Present Interest Challenge - FLP & Family LLC

The referenced authorities [Title 26 Subtitle B Chapter 12 Subchapter A §2503(b)] require a taxpayer claiming an annual exclusion to establish that the transfer in dispute conferred on the donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such immediate use, possession, or enjoyment be of a nature that substantial economic benefit is derived therefrom. In other words, taxpayers and the language of the FLP Agreement must prove from all the facts and circumstances that in receiving the FLP units, the donees thereby obtained use, possession, or enjoyment of the units or income from the units within the above-described meaning of section 2503(b). Nonetheless, the simple expedient of paper title does not in and of itself create a present interest for purposes of section 2503(b) unless all the facts and circumstances establish that such possession renders an economic benefit presently reachable by the donees.

Commentary

The Internal Revenue Service was successful in March 2002 in challenging the language in a Family Limited Partnership Agreement. Therefore, all clients and legal counselors having an interest in this topic are receiving this notice.

Successful Internal Revenue Service Arguments

The Internal Revenue Service argued successfully the transfers of the LLC units did not meet the essential elements of the “Present Interest” doctrine. The Internal Revenue Service used the language in the Operating Agreement (as could be done with any Limited Partnership Agreement) to win its case. The Court (obviously) agreed the language in the instrument fell short of conferring on the donees the requisite immediate and unconditional rights to the use, possession or enjoyment of property or the income from property. Lack of freedom to transfer the units, or to compel cash distributions from the entity prevented them from receiving any such benefit because of the transfers. The Internal Revenue Service argued successfully, the gifts postponed any economic benefit and were therefore of future interests. (Note: As a point of reference, this argument is not the same as many of the Internal Revenue Service’s Private Letter Rulings – a copy of one of those Letter Rulings is included herewith in the “Authorities Section” of this document.

Case and Ruling Summary

In Hackl v Internal Revenue Service, the government challenged transfers of FLP interests based upon failure to meet the qualifications of §2503(b) and was successful in disallowing the gift and estate tax benefits of a Family Limited Partnership. The Internal Revenue Service challenged the language of the FLP Agreement based upon the “Present Interest Requirement of 2503(b). A husband and wife gave their children ownership interests in a family LLC. These did not qualify for the annual gift tax exclusion because they were not gifts of a "present interest" in property, the U.S. Tax Court has ruled. (Held: The gifts of Treeco units made by Ps failed to qualify for the annual gift tax exclusion provided in sec. 2503(b), I.R.C.)

The ruling was based on provisions in the LLC agreement that are very common for both LLCs and family limited partnerships. Many of these partnerships restrict sales of the partnership units, do not distribute cash to the partners, or have other restrictions that might make the “ownership” contingent by some method.

These provisions restrict owners' rights, such as the right to receive cash distributions and to sell their interests.

Present Interest Discussion

The ruling comes as a big surprise to many estate planning, business and tax attorneys, who had assumed the problem could arise only from more extreme restrictions. In fact, this position reverses some of the Internal Revenue Service’s previous tax positions. A reprint of a Private Letter Ruling, which contradicts the included case, is included at the end of this document for convenience and contrast. Please Find PLR 199415007 located in the “Authorities Section”.

Internal Revenue Service Position and Arguments

The Internal Revenue Service successfully argued the transfers fell short of conferring on the donees the requisite immediate and unconditional rights to the use, possession, or enjoyment of property or the income from property. The Service also took the position the Internal Revenue Service Code is superior to State Law and therefore the Code is the sole authority to determine whether the gift was a transfer of a Present Interest. Moreover, the Court wrote the mere transfer of “title” does not in itself transfer to the donee a completed and present interest. The Court rejected the taxpayers’ contention that the transfer, once completed, did not require further analyses.

Court’s Statements

The Court used language which seemed to indicate the burden is placed upon the taxpayer to establish the donee possessed “an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such use, possession, or enjoyment be of a nature that substantial economic benefit is derived therefrom.”

Furthermore, the language of the Ruling seems to emphasize the importance of making certain the advisers use appropriate language in the applicable instruments — and the LLC or LP follows through by actual and documented actions with meeting the “Present Interest” criteria. Prudence must be exercised so the taxpayers abide by the carefully drafted documents and must take actions that do not conflict with the substance over form doctrine.

Highlights and Quotations From The Case

“Nonetheless, while State law defines property rights, it is Federal law which determines the appropriate tax treatment of those rights.”

“It is not enough to bring the exclusion into force that the donee has vested rights. In addition he must have the right presently to use, possess or enjoy the property. These terms are not words of art, like "fee" in the law of seizin * * *, but connote the right to substantial present economic benefit. The question is of time, not when title vests, but when enjoyment begins. Whatever puts the barrier of a substantial period between the will of the beneficiary or donee now to enjoy what has been given him and that enjoyment makes the gift one of a future interest within the meaning of the regulation.”

property, "No further analysis is needed or justified." To do so would be to sanction exclusions for gifts based purely on conveyancing form without probing whether the donees in fact received rights differing in any meaningful way from those that would have flowed from a traditional trust arrangement.”

immediate use, possession, or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such immediate use, possession, or enjoyment be of a nature that substantial economic benefit is derived therefrom. In other words, petitioners must prove from all the facts and circumstances that in receiving the Treeco units, the donees thereby obtained use, possession, or enjoyment of the units or income from the units within the above-described meaning of section 2503(b).”

possession of the Treeco units. Nonetheless, as previously explained, the simple expedient of paper title does not in and of itself create a present interest for purposes of section 2503(b) unless all the facts and circumstances establish that such possession renders an economic benefit presently reachable by the donees. It therefore is incumbent upon petitioners to show the present (not postponed) economic benefit imparted to the donees as a consequence of their receipt of the Treeco units.”

Problem Areas of the FLP Agreement Language

Very few planners and legal counselors expected this outcome. Here are a few considerations to make the Agreement align with the recent decision:

1. Allow sales, but place language in the agreement to require the selling party to first offer the units to the LLC or LP (first right of refusal)

4. Transfer cash to the children with the understanding the money will be used for purchasing the LLC or LP interest

Reprint from Lawyers Weekly “Family LLC Interest Gets No Gift Tax Exclusion”

Introduction

Where a husband and wife gave their children ownership interests in a family LLC, these did not qualify for the annual gift tax exclusion because they were not gifts of a "present interest" in property, the U.S. Tax Court has ruled.

The ruling was based on provisions in the LLC agreement that are very common for both LLCs and family limited partnerships.

These provisions restrict owners' rights, such as the right to receive cash distributions and to sell their interests.

The ruling comes as a big surprise to many estate planning, business and tax attorneys, who had assumed the problem could arise only from more extreme restrictions.

In many cases, lawyers will now want to draft LLC and limited partnership agreements differently to avoid the problem.

That may not always be worth doing, however. One reason is that loosening the restrictions could increase the value of the ownership interests, and thereby increase estate and gift taxes for a client giving those interests away.

Lawyers may also want to amend existing agreements where a client will be making future gifts of interests in an LLC or partnership. However, it will be too late to do anything about gifts that have already been made.

"Many clients who expected to get the annual exclusion won't," said Howard Zaritsky of Rapidan , Va. , editor of the Probate Practice Reporter. "A lot of clients are going to be angry."

He added, "The Tax Court construed the law in a manner that very few [attorneys] would have expected."

