Recent court rulings regarding family limited partnerships, including limited liability companies, have enabled the Internal Revenue Service to disallow the annual gift tax exclusion when the donor retains too much control over a gifted closely held interest. If you have limited partnership interests you are gifting, then you may have to take action.
Typically, a taxpayer will contribute real estate, a business or other assets into a limited partnership. The taxpayer will retain a small percentage of the partnership as a general partner, either directly or indirectly through a limited liability entity. The limited partner interests are then gifted at discounted values over a period of years to family members, generally taking advantage of the annual gift exclusion.
Restrictions may disallow the gift exclusion
Under the current tax law, a taxpayer can transfer property valued up to $11,000 annually to an individual ($22,000 for married taxpayers). However, the exclusion can only be taken if the gift is considered a present interest, meaning that the person receiving the interest has what the IRS considers "an unrestricted right to the immediate use, possession, or enjoyment of the property, or its income." When deciding whether or not to disallow the annual gift tax exclusion, restrictions on the property and income have been considered by the courts.
Many agreements contain language restricting the transferability of the gifted interest in order to control ownership in the closely held entity and to increase the valuation discount when valuing the gift for tax purposes. However, the restriction on the right to transfer the asset, combined with the lack of control in the business that a limited partner or member has, results in an insufficient present economic benefit that the IRS will use to disallow the annual gift exclusion.
A potential solution to the nontransferability issue is to amend the restriction to a right of first refusal clause, which permits the other members or partners to buy the interest first under the same terms, allowing present economic benefit to be realized. A caveat to reducing restrictions on transferability is that it may reduce or eliminate valuation discounts applied to the gift. A professional appraiser should be consulted to evaluate any changes in the gift valuation as a result of an amendment to the agreement.
Management discretion can cause problems
Many agreements also contain language stating that income and distributions will be made at the discretion of management, the general partner or managing member. The IRS will consider the right to possess or use income from the closely held entities when examining the annual gift exclusion. Making distributions at the discretion of management makes it difficult to prove that there will be a steady stream of income, or if the limited partner or member will ever receive income. Even if the business is not planning on having income for several years, the IRS may still disallow the annual gift exclusion.
To elevate the income and distribution restrictions, income-producing assets could be included in the closely held entity, which create an income stream that can be distributed proportionately to the partners or members. The agreement could also contain a provision to distribute income annually at a stated amount or as a percentage of income to cover the income tax liability associated with the ownership of the interest.
Protecting the gift exclusion
Reviewing your current partnership agreement to ensure the above provisions are considered will help protect the annual gift exclusion benefit for your family. Partnerships including limited liability companies are still a great way to transfer assets to the next generation at a reduced tax cost, but retaining too much control may reduce your tax benefit. Whether you currently have or are planning on using these types of entities to transfer wealth as part of your estate planning, you should consult your legal counsel, appraiser and/or tax adviser to assist you in amending or drafting your agreements.
Lofgren is a partner, Wilburn is a manager and Brown is a staff accountant with the San Diego-based accounting firm of Lavine, Lofgren, Morris & Engelberg LLP. The firm provides a broad range of services, including tax and accounting services and business and strategic counseling.