Monday, September 13, 2021
In Part One of this series, I discussed some of the basics with respect to gifting pre-death to facilitate estate planning and/or business succession. Also covered in Part One was a gifting technique utilizing what is known as the “Crummey demand power” as a means of moving property into trusts for minors and qualifying the gifts for the present interest annual exclusion. In Part Two, the commentary continues with the use of the Crummey gifting technique with respect to entity interests.
Gifting interests in closely-held entities – it’s the topic of today’s article.
Using Crummey-Type Demand Powers in the Entity Context – Significant Cases
Crummey-type demand powers may also be relevant in the context of gifted interests in closely-held entities. From a present-interest gifting standpoint, the issue is whether there are substantial restrictions on the transferred interests such that the donee does not have a present beneficial interest in the gifted property. If so, the present interest annual exclusion is not available for the gifted interests. The courts have set forth markers that provide guidance.
The Hackl case. In Hackl v. Comr., 118 T.C. 279 (2002), the taxpayer purchased two tree farms (consisting of about 10,000 acres) worth approximately $4.5 million. He contributed the farms along with another $8 million in cash and securities to Treeco, LLC (“Treeco”), and had an investment goal of long-term growth (the trees were largely unmerchantable timber). The actual tree farming activities were conducted via a separate entity. The taxpayer and his wife initially owned all of Treeco’s interests, with the taxpayer serving as Treeco’s manager. Under the LLC operating agreement, the manager could serve for life (or until he resigned, was removed or became incapacitated) and could also dissolve the LLC. The operating agreement also specified that the manager controlled any financial distributions and members needed the manager’s approval to withdraw from the company or sell their shares. As for cash distributions, the operating agreement specified that the taxpayer, as manager, “may direct that the Available Cash, if any, be distributed to the members pro rata in accordance with their respective percentage interests.” No member could transfer their respective interest unless the taxpayer gave prior approval. If a member made an unauthorized transfer of shares, the transferee would only receive the economic rights associated with the shares – no membership or voting rights transferred. In addition, before dissolution, no member could withdraw their respective capital contribution, unless the taxpayer approved otherwise. It also took an 80 percent majority to amend Treeco’s articles of organization and operating agreement and dissolve Treeco after the taxpayer ceased being the manager.
Upon Treeco’s creation, the taxpayer and his wife began transferring voting and nonvoting shares of Treeco to their eight children, the spouses of their children and a trust established for their 25 minor grandchildren. Eventually, a majority of Treeco’s voting shares were held by the children and their spouses. The taxpayer and his wife elected split-gift treatment, and reported the transfers as present interest gifts covered by the annual exclusion ($10,000 per donee, per year at the time). However, the IRS disallowed all of the annual exclusions, taking the position that the transfers involved gifts of future interests. The taxpayer claimed that the gifts were present interests because all legal rights in the gifted property were given up, but IRS viewed the gifted interests as still being subject to substantial restrictions that did not provide the donees with a substantial present economic benefit. As a result, the IRS position was that the gifts were future interests’ ineligible for the exclusion.
The Tax Court agreed with the IRS that the transfers were gifts of future interests that were not eligible for annual exclusions. The Tax Court determined that the proper standard for determining present interest gift qualification was established in Fondren, 324 U.S. 18 (1945), where the key question was whether the transferee received an immediate “substantial present economic benefit” from the gift. To answer that question, Treeco’s operating agreement became the focus of attention. On that point, the Tax Court noted that Treeco’s operating agreement required the donees to get the taxpayer’s permission before transferring their interests and gave the taxpayer the retained power to either make or not make cash distributions to the donees. In addition, the donees couldn’t withdraw their capital accounts or redeem their interests without the taxpayer’s approval, and none of them, acting alone, could dissolve Treeco. Based on those restrictions, the Tax Court determined that the donees did not realize any present economic benefit from the gifted interests. Instead, the restrictive nature of Treeco’s operating agreement “forclosed the ability of the donees presently to access any substantial economic or financial benefit that might be represented by the units.” Thus, the gifts, while outright, were not gifts of present interests. See also Treas. Reg. §25.2503-3. On appeal, the U.S. Court of Appeals for the Seventh Circuit agreed. Hackl v. Comr., 335 F.3d 664 (7th Cir. 2003).
