 1997, the printing company declared bankruptcyand in September of 1997 Royal Banks filed a noticeof appearance in the bankruptcy case.

34 69 T.C.M. 2852 (1995), aff’d, 91 F.3d 124 (3d Cir. 1996).35 The factors contained in Mandelbaum include: (1) the value

of the subject corporation’s privately traded securities vis-a-vis itspublicly traded securities; (2) the corporation’s financial state-ments; (3) the corporation’s dividend paying capacity, its history ofpaying dividends, and the amount of its prior dividends; (4) thenature of the corporation, its history, its position in the industry,and its economic outlook; (5) the corporation’s management; (6)the degree of control transferred with the block of stock to be val-ued; (7) any restriction of the transferability of the corporation’sstock; (8) the length of time an investor must hold the subject stock

to realize a sufficient profit; (9) the corporation’s redemption poli-cy; and (10) the cost of effecting a public offering of the stock to bevalued, e.g., legal, accounting and underwriting fees. With respectto Mr. Dankoff’s reliance on Mandelbaum, Judge Halpern ratherharshly stated that Mr. Dankoff was mistaken to the extent hebelieved the range of discounts utilized in that case was in any waycontrolling.

36 Judge Halpern noted the following two points: (i) Mr.Stryker did not statistically derive his discount from observed dis-counts, and (ii) he considered only domestic equity funds.

37 Judge Thornton wrote the opinion in Green.


The estate’s tax return was filed on November9, 1998. The Decedent’s estate reported the value ofthe Shares as $163,800 (or $50 per share). On August30, 1999, the Service determined a $1,205,541 defi-ciency and issued a notice of deficiency. The Servicedetermined the Shares had a fair market value of$1,048,320 (or $320 per share) as opposed to$163,800 as reported on the estate’s return. At thetime of trial the gap had closed somewhat with theService contending the Shares had a fair market valueof $860,000 (or $262.52 per share) and the estate con-tending the Shares had a fair market value of $655,200(or $200 per share).

B. Valuation Issues in the Case.1. Estate’s Expert.

The estate offered Gary L. Schroeder(“Mr. Schroeder”) as an expert witness.38 Mr.Schroeder concluded that a 17% lack of control dis-count was appropriate and a 40% lack of marketabilitydiscount was appropriate.

2. Service’s Expert.The Service offered William C. Herber

(“Mr. Herber”) as an expert witness.39 Mr. Herber con-cluded that a 15% lack of control discount was appro-priate and a 25% lack of marketability discount wasappropriate.

3. Methodologies.To determine the aggregate value of RBI

(before applying any discounts) both experts used anincome and a market approach. Under the incomeapproach the experts arrived at nearly identical values.Mr. Schroeder determined an aggregate undiscountedvalue of $23,370,000 and Mr. Herber determined anaggregate undiscounted value of $23,300,000. Underthe market approach, both experts performed a guide-line analysis of publicly held banks and a transactionanalysis of privately held banks. Under this approach,Mr. Schroeder determined an aggregate undiscountedvalue of $28,330,000 and Mr. Herber determined anaggregate undiscounted value of $28,000,000.

With respect to the transaction analysis,both experts identified a number of transactions involv-ing the acquisition of privately held banks which theexperts determined were similar to RBI’s bankingcompany. Mr. Schroeder identified five banks locatedin either Illinois or Missouri that were acquired withinthe 9-month period prior to the Decedent’s death. Mr.

Schroeder then determined a range of multiples basedon the price-to-earnings, price-to-equity and price-to-assets ratios of the acquired banks. Mr. Schroederselected multiples between the median and the low endof the range taking into consideration (1) the fact thatRoyal Banks was located in a more urban area than theacquired banks, and (2) “the potential of a significantpending loan impairment.” Based on these factors, Mr.Schroeder determined an aggregate controlling interestvalue of $25,920,000 for RBI’s stock.

Mr. Herber’s transaction analysis focusedon privately held commercial banks with assetsbetween $20 and $200 million whose sales wereannounced and completed between January 1996 andSeptember 26, 1997. Mr. Herber identified nine bankshe determined were comparable. Mr. Herber thendetermined the average and median price-to-earnings,price-to-equity and price-to-assets ratios of theacquired banks. He compared these ratios to RBI’sratios. As Judge Thornton noted, Mr. Herber did nottake into consideration the effects of any potential loanimpairment. Mr. Herber determined an aggregate con-trolling interest value of $28,500,000 for RBI’s stock.

The experts agreed that lack of controland lack of marketability discounts were appropriatein the valuation of the Decedent’s Shares. Bothexperts determined the lack of control discount by cal-culating the inverse of what they considered to be theappropriate control premium. Mr. Schroeder relied ondata contained in Mergerstat Review 1998 regardingoffers to acquire a majority interest in (or total owner-ship of) public companies. Mr. Schroeder calculated acontrol premium of 20% based on the “size, financialperformance and geographic location of Royal Banks”and an implied lack of control discount of 17%. Mr.Herber relied on a study of minority interest discountsby Christopher Mercer in Quantifying MarketabilityDiscounts. The Mercer study indicated a median andan average lack of control discount of 19%. Mr. Her-ber also conducted his own study of control premiumsbased on transactions involving banking companies.Based on his study, he determined a range of medianand average lack of control discounts from 18.4% to19.6%. Mr. Herber also considered the followingadditional factors: (1) the Decedent’s 5.09% interestin RBI was a “substantially larger interest than typicalminority interests in publicly traded shares in banks,”(2) because the banking industry was highly regulated,

38 Mr. Schroeder was accredited by the American Society ofAppraisers as a senior appraiser in the valuation of businesses andintangible assets and had been active in the appraisal and consult-ing profession since 1981.

39 Mr. Herber was an associate member of the American Soci-

ety of Appraisers and a member of the Institute of BusinessAppraisers, Inc. He specialized in the valuation of real estate, busi-ness enterprises and intangible property rights. He had been activein the valuation business since 1985.


banking companies were “transparent,”40 and (3) RBIwas well capitalized, had high returns on equity andassets, maintained a high rating in comparison to otherbanking companies and had offered a “favorable divi-dend” over the past five years. Taking into considera-tion these additional factors, Mr. Herber determined alack of control discount of 15%.

To determine the appropriate lack of mar-ketability discount, Mr. Schroeder relied on restrictedstock studies and pre-IPO studies. The restricted stockstudies indicated discounts in the range of 31.2 to 45%and an overall average discount of 34.9%. The pre-IPO studies indicated discounts in the range of 43% to45.7% and an overall average discount of 44.4%. Mr.Schroeder considered the following additional factors:(1) the potential loan impairment and (2) the pendingbankruptcy of the printing company. Mr. Schroederalso considered seven prior transactions involvingshares of RBI. As Judge Thornton noted, however, 6of the 7 transactions occurred more than 3 years beforethe Decedent’s death and the remaining transactionoccurred post death (in January of 1998). Mr.Schroeder did not provide Judge Thornton with anyspecifics regarding these transactions.

Mr. Herber relied on restricted stock stud-ies which indicated median discounts ranging from24% to 45%. Judge Thornton noted that Mr. Herberplaced “considerable reliance” on a MPI study, whichindicated an overall discount range of 26.2% to 32.7%with a central tendency of 30.5%. Mr. Herber alsoconsidered (1) RBI’s relatively smaller gross incomeand earnings and (2) the fact that the companies in thestudy tended not to pay dividends. Mr. Herber alsoconsidered certain factors identified in Mandelbaumfor determining whether an appropriate lack of mar-ketability discount should be higher than, the same as,or lower than the indicated range of discounts. Mr.Herber concluded that the appropriate lack of mar-ketability discount in terms of the Decedent’s Shares“would have a strong central tendency relative to theoverall studies.” Taking into account RBI’s risk as abank, however, Mr. Herber recommended a 25% dis-count which he characterized as being at the “slightlylower end” of the indicated range of median discounts.

C. Judge Thornton’s Conclusions.With respect to the income approach, Judge

Thornton quoted the following portion of the Service’sbrief: “The experts offered by the parties are in agree-ment as to the value of the Royal Bancshares derivedfrom the discounted net income method.” In light of

this concession and in fairness to the estate, JudgeThornton accepted Mr. Herber’s estimated value of$23,300,000. With respect to the experts’ guidelineanalysis, Judge Thornton again quoted the Servicewhich stated in its brief, “[t]he experts offered by theparties are in agreement on the value of Royal Banc-shares suggested by publicly-traded guideline banks.”Similarly, in light of this concession and in fairness tothe estate, Judge Thornton accepted Mr. Herber’s esti-mated value of $28,000,000.

With respect to the experts’ transaction analy-sis, Judge Thornton was unpersuaded by Mr. Schroed-er’s analysis with respect to the impact of the loanimpairment because Mr. Schroeder failed to articulatewhether, or to what extent, it depressed his appraisal.Accordingly, Judge Thornton concluded that Mr. Her-ber’s failure to consider the potential loan impairmentdid not “materially undermine” his valuation recom-mendations. Judge Thornton then determined in sum-mary fashion that the transaction analysis indicated avalue of $27,500,000. Giving equal weight to thesethree values, Judge Thornton determined the appropri-ate aggregate undiscounted value of the RBI’s stockwas $26,266,667.

With respect to the appropriate lack of controldiscount, Judge Thornton stated that neither expertadequately supported his recommended discount. Mr.Herber started with an initial range of 18.4% to 19.6%.However, Judge Thornton felt that Mr. Herber failed tosupport the downward adjustments he made to arriveat a discount below this initial range (i.e., 15%). Inresponse to Mr. Herber’s claim that a lower discountwas appropriate taking into consideration the fact thatthe Decedent’s 5.09% interest was a “substantiallylarger interest than typical minority interests,” JudgeThornton stated Mr. Herber failed to offer any “inde-pendent evidence or empirical data” to verify this con-clusion and therefore was unpersuaded that he “appro-priately relied on this factor in his discount analysis.”With respect to Mr. Herber’s “transparency” factor,Judge Thornton noted that the initial 18.4% to 19.6%range (indicated by Mr. Herber’s own study) involvedbanking companies and presumably already factoredin issues relating to the regulation of banking compa-nies. Finally, with respect to the remaining factors Mr.Herber considered (i.e., RBI’s capitalization, highreturns, high ratings and its “favorable dividend” his-tory), Mr. Thornton felt Mr. Herber again failed to pro-vide “independent evidence” or verification regardingthe comparisons between RBI and other banking com-panies and also failed to quantify the effects of those

40 Mr. Herber contended that shareholders of a banking com-pany had access to a great deal of information regarding the

company’s performance.


factors. In the end, Judge Thornton was unpersuadedthat those factors supported a lower lack of control dis-count. Because Mr. Schroeder’s recommended dis-count fell below the initial range indicated by Mr. Her-ber’s study, Judge Halpern accepted Mr. Schroeder’srecommendation of a 17% lack of control discount.

With respect to Mr. Schroeder’s lack of mar-ketability analysis, Judge Thornton believed Mr.Schroeder demonstrated an “incomplete knowledge”of the potential loan impairment and the pending bank-ruptcy, failed to verify the seven transactions involvingRBI stock or quantify the effects of such information.Moreover, Judge Thornton pointed out that while theexistence of prior transactions is a factor which usuallydecreases the lack of marketability discount, these par-ticular transactions were at prices significantly belowthe appraisal value at issue which is typically a factorthat would increase the lack of marketability discount.In short, Judge Thornton felt Mr. Schroeder’s discountwas “overstated” based on those factors. Finally,Judge Thornton noted that the remaining factors citedin Mr. Schroeder’s report actually supported a lowerlack of marketability discount.

With respect to Mr. Herber’s lack of mar-ketability discount analysis, Judge Thornton criticizedMr. Herber’s application of the analysis found in theMPI study. Mr. Herber compared RBI with the group-ing of companies with gross incomes of $10 to $30 mil-lion. The transactions involving those companies hadan overall average lack of marketability discount of30.8%. Of this group, only two transactions involvedcompanies with revenues comparable to RBI’s relative-ly small revenues. Judge Thornton made a point to notethat the MPI study indicated a “clear correlation”between the size of a company’s gross income and thesize of the lack of marketability discount. Judge Thorn-ton went on to use Mr. Herber’s own statement againsthim quoting the following portion of Mr. Herber’sreport, “in other words, restricted shares of companieswith higher gross income tended to sell for lower dis-counts than the restricted share of companies withlower gross income.” Accordingly, because RBI hadgross income at the lower end of the range indicated inthe MPI study, Judge Thornton reasoned an appropriatediscount for RBI would be higher than the overall aver-age lack of marketability discount (i.e., 30.8%) indicat-ed for the relevant grouping of companies. In the end,Judge Thornton determined that the appropriate lack ofmarketability discount was 35%. This was at the high-er end of the narrow range that Mr. Herber identified inhis report and was consistent with the average discount

Mr. Schroeder derived from the restricted stock studies.Judge Thornton therefore concluded that the fair mar-ket value of the Decedent’s shares of RBI was $721,297(or $220.18 per share).

Green is interesting because of the Tax Court’swillingness to base its conclusions on MPI’s restrictedstock study considering it could have utilized the samestudy in its analysis in Lappo but chose not to do so.On closer analysis, however, there is a key differencebetween Green and Lappo. In Lappo, the Tax Courthad the option of utilizing the Service’s expert’s pri-vate placement approach (as embodied in the Bajajstudy and utilized by the Tax Court in McCord).41 TheTax Court’s analysis is limited to the evidence con-tained in the record. Viewed in context, the TaxCourt’s reliance on MPI’s restricted stock study inGreen was not contradictory to its preferences inLappo, but rather consistent with the analyticalapproach currently taken by Tax Court.

VI. Thompson.

A. Facts.42

Thompson was an estate tax case. At issue inthe case was the fair market value of 487,440 shares(the “Shares”) of the voting common stock of ThomasPublishing Co., Inc. (“TPC”) owned by the estate ofJosephine T. Thompson (the “Decedent”). The rele-vant facts are as follows: The Decedent died on May2, 1998, a resident of New York. The Decedent’sShares represented approximately 20% of TPC’s totaloutstanding common stock and constituted the largestblock of TPC common stock owned by any singleshareholder. Under the terms of the Decedent’s Will,the Shares passed to her son, Carl T. Holst-Knudsen(“Carl”). Prior to his mother’s death, Carl owned162,000 shares of the voting common stock of TPC.These shares coupled with the Shares inherited underhis mother’s Will resulted in Carl owning approxi-mately 27% of the total outstanding common stock ofTPC. During the 10 year period prior to the Dece-dent’s death, approximately 13% of the total outstand-ing common stock of TPC was owned by a New YorkStock Exchange traded company (the “Outside Share-holder”). The remaining outstanding common stockwas owned by approximately 20 other relatives ofTPC’s founder, Harvey Mark Thomas. TPC’s stockhad never been publicly traded nor had there been anysales of the stock in the 10 year period prior to theDecedent’s death or in the years subsequent to theDecedent’s death through the time of trial.

41 Not that this approach is correct. For a criticism of Dr.Bajaj’s analysis, see Shannon P. Pratt, Defending Discounts for

Lack of Marketability, 29 ACTEC JOURNAL 276 (2004).42 Judge Swift wrote the opinion in Thompson.


TPC’s primary business was the production andsale of industrial and manufacturing business guides anddirectories. Secondary publication lines included a vari-ety of news magazines, software comparison guides,and a magazine relating to factory automation. TPC wasregarded as a successful and profitable company.

The development and expansion of the Inter-net allowed the traditional buyers of TPC’s print direc-tories to locate and purchase products on their ownwithout reference to TPC’s print directories. Inresponse, TPC began publishing and offering some ofits business-to-business buying directories on CD-ROM. TPC sought to secure a dominant position inthe electronic interchange of information amongindustrial buyers and sellers comparable to that whichit had enjoyed in the hard copy realm.

Historically, TPC’s revenue was generated fromthe sale of subscriptions to, and advertising in, its printdirectories. Over 90% of TPC’s revenue was generatedfrom the sale of advertising. Increases in advertising rev-enue more than offset decreases in TPC’s subscriptionrevenue when it began to make information available onCD-ROM and on the Internet. TPC invested approxi-mately $36 million in technology-related projects.

TPC owned substantial liquid short-terminvestment and marketable securities (close to$100,000,000 in 1998). TPC had a long history ofpaying annual cash dividends to its shareholders. Asof the date of the Decedent’s death, TPC’s manage-ment had no plans to liquidate or to sell TPC.

Carl and The Bank of New York were appointedCo-Executors of the Decedent’s Will. The Executorshired Mr. Goerig (“Goerig”), an Alaskan attorney, toprepare the valuation report for the Shares. Goerig wasassisted by Mr. Wichorek (“Wichorek”), an Alaskanaccountant (collectively, the “estate’s experts”). Goerigwas also granted limited estate administrative powers forthe purpose of representing the estate in connection withthe anticipated audit of the Federal estate tax returnincluding any negotiations over the fair market value ofthe Shares. Apparently, the Executors hired Goerig inanticipation of requesting a transfer in the event of anIRS audit from the Service’s New York City office totheir Alaska office. Goerig believed, and apparently rep-resented to the Executors, that he would be able toobtain a more favorable valuation of the Shares if theaudit was conducted out of the Service’s Alaska office.

Based on a valuation report prepared by theestate’s experts, the estate tax return reported the fairmarket value of the Shares as $1,750,000 (or $3.59 pershare). On audit, based on a valuation report dated

November 9, 2000, the Service determined the Shareshad a fair market value of $35,273,000 (or $72.36 pershare). Judge Swift determined the Shares had a fairmarket value of $13,525,240 (or $27.75 per share).Few valuation cases have presented the startling dis-parity in value that Thompson presents.

B. Valuation Issues in the Case.1. Estate’s Experts.

The estate’s experts concluded that a 40%lack of control discount was appropriate and a 45%lack of marketability discount was appropriate.

2. Service’s Expert.The Service offered Brian C. Becker

(“Mr. Becker”) as an expert witness. Mr. Becker con-cluded that a 30% lack of marketability discount wasappropriate. Mr. Becker did not apply a lack of con-trol discount in his valuation of the Shares. Mr. Beck-er believed his discounted cash flow method of valua-tion inherently reflected a minority interest in TPC andtherefore an additional lack of control discount wouldbe inappropriate.

3. Methodologies.After concluding there were no comparable

companies, the estate’s experts valued the Shares underthe capitalization of income valuation method. Mr.Becker used two valuation methods. He used the dis-counted cash flow method and a guideline (or compara-ble public) company analysis under a market approach.

Under a capitalization of income method,the company is valued based on a projected stream of“normalized” or sustainable income, capitalized by arisk-adjusted rate of return. Following are the basicsteps involved in this valuation method:

• A capitalization rate for the business is selected;• The company’s sustainable income is projected;• The capitalization rate is applied to the pro-

jected sustainable income to determine anoperating value for the business; and

• The amount, or value, of the company’s non-operating assets is added to the operatingvalue of the company.

The estate’s experts applied a capitaliza-tion rate of 30.5%. This rate was calculated by addingtogether the following risk factors and percentages:

• 6% to reflect a risk-free rate of return;• 7.8% to reflect an equity risk premium;43

• 4.7% to reflect a small stock risk;44 and

43 This compensates an investor for the risk of investing instocks as compared to long-term U.S. government securities.

44 This compensates an investor for the risk of investing instock of a small corporation as compared to a large corporation.


• 12% primarily to reflect risks relating to theInternet and other technology, the loss of adver-tising revenue related thereto and perceivedrisks in the management structure of TPC.

In estimating TPC’s sustainable annual netincome (against which to apply the cap rate), theestate’s experts adjusted TPC’s historical income bysubtracting $10 million per year from TPC’s pretaxincome to reflect projected expenditures to maintainand further TPC’s presence on the Internet and todevelop additional technology-related projects.45 Theestate’s experts determined the average sustainableannual net income for TPC was $25,784,000. Basedon this value, the estate’s experts determined an undis-counted value of the Estate’s 20% interest in TPC of$5,304,000. The estate’s experts then applied a 40%lack of control discount and a 45% lack of marketabil-ity discount, resulting in the discounted value of$1,750,000.

The estate’s experts based their 40% lackof control discount on their reading of general valua-tion texts. Their 45% lack of marketability discountwas based on the following factors: (1) the stated intentof management that TPC would not be going public;(2) the fact that no sales of TPC stock had occurred inthe 10 years prior to the date of the Decedent’s death;(3) the fact that a 20% interest in TPC was not a con-trolling interest; and (4) the fact that a shareholderholding 20% of the outstanding shares of TPC couldnot force a liquidation.

Judge Swift dismissed Mr. Becker’s entireanalysis. Due to significant errors and numerous “sus-pect recalculations” on the part of Mr. Becker, JudgeSwift rejected Mr. Becker’s discounted cash flowanalysis. Similarly, Judge Swift declined to accept Mr.Becker’s market analysis because his guideline groupof companies was not sufficiently comparable to TPC.Mr. Becker identified 11 publicly traded companiescomparable to TPC based on the following two broadcriteria: (1) the guideline companies were classifiedunder the same general U.S. Department of LaborStandard Industrial Code and (2) each company report-ed positive cash flows for 1995-97.

Mr. Becker determined a 30% lack of mar-ketability discount was appropriate. Mr. Becker basedhis marketability discount, as opposed to a higher dis-

count, on the following factors: (1) TPC was not pub-licly traded; (2) TPC was historically profitable; (3)investment risks associated with TPC were moderate;(4) TPC had consistently paid cash dividends; (5) TPCheld more than $137 million in liquid assets; and (6)the estate owned the single largest block of TPC stock.Mr. Becker did not apply a lack of control discountbecause he believed his discounted cash flow analysisinherently incorporated a lack of control discount.

