Family LLCs (FLLCs) and/or Family Limited partnerships’ (FLLPs) have long been popular devices to use when making intra-family gifts (note the terms are used interchangeably below). They are easy to understand and administer, and require very little reporting at the state level, unlike a corporation. They are especially valuable and popular because the parent who creates the FLLC and then gifts the FLLC units to children, grandchildren or trusts established for their benefit, often remains in control as the FLLC’s manager, thus retaining the right to make investment decisions and decide when to make distributions from the FLLC to its members.
Recent changes, however, make transfers and value realization more difficult, especially in light of 2017’s Powell v Commissioner decision, which now allows the IRS to attempt to include the value of the transferred FLLC units in the parent’s taxable estate. Powell, though transformational, is not the first judgement to give families and estate planners cause for concern. The following is a synopsis of Tax Court decisions to consider as modern FLLCs are structured and what to consider with Gifts of LLC Interests.
LLC Precedents
• Powell v. Commissioner
In Powell, the mother owned a non-controlling 99 percent limited partnership at the time of her death. Her sons owned the 1 percent controlling general partner interest. The Tax Court held that despite being the limited partner the mother could act in conjunction with the general partner either to make distributions or to liquidate the partnership, thus causing $10 million of partnership assets to be included in the mother’s taxable estate at their fair market value.
The Tax Court focused on the fact that the son-general partner held his mother’s durable power of attorney, and as such he had a fiduciary duty to her, which thus constrained his independence as the general partner.
• Senda v. Commissioner
In Senda, parents created an LLC to hold highly appreciated marketable stock. On the same day, the parents then gifted some of the LLC units to their children (or trusts for their benefit). The parents tried to extract more value and claimed valuation discounts because the subject of their lifetime gifts were (i) minority, non-controlling, interests in the LLC (ii) which were not readily marketable due to the transfer restrictions contained in the LLC’s operating agreement.
The Tax Court found that the interests were transferred at the same time that the LLC was funded with marketable securities. Collapsing those two steps, the Tax Court found that the subject of the gift was not the LLC units but was the appreciated marketable stock. The Tax Court supported the IRS’s position that the underlying assets held in the LLC, appreciated stock, were the actual subject of the gift, not the “discounted” LLC units. As a result, the Tax Court ignored the application of valuation discounts and assessed a gift tax, penalties and interest on the underpayment of the gift tax caused by the gift of appreciated marketable securities.
• Hackl v. Commissioner
In this case, Mr. Hackl transferred tree farms worth several million dollars to an LLC. The LLC was subjected to a highly restrictive operating agreement that vested exclusive management in a manager, where Mr. Hackl appointed himself “manager for life.” He also controlled all distributions from the LLC, and the operating agreement dictated that prior to the dissolution of the LLC “no Members shall have the right to withdraw the members’ capital contribution or to demand and receive property of the company or any distribution in return for the member’s capital contribution, except as may be approved by the manager.”
Additionally, the operating agreement implied each member waived his/her right to have any company property partitioned. Mr. Hackl then gifted LLC interests in the LLC to their eight children, their children’s spouses, and their 25 grandchildren claiming each transfer was subject to the annual gift tax exclusion amount. The Tax Court found that the transfers of the LLC units by Mr. Hackl were not present interest annual exclusion gifts. Instead they were taxable gifts that consumed part of Mr. Hackl’s lifetime gift tax exemption amount.
Solutions And Considerations
To avoid a Hackl-like result structure or any of the above, there are a few safeguards to put in place and maximize the interests of the FLLC. This includes:
Minimize Restrictions In The Short Term: Don’t impose any operating agreement restrictions on the transfer of the gifted interests for a specified period of time after the gift is made if the goal is to use the parent’s annual exclusion gifting opportunity. In other words, the gifted LLC interest is free from any transfer restrictions for a period of time, e.g., 90 days after the gift is made. Thereafter, the gifted interest will be subject to the LLC operating agreement’s restrictions and limitations on future transfers or liquidation voting rights.
Confer: Another approach is to confer along with the gift of the LLC units a put right. The donor gifts the LLC units to the donee coupled to which a put right compels the donor to buy-back the gifted interests for their fair market value. The existence of this put right, say for 30 days after the gift is made, enables the donee to convert the illiquid, non-income producing LLC units, back into cash, thus satisfying the definition of a present interest. While the donor may be reluctant to attach a put right to the gifted LLC units, it is much like making a gift to an irrevocable trust where the trust beneficiary is given a crummey withdrawal right, which is also intended to satisfy the present interest rule.
Monitor Timing: The timing of forming the FLLC or FLP entity and the subsequent gift of entity interests is frequently litigated. Often, the Tax Court will collapse the funding of the entity and the transfer of interests in the entity into a single transaction in order to ignore valuation discounts normally attached to the transfer of a minority, illiquid, closely held interest if there is insufficient time between the entity’s creation and the transfer of interests in the entity. Transfers on the same day thus can be aggregated into a single transaction. The creation, funding and transfer of interests in a family controlled entity should not take place on the same day, nor at the same table, if the Service’s step transaction doctrine is to be avoided and valuation discounts claimed for the gifted entity interest.
Conclusion And Best Practices
Planning with FLLCs and FLPs is much more challenging in light of the Tax Court’s decision in Powell, and the ongoing desire of the donor to retain as much control over the entity created. That control impulse needs to be checked, and thoughtful, comprehensive planning must take place as there are many other situations in which one must use caution. The following is a final list of simple best practices families can implement, including:
• Follow What The FLP Agreement Says: Always comply with the terms of the FLP agreement. If the partners fail to follow the procedures and processes spelled out in the FLP agreement or they fail to respect the FLP as a separate entity, the IRS will not respect the FLP either.
• Delay Entity Formation And Gifts: If FLP interests are to be gifted to family members, wait a reasonable period of time between the creation and funding of the FLP and the gift of the FLP interests to the donor’s family members. This delay will avoid the IRS from claiming that the underlying FLP assets were the subject of the gift.
• Relinquish (A Little) Control: If the donor of the FLP interest holds only limited partnership interest, avoid having the donor’s agent under the donor’s durable power of attorney also serve as the general partner of the FLP. The IRS will claim that the donor’s agent will be able to control distributions from, or liquidation of, the FLP.
George F. Bearup is a senior trust advisor for Greenleaf Trust, an $8 billion Michigan-headquartered wealth management firm with disciplines in asset management, trust administration and retirement plan services. A graduate of Northwestern University School of Law, George has over 45 years of practical experience as an estate planning attorney. He is a Fellow of the American College of Trust and Estate Counsel.