The Price and Fisher cases. In 2010, the Tax Court reached the same conclusion in a case that was factually identical to Hackl where the donees lacked the ability to “presently to access any substantial economic or financial benefit that might be represented by the ownership units.” Price v. Comr., T.C. Memo. 2010-2. Likewise, a federal district court reached the same result in Fisher v. United States, No. 1:08-cv-0908-LJM-TAB, 2010 U.S. Dist. LEXIS 23380 (S.D. Ind. Mar. 11, 2010). In Fisher, the taxpayers transferred 4.762 percent membership interests in an LLC to each of their seven children (one-third total interest in the LLC). The LLC’s primary asset was undeveloped land bordering Lake Michigan. The taxpayers claimed present interest annual exclusions for the gifts, but on audit, IRS disagreed on the basis that the gifts were future interests and assessed over a $650,000 gift tax deficiency.
The Fisher court noted that the LLC’s operating agreement specified that any potential of the LLC’s capital proceeds to the taxpayers’ children was subject to numerous contingencies that were completely within the LLC general manager’s discretion. So, consistent with Hackl, the court determined that the right of the children to receive distributions of the LLC’s capital proceeds did not involve a right to a “substantial present economic benefit.” As for the taxpayers’ argument that the children had the unrestricted right to possess, use and enjoy the LLC’s primary asset, the court noted that there was nothing in the LLC’s operating agreement that indicated such rights were transferred to the children when they became owners of the LLC interests. Finally, the court rejected the taxpayers’ argument that the children could unilaterally transfer their LLC interests. The court noted that such transfers could only be made if certain conditions were satisfied – including the LLC’s right of first refusal which was designed to keep the LLC interests within the family. Even if such a transfer stayed within the family, the LLC operating agreement still subjected the transfer to substantial restrictions. The result was that the court upheld the IRS’ determination that the gifts were not present interest gifts, just as the similarly structured transfers in Hackl and Price didn’t qualify as present interest gifts.
The Wimmer case. In Estate of Wimmer v. Comr., T.C. Memo. 2012-157, the decedent and his wife established an FLP to invest in land and stocks. The decedent also established a trust for his grandchildren. The trust was a limited partner of the FLP and was set-up as a Crummey Trust. The trust, as a limited partner, received dividends. The decedent and his wife were limited partners and they made gifts of partial limited partner interests on an annual basis consistent with the present interest gift tax exclusion. The gifts of the limited partner interests were significantly restricted, however, under the FLP agreement.
The IRS claimed that the gifts of limited partner interests were not present interests and, as such, were not excluded from the decedent's gross estate. However, the Tax Court concluded that while the donees of limited partner interests did not receive an unrestricted right to the interests, they did receive the right to the income attributable to those interests. The Tax Court also noted that the estate had the burden of establishing that the FLP would generate income and that some portion of that income would flow to the donees on a consistent basis and that the portion could be ascertained. Importantly, the FLP held dividend-producing, publicly traded stock. Thus, the court determined that the income from the stock flowed steadily and was ascertainable. Accordingly, the limited partners received present interests and the gifted amounts were excluded from decedent's estate. Based on Wimmer, an FLP that makes distributions on at least an annual basis should allow the use of present interest gifting.
If a partnership/LLC places sufficient restrictions on gifted interests or the general partner has unfettered discretion to make or withhold distributions, any gift of an interest in the partnership/LLC may be treated as a gift of a future interest that does not qualify for the annual gift tax exclusion. See, e.g., Tech. Adv. Memo. 9751003 (Aug. 28, 1997). In Hackl, Price and Fisher, there was no question that the donees had the immediate possession of the gifted interests. However, even if such interests have vested, the Tax Court (and the appellate court in Hackl) listed numerous factors that led to the conclusion that the gifted interests were not present interests. Unfortunately, from an estate and business planning perspective, those same factors are typically drafted into operating agreements with the express purpose of generating valuation discounts for estate and gift tax purposes.
So, there’s a trade-off between annual exclusion gifts and valuation discounts. But, Wimmer may provide a way around the corner on that problem if the FLP generates income and it can be established that at least some of that income will consistently flow to the donees in ascertainable amounts. Beyond that, there may be other ways to achieve both present interest status for gifts and valuation discounts for transfer tax purposes. Clearly, from a present interest perspective, the key is to gift equity interests in an entity that give a donee the right to withdraw from the entity, have less restrictions on sale or transfer and make regular distributions to a donee. Structuring to also take valuation discounts upon death could include drafting the entity’s operating agreement to specify that transferred interests are subject to put rights allowing the transferee the ability to force the entity or another transferee to repurchase the transferee’s interests at a particular price, after a specified date or upon the occurrence of a specified event. That seemingly provides the done with a present interest while preserving valuation discounts.
In any event, a combined strategy of present interest gifting of entity interests with valuation discounting requires careful drafting.
Present interest gifting is possible via entity interests. When valuation discounts upon death are also desired, the structuring and drafting becomes complex. In Part Three, I will focus on additional income tax considerations involving income tax basis as well as income tax issues associated with gifting partnership interests.