We’re never happy to report IRS wins at KYEstates, but if we have to bring you news of taxpayer defeat, we like it when the defeat breaks no new ground in favor of the government. KYEstates previously discussed the denial of the annual exclusion for gifts of limited partnership interests in Price, which was sort of “Hackl II“.
Like any self-respecting producer of action-adventure movies (e.g., Rocky, Rambo, Die Hard, Indiana Jones, Star Wars, Bourne, etc.), the IRS recognizes when the formula is working, and quickly serves up more of the same. The bad news of “Hackl III” is Fisher v. U.S., 105 A.F.T.R.2d 2010-1347 (S.D. Ind.) (Mar. 11, 2010).
In Fisher, the taxpayers sought refunds of gift taxes paid. The U.S. District Court for the Southern District of Indiana ruled on cross motions for summary judgment in which the single issue was whether gifts made by the taxpayers “to their children were transfers of present interests in property and, therefore, qualified for the gift tax exclusion under section 2503(b)(1).”
The facts were as follows:
From 2000 through 2002, the Fishers transferred 4.672% membership interests in Good Harbor Partners, LLC (a family LLC) to each of their seven children. During the years the gifts were made, the LLC’s “principal asset was a parcel of undeveloped land that borders Lake Michigan.” When they filed their gift tax returns, the Fishers initially claimed the annual exclusion for each transfer. The taxpayers lost the gift tax audit lottery. On audit, “the Government assessed a deficiency of $625,986.00 in additional gift tax owed…The Fishers paid the deficiency and filed a claim for refund, alleging, in part, that the gifts of membership interests in [the LLC] were gifts of present interests.”
The LLC’s operating agreement provided for the LLC to be managed by a management committee, that would appoint a general manager, who would determine the timing and amount of all distributions from the LLC. (The Fishers constituted the management committee, and Mr. Fisher was the general manager.) The operating agreement provided that any distributions that were made would be made pro-rata.
The operating agreement allowed members to transfer their right to a share of the LLC’s profits and losses and the right to receive distributions, subject to a right of first refusal held by the LLC. If the LLC exercised this right of first refusal, it would pay the transferring member with non-negotiable 15-year promissory notes providing for equal annual installments of principal and interest, beginning one year after the closing date. These transfer restrictions applied in all instances except transfers to the Fishers or their birth or adoptive descendants.
The District Court cited Hackl [a bad sign!] in its summary review of the present interest requirement under section 2503:
Internal Revenue Code provisions dealing with exclusions are matters of legislative grace that must be narrowly construed….The sole statutory distinction between present and future interests lies in the question of whether there is postponement of enjoyment of specific rights, powers or privileges which would be forthwith existent if the interest were present….In other words, the phrase ‘present interest’ connotes the right to substantial present economic benefit.
The District Court also cited Stinson Estate v. U.S., 214 F.3d 846, 849 (7th Cir. 2000):
Unless the donee is entitled unconditionally to the present use, possession, or enjoyment of the property transferred, the gift is one of a future interest.
Counsel for the Fishers did the best they could under the circumstances, and made three valiant arguments that the gifts of LLC interests satisfied the present interest requirement:
First, the Fishers argue that upon transfer, the Fisher Children possessed the unrestricted right to receive distributions of [the LLC’s proceeds].
The District Court didn’t bite:
However, under the Operating Agreement, any potential distribution of [the LLC’s proceeds] to the Fisher Children was subject to a number of contingencies, all within the exclusive discretion of the General Manager… Accordingly, the right of the Fisher Children to receive distributions…, when such distributions occur, is not a right to a ‘substantial present economic benefit.’
Second, the Fishers argue that upon transfer, the Fisher Children possessed the unrestricted right to possess, use, and enjoy [the LLC’s] primary asset, the Lake Michigan beach front property.
Likewise, this wasn’t sufficient for the District Court:
[T]he right to possess, use, and enjoy property, without more, is not a right to a ‘substantial present economic benefit.’…[instead, it] is a right to a non-pecuniary benefit.
Lastly, the Fishers assert that upon transfer, the Fisher Children possessed the unrestricted right to unilaterally transfer their interests in Good Harbor. The Fishers argue that this right is a present interest in property.
Relying again on Hackl, the District Court didn’t view this argument favorably. Reviewing the operating agreement’s transfer restrictions, it noted:
…due to the conditions restricting the Fisher Children’s right to transfer their interests in [the LLC], it is impossible for the Fisher Children to presently realize a substantial economic benefit.
If you sensed that this was not going to go well for the taxpayer, you were correct. The District Court held as follows:
Based on the undisputed facts, the Court [concludes] that the transfers of interests in the LLC from the Fishers to the Fisher Children were transfers of future interests in property and, therefore, not subject to the gift tax exclusion under [section 2503(b)(1)].
The District Court granted the government’s motion for summary judgment, and denied the taxpayers’ cross-motion.
Readers, this case reinforces the conclusion to be drawn from Price and Hackl. When making gifts of limited partnership or LLC interests, strongly consider giving donees a put option back to the donor(s) during a 30-day Crummey withdrawal period, at the appraised fair market value for such units found in connection with the gift. For additional resources on the put option solution to satisfying the present interest requirement, consult the end of KYEstates’ previous post on Price.
We’re sorry to report this taxpayer loss. The Fishers hadn’t had the benefit of Hackl‘s example when the gifts were made in 2000 and 2001, and their 2002 gifts might also have predated Hackl. The Service may have had easy pickings cleaning up on pre-Hackl LLC or limited partnership gifts. Readers, take note of Fisher‘s cautionary example and let’s not give the Service any more targets of opportunity, shall we?