C. Judge Swift’s Conclusions.Judge Swift had the following general criti-

cisms of both parties’ experts. With respect to thequalifications and credibility of the estate’s experts,Judge Swift took issue with the dual roles played byGoerig, noting what he believed to be an inherent ten-sion between Goerig’s role as a purported “indepen-dent valuation expert” and his role as a special admin-istrator hired to handle the anticipated estate taxaudit. Judge Swift also commented on the qualifica-tions, or lack thereof, of the estate’s experts, statingthey were “too inexperienced, accommodating, andbiased in favor of the estate.”46 With respect to theService’s expert, Judge Swift criticized Mr. Beckerfor the “casual manner” in which he selected his com-parable companies, the significant errors in his calcu-lations and analysis and the questionable and inade-quately explained adjustments he made in his dis-counted cash flow analysis. As noted above, JudgeSwift rejected Mr. Becker’s cash flow analysis andhis guideline company analysis. Judge Swift also dis-agreed with Mr. Becker that a lack of control discountwas inappropriate.

That left the estate’s experts’ reports and testi-mony. While Judge Swift did admit into evidence theestate’s experts’ valuation reports, he regarded theirreports as well as their testimony “marginally credi-ble.” In essence, Judge Swift believed the estate’sexperts (1) overestimated the risks associated with theInternet and technology and (2) applied excessive lackof control and lack of marketability discounts.

Judge Swift utilized the capitalization ofincome method to value TPC, but determined his owncapitalization rate, finding the estate’s experts’ capital-ization rate unjustifiable. Judge Swift made the fol-lowing comment regarding the importance of a reason-able capitalization rate:

45 The Estate’s experts also made an adjustment to reflect adisconnect between the reported rate of depreciation and the actualeconomic depreciation.

46 Goerig was an attorney with an audit and tax dispute reso-lution practice. He also prepared tax returns and occasionallyundertook valuations for small businesses and private individuals

and, as Judge Swift noted, had attended limited appraisal courses.Wichorek provided accounting and tax preparation services, busi-ness consulting and similarly undertook occasional valuations forsmall businesses, generally in the context of divorce and propertysettlement disputes.


Obviously, the particular capitaliza-tion rate that is selected has a signifi-cant impact on the ultimate valuationand is intended to reflect risks orvolatility associated with a company’sincome stream and seeks to reflectwhat a stockholder would require fora rate of return on an investment inthe company being valued. The morerisky and volatile the income streamis perceived to be, the higher the capi-talization rate. Conversely, the morestable the income stream is perceivedto be, the lower the capitalization rate.

Specifically, Judge Swift considered the 12%risk factor used by the estate’s experts to reflect therisks associated with the Internet, technology andTPC’s management structure excessive. Judge Swiftwas willing to accept the fact that the Internet posedcertain risks to TPC, but noted that it also provided TPCwith significant new business and financial opportuni-ties to increase its revenues. In addition, Judge Swiftreasoned that if TPC’s management actually thoughtTPC faced additional risky technology expenditures,TPC would not have paid out cash dividends in excessof $7 million in 1998 (an increase from prior years),noting an increase in cash dividends typically indicatesan optimistic outlook on the part of management. Inaddition, Judge Swift did not like the fact that theestate’s experts factored into their projections an addi-tional $10 million per year in technology-related expen-ditures but failed to project any additional income as aresult of such expenditures. Finally, Judge Swiftregarded TPC as an extremely well managed company,with top quality managers at each level of the manage-ment structure. Accordingly, Judge Swift rejected thiselement of the 12% risk factor. Judge Swift concludedthat TPC should be valued under a capitalization ofincome method but reduced the estate’s experts’ capital-ization rate by 12%, from 30.5% to 18.5%.

Judge Swift allowed a 15% lack of control dis-count and a 30% lack of marketability discount. JudgeSwift scaled backed the estate’s experts’ discounts,concluding they were “arbitrary” and unsupported. Inarriving at these discounts, Judge Swift took into con-sideration the existence of the Outside Shareholder.With respect to the lack of control discount, JudgeSwift reasoned that the existence of a longstandingunrelated shareholder reflected contentment on the partof minority shareholders which supported a lower dis-count. With respect to the lack of marketability dis-count, Judge Swift again scaled back the estate’sexperts’ discount but effectively treated Mr. Becker’s30% lack of marketability discount as a floor.

Thompson illustrates many of the same TaxCourt tendencies the other cases illustrate (e.g., theimportance of articulating, quantitatively, the effectsof specific factors relied upon by an expert). In addi-tion, Thompson highlights that accuracy in an expert’sreport is essential as are the credentials and objectivityof an expert. If not already obvious, this case confirmsthat the Tax Court does not take kindly to a witnesswho appears to be more of an advocate than an expert.

D. Second Circuit Decision on Appeal.The estate appealed to the Second Circuit, pri-

marily on the ground that under I.R.C. §7491, the bur-den of proof on the valuation issue shifted to the Ser-vice when the estate introduced credible evidence onthe issue. The estate argued that the Tax Court there-fore was required to adopt the estate’s valuation onceit rejected the Service’s. The Service also appealed,principally on the ground that the Tax Court erred inrefusing to impose an underpayment penalty.

The Court of Appeals rejected the estate’sI.R.C. §7491 argument. According to the appealscourt, the Tax Court was not required to adopt the tax-payer’s valuation whenever it rejected the Service’sproposed value; rather, the burden of disproving thetaxpayer’s valuation “can be satisfied by evidence inthe record that impeaches, undermines or indicateserror in the taxpayer’s valuation.” In the view of theappeals court, there was record evidence to indicateflaws in the estate’s valuation approach; moreover,I.R.C. §7491 did not alter the long-standing rule thatthe Tax Court was not bound by the opinion of anyexpert witness, but rather was free to reach a determi-nation of value based on its own analysis of the evi-dence in the record. The Court of Appeals noted thatbecause the Tax Court adopted some of the Service’sarguments in opposition to the estate’s valuation, it wasunnecessary for the appeals court to decide whetherI.R.C. §7491 would require a court to adopt a taxpay-er’s valuation if the court rejected all argumentsadvanced by the Service in opposition to that valuation.

In the alternative, the estate argued that theTax Court erred by counting certain short-term invest-ments as non-operating assets and omitting a technol-ogy-related risk factor from the capitalization rate thatthe Tax Court adopted. The Court of Appeals declinedto overturn the Tax Court’s analysis in the absence ofclear error, except that it did remand the case for theTax Court to correct a double-counting of short -terminvestments that both the estate and the Service agreedwas a calculation mistake.

Also, the Second Circuit concluded that theTax Court’s findings were insufficient to support itsdetermination that the I.R.C. §6664 reasonable causeexception to the I.R.C. §6662 accuracy-related penalty


47 Judge Vasquez wrote the opinion in Kelley.48 Mr. Lint had the designation of senior accredited appraiser

from the American Society of Appraisers.49 Dr. Widmer had an M.B.A. with a concentration in eco-

nomics and quantitative methods and a Ph.D. in economics. Theopinion does not indicate his specific credentials or affiliations asan appraiser.

applied, so this portion of the Tax Court‘s decisionwas vacated and remanded so that the Tax Court coulddetermine whether the estate’s reliance on its apprais-ers was reasonable and in good faith.

VII. Kelley.

A. Facts.47

Kelley was an estate tax case. Webster E. Kel-ley (the “Decedent”) died on December 8, 1999. Thesole issue for decision was the fair market value of theDecedent’s 94.83% limited partner interest in a familylimited partnership (“KLLP”) and his 33.33% interestin a limited liability company (“KLBP LLC”). On theDecedent’s date of death, the partnership held assetstotaling $1,226,421, which consisted of $807,271 incash and $419,150 in certificates of deposit. The part-nership had no liabilities. The sole asset of the limitedliability company was its 1% general partner interestin the limited partnership. The estate employedAppraisal Technologies, Inc. (“ATI”) to prepare a val-uation of the decedent’s interests in KLLP and KLBPLLC. The estate filed its 706 and the Service chal-lenged the discounts claimed by the estate.


The estate offered Ron Lint (“Mr. Lint”),the founder and president of ATI,48 as an expert wit-ness. Mr. Lint concluded that a 25% lack of controldiscount and a 38% lack of marketability discountwere appropriate.

2. Service’s Expert.The Service offered Raymond F. Widmer

(“Dr. Widmer”) as an expert witness.49 Dr. Widmerconcluded that a 12% lack of control discount wasappropriate and a 15% lack of marketability discountwere appropriate.

3. Methodologies.Both experts used the NAV approach. Mr.

Lint also employed the income approach. Mr. Lintgave 80% weight to the NAV approach and 20%weight to the income approach. Both experts deter-mined the discount for lack of control by reference togeneral equity closed-end funds and both expertsdivided the comparable closed-end funds into quar-tiles by price to NAV ratios. The first quartile repre-sented funds that are in high demand and thereforetrade at premiums or low discounts. The fourth quar-

tile represented funds that are in low demand and tradeat higher discounts.

With respect to the estate’s lack of control dis-count, Mr. Lint determined that KLLP would be mostcomparable to the closed-end funds in the fourth quar-tile with price to NAV discounts in the range of 21.8%to 25.5%. Once the appropriate discount range wasdetermined, Mr. Lint further adjusted the discount forlack of control based on several factors and restric-tions inherent in KLLP. In addition, Mr. Lint referredto certain partnership studies. The average discount toNAV was 27% for the transactions studied. Based onthose factors and the transactions studied, Mr. Lintconcluded a 25% lack of control discount was appro-priate. Mr. Widmer determined his lack of control dis-count by calculating an arithmetic mean of the entiredata set for closed-end funds, not only the fourth quar-tile. Dr. Widmer determined that it was essential touse the whole array of closed-end funds to remove themarketability element in the discounts/premiums.

With respect to the lack of marketability dis-count, both experts agreed that a discount for lack ofmarketability should apply. However, they disagreedon the magnitude of that discount. In determining thediscount for lack of marketability, Mr. Lint relied onrestricted stock studies. In addition, Mr. Lint listed anumber of additional factors specific to an interest inKLLP that would be barriers to marketability. Afterconsidering these factors and the restricted stock stud-ies, Mr. Lint concluded that a 38% discount for mar-ketability was appropriate.

The Service’s expert relied utilized the IPOapproach to determine a 15% discount for lack of mar-ketability. Dr. Widmer relied on Dr. Bajaj’s privateplacement study, which found that the private place-ment of unregistered shares has an average discount ofabout 14.09% higher than the average discount on reg-istered placements. Dr. Widmer also based his lack ofmarketability discount on the low risk of the partner-ship’s portfolio.

C. Judge Vasquez’s Conclusions.Judge Vasquez was not persuaded that the

estate’s expert’s exclusive use of the fourth quartile ofclosed-end funds was proper, noting that while the courthad utilized small samples in other valuation contexts,the court also recognized the basic premise, cited alsoin McCord, that as similarity to the company to be val-ued decreases, the number of required comparables


increases. Judge Vasquez also felt that Mr. Lint’s analy-ses of the partnership studies was less than accurate, pri-marily because Mr. Lint admitted that the discountscontained some element of a discount for lack of mar-ketability. As a result, Judge Vasquez concluded Mr.Lint’s results overstated the lack of control discount.Judge Vasquez preferred the approach of the Service’sexpert, which was to take the arithmetic mean of all ofthe closed-end funds, as shareholders in all closed-endfunds lack control. In the end, Judge Vasquez deter-mined that a 12% discount for lack of control wasappropriate for the following reasons: (1) the Serviceeffectively conceded that a discount factor of up to 12%would be appropriate and (2) the estate failed to provethat a figure greater than 12% would be appropriate.

Judge Vasquez did not agree with Mr. Lint’sdetermination of a 38% marketability discount, as therestricted stock studies referred to in Mr. Lint’s valua-tion report examined mostly operating companies,which Judge Vasquez felt were fundamentally differentfrom an investment company holding “easily valuedand liquid assets (cash and certificates of deposit),such as KLLP.” In addition, Judge Vasquez was notconvinced that Mr. Lint analyzed the data from thesestudies as they related to the transferred interests andas a result, was unwilling to accept the premise that theaverage discount was appropriate. With respect to theService’s expert, Judge Vasquez agreed that Dr. Bajaj’sprivate placement study was an appropriate tool indetermining the lack of marketability discount. Unfor-tunately for the Service, Judge Vasquez did not believethat Dr. Widmer’s conclusions based on that studywere accurate. In the end, Judge Vazquez, citingMcCord and Lappo, concluded that a 20% initial dis-count for lack of marketability was appropriate towhich he made an upward adjustment of 3% to “incor-porate characteristics specific to the partnership.”

Kelley exemplifies many of the same tendenciesas the other recent Tax Court valuation cases, such asthe Court’s willingness to scrutinize, and accept andreject portions of, the experts’ analyses. Of note also isJudge Vasquez’s comment that restricted stock studiesof operating companies may be of limited relevance indetermining lack of marketability discounts for interestsin an entity holding highly liquid, easily valued assets.

VIII. Temple.

A. Facts.50

Temple was a gift tax case involving the valu-ation of 1997 and 1998 gifts by Arthur Temple,

deemed to be made one-half by his wife Lottie byvirtue of the split gift election. The subjects of thegifts were interests in Ladera Land, Ltd. (“Ladera”),Boggy Slough West, LLC (“Boggy Slough”), TempleInterests, L.P. (“Temple Interests”) and Temple Part-ners, L.P. (“Temple Partners”). Ladera was formed toown and operate a ranch in south Texas. BoggySlough was formed to own and operate a winery inNapa County, California. Temple Interests and Tem-ple Partners were formed to own stock in Temple-Inland and Time Warner, both of which were publiclytraded Fortune 400 companies. Arthur in 1997 madegifts of limited partner interests in Ladera to his sonBuddy, to Buddy’s wife Ellen and to Arthur’s grand-children; gifts of LLC units in Boggy Slough to hisdaughter Charlotte and to trusts for his grandchildren;gifts of limited partner interests in Temple Interests toBuddy and to a charity; and gifts of limited partnerinterests in Temple Partners to Charlotte and to a char-ity. In 1998 Arthur made additional gifts of limitedpartner interests in Temple Interests and Temple Part-ners to Buddy and Charlotte and to Arthur’s grandchil-dren. On audit, the Service increased the value of thegifts. The Temples paid the additional gift taxesassessed and sued for refunds.

B. Valuation Issues in the Case.1. Taxpayers’ Expert.

The taxpayers’ appraiser in connectionwith the preparation of the estate tax return, at least forthe gifts of the Ladera and Boggy Slough interests, wasNancy M. Czaplinski (“Ms. Czaplinski”), who alsotestified at trial. The opinion does not discuss Ms.Czaplinski’s credentials. Ms. Czaplinski determined alack of control discount of 25% and a lack of mar-ketability discount of 45% for Arthur’s 1997 gifts ofinterests in Ladera and Boggy Slough. It is not clearfrom the opinion whether Ms. Czaplinski was alsoengaged to value the interests in Temple Interests andTemple Partners. At trial, Charles L. Elliot (“Mr.Elliot”) was an expert witness for the taxpayers. Theopinion does not discuss Mr. Elliot’s credentials.Another expert witness for the taxpayers, apparentlywith respect to the Boggy Slough gifts only, wasWilliam J. Lyon (“Mr. Lyon”), a Senior ResidentialAppraiser, MAI and Senior Real Estate Analyst.

2. Service’s Expert. The Service’s expert was Francis X. Burns

(“Mr. Burns”), who also was the Service’s expert inPeracchio, discussed above. For the gifts of interestsin Temple Interests and Temple Partners, Mr. Burnsconcluded that the lack of control discounts should be7.5%, 10.1% and 3.3% as of the three gift dates, andthat a 12.5% lack of marketability discount shouldapply. Although the opinion refers in passing to Mr.

50 Judge Thad Heartfield of the U.S. District Court for theEastern District of Texas wrote the opinion in Temple.


Burns’s methodology in valuing the Ladera and BoggySlough gifts, it is not clear from the court’s opinionwhat discounts he concluded were appropriate.

3. Methodologies.Ms. Czaplinski used the NAV approach to

value the Ladera gifts and apparently the Boggy Sloughgifts, although the opinion does not discuss in detail hermethodology with respect to the Boggy Slough gifts.She derived her 25% lack of control discount from aMergerstat study of the inverse of premiums paid toacquire control of public companies. At trial, Ms.Czaplinksi acknowledged that the Mergerstat studyinvolved operating companies, but that she classifiedLadera as a holding company. Another of the taxpay-ers’ experts, Mr. Elliot, recognized problems with theMergerstat study, in that it involved sales of entire pub-lic companies rather than specified percentage interests,and he testified that he did not use the Mergerstat studyto value interests in a real estate limited partnership.Ms. Czaplinski also characterized Ladera as weak on 9out of 10 attributes normally associated with investmentcompanies, but she did not interview anyone involvedin Ladera operations when preparing her analysis. Ms.Czaplinski calculated her 45% lack of marketabilitydiscount for the Ladera gifts based on the “QuantitativeMarketability Discount Model” developed by Z.Christopher Mercer. In applying that model, Ms.Czaplinski made several assumptions regarding theholding period of an interest in Ladera, the return oninvestment that an investor would require, the distribu-tion yield of Ladera and the expected rate of apprecia-tion in its real property, but she did not discuss theseassumptions with anyone associated with Ladera, nor,for example, was the assumed expected rate of appreci-ation tied to specific instances of south Texas real estateholdings similar to those of Ladera.

With respect to the Ladera gifts, Mr.Burns examined average discounts for real estate lim-ited partnerships. It is not entirely clear from thecourt’s opinion what conclusion Mr. Burns drew fromthis analysis.

As to the valuation of the Boggy Sloughgifts, since Boggy Slough could be dissolved by a vote of51% in interest of the members, the Service sought todeny a lack of control discount for the 76.6% BoggySlough interest that Arthur gave to his daughter Char-lotte. The Boggy Slough operating agreement, however,left the members who voted to dissolve the LLC freeeither to sell the underlying property or distribute it inkind. Any distribution in kind would be of undividedinterests to the members as tenants in common. Mr.Lyon testified that co-ownership of the Boggy Sloughproperty could create numerous problems, and thatbecause of zoning restrictions, the property could only bedivided into two tracts. The property contained three

types of land with varying values. In fact, Mr. Lyoncould not determine a partitioning approach, by value orarea, that would comply with the zoning restrictions. Mr.Lyon’s valuations supported Ms. Czaplinski’s conclu-sions of a 25% lack of control discount and a 45% lack ofmarketability discount for the Boggy Slough gifts.

Mr. Burns used the NAV approach invaluing the gifts of interests in Temple Interests andTemple Partners. To derive a lack of control discount,he relied on a published weekly list of closed-endfunds, and determined lack of control discounts of7.5%, 10.1% and 3.3% as of the three gift dates. Mr.Elliot used a similar approach but excluded some ofthe funds used by Mr. Burns. Mr. Elliot also testifiedthat a sale of stocks by Temple Interests or TemplePartners would subject the donees to a large capitalgains tax. The court, however, found this testimonyinconsistent with I.R.C. §704(c)(1), providing forbuilt-in capital gain in property contributed to a part-nership to be allocated to the contributing partner. Mr.Elliot also testified that the stock held by TempleInterests and Temple Partners could not be sold todiversify the portfolio, but in fact Temple Partners didsell some of its stock for diversification. Mr. Burnscalculated a 12.5% lack of marketability discount forthe interests in Temple Interests and Temple Partnersby considering restricted stock studies, academicresearch, the costs of going public, secondary markettransactions, asset liquidity, partnership interest trans-ferability and whether distributions were made. Tem-ple Partners and Temple Interests held highly liquidstocks and had distributed to the partners nearly all ofthe dividends that they received. Partners could trans-fer their interests to third parties, subject to a right offirst refusal in the other partners. Mr. Elliot and Mr.Burns disagreed on whether a discount for built-incapital gains was applicable. They had taken the samerespective positions in Estate of Jones v. Commission-er,51 in which the Tax Court held that because thehypothetical buyer and seller would likely negotiatewith the understanding that the partnership wouldmake an election under I.R.C. §754, no discount forbuilt-in capital gains was appropriate.

C. Judge Heartfield’s Conclusions. Judge Heartfield concluded that the Ladera

gifts should be discounted by 33% for a combinedlack of marketability and lack of control and that anadditional incremental lack of marketability discountof 7.5% applied because the partnership interestswere private and unregistered. Therefore, the totaldiscount applicable to the Ladera gifts was 38%.

51 116 T.C. 121 (2001).


Judge Heartfield did not go into detail regarding howhe derived these discounts, except to say that he con-sidered the preponderance of the evidence, and toindicate that he found Mr. Burns’s analysis more per-suasive than Ms. Czaplinski’s, particularly in view ofsome of the assumptions that Ms. Czaplinski hadmade. Judge Heartfield did not allow any discount forbuilt-in capital gains, reasoning that a buyer of aninterest would negotiate for an election under I.R.C.§754 by the partnership.

As to the Boggy Slough gifts, Judge Heart-field was persuaded by Mr. Lyon’s report and testimo-ny, and concluded that a 60% total discount shouldapply to the 76.6% interest given to Charlotte Temple.The Judge alluded to a “sales comparison approach”used by Mr. Lyon, but did not elaborate on what thatapproach involved. Here again, the Judge concludedthat no discount for built-in capital gains shouldapply. He concluded that for the gifts of much small-er interests in Boggy Slough to Arthur’s grandchil-dren, a 33% combined lack of control and lack ofmarketability discount, and a 7.5% incremental lackof marketability discount, were appropriate, resultingin a total discount of 38%.

