DOJ Argues Couple Transferred Limited Partnership Interests Not Assignee Interests

In 1993 Baine and Mildred Kerr and their children formed two family limited partnerships, KFLP and KILP, under Texas law. The Kerrs contributed all the capital and were the sole general partners, but they immediately assigned a portion of each to their children. The partnership agreements restricted dispositions of partnership interest to any persons other than "permitted assignees" (descendants of the Kerrs or certain entities owned by such assignees). The agreements also stated that the partnerships would dissolve and liquidate at the end of 2043, by agreement of all partners, or on the occurrence of certain acts of dissolution, whichever occurred earlier.

In June 1994 the Kerrs transferred limited partnership interests in both KFLP and KILP to the University of Texas. On December 28, Baine and Mildred each created a GRAT and transferred a 44.5 percent limited partnership interest in KFLP. The GRATs were permitted assignees. On December 31 of 1994 and 1995, the Kerrs transferred additional class B limited partnership interests to each child.

The Kerrs filed gift tax returns for 1994, reporting tax liabilities attributable to their transfers to the GRAT trustees and to their children. They valued the KFLP limited partnership interests transferred to the GRATs by applying discounts for lack of liquidity and minority interest; for the value of the KILP limited partnership interests transferred to their children, they applied a discount for lack of liquidity.

The IRS determined deficiencies against both Blaine and Mildred for both 1994 and 1995, asserting that the couple had understated the values of the transferred partnership interests. The IRS determined that the liquidation restrictions in the partnership agreements were "applicable restrictions" within the meaning of section 2704(b) and, thus, that the liquidation restrictions should have been disregarded in the valuations, i.e., that no liquidity discount was allowable.

The Tax Court rejected the Kerrs' contention that they merely transferred assignee interests to the GRATs and held that the couple transferred limited partnership interests. But the court then determined that section 2704(b) did not apply because the partnership agreements' liquidation restrictions were not "applicable restrictions" under section 2704(b)(3)(B) and reg. section 25.2704- 2(b). The court concluded that the dissolution and liquidation provision contained in the partnership agreements was no more restrictive than the limitations that would apply generally to the partnership under Texas law, thus under reg. section 25.2704-2(b), the partnerships' dissolution and liquidation provisions were not "applicable restrictions." (For a summary of this opinion, see Tax Notes, Jan. 3, 2000, p. 72; for the full text, see Doc 2000-296 (41 original pages) or 1999 TNT 247-58 .)

The Justice Department argues that the Tax Court correctly held that the Kerrs', in substance as in form, transferred limited partnership interest to themselves. The DOJ emphasizes that the couple's lack of formality in admitting their children as general partners of KFLP contradicts their claim that the children's formal consent was required for their own admission as limited partners. The Justice Department further insists that the documentary evidence and the objective economic realities underlying the transfers show that the transferred interests were limited partnership interests in form and substance. Finally, the DOJ argues that even if the transferred interests were assignee interests, under Texas law, section 2704(b) applies to those interests.

[1] Pursuant to Local Rule 28.2.4 of this Court, the Commissioner, as appellant-cross-appellee herein, hereby respectfully informs the Court that he believes that oral argument would be of material assistance to the Court because this is a case of first impression.

TABLE OF CONTENTS

REPLY BRIEF FOR THE COMMISSIONER AS APPELLANT

[2] This reply brief is directed to those matters in the answering brief of the appellees that warrant a response. With respect to matters relating to the Commissioner's appeal that are not addressed herein, we rely on our opening brief.

[3] 1. In our opening brief, we argued (pp. 20-41) that the Tax Court erred in holding that the restrictions in the Kerr partnership agreements limiting a partner's right to liquidate his limited partnership interest were not "applicable restrictions" within the meaning of I.R.C. section 2704(b). Specifically, we contended (pp. 30-36) that the Tax Court incorrectly held that restrictions on a limited partner's right to withdraw his partnership interest were not restrictions on liquidation for purposes of the statute. We explained that the express language of Treas. Reg. section 25.2704-2(b), the congressional purpose behind section 2704, the statute's intended broad scope, and the guidance of Treas. Reg. section 25.2704-2(d) (Example 5) all demonstrated that section 2704(b) reaches restrictions on liquidation of a particular interest in an entity.

[4] Taxpayers, however, attempt (Br. 35) to defend the Tax Court's conclusion by noting that a limited partner can withdraw from a partnership without causing the complete liquidation of that partnership. But the express language of Treas. Reg. section 25.2704- 2(b), which taxpayers gloss over, makes it clear that section 2704(b) reaches restrictions on partial, as well as complete, liquidations of a partnership. The regulation states that an "applicable restriction" is "a limitation on the ability to liquidate the entity (in whole OR IN PART) . . . " Treas. Reg. section 25.2704-2(b) (emphasis added). Because this language plainly provides that an "applicable restriction" includes restrictions on partial liquidations of a partnership, taxpayers' emphasis on the fact that a limited partner's withdrawal of his partnership interest does not necessarily result in the complete liquidation of the partnership is beside the point.

[5] Instead, the relevant point here is that a limited partner's liquidation of his partnership interest results in the partial liquidation of the partnership. ¹ As we noted in our opening brief (p. 33), the limited partner's interest is liquidated in that it is converted into cash or property, and the partnership itself is diminished, having parted with assets to pay the withdrawing partner whatever the partnership agreement provides. Thus, a restriction on a limited partner's right to withdraw from a partnership is a restriction on the partial liquidation of a partnership, and as such, it falls within the scope of section 2704(b) and Treas. Reg. section 25.2704-2(b).

[6] Taxpayers also seek (Br. 36-37) to dismiss the significance of Treas. Reg. section 25.2704-1(a)(2)(v), which defines a "liquidation right" as "a right or ability to compel the entity to acquire all or a portion of the holder's equity interest in the entity . . . whether or not its exercise would result in the complete liquidation of the entity." They note that this regulation addresses section 2704(a), rather than section 2704(b), and that the term "liquidation right" does not appear in Treas. Reg. section 25.2704- 2(b).

[7] We specifically noted in our opening brief (p. 32) that Treas. Reg. section 25.2704-1(a)(2)(v) was promulgated under section 2704(a). Nevertheless, the regulation is also instructive as to the scope of section 2704(b). Indeed, the two subsections of section 2704 target alternative methods of using disappearing restrictions to avoid tax on intra-family transfers. Specifically, section 2704(a) addresses restrictions that lapse after the transfer, while section 2704(b) addresses restrictions that can be removed by the family after the transfer. The subsections complement one another, and they are intended to reach the same types of restrictions on liquidation, whether they disappear by lapsing or by family removal. The fact that a "liquidation right" under section 2704(a) includes a right to liquidate a particular interest in the entity, see Treas. Reg. section 25.2704-1(a)(2)(v), justifies the conclusion that section 2704(b) also reaches restrictions on the liquidation of a particular interest in an entity, not just a liquidation of the entity itself.

