Gifting LLC Interests; A New Hidden Trap
By Douglas C. Alexander
SAALFELD GRIGGS PC
Many people have organized limited liability companies as entities through which to conduct their businesses. One reason for choosing an LLC is the ease with which the membership interests can be transferred, thus facilitating gifts, including gifts that qualify for the annual gift tax exclusion. Often, parents who have accumulated significant real property holdings as part of a strategy of transitioning the business and its appreciated assets to their children will make gifts of their LLC interest to the children, utilizing the $11,000 per donee annual gift tax exclusion available under Section 2503(b) of the Internal Revenue Code. In a recent US Tax Court case, the court imposed new and significant restrictions on making such gifts of LLC membership interests that qualify for the annual exclusion.
In Hackl v. Commissioner, 118 TC 14 (March 27, 2002), the controversy centers on whether gifts of LLC membership interests by parents to children, spouses of children, and grandchildren, were eligible for the annual gift tax exclusions. The Hackls operated a tree farming business on 11,000 acres in Florida and Georgia, funded by a contribution of $8 million in cash and securities by Mr. & Mrs. Hackl (the parents) upon formation of the LLC. The LLC was manager managed, with Mr. Hackl (the father) serving as the manager. Because of the nature of the business, the members and managers anticipated that the company would generate losses and would not make any distributions for years, likely until the trees were harvested; capital appreciation and long term gains were the goal rather than current income generation.
An Operating Agreement was adopted for the LLC. Under the terms of the Operating Agreement, the manager could make distributions to the members only after the payment of operating expenses and debts, and only after funding a capital reserve. Furthermore, the members could not receive distributions, sell their ownership interests, withdraw their capital contributions, or withdraw from the LLC without the consent of the manager. A majority of the members could remove the manager, but only the vote of 80% of the members could cause a change in the Operating Agreement.
The Hackls proceeded to make gifts each year to their children, sons and daughters in law, and grandchildren, each time claiming that the gifts qualified for gift tax exclusion under Section 2503(b). Eventually, the Hackls had gifted enough of the LLC to become minority holders. The IRS brought suit against the taxpayers, claiming that the gifts did not qualify for the exclusion.
At trial, the Tax Court concurred with the IRS position. The court ruled that the gifts were not gifts of present interests. To qualify for the annual exclusion, a gift must result in a donee receiving a substantial present economic benefit. The Tax Court concluded that the Operating Agreement contained restrictions that had the effect of preventing the donees from receiving any economic benefit from the LLC membership interests transferred. The inclusion of the provision that all transfers were subject to approval of the manager effectively prevented the donees from obtaining any value for the membership interests received. The court also ruled that in addition to being non-contingent, the rights of a member to receive economic benefit must be able to be exercised independently. The court concluded that this condition was not met because the removal of the manager required majority action. Furthermore, the court stated that the entity must have income. In this case, the LLC did not generate current income, and even if it had, the fact that the manager had absolute discretion over any distributions resulted in a conclusion that the gifts were of a “future” rather than a “present” interest, and thus ineligible for the annual exclusion.
The code and regulations define a present interest as an unrestricted right to the immediate use, possession, or enjoyment of property or income therefrom. In Hackl, the Tax Court stated that to qualify as a present interest, the gift must give the donee “a substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or the income form the property.”
This case has significant implications for business owners using LLCs as a tool to transfer business interests to successors. Until this ruling, planners felt comfortable concluding that an outright gift of an LLC interest constituted the gift of a present interest, and thus it was eligible for the annual gift tax exclusion. Now, if the LLC does not make regular distributions to its members, then to qualify as a present interest, the donees must have a presently exercisable right to either demand a distribution, or to unilaterally sell or otherwise receive value for their ownership interests. Those “presently exercisable rights” should be equal in value to at least the annual exclusion amount ($11,000 in 2002).
LLC owners who have a plan of gifting in place should carefully evaluate the terms of their operating agreements to verify that they do not contain restrictions which will result in loss of the right to claim the annual gift tax exclusion. If you would like assistance in determining how the Hackl case may affect you, please feel free to call us.