How Do Gifts of LLC Interests Work?

Family LLCs (FLLCs) and/or Family Limited partnerships’ (FLLPs) have long been popular devices to use, when making intra-family gifts (note the terms are used interchangeably below).

Family LLCs and Family Limited Partnerships are easy to understand and to administer, and they require very little reporting at the state level, explains Financial Advisor in the article “Use Caution With Gifts Of LLC Interests.” A parent who creates the FLLC, and then gifts FLLC units to either children, grandchildren or trusts established for their benefit, remains in control as the FLLC manager. That means the parent can make all the investment decisions and decide when to make distributions.

There have been a few changes that have made this a little more complex, most notably the Powell v. Commissioner decision from 2017. As a result of that decision, the IRS can attempt to include the value of the transferred FLLC units in the parent’s taxable estate. Powell is not the first judgment to give families and estate planners some concern over using FLLCs. Here’s a look at two Tax Court decisions to bear in mind, when considering a FLLC and Gifts of LLC interests.

The Powell v. Commissioner decision was the result of a case where the mother owned a non-controlling 99% limited partnership at the time of her death. Her sons owned the 1% controlling general partner interest. The Tax Court held that despite being the limited partner, the mother could act in conjunction with the general partner either to make distributions or liquidate the partnership. This caused $10 million of partnership assets to be included in her taxable estate at the fair market value. The Tax Court focused on the fact that the son-general partner held his mother’s durable power of attorney and had a fiduciary duty to her as a result. This constrained his independence as the general partner.

Another decision, Senda v. Commissioner, arose from a situation where parents created an LLC to hold highly appreciable marketable stock. On the same day the LLC was created, the parents gifted some of the LLC units to their children (or trusts for their benefit). The parents tried to extract a little more value out of this strategy, by claiming valuation discounts because the subject of their lifetime gifts were minority non-controlling interests in the LLC, which were not readily marketable, due to transfer restrictions contained in the LLC’s operating agreement.

The Tax Court found that the interests were transferred at the same time the LLC was funded with marketable securities. By collapsing those two steps, the Tax Court found that the subject of the gift was not the LLC units, but the appreciated marketable stock. The Tax Court supported the IRS’s position that the underlying asset in the LLC, appreciated stock, was the actual subject of the gift, and not the “discounted” LLC units. The Tax Court ignored the application of the valuation discounts and assessed a gift tax, penalties and interest in the underpayment of the gift tax, caused by the gift of appreciated marketable securities.

These are just two of several cases, where the FLLC strategic planning went bad. There are safeguards to put into place to maximize the interest of the FLLC, without putting it at risk. Speak with an estate planning attorney, who is knowledgeable about using FLLCs and current cases, to ensure that a good plan does not become an expensive mistake.

Reference: Financial Advisor (March 25, 2019) “Use Caution With Gifts Of LLC Interests”

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