When is a gift not a gift? According to a recent U.S. Tax Court case, Hackl, 118 TC No. 14 (03/27/02), the outright transfer of interests in a limited liability company (“LLC”) which were subject to certain restrictions in the LLC’s operating agreement were not considered gifts of a present interest for federal gift tax purposes.
The Hackls are a married couple who have eight children and 25 minor grandchildren. Mr. Hackl set up an LLC to conduct a tree-farming operation and to accomplish certain other objectives, including estate tax planning. The LLC’s operating agreement contained various restrictions relating to the transferability of the interests as well as restrictions disallowing the members to withdraw from the LLC.
In 1995 and 1996, the Hackls transferred membership interests in the LLC to each child and their spouses and to an irrevocable trust for their grandchildren (the “donees”). The gifts were reported on gift tax returns in which annual exclusion gifts were claimed.
Gift Tax Exclusion?
The issue in Hackl was whether the transfers qualified for the annual gift tax exclusion under Internal Revenue Code Section 2503(b), which provides that the first $11,000 (as of 2002) of present interest transfers to each person are excluded from federal gift tax. If the transfer is of a future interest, it does not qualify for the exclusion. The regulations under the Internal Revenue Code provide that a present interest is the “unrestricted right to the immediate use, possession, or enjoyment of property or the income from the property.”
The specific issue the Hackl court addressed was whether the restrictions in the LLC operating agreement converted what would have otherwise been a present interest into a future interest.
The IRS argued that the terms of the operating agreement contained significant restrictions that made it impossible for the membership interests to provide the Hackls’ children and grandchildren with immediate and unconditional rights to use, possess, or enjoy the property or the income from the property. Thus, the transfers would not qualify for the annual exclusions under IRC Section 2503(b) and would be taxable gifts.
The Hackls countered the IRS’ position by arguing that they made direct, outright transfers of the LLC interests to the donees, that the LLC interests are personal property separate and distinct under state law from the LLC’s assets, that the donees acquired full ownership of the gifted interests, and that there was no postponement of the donees’ rights to enjoy the property they received outright.
The court in Hackl agreed with the IRS in holding, “to constitute a present interest, a gift must convey meaningful economic, rather than merely paper, rights.” The court stated, “we reject petitioner’s contention that when a gift takes the form of an outright transfer of an equity interest in a business or property, no further analysis is needed or justified. To do so would be to sanction exclusions for gifts based purely on conveyancing form without probing whether the donees in fact receive rights differing in any meaningful way from those that would have flowed from a traditional trust arrangement.”
The Hackl decision is significant in its analysis, which could be applied to gifts of a variety of family business interests. Even though the Hackls created the LLC to achieve certain estate tax planning goals, the holding of Hackl can be applied to transfers of ownership interests of stock or partnership interests that are subject to restrictions. Closely held entities usually contain certain restrictions for reasons other than estate tax planning, and the Hackl case may adversely impact transfers of those ownership interests.
There are some planning opportunities that could be employed in response to the Hackl decision. First, the Tax Court implied that if the LLC distributed income to the donees on a regular basis, the transfers would have qualified for the annual exclusion regardless of the ownership restrictions contained in the operating agreement. Second, the restrictions could be designed to permit the donees to sell or assign their interests subject only to a right of first refusal. Finally, the donees could be given a limited right to sell back the LLC interests to the LLC (a “put”) for fair market value within a short time period after receiving the gift.
If any of these planning alternatives had been used by the Hackls, it is likely that the transfers would have qualified for the annual exclusion.
E. Paul Amata is an attorney with the Springfield firm Robinson Donovan Madden & Barry, specializing in taxes and estate planning; (413) 732-2301.