For the interests in Temple Partners and Tem-ple Interests, Judge Heartfield agreed with theapproach, used in principle by both Mr. Burns andMr. Elliot, of examining transactions involvingclosed-end funds in order to derive the lack of controldiscount. The Judge criticized Mr. Elliot, however,for choosing the discount represented by the 75th per-centile of a restricted group of funds, for excludingsome funds without explanation or justification, andfor failing to exclude funds that used substantialleverage. Judge Heartfield agreed with Mr. Burns’smethodology, considering restricted stock studies andseveral other factors, in calculating the lack of mar-ketability discount. The Judge criticized Mr. Elliotfor simply listing the studies that he reviewed andpicking a discount based on the range of numbers inthe studies, rather than explaining the relationship ofthe restricted stock data to the interests being valued.According to Judge Heartfield, a discount for built-incapital gains did not apply, for reasons discussedabove. Finally, the Judge concluded that the lack ofcontrol discounts should be 7.5%, 10.1% and 3.3% asof the three gift dates, and that a 12.5% lack of mar-ketability discount applied.

Temple illustrates that federal district courtsmay be just as inclined as the Tax Court to critique indetail the opinions of valuation experts.

IX. Kohler.

A. Facts.52

Kohler was an estate tax case. Frederic C.Kohler (the “Decedent”) died on March 4, 1998, owningapproximately 12.85% of the stock of Kohler Co.(“Kohler”), a privately held international manufacturerof plumbing and other products that also owned andoperated hospitality and real estate businesses. Kohlerhad a stated policy of reinvesting at least 90% of its earn-ings in the business and paying 7-10% out in dividendseach year. The estate reported its Kohler stock as worth$47,009,625 on the alternate valuation date. Upon audit,the Service determined the value to be $144.5 million.


The estate engaged Willamette Manage-ment Associates (“WMA”) to value the Kohler stock.WMA had periodically appraised the company in thepast and was familiar with its business. Robert Schweihs(“Mr. Schweihs”) was the WMA appraiser who handledthe valuation; he had been specifically involved inWMA’s previous work for Kohler. The estate also pre-sented a Mr. Grabowski as an expert witness at trial.

2. Service’s Expert.The Service’s valuation of the stock at

$144.5 million was based on an appraisal by RichardMay of Valumetrics Advisors, Inc. At trial, the servicepresented Dr. Scott Hakala (“Dr. Hakala”) of CBIZ asan expert witness.

3. Methodologies.The Service’s expert Dr. Hakala used both

the income approach and the market approach. Underthe income approach, he used only a discounted cashflow (“DCF”) method, which discounts to presentvalue the expected future income of a company; he didnot use a dividend-based method. In forecasting thecash flow for the DCF method, Dr. Hakala did not usethe expense projections that Kohler provided him, butinstead made his own assumptions about expenses. Hedid not discuss those expenses with anyone at Kohler.Dr. Hakala gave the “management plan” based model,which the Court characterized as more “realistic,” a20% weighting within the DCF model, and he gave the“operations plan” based model, which the Courtviewed as more “aspirational,” an 80% weighting,because he thought the operations plan was a morelikely scenario. Under the market approach, Dr.Hakala used both the guideline company method,which examines financial information and marketprices of publicly traded comparable companies, andthe transaction method, which focuses on comparablecompanies that have recently been acquired and com-pares the financial information to the price obtained in52 Judge Kroupa wrote the opinion in Kohler.


the transaction, rather than the market price. Withinhis market approach analysis, Dr. Hakala gave theguideline company method an 80% weighting and thetransaction method a 20% weight. After weighting thevalues that he found under the income and marketapproaches, Dr. Hakala averaged the approaches andapplied a 25% discount for lack of marketability.

The estate’s expert Mr. Schweihs used theincome approach and the market approach. Under theincome approach, he employed the discounted dividendand dividend capitalization methods as well as the DCFmethod. Under the market approach, Mr. Schweihsused the guideline company method. Unlike Dr.Hakala, he did not use the transaction method, becausehe could not find transactions in companies sufficientlysimilar to Kohler where there was adequate informationavailable. Mr. Schweihs did not take into account priorsales of Kohler stock, because he determined that thosesales involved a premium, which could not be quanti-fied, for being a shareholder in a prominent privatecompany, and moreover the prices paid in the priorsales were not justified by an analysis of past andexpected performance. Mr. Schweihs then applied a45% lack of marketability discount to the values that hedetermined under the DCF method and the guidelinecompany method, and a 10% lack of marketability dis-count to the values he determined under the discounteddividend method and the capitalization of dividendsmethod. He used lower lack of marketability discountsunder the dividend-based methods on the ground thatthose methods more directly reflected the share value.Mr. Schweihs also applied a 26% discount for lack ofcontrol to the value he determined under the DCFmethod. He weighted the DCF method and the guide-line company method each 20%, and gave 30% weightsto each of the dividend-based methods. Mr. Schweihsconcluded that the estate’s Kohler stock was worth$47,010,000 on the alternate valuation date. As notedabove, Mr. Schweihs was already familiar with Kohlerfrom WMA’s previous work for the company.

Mr. Grabowski, the estate’s other expert,spent three and a half days at Kohler and interviewedtwelve employees, including the President and Chair-man of the Board and General Counsel, as well as con-sidering other company and industry information andgeneral economic conditions. Mr. Grabowski used theincome and market approach, and within the incomeapproach he used the DCF method, the discounted divi-dend method and the adjusted discounted dividendmethod. Under the market approach Mr. Grabowskiused the guideline company method. He found that thevalues he had determined under the various methods allcame out fairly close to each other. He decided that theadjusted discounted dividend method was the mostappropriate because it reflected the actual cash flows

that a shareholder could expect to receive, and alsoreflected the remote possibility that the company wouldbe sold or undergo an initial public offering. Mr.Grabowski then applied a 35% lack of marketabilitydiscount, based in part on restricted stock studies plusan upward adjustment to reflect the unlikelihood ofKohler’s ever going public. He concluded that a 25%lack of control discount was appropriate only in consid-ering the value of the Hospitality Group, a proportional-ly small portion of Kohler’s overall operations, and inconsidering the price paid to dissenting shareholders ina reorganization that occurred shortly after the Dece-dent’s death but prior to the alternate valuation date.Mr. Grabowski concluded that the estate’s Kohler stockwas worth $63,385,000 on the alternate valuation date.

C. Judge Kroupa’s Conclusions. Judge Kroupa noted that the Tax Court was not

obligated to pay any regard to an expert report thatlacked credibility, and that the Court might find evi-dence of valuation provided by one party to be so muchmore credible than that of the other party, that theCourt’s findings resulted in a significant victory for oneside rather than a compromise between the two.

Judge Kroupa expressed, in her phrase, “graveconcerns” about Dr. Hakala’s valuation methods andconclusions. The Judge noted that Dr. Hakala was achartered financial analyst but was not a member of theAmerican Society of Appraisers nor the AppraisalFoundation. Moreover, Dr. Hakala’s report was notsubmitted in accordance with the Uniform Standards ofProfessional Appraisal Practice (“USPAP”). Dr.Hakala met with Kohler management only once, forabout two and a half hours, though he did consider bothcompany financial information and industry informa-tion. Moreover, Dr. Hakala admitted that his originalreport submitted to the Tax Court before trial overval-ued the estate’s Kohler stock by $11 million, which fur-ther undermined the Judge Kroupa’s confidence in him.The Judge was convinced from his report and testimonythat Dr. Hakala did not understand Kohler’s business.For example, as noted above, he did not discuss hisinvented set of expense projections with anyone in com-pany management, and within the income approach hegave the company’s “operations plan” model an 80%weighting even though management told him that theoperations plan projections could only be achieved in aperfect environment. Judge Kroupa also criticized Dr.Hakala for not using a dividend-based method underthe income approach, even though dividends were theprimary means of obtaining a return on Kohler. JudgeKroupa found that Dr. Hakala’s conclusions were“incredible” and should be given no weight.

The estate’s experts, in Judge Kroupa’s view,had provided “thoughtful, credible” valuations. Since


the Service had failed to meet its burden of proofunder I.R.C. §7491, the Judge found the value of theestate’s Kohler stock to be the amount it reported onits return, $47,009,625.

As illustrated by Kohler, the Tax Courtremains willing to in effect throw out a valuationexpert’s report that it finds lacking credibility.

X. Gimbel.

A. Facts.53

Gimbel was an estate tax case involving thevaluation of restricted shares of the common stock ofReliance Steel and Aluminum Company (“Reliance”), aNew York Stock Exchange traded company. GeorginaT. Gimbel (the “Decedent”) died on June 5, 2000. TheDecedent’s gross estate included shares of Relianceheld by trusts created by her predeceased husband, byher account in Reliance’s ESOP, by her IRA and by herindividually. Of the 3,601,267 Reliance shares includ-ed in her gross estate, which represented about 13% ofthe outstanding common stock of Reliance, approxi-mately 3,548,450 shares were unregistered. Owing tothe large number of the Decedent’s Reliance shares(including those attributed to her as trustee and benefi-ciary of the trusts and those that she owned through herESOP account and IRA, as well as her individuallyowned shares, all of which are sometimes referred tocollectively here as the estate’s Reliance shares), shewas considered an affiliate of Reliance under the feder-al securities laws. Under the SEC Rule 144 volumelimitations, the sale of the 3,601,267 shares in the pub-lic market would have taken a minimum of 39 months(the “dribble-out” method). Although the estate’sReliance shares could have been sold to certain kinds ofinvestors in a private placement or under SEC Rule144A without being limited by the volume restrictions,a purchaser in such a transaction would have been sub-ject to the same public resale restrictions as the estate.

In late 1994, about five and a half years beforethe Decedent’s death, Reliance had adopted a stockrepurchase plan which allowed for the repurchase ofup to 2.25 million shares.

In 1998, the number of shares that Reliancewas authorized to repurchase under the plan wasincreased by the board of directors to 6 million.Between 1994 and the Decedent’s death, Reliance pur-chased in the public market about 2.7 million shares(after adjustment for a stock split) for approximately$27 million. The largest repurchase during that periodinvolved 646,200 shares repurchased for $11,090,017.About 10 days before the Decedent’s death, Reliance’s

CEO stated in a presentation at a steel industry confer-ence that 1999 had been a “record year” for Relianceand that the company would consider repurchasingshares at around $19 per share, as it had done in therecent past. The Decedent had not discussed withmanagement the possibility of a repurchase of hershares upon her death. Shortly after her death, herestate inquired of Reliance’s management whetherthere might be investors interested in purchasing someof the estate’s shares. After efforts to identify privateinvestors who might be interested in such a purchaseproved unsuccessful, the Reliance board began dis-cussing the possibility of the company’s repurchasingsome of the estate’s shares. At an October 18, 2000meeting, a little over four months after the Decedent’sdeath, the board approved the repurchase of up to $50million worth of the estate’s Reliance shares at $19.35per share. There was testimony that in arriving at thisprice, management considered advice from Reliance’sinvestment banking firm, DLJ, that the repurchaseprice should reflect a 10-15% discount from the trad-ing price. On October 30, 2000, Reliance privatelyrepurchased 2.27 million of the estate’s shares (repre-senting 63% of the estate’s Reliance shares) at $19.35per share, for a total price of $43,924,500.

On the estate tax return, the Reliance stockwas valued at the $20.8125 date of death trading pricefor publicly traded Reliance shares, less a 20.72% dis-count for lack of marketability and liquidity in view ofthe resale restrictions and the size of the estate’s blockof Reliance shares. On audit, the Service determinedthat the estate’s Reliance shares should be discountedby only 8% from the date of death trading price. Therecord in the case did not indicate how the Servicedetermined the 8% discount.

B. Valuation Issues in the Case.1. Estate’s Experts.

In connection with the preparation of theestate tax return, the estate’s attorney retained Mr. Gre-gory Range (“Mr. Range”), who reached the conclu-sions discussed above under “Facts.” At trial, the estateoffered Curtis Kimball (“Mr. Kimball”) as its expert.He concluded that the estate’s Reliance shares shouldbe valued at the trading price discounted by 17.4%.

2. Service’s Expert.At trial, the Service offered Ken Nunes (“Mr.

Nunes”) as its expert. He concluded that the estate’sReliance shares should be valued at the trading pricediscounted by 9%.

3. Methodologies.Both parties’ experts considered four pos-

sible kinds of transactions—a secondary public offeringof the estate’s Reliance shares, a private placement witha third party or a sale under Rule 144A, a repurchase by53 Judge Swift wrote the opinion in Gimbel.


Reliance, and open market sales subject to the Rule 144dribble out rule. The experts agreed that Reliance, forbusiness reasons, probably would not have approved asecondary public offering. The experts also generallyagreed that a private placement or a sale under Rule144A would not have been feasible because there wereno prospective strategic investors for the estate’sReliance shares, and even if a strategic investor existed,the estate’s block was a minority interest that likelywould not have been marketable to such an investor.The resale restrictions on the estate’s Reliance shares,which would also have applied to a purchaser in a pri-vate placement or Rule 144A sale, would also havemade the shares unattractive to an institutional investor.

Mr. Kimball concluded that as of the dateof the Decedent’s death, it was not reasonably foresee-able that Reliance would repurchase any of the estate’sshares, and therefore he did not factor that possibilityinto his valuation. Mr. Nunes, on the other hand, con-cluded that as of the date of the Decedent’s death, itwas reasonably foreseeable that Reliance would repur-chase 50% of the estate’s shares and that the discounton the purchase price would be 13.9%. Mr. Nunesarrived at the repurchase discount as follows. First, heassumed that on the date of death, DLJ would havesuggested to Reliance the same 10-15% discountrange that DLJ in fact suggested in connection withthe repurchase of shares from the estate four monthslater. Mr. Nunes then chose the 12.5% midpoint ofthat range. Next, he discounted the estimated salesproceeds that would be realized on the repurchase, toaccount for holding costs and the time value of moneyduring the three-month period that he estimated itwould have taken to complete the repurchase. Mr.Nunes calculated that this adjustment increased therepurchase discount from 12.5% to 13.9%. Again, thisportion of Mr. Nunes’ discount analysis just related tothe 50% of the estate’s Reliance shares that wouldhypothetically have been repurchased by Reliance.

The experts agreed that under the Rule144 dribble-out method, it would have taken 39months to liquidate all of the estate’s Reliance shares,but they disagreed on how to discount the dribble-outsales proceeds to reflect the time value of money andthe risk of a decline in the stock price during the drib-ble-out period. Mr. Range used a risk-free rate ofreturn to discount the sale proceeds to present value asof the date of the Decedent’s death, and he also con-cluded that a hypothetical investor dribbling out theshares would buy put options to hedge the risk of adecline in the stock value. He calculated a cost for thehypothetical put options and subtracted it from thepresent value of the dribble-out sale proceeds. Theresult was a 24.5% overall discount from the date ofdeath trading value. Mr. Kimball, on the other hand,

added to the dribble-out sales proceeds the estimateddividends that would be paid on the shares during thedribble-out period (Mr. Range had also taken the esti-mated future dividends into account, but he includedthem as an element in the pricing of the put options).Mr. Kimball then discounted this total amount to pre-sent value using a discount factor equal to a 13.2%expected rate of return on Reliance equity. He arrivedat a 17.4% overall discount from the date of deathtrading value. While Mr. Range and Mr. Kimballapplied the dribble-out analysis to all or substantiallyall of the estate’s Reliance shares, Mr. Nunes applied adribble-out analysis only to the 50% of the estate’sReliance shares remaining after his hypothetical sharerepurchase by Reliance. Mr. Nunes took the view thatto protect against the risk of a decline in the stockprice during the dribble-out period, a hypotheticalinvestor would have entered into hedging contracts,such as cashless collars or prepaid variable forwardcontracts, and he subtracted the estimated cost of thosecontracts from the dribble-out sales proceeds, arrivingat a 5% discount from the date of death trading value.Mr. Nunes’ 13.9% discount for the hypotheticallyrepurchased shares and 5% discount for the hypotheti-cally dribbled-out shares translated into a combined9.5% discount from the date of death trading value forthe estate’s Reliance shares. (Elsewhere in the opinionit is stated that Mr. Nunes arrived at a 9.0% discountfrom the trading price. It is not clear why there is adiscrepancy in the references.)

C. Judge Swift’s Conclusions. Judge Swift agreed with the experts that as of

the date of the Decedent’s death, Reliance probablywould not have approved a secondary public offering,particularly since Reliance would then have beenrequired to disclose a pending acquisition of anothercompany, in violation of a confidentiality agreement.Judge Swift also agreed with the general view of theexperts that a private placement or Rule 144A salewould not have been feasible.

The Judge agreed with Mr. Nunes that as ofthe date of the Decedent’s death, a repurchase byReliance of some of the estate’s shares was reasonablyforeseeable, since the company had a track record forrepurchasing shares, but the Judge disagreed that itwas reasonably foreseeable that Reliance would repur-chase 50% of the estate’s shares. Judge Swift point-ed out that at the time, Reliance was negotiating alarge company acquisition which, if successful, wouldhave required significant cash and credit. Also, arepurchase of 50% of the estate’s Reliance shareswould have cost the company approximately threetimes as much as the largest previous repurchase.Judge Swift concluded that as of the time of the Dece-


dent’s death, it was reasonably foreseeable thatReliance would be financially able and willing torepurchase 20%, or 720,253, of the estate’s 3,601,267Reliance shares. Although Judge Swift stated that hefound some flaws in Mr. Nunes’ discount methodolo-gy, neither of the estate’s experts had offered amethodology for estimating the repurchase discount,and Judge Swift concluded that it was appropriate touse Mr. Nunes’ 13.9% repurchase discount in valuingthe 20% (as opposed to 50%) of the estate’s Relianceshares that Judge Swift thought it was foreseeablewould have been repurchased by Reliance.

With respect to the balance of the estate’sReliance shares, Judge Swift applied a dribble-outanalysis. He concluded, however, that the hedgingcontracts assumed by Mr. Range and Mr. Nunes wouldhave been unavailable for a block of stock such as theestate’s Reliance shares, in view of the size of theblock and the Rule 144 resale restrictions. Mr. Kim-ball had testified to this effect. Judge Swift adoptedMr. Kimball’s dribble-out valuation methodology, butapplied it only to 80% of the estate’s Reliance shares,since he had found it reasonably foreseeable thatReliance would have repurchased 20% of the estate’sshares. Applying the dribble-out analysis to the lessernumber of shares shortened the dribble-out periodfrom 39 to 31 months.

Overall, Judge Swift arrived at a value of$64,320,892 for the estate’s Reliance shares, reflect-ing a 14.2% discount from the trading value. Thiscompared with a value of $59,420,918 reported on theestate tax return and a value of $68,964,263 assertedby the Service in its deficiency notice.

Gimbel is noteworthy for Judge Swift’s will-ingness to make his own determination, which differedfrom that of either party’s expert, concerning howmany shares it was reasonably foreseeable thatReliance would repurchase from the estate.

XI. Jelke.

A. Facts.54

Jelke was an estate tax case. Frazier Jelke, III(the “Decedent”), died on March 4, 1999, owning3,000 shares, representing a 6.44% stock interest, in aclosely held investment holding company called Com-mercial Chemical Company (“CCC”), which in turnowned appreciated marketable securities. Specifical-ly, at the date of the Decedent’s death, 92% of CCC’sstock portfolio consisted of “blue chip” domestic equi-

ties and 8% consisted of international equities withreadily available market values. CCC had a net assetvalue of approximately $188.6 million, before anyreduction for built-in capital gain tax. It was a C cor-poration. If CCC’s marketable securities had beensold on the date of the Decedent’s death, there wouldhave been a capital gain tax liability of about $51.6million. On the estate tax return, the Decedent’s stockin CCC was valued at $4,588,155, which was comput-ed by reducing CCC’s net asset value by the built-incapital gain tax liability and then applying discountsof 20% for lack of control and 35% for lack of mar-ketability. The Service in its notice of deficiency val-ued the Decedent’s CCC stock at $9,111,111, applyingno discount for built-in capital gain tax and what theService referred to as “reasonable” discounts for lackof control and lack of marketability.


The estate’s expert was a Mr. Frazier whois not otherwise identified in the Tax Court opinion,though he may have been the same William H. Frazierwho was an expert witness for the estate in McCord.Mr. Frazier applied a dollar for dollar discount for thebuilt-in capital gains tax of $51.6 million, and thenapplied a 25% discount for lack of control and a 35%discount for lack of marketability.

2. Service’s Expert.The Service’s expert was a Mr. Shaked

who was not otherwise identified in the Tax Courtopinion. At trial, the Service admitted that somereduction or discount was appropriate for the built-incapital gain tax liability. Mr. Shaked did not apply adollar for dollar discount, however, but rather applieda discount of $21.1 million for this element, based ona present value analysis of the built-in capital gain tax.Mr. Shaked then applied a 5% discount for lack ofcontrol and a 10% discount for lack of marketability.

3. Methodologies.The estate’s expert used what he

described as a combination of the market and assetapproaches. He used the market approach to valueCCC’s securities, but then, stating that he was usingthe asset approach, he reduced the aggregate marketprice of CCC’s securities by the liabilities shown onthe books of CCC and also by the full amount of thebuilt-in capital gain tax liability.

