Taxes—How to Make Limited Partnership Gifts
Qualify for the Annual Exclusion
IRC Section 2503(b) provides an exclusion from gift tax for the first $13,000 of present interest gifts a donor makes to any person or persons during a calendar year. Treasury regulations define “present interest” as the unrestricted right to the immediate use, possession or enjoyment of property or the income from property. In contrast, the annual exclusion is denied for gifts of “future interests,” including reversions, remainders and other interests designed to commence in use, possession or enjoyment at some future date or time.
A question, which has surfaced from time to time, is whether limited partnership interests (or limited liability company memberships) created in connection with discount family limited partnerships (or discount limited liability companies) qualify for the annual exclusion. The question arises because such interests are often transferred by gift to younger-generation family members in an effort to shift future appreciation out of the older generation’s larger estate. Furthermore, these interests have limited withdrawal rights, restrictions on marketability, and typically lack voting power including the power to distribute income.
Although such limitations and restrictions yield significant discounts for estate and gift tax purposes, they have led the IRS to question whether they also create a future interest rather than a present interest.
The courts first addressed this question in 2002, in the case of Hackl v. Commissioner, 335 F.3d 664 (7th Cir. 2003), aff’g 118 T.C. 279 (2002).
Both the Tax Court and the Seventh Circuit rejected the taxpayer’s argument that they were entitled to annual exclusions for their gifts of LLC interests because they had made direct outright gifts of personal property of substantial value (the LLC interests), transferring all of their rights in that property. The courts focused on the LLC agreement to determine whether the donees had received any immediate, substantial economic value.
In reaching its conclusion, the Tax Court pointed to the following:
- The company’s agreement required the manager’s consent for withdrawal;
- The donees lacked the ability to effect dissolution of the company; and
- There was no LLC income.
The Seventh Circuit agreed and went on to apply a further three-part test in reaching its conclusion that the donees were not entitled to income from the gifted property:
- The partnership should generate income at or near the time of the gifts;
- Some portion of that income would flow steadily to the donees; and
- The portion of income flowing to the donees can be readily ascertained.
In the court’s opinion, the taxpayers did not satisfy the second and third requirements of the test. Rather, the evidence showed that there were no LLC distributions in either 1997 or in 2001. Furthermore, the LLC’s agreement’s requirement of discretionary distributions prevented a finding that the income flowing to the donees was readily ascertainable.
In the years following Hackl, savvy practitioners have drafted LLC and FLP agreements to comply with the three-pronged test used in that case, while at the same time continuing to restrict transferability of gifted interests in order to obtain valuation discounts. The issue went un-litigated until Price v. Commissioner, T.C. Memo. 2010.
In Price, the IRS argued that the transferred interests were future interests because the partnership agreement did not allow transfers to third parties and the agreement did not grant the FLP limited partners a present right to income distributions, and denied their annual exclusions.
The court agreed with the IRS. It explained that a fiduciary’s discretion (a general partner has a fiduciary duty to limited partners) to withhold income payments negates the present interest requirement. According to the court, to qualify for the annual exclusion, the donor must give the income beneficiary an immediate right to enjoy substantial economic benefits in the transferred property.
Estate of Wimmer v. Comm’r, TC Memo 2012-157
Now, welcome the Wimmer case into the mix.
George Wimmer and his wife formed a family limited partnership in 1996. Partnership assets included public stock, which paid dividends. The partnership agreement restricted transfers of partnership interests and limited the ability of unrelated transferees to become substitute limited partners.
In years 1996 through 2000, the Wimmers gave limited partnership interests to family members and to a trust for grandchildren. The partnership received dividends from the publicly-traded stock it owned and in 1996 began making cash distributions to partners sufficient to cover their pro rata share of income taxes due. In 1999 the partnership began distributing all cash dividends to partners on a pro rata basis.
In a significant victory for taxpayers, the Tax Court applied the Seventh Circuit’s three-pronged test from Hackl and concluded that:
- The partnership holds stock that is expected to produce income;
- The partnership agreement and fiduciary duties obligate the distribution of income at least sufficient to pay taxes; and
- The amount of the income distributed can be estimated because the stock is publicly traded with an established dividend history. Therefore, each of the three requirements is satisfied and the gifts qualify for the gift tax annual exclusion.
In discussing FLPs and family LLCs with clients, the annual exclusion for gifts of limited partnership or LLC membership interests cannot be taken for granted. The availability of the annual exclusion depends on the underlying agreement. Clients may have to choose between deep discounts and the annual exclusion. Although the Wimmer case does not discuss valuation, presumably a limited partnership interest that provides a dependable income stream to the donee is worth more for gift tax purposes than a limited partnership that does not provide such an income stream.
Taxes and similar topics are covered in great detail in many of Cannon’s professional development solutions. To find out more visit: www.cannonfinancial.com.
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