In a Tax Court memo issued at the beginning of this year (2010-2), the Tax Court followed an earlier ruling in Hackl (2002) 118 TC 279 that for a gift to qualify for the annual exclusion under code section 2503(b), the party receiving the gift must have the unrestricted and uncontingent right to the immediate use, possession and enjoyment of the property and/or the income from the property. This is known as the present interest rule.
Over a period of five years, Mr. and Mrs. Price gave their three adult children interests in a partnership (price investment limited partnership) which owned stock in a diesel power equipment company and commercial real estate. Subsequently, the partnership sold the diesel power equipment company stock and invested the proceeds in securities.
The IRS contended that the partnership interests transferred to the children represented future interests because under the terms of the partnership agreement, transfers to third parties were effectively barred and the partnership did not require annual distributions to the limited partners. The partnership agreement generally prevented any partner from withdrawing its capital contributions and restricted the transfer and assignment of partnership interests. The taxpayer argued that the partnership interests were gifts of present interest because the children could freely transfer their interest to one another and to the general partner.
The Tax Court concurred with the IRS, claiming the taxpayers failed to show that the transferred partnership interests gave the beneficiaries the immediate use, possession or enjoyment of the transferred property or the income from the partnership.
The court focused on the fact that the partnership agreement restricted withdrawals from the partnership and return of a partner’s capital account and expressly prohibited limited partners from selling, assigning or transferring their partnership interests to third parties or otherwise disposing of their partnership interests without the written consent of all the partners (limited and general).
Following the Tax Court ruling in Hackl, the court believed that the taxpayer had to show that the partnership would generate income in the period immediately after the gift, that there would be a steady flow of income to the donees and that the income flowing to the donees could be ascertained with reasonable certainty.
On the surface it appeared that the partnership passed some of these tests since it did own real property under long term leases which produced rental payments. The court felt that while the partnership could be expected to generate income in the immediate time frame following when the gifts were made, it was not ascertainable whether or not the income would flow on a steady basis to the donee at the time of the gift, thus failing to meet the present interest test since the gift did not confer on the donees the right to immediate use, possession or enjoyment of either the transferred property or the income therefrom.
What do you do?
There are probably two ways to respond to this Tax Court memorandum. One is to re-write limited partnership agreements and/or operating agreements for limited liability companies to allow for the unrestricted transfer of ownership interests to third parties. The other method is to consider giving the donee a “crummy” power to effectively demand income or principal for a short, limited period of time after the gift. This power is commonly used in connection with annual gifts in life insurance trusts and has been deemed to meet the present interest requirements.
While we understand a client’s reluctance to allow free transferability or less restricted transferability of limited partner and limited liability company interests, our experience has been that this is more of a fear than an actual reality. It is very unusual and highly unlikely for a third party to be interested in purchasing minority interests in family limited partnerships or limited liability companies. If you are unwilling to consider totally free transferability of membership interests, then free transferability subject to a right of first refusal to the partnership or limited liability company should be considered. Even if a transfer is subject to a right of first refusal, it would at least allow for the immediate use, possession and enjoyment of the transferred property.
Bottom line, if you are contemplating giving gifts of limited partnership or limited liability interests using the annual exclusion (currently $13,000 for an individual and $26,000 for a couple), you should have the limited partnership and/or limited liability company agreement reviewed (and revised) prior to making any further gifts. Alternatively, consider giving the beneficiary a “crummy” power to demand income or principal in lieu of the gift of partnership or membership interests.