Tax litigator Owen Fiore of San Jose , Calif. , predicts the IRS will apply the new ruling aggressively, as one more way to attack the use of family limited partnerships and LLCs to obtain "discounts" for estate and gift tax purposes in the value of property taxpayers give to their children.

"The government is likely to go after the annual exclusion where they are losing the valuation wars, because these are cases they can win," he said.

No 'Present Interest'

The Tax Court case involved a couple, A.J. and Christine Hackl, who had eight children and 25 grandchildren. The husband was a retired, very successful corporate executive.

In 1995 and 1996, the Hackls bought over $7 million of land in Florida and

Georgia

to operate as tree farms. They formed an LLC and transferred the land to it.

Then they both gave LLC interests to each of their children, the children's spouses, and the grandchildren. They made such gifts each year and claimed annual exclusions, which the IRS denied.

Under the Tax Code, there is an annual exclusion for gifts "other than future interests in property." At the time of the Hackls' gifts the limit was $10,000 per donee, but that has since increased to $11,000 per donee. (Sect. 2502[b]).

The Tax Court said that for a gift to qualify as a "present interest," rather than a "future interest," the donee must receive "a substantial economic benefit" consisting of "an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property."

The court concluded that the Hackls' gifts did not meet this test, noting that the LLC operating agreement prohibited the owners from selling their full ownership interests without Mr Hackl's approval, although they could freely sell their rights to receive a share of the LLC's profits and distributions.

The operating agreement also gave Mr. Hackl, as the LLC's manager, discretion to make or not make cash distributions to the owners.

After more than five years of operation, the LLC had yet to make distributions. Nor had the tree farming business earned a profit, although it was expected to produce steady income in the future.

The agreement also prevented the LLC owners from withdrawing their capital accounts or redeeming their interests without Mr. Hackl's approval, and it provided that no single owner could dissolve the company.

"While we are aware of petitioner's contentions and the parties' rather conclusory stipulations that [the LLC] was a legitimate operating business entity and that restrictive provisions in the agreement are common in closely held enterprises and in the timber industry, such circumstances (whether or not true) do not alter the criteria for a present interest or excuse the failure here to meet those criteria."

The court also said it didn't matter that the interests were given outright, rather than through a trust, or that the IRS stipulated that the interests in fact had a value of $10.43 per unit.

The Hackls' attorney, Barton Sprunger of Indianapolis , said an appeal is planned.

What To Do

Attorneys told Lawyers Weekly USA that they are considering five different ways of dealing with the problem. Most are focusing primarily on the first two.

· "Right of first refusal."

One way to address the problem is to provide that owners can sell their interests without approval, but that the LLC or limited partnership has a "right of first refusal." Upon finding a buyer, an owner must first offer to sell his interest to the LLC or limited partnership at the same price.

Lawyers agree that this strategy should give owners sufficient ability to obtain "immediate use, possession, or enjoyment" of their interests by converting them into cash.

Louis Mezzullo of Richmond , Va. , a past regent of the American College of Trust and Estate Counsel, said there are IRS rulings "where the IRS has taken that exact position."

St. Louis estate planning attorney Lawrence Katzenstein said this "is the simplest way to avoid the issue."

A drawback is that the strategy could increase the value of the interests for gift and estate tax purposes by lowering the "discount" in value for "lack of marketability."

However, the effect on the value will probably be small, because an interest in a family business would still be difficult to sell.

"This is not a very attractive asset," said Alvin Golden, an estate-planning attorney in Austin , Texas . "Where are you going to find a buyer anyway?"

Another danger is that if an owner did, in fact, find a buyer, the LLC or limited partnership would have to choose between buying the interest or allowing a new person to join the business.

The problem with this, said Dallas estate planning attorney Steve Akers is that, "from a business perspective, most business people putting together a partnership don't want just a right of first refusal, where if they don't buy it anybody can become their partner."

However, lawyers agreed that the risk of the option being exercised is very small, again because of the difficulty of finding a buyer.

· Temporary sell-back or withdrawal right.

Another option is to provide that where children or grandchildren receive gifts of interests, they can sell them back to the LLC or limited partnership at a certain price for a limited period of time, such as 30 days.

A variation is to give them a temporary right to withdraw their share of capital from the LLC or limited partnership up to the amount of the annual exclusion.

Either approach should solve the problem. Lawyers note that both are analogous to the "Crummey power" that beneficiaries of trusts are temporarily given to withdraw cash, so that contributions to the trust qualify for the annual gift tax exclusion.

It's not clear, however, whether either approach would have the drawback of increasing the value of the interests for estate and gift tax purposes.

Boston estate planning attorney Natalie Choate said this shouldn't be a problem if the sell-back price or the amount that can be withdrawn is based on the fair market value of the interests, where that value is determined by taking into account all "valuation discounts," but not taking into account the sell-back or withdrawal right.

"It doesn't affect valuation, because the right is limited to the discounted value of the interests," he said.

"The question is whether you get treated as having given away a family limited partnership or LLC interest if the donee has the immediate right to convert it to cash or other assets," he said. "I suggest you do not."

Another problem is that the sell-back or withdrawal right might be exercised, requiring the LLC or limited partnership to pay out cash or other property.

However, it's likely that children and grandchildren can be persuaded not to exercise the right if they are looking forward to receiving future gifts.

In any event, provisions creating a sell-back or withdrawal right should be drafted so they apply only to interests transferred as gifts for which an annual exclusion is sought.

Choate said this can be accomplished in many cases by providing that the right only applies to interests that are transferred as a gift from a parent to a child.

· Temporary right to sell.

Another option is to grant new owners a temporary right to sell their interests to anyone.

A big drawback to this strategy is that if it were exercised, the other owners would have no control over who their new co-owner might be.

Akers said the other owners "would be subject to anyone becoming their partner the next day."

There also would probably be an increase in the value of the interests for gift and estate tax purposes.

· Cash gifts.

Taxpayers could also elect to give children cash, with the understanding that they will use it to purchase interests in the family limited partnership or LLC.

"That certainly is do-able and may be the cleanest thing," Akers said. "On the gift tax return, you would just report gifts of cash."

A potential problem, however, is that the IRS may argue that the transaction was a sham and should be treated as a gift of LLC or limited partnership interests.

Another problem is that income tax may be triggered by the gain on the sale of interests to the children.

Timothy O'Sullivan, an estate-planning attorney in Wichita , Kan. , said that a way around this would be to make the cash gift to an "intentionally defective grantor trust" of which the children are beneficiaries. The trust would then buy interests in the LLC or limited partnership.

Yet another problem, said Mezzullo, is that if the children have not agreed to buy interests in the LLC or limited partnership, they might spend the cash on other things.

· Mandatory distributions.

An LLC or limited partnership agreement can also provide for mandatory distributions of earnings.

A problem with this strategy, however, is that clients may be very reluctant to agree to it.

"Clients want to maintain control over distributions, especially if there is an operating business involved," said Ronald Aucutt of McLean , Va. , a past chair of the American Bar Association Estate and Gift Tax Committee.

One approach is to draft a provision that limits discretion over distributions but doesn't eliminate it entirely.

For instance, it could provide that "net cash flow" must be distributed annually, but then define that term to be net of such things as "additions to reserves for debt service, capital acquisitions, operating deficits, and working capital."

However, it's not clear whether such a provision would satisfy the Tax Court's test.

It's not even clear whether a very strict requirement of mandatory distributions would satisfy the test, especially if the business is not expected to produce income for a while, like the tree farms in the recent case.

