Gifting LLC interests: Be safe rather than sorry?

Posted on October 13, 2009 by John Hugg

Recently, a number of cases have come out addressing when a gift of an LLC interest is really a gift of an underlying asset owned by the LLC. Two of these cases were decided right here in Federal District Court in Washington: Heckerman v. U.S., U.S. Dist. Ct., W.D. Washington, Cause No. C08-0211-JCC (July 27, 2009) and Linton v. U.S., U.S. Dist. Ct. W.D. Washington, Cause No. C08-227Z (July 1, 2009).

To summarize the cases very briefly, families in each case formed an LLC and the senior generation contributed various assets to the respective LLCs. On the same day the LLC contributions were made, gifts of LLC interests were made to trusts for their respective children. Each family claimed a valuation discount of the LLC interests for gift tax purposes. The IRS applied the indirect gift and step transaction doctrines to attempt to eliminate the discounts. In effect, the IRS said the parents made a gift of an actual asset and not an LLC interest. Valuation discounts apply to the latter. The IRS was successful in both cases.

The primary basis for denying the valuation discounts was the indirect gift doctrine. Application of this doctrine can frustrate a valuation discount if there is insufficient evidence to conclude what occurred first, funding the LLC or making gifts. In each case, with funding and gifting occurring on the same day, the necessary evidence was absent. An additional basis was the step transaction doctrine where a series of separate ‘steps’ are seen in substance as integrated, interdependent, and focused toward a particular result. There are three different tests used to determine if the step transaction doctrine applies in a given transaction: the “binding commitment test” where there is a binding commitment to undertake several different acts that, when viewed as a whole, are really one transaction; the “end result test” where one gleans an overriding transaction based on achieving an end result, such as tax savings; and the “interdependence test” where one act is ultimately fruitless without additional acts.

Can these problems be addressed with proper planning and drafting? Ultimately, the answer is somewhat unclear. What seems obvious is to set up an LLC or partnership first, then subsequently fund it with the assets desired. Other case law also indicates that when contributing property to the LLC the value of the asset should be attributable to the contributor’s capital account only. At a later point in time, seemingly the more elapsed time the better, a person would make gifts of the LLC interests. Presumably, if you are gifting to a trust, as is often the case, setting up the trust subsequent to the creation and funding of the LLC would seem prudent. Conducting affairs in this manner should automatically avoid the indirect gift doctrine and, assuming proper drafting, the “binding commitment test.” It should also go a long way to avoiding the “interdependence test,” however, given that the “end result test” can be apparently be satisfied by evidence of the “subjective intent” of the parties, it is unclear how one would plan to avoid this part of the step transaction doctrine. Stay tuned for further developments.
 

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Pierre v. Commissioner

Posted on September 8, 2009 by John Hugg

In a recent ruling, the U.S. Tax Court concluded that transfers of LLC interests were in fact transfers of LLC interests. If this conclusion sounds obvious, it isn’t. In Pierre, the owner of certain assets formed a single member limited liability company, or LLC, contributed those assets to the company, then both gifted and sold portions of the company to trusts for her children – a fairly standard estate planning strategy.

When forming such an entity the IRS allows the selection of several different ways to be taxed. Among the options are for a LLC to be taxed as a corporation or as a “disregarded entity.” Here, the owner opted for the LLC to be taxed as a disregarded entity. That means that “for tax purposes” the entity is viewed not to exist and all tax aspects flow directly to the sole owner of the LLC. For ownership and liability purposes however, the entity very much exists. Under New York law (where the company was located) the owner of an LLC has no interest in the assets held by the LLC, she only had a personal property interest in the entity itself. It is these two conflicting legal concepts on which Pierre turned. The IRS argued, unsuccessfully, that a transfer of an interest in a disregarded entity was actually a transfer of the underlying asset(s) held by the LLC because “for tax purposes” the LLC doesn’t exit. Pierre argued that, under state law, she had no interest in the underlying asset to transfer, only LLC interests and therefore could not transfer the underlying asset(s). A rather divided tax court ultimately agreed with Pierre saying the entity selection rules, otherwise referred to as the “check-the-box” rules, that allow the entity to be “disregarded for tax purposes” did not apply to transfers of an interest in the company. Accordingly, a transfer of a LLC interest is a transfer of an interest in the entity and not a transfer of any specific asset owned by the entity.

There are two questions you should be asking yourself. First, what is the significance of this ruling? Well, if you gift a piece of real property worth one million dollars the gift tax would generally be based on the full one million dollar value. However, when the same asset is owned in a LLC and an interest in the LLC is gifted the tax code allows you to discount the value of the LLC interest transferred. So in this example you might get a 20% discount and only have to pay tax on $800,000 and not one million dollars (this is an oversimplified example). Second, does this ruling apply to Washington state LLC’s? The answer presumably is yes. Washington State’s limited liability company act contains a provision very similar to that of New York where the owner of the LLC has only an interest in the company and not in the assets owned by the company.
 

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