[8] Furthermore, the fact that the term "liquidation right" does not appear in Treas. Reg. section 25.2704-2(b) does not mean that section 2704(b) does not apply to restrictions on a limited partner's right to liquidate his partnership interest. To the contrary, Treas. Reg. section 25.2704-2(b) makes clear by its terms that section 2704(b) reaches restrictions on the liquidation of a particular interest in an entity because it states that an "applicable restriction" is "a limitation on the ability to liquidate the entity (in whole OR IN PART)." (Emphasis added.) Treas. Reg. sections 25.2704-2(c) and 25.2704-2(d) (Example 5) further clarify this point by providing that a restriction on a shareholder's right to liquidate his preferred stock may constitute an applicable restriction. Specifically, Example 5 of Treas. Reg. section 25.2704- 2(d) states:

D owns 60 percent of the preferred and 70 percent of the common

[10] Second, it is immediately apparent that the two examples describe entirely different factual scenarios. In Example 3, D owns 60% of the stock of Corporation X, no distinction is made between preferred and common stock, and the issue involves a 10-year restriction on liquidation of the entire corporation. Treas. Reg. section 25.2704-2(d) (Example 3). By contrast, in Example 5, D owns 60% of the preferred and 70% of the common stock in Corporation X, and the issue involves a restriction that prevents D from liquidating his preferred stock before 1999. Treas. Reg. section 25.2704-2(d) (Example 5). Thus, the factual descriptions plainly demonstrate that the two examples are wholly separate.

[11] Finally, under taxpayers' interpretation, Example 5 would be meaningless. If, as taxpayers argue, the final sentence of Example 5 refers to the restriction described in Example 3, then Example 5's discussion of the restriction prohibiting D from liquidating his preferred stock is superfluous. Under the well-established rules of statutory construction, an interpretation that renders part of a statute superfluous or inoperative is to be avoided. See, e.g., Forsyth v. Barr, 19 F.3d 1527, 1543 (5th Cir. 1994). See also KCMC, Inc. v. Federal Communications Commission, 600 F.2d 546, 549 (5th Cir. 1979) (rules of statutory constructions apply in construing regulations).

[12] In short, taxpayers' interpretation of Example 5 strains credulity, ignores the structural separation and factual differences between Examples 3 and 5, and defies the rules of statutory construction. Indeed, the weakness of taxpayers' argument simply underscores the merit of our contention that the Tax Court erred in holding that restrictions on the right of a limited partner to withdraw his partnership interest are not restrictions on liquidation for purposes of section 2704(b) and Treas. Reg. section 25.2704-2(b).

[13] 2. Taxpayers claim (Br. 38-44) that even if, as a general rule, restrictions on a partner's right to withdraw his interest are restrictions on liquidation within the scope of section 2704(b), the restrictions contained in the Kerr agreements still do not constitute "applicable restrictions." First, they argue (Br. 40-43) that the restrictions in the Kerr agreements on a limited partner's withdrawal of his interest are no more restrictive than the rules that would generally apply under Texas law, and second, they contend (Br. 43-44) that the restrictions could not be removed by the family after the transfer. Again, neither argument has merit.

[14] As discussed in our opening brief (pp. 38-40), under sections 9.02 and 10.01 of the Kerr agreements, a limited partner cannot withdraw his partnership interest until the partnership terminates, which will not occur until 2043 (50 years after inception) or upon the consent of all partners. (Exs. 12-J at 45-47, 31-J at 44-46.) By contrast, Texas law provides that if a partnership agreement does not specify otherwise, a limited partner may withdraw upon six months notice and receive the fair value of his interest. TRLPA sections 6.03, 6.04. Specifically, TRLPA section 6.03 states:

A limited partner may withdraw from a limited partnership at the

[15] Contrary to taxpayers' contention (Br. 41-42), the exception in the Kerr agreements giving class B limited partners a put right does not render the agreements less restrictive than Texas law. As explained in our opening brief (pp. 38-40), a class B limited partner who exercises his put right under the Kerr agreements receives only the going concern value of his interest. (Exs. 12-J at 38-39, 45, 31-J at 37-39, 44-45.) Under Texas law, however, a withdrawing partner is entitled to receive the fair value of his interest. TRLPA section 6.04. Therefore, while the Kerr agreements allow a class B limited partner to withdraw his interest at any time, the agreements are more restrictive than the Texas law rules that would normally apply because they limit the amount the withdrawing partner would receive to the going concern value, instead of the fair value, of his interest.

[16] Taxpayers also err in asserting (Br. 40-43) that the six- month minimum term under TRLPA section 6.03 is not relevant in this case. Their argument is based on the fact that under TRLPA section 6.03, the six-month term is a default term that only applies where a partnership agreement does not specify when a limited partner can withdraw or provide a definite time for termination. Taxpayers contend that the Kerr agreements, by virtue of the 50-year term therein, specify a definite time for termination, and, therefore, that the default six-month term under Texas law would not apply under the Kerr agreement.

[17] Taxpayers' argument, however, ignores the fact that an "applicable restriction" is expressly defined as a restriction on liquidation "that is more restrictive than the limitations that would apply under the State law generally applicable to the entity IN THE ABSENCE OF THE RESTRICTION." Treas. Reg. section 25.2704-2(b) (emphasis added). Thus, the fact that the 50-year term in the Kerr agreements provides a definite time for dissolution and the default rule would not actually apply is irrelevant. The question is what restrictions normal Texas law rules would place on a limited partner's liquidation rights IN THE ABSENCE OF THE 50-YEAR TERM, and whether those restrictions are less restrictive than the 50-year term. Because, in the absence of the 50-year term, a limited partner would be able to withdraw his interest upon six months notice, see TRLPA section 6.03, the 50-year term is an "applicable restriction."

[18] For the same reason, there is no merit to taxpayers' attempt (Br. 41-42) to create a distinction between "at-will partnerships" and "term partnerships," in which they claim a limited partner has no withdrawal rights except those provided in the partnership agreement. Again, the issue under Treas. Reg. section 25. 2704-2(b) is what withdrawal rights a limited partner would have under Texas law if the Kerr agreements did NOT contain a 50-year term. Thus, the question of how that 50-year term might affect the application of normal Texas law rules is irrelevant.

[19] Finally, taxpayers assert (Br. 42-43) that the 50-year term cannot be a restriction on liquidation because it insures that the Kerr partnerships will liquidate at a certain point in the future. This contention is specious. While it is true that the 50- year term provides that the partnerships must dissolve at a certain point, it also serves to prohibit a limited partner from withdrawing his interest before then because, under section 9.02 of the Kerr agreements, a limited partner cannot withdraw his interest before termination. (Exs. 12-J at 45-46, 31-J at 44-45.) Therefore, the 50- year term restricts a limited partner's right to liquidate his interest, and as discussed above and in our opening brief, is a restriction on liquidation that is more restrictive than the limitations under normal Texas law rules.