A strict requirement, said O'Sullivan, "gives more weight to the argument that there is a present interest, but it doesn't necessarily solve the problem."

'Choose Your Strategy'

Experts agree that clients now will often have to choose between provisions that meet the Tax Court's test for the annual gift tax exclusion and those that will maximize "valuation discounts" and give the client the control desired.

Attorney Martin Shenkman of Teaneck , N.J. , the author of numerous books on estate planning, noted that clients may also have to choose between meeting the Tax Court's test and protecting a business from creditors.

"If you are creating ways for the owners to get the money out, you may not have the same ability to fend off creditors," he said.

"For people wanting to make a million-dollar gift now, it's generally not important," said Akers.

However, he believes more family limited partnerships are being used for making annual exclusion gifts over time than for making one large gift.

The annual exclusion can be especially important to clients who, like the Hackls, have numerous children and grandchildren.

New York estate planning attorney Arthur Sederbaum noted that since each spouse is entitled to the exclusion, they can annually exclude $22,000 per donee.

"$22,000 is a lot of money, and if you multiply it by a significant number of donees, it adds up," he said.

No Exclusion For LLC Interests?

Some lawyers worry that the ruling may prevent annual exclusions for any gift of a limited partnership interest or a nonvoting interest in an LLC or corporation.

The reason is that the Tax Court's test was not met here even though the LLC owners were free to sell, without Mr. Hackl's approval, their rights to receive a share of the LLC's profits and distributions.

Limited partnership interests "are essentially the same as nonvoting LLC interests," O'Sullivan said. "Under the decision, there is no present interest for a gift of nonvoting rights in anything."

However, Zaritsky said he doubts there is any danger, because the IRS's argument would be "ridiculous."

"With that logic there is no present interest in the stock of any company that doesn't pay dividends, like Microsoft," he said. "That's clearly not the case."

U.S.

Tax Court. Hackl v. Commissioner, 118 T.C. No. 14. March 27, 2002 . Lawyers Weekly

USA

No. 9922939.

Sample FLP Provision

Sample "sell-back," or "put," provisions drafted by Boston attorney Natalie Choate, for obtaining the annual gift tax exclusion for gifts of interests in family limited partnerships and LLCs in light of the U.S. Tax Court decision in Hackl v. Commission, 118 T.C. No. 14 (March 27, 2002).

Permitted Transferees. Limited Partnership units may be assigned by gift, sale or otherwise to any person who is already, immediately prior to the transfer, a Partner, or to a trust for the exclusive benefit of an existing Partner, the Trustee of which either is an existing Partner or is approved by the General Partners. No other transfer shall be permitted unless assented to by a majority of the Partners (other than the transferor) and by all the General Partners.

Put Right Of Certain Transferees. If a Permitted Transferee (the "Donee") receives a Limited Partnership Unit as a gift (the "Gift Unit") from [here insert the names of the individual partners who will be making annual exclusion gifts of partnership units, such as "John Doe, Mary Doe, or Richard Doe"], the Donee shall have the right to "put" the Gift Unit to the Partnership at its External Fair Market Value. This right may be exercised by executing and delivering to the General Partner all documents necessary to transfer the Gift Unit to the Partnership, accompanied by written notice that the Donee is exercising his put. Upon receipt of such documents and notice, the General Partner shall forthwith transfer to the Donee, in exchange for the Gift Unit, cash or property (of any type) having a fair market value equal to the External Fair Market Value of the Gift Unit. This right of the Donee shall expire, as to any Gift Unit, thirty (30) days after the date of the gift of such unit.

External Fair Market Value. The External Fair Market Value of any interest in the Partnership shall mean, for purposes of this Agreement, the price that a willing buyer would pay to a willing seller of such interest (neither being under any compulsion to buy or sell),

(a) determined without regard to the existence of the put rights under [the section "Permitted Transferees"], i.e. determined as if the holder of the interest had no such rights; and

(b) determined without regard to any restrictions on the transfer of such interest contained in this Agreement to the extent such restrictions are more restrictive than the provisions of the ULPA that would apply in the absence of a specific provision herein; but

(c) otherwise taking into account all applicable factors, including the voting rights attached to such interest; whether such interest is a "minority" or "controlling" interest; and appropriate discounts for lack of marketability.

If the General Partner and the Donee do not agree upon the External Fair Market Value of the interest to be purchased, the same shall be determined by a professional appraisal to be performed by a qualified appraiser selected by the accounting firm which regularly prepares the Partnership's tax returns.

Authorities Section

The following should assist with the analysis of the FLP or Family LLC at issue.

Case Identification Hackl v. Internal Revenue Service

Background

In 1995 and 1996, Ps A and C made gifts to their children and grandchildren of membership units in Treeco, LLC, a limited liability company. Treeco had previously been organized by A to hold and operate tree farming properties. This timberland had been purchased by A to provide investment diversification in the form of long-term growth and future income. Treeco was governed by an Operating Agreement which set forth the rights and duties conferred on members and the manager and which designated A as manager. At the time of the gifts, it was correctly anticipated that Treeco and its successor entities would generate losses and make no distributions for a number of years.

OPINION

deficiency in the 1996 Federal gift tax liability of petitioner Christine M. Hackl (Christine Hackl) in the amount of $309,866 and in the 1996 Federal gift tax liability of Albert J. Hackl, Sr. (A. J. Hackl), in the amount of $309,950. Petitioners each timely filed for redetermination by this Court, and, due to an identity of issues, the cases were consolidated for purposes of trial, briefing, and opinion. In accordance with stipulations of partial settlement filed by the parties, the sole matter remaining for decision is whether gifts made by petitioners of units in a limited liability company qualify for the annual exclusion provided by section 2503(b).

Unless otherwise indicated, all section references are to sections of the Internal Revenue Code in effect for the year at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

BACKGROUND

These cases were submitted fully stipulated pursuant to Rule 122, and the facts stipulated are so found (except as noted in footnote 1). The stipulations of the parties, with accompanying exhibits, are incorporated herein by this reference. At the time their respective petitions were filed, petitioners resided in Indianapolis , Indiana .

PERSONAL, EDUCATIONAL, AND OCCUPATIONAL BACKGROUND

Petitioners are husband and wife and are the parents of eight children. As of the date of the gifts at issue, they were also the grandparents of 25 minor grandchildren.

A. J. Hackl was born on December 29, 1925 , and Christine Hackl was born on June 16, 1927 . Since obtaining a Bachelor of Mechanical Engineering degree from Georgia Institute of Technology in 1946, A. J. Hackl has pursued a successful career in business. He was employed by The Trane Company from 1946 to 1959, during which time he became a licensed professional engineer and worked in several management positions. He next accepted employment with Worthington Corporation, serving in management and executive capacities within the company's air conditioning division from 1959 to 1968. Then, from 1968 until his retirement in 1995, A. J. Hackl served as chief executive officer of Herff Jones, Inc. During that period, Herff Jones grew from a small, publicly held manufacturer of scholastic recognition and motivational awards, with $18 million in annual sales, to a national company with a broad line of products and annual sales of $265 million. At the time of his retirement in 1995, A. J. Hackl owned a significant amount of Herff Jones stock, which he sold to the company's employee stock ownership plan. He then remained as chairman of the board of directors until 1998.