The Service’s expert started with the samemarket value for CCC’s securities as did Mr. Frazier,

54 Judge Gerber wrote the opinion of the Tax Court andJudge Hill wrote the opinion of the Eleventh Circuit Court of

Appeals in Jelke.


and likewise subtracted the liabilities on CCC’s books.With respect to the built-in capital gain tax liability,however, the Service’s expert took a more complexapproach. Based on data for 1994-1998, the Service’sexpert computed an average annual turnover rate of5.95% in CCC’s securities portfolio. The use of the5.95% turnover rate would result in incurrence of thebuilt-in capital gain tax over a 16.8 year span. TheService’s expert then calculated the average annualcapital gain tax liability over an assumed 16 year peri-od, and selected a 13.2% discount rate based on theaverage annual rate of return for large-capitalizationstocks in the period 1926-1998. He used that rate todiscount the assumed annual capital gain tax liabilitiesto present value, arriving at a present value of approx-imately $21.1 million, which he applied as a subtrac-tion from the net asset value of CCC (as contrastedwith the approximately $51.6 million subtractionmade by the estate’s expert based on the entire built-incapital gains tax as if CCC had been liquidated imme-diately upon the Decedent’s death).

The estate’s expert argued that it was inap-propriate for the Service’s expert to discount the built-in capital gain tax liability to present value, because thesecurities held by CCC could be expected to appreci-ate, thereby increasing the future tax payments. TheService’s expert’s response to this argument was thathe was simply calculating the built-in capital tax liabil-ity by determining when it would likely be incurred; ifhe were to consider possible future appreciation, thenhe would be inappropriately considering a tax that wasnot “built in” as of the valuation date.

In calculating his 25% lack of controldiscount, Mr. Frazier compared CCC to a closed-end,not widely traded investment fund holding publiclytraded securities. He concluded that because closed-end funds were flow-through entities for income taxpurposes, the discounts reflected in those funds didnot include any reduction for built-in capital gain tax,and he also reasoned that because closed-end fundsare publicly traded in most cases, none of the dis-counts relating to them would be attributable to lackof marketability. Mr. Frazier reviewed 44 domesticequity funds and selected 15 that were comparable;he then removed eight of these from the samplebecause they had guaranteed payouts. The remainingseven funds had an average discount rate of 14.8%, amedian discount rate of 17.2% and a 75th percentilediscount rate of 17.3%. Mr. Frazier eliminated thetwo funds with the lowest discounts because he con-cluded that the low discounts resulted from consis-tently high returns. In his view, CCC was more simi-lar to the funds in the upper end of the discount rangebecause CCC’s inconsistent returns and relativelysmall size. He concluded that an investor would

demand a higher rate of return or a larger discount forCCC than for his comparables, in view, for example,of CCC’s size and the fact that CCC paid lower divi-dends than was true on average for the comparables.Within the upper quartile of his seven comparables,the average discount rate was 18.3%. Mr. Frazierconcluded that a hypothetical buyer would seek a25% lack of control discount.

Mr. Shaked, in arriving at his 5% lack ofcontrol discount, began with an 8.61% average dis-count for closed-end funds that he obtained from anarticle in the Journal of Economics. Since CCC held adiversified portfolio of marketable securities, Mr.Shaked reasoned that management decisions were lesscritical for CCC than for an operating company, andtherefore that a hypothetical investor would be lessconcerned about lack of control. Indeed, Mr. Shakedthought that an investor in CCC, like a mutual fundinvestor, would prefer not to have control. Mr. Shakedviewed CCC’s performance record more favorablythan did Mr. Frazier.

Mr. Frazier, in calculating his 35% dis-count for lack of marketability, considered studies ofoperating companies with a minimum resale restric-tion of at least two years. Although he conceded thatoperating companies are riskier than holding compa-nies, he considered the marketability discount forCCC comparable to that of an operating companybecause CCC was not expected to liquidate for at least20 years. Mr. Frazier believed that CCC’s dividendpattern and the fact that it was an investment companyargued for an average to below average discount, buton the other than the long holding period and theabsence of any prospect of CCC’s going public sup-ported a higher discount.

In arriving at his 10% discount for lack ofmarketability, Mr. Shaked analyzed the factors thatJudge Laro considered in Mandelbaum.55 Mr. Shakedtook the view that CCC’s diversified portfolio result-ed in low price volatility and suggested a lower dis-count, and that it would be easier to find a willingbuyer for CCC than for a riskier company. The Ser-vice argued that the estate’s expert’s analysis ofrestrictions on transferability was misguided, becauseCCC stock could be sold in the private market. Also,the Service contended that were was a market forCCC shares, because even though none of the share-holders had any contractual right to have his or hershares redeemed, the minutes of the board of directorsindicated that the company “did maintain a sufficientcash position in the event that the estate requestedredemption of its shares.”

55 See footnote 34 above.


C. Judge Gerber’s Conclusions. Judge Gerber criticized the estate’s expert’s

dollar for dollar subtraction of the built-in capital gaintax. The Judge thought it significant that a hypotheticalbuyer of a 6.44% interest would be unable to cause aliquidation of CCC, and that there was no evidence ofan intention to liquidate. Judge Gerber noted that sinceappeal in the case would not lie to the Fifth Circuit, theTax Court was not bound to follow the Fifth Circuit’sdecision in Estate of Dunn.56 Judge Gerber also sug-gested that the case before him might be distinguish-able from Estate of Dunn because the Dunn caseinvolved a majority interest. The estate had argued thatCCC’s relatively low earnings and modest dividendswould cause a hypothetical buyer to prefer liquidation,but Judge Gerber considered this contention a “meresupposition” belied by the fact that CCC had per-formed well when one took capital appreciation intoaccount. Judge Gerber also agreed with the Service’sexpert that in discounting to present value the built-incapital gain tax, possible future appreciation in thesecurities held by CCC should be disregarded, becauseif future appreciation were considered then one wouldbe taking into account tax that was not “built in” on thevaluation date. Judge Gerber found the Service’sexpert’s 13.2% discount rate reasonable (the estate hadconceded that the rate was reasonable if the premisewere accepted that the built-in capital gain tax shouldbe discounted). Judge Gerber determined that the sub-traction for the discounted built-in capital gain tax lia-bility should be approximately $21.1 million, as theService’s expert had concluded.

In connection with the lack of control discount,Judge Gerber agreed to some extent with the Service’sexpert’s view that control would be less important to aninvestor in CCC than to an investor in an operatingcompany or in a company without a diversified portfo-lio of marketable securities. Judge Gerber thought thatthe estate’s expert did not provide enough justificationfor eliminating two funds as comparables, and that theestate’s expert had ignored the fact that some of his cho-sen comparables appeared to be riskier than CCCbecause they held investments in small-capitalizationstock funds or were less diversified than CCC. In JudgeGerber’s view, CCC was most similar to a diversifiedstock fund in the estate’s expert’s sample that investedin New York Stock Exchange listed securities, and thatfund had only a 7.3% discount. The Judge also per-ceived other flaws in the estate’s expert’s analysis of hiscomparables. For example, the Judge did not agreewith the estate’s expert’s assumption that the discountsreflected in his comparables were due solely to lack of

control, since other factors such as investment strategyrisks, management quality issues or company-specificrisks could also play a role. Finally, after considering avariety of factors including the fact that CCC did under-perform some of the comparables, and was relativelysmall in relation to the comparables, but on the otherhand was well-diversified, Judge Gerber concluded thata 10% lack of control discount was appropriate.

Judge Gerber found “critical errors” in boththe estate’s and the Service’s analyses of the lack ofmarketability discount, found those analyses only“minimally helpful,” and used his own methodology,guided by the Mandelbaum factors. The Judgethought that CCC’s financial performance, given itshistory of long-term appreciation and its diversifiedportfolio of blue chip securities, justified a lower thanaverage discount. There was, the Judge noted, noindication that CCC’s portfolio or performancewould change from the historical course. Also, therewere no restrictions on transfers of CCC shares,though CCC was not a public company and the Judgethought that the Service had failed to demonstrate theexistence of a private market for the shares. Factorsweighing toward a higher discount, in Judge Gerber’sview, included the fact that the relatively high depen-dence on long-term appreciation as an element ofreturn would extend the necessary holding period torealize an investor’s goals, and the lack of a corporateredemption policy. Overall, Judge Gerber concludedthat a lower than average discount for lack of mar-ketability was justified, and that the appropriate dis-count was 15%.

Accordingly, Judge Gerber found that theDecedent’s CCC shares had an estate tax value of$8,254,696, compared with $4,588,155 reported onthe estate tax return and $9,111,111 asserted in theService’s deficiency notice.

D. Eleventh Circuit Decision on Appeal.The taxpayer appealed to the Eleventh Circuit.

The case was heard by Judges Tjoflat, Carnes and Hill,and Judge Hill wrote the opinion. He focused on theissue of the discount for built-in capital gain tax liabil-ity, noting that this was an issue of first impression inthe Eleventh Circuit.

The Eleventh Circuit Court of Appeals decid-ed to follow the “simple yet logical” analysis of theFifth Circuit in Estate of Dunn v. Commissioner,57

observing that this approach would provide “practicalcertainty.” The appeals court’s opinion reviewed thehistory of the built-in capital gain tax issue in the caselaw, beginning with the pre-1986 cases (which gener-

56 301 F.3d 339 (5th Cir.2002). 57 Supra note 56.


ally denied a discount for built-in capital gain taxunless a sale or liquidation was planned or imminent);then discussing the implications of the Tax ReformAct of 1986, the Tax Court’s change of stance inEstate of Davis58 (holding that built-in capital gains taxdid not give rise to a separate discount but could be anelement of the lack of marketability discount); theSecond Circuit’s holding in Estate of Eisenberg v.Commissioner59 (holding that some discount at leastshould be allowed for built-in capital gains tax); Estateof Welch v. Commissioner60 (unpublished) (taking asimilar approach to Estate of Eisenberg); Estate ofJameson v. Commissioner61 (vacating Tax Court deci-sions with instructions to reconsider amounts of dis-counts for built-in capital gains tax); and, finally,Estate of Dunn,62 which involved a majority interest ina family-owned equipment rental company (but aninterest that fell short of the 66.66% interest requiredunder Texas law to liquidate the company). In Estateof Dunn, the Fifth Circuit held that a hypotheticalbuyer must always be assumed to liquidate the corpo-ration immediately, triggering a tax on the built-ingains, and that the appropriate discount was 100% ofthe built-in capital gain tax liability.

The Eleventh Circuit in Estate of Jelke rejectedthe Tax Court’s attempt to distinguish Estate of Dunnon the basis that the latter case involved a majorityinterest; in the view of the Eleventh Circuit, whetherthe interest being valued was a majority or minorityinterest made no difference, because either way theeconomic reality (that a hypothetical willing buyer ofshares would adjust his or her purchase price to reflecthis or her proportional share of the entire built-in capi-tal gain tax) required taking a “snapshot” of value onthe valuation date as though a liquidation took placethen. Even though the Eleventh Circuit stated severaltimes in its opinion that the Fifth Circuit in Estate ofDunn had made an “arbitrary” assumption of a liquida-tion on the valuation date, the Eleventh Circuit never-theless thought that that approach offered importantadvantages of certainty, avoiding the need for prophe-cies about when assets would be sold, and avoiding“the unnecessary expenditure of judicial resourcesbeing used to wade through a myriad of divergentexpert witness testimony, based upon subjective con-jecture, and divergent opinions.” Under a de novoreview as a matter of law, therefore, the Eleventh Cir-cuit vacated the judgment of the Tax Court andremanded with instructions that the Tax Court apply adollar for dollar reduction to the net asset value of CCC

for the entire built-in capital gain tax liability. As to the lack of control and lack of mar-

ketability discounts, the Court of Appeals was satis-fied that the Tax Court did not commit clear error, andtherefore affirmed the Tax Court on those two issueswithout further discussion.

There was a sharp dissent by Judge Carnesconcerning the built-in capital gain tax issue. He con-tended that the majority, in the interest of avoiding theeffort required for a more accurate calculation ofvalue, “simply assume[d] a result that we all know iswrong.” He favored the Service’s admittedly “morecomplicated” approach over the “simple but arbitraryassumption’ made by the estate and by the EleventhCircuit majority. In response to the majority’s rhetori-cal question why a buyer would not adjust his or herpurchase price to reflect the entire built-in capital gaintax liability, Judge Carnes responded that the buyercould not reasonably expect the seller to agree to aprice reduction that ignored the time value of money.

XII. Astleford.

A. Facts.63

Astleford was a gift tax case involving inter-ests in the Astleford Family Limited Partnership(“AFLP”). AFLP was formed on August 1, 1996, tofacilitate the ownership, development and manage-ment of various real estate investments and partnershipinterests that the taxpayer, Jane Astleford, owned, andalso to facilitate gifts to her three adult children. Thepartnership agreement provided for annual distribu-tions of net cash flow to the partners. No one outsidethe family could become a partner, nor could a limitedpartner transfer any of his or her interest, withoutJane’s consent as general partner. On the same day asthe formation of the partnership and its funding by thetransfer of Jane’s interest in an elder-care facility, Janegave each of her children a 30% limited partner inter-est in AFLP, retaining a 10% general partner interest.On December 1, 1997, Jane made an additional capitalcontribution of an interest in a preexisting generalpartnership called Pine Bend (which in turn ownedreal estate), and 14 other real estate properties, toAFLP, substantially increasing her percentage generalpartner interest and reducing the children’s percentagelimited partner interests, but on the same day as thatadditional contribution, Jane gave each of her childrenadditional limited partner interests so that her generalpartner interest was reduced once more to approxi-

58 110 T.C. 530 (1998).59 155 F.3d 50 (1998), acq. 1999-1 C.B. xix.60 208 F.3d 213 (6th Cir. 2000)

61 267 F.3d 366 (5th Cir. 2001)62 Supra note 56.63 Judge Swift wrote the opinion in Astleford.


mately 10% and the children’s limited partner interestswere increased to about 30% apiece. Jane filed gift taxreturns for 1996 and 1997. On audit, the Servicesought to increase the 1996 taxable gift from $277,441to $626,898, and the 1997 taxable gift from$3,954,506 to $10,937,268. The disputed issues relat-ed to the value of the underlying property in PineBend, whether the Pine Bend interest should be valuedas a general partner interest or as an assignee interest,and the lack of control and lack of marketability dis-counts that should apply to the Pine Bend interest thatJane contributed to AFLP and the limited partner inter-ests in AFLP that Jane gave to her children. Our dis-cussion here deals only with the discount issues.Judge Swift held that, in accordance with the govern-ment’s contention and contrary to Jane’s, the PineBend interest should be treated as a general partnerinterest and not a mere assignee interest, and the dis-cussion below reflects that conclusion.


Judge Swift’s opinion notes that Jane hadfour expert witnesses at trial, but the opinion does nototherwise identify them. Jane’s experts concluded thata 40% combined discount for lack of control and lackof marketability was appropriate for the 50% generalpartner interest in Pine Bend that Jane contributed toAFLP. As to the limited partner interests in AFLP,Jane’s experts concluded that the lack of control dis-count should be 45% for 1996 and 40% for 1997, andthat the lack of marketability discount should be 15%for 1996 and 22% for 1997.

2. Service’s Expert.Judge Swift’s opinion states that the Ser-

vice had two expert witnesses at trial, but the opiniondoes not further identify them. The Service’s experts,as discussed below under “Methodologies,” took theview that no discount was called for at the Pine Bendlevel. For the limited partner interests in AFLP, theService determined lack of control discounts of 7.14%for 1996 and 8.34% for 1997, and a lack of marketabil-ity discount of 21.23% for 1996 and 22% for 1997.

3. Methodologies.In calculating lack of control and lack of

marketability discounts for the 50% general partnerinterest in Pine Bend that Jane contributed to AFLP,and the limited partner interests in AFLP that Janegave to her children, Jane’s experts relied on compara-bility data from sales of interests in registered realestate limited partnerships (“RELPs”).

Jane’s experts, in evaluating the lack ofcontrol and lack of marketability discounts for the50% Pine Bend interest, identified trading discounts in17 RELP comparables traded on the secondary mar-

ket. Next, Jane’s experts derived what they believedshould be a lower limit of 22% and an upper limit of46% for the combined discount, but then they “abrupt-ly,” in Judge Swift’s words, concluded that a combineddiscount of 40% for lack of control and lack of mar-ketability was appropriate, without explaining howthey picked 40% rather than some other figure withinthe 22%-46% range. The Service’s experts, by con-trast, concluded that since the Pine Bend interest wasan asset of AFLP, the discounts that those expertsapplied at the AFLP level eliminated the need to applyan additional, separate discount at the Pine Bend level.

In analyzing the lack of control discountsfor the limited partner interests in AFLP, Jane’sexperts selected nine RELP comparables, and thennarrowed the sample to four comparables which hadtrading discounts ranging from 40-47%. The Service’sexperts, on the other hand, studied trading prices andper share NAVs for about 75 REITs. Since REITsallow investors to own a noncontrolling but liquidinvestment in an otherwise illiquid asset, i.e. realestate, REIT investors are willing to pay a liquiditypremium (relative to per share NAV). Therefore, inanalyzing REIT comparables, one can calculate andthen reverse out of the trading prices any liquidity pre-miums, and that calculation gives rise to a REIT dis-count for lack of control.

C. Judge Swift’s Conclusions. Judge Swift disagreed with the view of the Ser-

vice’s experts that no separate discount was warrantedat the Pine Bend level. He cited several Tax Court casesin which two layers of discounts had been appliedwhere a taxpayer held a minority interest in an entitythat in turn owned a minority interest in another entity,though he acknowledged that other Tax Court cases hadrejected multiple discounts to tiered entities where thelower level interest was a significant part of the parententity’s assets, or where the lower level entity was theparent’s principal operating subsidiary. The Pine Bendinterest made up less than 16% of the NAV of AFLPand was only one of 15 real estate investments held byAFLP. Therefore, in Judge Swift’s view, lack of controland lack of marketability discounts at both the PineBend level and the AFLP level were appropriate.

As noted above, Jane’s experts relied onRELP data and the Service’s experts relied on REITdata. Judge Swift declined to declare either RELP orREIT data generally superior to the other. On the onehand, he thought that RELPs more closely resembledPine Bend and AFLP than did REITs, and he did notthink that the trading volume on the RELP secondarymarket was so low as to make the available RELP dataunreliable; on the other hand, he also believed that thelarge number of sales of interests in REITs tended to


produce more reliable data than did the limited num-ber of RELP sales, and that the differences betweenREITs and partnerships such as Pine Bend and AFLPcould be minimized given the large number of REITsfrom which to select comparables.

Judge Swift eliminated four of the 17 RELPcomparables that Jane’s experts had considered inconnection with the valuation of the Pine Bend inter-est, because the data in those four comparables wasbased on 1999 information whereas the gifts at issuewere in 1996 and 1997. Based on the median andmean trading discounts in the remaining RELP com-parables and additional RELP comparables consideredby Judge Swift, he concluded that a combined dis-count of 30% for lack of control and lack of mar-ketability was appropriate for the Pine Bend interest.

In considering the appropriate lack of controldiscounts for the limited partner interests in AFLP,Judge Swift pointed out that the RELP comparablesselected by Jane’s experts were much more leveragedthan was AFLP. Therefore, he did not find the 45% and40% discounts determined by Jane’s experts to be cred-ible. Jane’s experts had also acknowledged that thehigher an RELP’s cash distribution rate, the lower theinvestor risk, which would suggest a lesser lack of con-trol discount. AFLP’s cash distribution rate was 10%,compared with the 6.7% cash distribution rate in theRELP comparables observed by Jane’s experts. JudgeSwift viewed more favorably the methodology used bythe Service’s experts, utilizing REIT data and reversingout of the trading prices any liquidity premiums, but hethought that the REIT liquidity premium determined bythe Service’s experts was too low. Some of the studiescited by the Service’s experts suggested that liquiditypremiums for publicly traded investments might benearly twice the premiums that those experts used, andmoreover, the lack of control discounts of 7.14% and8.34% derived from reversing out the assumed liquiditypremiums appeared to Judge Swift to be “unreasonablylow” on their face. Therefore, Judge Swift looked to thedifference in average discounts observed in privateplacements of registered and unregistered stock, basedon the premise that such discounts reflected pure liquid-ity concerns. According to two studies cited by the Ser-vice’s experts, the discount was about 14%, resulting ina general liquidity premium in publicly traded assets of16.27% which Judge Swift thought would also beapplicable to publicly traded REITs. Judge Swift thenreversed that liquidity premium out of the data on theREIT comparables, and derived, for the limited partnerinterests in AFLP, lack of control discounts of 16.17%for 1996 and 17.47% for 1997.

Since the lack of marketability discount of21.23% determined by the Service’s expert for the1996 gifts of limited partner interests in AFLP was

greater than the 15% discount estimated by Jane’sexperts, Judge Swift adopted the 21.23% lack of mar-ketability discount without further discussion. As tothe 1997 gifts of limited partner interests in AFLP,both parties’ experts agreed on a lack of marketabilitydiscount of 22%, which Judge Swift adopted.

Astleford illustrates once more the willingnessof a Tax Court Judge to engage in his or her own valu-ation analysis, selectively agreeing and disagreeingwith the methodologies of both parties’ experts. Thecase is also worth reading for its discussion of, andreview of case law in connection with, multiple dis-counts in tiered entity structures.

XIII. Holman.

A. Facts.64

Holman was a gift tax case. There were severalissues in the case, but the valuation issues related to lim-ited partner interests in The Holman Limited Partnership.