[20] Taxpayers argue (Br. 43-44) that even if the restrictions on liquidation in the Kerr agreements are more restrictive than general Texas law rules, they are not "applicable restrictions" because the Kerr family could not remove them after the transfer without the consent of the University of Texas. As noted in our opening brief (p. 40), taxpayers transferred class A limited partnership interests to the University of Texas after their estate planning attorney advised them of his belief that they could circumvent section 2704(b) by giving interests in their partnerships to a charity (Ex. 10-J at 2).

[21] Notably, taxpayers do not contest our assertion (at pp. 40-41 of our opening brief) that the record shows that if the Kerr family proposed removing the restrictions on liquidation in the Kerr agreements, the University of Texas would agree. Instead, they claim that such evidence is irrelevant. But their attempt to brush aside the evidence that the University of Texas would consent to removal of the restrictions on liquidation in the Kerr agreements only underscores the import of that evidence. Because the evidence demonstrates that the Kerr family could remove the restrictions on liquidation after the transfers, it shows that those restrictions were "applicable restrictions" because they were restrictions on liquidation which "[t]he transferor or any member or the transferor's family, either alone or collectively, has the right after such transfer to remove, in whole or in part . . ." I.R.C. section 2704(b)(2)(B)(ii).

[22] Accordingly, taxpayers' attempt to avoid section 2704(b) by transferring interests to the University of Texas must fail. The restrictions on liquidation of a limited partner's interest contained in the Kerr agreements were more restrictive than the normal Texas law limitations that would apply in their absence, and they could be removed by the Kerr family after the transfers at issue. Those restrictions thus constitute "applicable restrictions" under section 2704(b) and Treas. Reg. section 25.2704-2(b) and, as such, they must be disregarded in valuing the transferred partnership interests.

[23] 3. Finally, taxpayers argue at great length (Br. 44-56) about the meaning of the term "fair value" under TRLPA section 6.04. First, they erroneously claim (Br. 44-45, 56) that we have equated fair value to liquidation value, and then argue that such an equation is incorrect. In so doing, taxpayers have erected a straw man and knocked him down, for we never asserted that fair value equals liquidation value, or that a withdrawing limited partner under Texas law receives the liquidation value of his interest.

[24] To the contrary, we discussed fair value only in noting in our opening brief (pp. 38-40) that the exception in the Kerr agreements granting class B limited partners a put right does not render the agreements less restrictive than normal Texas law rules. Specifically, we observed that under the Kerr agreements, a withdrawing class B limited partner receives only the "going concern" value of his interest, and that taxpayers' estate planning attorney had expressly advised them that the going concern value of an interest can be substantially less than its liquidation value. (Ex. 10-J at 5-6.) We then noted that under the normal Texas law rules that would apply in the absence of this restriction, a withdrawing limited partner would be entitled to receive the "fair value" of his interest. TRLPA section 6.04. In a footnote (p. 39 n.11), we stated that we were unaware of any Texas case law specifically addressing the definition of fair value under TRLPA section 6.04, but that the term is widely used in dissenters' rights cases and is an equitable standard under which courts have broad discretion to determine an appropriate value in the context of the case.

[25] Accordingly, we asserted (p. 40) that even though the Kerr agreements give class B limited partners a put right, the agreements are more restrictive than normal Texas law rules "because they limit the amount the withdrawing partner would receive to the going concern value, as opposed to the fair value, of his interest." Thus, we specifically noted that the distinction at issue was between the right to receive the fair value, as opposed to the going concern value, of one's limited partnership interest. ³

[26] Contrary to taxpayers' claims (Br. 45, 55), we never argued that because Texas law entitles a withdrawing limited partner to receive fair value, the fair market value of the transferred interests at issue here must equal their liquidation value. Rather, we noted (p. 37 n.10) that if this Court reverses the decision of the Tax Court and holds that the restrictions on liquidation in the Kerr agreements are applicable restrictions under section 2704(b), the value of the transferred interests would need to be determined on remand. In that valuation, the transferred interests would be valued as if the restrictions in the Kerr agreements did not exist and as if the rights of the transferor were determined under normal Texas law rules. See Treas. Reg. section 25.2704-2(c). Therefore, the right of a limited partner under Texas law to withdraw on six months notice and receive the fair value of his interest is simply one of the factors to be considered in determining the fair market value of the transferred interests. ⁴

[27] Finally, taxpayers note (Br. 44-45) that the fair value standard of TRLPA section 6.04 is a default rule that applies only where a partnership agreement does not specify the value to be received by a withdrawing limited partner, and they emphasize that the Kerr agreements provide that a withdrawing class B limited partner will receive going concern value. They thus contend that the Kerr agreements are consistent with TRLPA section 6.04. But as we explained in connection with taxpayers' argument that the six-month term under TRLPA section 6.03 was a default rule that was inapplicable under the Kerr agreements, infra pp. 9-10, the pertinent question under section 2704(b) and Treas. Reg. section 25.2704-2(b) is not WHETHER the default Texas law rules would actually apply under the agreements, but rather IF they applied, what the relevant restrictions on liquidation would be. Stated another way, the question under section 2704(b) is not whether the Kerr agreements are "consistent" with Texas law, but rather, whether they are more restrictive than the Texas law rules that would generally apply in the absence of those agreements.

[28] In short, taxpayers' fair value arguments are simply irrelevant to this appeal. They in no way rebut our contention that the Kerr agreements' restrictions on a limited partner's right to withdraw his interest are "applicable restrictions" under section 2704(b) that must be disregarded in valuing the interests that taxpayers transferred to their children and GRATs in 1994 and 1995.

CONCLUSION

[29] For the reasons stated above and in our opening brief, that aspect of the Tax Court's decision determining that I.R.C. section 2704(b) is not applicable in valuing the transferred partnership interests is erroneous and should be reversed, and the case should be remanded for further valuation proceedings.

II

STATEMENT OF THE ISSUE

[31] Whether the Tax Court correctly held that the KFLP interests that taxpayers transferred to themselves as trustees of their grantor retained annuity trusts in 1994 were limited partnership interests, as opposed to assignee interests.

STATEMENT OF THE CASE

[32] The statement of the case contained in the Commissioner's opening brief (pp. 2-4) sets forth the course of proceedings relevant to taxpayers' cross-appeal.

STATEMENT OF THE FACTS

[33] The statement of facts contained in the Commissioner's opening brief (pp. 4-14) sets forth the facts relevant to taxpayers' cross-appeal.

SUMMARY OF ARGUMENT

[34] Here, as part of a complex series of transactions designed to reduce transfer taxes, taxpayers created two family limited partnerships, KFLP and KIL, and transferred interests in those partnerships to their children and to GRATs. At issue in this case is whether the special valuation rules that Congress has provided for intra-family transfers under I.R.C. section 2704(b) apply in valuing the transferred interests. In their cross-appeal, taxpayers claim that section 2704(b) does not apply to the KFLP interests they transferred to themselves as trustees of the GRATs because those interests were assignee interests, rather than limited partnership interests. The Tax Court correctly held that the transferred interests were limited partnership interests in both form and substance.