INITIATION OF TREE FARM INVESTMENT

In the mid-1990s, in anticipation of the sale of his Herff Jones stock, A. J. Hackl began to research ways to diversify his financial net worth into investments other than publicly traded

U.S.

marketable securities, of which he had already accumulated a substantial portfolio. He concluded that an investment in real estate would achieve his objective of diversification and, after consideration of a wide range of real estate ventures, decided that tree farming presented an attractive business opportunity which would both include the acquisition of significant parcels of real estate and also fulfill his interest of remaining personally active in business.

Since his other investments were generating a considerable amount of current income, A. J. Hackl's investment goal with respect to his tree farming business was long-term growth. He therefore chose to purchase land for use in the tree farming business with little or no existing merchantable timber because such land was significantly cheaper, and would provide a greater long-term return on investment, than land with a substantial quantity of merchantable timber.

In 1995, A. J. Hackl purchased two tree farms: (1) A 3,813.8 acre tract in Putnam County , Florida (Putnam County Farm) and (2) a 7,771.88 acre tract in McIntosh County ,

Georgia

(McIntosh County Farm). The Putnam County Farm was purchased on January 6, 1995 , for $1,945,038, and contained merchantable timber valued at $140,451 as of the time of

FORMATION OF TREECO, LLC, AND GIFTING OF INTERESTS THEREIN

related to the tree farming business from potential liability associated with that business, (2) to create a separate enterprise in which family members could participate, and (3) to facilitate the transfer of ownership interests in the tree farming business to his children, their spouses, and his grandchildren. Accordingly, A. J. Hackl executed Articles of Organization creating Treeco, LLC, and on October 6, 1995 , such articles were filed with the Office of the Indiana Secretary of State. As a result, Treeco was duly and validly organized as a limited liability company (LLC) under the Indiana Business Flexibility Act. The LLC format was selected by A. J. Hackl to obtain liability protection for members, to provide protection of assets inside the LLC from members' creditors, to provide

County Farms to Treeco. Thereafter, on December 11, 1995 , petitioners each recorded a capital contribution to Treeco of $500 in exchange for 50,000 voting and 450,000 nonvoting units in the LLC, thereby becoming the initial members of the entity and each holding 50-percent ownership. They also on that date, in their capacities as initial members, executed an Operating Agreement to govern the Treeco enterprise.

business shall be exclusively vested in a Manager" and specified that such manager "shall perform the Manager's duties as the Manager in good faith, in a manner the Manager reasonably believes to be in the best interests of the Company, and with such care as an ordinarily prudent person in a like position would use under similar circumstances." The document designated A. J. Hackl as the initial manager to serve for life, or until resignation, removal, or incapacity, and also conferred on him the authority to name a successor manager during his lifetime or by will.

direct that the Available Cash, if any, be distributed to the Members, pro-rata in accordance with their respective Percentage Interests." Available cash was defined as cash funds on hand after payment of or provision for all operating expenses, all outstanding and unpaid current obligations, and a working capital reserve. In addition, the Agreement provided that, prior to dissolution, "no Member shall have the right to withdraw the Member's Capital Contribution or to demand and receive property of the Company or any distribution in return for the Member's Capital Contribution, except as may be approved by the Manager." Members also in the Agreement waived the right to have any company property partitioned.

Concerning changes in members and disposition of membership interests, the Operating Agreement set forth specific terms with respect both to withdrawal of members and transfer of membership interests. Members could not withdraw from Treeco without the prior consent of the manager. However, under the Agreement "A Member desiring to withdraw may offer his Units for sale to the Company, in the person of the Manager, who shall have exclusive authority on behalf of the Company to accept or reject the offer, and to negotiate terms." Pertaining to transfer of interests, the document recited as follows:

If a transfer was permitted in accordance with this provision, the transferee would have the right to be admitted as a substitute member. If a transfer was made in violation of the foregoing procedure, the transferee would be afforded no opportunity to participate in the business affairs of the entity or to become a member; rather, he or she would only be entitled to receive the share of profits or distributions which otherwise would have inured to the transferor.

(2) voting members had the right to amend the Operating Agreement by an 80-percent majority vote;

(3) voting and nonvoting members had the right to access the books and records of the company;

(i) While A. J. Hackl is the Manager, by his written determination that the Company should be dissolved;

(ii) Following the tenure of A. J. Hackl as Manager by a written determination by Voting Members owning not less than eighty percent (80%) of the Voting Units of the Company that the Company should be dissolved;

resignation, expulsion, bankruptcy, death, insanity, retirement, or dissolution of the Manager"] if the Company is not continued * * *

Subsequent to completion of the foregoing formalities, petitioners on December 22, 1995 , made further contributions to Treeco. On that date petitioners contributed cash in the amount of $5,000,000 and publicly traded securities valued at $2,918,956. The cash and securities were held by Treeco to serve as working capital and to finance additional purchases of tree farm property.

Then, on December 29, 1995 , petitioners commenced a program of gifting interests in Treeco to family members. Petitioners transferred 500 voting and 700 nonvoting units in Treeco to each of their eight children and to the spouse of each such child. At that time, each donee executed an acceptance of the Treeco Operating Agreement. Petitioners reported the 1995 gifts of Treeco units on timely filed gift tax returns and elected on those returns to treat the gifts as made one-half by each of the petitioners pursuant to section 2513. Petitioners also treated the gifts as qualifying for the annual exclusion of section 2503(b). Respondent did not issue notices of deficiency to petitioners for 1995.

County, Florida (Flager County Farm), using $5,750,436 of the LLC's cash and securities. The Flager County Farm consisted of 8,382 acres and contained merchantable timber valued at $23,638 at the time of sale.

Irrevocable Trust (Grandchildren's Trust), for the benefit of petitioners' minor grandchildren. At that time, petitioners each transferred 31,250 nonvoting units in Treeco to the Grandchildren's Trust, representing 1,250 units for each of their 25 minor grandchildren. Three of petitioners' children were named as trustees of the Grandchildren's Trust and in that capacity executed an acceptance of the Treeco Operating Agreement. Petitioners reported the gifts made in 1996 on timely filed gift tax returns and elected on those returns to treat the gifts as made one-half by each of them pursuant to section 2513. As previously, annual exclusions were claimed under section 2503(b) with respect to the gifts. Respondent disallowed the exclusions by separate notices of deficiency dated April 14, 2000 .

OPERATIONS OF TREECO, LLC, AND SUCCESSOR ENTITIES

into Hacklco, LLC. Similarly, on May 20, 1997 , Treesource, LLLP, a Georgia limited liability limited partnership, was organized, and Hacklco was merged into this entity in 1998. These changes appear to have wrought no alteration in the nature and operation of the Treeco enterprise and, while enumerated for clarity, do not affect our analysis of the gifted units. Petitioners continued making gifts of voting and nonvoting units of Treeco's successors in interest in 1997 and 1998, resulting in petitioners' children and their spouses owning, at all times subsequent to January 2, 1998 , 51 percent of the voting power of Treesource.

