Editor: Rick Klahsen, CPA
On January 4, 2010, the Tax Court held, in Price, T.C. Memo. 2010-2, that the taxpayers failed to show that gifts of partnership interests conferred on the donees an unrestricted right to immediately use, possess, or enjoy either the property itself or income from the property. Thus, the taxpayers were not entitled to annual gift tax exclusions under Sec. 2503(b) for the outright gifts of the partnership interests. The decision in Price reinforces the IRS position set forth in Hackl, 335 F.3d 664 (7th Cir. 2003). The Hackl case examined how the partnership’s operating agreement and actual operations affect the gift of partnership interests and, more importantly, the availability of annual exclusions. These court decisions challenge tax practitioners to review all aspects when gifting partnership interests.
Background
Generally under Sec. 2503(b), the first $13,000 ($10,000 in the Code, indexed for inflation) of an individual’s gifts to any person during the calendar year is excluded from the total gifts for that year. However, in order for the annual exclusion to apply, the gift must be a present interest rather than a future interest in the property. A future interest differs from a present interest because it postpones the right to use, possess, or enjoy the property. It is irrelevant as to when the donee vests in the property, as an immediate vesting does not always coincide with enjoyment.
The Code does not define future interest, but Regs. Sec. 25.2503-3(a) states that “‘future interest’ is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.” Regs. Sec. 25.2503-3(b) further adds that a present interest is “an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain).” Price and Hackl deny the premise that the mere transfer of partnership interests automatically qualifies as a present interest and thus is entitled to gift tax annual exclusions.
Hackl
A. J. Hackl bought two tree farms after his retirement to stay connected to the business world and diversify his investments. He then contributed the two farms, valued at $4.5 million and $8 million in cash and securities, to Treeco, LLC, a limited liability company (LLC). Serving as the company’s manager, Hackl controlled any financial distributions, and members needed his approval to withdraw from the company or sell shares. He also had the power to dissolve the company. Treeco, under Hackl’s management, never turned a profit and never made any distributions.
From 1995 to 1998, the Hackls annually transferred shares of voting and nonvoting stock to their children and their spouses. In order to shield the transfers from tax, Hackl (and his spouse) treated them as excludible gifts on their gift tax returns. The taxpayers argued that the transfer of member interests is a legal transfer and that they gave up their full property rights. The IRS interpreted the annual exclusion more narrowly and argued that a transfer without a substantial present economic benefit is a future interest and ineligible for the exclusion. The IRS argued that Treeco’s restrictions on the transferability of shares meant the donees had little immediate economic benefit. In addition, Treeco never made an income distribution, precluding it from the regulations’ second standard of receiving a present income interest. Accordingly, the Tax Court concluded that the Hackls’ stock transfers were outright transfers without a present economic benefit and thus were future interests and were not eligible for the gift tax annual exclusion.
Price
Walter Price began his company, Diesel Power Equipment Co., in 1976. Because their children had no career interest in working for the company, the Prices decided to sell the business as part of a financial plan. This first involved placing the company stock in a limited partnership, Price Investment Limited Partnership. The partnership also contained three parcels of commercial rental real estate leased to Diesel Power and another company. The partnership agreement generally prevented any partner from withdrawing capital and also restricted transfer and assignment of partnership interests. Partners were unable to make a transfer in any manner without the written consent of all the partners. One of the main stated purposes of the partnership was to achieve a reasonable, compounded rate of return on a long-term basis for its investments. Such statements are common for closely held businesses in order to establish a bona fide business purpose.
From 1997 through 2002, each petitioner gave each of their three adult children interests in the partnership. The Prices reported annual exclusions on their gift tax returns for each of the transfers. As in Hackl, the IRS contended that the transfers were a future interest due to the restrictions on the transfer of partnership interests. The Prices then argued that the partners had a present income interest because the partnership had made distributions for three of the five years. The Tax Court, again following its Hackl decision, held that in order to qualify for a present income interest, three circumstances must exist:
- The partnership would generate income at or near the time of the gift;
- Some portion of that income would flow steadily to the donees; and
- The portion of the income flowing to the donees can be readily ascertained.
The court determined that the payments were discretionary, so the donees acquired no present right to use, possess, or enjoy the income interest of the partnership’s income. The Prices’ final argument was that the donees could use the partnership income reflected on their tax returns as evidence of their own personal assets, thus enhancing their “financial borrowing ability.” The Tax Court held that there was no evidence of this contention and disregarded it as highly contingent and not constituting a source of economic benefit. Accordingly, the Tax Court ruled that the Prices had failed to show that the gifts of partnership interests conferred on the donees an unrestricted and noncontingent right to immediately use, possess, or enjoy either the property itself or income from the property.
Implications
Price reinforces the criteria the Tax Court set out in Hackl for determining whether an outright gift of a partnership or LLC interest is a future interest or a present interest. When seeking to set up partnerships or LLCs that they plan to use as a vehicle for transferring property, tax planners will need to create partnership agreements that satisfy not only the needs of family interests, valuation issues, and estate tax issues but also gift tax planning concerns. When a client makes a gift of a partnership or LLC interest, tax practitioners should carefully review partnership operating agreements to decide whether an annual exclusion applies and whether a taxpayer is required to file a gift tax return for a future interest gift of any size.
EditorNotes
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or rick.klahsen@rsmi.com.