[35] The evidence in the record fully supports the Tax Court's conclusion that the transferred interests were limited partnership interests. First, taxpayers' lack of formality in admitting their children as general partners of KFLP contradicts their claim that their children's formal consent was required before taxpayers, in their capacity as the GRATs' trustees, could be admitted as limited partners. The terms of the KFLP agreement plainly provide that taxpayers' assignment of general partnership interests to their children should have resulted only in the children's admission as limited partners. Taxpayers, however, treated those assignments as conferring general partner status on their children, although they did not take any formal steps to consent to their children's admission as general partners. Accordingly, taxpayers' contention that their children's formal consent was required to admit them, in their capacity as the GRATs' trustees, as limited partners is discredited by their very own actions.

[36] Second, the documentary evidence in the record shows that the transferred interests were limited partnership interests in form. The transfer documents themselves specifically identify the transferred interests as class B limited partnership interests, and state that all necessary consents to the transfers were obtained. Because taxpayers were free under the terms of the KFLP agreement to transfer assignee interests to themselves without the other partners' consent, the statement that all necessary consents to the transfers were obtained confirms that the transferred interests were limited partnership interests. Furthermore, in their GRAT agreements, taxpayers identified the transferred interests as limited partnership interests, and they subsequently used those interests to secure demand notes that they executed to themselves on behalf of the GRATs. The security agreements also describe the transferred interests as limited partnership interests and indicate that the transferred interests conferred the status of limited partners on taxpayers. Thus, the documentary evidence in the record clearly demonstrates that the transferred interests were limited partnership interests. Because the Kerr children's testimony that they did not consent to the transfers was contradicted by substantial documentary evidence, the Tax Court was well within its discretion in disregarding that testimony.

[37] Third, it is well settled that the tax effects of a transaction are governed by the substance of the transaction, rather than its form. Thus, even if taxpayers were able to establish that the transferred interests were assignee interests in form, that form would not govern for federal tax purposes because the objective economic realities underlying the transfers show that in substance, the transferred interests were limited partnership interests. The evidence shows that under the KFLP agreement, there were no significant differences between the rights of an assignee and a limited partner. But even if the rights of an assignee and a limited partner were not substantially similar under the agreement, there still would be no meaningful difference between the transfer of an assignee interest and a limited partnership interest under the circumstances of this case because here, taxpayers occupied every role with respect to the transfers. They were the grantors, initial beneficiaries and trustees of the GRATs, and also the founders and managing partners of KFLP. Therefore, even if they had transferred assignee interests to themselves, they still had the right to vote the underlying limited partnership interest, and, with their children, could convert the interests to limited partnership interests at any time.

[38] The only reason taxpayers seek to distinguish between assignee and limited partnership interests is to avoid section 2704(b). Although a tax avoidance motive does not invalidate a transaction, it cannot give the transaction sufficient economic substance to require its recognition for federal tax purposes. Taxpayers' complaint that the Tax Court incorrectly took their tax avoidance motives into account has no merit because the Supreme Court long ago held that consideration of tax avoidance motives is proper where a transaction lacks economic substance.

[39] Accordingly, the Tax Court's conclusion that the transferred interests were limited partnership interests both in substance and in form is amply supported by the record. Even if taxpayers could establish that the transferred interests would be assignee interests under Texas law, however, section 2704(b) would still apply to those interests. Although state law generally controls the determination of the nature of a taxpayer's interest in property, federal tax law designates what interests shall be taxed. The Supreme Court has made clear that if an interest created by state law is the object intended to be taxed, federal tax law prevails regardless of how the interest might be characterized under state law.

[40] Therefore, taxpayers' recitation of general principles of Texas partnership law is misplaced. The language and legislative history of section 2704(b), as well as the regulations under it, make clear that the federal tax statute applies without regard to whether a transferred partnership interest would be designated as an assignee interest under state law. Indeed, this rule is appropriate because section 2704(b) applies only to family controlled entities, and in such entities, the assignee status of a transferred interest is insignificant because the family can convert the interest to a full partnership interest. Accordingly, even if taxpayers could establish that the transferred interests were assignee interests under Texas law, section 2704(b) would still apply to those interests.

[41] The Tax Court's conclusion that taxpayers transferred limited partnership interests to themselves in their capacity as the GRATs' trustees should be affirmed.

ARGUMENT

A. INTRODUCTION

[43] In this case, taxpayers, in an effort to reduce their transfer tax liability, used a complex series of transactions to transfer wealth to their descendants. Briefly summarized, they created two family limited partnerships, KFLP and KIL, to which they transferred assets totaling approximately $7 million and $20 million, respectively, and in which they gave interests to their children. (Doc. 32, paragraphs 25-26, 44-46; Exs. 12-J, 31-J.) They then created two grantor retained annuity trusts (GRATs) to which they transferred 89.07% of KFLP (which owned 20% of KIL, the other family partnership). (Doc. 32, paragraphs 27-30.) Although the GRATs were required to make annuity payments to taxpayers, those payments were never made. Instead, taxpayers, who were the sole trustees of the GRATs, executed demand notes to themselves in the amount of the owed payments. (Id. at paragraphs 29-35.) The GRATs thereafter terminated, and their assets and liabilities (including the demand notes) passed to trusts benefitting taxpayers' grandchildren. (Id. at paragraph 29.) Taxpayers then forgave the demand notes. (Id. at paragraph 37.) The end result of these transactions is that taxpayers' grandchildren will eventually receive, directly or indirectly, 89.07% of the $7 million in assets given to KFLP and 16.03% of the $20 million in assets given to KIL. ⁵ Taxpayer Baine Kerr admitted that minimizing transfer taxes "was certainly one of my intentions" in engaging in these transactions. (Doc. 34 at 51.)

[44] At issue in this case is whether the special valuation rules that Congress has provided for intra-family transfers under I.R.C. section 2704(b) apply in valuing the KFLP and KIL interests that taxpayers transferred in 1994 and 1995. As discussed in detail in our opening brief (pp. 20-26), section 2704(b) provides that where a taxpayer transfers an interest in a partnership to or for the benefit of his family member, and he and his family control the partnership immediately before the transfer, the transferred interests must be valued without regard to any "applicable restriction." An "applicable restriction" is a restriction on the ability to liquidate the entity (in whole or in part) that is more restrictive than the normal state law rules would be. Treas. Reg. section 25.2704-2(b).

[45] In their cross-appeal, taxpayers challenge the Tax Court's fact-based conclusion that the KFLP interests they transferred to their GRATs were limited partnership interests, as opposed to assignee interests. ⁶ They claim (Br. 12) that if the transferred interests were assignee interests, section 2704(b) would not apply because an assignee's liquidation rights under the KFLP agreement are the same as an assignee's liquidation rights under Texas law. As discussed below, the evidence in the record fully supports the Tax Court's finding that the transferred interests were, both in form and substance, limited partnership interests. ⁷

[46] At the outset, however, taxpayers seek to deflect attention from the facts of the case by reiterating (Br. 13-15) the principle that the nature of a transferred property interest is generally determined under state law, and then reciting (Br. 15-16) various Texas partnership law rules governing the assignment of partnership interests. Specifically, taxpayers rely on TRLPA section 7.02(a)(2), which states in pertinent part that "[u]nless otherwise provided by the partnership agreement . . . an assignment of a partnership interest does not . . . entitle the assignee to become, or to exercise the rights or powers of, a partner," and TRLPA section 7.04(a), which provides that an assignee of a partnership interest may become a limited partner "if and to the extent that: (1) the partnership agreement provides; or (2) all partners consent."