Hackl, as manager of Treeco and its successors, devotes approximately 750 to 1000 hours per year to the farming operations. In addition, Georgia Pacific Corporation and F & W Forestry Services, Inc., were retained by Treeco to provide consulting and management services for the tree farms. Contained in the record are a Five-Year Timber Operating Budget for the McIntosh County Farm, prepared by F & W Forestry Services, and detailed forest management plans for the Putnam and Flager County Farms, prepared by Georgia Pacific. These documents discuss, among other things, plantation thinning, reforestation, fertilization, and capital improvements. The F & W Forestry Services budget projects losses through 2000 but characterizes the McIntosh tract as having "great future income potential". The Georgia Pacific plan describing the Putnam property similarly states: "These recommendations, if followed, will provide you with a healthy, fast growing forest which will lead to a steady stream of income in the future." A. J. Hackl meets on a regular basis with consultants from Georgia Pacific and F & W Forestry Services regarding maintenance of the tree farms. The parties have stipulated that he has always managed Treeco and its successors with such care as an ordinarily

expect that these entities would be making distributions to members during such years. Treeco reported losses in the amounts of $42,912, $121,350, and $23,663 during 1995, 1996, and 1997, respectively. Hacklco reported losses of $52,292 during 1997. Treesource reported losses in the amounts of $75,179, $153,643, and $95,156 <<ENDNOTE 1>> in 1997, 1998, and 1999, respectively. Neither Treeco nor its successors had at any time through April 5, 2001 , generated net profits or made distributions of cash or other property to members.

DISCUSSION

I. SETTLED AND DISPUTED ISSUES

The parties have previously filed a Stipulation of Partial Settlement, and a Supplemental Stipulation of Partial Settlement, in which they agreed that the fair market value of both the voting and nonvoting units of Treeco, LLC, was $10.43 per unit on the date of the 1996 gifts at issue in these cases. Accordingly, the sole issue for determination by the Court is whether petitioners' gifts of units in Treeco qualify for the annual exclusion provided by section 2503(b), a dispute which turns on whether the transfers constitute gifts of a present interest for purposes of the statute. In this connection, the parties have also stipulated that the Grandchildren's Trust satisfies the requirements of section 2503(c) such that the annual exclusion will be applicable for gifts thereto provided that the gifts are otherwise determined to be of a present interest.

favor, then in computing gift tax liability for 1996, the amounts of prior period taxable gifts reported on petitioners' 1996 returns shall be accepted as filed. Conversely, if the above question is decided in favor of respondent, the amounts of prior period taxable gifts reported on petitioners' 1996 returns shall be increased to reflect the annual

II. STATUTORY AND REGULATORY LAW

Section 2501 imposes a tax for each calendar year "on the transfer of property by gift" by any taxpayer, and section 2511(a) further clarifies that such tax "shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible". The tax is computed based upon the statutorily defined "taxable gifts", which term is explicated in section 2503. Section 2503(a) provides generally that taxable gifts means the total amount of gifts made during the calendar year, less specified deductions. Section 2503(b), however, excludes from taxable gifts the first $10,000 "of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year". In other words, the donor is entitled to an annual exclusion of $10,000 per donee for present interest gifts.

III. CASE LAW DEVELOPMENT

including a series of seminal decisions by the Supreme Court in the 1940s. Commissioner v. Disston, 325 U.S. 442 (1945); Fondren v. Commissioner, 324 U.S. 18 (1945); Ryerson v.

United States

, 312 U.S. 405 (1941);

United States

v. Pelzer, 312 U.S. 399 (1941); Helvering v. Hutchings, 312 U.S. 393 (1941); see also Calder v. Commissioner, 85 T.C. 713 (1985); Blasdel v. Commissioner, 58 T.C. 1014 (1972), affd. 478 F.2d 226 (5th Cir. 1973). Additionally, parallel to the developments in the trust area and incorporating many of the same principles, a line of cases has addressed the related situation where transfers of property are made to an entity with preexisting interest-holders. See, e.g., Stinson Estate v.

United States

, 214 F.3d 846 (7th Cir. 2000); Chanin v.

United States

, 183 Ct. Cl. 840, 393 F.2d 972 (1968).

In both scenarios, the gift in question takes the form of an indirect gift of the underlying property to the beneficiaries of the trust or to those holding interests in the entity. Helvering v. Hutchings, supra at 398; Chanin v.

United States

, supra at 975; Blasdel v. Commissioner, supra at 1022. Furthermore, it has become well settled that to qualify as a present interest, such a gift must confer on the donee not just vested rights but a substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or income from the property. Fondren v. Commissioner, supra at 20-21; Estate of Holland v. Commissioner, T.C. Memo. 1997-302.

where the use, possession, or enjoyment is postponed to the happening of a contingent or uncertain future event, such as where distributions of property or income will occur only at the discretion of a trustee or upon joint action of entity interest holders, or where there is otherwise no showing from facts and circumstances of a steady flow of funds from the trust or entity, the gift will fail to qualify for the section 2503(b) exclusion. Commissioner v. Disston, supra at 449; Ryerson v.

United States

, supra at 406-408;

United States

v. Pelzer, supra at 403-404; Chanin v. United States, supra at 976; Calder v. Commissioner, supra at 727-730.

other than of a future interest. <<ENDNOTE 2>> Rule 142(a); Commissioner v. Disston, supra at 449; Stinson Estate v.

United States

, supra at 848.

IV. CONTENTIONS OF THE PARTIES

parties before us. Petitioners contend their transfers of units in Treeco are properly characterized as present interest gifts. Petitioners emphasize that they made direct, outright transfers of the Treeco units, which are personal property separate and distinct under Indiana law from Treeco's assets. Petitioners further maintain that the units had a substantial and stipulated value; that petitioners' transfers placed no restrictions on the donees' interests in the units; and that the donees upon transfer acquired all rights in and to the gifted units, which rights were identical to those petitioners had in the units they retained. Hence, according to petitioners, their transfers involved no postponement of rights, powers, or privileges that would cause the gifts to constitute future interests.

through trusts and corporations are inapplicable to the direct transfers at issue here. Petitioners allege:

rights may be. The lack of any "postponement" of the donee's rights to enjoyment of the equity interest (or other property) is manifestly clear. * * *

referenced to analyze whether rights are postponed when interests in the subject property are held only indirectly through the conduit of a trust or corporate entity have no place in the present situation.

units fail to qualify as gifts of present interests. Respondent avers that because of the restrictions contained in the Treeco Operating Agreement, the transfers fell short of conferring on the donees the requisite immediate and unconditional rights to the use, possession, or enjoyment of property or the income from property. Unlike petitioners, respondent finds the body of law regarding indirect transfers to constitute "substantial analogous authority" and the principles espoused therein to control the outcome of these cases. Specifically, respondent emphasizes the requirement of present economic benefit and contends that the inability of the donees to freely transfer the units or to compel distributions from the entity prevented them from receiving any such benefit on account of the transfers. Thus, in respondent's view, the gifts postponed any economic benefit and therefore were of future interests.

V. ANALYSIS

correctly note, the property with which we are concerned in this matter is an ownership interest in an entity itself, rather than an indirect gift in property contributed to the entity. Treeco was duly organized and operating as an LLC, units of which under Indiana law are personal

property separate and distinct from the LLC's assets. See Ind. Code Ann. secs. 23-18-1-10, 23-18-6-2 (West 1994). Nonetheless, while State law defines property rights, it is Federal law which determines the

appropriate tax treatment of those rights.

United States

v. Natl. Bank of Commerce, 472

U.S.

713, 722 (1985); Knight v. Commissioner, 115 T.C. 506, 513 (2000). It thus is Federal law which controls whether the property rights granted to the donees as LLC owners under State law were sufficient to render the gifts of present interests within the meaning of section 2503(b). See United States v. Pelzer, 312 U.S. at 402-403.

extensive litigation involving indirect gifts. To disregard longstanding directives that a present interest gift exists only where a donee receives noncontingent, independently exercisable rights of substantial economic benefit cannot be justified in the face of either the language used by the Supreme Court or the subsequent application of such language. See Fondren v. Commissioner, 324

U.S.

at 20-21; Ryerson v.