Tom and Kim Holman were husband and wife.Tom was employed by Dell Computer Corporation(“Dell”) and had received a substantial amount of Dellstock through exercise of options, and he and Kim hadbought additional Dell stock. After about two years ofdiscussion with estate planning advisors regarding theirgoals, which included promoting long-term assetgrowth, asset preservation and protection, and educatingtheir children on business matters, Tom, and Kim and atrust for their children formed The Holman LimitedPartnership. On November 2, 1999, Tom and Kim eachcontributed 625 shares of Dell stock to the partnership inexchange for a 0.89% general partner interest and34,375 Dell shares in exchange for a 49.04% limitedpartner interest. The trust contributed 100 Dell shares inexchange for a 0.14% limited partner interest. There-fore, the partnership owned a total of 70,100 Dell shares.

The partnership agreement recited that thepurposes of the partnership included, among otherthings, the preservation of family assets, restricting theright of non-family members to acquire interests infamily assets, and protection of family assets fromclaims of family members’ future creditors. Limitedpartners were generally prohibited from assigningtheir interests in the partnership without the prior con-sent of all partners. A limited partner could, however,assign his or her interest to a revocable trust of whichhe or she was sole beneficiary, to another family mem-ber, to a custodian for a family member under anapplicable transfers to minors act, to another partner inthe partnership, or to a trust for the benefit of familymembers even if the trust also included non-family

64 Judge Halpern wrote the opinion in Holman.


members as beneficiaries. If a prohibited assignmentturned out nevertheless to be effective according tothen applicable law, the partnership had an option toreacquire the interest of the assignee for its fair marketvalue based on the assignee’s right to share in partner-ship distributions, as determined by an independentappraiser selected by the general partners. The pur-chase price upon exercise of this option could be paid10% down with the balance over five years with inter-est at the applicable federal rate. Even if the partner-ship did not exercise its option to reacquire the inter-est, the assignee would not become a full limited part-ner unless all of the other partners consented. Underthe partnership agreement, the partnership would bedissolved on December 31, 2049, or would be dis-solved earlier with the written consent of all partners.

On November 8, 1999, Tom and Kim madegifts of limited partner interests to the trust for theirchildren and to Tom’s mother as custodian for theiryoungest child. Tom and Kim filed gift tax returns for1999, making the split gift election, and reporting thevalue of the gifts from each of Tom and Kim as$601,827, based on an independent appraisal. Theappraiser applied a discount of 49.25% to the partner-ship’s net asset value (i.e., the value of the Dell shares).On December 13, 1999, custodial accounts for Tom’sand Kim’s four children, with Tom’s mother as custodi-an, contributed a total of 30,120 Dell shares to the part-nership in exchange for limited partner interests, so thatthe partnership owned 100,220 shares of Dell stock. OnJanuary 4, 2000, Tom and Kim gave small limited part-ner interests to the custodial accounts. Tom and Kimfiled gift tax returns for 2000, making the split gift elec-tion, and reporting the value of the gifts by each of Tomand Kim as $40,000, based on an independentappraisal. As with the 1999 gift, the appraiser applied adiscount of 49.25% to the partnership’s net asset value.On January 5, 2001, Tom and Kim each contributed5,440 shares of Dell stock to the partnership, so that thepartnership owned 111,100 Dell shares. On February 2,2001, Tom and Kim gave small limited partner intereststo the custodial accounts. Tom and Kim filed gift taxreturns for 2001, making the split gift election, andreporting the value of the gifts by each of Tom and Kimas $40,000, based on their estimate of value in light ofthe appraisals of the 1999 and 2000 gifts.

After all of these contributions and gifts, Tomand Kim each owned a 0.56% general partner interest

and a 5.04% limited partner interest, the children’s trustowned a 44.29% limited partner interest, and each of thefour custodial accounts for the children owned an11.13% limited partner interest. At the time of each ofthe gifts, the sole asset of the partnership was Dell stock.

B. Valuation Issues in the Case.1. Taxpayers’ Expert.

The Holmans offered Troy D. Ingham(“Mr. Ingham”) as an expert witness.65 Mr. Inghamconcluded that the lack of control discount should be13.4% for the 1999 gift, 16.3% for the 2000 gift and10% for the 2001 gift. He concluded that the properlack of marketability discount was 35%.

2. Service’s Expert.The Service offered Francis X. Burns

(“Mr. Burns”) as an expert witness.66 Mr. Burns con-cluded that the lack of control discount should be11.2% for the 1999 gift, 13.4% for the 2000 gift and5% for the 2001 gift. He concluded that the appropri-ate lack of marketability discount was 12.5%.

3. Methodologies.The parties’ experts agreed that the start-

ing point for valuing the limited partner interestsshould be the partnership NAV, which equaled thevalue of the Dell shares. The parties’ experts dis-agreed, however, on the calculation of NAV on thedates of the 2000 and 2001 gifts. Mr. Burns calculatedthe NAV based on the averages of the high and lowprices on those dates, in view of Treas. Reg. §25.2512-2(b)(1), which provides that if there is a market forstocks, the mean between the highest and lowest quot-ed selling prices on the gift date is generally the fairmarket value. Mr. Ingham, on the other hand, calculat-ed NAV based on the closing values of the Dell stockon those gift dates. The Holmans argued that the regu-lation did not apply because the gifts being valued weregifts of limited partner interests, not marketable stocks,and moreover that Mr. Ingham’s lack of control dis-count analysis used data showing that shares of pub-licly held investment companies generally traded at adiscount from NAV, determined by comparing the priceof the company to its end-of-day NAV. As noted below,the Tax Court agreed with the Service on this issue.

Both parties’ experts, in evaluating the lackof control discount, considered prices of shares of pub-licly traded closed-end investment funds with portfoliosconsisting predominantly of domestic common stocks.

65 Mr. Ingham was a vice president and director with Manage-ment Planning, Inc., had been performing valuation services since1996, and was a candidate for the American Society of Appraisers.

66 Mr. Burns was a vice president of CRA International, Inc.,an international consulting firm that provided business valuation

services, and was an accredited senior appraiser in business valua-tion within the American Society of Appraisers and a member ofthe Institute of Business Appraisers. Mr. Burns had been an expertwitness for the Service in a number of valuation cases, includingPeracchio and Temple, both discussed above.


Each expert relied on three samples, one for the date ofeach gift, and the samples were similar in size betweenthe experts. Mr. Burns relied solely on general equityfunds, whereas Mr. Ingham included in his samples sev-eral specialized equity funds with investments in thehealth care, petroleum and resources, and bankingindustries. Mr. Burns computed, for his sample, themedian, mean and interquartile mean discounts, whileMr. Ingham computed only the median discounts. Mr.Ingham considered adjustments to his median discountfigures to reflect quantitative factors, namely the part-nership size, the volatility of its portfolio, and measuresof return and yield, but concluded that those factors werenot significant. He also considered qualitative factors,namely the lack of diversification in the partnership’sportfolio, the depth and qualify of the partnership’s man-agement and the partnership’s income tax status, andconcluded that a willing buyer of a limited partner inter-est would require a discount 10% greater than the medi-an discounts that he had determined. Mr. Burns, by con-trast, relied on the interquartile mean discount (i.e., themean of the 50% of the data points falling between the25th and 75th percentiles). He considered, but rejected,a downward adjustment in the discount to reflect thelarge proportional limited partner interest held by thetrust for the children and any influence that that mightgive the trust over the general partners.

Concerning the lack of marketability dis-count, Mr. Ingham and Mr. Burns differed sharply overboth the existence of a market for limited partner inter-ests and the weight that should be given to various qual-itative factors. Mr. Ingham relied on his own and others’studies of restricted stock transactions that compared theprivate-market prices of restricted shares of public com-panies with the coeval public market price. Based onboth the restricted stock analysis and his analysis of the“investment quality” of the limited partner interests inthe Holman partnership, he concluded that 35% was theappropriate lack of marketability discount.

Mr. Burns took a more complex approachto the lack of marketability discounts. He consideredrestricted stock studies from three different periods—(i) prior to 1990, when the SEC adopted Rule 144Aallowing institutional buyers to buy and sell restrictedstock, (ii) 1990-1997, and (iii) 1997-1998. In 1997,the SEC reduced the required holding period underRule 144 from two years to one. Based on the declinein average discounts over this period, Mr. Burns con-cluded that the main factors influencing investors werethe limited access to a liquid market and the requiredholding period before the stock could be freely traded.Although Mr. Burns recognized that the Holman part-nership was very different from the operating compa-nies that were the subject of the restricted stock stud-ies, he concluded that the 12 percentage point differ-

ence in average discount between the pre-1990 studiesand the 1990-1997 studies was indicative of the por-tion of the discount attributable to lack of access to aready resale market. Mr. Burns thought that theremaining 22 percentage points of the average pre-1990 discount of 34% were attributable to holdingperiod restrictions and factors unrelated to marketabil-ity. He concluded that for investment companies suchas the partnership, where there were no legally man-dated holding periods and, in his view, the operatingand financial risks of typical restricted shares wereabsent, an analysis of the restricted stock studies sug-gested a lack of marketability discount around 12%.Mr. Burns then considered factors specific to the Hol-man partnership, specifically, the failure to make dis-tributions, the nondiversified portfolio, the restrictionson transfers of limited partner interests, the dissolutionprovisions of the partnership agreement (allowing dis-solution with the consent of all partners) and the liq-uidity of Dell shares. In Mr. Burns’s view, the last twofactors increased the marketability of the limited part-ner interests. He concluded that the appropriate dis-count for lack of marketability was 12.5%.

C. Tax Court’s Conclusions. Though our discussion here focuses on the

discount analysis, it is of interest that the Tax Courtconcluded that the transfer restrictions in the partner-ship agreement should be disregarded for valuationpurposes under I.R.C. §2703. The Tax Court deter-mined that these restrictions did not constitute a bonafide business arrangement within the meaning ofI.R.C. §2703(b)(1), and did constitute a device, withinthe meaning of I.R.C. §2703(b)(2), to transfer limitedpartner interests to the natural objects of Tom’s andKim’s bounty for less than adequate consideration.

With respect to the calculation of NAV on thedates of the 2000 and 2001 gifts, the Tax Court reject-ed the Holmans’ argument that Treas. Reg. §25.2512-2(b)(1), requiring valuation of stocks based on themean between the highest and lowest quoted sellingprices for the date of each gift, did not apply and thatreference should be made to the closing price for eachdate. The Tax Court held that the regulation could notbe dismissed, and also concluded that the Holmanshad failed to show that any statistical inference to bedrawn from the data on publicly held investment com-pany date would be any different if an average of thehighs and lows of component securities, rather thanend of day values, were used to determine NAVs.

In connection with the lack of control dis-counts and the composition of the samples of closed-end investment funds, Mr. Ingham agreed with thegovernment’s counsel on cross-examination that thespecialized equity funds he had included in his sam-


ples resembled the Holman partnership only in thatthey were specialized in their investments. He hadincluded no explanation in his report for the inclusionof the particular specialized funds. The Tax Court,noting (i) that the mean and median discounts for thespecialized funds as of the first gift date were signifi-cantly greater than the mean and median discounts forthe full sample and (ii) that Mr. Ingham and Mr. Burnsagreed that a sample of general equity funds yieldeduseful information but disagreed over whether consid-eration of funds specializing in industries differentfrom Dell’s shed light on the appropriate discounts,concluded that a sample of general equity funds onlywas sufficiently reliable. Therefore, the Tax Courtconstructed samples for each gift valuation date fromthe overlap of the experts’ data sets for that date.

Mr. Ingham had relied on the median of eachsample to neutralize the effect of outliers, but inresponse to a question from the Court, he could not saywhether outliers caused a significant differencebetween the means and the medians in his samples,because he had not computed the means. The TaxCourt found the approach of Mr. Burns, who computedthe mean, median and interquartile means, to be morethoughtful, and therefore followed Mr. Burns’s lead ofrelying on the interquartile mean of each sample.

The Tax Court also agreed with Mr. Burns thatno adjustment to the averages so obtained was appropri-ate. Mr. Ingham failed to convince the Court that lack ofportfolio diversification and lack of professional man-agement justified an increase in the lack of control dis-count. Mr. Ingham had conceded in his report that thepartnership’s simple portfolio negated the significanceof lack of professional management. The Tax Court didnot see how lack of diversification could warrant agreater lack of control discount “since the partnershipwas, on the valuation dates, transparently, the vehicle forholding shares of stock of a single, well-known corpora-tion.” The appropriate lack of control discounts, theCourt concluded, were 11.32% for the 1999 gift,14.34% for the 2000 gift and 4.63% for the 2001 gift.

As to the lack of marketability discount, theTax Court noted that the parties’ experts disagreedprincipally over the likelihood of a private marketamong the partners for limited partner interests. Mr.Burns argued that under Mr. Ingham’s theory that therewas no such market, it seemed arbitrary to stop at a35% discount as Mr. Ingham did, since it would seemthat if a limited partner interest could not be sold, itsvalue would be near zero or it could not be valued atall. The Tax Court thought that Mr. Burns had a pointhere: “Mr. Ingham has not persuaded us that his stop-ping point, 35%, is anything but a guess.” Mr. Inghamhad failed to build from his observed sample medianand mean discounts of 24.8% and 27.4%, respectively,

to his 35% discount conclusion by quantitative means,and the Court found Mr. Ingham’s analysis of qualita-tive factors inadequate and vague. The Tax Courtfound Mr. Burns’s analysis of the lack of marketabilitydiscount much more persuasive. The Court noted thatsince the partnership held only Dell stock, a highlymarketable and liquid asset, the remaining partnerswould appear to bear little or no economic risk inagreeing to a redemption of a limited partner interest inorder to accommodate a partner who wanted to makean assignment. Interestingly, the Tax Court was rela-tively dismissive of the partnership’s stated purpose ofpreserving family assets; the Tax Court thought that thepartnership agreement provision allowing consensualdissolution showed that asset preservation “was not anunyielding purpose.” The Tax Court agreed with Mr.Burns that the holding period component of the dis-count had little if any significance, and that the onlytruly relevant element of the lack of marketability dis-count was the market access component. Concludingthat based on the record and the testimony, the Courtcould not improve upon Mr. Burns’s estimate of thelack of marketability discount, the Tax Court deter-mined that discount to be 12.5%.

The Tax Court’s construction of its own dataset, from the overlap of the experts’ samples, in evalu-ating the lack of control discount is consistent with the“pick and choose” theme reflected in so many otherrecent cases. The Tax Court’s acceptance of the lackof marketability discount analysis presented by Mr.Burns is both interesting and troubling, however. Theassumption that the other partners would willinglyredeem out a limited partner, and the Service’s inter-pretation of the restricted stock studies, are certainlydebatable, and the 12.5% lack of marketability dis-count is well below the range that many practitionershave considered relatively “safe.”

XIV. Conclusion.

These twelve cases illustrate that the persuasive-ness of an expert’s analysis depends on whether or notthe court concludes that (1) the size of the sample issufficient; (2) the sample funds actually resemble, tothe extent possible, the particular asset class ownedby the partnership or other entity that is the subject ofthe valuation; and (3) the data relied on by the expertare contemporaneous (i.e., as close as possible to thevaluation date). In addition, the expert must be ableto explain the underlying data and methodologiesused in the expert’s analysis and be prepared todefend his or her opinion. Moreover, any internalinconsistencies will negatively affect the credibilityof an expert’s valuation analysis. Failure to quantify,or at least explain the significance of, “subjective”


factors used when adjusting discounts, or choosing arepresentative discount from within a specific rangeof discounts, will likewise undercut the persuasive-ness of an expert’s opinion. At a bare minimum, anexpert must select companies which relate to the com-pany being valued in meaningful ways, base dis-counts on the specific facts of the case, and quantify,or at least articulate, the effects of any additional fac-tors an expert chooses to rely on when making adjust-ments within a discount range.

The court may, depending on its assessment of theexperts’ credibility, choose to give little or no weight tothe analysis and conclusions of one party’s expert. Theresult may be a complete victory for the other party, aswith the taxpayer win in Kohler, but that will notalways be so. In Thompson, the Second Circuit heldthat because the Tax Court did adopt some of the Ser-vice’s arguments despite the Tax Court’s severe criti-cism of the Service’s expert, the burden of proof provi-

sion, I.R.C. §7491, did not require the Tax Court toaccept the taxpayer’s valuation. Alternatively andmore typically, a court may perceive strengths andweaknesses in the analyses by both parties’ experts,leading it to construct its own analysis that draws selec-tively from the work of each expert. A court may even,as in Gimbel, make its own independent determinationof how much of a deceased shareholder’s stock it wasreasonably foreseeable that the company would repur-chase, based on the court’s consideration of the compa-ny’s policies and competing liquidity needs.

Taxpayers, especially in the Eleventh Circuit, withthe built-in capital gain tax issue should be encouragedby the appellate decision in Jelke.

Astleford is, among other things, a reminder thatmulti-level discounts for tiered entities may beallowed in appropriate circumstances. Holman mayreflect a disturbing trend in the Tax Court concerningthe analysis of lack of marketability discounts.


Editors’ Synopsis: This article examines the secu-rities and commodities law issues that may arise inconnection with the design, establishment and opera-tion of a family office. The article closely analyzes therelevant federal statutes and applicable regulationsand serves as a guide to enable the family office advi-sor to navigate successfully through an area of law thatis largely unfamiliar to most trusts and estates lawyers.

INTRODUCTION.

Family office1 pooled investment vehicles and theiroperations are within the scope of regulations that gov-ern other pooled investment vehicles under federal secu-rities and commodities laws. Under certain circum-stances, self-executing statutory or regulatory provi-sions, or an agency order exempting a specific familyoffice structure, may enable a family office to operatewithout the regulatory compliance burdens otherwiseimposed by the various laws, such as registration,recordkeeping and reporting requirements. A familyoffice may be able to operate under conditional statutoryexemptions or, alternatively, under an order of exemp-tion from the Securities Exchange Commission (“SEC”)or “no-action letter from the Commodity Futures Trad-ing Commission (“CFTC”). Aspects of a family officemay result in the management of the family office hav-ing the status of an investment adviser, commoditiestrading adviser or commodities pool operator or one ormore pooled investment vehicles having the status of aninvestment company or a commodities pool. The gov-erning federal law consists of the Securities Act of 1933(“1933 Act”),2 the Advisers Act of 1940 (“AdvisersAct”),3 the Investment Company Act of 1940 (“1940Act”)4 and the Commodity Exchange Act (“CEA”)5 andthe rules adopted thereunder.6 Federal securities andcommodities laws apply to: the organization and opera-tion of a family office and to the recommendations or

advice given as to investments, which may be subject tothe Advisers Act and the CEA; the organization andoperation of a pooled investment vehicle, which may besubject to the 1940 Act and the CEA; and the distribu-tion of interests in the investment vehicle, which may besubject to regulation under the 1933 Act.

ADVISERS ACT.

The provision of advisory and portfolio manage-ment services could subject the manager of the familyoffice to the registration requirements under theAdvisers Act. Federally registered advisers are sub-ject to certain filing, recordkeeping, disclosure andanti-fraud requirements in addition to periodic inspec-tions and examinations by the SEC. The initial inquiryis whether the activities of the manager of the familyoffice bring the individual or firm within the definitionof investment adviser. Section 202(a)(11)7 of theAdvisers Act defines investment adviser as:

Any person who, for compensation,engages in the business of advisingothers, either directly or through publi-cations or writing, as to the value ofsecurities or as to the advisability ofinvesting in, purchasing, or sellingsecurities, or who, for compensationand as part of a regular business, issuesor promulgates analyses or reports con-cerning securities, (Emphasis added).

The SEC has provided guidance on the elementsof the investment adviser definition through variousreleases and interpretive letters. Providing advice orissuing reports or analyses to others regarding securi-ties includes: advice, recommendations, reports oranalyses about specific securities;8 advice about

* Copyright 2009 by Audrey C. Talley. All rights reserved.1 “Family office” refers to one or more entities organized pri-

marily to manage the assets and provide investment-related ser-vices such as estate planning, trust administration and coordinationof professional relationships for the members of an extended singlefamily.

2 15 U.S.C. §§ 77a-77aa.3 15 U.S.C. §§ 80b-1-80b-21.4 15 U.S.C. §§ 80a-1-80a-52.

5 7 U.S.C. §§ 1-25.6 State laws vary as to investment adviser and securities reg-

ulations and should be consulted in addition to federal law.7 15 U.S.C. § 80b-2(a)(11).8 Applicability of Investment Advisers Act to Financial Plan-

ners, Pension Consultants, and Other Persons Who Provide Invest-ment Advisory Services as a Component of Other Financial Ser-vices, Investment Advisers Act Release No. 1092 (Oct. 8, 1987)(52 Fed. Reg. 38400, (Oct 16, 1987)).

Family Offices:Securities and Commodities Law Issues

by Audrey C. Talley Philadelphia, Pennsylvania*


securities generally;9 advice concerning the relativeadvantages and disadvantages of investing in securi-ties as compared to other investments;10 advice as tothe selection or retention of an investment manageror managers;11 and providing a market timing serviceor offering market timing advice.12 Issuing reportsdoes not make a person an investment adviser if theinformation contained within the reports is readilyavailable to the public, the categories of informationpresented are not highly selective and the informa-tion does not suggest the purchase, holding or sale ofa security.13 In the SEC’s adopting release for itshedge fund adviser registration rule,14 and in a no-action letter to the American Bar Association,15 theSEC declined to adopt a rule or take a no-action posi-tion that would exclude limited partnerships (andother family investment funds) owned or controlledby members of a single family from the adviser regis-tration rule requirements.