[47] Recitation of these general Texas law principles, however, does not address or answer the question whether, in a particular case, the partnership agreement provided for the transfer of a limited partnership interest or whether there was consent to such a transfer. Taxpayers' primary argument thus begs the question. As discussed below, the Tax Court correctly found that the facts established that taxpayers' claim that their children's formal consent was required for them to transfer limited partnership interests to themselves was inconsistent with their own actions under the KFLP agreement, and the documents relating to the transfers show that all necessary consents to the transfers were obtained. Thus, under the KFLP agreement and Texas law, the transferred interests were limited partnership interests.

[48] Moreover, even if taxpayers had shown that the transferred interests were assignee interests in form, it is well established that the tax effects of a transaction are governed by the substance of the transaction, rather than its form. See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978); Gregory v. Helvering, 293 U.S. 465, 469 (1935); Merryman v. Commissioner, 873 F.2d 879, 881 (5th Cir. 1989). As the Supreme Court stated in Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945):

The incidence of taxation depends upon the substance of the

[49] Here, the Tax Court found that the objective economic realities and tax motivation underlying the transfers demonstrated that the transferred interests were limited partnership interests in substance as in form. (Doc. 38 at 30-32.) Taxpayers' contention (Br. 18) that the Tax Court erred in applying the economic substance doctrine to this case is mistaken. While the doctrine is more commonly applied in income tax cases, it also has been held to be applicable in the transfer tax context. See, e.g., Sather v. Commissioner, 251 F.3d 1168, 1174 (8th Cir. 2001); Heyen v. United States, 945 F.2d 359, 363 (10th Cir. 1991); Griffin v. United States, 42 F.Supp.2d 700, 704 (W.D. Tex. 1998); Estate of Murphy v. Commissioner, 60 TCM (CCH) 645, 661 (1990). ⁸ Indeed, as "the cornerstone of sound taxation," Estate of Weinert, 294 F.2d at 755, there is no sound reason not to treat the economic substance doctrine as applicable to all disputes arising under the Internal Revenue Code.

[50] The Tax Court properly evaluated the facts, testimony, and documentary evidence pertaining to the transfers, and concluded that, both in form and in substance, taxpayers had transferred limited partnership interests. (Doc. 38 at 26-32.) Far from being clearly erroneous, the Tax Court's findings are amply supported by the record. ⁹

B. THE TAX COURT CORRECTLY HELD THAT TAXPAYERS, IN SUBSTANCE AS

[52] As the Tax Court found (Doc. 38 at 26-27), taxpayers' argument is refuted by their own actions in assigning general partnership interests to their children. When taxpayers formed KFLP, they made capital contributions of life insurance policies worth $7 million. (Doc. 32, paragraph 26.) They then immediately assigned a small percentage of their general partnership interests in KFLP to their children, by providing in section 4.01 of the KFLP agreement that "[taxpayers] hereby assign a portion of their General Partnership Interest to each of [their children] as his or her sole and separate property . . ." (Ex. 12-J at 22.) Taxpayers have treated these assignments as conferring general partner status on their children.

[53] Under the terms of the KFLP agreement, however, taxpayers' assignment of general partnership interests to their children should not have resulted in the children's admission as general partners. Under section 8.03 of the agreement, the Kerr children are "permitted assignees," and under section 8.20, if a general partner transfers a general partnership interest to a permitted assignee, "the General Partners shall admit such transferee into the Partnership as a Class B Limited Partner." (Ex. 12-J at 32, 43-44.) Thus, under the plain language of the KFLP agreement, taxpayers' assignments of general partnership interests to their children should have resulted only in the children's admission as class B limited partners.

[54] Despite the unambiguous terms of the KFLP agreement, taxpayers did not take any formal steps to consent to their children's admission as general partners instead of limited partners. As the Tax Court observed (Doc. 38 at 26-27), taxpayers' lack of formality in admitting their children as general partners indicates that they either did not appreciate the terms of the KFLP agreement or considered formal consents unnecessary under those terms. Either way, their informality in admitting their children as general partners discredits their claim that the children's formal consent was required to admit them, in their capacity as the GRATs' trustees, as limited partners. Put simply, taxpayers cannot now insist on the necessity of certain actions or formalities which they previously treated as unnecessary. As this Court has stated, "[i]t is no more right to allow a party to blow hot and cold as suits his interests in tax matters than in other relationships." Alamo Nat'l Bank v. Commissioner, 95 F.2d 622, 623 (5th Cir. 1938) (requiring consistency in tax accounting).

[55] On appeal, taxpayers seek to avoid the implications of their prior conduct by asserting (Br. 18-20) that they did not transfer general partnership interests to their children, but rather that their children were simply original general partners of KFLP. This contention is flatly contradicted by the plain language of section 4.01 of the KFLP agreement, which states (Ex. 12-J at 22) (emphasis added):

[Taxpayers] hereby ASSIGN A PORTION OF THEIR GENERAL PARTNERSHIP

At the time the partnership was created, the only general

2. THE DOCUMENTARY EVIDENCE RELATING TO THE TRANSFERS SHOWS

[59] The statement that all necessary consents to the transfers had been obtained shows that the transferred interests were limited partnership interests because, under the terms of the KFLP agreement, no consents were required for taxpayers to transfer assignee interests to themselves. Specifically, section 8.01 of the agreement provides that, as a general rule, no limited partner may dispose of a partnership interest without the written consent of the partnership and all other partners. (Ex. 12-J at 31.) Section 8.02, however, states that a "disposition" "SHALL NOT INCLUDE . . . a sale, assignment, gift, exchange, transfer, . . . or any other disposition of a Limited Partnership Interest, to a Permitted Assignee or Permitted Assignees." (Id. at 31-32 (emphasis in original).) Taxpayers have admitted (Doc. 25 at 2) that they, in their capacity as the GRATs' trustees, were "permitted assignees" under the KFLP agreement.

[60] Under these provisions, taxpayers were free to transfer assignee interests to themselves as the GRATs' trustees without the other partners' consent. Therefore, the fact that the transfer documents explicitly state that all required consents to the transfers were obtained confirms that the transferred interests were limited partnership interests.