United States

, 312

U.S.

at 408;

United States

v. Pelzer, supra at 403-404.

explains the meaning of future versus present interest in general terms, stating:

it is not enough to bring the exclusion into force that the donee has vested rights. In addition he must have the right presently to use, possess or enjoy the property. These terms are not words of art, like "fee" in the law of seizin * * *, but connote the right to substantial present economic benefit. The question is of time, not when title vests, but when enjoyment begins. Whatever puts the barrier of a substantial period between the will of the beneficiary or donee now to enjoy what has been given him and that enjoyment makes the gift one of a future interest within the meaning of the regulation.

The Court thus says that the terms "use, possess or enjoy" connote the right to substantial present economic benefit. This phraseology is broad and is in no way limited to the factual context presented. It defines the root words of the regulatory standard which no party disputes is a generally applicable and valid interpretation of section 2503(b). See sec. 25.2503-3, Gift Tax Regs. We therefore would be hard pressed to construe "use, possession, or enjoyment" as meaning something different or less than substantial present economic benefit simply because of a shift in the factual scenario or form of gift to which the test is being applied. Accordingly, we are satisfied that section 2503(b), regardless of whether a gift is direct or indirect, is concerned with and requires meaningful economic, rather than merely paper, rights.

Furthermore, this idea is buttressed by recognition that in an earlier case we quoted the very language from Fondren v. Commissioner, supra, set forth above in a context that involved outright gifts. In Estate of Holland v. Commissioner, T.C. Memo. 1997-302, we quoted the Fondren text en route to concluding that outright gifts in the form of $10,000 checks, which had been properly endorsed and deposited, were gifts of a present interest.

principles established in

United States

v. Pelzer, supra at 403-404, and Ryerson v.

United States

, supra at 408, regarding contingency and joint action are not restricted in their applicability to indirect gift

situations. In Skouras v. Commissioner, 14 T.C. 523, 524-525 (1950), affd. 188 F.2d 831 (2d Cir. 1951), the taxpayer assigned outright all incidents of ownership in several insurance policies on his life to his five children jointly and continued to pay the premiums thereon. Given these facts, we, citing

United States

v. Pelzer, supra, stated broadly that "where the use, possession, or enjoyment of the donee is postponed to the happening of future uncertain events the interest of the donee is a future interest within the meaning of the statute." Id. at 533. Then, relying on Ryerson v. United States, supra, and in spite of the taxpayer's argument that "there was not a grant to trust as in the Ryerson case", we ruled that the taxpayer, by "making the assignments to his five children jointly, had postponed the possession and enjoyment of the rights and interests in and to the policies or the proceeds thereof until his death or until such time as the children, acting jointly, might change or negative the action he had thus taken." Id. at 534.

gift tax consequences turned entirely upon distinctions in the ordering of transactions, rather than in their substance. For example, while

petitioners contributed property to an LLC and then gifted ownership units to their children and grandchildren, a similar result could have been achieved by first transferring ownership units and then making

precedent while the former is independent thereof. We decline to take such an artificial view.

principles discussed above with the assertion that the postponement question deals with rights to present use, possession or enjoyment of the transferred property, not the likelihood of the actual use, possession, or enjoyment of the property. See, Estate of Cristofani v. Comm'r, 97 T.C. 74 (1991); Crummey v. Comm'r, 397 F.2d 82 (9th Cir. 1968); Kieckhefer v. Comm'r, 189 F.2d 118 (7th Cir. 1951); Gilmore v. Comm'r, 213 F.2d 520, 522 6th Cir. 1954) * * *

interpreted to establish a rule inconsistent with those enunciated by the Supreme Court. See Rassas v. Commissioner, 196 F.2d 611, 613 (7th Cir. 1952) (distinguishing Kieckhefer v. Commissioner, supra), affg. 17 T.C. 160 (1951). Thus, instead of adopting an approach which would undermine the purpose and integrity of the section 2503(b) exclusion, we for the reasons explained above conclude that petitioners are not by virtue of making outright gifts relieved of showing that such gifts in actuality involved rights consistent with the standards for a present interest set forth in regulations and existing caselaw.

Operating Agreement in our analysis. Petitioners state that each gifted Treeco unit "represented a significant bundle of legal rights in the venture, rights which are defined by the Operating Agreement, Treeco's Articles of Organization, and Indiana statutory and common law". At the same time, petitioners aver: "The postponement question is not concerned with contractual rights inherent in the transferred property, but rather in whether, in the transfer of the property, the transferor imposed limitations or restrictions on the present enjoyment of the property."

They then go on to quote the language from section 25.2503-3(a), Gift Tax Regs., which references contractual rights in a bond, note, or insurance policy that do not result in a future interest characterization. Hence, while petitioners seem to acknowledge that the Operating Agreement in large part defines the nature of the property received by the donees, they also apparently would have us ignore any provisions of the Agreement which limited the ability of the donees to presently recognize economic value as akin to the contractual rights mentioned in the regulation.

However, petitioners' reliance on section 25.2503-3(a), Gift Tax Regs., is misplaced. This Court has previously taken a much narrower view of the cited regulatory language. In Estate of Vose v. Commissioner, T.C. Memo. 1959-175, vacated and remanded on another issue 284 F.2d 65 (1st Cir. 1960), we opined that the regulations were "designed to cover notes and bonds which, although perhaps not containing all of the attributes of negotiable instruments, are at least definitely enforceable legal obligations payable on a day certain and immediately disposable by the obligee." LLC units hardly fall within these parameters, and we observe that the quoted reasoning is consistent with our focus on requiring some presently reachable economic benefit.

Furthermore, petitioners' attempts to find in these regulations support for a distinction between limitations contractually inherent in the transferred property and restrictions imposed upon transfer are not well taken. All facts and circumstances must be examined to determine whether a gift is of a present interest within the meaning of section 2503(b), and this will be true only where all involved rights and restrictions, wherever contained, reveal a presently reachable economic benefit. Since here the primary source of such rights and restrictions is the Treeco Operating Agreement, its provisions, in their cumulative entirety, must largely dictate whether the units at issue conferred the requisite benefit. Accordingly, we now turn to the Operating Agreement to flesh out the nature of the property rights transferred to the donees at the time of their receipt of the Treeco units and whether such rights rose to the level of a present interest on account of either the units themselves (considered in this section) or the income therefrom (considered in section IV.C., infra).

obligations in the gifted Treeco units which were identical to those which Petitioners had in the Treeco units they retained, including the rights under the Treeco Operating Agreement to have all net income or capital gains allocated, all cash distributions made, and net loss allocated (subject to an allocation of losses to A. J. Hackl for a period which was designed to ensure the current deductibility of Treeco losses for federal income tax purposes) based on the number of units held in relation to the total number of units, the right to have capital accounts established and maintained on behalf of each member in the manner provided by Treas. Reg. section 1.704-1(b)(2)(iv), the right to offer units for sale to Treeco, or to sell their units to third parties (subject to manager approval), the rights (voting members) to remove the manager, amend Treeco's organizational documents, dissolve Treeco, approve salaries or bonuses paid to any manager, etc., all of which rights are entitled to court enforcement. * * *

At the outset, we note that petitioners' repeated assertions that the rights conferred on the donees were identical to those retained by the donors have little bearing on our analysis. A similar fact did not

Commissioner, 58 T.C. 1014 (1972), and we are satisfied that it should be given no more weight here.

created a trust, named themselves as 2 of the trust's beneficiaries, and conveyed beneficial interests to 18 other family members. Although we explicitly observed that "the donees acquired their fractional beneficial interests subject to the same terms and limitations as petitioners held theirs", we nonetheless based our decision on the nature of those terms, without regard to any identity of rights between donors and donees. Id. at 1018-1020; see also Hamilton v.

