No Annual Gift Tax Exclusion for Gift of LLC Membership Units

TAX CASE

Generally speaking, IRC section 2503(b) allows donors an annual gift tax exclusion on the first $11,000 (the statutory $10,000 adjusted for inflation for 2003) of gifts made to each person during the year. The code specifies that gifts of future interests in property do not qualify for the exclusion. More specifically, Treasury regulations section 25.2503-3 distinguishes a future interest from a present one. A future interest is one that limits use, possession or enjoyment to some future date. A present interest is an unrestricted right to the immediate use, possession or enjoyment of property or the income from it.

A.J. and Christine Hackl, a wealthy retired couple, invested in tree farms as a way to diversify into real estate and keep A.J. active in business. The Hackls purchased two tree farms they then contributed to an LLC, Treeco, to protect their assets from potential liability, to create a separate business in which family members could participate and to allow the transfer of ownership interests to family members.

Initially, the Hackls were the only two LLC members. They executed an operating agreement to govern Treeco. It designated A.J. as manager and set forth numerous stipulations about membership changes and unit dispositions, among other things. According to the agreement, the manager had to give his permission for a member to withdraw or transfer his or her membership interest. If the manager did not approve a transfer, the transferee would lose voting and membership rights.

The Hackls contributed additional cash and securities totaling close to $8 million to Treeco and soon began making gifts of LLC membership units to their eight children and their spouses and to a trust for their grandchildren. They filed timely gift tax returns that consistently claimed annual gift tax exclusions. Treeco purchased a third tree farm and eventually merged into Treesource, LLP. None of the three farms was expected to be profitable for some years. The IRS disallowed the gift tax exclusions because it said the membership units were not gifts of present interests. The Hackls took the case to the Tax Court, which ruled in favor of the IRS. They then appealed the case to the Seventh Circuit Court of Appeals.

Result. For the IRS. The Seventh Circuit affirmed the Tax Court decision that the Hackls’ gifts of LLC membership interests were gifts of future interests and as such did not qualify for the annual gift tax exclusion. The Hackls argued the gifts were present interests because they were direct, outright transfers of all legal rights in the membership units. The IRS maintained that any transfer without a substantial present economic benefit is a future interest and ineligible for the exclusion. The court found Treeco’s operating agreement “clearly foreclosed the donees’ ability to realize any present economic benefit.” The restrictions on membership changes and unit dispositions resulted in the units having no immediate value to donees. The Hackls further argued that many closely held LLCs have such restrictions. The Seventh Circuit said that “the onus is on the taxpayers to show that their transfers qualify for the gift tax exclusion, a burden the Hackls have not met.”

This case is significant for taxpayers and CPAs who set up closely held entities, such as LLCs and LLPs, that the IRS considers similar to family limited partnerships. To qualify for the gift tax exclusion, the operating agreement must allow for transferred units to have immediate value to the donees. This might be accomplished by allowing donees the unrestricted ability to sell or convert their interests, or a limited right to withdraw income or part of their capital account.

Hackl, Sr. v. Commissioner , 92 AFTR2d 2003-5254 (335 F3d 664).

Prepared by Karyn Bybee Friske, CPA, PhD, associate professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University at Canyon.