[61] This conclusion is further bolstered by the language that taxpayers used to identify the transferred interests in their GRAT agreements, which each state that taxpayers "transferred to [themselves as trustees] a 44.535% Class B limited partnership interest in [KFLP]." (Exs. 13-J, 14-J at Exhibits A.) Furthermore, when taxpayers, as trustees, executed demand notes to themselves in lieu of the annuity payments due from the GRATs, they used the limited partnership interests they had transferred to their GRATs as security for the notes. (Exs. 20-J, 21-J.) The security agreements grant taxpayers a security interest in "[the trustee's] 44.535% Class B limited partnership interest in the Partnership" and in "all other proceeds or assets received or receivable by [the trustee] in respect of HIS STATUS AS A PARTNER in the Partnership." (Id. at 2, section 2 (emphasis added).) This language plainly demonstrates that the interests transferred to the GRATs' trustees were limited partnership interests that conferred the status of limited partner. Indeed, if the transferred interests were merely assignee interests, then the security agreements would make no sense. For instance, section 10 of the security agreements provides that the grantees of the security interests would not become partners in KFLP nor be obligated to pay any partnership liabilities or to perform any partnership obligations by virtue of the security agreements. (Id. at 6, section 10.) Obviously, if the trustees had only received assignee interests in KFLP, they could not transfer anything but assignee status to the grantees of the security interest, and section 10 would be completely unnecessary.

[62] The valuation report that taxpayers attached to their 1994 gift tax return also identifies the transferred interests as limited partnership interests. It states that taxpayers had requested an opinion as to the value of "two 44.535 percent Class B Limited Partnership interests," and it repeatedly describes the transferred interests as limited partnership interests. (Ex. 40-J, Attached appraisal report, opinion letter and p. 23, 32.)

[63] Accordingly, the documentary evidence in the record clearly shows that the transferred interests were limited partnership interests. Taxpayers, however, try (Br. 21-22) to dismiss all of this evidence by summarily claiming it to be irrelevant and reiterating their contention that they could not transfer limited partnership interests without their children's consent. Citing their children's testimony, taxpayers then claim that it is "undisputed" that their children did not give such consent.

[64] Taxpayers' assertion is disingenuous. First, it completely ignores the fact that the transfer documents, which expressly state that all necessary consents to the transfers were obtained, contradict their children's testimony. Moreover, it fails to acknowledge the Tax Court's decision to credit the documentary evidence over that testimony. It is well established that weighing evidence and drawing factual inferences are within the province of the Tax Court, and that the Tax Court is free to reject a taxpayer's testimony, even where that testimony is uncontradicted. See, e.g., Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 123-124 (1944); Potito v. Commissioner, 534 F.2d 49, 51 (5th Cir. 1976); MacGuire v. Commissioner, 450 F.2d 1239, 1244-1245 (5th Cir. 1971). Here, far from being uncontradicted, the Kerr children's testimony was in conflict with substantial documentary evidence. Accordingly, the Tax Court was well justified in disregarding that testimony, and did not clearly err in finding that, in form, taxpayers transferred limited partnership interests.

3. THE OBJECTIVE ECONOMIC REALITIES UNDERLYING THE

[66] Neither assignees nor limited partners had management rights under the KFLP agreement, although a limited partner had a right to vote on certain "major decisions" enumerated in section 3.10(e) of the KFLP agreement. (Ex. 12-J at 19-21.) But, as the Tax Court correctly observed (Doc. 38 at 30-31), the matters constituting such major decisions were so rare and extraordinary, such as filing for bankruptcy, that the right to vote on those matters is not significant for the purposes of this case. Furthermore, a limited partner's right to vote on those decisions has little meaning, given that section 3.10(e)(iii) of the KFLP agreement allows general partners to make many major decisions without the prior consent of a majority of the limited partners. (Ex. 12-J at 21.)

[67] Assignees and limited partners also have similar withdrawal rights under the KFLP agreement. Under section 9.02, class B limited partners have a put right under which they can sell their interest to the partnership. (Ex. 12-J at 45-46.) While assignees do not have a put right, they have, in the words of the Tax Court, a "substantially equivalent right." (Doc. 38 at 30.) Specifically, under section 8.21, assignees are treated as substituted partners for purposes of disposing of their interests, and they therefore can offer their interests for sale to the partnership under section 8.04. (Ex.12-J at 32-33, 44.)

[68] With respect to information rights, Article VI of the KFLP agreement directs that certain financial information be provided to the partners. (Ex. 12-J at 29-30.) It is clear that, as a practical matter, taxpayers would receive this information whether the transferred interests were assignee or limited partnership interests since, as managing partners, they were responsible for distributing the information. (Id. at 12, 29-30.) But even assuming that taxpayers were assignees and somehow did not receive such information, they could seek it through their arbitration rights under section 11.01 of the agreement. (Id. at 49-50.)

[69] Thus, the Tax Court correctly found that there were no significant differences between the rights of assignees and limited partners under the KFLP agreement. (Doc. 38 at 30-31.) Even if the rights of assignees and limited partners under the agreement were not substantially similar, it is clear that under the circumstances of this case, there would be no meaningful difference between the transfer of an assignee interest and a limited partnership interest. Taxpayers were the grantors, initial beneficiaries, and trustees of their GRATs, as well as the founders and managing partners of KFLP. (Doc. 32, paragraphs 25, 28-29; Exs. 12-J-14-J.) Thus, even if taxpayers transferred assignee interests, instead of limited partnership interests, to themselves, they nevertheless had the right to vote the underlying limited partnership interests (albeit in their individual capacity as opposed to their trustee capacity). Furthermore, taxpayers and their children, as general partners of KFLP, could convert the alleged assignee interests to limited partnership interests at any time.

[70] In short, because taxpayers occupied every role with respect to the transfers, it is apparent that there was no substantive difference between transferring an assignee interest and a limited partnership interest. Cf. Merryman, 873 F.2d at 882 (interconnected ownership of partnership and related entities and circular flow of funds between them indicated that transaction lacked economic substance); Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968) (where taxpayers are on both sides of a transaction, the labels they attach to it may have no meaning). Indeed, the only reason taxpayers now seek to make a distinction between assignee interests and limited partnership interests is to avoid the special intra-family transfer tax valuation rules of I.R.C. section 2704(b). ¹¹

[71] To be respected for tax purposes, a transaction must "have purpose, substance, or utility apart from [its] anticipated tax consequences." Goldstein v. Commissioner, 364 F.2d 734, 740 (2d Cir. 1966). See also Knetsch v. United States, 364 U.S. 361, 366 (1960) (transaction that did not "appreciably affect [taxpayer's] beneficial interest except to reduce his tax" must be disregarded for federal tax purposes); Gregory v. Helvering, 293 U.S. 465, 469 (1935) (question is "whether what was done, apart from the tax motive, was the thing which the statute intended"); Blueberry Land, 361 F.2d at 102 (disregarding transaction that served no real purpose apart from tax savings). Because taxpayers' transfers of alleged assignee interests had no independent economic significance, and were "shaped solely by tax-avoidance features that have meaningless labels attached," the purported assignee form does not merit recognition for federal tax purposes. Frank Lyon, 435 U.S. at 583-584.

[72] Taxpayers do not dispute that they had tax avoidance motives, but instead assert (Br. 23-25) that the Tax Court's consideration of such motives was erroneous. Their reliance (Br. 24) on Gregory v. Helvering, 293 U.S. 465 (1935), in this regard is misplaced. Although the Court in Gregory acknowledged that a tax avoidance motive did not itself invalidate a transaction, it concluded that "[t]he rule which excludes from consideration the motive of tax avoidance is not pertinent" where a transaction lacks economic substance because "[t]o hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose." Id. at 470.