Investment advisers with $25 million to $30 millionunder management who use the mails or a means orinstrumentality of interstate commerce to conduct theirbusiness are required to register with the SEC. Otherinvestment advisers are subject to state regulation.16

The Advisers Act provides exclusions17 from thedefinition of investment adviser and exemptions fromregistration requirements that may provide relief fromthe regulatory burdens imposed on registered advisersfor the manager of the family office. Advisers canavoid registration if they do not take compensation formanaging the assets of the family office. An advisercan avail itself of the SEC’s de minimis exemption if ithas fewer than 15 clients in a 12 month period, doesnot hold himself out to the public as an investmentadviser and does not advise an investment company orbusiness development company.18

Special rules govern counting clients. Each for-mally organized entity such as a limited partnership orlimited liability company would be one client, and alltrusts for a particular individual would be counted asone client.19 Rule 203(b)(3)-1 provides a definition of“client” of an investment adviser. This definition canbe used to determine the availability of the exemptionfrom investment adviser registration provided in Sec-tion 203(b)(3) of the Advisers Act, which is based onan adviser’s number of clients. (The Rule cannot beused to determine the number of investors in a 3(c)(1)private fund. See 1940 Act discussion below.)

The following would be considered a “singleclient”: a natural person, and: any minor child of thenatural person; any relative, spouse, or relative of thespouse of the natural person who has the same princi-pal residence; all accounts of which the natural personand/or the persons referred to in this definition are theonly primary beneficiaries; or all trusts of which thenatural person and/or such persons are the only prima-ry beneficiaries.

Also considered a single client is a corporation,general partnership, limited partnership, limited liabili-ty company, trust (other than a trust of the typedescribed in the preceding paragraph) or other legalorganization to which advice is rendered directlyinstead of to the owners. When counting these legalentities, it is permissible to count as one client two ormore organizations that have identical owners. Note,also, that a limited partnership or limited liability com-pany is considered a client of any general partner, man-aging member or other person acting as investmentadviser to the partnership or limited liability company.

Satisfaction of the “business of” element of theAdvisers Act’s definition of investment adviserdepends on the degree of advisory activities based on

9 College Resource Network, 1993 SEC No-Act. LEXIS 630.10 Id.11 Id.12 David Parkinson, 1995 SEC No-Act. LEXIS 751.13 Butcher & Singer, Inc., 1987 SEC No-Act. LEXIS 1477.14 See Registration under the Advisers Act of Certain Hedge

Fund Advisers, Investment Advisers Act Release No. 2333, n. 249(Dec. 2, 2004). The SEC’s hedge fund adviser rules were struckdown in Goldstein v. Securities and Exchange Commission, 451F.3d 873 (D.C. Cir. 2006), based on a finding that the SEC exceed-ed its authority when it adopted the rules.

15 American Bar Association, 2005 SEC No-Act. LEXIS 829.16 See 15 U.S.C. § 80b-3(a).17 15 U.S.C. § 80b-2(a)(11) excludes the following entities

from the definition of investment adviser: banks or bank holdingcompanies (except a bank acting as an investment adviser to a reg-istered investment company); any lawyer, accountant, engineer orteacher whose performance of advisory services is incidental to the

practice of his profession; any broker or dealer whose performanceof such services is solely incidental to the conduct of his businessas a broker or dealer and who receives no special compensationtherefor; any publisher of any bona fide newspaper, news magazineor business or financial publication of general and regular circula-tion; and a person who provides advice solely with respect to U.S.government securities.

18 15 U.S.C. § 80b-3(b) also provides exemptions for advisersthat engage in an intrastate business and do not give advice onexchange-listed securities, have only insurance companies asclients, are charitable organizations, are church plans or are com-modity trading advisers.

19 See 15 U.S.C. § 80a-2(a)(51) and Rule 203(b)(3)-1 17C.F.R. § 275.203(b)(3)-1 [2008]. The state in which the adviseroperates under its exemption probably would require a letter ofnotice that the adviser operates under an exemption and the fil-ing of a consent to service of process by the state securities com-mission.


facts and circumstances. A person engages in an advi-sory business if: he holds himself out as an investmentadviser; receives separate or additional compensationthat is clearly payment for advisory services asopposed to transaction-based compensation; or, onanything but rare, isolated and non-periodic instances,provides advice.20

Compensation means any direct or indirect eco-nomic benefit from any source.21

EXEMPTIONS FROM REGISTRATION BY ORDER.

Beginning with In the Matter of Donner Estates,Inc.,22 the SEC has issued exemptive orders declaringthe applicant not to be an investment adviser withinthe intent of Section 202(a)(11) of the Advisers Actwhere the family office was not within exclusionsfrom the definition of investment adviser or exemp-tions from registration as an adviser. Donner Estates,Inc., was formed to act as investment adviser to thirty-six trusts which were organized for the benefit of theDonner family; however, one trust was formed for thebenefit of a former family employee and one wasformed as a charitable trust. Donner Estates, Inc. alsoacted as adviser to a Donner family charitable corpora-tion. Donner Estates, Inc. was owned by a trust for thebenefit of certain Donner family members and gov-erned by a board of directors consisting of members ofthe Donner family. Donner Estates, Inc. did notreceive compensation from several of the trusts, but itreceived nominal compensation from twenty-sevenpersonal trusts and the charitable corporation.

Since issuance of the Donner Estates, Inc. exemp-tive order, the SEC has issued numerous similarorders23 where:

1. The applicant performed advisory and portfo-lio management services for a family officeorganized for the benefit of a single family;

2. The applicant did not hold itself out to thepublic as an investment adviser;

3. The only other clients were:(a) Entities owned, established or controlled

by the family; and(b) A very limited number of other clients,

usually former employees of the family(the applicant represented that no newnon-family member clients would beaccepted); and

4. The fees charged were for administrative ser-vices or, if for portfolio management, wereintended to cover the cost of providing the ser-vice without a profit.

PERFORMANCE FEES.

The Advisers Act regulates certain provisions ofan investment advisory contract.24 One such provisionis compensation in the form of a performance fee, i.e.,a share of the capital gains on, or capital appreciationof, a client’s assets. A performance or incentive fee issaid to align an adviser’s interests with its client’sbecause the adviser’s compensation increases basedon the increase in value of the client’s assets. The per-formance fee could be structured as a base fee plus apercentage of gains. The percentage of gains or appre-ciation is usually tied to a positive return of an index orother benchmark or the adviser’s exceeding a fixedperformance hurdle.

Rule 205-3 permits performance fees in contractswith the following qualified clients:

1. A natural person who has, or a company thatimmediately after entering into the contracthas, at least $750,000 under the managementof the investment adviser;

2. A natural person who has, or a company thatthe investment adviser entering into the con-tract (and any person acting on his behalf) rea-

20 Applicability of Investment Advisers Act to Financial Plan-ners, Pension Consultants, and Other Persons Who Provide Invest-ment Advisory Services as a Component of Other Financial Ser-vices, Investment Advisers Act Release No. 1092 (Oct. 8, 1987)(52 Fed. Reg. 38400, (Oct 16, 1987)).

21 Pension and Welfare Benefit Administration, EmployerSponsors of Defined Contribution Plans, 1995 SEC No-Act.LEXIS 1044.

22 In the Matter of Donner Estates, Inc, Investment AdvisersAct Release No. 21 (Nov. 3, 1941), 10 SEC 400, CCH Fed. Sec. L.Rep. 1941-1945 Transfer Binder.

23 See SEC exemptive orders: In the Matter of MorelandManagement Company, Investment Advisers Act Release No. 1700(Feb. 12, 1998) (63 Fed. Reg. 8710, (Feb. 20, 1998)); Investment

Advisers Act Order 1706 (Mar. 10, 1998); In the Matter ofLongview Management Group, LLC, Investment Advisers ActRelease No. 2008 (Jan. 3, 2002); Investment Advisers Act Order2013 (Feb. 7, 2002); In the Matter of Adler Management L.L.C.,Investment Advisers Act Release No. 2500 (Mar. 21, 2006) (71Fed. Reg. 15498, (Mar. 28, 2006)); Investment Advisers Act Order2508 (Apr. 14, 2006); In the Matter of Slick Enterprises, Inc.,Investment Advisers Act Release No. 2736 (May 22, 2008) (73Fed. Reg. 30984, (Mar. 29, 2008)); Investment Advisers Act Order2745 (Jun. 20, 2008); In the Matter of Woodcock Financial Man-agement Company, L.L.C., Investment Advisers Act Release No.2772 (Aug. 26, 2008, (73 Fed. Reg. 51322)).

24 15 U.S.C. § 80b-5(a); 17 C.F. R. § 205-3(d) [2008].


sonably believes, immediately prior to enter-ing into the contract, either:(a) Has a net worth (together, in the case of a

natural person, with assets held jointlywith a spouse) of more than $1,500,000 atthe time the contract is entered into; or

(b) Is a qualified purchaser as defined in Sec-tion 2(a)(51)(A) of the 1940 Act at thetime the contract is entered;25 or

3. Certain officers, directors and professionalemployees of the investment adviser.

The performance fee regulations do not apply toinvestment advisers exempt from registration26 or toprivately offered pooled investments exempt from reg-istration under Section 3(c)(7) of the 1940 Act.27 Eachinvestor in a 3(c)(7) fund is not required to satisfy thequalified client eligibility requirements of Rule 205-3(d) for an adviser to charge a performance fee to theFund.28 However, in the case of 3(c)(1) funds,29 theadviser is required to look through the entity to deter-mine which equity owners are qualified clients. Theadviser can then charge the performance fee only toequity owners that are qualified clients. A registeredadviser to a family office is subject to the performancefee rule. When the SEC adopted Rule 205-3(d) to per-mit performance fees in certain advisory contracts, itspecifically rejected suggestions that the net worthstandard permit the aggregation of the assets of allfamily members whether or not a spousal relationshipexists.30

1940 ACT.

A family office pooled investment vehicle mayfall within the definition of an investment company,and, if it does, it will be subject to registration with theSEC unless an exemption from registration is availableor the SEC issues an order that declares that the invest-ment vehicle is not an investment company. Registra-

tion as an investment company would be burdensomebecause it entails, among other things, filing a registra-tion statement and annual amendments, financialreports that have specific disclosure requirements,restrictions on the types and quantities of certaininvestments and restrictions on transactions with affil-iated persons.

Section 3(a)(1)(A) of the 1940 Act31 defines an“investment company” as any issuer which is or holdsitself out as being engaged, or proposes to engage, pri-marily in the business of investing, reinvesting, ortrading in securities. Family office pooled investmentvehicles usually can operate without registration underthe 1940 Act based on compliance with either of twoexclusions from the definition of investment companycontained in Sections 3(c)(1)32 and 3(c)(7).33

Section 3(c)(1) Companies.Section 3(c)(1) excludes from the definition of

investment company “any issuer whose outstandingsecurities are beneficially owned by not more than onehundred persons and which is not making a publicoffering of its securities.”

Section 3(c)(1)(A) states how a 3(c)(1) company istreated as an owner of securities. It essentially providesthat beneficial ownership by a company shall bedeemed to be beneficial ownership by one person,except that, if the investing company owns 10% or moreof the outstanding voting securities of an issuer and is,or but for the exclusions from the definition of invest-ment company provided by Sections 3(c)(1) and 3(c)(7)of the 1940 Act would be, an investment company, thebeneficial ownership by the investing company isdeemed to be the beneficial ownership of the holders ofthe investing company’s outstanding securities. (This iscommonly referred to as the 10% look through test.)

Section 3(c)(7) Companies.Section 3(c)(7)(A) excludes from the definition of

investment company “any issuer, the outstanding secu-

25 15 U.S.C. § 80a-2(a)(51)(A). Generally speaking, this is aninvestor with at least $5 million dollars in “investments,” as thatterm is defined in the 1940 Act, and is the principal eligibility testfor investment in a 3(c)(7) fund. See below.

26 15 U.S.C. § 80b5-(a)(1).27 15 U.S.C. 80b-5(b)(4).28 Exemption to Allow Investment Advisers to Charge Fees

based Upon a Share of Capital Gains upon or Capital Appreciationof a Client’s Account, Investment Advisers Act Release No. 1731,n. 23 (Jul. 15, 1998) (63 Fed. Reg. 39022, (Jul. 21, 1998)).

29 Id. A 3(c)(1) fund is a privately offered fund with not morethan one hundred investors. If a privately offered fund relying onthe 3(c)(1) or 3(c)(7) exemption owns 10% or more of a 3(c)(1)fund, each one of its individual investors must be counted for pur-

poses of satisfying the 100 investor limit. The requirement in Rule205-3 to look through private investment companies to determinethat each equity owner is a qualified client requires lookingthrough every level of private investment companies to identify theultimate individual client.

30 Exemption to Allow Investment Advisers to Charge Feesbased Upon a Share of Capital Gains upon or Capital Appreciationof a Client’s Account, Investment Advisers Act Release No. 996,(Nov. 14, 1985) (50 Fed. Reg. 48556, (Nov. 26, 1985)).

31 15 U.S.C. § 80a-3(a)(1)(A).32 15 U.S.C. § 80a-3(c)(1).33 15 U.S.C. § 80-3(c)(7) amended by act of October 11,

1996, Pub. L. 140-290, 110 Stat. 3416.


rities of which are owned exclusively by persons who,at the time of acquisition of such securities are qualifiedpurchasers, and which is not making and does not atthat time propose to make a public offering of securi-ties.” The categories of “qualified purchaser” are setforth in Section 2(a)(51)(A) of the 1940 Act, as follows:

1. Any natural person (including any person whoholds a joint, community property, or othersimilar shared ownership interest in an issuerthat is excepted under Section 3(c)(7) withthat person’s qualified purchaser spouse) whoowns not less than $5,000,000 in investments,as defined by the SEC.

2. Any company that owns not less than$5,000,000 in investments and that is owneddirectly or indirectly by or for two or morenatural persons who are related as siblings orspouse (including former spouses), or directlineal descendants by birth or adoption, spous-es of such persons, the estates of such personsor foundations, charitable organizations, ortrusts established by or for the benefit of suchpersons (“Family Company” as defined inRule 2a51-1(2));

3. Any trust that is covered by clause (2) and thatwas not formed for the specific purpose ofacquiring the securities offered, as to whichthe trustee or other person authorized to makedecisions with respect to the trust, and eachsettlor or other person who has contributedassets to the trust, is a person described inclause (1), (2) or (4); or

4. Any person, acting for its own account or theaccounts of other qualified purchasers, who inthe aggregate owns and invests on a discre-tionary basis, not less than $25,000,000 ininvestments.

A company itself is not a qualified purchaser forpurposes of clauses (2) and (4) above unless all benefi-cial owners are qualified purchasers.34 A company isdeemed a qualified purchaser if all of its beneficialowners are qualified purchasers.

Investments generally includes securities, invest-ment vehicles, public companies, real estate, commod-ity interests, physical commodities, financial contracts,cash and cash equivalents, bank instruments and the netcash surrender value of an insurance policy.35

A family that cannot avail itself of the exemptionsprovided by Section 3(c)(1) and 3(c)(7) of the 1940 Actcould request exemptive relief from the SEC. The SEChas issued an order of exemption in the case of multiplerelated family investment vehicles which soughtexemption from all provisions of the 1940 Act.36 Anorder was granted in 1987 to existing and future invest-ment vehicles primarily owned or controlled by theRockefeller family when the investment vehicles couldno longer rely on the Section 3(c)(1) private investmentcompany exemption of the 1940 Act.

1933 ACT EXEMPT SECURITIES ANDTRANSACTIONS.

Definition.The 1933 Act requires the registration with the

SEC of public offerings of securities. Section 2(a)(1)of the 1933 Act defines “security” as:

…any note, stock treasury stock, secu-rity future, bond debenture, evidence ofindebtedness, certificate of interest orparticipation in any profit-sharingagreement, collateral-trust certificate,preorganization certificate or subscrip-tion, transferable share, investmentcontract, voting-trust certificate, certifi-cate of deposit for a security, fractionalundivided interest in oil, gas, or othermineral rights, any put, call, straddle,option, or privilege on any security,certificate of deposit, or group or indexof securities (including any interesttherein or based on the value thereof),or any put, call, straddle, option or priv-ilege entered into on a national securi-ties exchange relating to foreign cur-rency, or, in general, an interest orinstrument commonly known as a“security,” or any certificate of interestor participation in, temporary or inter-im certificate for, receipt for, guaranteeof, or warrant or right to subscribe to orpurchase, any of the foregoing.

Many family offices use the limited partnership orlimited liability company form of organization.Although interests in either are not specifically

34 15 U.S.C. § 80a-2(a)(51), see 17 C.F.R. § 270.2a51-3[2008]. See also Cabot Wellington, LLC (June 17, 2008), 2008SEC No-Act LEXIS 499.

35 See 17 C.F.R. § 270.0-1 [2008].

36 In the Matter of 5600, Inc., Investment Company ActRelease No. 16004, (Sept. 25, 1987) (52 Fed. Reg. 36856, (Oct. 1,1987)). The order pre-dates the enactment of Section 3(c)(7). Seefootnote 33.


referred to in the 1933 Act definition of security, eachis considered a security as a result of judicial interpre-tations.37 The cases rely on the following elements todetermine whether an investment contract exists:

Investment of money; in a common enterprise; with profits derived from the effortsof others.

Therefore, an interest in a family office pooledinvestment vehicle organized in such a manner is asecurity.

Transaction Exemption – Section 4(2) and Reg. D.Family pooled investment vehicles do not have to

operate under Regulation D38 of the 1933 Act and, con-sequently, do not have to file a Form D Notice of anunregistered offering of securities with the SEC.Instead, such pooled investment vehicles can rely onthe Section 4(2) private offering exemption.

Transactions by an issuer not involving any publicoffering are exempt under Section 4(2) of the 1933 Act.Section 2(a)(4) of the 1933 Act defines issuer as everyperson who issues or proposes to issue any security.39

Reg. D under the 1933 Act is a safe harbor forprivate offerings. An issuer’s compliance with limi-tations as to investors, disclosure and the Form Dnotice of sale filing requirements perfect the Section4(2) exemption from registration. The purposeunderlying the SEC’s adoption of Reg. D is inconsis-tent with the purpose for establishing a family officeand the distribution of interests in family pooledinvestment vehicles.

Reg. D was adopted to provide a coherent patternof exemptive relief as it relates to the capital forma-tion needs of small businesses.40 It was enacted fol-lowing a SEC study on the impact of its rules and reg-ulations on the ability of small businesses to raisecapital and to alleviate disproportionate restraints onsmall issuers. Form D was adopted to provide empir-

ical data to the SEC for rulemaking and to provideinformation necessary to assess the effectiveness ofReg. D as a capital raising device and for investor pro-tection. Recently, the SEC characterized the two pri-mary purposes of the Form D as: “collection of datafor use in the Commissioner’s rulemaking efforts; andenforcement of the federal securities laws, includingenforcement of the exemption in Reg. D.”41 Reg. D isnow used to provide exemptions for certain privateofferings by small and other businesses.42 Familyoffices generally do not file Form D upon formationof the related partnerships or LLCs because the origi-nal intent of the SEC with respect to Reg. D was lim-ited to commercial transactions.

A distribution of interests in a family office pooledinvestment vehicle should qualify for the private offer-ing transaction exemption. In an early advisory opin-ion issued by the general counsel of the SEC, factorswere set forth to be considered in determining theavailability of the Section 4(2) exemption (at that timeSection 4(1)). Included in the factors were:

• The number of persons to whomthe security in question is offeredfor sale and their relationship toeach other and the issuer. Anoffering to members of a classwho should have special knowl-edge of the issuer is more likelyto be a private offering.

• An insubstantial number of unitsusually indicates a private offering,while many units in small denomi-nations is likely to be public.

• The manner of disseminating theoffering should be considered.The purpose of the exemption ofnon-public offering is generallyfor those cases where the issuerwants to consummate a few trans-actions with particular persons.43

37 See 15 U.S.C. § 77(b)(a)(1); Reeves v. Teuscher 881 F. 2d1495 (1989), CCH Fed. Sec. L. Rep. Dec. ¶ 94,541; SEC v. W. J.Howey Co. 328 U.S. 293 (1946), CCH Fed. Sec. L. Rep. Dec. ¶90,341.

38 17 C.F.R. § 230.501 [2008].39 15 U.S.C. § 77b(a)(4).40 Revision of Certain Exemptions from Registration for

Transactions Involving Limited Offers and Sales, Securities Act of1933 Release No. 33-6389 (47 Fed. Reg. 11251, (Mar. 8, 1982));Non-Public Offering Exemption Securities Act of 1933 ReleaseNo. 33-4552 (27 Fed. Reg. 11316, (Nov. 6, 1982)).

41 Securities Act of 1933 Release No. 33-8814 (72 Fed. Reg.37376, (Jun. 29, 2007)).

42 Revision of Certain Exemptions from Registration forTransactions Involving Limited Offers and Sales, Securities Act of1933 Release No. 33-6389 (47 Fed. Reg. 11251, (Mar. 8, 1982));Proposed Revision of Certain Exemptions From the RegistrationProvisions of the Securities Act of For Transactions Involving Lim-ited Offers and Sales, Securities Act of 1933 Release No. 33-6339(46 Fed. Reg. 41791, (Aug. 8, 1981)); Revisions of Limited Offer-ing Exemptions in Regulation D, Securities Act of 1933 ReleaseNo. 33-8828 (72 Fed. Reg. 45116, (Aug. 3, 2007)); Electronic Fil-ing and Regulation of Form D, Securities Act of 1933 Release No.33-8891 (73 Fed. Reg. 10592, (Feb. 6, 2008)).

