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Too Restrictive Operating Agreement Leads to Loss of Gift Tax Exclusion

Posted by Keith Codron | Mar 31, 2010 | 0 Comments

A federal district court in Indianapolis recently held that the annual gift tax exclusion did not apply to taxpayers' gifts to their children of membership interests in a family-owned limited liability company. The court found that, based on certain restrictive provisions in the LLC's operating agreement, the membership interests represented "future interests" rather than "present interests" in the entity's assets.

The distinction between a present interest and a future interest lies in whether the donee has an unrestricted and unqualified right to the immediate use, possession and enjoyment of the gifted property, or the income therefrom (i.e., a substantial present economic benefit in the gifted property), or, on the contrary, whether such right is postponed or limited in its effectiveness to some future date or time. Gifts of remainders, reversions, executory interests and similar beneficial rights, whether vested or contingent, the use, possession and enjoyment of which, or the income from which, can only be had at some future date or time, represent gifts of future interests in property.

Under federal law, a taxpayer is entitled to an exemption from gift tax with respect to the first $1 million of taxable gifts made over the course of one's lifetime, computed cumulatively on a calendar year basis. Once the $1 million exemption is fully depleted, the tax rate is a flat 35% of a gift's value. Unlike the federal estate tax, the gift tax is not repealed for 2010 or any other year. In determining the amount of a donor's "taxable gifts" for each calendar year period, the first $13,000 of money or other property given to a donee in that calendar year is excluded, provided that the gift is of a present interest. [The annual exclusion amount is indexed for inflation.] A future interest in money or other property does not qualify for the annual gift tax exclusion under §2503(b) of the Tax Code. As a result, a gift of a future interest is deemed a taxable gift in its entirety and causes a depletion of the donor's $1 million lifetime exemption, in whole or in part, whereas a gift of a present interest is deemed a taxable gift only to the extent that the value of the gift exceeds $13,000 per donee per calendar year.

In the Indiana case, Fisher v. United States [S.D. Indiana, 2010-1 USTC ¶60,588 (3/11/2010)], a married couple transferred minority, non-controlling membership interests in their LLC to each of their 7 children.  The taxpayer-donors retained full management control over the LLC, the principal asset of which was an extremely valuable parcel of undeveloped beachfront land bordering Lake Michigan. When taxpayers filed their gift tax returns they claimed the annual exclusion pertaining to each such transfer. However, upon audit of those returns IRS claimed that the gifts were of future interests and assessed the Fishers a gift tax deficiency in the amount of $625,986! The Fishers paid the deficiency and filed a claim for refund in federal district court, alleging, among other things, that the transferred interests in the LLC were gifts of present interests.

The district court held in favor of IRS, stating that the membership interests received by taxpayers' children constituted a future interest, not a present interest, and that, consequently, no annual exclusion would be allowed.  The court based its decision on the following three factors: (1) the children's membership interests did not confer on them a substantial present economic benefit in the LLC's property because, under the operating agreement, the children's right to receive distributions of capital proceeds, whenever such distributions might occur, was subject to a number of contingencies, all of which were within the e

About the Author

Keith Codron

Keith Codron is an Orange County attorney with more than 40 years of experience in the field of trusts and estates. He has been certified as a specialist in estate planning, trust and probate law by the Board of Legal Specialization of the State Bar of California. Mr. Codron's practice is focused...

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