[73] Furthermore, the Supreme Court long ago rejected the same Gregory-based argument that taxpayers now advance. In Commissioner v. Tower, 327 U.S. 280, 288 (1946), the taxpayer claimed that the Tax Court's refusal to recognize for federal tax purposes a partnership which he had formed under state law was contrary to the Gregory principle that taxpayers may decrease their taxes by legally- available means. The Supreme Court rejected the taxpayer's contention, noting that where a taxpayer "draws a paper purporting" to transfer a partnership interest but actually continues to control the business and channel income to his wife, "[t]hen a showing that the arrangement was made for the express purposes of reducing taxes simply lends further support to the inference that [the arrangement should be disregarded for federal tax purposes]." 327 U.S. at 289.

[74] Taxpayers' citation (Br. 24) of Wheeler v. United States, 116 F.3d 749 (5th Cir. 1997), is also unavailing. At issue in Wheeler was whether a certain sale constituted "a bona fide sale for an adequate and full consideration" for purposes of I.R.C. section 2036(a). In deciding that question, this Court determined that under section 2036(a), traditional subjective intent inquiries regarding whether a gift was made in contemplation of death had been supplanted by objective statutory requirements. 116 F.3d at 765-766. Then, in the very passage that taxpayers quote, this Court specifically contrasted section 2036(a) to the Chapter 14 valuation rules at issue here, noting that the rules provide "that intrafamily transfers are to be treated differently." Id. at 766. This Court further observed that the Chapter 14 rules "were designed to address the perceived shortcomings of section 2036(a)." Id. at 767.

[75] Because Wheeler did not entail an economic substance analysis and involved a different statute, it is simply inapplicable here. Furthermore, taxpayers' attempt to convert Wheeler's holding regarding section 2036(a) into a universal prohibition against considering tax avoidance motives in any transfer tax case has no merit. Indeed, if Wheeler has any connection to this case, it is its observation that the Chapter 14 rules were enacted to combat the very sort of abusive intra-family transfers at issue here.

[76] Taxpayers' reliance (Br. 14-15, 18, 20-22, 25) on this Court's unpublished opinion in Estate of McLendon v. Commissioner, 77 F.3d 477 (Table), 1995 U.S. App. LEXIS 41277 (5th Cir. 1995), on remand, 72 T.C.M. (CCH) 42 (1996), rev'd, 135 F.3d 1017 (5th Cir. 1998), is equally unavailing. ¹² As an initial matter, it is important to note that, as in Wheeler, the transfers in McLendon occurred before the statutory provisions at issue here went into effect. See 1995 U.S. App. LEXIS 41277, at *14; Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, section 11602(a), 104 Stat. 1388, 1388-491 - 1388-501. Thus, McLendon does not even consider the special valuation rules of Chapter 14.

[77] Moreover, this Court's conclusion that the interests in McLendon were remainders in assignee interests, rather than partnership interests, was based on the specific facts of that case. Significantly, this Court noted that the Tax Court's finding that the transferred interests were partnership interests rested on facts which the Commissioner had conceded on appeal to be incorrect. See 1995 U.S. App. LEXIS 41277, at *21-22. Given these factual inaccuracies and the fact that the Tax Court had not found that the transfers were a contrivance to avoid taxes, this Court determined that the transfers must be taken at face value. Id. at 24-25.

[78] Because it viewed the transaction at face value, this Court looked to Texas law and the parties' agreements to evaluate the nature of the transfers. 1995 U.S. App. LEXIS 41277, at *24-25. It noted that the partnership agreements did not permit transfers of partnership interests without consent of the partners, and that Texas law reinforced this consent requirement. Id. at *25-26. It concluded that the transfer documents did not reflect any such consent, and that such consents could not be imputed because the partners had formally approved other partnership amendments. Id. at *27. In addition, this Court noted that intra-family transfers were not to be interpreted specially and that construing the transfers as partnership interests was inconsistent with the transferor's intent to prevent management interference by the transferees. Id. at *28-29. Accordingly, it held that the transferred interests were assignee interests.

[79] Thus, the facts of McLendon stand in sharp contrast to the facts here. As discussed above, taxpayers' claim that formal consents were required was contradicted by their own failure to formally consent to their children's admission as general partners. The transfer documents stated that all necessary consents to the transfers were obtained, and tax avoidance motives underlay the transfers. Furthermore, since Chapter 14, which governs here, specifically provides that intra-family transfers are to be treated differently, the statement in McLendon that intra-family transfers would not be specially interpreted has no bearing in this case. Accordingly, taxpayers' attempt to expand the fact-specific holding of the unpublished McLendon opinion into a rule that as a matter of Texas law the interests here are assignee interests must fail.

C. IN ANY EVENT, EVEN IF THE TRANSFERRED INTERESTS WERE ASSIGNEE

[81] Similarly, in Harmel, 287 U.S. at 109-111, the Supreme Court held that an oil and gas lease was not a "sale" for federal tax purposes although it was regarded as a sale under Texas law. The Court held that in determining whether particular payments fell within the federal tax statute at issue, "[i]t is the will of Congress which controls." Id. at 110. Because the federal tax statute did not make its operation dependent on state law, it was to be applied "irrespective of any particular characterization of the payments in the local law." Id.

[82] In addition, the Supreme Court long ago made it clear that state partnership law does not control whether a partnership is recognized for federal tax purposes. Commissioner v. Tower, 327 U.S. 280, 287-288 (1946). In Tower, the Court upheld the Tax Court's conclusion that the partnership at issue was not a genuine partnership for federal tax purposes even though it might have been a valid partnership under Michigan law. Id. at 287. The Court emphasized that "the Tax Court in making a final authoritative finding on the question whether this was a real partnership is not governed by how Michigan law might treat the same circumstances for purposes of state law," and that federal tax laws "are not to be frustrated by state laws which for state purposes prescribe the relations of the members to each other and to outsiders." Id. at 287- 288; see also Britt v. United States, 431 F.2d 227, 237 (5th Cir. 1970) ("[t]he fact that a state has conferred a label of 'corporation' on a business organization should not per se control its status for federal tax purposes"); Markosian v. Commissioner, 73 T.C. 1235, 1241 (1980) (taxpayers cannot hide behind technical and legal niceties of state law of trusts to avoid federal taxes).

