Families with significant means have long used limited partnerships (LPs) and limited liability companies (LLCs) to consolidate and manage family assets and to transfer assets to younger generations in a controlled, efficient manner. In recent years, planning with LPs and LLCs has been highly scrutinized by the IRS, and there has been speculation that the effectiveness of this planning vehicle may be limited or eliminated entirely. This article includes a high-level overview of four primary areas of business entity planning: (1) valuation discounts; (2) inclusion of LP and LLC assets in a decedent’s estate; (3) indirect gifts; and (4) the use of the gift tax annual exclusion when making gifts of entity interests.
A lack of control discount can be based on the premise that the interest is worth less because the interest holder does not have the right to make certain decisions regarding the entity, such as liquidation and distribution decisions. The inability to control these decisions limits the financial benefits an owner of a business interest would typically have and thus can decrease the value of the interest. These restrictions stem from the entity’s governing instrument or state law.
A lack of marketability discount is driven by the fact that an owner of an interest in an LP or LLC created to manage family wealth may not be able to find a willing buyer due to restrictions on transferability of the interest and limits on the financial benefits enjoyed by the interest’s owner. Historically, the IRS has vigorously contested valuation discounts in the estate planning context, challenging them as an artifice to transfer wealth with reduced transfer taxes. However, courts have frequently upheld even quite substantial valuation discounts for lack of control and lack of marketability.
Moreover, although legislation restricting or eliminating valuation discounts in family transactions continues to be discussed and even proposed, no legislation limiting or eliminating valuation discounts has been passed to date. Valuation discounts would, therefore, appear to have continuing viability (at least in the near-term), though discounts should not be applied haphazardly. A thorough appraisal prepared by a qualified appraiser is a must for any transfer of a LP or LLC interest for which a discount is applied. Transferors must not underestimate the importance of the appraisal as it is the most critical element in justifying the value of a transfer.
Inclusion of Assets in a Deceased’s Estate for Estate Tax Purposes
Court cases have focused on whether or not a LP or LLC is a legitimate business entity (and not one created solely for estate tax planning purposes) and therefore whether or not transferred interests should be included in the transferor’s estate for federal estate tax purposes. In some cases where the formalities of the entity have not been followed, the entity has been disregarded and transferred interests were included in the transferor’s taxable estate. These cases also discuss the requirement of a bona fide sale for adequate and full consideration, which is found when: (1) there is an arm’s length transaction; (2) there is a significant legitimate nontax reason for the entity; and (3) the transferor received interests proportionate to the value transferred.
A few examples of significant legitimate nontax reasons noted by courts, which when present have helped the taxpayer’s case, have been: (1) continuance of family investment management philosophy; (2) protecting family assets from divorce; and (3) preserving family legacy assets (such as a significant holding in a particular company).
Key to the success of the taxpayer in these cases has been maintaining the formalities of the entity. Evidence that formalities of an entity have been respected may include: (1) maintaining detailed records of partnership accounting and activities; (2) holding regular meetings of partners; (3) complete separation of personal assets from entity assets; (4) making proportionate distributions to each owner of the entity (i.e., avoiding non-pro rata distributions); and (5) keeping sufficient assets outside the entity for maintaining the transferor’s lifestyle.
Courts have found that some gifts of partnership interests are actually gifts of the underlying assets, and in such cases, the entity may be disregarded and any discounts the taxpayer may have taken are also disregarded. The creation and funding of an entity should therefore be completed prior to the transfer of any interests in the entity.
Based on case law, the following are observations of what might be required to fully create and fund an entity prior to transferring any interests: (1) prepare and execute governing documents prior to drafting documents transferring interests via gift or sale; (2) clearly document which assets are to be transferred to the entity and complete the transfer documents facilitating transfers into the entity prior to completing a gift or sale of an interest; and, (3) wait a period of time after creating and funding the entity before transferring any interests via gift or sale.
Gift Tax Annual Exclusion
Courts have held that gifts of partnership interests did not qualify as annual exclusion gifts for purposes of Internal Revenue Code 2503(b). While current, outright ownership of any asset, including a partnership interest, might seem to be an obvious present interest, some courts have found that certain restrictions in the partnership agreement would cause gifts of partnership interests to be of future interests rather than present interests.
Generally, the gift tax annual exclusion is available only for gifts of a present interest. A present interest is defined as an unrestricted right to the immediate use, possession or enjoyment of either the property or its income, and the recipient must derive a substantial present economic benefit. Courts have found that certain restrictions in the LP and LLC agreements, such as the prohibition of capital withdrawals and of transfers or sales of interests without the consent of all partners, were sufficiently onerous as to limit present enjoyment of the partnership interests. Courts have focused on an LP’s or LLC’s right of first refusal to purchase the interest at fair market value. In some cases, the time period to exercise this right of refusal may be months or even an indefinite time period. Further, the LP or LLC could issue a long-term promissory note in exchange for the interests. This right of first refusal can be an additional and significant contingency which restricts use, possession and enjoyment so that the done does not enjoy a substantial present economic benefit.
A possible scenario may be as follows: Matriarch (M) and Patriarch (P) create a family LLC and transfer family assets to the LLC for management, wealth preservation, profitability and wealth transfer purposes (all of which together establish a legitimate business purpose). M and P incorporate restrictions in the LLC agreement that are designed to maintain family ownership of the LLC and control over the purse strings.
M and P make gifts of LLC units to their children equal to the applicable annual exclusion amount in anticipation that the gifts will qualify for the gift tax annual exclusion. M and P make annual exclusion gifts of LLC interests over a period of 10 years. Upon review by the IRS, the LLC agreement is determined to include restrictions that cause the gifts to be of future interests, thus disqualifying the gifts as annual exclusion gifts, meaning the gifts are deemed to be taxable gifts. Taxes, interest and penalties are assessed for the 10-year period.
Possible Solution: Partnership agreements and LLC operating agreements must be carefully drafted if gifts of interests are to qualify for the gift tax annual exclusion. Possible solutions may be: (1) provide a 60-day period of free transferability after a gift is made; (2) limit the duration of any right of first refusal and indicate that it is to be funded in cash rather than a promissory note; (3) utilize a portion (or all) of the lifetime gift tax exemption to make gifts of business interests rather than relying on annual exclusion gifts of partnership and LLC interests; or (4) provide in the governing documents that the donee has the right, for a reasonable amount of time, to require the partnership to buy back the donee’s units received at the fair market value of the units as of the date of the gift. This resembles a “Crummey” withdrawal right commonly used when making gifts in trusts so that such qualify for the gift tax annual exclusion.
In light of case law development over the past several years, those who are currently utilizing entities for consolidated family wealth management and transfer purposes, and those who may be contemplating establishing a family entity, should consider the tax and governance issues discussed in this article. It is imperative to obtain sound legal and tax advice and to plan thoughtfully and carefully prior to implementing this potentially powerful family wealth management and transfer tool.