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Take Care When Gifting Closely Held Business Interests

Take Care When Gifting Closely Held Business Interests if you plan on Sheltering the Gift using the Annual Gift Tax Exclusion. By John C. Hale, Esq.

The current tax laws permit each individual to make annual present interest gifts valued at up to $13,000.00 to any individual (the "Annual Exclusion").[1] Traditionally, the Annual Exclusion is used to transfer property tax free to children. A married couple using this system can transfer $26,000.00 each year to each child tax free. It should be kept in mind, however, that this exemption is not restricted to children or other family members. The Annual Exclusion may be used to transfer property to anyone and for any purpose. If a regular gift giving program is followed, it can substantially reduce a taxable estate. To qualify for the Annual Exclusion, however, the gift must be of a present interest which requires an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.[2]

In 2002, the Tax Court held that to qualify for the Annual Exclusion a taxpayer must show that a gift gives a donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property to such an extent that a substantial economic benefit is derived from it. The decision was subsequently affirmed by the Court of Appeals for the Seventh Circuit in 2003. [3] The concern this decision generated was whether an interest in a closely held business such as a partnership or a limited liability company would qualify for the Annual Exclusion if there were restrictions on the transferred interests (as is typically the case with these types of closely held business arrangements).

On January 4, 2010, the US Tax Court ruled that a husband and wife's gifts of membership interests to each of their three adult children in a family limited partnerships were gifts of future interests and therefore did not qualify for the Annual Exclusion. The Court noted that the donors bore the burden of proving that their gifts qualified for the Annual Exclusion. Both the IRS and the donors cited the Hackl case mentioned in the paragraph above in support of their positions. The Tax Court found that the facts in Hackl were indeed not different in any material way. In reaching its finding the Court noted, among other things, that: (1) under the partnership agreement the donees had no unilateral right to withdraw their capital accounts (2) the partnership agreement prohibited all partners from selling, assigning, or transferring their partnership interests to third parties or from otherwise encumbering or disposing of their partnership interests without the written consent of all partners; (3) upon the transfers the donees did not become substituted limited partners, rather, the gifts were effective only to give each child a share of the profits as an assignee.

On March 11, 2010, Judge Larry J. McKinney, of the United States District Court, Southern District of Indiana, similarly ruled that a husband and wife's gifts of membership interests to their children in a family limited liability company were gifts of future interests and therefore did not qualify for the Annual Exclusion.[4] Although the taxpayer in Fisherraised several arguments, the Court made quick work of the arguments and its central focus appeared to be the number of conditions which restricted the children's right to transfer their gifted interests, therefore making it difficult for them to realize a substantial economic benefit in any immediate or "present" fashion.

To attempt to avoid IRS challenges in this regard, many practitioners have been amending their business documents to provide a donee a limited right to demand and withdraw income or principal, much like a "Crummey" power (named after the case Crummey v. Commissioner, a 1968 9th Circuit Federal Court case) which allows a trust beneficiary to have a right to withdraw a limited amount of trust principal within a restricted period, a technique which has long been used to qualify gifts in trust for the Annual Exclusion. In light of the most recent cases, it is clear that the taxpayer needs to address this issue in a straight-forward manner. Feel free to contact us to discuss this and other issues relative to planning with business entities.


[1] Under the 1997 Tax Act, the annual exclusion which was $10,000.00 at the time was indexed for inflation and is increased in $1,000 increments. An increase to $11,000 occurred in 2002, an increase to $12,000.00 occurred in 2006, and finally an increase to $13,000.00 occurred in 2009.

[2]IRC Sec. 2503(b); Reg. § 25.2503-3.

[3] Hackl v. Commsr., 118 TC 279, aff'd. by 335 F.3d 664.

[4] John W. Fisher and Janice B. Fisher vs. US, No. 1:08-cv-0908-LJM-TAB, 105 AFTR 2d ¶ 2010-600.

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