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Gifts of LLC Interest Not Qualifying for Annual Exclusion

Author: Ronald E. Lyons Date: 06/29/2010

Categories: Estate Planning and Administration, Tax Services

The gift tax annual exclusion allows an individual to gift $13,000.00 (as indexed for 2010) to an unlimited number of donees each year without paying gift tax. In order to qualify for the annual exclusion, however, a gift must be of a “present interest” in accordance with IRC 2503(b). To qualify as a present interest in property, the recipient needs to have an unrestricted right to the immediate use, possession, or enjoyment of the property or the income from the property.

This is important in light of a recent Indiana District Court case which held that a married couple’s gifts of membership interests in a limited liability company to their children did not qualify for the gift tax annual exclusions because they were deemed to be gifts of future (rather than present) interests. The Court in Fisher v. U.S. determined that there were significant restrictions preventing the donees from presently realizing any substantial financial or economic benefit from the interests conveyed to them.

The Fisher case relied heavily upon the 2002 landmark case of Hackl v. Commissioner. The court in Hackl held that, to establish entitlement to an annual donee exclusion, a taxpayer must show that the transfer conferred on the donee an unrestricted and non-contingent right to the immediate use, possession, or enjoyment of the property or the income from the property. Either way, the immediate use, possession, or enjoyment must be of such a nature that substantial economic benefit is derived from it.

In the Fisher case, the parents transferred a 4.762% membership interest in their LLC to each of their seven (7) children. The LLC’s principal asset was a parcel of undeveloped land. Under the company’s Operating Agreement, all powers were exercisable by the management committee, which consisted of the parents, and its decisions were binding on the LLC and its members. The General Manager (Mr. Fisher) was appointed by the management committee. He supervised the day-to-day operations of the LLC and determined the timing and amount of all distributions. In addition, there were significant restrictions on the ability of the children to transfer their membership interests in the LLC. Moreover, the company had a right of first refusal to purchase a prospective transferor’s interest. If exercised, the company would pay the transferor with a non-negotiable promissory note payable over an extended period of time. This right of first refusal could only be disregarded in the event of a transfer by the children to one of their own descendants.

The parents argued that the transfers of interest in the LLC to their children were gifts of present interests in property because (1) their children possessed the unrestricted right to receive distributions of capital proceeds; (2) the children possessed the unrestricted right to possess, use, and enjoy the company’s primary assets; and (3) the children possessed the unrestricted right to unilaterally transfer their interests in the company.

The District Court rejected the arguments of the parents. The Court found that the right of the children to receive distributions of the company’s capital proceeds, when such distributions occur, was not a right to receive a “substantial present economic benefit.” The Court referred back to its decision in Hackl that when a trust provides for a distribution of the corpus or trust income only after some uncertain future event, the trustee possesses a future interest. Based upon the Operating Agreement of the Fishers’ company, any potential distribution of capital proceeds to the children was subject to a number of contingencies, all of which were within the exclusive discretion of the manager.

The Court further indicated that the right to possess, use, and enjoy property, without more, is not a right to a substantial present economic benefit. Rather, it is a right to a non-pecuniary benefit. Finally, the Court took note of the fact that the children could only unilaterally transfer their right to receive distributions from the company if prior conditions were first satisfied. Under the facts of the Fisher case, this meant that they could not, effectively, transfer their interest in the company in exchange for immediate value unless the transfer was to a Fisher family descendant.

The unspoken implication is that gifts convey present rights of substance to the beneficiaries in order to enhance the likelihood that the gift qualifies for the annual gift exclusion. Consideration should be given to providing the donees with a limited right to demand income or principal. This would be similar to a Crummey power which is commonly used to qualify gifts to irrevocable trusts for the annual exclusion.