Caution Required When Making Gifts Of LLC Interests

By: Randall A. Denha, J.D., LL.M

One of the strategies for reducing potential estate taxes is by gifting some or all a company’s ownership from the business owner to their children or a family member during their lifetime.  By gifting ownership, business valuators can utilize discounts to reduce the value of the business. The following are some of the discounts available for use when determining values for gifting purposes.

While there are many techniques for accomplishing the gift giving process and shifting opportunity to the next generation, one popular technique involves the use of Family LLCs, or Family Partnerships (sometimes “FLP”). Family Partnerships have proliferated over the years, with families using them for multiple purposes, including centralized asset management, creditor protection, and efficient transfer tax planning.  Intra-family transfers of interests in these entities often generate valuation discounts for lack of marketability, lack of control, or other voting or liquidation restrictions, which allow for more efficient tax transfers.

Family Partnerships can be easily established and quite easy to administer. The Family Partnership units can be gifted to the next generation or to trusts for their benefit.  Aside from the tax benefits, Family Partnerships offer several practical benefits, including centralized family wealth management and succession, the development of a coherent family investment philosophy, and confidentiality and creditor protection for family members. Families can pool assets within the Family Partnerships to provide the family with greater access to certain investment opportunities and the ability to achieve better diversification and risk allocation for its overall wealth. They can be used to teach fiscal responsibility for younger generations by giving them a role in the investment management, with family oversight.  They can also be used to facilitate the transfer of diverse investments among generations by consolidating assets under a single ownership structure.

Many taxpayers who use Family Partnerships do so to accomplish the non-tax reasons mentioned above as well as achieve tax savings which recognize the reality of transfers of assets owned by a Family Partnerships. Here is a simple and routine example:

For valid business purposes, Mom and Dad transfer their real estate holdings to a Family Partnership. Mom and Dad (or another entity owned by them) serve as general partner or managers (1% each) and Mom and Dad each own a 49% limited partner or non-voting membership interest. Sometime in the future, Mom and Dad begin a gift program by transferring limited partner interests to their children and grandchildren (or trusts for their benefit). Later, Mom contributes her marketable securities to the partnership while Dad contributes his art collection. Mom and Dad continue to give limited partner interests to their children. The limited partner interests transferred may qualify for discounts from FMV of the underlying assets based on lack of marketability and control (or “minority”) discounts.

Recent changes, however, make transfers and value realization more difficult, especially in light of 2017’s Powell v Commissioner decision, which now allows the IRS to attempt to include the value of the transferred FLLC units in the parent’s taxable estate. This particular case was a bad facts Family Partnership case. Nonetheless, it has given estate planners cause for concern. Despite many attempts, the IRS has failed to eliminate the valuation discount for an interest in a family business entity.

Cases In The Family Partnership Area

Powell v. Commissioner

In Powell, the mother transferred $10 million of cash and marketable securities into a Family Partnership owned by her sons. Mother retained the limited partner units and the sons owned the general partner units at the time of her death. The Tax Court held that despite being the limited partner the mother could act in conjunction with the general partner either to make distributions or to liquidate the partnership, thus causing $10 million of partnership assets to be included in the mother’s taxable estate at their fair market value. The same day as the FLP was formed the son, acting under a durable power of attorney, transferred his mother’s 99% limited partnership interest into an irrevocable trust. The Tax Court focused on the fact that the son-general partner held his mother’s durable power of attorney, and as such he had a fiduciary duty to her, which thus constrained his independence as the general partner. The transactions were consummated about a week before the taxpayer’s death, and when the taxpayer was incapacitated, in a clear case of deathbed planning.

Senda v. Commissioner

In Senda, parents created an LLC to hold highly appreciated marketable stock. On the same day, the parents then gifted some of the LLC units to their children (or trusts for their benefit). The taxpayers failed to properly account under the partnership tax rules for the gifts made and the timing of the gifts were incorrect. Additionally, the taxpayers attempted to further reduce the value and claimed valuation discounts because the subject of their lifetime gifts were (i) minority, non-controlling, interests in the LLC (ii) which were not readily marketable due to the transfer restrictions contained in the LLC’s operating agreement.

The Tax Court found that indirect gifts of stock were made and the interests were transferred at the same time that the LLC was funded with marketable securities. Collapsing those two steps, the Tax Court found that the subject of the gift was not the LLC units but was the appreciated marketable stock. The Tax Court supported the IRS’s position that the underlying assets held in the LLC, appreciated stock, were the actual subject of the gift, not the “discounted” LLC units. As a result, the Tax Court ignored the application of valuation discounts and assessed a gift tax, penalties and interest on the underpayment of the gift tax caused by the gift of appreciated marketable securities.

The taxpayers, through sloppy handling of the partnership, now owe Federal gift taxes of almost $500,000 for gifts of stock whose value had subsequently declined by almost 90%.