United States

, 553 F.2d 1216, 1218 (9^th Cir. 1977). In addition, given the authority granted here to A. J. Hackl as manager, we observe that the alleged equality, when viewed from a practical standpoint, is less than petitioners would have us believe.

Concerning the specific rights granted in the Operating Agreement, we are unable to conclude that these afforded a substantial economic benefit of the type necessary to qualify for the annual exclusion. While we are aware of petitioners' contentions and the parties' rather conclusory stipulations that Treeco was a legitimate operating business entity and that restrictive provisions in the Agreement are common in closely held enterprises and in the timber industry, such circumstances (whether or not true) do not alter the criteria for a present interest or excuse the failure here to meet those criteria.

Treeco Operating Agreement foreclosed the ability of the donees presently to access any substantial economic or financial benefit that might be represented by the ownership units. For instance, while an ability on the part of a donee unilaterally to withdraw his or her capital account might weigh in favor of finding a present interest, here no such right existed. According to the Agreement, capital contributions could not be demanded or received by a member without the manager's consent. Similarly, a member desiring to withdraw could only offer his or her units for sale to the company; the manager was then given exclusive authority to accept or reject the offer and to negotiate terms. Hence some contingency stood between any individual member and his or her receipt from the company of economic value for units held, either in the form of approval from the current manager or perhaps in the form of removal of that manager by joint majority action, followed by the appointment of and approval from a more

compliant manager. Likewise, while a dissolution could entitle members to liquidating distributions in proportion to positive capital account

Moreover, in addition to preventing a donee from unilaterally obtaining the value of his or her units from the LLC, the Operating Agreement also foreclosed the avenue of transfer or sale to third parties. The Agreement specified that "No Member shall be entitled to transfer, assign, convey, sell, encumber or in any way alienate all or any part of the Member's Interest except with the prior written consent of the Manager, which consent may be given or withheld, conditioned or delayed as the Manager may determine in the Manager's sole discretion." Hence, to the extent that marketability might be relevant in these circumstances, as potentially distinguishable on this point from those in indirect gift cases such as Chanin v.

United States

, 393 F.2d at 977, and Blasdel v. Commissioner, supra at 1021-1022 (both dismissing marketability as insufficient to create a present interest where the allegedly marketable property, an entity or trust interest, differed from the underlying gifted property), the Agreement, for all practical purposes, bars alienation as a means for presently reaching economic value. Transfers subject to the contingency of manager approval cannot support a present interest characterization, and the possibility of making sales in violation thereof, to a transferee who would then have no right to become a member or to participate in the business, can hardly be seen as a sufficient source of substantial economic benefit. We therefore conclude that receipt of the property itself, the Treeco units, did not confer upon the donees use, possession, or enjoyment of property within the meaning of section 2503(b).

donees the right to use, possession, or enjoyment of income therefrom, we again answer this question in the negative. As before, broadly applicable standards and reasoning derived from both the trust cases and the cases involving gifts to a partnership or corporate entity call for this result.

In particular, this Court has distilled caselaw in these areas into a three-part test for ascertaining whether rights to income satisfy the

criteria for a present interest under section 2503(b). Calder v. Commissioner, 85 T.C. at 727-728. The taxpayer must prove, based on

out to the beneficiary can be ascertained." Id. ; see also Md. Natl. Bank v.

United States

, 609 F.2d 1078, 1080-1081 (4th Cir. 1979).

Treeco and its successors was to acquire and manage timberland for long-term income and appreciation, "and not to produce immediate income." The parties further stipulated: "Petitioners anticipated that all three entities would operate at a loss for a number of years, and therefore, they did not expect that these entities would be making distributions to members during such years." The record then validates these assumptions by stipulating to losses, negative cashflows, and an absence of distributions from 1995 to April of 2001. Hence, even the first receipt of income prong has not been established on the facts before us.

Furthermore, even if petitioners had shown that Treeco would generate income at or near the time of the gifts, the record fails to establish that any ascertainable portion of such income would flow out to the donees. Members would receive income from Treeco only in the event of a distribution. However, the Operating Agreement states that distributions were to be made in the manager's discretion. This makes the timing and amount of distributions a matter of pure speculation and also raises again the specter of some form of joint action to oust a manager whose distribution policy failed to satisfy members. As a result, the facts in this case convince us that any economic benefit the donees may ultimately obtain from their receipt of the Treeco units is future, not present. In other words, the economic benefit has been postponed in a manner contrary to the regulatory and judicial pronouncements establishing the meaning of a present interest gift for purposes of section 2503(b).

Additionally, we note that the fact the parties have stipulated a value for the Treeco units does not affect the foregoing analysis. Although petitioners mention this fact repeatedly, it has long been established that "the crucial thing is postponement of enjoyment, not the fact that the beneficiary is specified and in esse or that the amount of the gift is definite and certain." Fondren v. Commissioner, 324

U.S.

at 26-27. Entity interest values can be based, as the facts and circumstances indicate is the case here, on the worth of underlying assets and the future income potential they represent, neither of which may be presently reachable. We therefore hold that petitioners are not entitled to exclusions under section 2503(b) for their gifts of Treeco units.

1/ Although the parties stipulated that Treesource reported a loss of $99,156 for 1999, Treesource's 1999 return in fact reflects a loss of $95,156. See Cal-Maine Foods, Inc. v. Commissioner, 93 T.C. 181, 195

(1989) (holding that stipulations are properly disregarded where clearly contrary to evidence contained in the record).

2 Cf. sec. 7491, which is effective for court proceedings that arise in connection with examinations commencing after July 22, 1998 , and which can operate to place the burden on the Commissioner in enumerated

circumstances. Petitioners here have not contended, nor is there evidence, that their examinations commenced after July 22, 1998 , or that sec. 7491 applies in these cases.

PLR 199415007 12/12/1994

Comment: Please use this Private Letter Ruling to contrast this Internal Revenue Service Tax Position with the Tax Position it successfully argued in the Case which is the topic of this discussion.

* Sec. 2036 Issues: Transfers with retained life estate (included v. not included in gross estate).

* Sec. 2038 Issues: Revocable transfers (included v. not included in gross estate).

This is in response to your December 8, 1993 letter requesting rulings under sections 2036, 2038, 2503, and 2701 of the Internal Revenue Code with respect to proposed transfers of limited partnership interests by a general partner.

The Transferor and his wife created the limited partnership (Partnership) in 1993. The Transferor initially contributed cash to the Partnership in exchange for a 9.259 percent general partnership interest and a 90.278 percent limited partnership interest. The Transferor's wife initially contributed cash in exchange for a 0.463 percent limited partnership interest. Subsequently, the trustees of certain trusts for the benefit of the Transferor's family and a custodian under a uniform gifts to minors act account invested additional funds in the Partnership in exchange for limited partnership interests.

The Transferor as general partner has exclusive management control of the Partnership, including full discretion to determine the amount and timing of distributions to the partners; provided, however, that if the general partner directs the distribution of partnership funds to the partners, distributions must be made to all partners at the same time in accordance with each partner's percentage interest in the Partnership (based on each partner's capital account).

