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.