Keith Codron's Law Blog

Wednesday, March 31, 2010

Too Restrictive Operating Agreement Leads to Loss of Gift Tax Exclusion

A federal district court in Indianapolis recently held that the annual gift tax exclusion did not apply to taxpayers' gifts to their children of membership interests in a family-owned limited liability company. The court found that, based on certain restrictive provisions in the LLC's operating agreement, the membership interests represented "future interests" rather than "present interests" in the entity's assets.

The distinction between a present interest and a future interest lies in whether the donee has an unrestricted and unqualified right to the immediate use, possession and enjoyment of the gifted property, or the income therefrom (i.e., a substantial present economic benefit in the gifted property), or, on the contrary, whether such right is postponed or limited in its effectiveness to some future date or time. Gifts of remainders, reversions, executory interests and similar beneficial rights, whether vested or contingent, the use, possession and enjoyment of which, or the income from which, can only be had at some future date or time, represent gifts of future interests in property.

Under federal law, a taxpayer is entitled to an exemption from gift tax with respect to the first $1 million of taxable gifts made over the course of one's lifetime, computed cumulatively on a calendar year basis. Once the $1 million exemption is fully depleted, the tax rate is a flat 35% of a gift's value. Unlike the federal estate tax, the gift tax is not repealed for 2010 or any other year. In determining the amount of a donor's "taxable gifts" for each calendar year period, the first $13,000 of money or other property given to a donee in that calendar year is excluded, provided that the gift is of a present interest. [The annual exclusion amount is indexed for inflation.] A future interest in money or other property does not qualify for the annual gift tax exclusion under §2503(b) of the Tax Code. As a result, a gift of a future interest is deemed a taxable gift in its entirety and causes a depletion of the donor's $1 million lifetime exemption, in whole or in part, whereas a gift of a present interest is deemed a taxable gift only to the extent that the value of the gift exceeds $13,000 per donee per calendar year.

In the Indiana case, Fisher v. United States [S.D. Indiana, 2010-1 USTC ¶60,588 (3/11/2010)], a married couple transferred minority, non-controlling membership interests in their LLC to each of their 7 children.  The taxpayer-donors retained full management control over the LLC, the principal asset of which was an extremely valuable parcel of undeveloped beachfront land bordering Lake Michigan. When taxpayers filed their gift tax returns they claimed the annual exclusion pertaining to each such transfer. However, upon audit of those returns IRS claimed that the gifts were of future interests and assessed the Fishers a gift tax deficiency in the amount of $625,986! The Fishers paid the deficiency and filed a claim for refund in federal district court, alleging, among other things, that the transferred interests in the LLC were gifts of present interests.

The district court held in favor of IRS, stating that the membership interests received by taxpayers' children constituted a future interest, not a present interest, and that, consequently, no annual exclusion would be allowed.  The court based its decision on the following three factors: (1) the children's membership interests did not confer on them a substantial present economic benefit in the LLC's property because, under the operating agreement, the children's right to receive distributions of capital proceeds, whenever such distributions might occur, was subject to a number of contingencies, all of which were within the exclusive discretion of taxpayers as general managers of the LLC; (2) under the operating agreement there was no indication that an unrestricted right to use, possess or enjoy the LLC's property was in fact transferred to the children, and, in any event, the children's right to use, possess or enjoy beachfront land, without more, did not confer on them a substantial economic benefit in the LLC; and (3) although it was claimed that the Fisher children had the right to unilaterally transfer their membership interests in the LLC, under the operating agreement they could do so only if certain conditions were satisfied (such as the fact that the LLC had a right of first refusal if any purchase offers were made), conditions which effectively prevented the children from transferring their interests for immediate value, even to their own family members.

For further information about this or any other blog on this web site, please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.

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