43 Advisory Opinion Letter of General Counsel, SecuritiesAct of 1933 Release No. 33-285 (Jan. 24, 1935).


The SEC later reiterated the factors to be consideredmore generally stating that:

“Whether a transaction is one notinvolving any public offering is essen-tially a question of fact and necessi-tates a consideration of all surround-ing circumstances, including suchfactors as the relationship between theofferees and the issuer, the nature,scope, size type and manner of theoffering.”44

As a result of judicial and SEC interpretations, theavailability of the Section 4(2) private offering exemp-tion depends on whether the particular class of personsaffected needs the protection of the 1933 Act, particu-larly the information disclosed in the registrationprocess that is necessary to informed investment deci-sions. The U.S. Supreme Court stated that “theexemption question turns on the knowledge of theofferees.”45 The Supreme Court stated in Ralston Puri-na that the quantity of persons to whom an offer ismade does not determine whether the offer is a privateoffering. An examination is required of the circum-stances under which the “private” or “public,” offeringdistinction is being made and the purpose of the dis-tinction.46 Section 4(2) was intended for persons whoare able to fend for themselves. The Court cited the1935 SEC General Counsel’s advisory opinion,47

agreeing that “an offering to the members of a classwho should have special knowledge of the issuer isless likely to be public,” than offerings to persons whodo not have such knowledge.

In sum, the familial relationships coupled with thepresumed access to information makes the Section4(2) private offering exemption available to familyinvestment vehicles.

Commodity Exchange Act. If a family pooled investment vehicle invests in

commodity futures or options contracts, the managerof the investment vehicle could be within the CEA48

definition of commodity trading adviser (“CTA”) and,consequently subject to registration with the NationalFutures Association (“NFA”), a self-regulatory organi-

zation for the futures industry, and regulation by theCommodity Futures Trading Commission (“CFTC”).The manager of the investment vehicle could also bewithin the definition of “commodity pool operator”(“CPO”) with similar consequences. The familypooled investment vehicle could be a “commoditypool” by definition under the CEA and subject to theattendant regulatory scheme. The CFTC has adoptedexemptions that may be available to family officepooled investment vehicles. Family pools that qualifyfor the exemptive rules are required to file a noticewith the NFA.

Definition.Section 1a (5) of the CEA49 defines“commodity pool operator” as:

…any person engaged in a businessthat is of the nature of an investmenttrust, syndicate, or similar form ofenterprise, and who, in connectiontherewith, solicits, accepts, orreceives from others, funds, securi-ties, or property, either directly orthrough capital contributions, the saleof stock or other forms of securities,or otherwise, for the purpose of trad-ing in any commodity for futuredelivery on or subject to the rules ofany contract market or derivativestransaction execution facility.

Section 1a (6) of the CEA50 defines “commoditytrading adviser” as any person who:

1. For compensation or profit, engages in thebusiness of advising others, either directly orthrough publications, writings, or electronicmedia, as to the value of or the advisability oftrading in:(a) Any contract of sale of a commodity for

future delivery made or to be made on orsubject to the rules of a contract market orderivatives transaction execution facility;

(b) Any commodity option authorized undersection 4c of the CEA; or

44 Non-Public Offering Exemption, Securities Act of 1933Release No. 66-4552, (27 Fed. Reg. 11316, (Nov 6, 1982)).

45 Securities and Exchange Commission v. Ralston PurinaCo., 346 U.S. 119 (1953) (hereinafter “Ralston Purina”). This caseresulted from Ralston Purina’s unregistered offer of treasury stockto its key employees, which the SEC sought to enjoin. TheSupreme Court held that the corporation should be required to reg-ister the offering.

46 Securities and Exchange Commission v. Sunbeam GoldMines Co. 95 F.2d 699 (1938).

47 Advisory Opinion Letter of General Counsel, SecuritiesAct of 1933 Release No. 33-285 (Jan. 24, 1935).

48 7 U.S.C. § 1.49 7 U.S.C. § 1a(5).50 7 U.S.C. § 1a(6).


(c) Any leverage transaction authorizedunder section 19 of the CEA; or

2. For compensation or profit, and as part of aregular business, issues or promulgates analy-ses or reports concerning any of the activitiesreferred to in clause (1) above.

Regulation Section 4.10(d)(1) under the CEA51

defines “pool” as:

…any investment trust syndicate orsimilar form of enterprise operatedfor the purpose of trading commodityinterests.

Exemptions.Section 4m(1) of the CEA

Section 4m(1)52 exempts from CTA and CPO reg-istration any CTA who, during the course of the pre-ceding twelve months, has not furnished commoditytrading advice to more than fifteen persons and whohas not held himself out generally to the public as aCTA. Pursuant to Regulation Section 4.14(a)(10)under the CEA,53 a single person is defined as:

1. A natural person (including minor childrenand relatives with the same principal resi-dence, all accounts and trusts); and

2. A corporation, general partnership, limitedpartnership, limited liability company, trust orother such legal entities that have identicalowners, are counted as one person.

Regulation Section 4.13 under the CEA54

exempts from registration certain CPOs where: nocompensation is paid for operating the pool; onlyone pool at a time is operated; each pool has no morethan fifteen participants; the total gross capital con-tributions in all pools in the aggregate does notexceed $400,000; the pool’s interests are exemptfrom regulation under the 1933 Act; all investors areaccredited investors; and a notice of exemption filingis required.

Regulation Section 4.13(a)(i) exempts a CPOfrom registration if the pool has no more than fifteenparticipants at a time. Excluded from counting the fif-teen and excluded from those considered to have madecontributions are:

The pool’s operator, adviser, the prin-cipal and their: children, siblings,parents, spouses, relatives and rela-tives of a spouse with the same princi-pal residence.

This exemption may be used by managers of familypooled investment vehicles. Regulation Section4.13(b) requires that anyone relying on this exemptionmust file electronically a notice of exemption fromCPO registration with the NFA.

CFTC Reg. 4.14(a)(5)55

Section 4.14(a)(5) exempts a person from CTAregistration if:

…it is exempt from registration as acommodity pool operator and the per-son’s commodity trading advice isdirected solely to, and for the sole useof, the pool or pools for which it is soexempt.

Consequently, the manager of the pooled invest-ment vehicle will be exempt from CTA registration ifit limits its futures trading activity to a pool as towhich the manager is eligible to claim an exemptionfrom registration as a CPO.

A family pooled investment vehicle that cannotavail itself of the Reg. §§ 4.13 and 4.14 exemptions,can file a request with the CFTC for an interpretativeletter that excludes the family vehicle and its managersfrom CTA and CPO registration.

The CTFC has issued numerous interpretive letterswhich confirmed that various family investment vehi-cles were not pools, that the operators of the investmentvehicles were not commodity pool operators and thatthe managers that provide investment advice to theinvestment vehicles were not CTAs.56 Some of thecommon facts in the CFTC no-action letters included:the investment vehicle is solely for one extended fami-ly for the purpose of investing the assets of the family;57

the managing partner or member receives reimburse-ment for operating expenses, but not for investmentmanagement services and does not provide investmentmanagement services to other persons or entities; thereis no public solicitation with respect to investment inthe investment vehicles and no activities make the

51 17 C.F.R. § 4.10(d)(1) [2008].52 7 U.S.C. § 6m.53 17 C.F.R. § 4.14(a)(10) [2008].54 17 C.F.R. § 4.13 [2008].55 17 C.F.R. § 4.14(a)(5) [2008].

56 U.S. Commodity Futures Trading Commission interpreta-tive letter 00-98 (May 22, 1998); U.S. Commodity Futures TradingCommission interpretative letter 99-43 (Sept. 15, 1999).

57 U.S. Commodity Futures Trading Commission interpreta-tive letter 99-89 (Oct. 27, 1997).


vehicle a matter of public interest; there are restrictionson transfers of interests; and there is no intent to openthe family vehicles to the general public.

CONCLUSION.

A family office comprised of one or more pooledinvestment vehicles such as limited partnerships andlimited liability companies are generally subject to the1933 Act, the 1940 Act, the Advisers Act and the CEA,including relevant regulations thereunder. There are

exemptions from the registration, recordkeeping andreporting requirements under each of these statutesand the corresponding regulations. Counsel shoulddetermine whether the family office, as structured,may rely on self-executing exemptions, needs to sub-mit a notice to a regulatory authority to perfect anexemption or, in those cases where, because of thefacts, the family cannot avail itself of the exemptions,an application for an exemptive order should be filedwith the SEC, or a no-action letter should be requestedfrom the CFTC.


Editors’ Synopsis: This recently updated chartprovides a summary and comparison of the character-istics and attributes of domestic asset protection trustsin those states which have enacted such legislation.

INTRODUCTION

A domestic asset protection trust (hereinafterreferred to as a “DAPT”) is generally, an irrevocabletrust with an independent trustee who has absolute dis-cretion to make distributions to a class of beneficiarieswhich includes the settlor. The primary goals ofDAPTs are asset protection and, if so designed, trans-fer tax minimization.

Prior to 1997, several states had statutory provi-sions which appear to support the formation ofDAPTs. In 1997, Alaska was the first state to enact ausable DAPT statute. In the ten years since, otherstates have followed suit. There are now eleven(arguably 12, if Colorado is included) states that allowfor the formation of DAPTs.

Legislatures have taken different approaches. Theoriginal statutes are terse and only indicate a publicpolicy (Missouri and Colorado). Some of the newstatutes amend existing statutes, and others enact new“Acts.” Interest groups within the various states haveinfluenced the extent of the asset protection providedby the statutes.

If implemented correctly, the DAPT approachmay be used successfully by residents of states with

DAPT statutes. An interesting issue remains whethernon-residents of DAPT states may form a DAPT underone of the DAPT state’s laws and obtain the desiredasset protection and tax benefits. The analysis of thisissue involves the conflict of laws. The most likelytest is whether the non-resident’s domiciliary state hasa “strong public policy” against DAPT asset protec-tion. The fact that twelve states now have DAPTstatutes moves this approach from the eccentric anom-aly category to an accepted asset protection and trans-fer tax minimization planning technique. As more andmore states enact DAPT statutes, the conclusion that anon-DAPT state has a “strong public policy” against aDAPT trust seems less likely.

The DAPT chart below is designed to give thereader an easy and quick comparison of the variousDAPT statutes. A chart, by its very nature, is an over-simplification. The reader is urged to carefully ana-lyze the provisions of a statute before implementing aDAPT.

The following ACTEC Fellows generouslyreviewed and edited their state’s summaries foraccuracy: Marc A. Chorney (Colorado); Richard G.Bacon (Delaware); Larry P. Katzenstein (Missouri);Layne Rushforth (Nevada); William Zorn (NewHampshire); Richard B. Kells (Oklahoma); MaryLouise Kennedy (Rhode Island); John H. Raforth(South Dakota); Bryan Howard (Tennessee);Thomas Christensen, Jr. (Utah); and Robert H.Leonard (Wyoming).

* Copyright 2009 by David G. Shaftel. All rights reserved.

Comparison of the Twelve Domestic AssetProtection Statutes

Updated Through November, 2008

by David G. Shaftel Anchorage, Alaska*


SUBJECT ALASKA COLORADO** DELAWARE MISSOURI

Citation:Alaska Stat. § 34.40.110

Effective Date:April 2,1997

URL:http://www.legis.state.ak.us

Citation:Colo. Rev. Stat. §§ 38-10-111

Effective Date: 1861

URL:http://www.state.co.us

Citation:Del. Code Ann. tit. 12, §§ 3570-3576

Effective Date:July 1, 1997

URL:http://www.delcode.state.de.us

Citation:Mo. Rev. Stat. §§ 456.5-505

Effective Date: 1989

URL:http://www.moga.mo.gov

1. What require-ments must trustmeet to comewithin protectionof statute?

Trust instrumentmust: (1) be irrevo-cable; (2) expresslystate AK law governsvalidity, construction,and administration oftrust (unless trust isbeing transferred toAK trustee from non-AK trustee); (3) contain spend-thrift clause.

In trust, limited tofuture creditors.

Trust instrumentmust: (1) be irrevo-cable; (2) expresslystate that DE lawgoverns validity, con-struction, and admin-istration of trust(unless trust is beingtransferred to DEtrustee from non-DEtrustee); (3) contain spend-thrift clause.

Trust instrumentmust: (1) be irrevo-cable; (2) contain aspendthrift clause;(3) have more thanthe settlor as a beneficiary;(4) settlor’s interestmust be discretionary.

2. May a revocabletrust be used forasset protection?

No. No. No. No.

3. Has the state legislature consis-tently supportedDAPTs and related estateplanning by continuedamendments?

Yes, amendmentsenacted in: 2006,2004, 2003, 2001,2000, and 1998.

No amendments. Yes, amendmentsenacted in: 2008,2007, 2006, 2005,2003, 2002, 2001,2000, and 1998.

Amendments enactedin 2004.

4. What contactswith state aresuggested orrequired to establish situs?

Suggested: (1) someor all of trust assetsdeposited in state; (2) AK trustee whosepowers include (a) maintainingrecords (can be non-exclusive), (b) pre-paring or arrangingfor the preparation ofincome tax returns(can be non-exclu-sive); (3) part or all of the administrationoccurs in state,including mainte-nance of records.

Not addressed bystatute.

Required: (1) some orall of trust assetsdeposited in state; (2) DE trustee whosepowers include (a) maintainingrecords (can be non-exclusive),(b) preparing orarranging for thepreparation of incometax returns; (3) or, otherwisematerially partici-pates in the admin-istration of the trust.

Principal place ofbusiness or residenceof trustee in designat-ed jurisdiction, orpresence of all or partof the administrationin designated juris-diction; statuteincludes procedurefor transfer of princi-pal place of business. RSMo § 456.11-1108

** It is unclear whether Colorado’s statutue qualifies as a DAPT statute. Compare In Re Baum, 22 F.3d 1014, 1017 (10th Cir. 1994), with Inthe Matter of Cohen, 8 P.3d 429 (Colo. 1999). See also Howard D. Rosen and Gideon Rothschild, 810 2nd T.M., ASSET PROTECTION PLAN-NING, A-96 (2008) (contending that the Colorado statute qualifies as a DAPT statute as to future creditors).



5. What interests in principal andincome may settlor retain?

Settlor may retaininterests in: (1) CRT;(2) total-return trust;(3) GRAT or GRUT;(4) QPRT; (5) IRA.


Settlor may retaininterests in: (1) cur-rent income; (2) CRT;(3) up to 5% interestin total-return trust;(4) GRAT or GRUT;(5) QPRT; (6) quali-fied annuity interest;(7) ability to be reim-bursed for incometaxes attributable totrust; and (8) theability to have debts,expenses and taxes ofthe settlor’s estatepaid from the trust.

Settlor may be one ofa class of beneficia-ries of a trust discre-tionary as to incomeor principal.RSMo § 456.5-505.3

6. What is trustee’sdistributionauthority?

Absolute discretion. Not addressed bystatute.

(1) Discretion; or (2) pursuant to astandard.

Not directlyaddressed by statute.

7. What powersmay settlorretain?

Settlor may retain:(1) power to veto dis-tributions; (2) non-general testamentarypower of appoint-ment; and (3) right toappoint trust protec-tor of trustee advisor.


Settlor may retain:(1) power to veto distributions; (2) non-general testa-mentary power ofappointment; and (3) power to replacetrustee/advisor.

None.

9. May non-quali-fied trusteesserve?

Yes. Not addressed bystatute.

Yes, as a co-trustee. Not addressed bystatute.

10. May trust havedistribution advi-sor, investmentadvisor, or trustprotector?

Yes. Trust may havetrust protector (whomust be disinterestedthird party) andtrustee advisor. Sett-lor may be advisor ifdoes not have trusteepower over discre-tionary distributions.


Yes. Trust may haveone or more advisors(other than trustor)who may remove andappoint qualifiedtrustees or trust advi-sors or who haveauthority to direct,consent to, or


8. Who must serveas trustee tocome within protection ofstatute?

Alaska trustee notrequired, but suggest-ed to establish situs.Resident individual ortrust company orbank that possessestrust powers and hasprincipal place ofbusiness in Alaska.


Resident individual orcorporation whoseactivities are subjectto supervision byDelaware Bank Commissioner, FDIC,Comptroller of Currency, or Office of Thrift Supervision.





10. (Continued) disapprove distribu-tions from trust.Trust may haveinvestment advisor,including trustor. The term “advisor”includes a protector.

11. Are fraudulenttransfers excepted fromcoverage?

Yes. Alaska has notadopted UniformFraudulent TransferAct. Alaska statutesets aside transfersmade with intent todefraud.

Yes. Uniform Fraudu-lent Transfer Actapplies and sets asidetransfers with intentto hinder, delay ordefraud, and transfersmade with construc-tive fraudulent intent.

Yes. Uniform Fraudu-lent Transfer Actapplies and sets asidetransfers with actualintent to hinder, delayor defraud, and trans-fers made with con-structive fraudulentintent. However,future creditors mayset aside transfer onlyif transfer made withintent to defraud.

Yes. Uniform Fraudu-lent Transfer Actapplies and sets asidetransfers with intentto hinder, delay ordefraud, and transfersmade with construc-tive fraudulent intent.RSMo § 456.5-505.

12. Fraudulenttransfer action:burden of proofand statute oflimitations.

Burden not addressedby statute.Existing creditors:Four years after trans-fer, or one year aftertransfer was or couldreasonably have beendiscovered, but futurecreditor must estab-lish claim within fouryears after transfer.Future creditors: Fouryears after transfer.

Clear and convincingevidence.Existing creditors andfuture creditors: Fouryears after transfer, orone year after transferwas or could reason-ably have been dis-covered if claimbased upon intent tohinder, delay ordefraud. Four yearsafter transfer if claimbased upon construc-tive fraud.

Clear and convincingevidence.Existing creditors:Four years after trans-fer, or one year aftertransfer was or couldreasonably have beendiscovered if claimbased upon intent tohinder, delay ordefraud. Four yearsafter transfer if claimbased upon construc-tive fraud.Future creditors: Fouryears after transfer.


13. Does statute pro-vide an exception(no asset protec-tion) for a childsupport claim?

Yes, if settlor was 30 days or more indefault of mak-ingpayment at time oftransfer of assets totrust.

No. Yes. Yes.RSMo § 456.5-503.2

14. Does the statuteprovide anexception (noasset protection)for alimony?

No. No. Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust.

Yes.RSMo § 456.5-503.2




15. Does statute pro-vide an exception(no asset protec-tion) for proper-ty division upondivorce?

Yes, if assets weretransferred to trustduring or less than 30 days prior to marriage. Otherwise,assets are protected.

No. Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust. Otherwise,assets are protected.

No.

16. Does statute pro-vide an exception(no asset protec-tion) for tortclaims?

No. No. Yes, for claims thatarise as a result ofdeath, personal injury,or property damageoccurring before or onthe date of transfer.

No.

17. Does statute provide otherexpress excep-tions (no assetprotection)?

No. No. No. Yes if another governing lawsupercedes.

18. Does statute pro-hibit any claimfor forced heir-ship, legitime orelective share?

No. No. Yes. No.

19. Are there provi-sions for movingtrust to state andmaking it subjectto statute?

Yes. No. Yes. No.

21. Does statute pro-vide that trusteeautomaticallyceases to act ifcourt has juris-diction anddetermines thatlaw of trust doesnot apply?

No. No. Yes. No.

20. Does statute pro-vide that spend-thrift clause istransfer restric-tion described inSection 541(c)(2)of the Bankrupt-cy Code?

Yes. No. Yes. No.




22. Does statute provide thatexpress/impliedunderstandingsregarding distri-butions to settlorare invalid?

Yes. No. Yes. No.

23. Does statute pro-vide protectionfor attorneys,trustees, and others involvedin creation andadministration of trust?

Yes, and also pro-vides protection forfunding limited part-nerships and LLCs.

No. Yes. No.

24. Does statuteauthorize a bene-ficiary to use oroccupy realproperty orintangible per-sonal propertyowned by trust,if in accordancewith trustee’sdiscretion?

Yes. No. No, except for QPRTresidence.

No.

25. Is a non-settlorbeneficiary’sinterest protect-ed from propertydivision atdivorce?

Yes, and may not beconsidered in proper-ty division.

Increases in the valueof and income fromseparate propertyafter marriage aremarital property.

Yes, but may be con-sidered in propertydivision.


26. Are due dili-gence proce-dures requiredby statute?

Yes; affidavitrequired.

No. No. No.

27. Is the trusteegiven a lienagainst trustassets for costsand fees incurredto defend thetrust?

Yes. No. Yes. Yes.RSMo § 456.7-709.




28. Is there statutoryauthority sup-porting a trust’snon-contestabili-ty clause even ifprobable causeexists for contest?

Yes. No. Yes. No.

29. Is the trusteegiven “decant-ing” authority tomodify the trust?

Yes. No. Yes. No.

32. Have state limit-ed partnershipand LLCstatutes beenamended to provide maxi-mum creditorprotection?

Yes, charging order isonly remedy.




30. What is allow-able duration oftrusts?

Up to 1,000 years. Up to 1,000 years. Abolished rule againstperpetuities for per-sonal property (whichincludes LLC and LPinterests). 110 yearsfor real property.

Abolished ruleagainst perpetuitieswhen trustee haspower of sale; gener-ally effective fortrusts created only on or after August 28,2001.RSMo § 456.025.1

31. Does state assertincome taxagainst DAPTsformed by non-resident settlors?

No. Yes. No. However, doesimpose its income taxupon trusts that accu-mulate income forDelaware residents.