Hackl v. Commissioner

The Tax Court in Hackl for the first time specifically denied that the mere transfer of a partnership interest automatically qualifies as a gift of a present interest qualifying the transfer for the gift tax annual exclusion. The court required the taxpayer to establish that the transfer in dispute conferred on the donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment of property or of income from property.

The test to determine whether the transfer of property is a gift of a present interest was established by the Tax Court in the Hackl case. To be a present interest under the Hackl test, the gift must provide the donee a substantial present economic benefit by reason of use, possession or enjoyment of either (1) the property or (2) the income from the property. To satisfy the first requirement, the taxpayer must prove that the facts and circumstances establish that possession of the interest renders an economic benefit reachable by the donee (via sale, acquisition or otherwise). To satisfy the second requirement, the taxpayer must prove that (i) income will, in fact, be produced; (ii) that some portion of that income will flow steadily to the beneficiary; and (iii) that the portion of income flowing out to the beneficiary can be ascertained.

In this case, Mr. Hackl transferred tree farms worth several million dollars to an LLC. The LLC was subjected to a restrictive operating agreement that vested exclusive management in a manager, where Mr. Hackl appointed himself “manager for life.” He also controlled all distributions from the LLC, and the operating agreement dictated that prior to the dissolution of the LLC “no Members shall have the right to withdraw the members’ capital contribution or to demand and receive property of the company or any distribution in return for the member’s capital contribution, except as may be approved by the manager.”

Additionally, the operating agreement implied each member waived his/her right to have any company property partitioned. Mr. Hackl then gifted LLC interests in the LLC to their eight children, their children’s spouses, and their 25 grandchildren claiming each transfer was subject to the annual gift tax exclusion amount. The Tax Court found that the transfers of the LLC units by Mr. Hackl were not present interest annual exclusion gifts. Instead they were taxable gifts that consumed part of Mr. Hackl’s lifetime gift tax exemption amount.

In summary, the Tax Court found that transfers of LLC interests were gifts of future interest and the court ruled that the gifts did not qualify for the annual gift tax exclusion. According to Hackl, to prove gifts are present interests, it must be shown that: (1) The LLC would generate income at or near the time of the gifts, (2) Some portion of that income would flow steadily to the donees, and (3) The portion of income flowing to the donees can be readily ascertained.

Solutions And Considerations

To avoid the results of any of the above cases, there are a few safeguards to put in place and maximize the interests of the FLLC such as:

Minimize Restrictions In The Short Term: Don’t impose any operating agreement restrictions on the transfer of the gifted interests for a specified period of time after the gift is made if the goal is to use the parent’s annual exclusion gifting opportunity. In other words, the gifted LLC interest is free from any transfer restrictions for a period of time, e.g., 90 days after the gift is made. Thereafter, the gifted interest will be subject to the LLC operating agreement’s restrictions and limitations on future transfers or liquidation voting rights.

Put Right: Another approach is to provide along with the gift of the LLC units a put right. The donor gifts the LLC units to the donee coupled to which a put right compels the donor to buy-back the gifted interests for their fair market value. The existence of this put right, say for 30 days after the gift is made, enables the donee to convert the illiquid, non-income producing LLC units, back into cash, thus satisfying the definition of a present interest.

Monitor Timing: The timing of forming the Family Partnership and the subsequent gift of entity interests is frequently litigated. Often, the Tax Court will collapse the funding of the entity and the transfer of interests in the entity into a single transaction in order to ignore valuation discounts normally attached to the transfer of a minority, illiquid, closely held interest if there is insufficient time between the entity’s creation and the transfer of interests in the entity. Transfers on the same day thus can be aggregated into a single transaction. The creation, funding and transfer of interests in a family controlled entity should not take place on the same day, nor at the same table, if the Service’s step transaction doctrine is to be avoided and valuation discounts claimed for the gifted entity interest.

Conclusion And Best Practices

Planning with FLLCs and FLPs is much more challenging in light of the Tax Court’s decision in Powell, and the ongoing desire of the donor to retain as much control over the entity created. That control impulse needs to be checked, and thoughtful, comprehensive planning must take place as there are many other situations in which one must use caution. The following is a final list of simple best practices families can implement, including:

• Follow What The Family Partnership Agreement Says: Always comply with the terms of the FLP agreement. If the partners fail to follow the procedures and processes spelled out in the FLP agreement or they fail to respect the FLP as a separate entity, the IRS will not respect the FLP either.
• Delay Entity Formation And Gifts:If FLP interests are to be gifted to family members, wait a reasonable period of time between the creation and funding of the FLP and the gift of the FLP interests to the donor’s family members. This delay will avoid the IRS from claiming that the underlying FLP assets were the subject of the gift.
• Relinquish (A Little) Control: If the donor of the FLP interest holds only limited partnership interest, avoid having the donor’s agent under the donor’s durable power of attorney also serve as the general partner of the FLP. The IRS will claim that the donor’s agent will be able to control distributions from, or liquidation of, the FLP.