[83] Accordingly, taxpayers' citation (Br. 13-14, 18, 22) of Aldrich v. United States, 346 F.2d 37 (5th Cir. 1965), is inapposite. At issue in Aldrich was whether a partnership interest was owned by decedent at the time of his death and thus includable in his estate for estate tax purposes or had been transferred to his wife prior to his death. This Court held that state law determined the ownership of the partnership interest at the time of decedent's death. 346 F.2d at 40. Here, however, the issue in dispute is not the ownership of the transferred interests, but rather whether the purported form of the transfers should be recognized for federal tax purposes. As noted above, in making such a determination, state law is not dispositive. Tower, 327 U.S. at 287; Britt, 431 F.2d at 237. ¹³

[84] Therefore, taxpayers' recitation of the principle that state law generally determines the nature of a property interest and their formalistic reliance on Texas partnership law is misplaced. Even if taxpayers were correct that the transferred partnership interests are assignee interests under Texas law, the interests still would be subject to section 2704(b). As discussed in our opening brief (pp. 20-26), the federal tax statutes of Chapter 14 were designed to tax the property interests that are actually, rather than ostensibly, transferred between family members. The language and legislative history of section 2704(b), as well as the regulations under it, make clear that in order to accomplish that goal, section 2704(b) applies without regard to whether a transferred partnership interest would be characterized as an assignee interest under state law.

[85] The legislative history confirms the conclusion that section 2704(b) applies without respect to whether, after the transfer, the partnership interest would be characterized under state law as an assignee interest. In explaining section 2704, the Conference Report states (H.R.Conf. Rep. 101-964 at 1138, reprinted in 1990 U.S.C.C.A.N. at 2843):

Example 8. -- Mother and Son are partners in a two-person

[87] Example 1 of Treas. Reg. section 25.2704-2(d) also illustrates that the assignee status of a transferred interest is not taken into account for purposes of section 2704(b). The example provides:

D owns a 76 percent interest and each of D's children, A and B,

[88] As these examples show, the fact that a transferred interest is an assignee interest in the hands of the transferee is simply not relevant to the section 2704(b) analysis. This rule is appropriate because section 2704(b) applies only to family-controlled entities. In such entities, the assignee status of a transferred interest is immaterial because the family can convert the interest to a full partnership interest. Therefore, even if taxpayers were correct in arguing that the interests they transferred to themselves as trustees of the GRATs are assignee interests under Texas law, section 2704(b) would still apply to those interests.

CONCLUSION

[89] For the reasons stated above and in the Commissioner's opening brief, that aspect of the Tax Court's decision determining that I.R.C. section 2704(b) is not applicable in valuing the transferred partnership interests is erroneous and should be reversed, and the case should be remanded for further valuation proceedings. In all other respects, the decision should be affirmed.

Respectfully submitted,

[90] It is hereby certified that service of the foregoing answering and reply brief has been made on counsel for the appellees- cross-appellants, on this 10th day of August, 2001, by mailing two paper copies and one copy on computer diskette to them, properly addressed as follows:

John W. Porter, Esquire

² Example 3 of Treas. Reg. section 25.2704-2(d) states:

D owns 60 percent of the stock of Corporation X. The corporate

⁴ To the extent that taxpayers' fair value argument is an attempt to ask this Court to rule on a specific valuation methodology, that request is premature. Because the Tax Court held that section 2704(b) did not apply, it never reached the issue of the fair market value of the transferred interests if section 2704(b) applied or considered the meaning of fair value under TRLPA section 6.04. Indeed, taxpayers' fair value argument becomes relevant only if the Commissioner's appeal is successful and the case is remanded to the Tax Court for proceedings regarding the value of the transferred interests with application of section 2704(b).

⁵ KFLP owned a 2% general partnership interest and an 18% class B limited partnership interest in KIL. (Doc. 32 at paragraph 27; Ex. 31-J.) Thus, when the grandchildren's trusts received the 89.07% class B limited partnership interests in KFLP, they also became indirect owners of 16.03% of KIL (89.07% of 18%).

⁶ As noted in our opening brief (p. 12-13), taxpayers have conceded that the KIL interests they transferred to their children in 1994 and 1995 were limited partnership interests. (Doc. 28 at 14, 23; Doc. 34 at 8-9.)

⁷ Taxpayers' assertion (Br. 12) that the Commissioner has admitted that section 2704(b) would not apply if the transferred interests were assignee interests is simply not true. In the section of the Rule 50(c) statement that taxpayers cite in support of their claim, the Commissioner stated that (Doc. 23 at 13):

. . . if the assignee status of a partnership interest is the

⁸ The Tax Court recently issued two reviewed decisions involving the Chapter 14 valuation rules and economic substance doctrine, Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), and Knight v. Commissioner, 115 T.C. 506 (2000). Although in both cases the majority purported to apply the economic substance doctrine, it held that the partnerships at issue had sufficient substance to be recognized for federal tax purposes because they were validly formed under state law. Strangi, 115 T.C. at 486-487; Knight, 115 T.C. at 514-515. We believe that this conclusion is plainly wrong in light of the well-established principle that state law does not control whether an entity is recognized for federal tax purposes, see, e.g., Commissioner v. Tower, 327 U.S. 280, 287-288 (1946), discussed supra, pp. 45, and that it contradicts the economic substance doctrine. For present purposes, however, it is worth noting that the majority's decisions in Strangi and Knight reflect an assumption that the economic substance doctrine applies to Chapter 14 cases. The Commissioner has appealed the Strangi decision to this Court, see Estate of Strangi v. Commissioner, No. 01-60538.

⁹ In a footnote (Br. 17 n.5), taxpayers claim that the Tax Court's determination that the transferred interests were limited partnership interests ignores the hypothetical willing buyer/willing seller standard of valuation. Their argument, however, confuses the identification of a property interest with the valuation of that interest once it has been identified. The standard governing the determination of value, i.e., what a hypothetical willing buyer would pay for the transferred interest, has no relevance to the question of identifying the transferred interest in the first place and, as the Tax Court held (Doc. 38 at 33), it cannot be used to redefine the character of the transferred property. Therefore, taxpayers' suggestion that the hypothetical willing buyer standard of valuation was disregarded is meritless.

¹⁰ Taxpayers now attempt to escape the unambiguous language of section 4.01 by claiming (Br. 20 n.6) that their transfers of general partnership interests to their children should be reflected as gifts of capital contributions, rather than general partnership interests. This argument is simply another example of taxpayers' willingness to disregard the literal terms of the KFLP agreement, and thus further supports the Tax Court's conclusion (Doc. 38 at 27) that taxpayers' claim that the KFLP agreement must be strictly construed to require formal consents to the transfers at issue is belied by their own conduct.

¹¹ As the Tax Court noted (Doc. 38 at 31), the writings of taxpayers' estate planning attorney reveal his belief that intra- family transfers of assignee interests circumvent section 2704(b). See, e.g., S. Stacy Eastland, "The Art of Making Uncle Sam Your Assignee Instead of Your Senior Partner: The Use of Family Partnerships in Estate Planning," C901 A.L.I.-A.B.A. 581 (1994).

¹² Pursuant to Local Rule 47.5.3, we have attached a copy of the unpublished McLendon opinion to this brief.

¹³ Furthermore, unlike Aldrich, 346 F.2d at 39, where it was specifically noted in the portion of the government's brief quoted by this Court that tax avoidance was not a concern in the case, taxpayers here recite state law in an attempt to defeat federal taxes. But, as the above cases make clear, technical considerations and legal niceties of state law cannot be used to avoid federal taxes. See, e.g., Markosian, 73 T.C. at 1241.