Yes, if from sourceswithin Missouri.Probably no if frommarketable securities.

33. What is the procedure andtime period for atrustee to providean accountingand be dis-charged from liability?

(1) Trustee petitionand court discharge;or (2) six monthsafter trustee providesreport that adequatelydiscloses claims.

Six months afterreceipt of a finalaccount or otherstatement fully dis-closing the matter andshowing terminationof the trust relation-ship between thetrustee and the beneficiary.

Trustee filing andcourt discharge. Discharge occurs twoyears after delivery of statement that dis-closes the facts givingrise to the claim.(Accountings do nothave res judicataeffect in Delawareexcept as to mattersactually contested inthe accounting pro-ceeding.)

One year after trusteeprovides report thatadequately disclosesclaims.RSMo § 456.10-1005.



SUBJECT NEVADA NEW HAMPSHIRE OKLAHOMA RHODE ISLAND


Trust instrumentmust: (1) be irrevoca-ble; (2) all or part ofcorpus of trust mustbe located in Nevada,domicile of settlormust be in Nevada, ortrust instrument mustappoint Nevadatrustee; and(3) distributions tosettlor must beapproved by someoneother than the settlor.

Trust instrumentmust: (1) be irrevoca-ble; (2) expresslystate that NH lawgoverns validity, con-struction, and admin-istration of trust(unless trust is beingtransferred to NHtrustee from non-NHtrustee); (3) contain spend-thrift clause.

Trust instrument maybe revocable or irrev-ocable. Trust instru-ment must:(1) expressly stateOklahoma law gov-erns; (2) have quali-fied beneficiaries(ancestors or descen-dants of grantor,spouse of the grantor,charities, or trusts forsuch beneficiaries);(3) recite that incomesubject to income taxlaws of Oklahoma; (4) limited to$1,000,000 of assetsplus growth.

Trust instrumentmust: (1) be irrevo-cable; (2) expresslystate R.I. Law governs validity,construction, andadministration oftrust; (3) containspendthrift clause.


No. No. Yes. Settlor mayrevoke or amend trustand take back assets.No court or otherjudicial body maycompel such revoca-tion or amendment.

No.

3. Has the state legislature consis-tently supportedDAPTs and relat-ed estate planningby continuedamendments?

Yes. The 2007 legis-lature approved minoramendments.

No amendments.Statute first enactedin 2008.

Yes, amendmentenacted in 2005.

Yes, amendmentenacted in 2007.

4. What contactswith state are sug-gested or requiredto establish situs?

Required: (1) all orpart of assets are instate; (2) Nevadatrustee whose powersinclude:(a) maintainingrecords, (b) prepar-ing income taxreturns; (3) all or part

Required: (1) some orall of trust assetsdeposited in state; (2) NH trustee whosepowers include (a) maintainingrecords (can benonexclusive),(b) preparing or

Required:(1) Oklahoma trustee; (2) majority of valueof assets comprisedof Oklahoma assets.

Required: (1) some orall of trust assetsdeposited in state; (2) R.I. trustee whosepowers include:(a) maintainingrecords (can be non-exclusive),(b) preparing or

Citation:Nev. Rev. Stat. §§166.010-166.170

Effective Date:Oct. 1, 1999

URL:http://www.leg.state.nv.us

Citation:N.H. Rev. Stat. Ann. § 564-D: 1 -18

Effective Date:Jan. 2, 2009

URL:http://www.gencourt.state.nh.us

Citation:Okla. Stat. tit. 31 § 11,et seq.

Effective Date:June 9, 2004

URL:http://www.lsb.state.ok.us

Citation:R.I. Gen Laws §§ 18-9.2-1 - 18-9.2-7


URL:http://www.rilin.state.ri.us



5. What interests inprincipal andincome may settlor retain?


Settlor may retaininterests in: (1) cur-rent income; (2) CRT;(3) up to five percentinterest in total returntrust; (4) QPRT; (5) GRAT or GRUT;(6) the ability to havedebts, expenses andtaxes of the settlor’sestate paid from thetrust; (7) ability to be reimbursed forincome taxes attribut-able to trust.

Irrevocable trusts: notaddressed by statute.Revocable trusts: seeItem 7.

Settlor may retaininterests in: (1) cur-rent income; (2) CRT;(3) up to five percentinterest in total returntrust; QPRT; ability tobe reimbursed forincome taxes attribut-able to trust.


Absolute discretion. (1) Discretion; or (2) pursuant to anascertainable standard.

Irrevocable trusts: notaddressed by statute.Revocable trusts: seeItem 7.

Discretion, or pur-suant to a standard.

8. Who must serveas trustee to comewithin protectionof statute?

Resident individual ortrust company orbank that maintainsoffice in Nevada.

Resident individual ora state or federallychartered bank ortrust company havinga place of business inNew Hampshire.

Oklahoma basedbank or credit unioninsured by FDIC orNCUA or Oklahomabased trust companychartered under Okla-homa law or national-ly chartered, and hasplace of business inOklahoma.

Resident individual(other than the trans-feror) or corporationwhose activities aresubject to supervisionby R.I. Dept. of Business Regulation,FDIC, Comptroller of Currency, or Officeof Thrift Supervision.

7. What powers maysettlor retain?

Settlor may retain:(1) power to veto distributions; and (2) special testamen-tary power ofappointment or othersimilar power.

Settlor may retain:(1) power to veto distributions; (2) non-general testa-mentary power ofappointment; and (3) power to replacetrustee/advisor withnonrelated/nonsubor-dinate party.

Irrevocable trusts: notaddressed by statute.Revocable trusts:settlor may revoke oramend.

Settlor may retain:(1) power to veto distributions; and (2) special testamen-tary power ofappointment.

4. (Continued) of administration instate.

arranging for thepreparation of incometax returns; (3) or,otherwise materiallyparticipates in theadministration of thetrust.

arranging for thepreparation of incometax returns; (3) or,otherwise materiallyparticipates in theadministration of thetrust.



10. May trust havedistributionadvisor, invest-ment advisor, ortrust protector?


Yes. Trust may haveone or more trustadvisors who mayremove and appointqualified trustees ortrust advisors or whohave authority todirect, consent to, ordisapprove distribu-tions from trust.“Trust advisor”includes a trust pro-tector or any otherperson who holds oneor more trust powers.


Yes. Trust may haveone or more advisors(other than trustor)who may remove andappoint qualifiedtrustees or trust advisors or who haveauthority to direct,consent to, or disap-prove distributionsfrom trust. Trust mayhave investment advi-sor, including trustor.The term “advisor”includes a protector.


Clear and convincingevidence.Future creditors:Two years after trans-fer.Existing creditors:Two years after trans-fer, or, if longer, sixmonths after transferwas or could reason-ably have been dis-covered if claimbased upon intent tohinder, delay ordefraud (rather thanconstructive fraud).2007 amendment(effective 10/1/2007)provides that transferis deemed discoveredwhen reflected in apublic record.

Case law: Actualfraud must be provedby clear and convinc-ing evidence; con-structive fraud by apreponderance of theevidence.Existing creditors:Four years after trans-fer, or one year aftertransfer was or couldreasonably have beendiscovered if claimbased upon intent tohinder, delay ordefraud. Four yearsafter transfer if claimbased upon construc-tive fraud.Future creditors: Fouryears after transfer.


Clear and convincingevidence.Existing creditors:Four years after trans-fer, or one year aftertransfer was or couldreasonably have beendiscovered if claimbased upon intent tohinder, delay ordefraud. Four yearsafter transfer if claimbased upon construc-tive fraud.Future creditors: Fouryears after transfer.


Yes. Uniform Fraudu-lent Transfer Actapplies, and sets asidetransfers with intentto hinder, delay ordefraud, and transfersmade with construc-tive fraudulent intent.




9. May non-qualified trusteesserve?

Yes. Yes. Yes. Yes.




No. Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust.

No. Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust.




17. Does statute pro-vide otherexpress excep-tions (no assetprotection)?

No. No. Yes, statute does notprotect excess over$1,000,000 of con-tributed property.

No.


No. Yes, for claims thatarise as a result ofdeath, personal injury,or property damageoccurring before or onthe date of transfer.

No. Yes, for claims thatarise as a result ofdeath, personal injury,or property damageoccurring before or onthe date of transfer.


No. No. No. No.


No. Yes. Yes. Yes.


No. Yes, unless the trans-feror made the quali-fied disposition forthe purpose of defeat-ing the survivingspouse’s electiveshare rights.

No. No.


No. Yes. Yes. Yes, if at the time oftransfer a court orderfor child supportexisted.




No. Yes. No. Yes.


No. No, except for QPRTresidence.

No. No, except for QPRTresidence.


No. Yes. No. Yes.


Yes, if property isretained in a spend-thrift trust for thebeneficiary. Even ifnot retained in trust,property received bygift or inheritance isthe beneficiary’s sep-arate property; how-ever, trust income andassets can be consid-ered a resource forpurposes of determin-ing alimony and childsupport.

No, however case lawestablishes that onlyvested and definedtrust interests areincluded in the valua-tion of maritalestates.

Yes, if property isretained in a spend-thrift trust for thebeneficiary. Even ifnot retained in trust,property received bygift or inheritance isthe beneficiary’s sep-arate property; how-ever, trust income andassets can be consid-ered a resource forpurposes of determin-ing alimony and childsupport.



No. No. No. Yes.




No. Yes. No. Yes.

29. Is the trusteegiven “decant-ing” authority tomodify the trust?

No. Yes.N.H. Rev. Stat. Ann. § 564-B: 4-418.

No. No.

28. Is there statutoryauthority sup-porting a trust’snon-contestabilityclause even ifprobable causeexists for contest?

No. No. No. No.

32. Have state limit-ed partnershipand LLC statutesbeen amended toprovide maxi-mum creditorprotection?





33. What is the pro-cedure and timeperiod for atrustee to providean accountingand be dischargedfrom liability?

Trustee petition andcourt discharge.

One year after trusteeprovides report thatadequately disclosesclaims.N.H. Rev. Stat. Ann. § 564-B: 10-1005.

Two years aftertrustee providesreport that adequatelydiscloses claims.

Trustee applicationand court discharge.


Up to 365 years. Abolished ruleagainst perpetuities ifthe trust instrumentexpressly exempts theinstrument from therule against perpetu-ities and a trustee hasthe power to sell.

Rule against perpetu-ities.

Abolished ruleagainst perpetuities.


No. Nevada has nostate income tax.

Yes Yes No

26. Are due diligenceproceduresrequired bystatute?

No. No. No. No.


SUBJECT SOUTH DAKOTA TENNESSEE UTAH WYOMING


Trust instrumentmust:(1) be irrevocable; (2) expressly statethat S.D. law governsvalidity, construction,and administration oftrust (unless trust isbeing transferred toS.D. trustee fromnon-S.D. trustee); (3) contain spend-thrift clause; specifi-cally refer to S.D.Act.

Trust instrumentmust:(1) be irrevocable; (2) expressly state TNlaw governs validity,construction andadministration of thetrust; (3) contain aspendthrift clause.

Trust instrumentmust: (1) be irrevoca-ble; (2) containspendthrift clause.

Trust instrumentmust: (1) state thattrust is a “qualifiedspendthrift trust”under § 4-10-510 ofWyoming statutes; (2) be irrevocable; (3) expressly stateWyoming law gov-erns validity, con-struction and admin-istration of the trust;(4) contain a spend-thrift clause; (5) sett-lor must have person-al liability insuranceequal to lesser of$1,000,000 or valueof trust assets.


No. No. No. No.

3. Has the state legis-lature consistentlysupported DAPTsand related estateplanning by con-tinued amend-ments?

No amendments. Yes. Amendmentsenacted in 2008.Public Chapter No.1010.

No amendments. No amendments toDAPT statute whichwas enacted in 2007.However, Legislaturehas annually support-ed estate and trustlegislation.

4. What contactswith state are sug-gested or requiredto establish situs?

Suggested: (1) someor all of trust assetsdeposited in state; (2) S.D. trusteewhose powers include(a) maintainingrecords (can be non-exclusive), (b) pre-paring or arrangingfor the preparation ofincome tax returns;(3) or otherwise materially participatesin the administrationof the trust.

Required: (1) some orall of trust assetsdeposited in state; (2)Tennessee trusteewhose powers include(a) maintainingrecords (can be non-exclusive), (b) prepar-ing or arranging forthe preparation ofincome tax returns;(3) or, otherwisematerially partici-pates in the adminis-tration of the trust.

Required: (1) Utahtrust company; (2)some or all of theassets held in certaintypes of accounts instate.

Required: Wyomingtrustee who: (a) main-tains custody of someor all of trust assets instate; (b) maintainsrecords (can be nonexclusive); (c) pre-pares or arranges forthe preparation ofincome tax returns;(d) or, otherwisematerially partici-pates in the adminis-tration of the trust.

Citation:S.D. Codified Laws§§ 55-16-1 - 55-16-17

Effective Date:March 2, 2005

URL:http://www.legis.state.sd.us

Citation:Tenn. Code Ann. § 35-16-101


URL:http://www.legislature.state.tn.us

Citation:Utah Code Ann. § 25-6-14

Effective Date:December 31, 2003

URL:http://www.le.utah.gov

Citation:Wyo. Stat. §§ 4-1-505 and 4-10-510 - 523


URL:http://legisweb.state.wy.us




(1) Absolute discre-tion; (2) pursuant to anascertainable standard.

(1) Absolute discre-tion; (2) pursuant to astandard.

(1) Absolute discre-tion; (2) pursuant to anascertainable standard.

(1) Absolute discre-tion; (2) pursuant to astandard.

7. What powersmay settlorretain?

Settlor may retain:(1) power to veto dis-tributions; (2) non-general testamentarypower of appoint-ment; and (3) powerto replace trustee/advisor with nonrelat-ed/nonsubordinateparty.

Settlor may retain:(1) power to veto dis-tribu-tions; (2) non-general testamentarypower of appoint-ment; (3) power toreplace trustee/advisor with nonrelat-ed/nonsubordinateparty; and (4) serve as an investmentadvisor.

Settlor may retain:(1) power to veto dis-tributions; (2) testa-mentary specialpower of appoint-ment; and (3) powerto appoint nonsubor-dinate advisors/protectors.

Settlor may retain:(1) power to veto dis-tributions; (2) intervivos or testamentarygeneral or limitedpower of appoint-ment; (3) power toadd or remove atrustee, trust protec-tor, or trust advisor;(4) serve as an invest-ment advisor.

8. Who must serveas trustee tocome within protection ofstatute?

Resident individual orcorporation whoseactivities are subjectto supervision byS.D. Division ofBanking, FDIC,Comptroller of Currency, or Office of Thrift Supervision.S.D. trustee automati-cally ceases to serveif it fails to meetthese requirements.

Resident individual,or is authorized byTennessee law to actas a trustee and whoseactivities are subjectto supervision by theTennessee Dept. ofFinancial Institutions,the FDIC, the Comp-troller of the Curren-cy, or the Office ofThrift Supervision, orany successor thereto.

Institution authorizedto engage in trustbusiness in Utah,including Utahdepository institu-tions, non-Utahdepository institu-tions authorized to do business in Utah,and certain otherinstitutions.

Resident individual ora person authorizedby Wyoming law toact as trustee or a regulated financialinstitution.

9. May non-qualified trusteesserve?

Yes Yes Yes. Individual co-trustees may serve.

Yes

10. May trust havedistributionadvisor, invest-ment advisor, ortrust protector?

Yes. Trust may haveone or more advisors(other than trustor)who may remove andappoint qualifiedtrustees or trust advi-sors or who haveauthority to direct,consent to, or disap-prove distributionsfrom trust. Trust mayhave investment advi-sor, including trustor.

Yes. Trust may have:(1) advisors who haveauthority to removeand appoint qualifiedtrustees or trust advi-sors; (2) advisors whohave authority todirect, consent to ordisapprove distribu-tions from the trust;and (3) investmentadvisors. The term“advisor” includes atrust protector.

Yes. Trust may havenon-subordinate advi-sors/protectors whocan remove orappoint trustees;direct, consent to, ordisapprove distribu-tions; or serve asinvestment directors.Settlor may be invest-ment director.

Yes. Trust may havetrust protector whocan remove orappoint trustees;direct, consent to, ordisapprove distribu-tions; change govern-ing law; change bene-ficiary’s interests; andgrant or terminatepowers of appoint-ment. Trust may haveadvisors. Settlor maybe an advisor.

5. What interests inprincipal andincome may sett-lor retain?

Settlor may retaininterests in: (1) cur-rent income; (2) CRT;(3) up to 5% interestin total-return trust;(4) GRAT or GRUT;(5) QPRT.

Settlor may retaininterests in:(1) current income;(2) CRT; (3) up to 5%interest in total-returntrust; (4) QPRT.

Settlor may retaininterest in CRT.

Settlor may retaininterests in:(1) current income;(2) CRT; (3) up to 5%interest in total-returntrust; (4) QPRT.





Burden not addressedby statute.Existing creditors:Four years after trans-fer, or one year aftertransfer was or couldreasonably have beendiscovered if claimbased upon intent tohinder, delay ordefraud. Four yearsafter transfer if claimbased upon construc-tive fraud.Future creditors: Fouryears after transfer.


Burden not addressedby statute.Existing creditors andfuture creditors: Fouryears after transfer, orone year after transferwas or could reason-ably have been dis-covered if claimbased upon intent tohinder, delay ordefraud. Four yearsafter transfer if claimbased upon construc-tive fraud.


Yes. Yes. Yes. Yes.


Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust. Otherwise,assets are protected.

Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust. Otherwise,assets are protected.

Yes. No.


Yes, for claims thatarise as a result ofdeath, personal injury,or property damageoccurring before or onthe date of transfer.

No. Yes, see Item 17,below.

No.


Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust.

Yes, if ex-spouse wasmarried to settlorbefore or on date oftransfer of assets totrust.

Yes. No.









No. No. No. No.


Yes. Implied, based on atrustee’s power tomake contributions toa DAPT.

Yes. Yes, permits transferof trust property fromtrust created in anoth-er jurisdiction withsimilar creditor pro-tection for settlorwith creditor protec-tion relating back todate of funding oftrust created in otherjurisdiction. Irrevo-cable trusts fromother states may alsoelect to become quali-fied spendthrift trustsif they incorporatelaw of Wyoming,obtain qualifiedtrustee, and havespendthrift clause.


Yes. Yes. Yes. Yes.

17. Does statute provide otherexpress excep-tions (no assetprotection)?

No. No. Yes: (1) claim is deci-sion or ruling result-ing from judicial,arbitration, media-tion, or administrativeproceeding com-menced prior to orwithin three yearsafter trust created; (2)public assistance; (3)taxes; (4) violation ofcertain written repre-sentations or agree-ments; (5) fraud.

Yes. (1) Qualifiedtrust property that islisted upon an appli-cation or financialstatement used toobtain or maintaincredit other than forthe benefit of thequalified spendthrifttrust; (2) property ofa qualified spendthrifttrust that was trans-ferred to the trust by asettlor who receivedthe property by afraudulent transfer.




Yes. Yes. No. No.


Yes. Yes. Yes. Yes.


Yes. Yes. No. No, except for QPRTresidence.


No. Yes, but may be con-sidered in propertydivision.

No. Yes, but may be con-sidered in propertydivision.

26. Are due diligenceproceduresrequired bystatute?

No. Yes; affidavitrequired.

No. Yes; affidavitrequired.


No. Yes. No. Yes.



28. Is there statutoryauthority sup-porting a trust’snon-contestabilityclause even ifprobable causeexists for contest?

No. No. No. No.


Abolished ruleagainst perpetuities.

Up to 360 years. Up to 1,000 years. Up to 1,000 years,except for real prop-erty.

29. Is the trusteegiven “decanti-ng” authority tomodify the trust?

Yes. Yes. No. No, but trust protectormay have a similarpower.

33. What is the pro-cedure and timeperiod for atrustee to pro-vide an account-ing and be dis-charged from liability?

180 days after trusteeprovides accounting,or by order of courtfor supervised trusts.

One year after trusteeprovides report thatadequately disclosesclaims.

Six months aftertrustee providesreport that adequatelydiscloses claims.

Two years aftertrustee providesreport that adequatelydiscloses claims.


No. No, if the beneficia-ries are nonresidents. If the beneficiariesare residents, a tax islevied on dividendsand interest.

No, except for Utahsource income, suchas rental income fromUtah real property.

No.

32. Have state limit-ed partnershipand LLC statutesbeen amended toprovide maxi-mum creditorprotection?

Yes; charging order isonly remedy.

Yes for LLCs; charg-ing order is only rem-edy.

No for LPs.


Yes; charging order isexclusive remedy.


Yes. Yes. Yes. Yes.


Volume 34, No. 4, Spring 2009

© 2009 The American College of Trust and Estate Counsel. All Rights Reserved.

The ACTEC Journal (ISSN 1544-4945) is published quarterly for the Fellows of The

American College of Trust and Estate Counsel as a professional service.

Members of the College receive a subscription to ACTEC Journal without charge. Non-

members may subscribe to ACTEC Journal for $60 per year. Price for single issue, if available, is

$15 per issue.

This publication contains articles that express various opinions. The opinions expressed in

such articles are those of the authors and do not necessarily reflect the opinion of the College.

Correspondence with respect to College business may be addressed to Executive Director,

The American College of Trust and Estate Counsel, 3415 S. Sepulveda Boulevard, Suite 330,

Los Angeles, California 90034. Telephone: (310) 398-1888. Fax: (310) 572-7280.

Website: www.actec.org.

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