Under the terms of the partnership agreement and applicable state law, the Transferor as general partner has a fiduciary duty to the limited partners to manage and operate the Partnership in the best interests of the Partnership and its partners. In exercising the powers granted in the partnership agreement, the general partner is bound to act in accordance with this fiduciary duty.

The partnership agreement provides that all items of income and deductions are to be allocated in accordance with the principles of section 704(b) and the regulations thereunder.

During the term of the Partnership, no partner is entitled to demand a distribution or a return of his capital account. However, the partners have the right to sell their interests to third parties, subject to the right of first refusal granted to the other partners.

When the partnership is dissolved, its assets will be distributed to the partners on a pro rata basis in accordance with their respective partnership interests.

If the transferor desires to have a particular gift qualify for the $10,000 annual exclusion under section 2503(b), he will make the transfer either outright or to a trustee of a trust that meets the requirements of section 2503(c).

1. The Transferor's proposed transfers (outright or to S trusts qualifying under section 2503(c)) of limited partnership interests will constitute gifts of present interests for purposes of section 2503(b).

2. The value of the limited partnership interests gratuitously transferred will not be subject to the special valuation rules under section 2701.

3. Upon the death of the Transferor, the value of the transferred partnership interests will not be includible in the Transferor's gross estate under sections 2036 or 2038 as a result of the Transferor's retained powers as general partner.

Section 2501(a)(1) provides for the imposition of a tax on the transfer of property by gift. Section 2511 provides that the gift tax applies to a transfer by way of gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

Section 2503(b) provides that in the case of gifts (other a than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not be included in the total amount of gifts made during such year.

The annual exclusion is only allowed for gifts of present interests in property. Section 25.2503-3(b) of the Gift Tax Regulations provides that a present interest in property is an unrestricted right to the immediate use, possession, or enjoyment of the property (such as a life estate or a term certain).

Section 25.2503-3(a) of the regulations defines "future interests" as a legal term that includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment some future date or time.

Section 2503(c) provides that no part of a gift to an individual who has not attained the age of 21 on the date of the transfer shall be considered a gift of a future interest for purposes of section 2503(b) if the property and the income therefrom (1) may by expended by, or for the benefit of, the donee before he attains the age of 21 and (2) will, to the extent not so expended, pass to the donee upon his attaining age 21 or be payable to his estate or as he may appoint under a general power of appointment in the event that he dies before attaining age 21.

In the subject case, the proposed gifts of limited partnership interests will constitute outright gifts of ownership interests in a business entity. Each donee will receive the immediate use, possession, and enjoyment of the subject matter of the proposed gifts, including the right to sell or assign the interest (subject to the right of first refusal).

Accordingly, we conclude that the proposed gifts of limited partnership interests by the Transferor will constitute gifts of present interests that will qualify for the annual exclusion under section 2503(b).

Section 2701 provides that special valuation rules are applicable to a transfer of an interest in a corporation or partnership to a member of the transferor's family if the transferor or an applicable family member retains an "applicable retained interest."

25.2701-2(b)(1) to include (among other things) an equity interest that constitutes a "distribution right" (as defined in section 25.2701-2(b)(3)) in a "controlled entity" (as defined in section 25.2701-2(b)(5).

Section section 25.2701-2(b)(5) provides in part that, for purposes of section 2701, a "controlled entity" includes a partnership controlled, immediately before a transfer, by the transferor, applicable family members, and any lineal descendants of the parents of the transferor or the transferor's spouse. Section 25.2701-2(b)(5)(iii) provides in part that, in the case of a limited partnership, "control" means the holding of any equity interest as a general partner. Thus, in the subject case, the Partnership is a "controlled entity" vis a vis the Transferor because of his status as a general partner.

Section 25.2701-2(b)(3)(i) provides that a "distribution right" does not include any right to receive distributions with respect to an interest that is of the same class as the transferred interest. Under section 25.2701-1(c)(3), a retained interest is in the same class as the transferred interest if the rights in the retained interest are identical to the rights of the transferred interest except for, in the case of a partnership, non-lapsing differences with respect to management and limitations on liability. For this purpose, non-lapsing provisions necessary to comply with partnership allocation requirements of the Internal Revenue Code (e.g., section 704(b)) are non-lapsing differences with respect to limitations on liability.

In the subject case, the right to distributions that the Transferor/general partner proposes to retain are rights with respect to an interest that is of the same class as the interests that he proposes to transfer. Consequently, the rights to be retained by the Transferor will not constitute "distribution rights." Thus, an "applicable retained interest" will not exist after the proposed transfers, and section 2701 will not apply.

Section 2036(a) provides that a decedent's gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth) by trust or otherwise under which he has retained, for his life or for any period not ascertainable without reference to his death or any period that does not in fact end before his death, (1) the possession or enjoyment of, or the right to the income, from the property, or (2) the right, either alone or in conjunction with any person, designate the persons who shall possess or enjoy the property or the income therefrom.

Section 2036(b) provides that, for purposes of section 2036(a)(1) the retention of the right to vote, directly or indirectly, shares of stock of a controlled corporation shall be considered a retention of the enjoyment of the transferred property.

United States

v. Byrum, 408

U.S.

125 (1972), 1972-1 C.B. 518, the decedent was a controlling shareholder and a member of the board of directors of a closely-held corporation. The Court held that stock in the corporation transferred by the decedent to an irrevocable trust was not included in his gross estate under section 2036 even thought the decedent expressly retained the right to vote the transferred stock and to veto the sale or disposition of the stock by the trustee. The Court held that the decedent, as a controlling shareholder and a member of the board of directors, had a fiduciary duty to promote the interests of the corporation and not to exercise his voting power to promote his personal interests at the expense of the minority shareholders. Accordingly, the decedent's retained power to vote the stock did not constitute the retained enjoyment of the transferred stock or right to designate the income from the transferred stock for purposes of section 2036.

As indicated above, the Transferor in the subject case is the general partner of the Partnership and as such has management authority over the Partnership, including the authority to control partnership distributions.

However, as in the case of the decedent in Byrum, the Transferor in the subject case occupies a fiduciary position with respect to the limited partners and cannot distribute or withhold distributions or otherwise manage the partnership for purposes unrelated to the conduct of the partnership business.

Section 2038 provides that the value of the gross estate shall include the value of all property of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth) in trust or otherwise, where the enjoyment thereof was subject to a power in the decedent to alter, amend, revoke, or terminate such interest or where any such power was relinquished during the 3-year period ending on the date of the decedent's death. Based upon the foregoing analysis with respect to section 2036, the Transferor's fiduciary duty with respect to the management of the Partnership will also preclude an inclusion in his gross estate under section 2038.

Accordingly, we conclude that the value of the partnership interests proposed to be transferred by the Transferor will not be includible in his gross estate under sections 2036 or 2038 by reason of his status as general partner.

This ruling is based on the facts and applicable law in effect on the date of this letter. If there is a change in material fact or law (local or federal) the ruling will have no force or effect. If the taxpayer is in doubt whether there has been a change in material fact or law, a request for reconsideration of this ruling should be submitted to this office.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

	Engagement Status Letter ~ WARNING!

Family Ltd Partnerships or Family LLC's

Recent Tax Court Decisions - "Present Interest" Requirements

PLR 199415007 12/12/1994

Engagement Status Letter ~ WARNING!