Making Annual Gifts - FLP Interests

Gifting FLP Interests

Community Property

When community property transfer are made, the presumption is 50% is transferred by each spouse.  Normally, the gift tax return is not unduly complex to prepare and file.  My advice is to file the return, show the gifts, and values thereof.  By making the filing the tax return will be recorded on the government's records, and show no tax assessment - thereby establishing the bar date for collection of tax, or challenging of the values of the gifts.  Without the filing, the bar-date for any challenge by the IRS is NOT established, leaving the valuation open to challenge.  My Advice - file the return.

Qualifying for the Annual Gift Tax Exclusion. To qualify for the $11,000 annual gift tax exclusion, a gift must be a present (as opposed to a future) interest in property [IRC Sec. 2503(b)]. Common types of future interests include reversionary or remainder interests, which are typically created when property is transferred to trusts. Generally, a gift of a partnership interest is a present interest. However, restrictions (e.g., transferability restrictions or inability to withdraw at will) are often placed on the limited partner interests in an FLP to create valuation discounts. These restrictions may so limit the partner’s ability to benefit economically that the limited interest does not qualify as a present interest for gift tax purposes.

Although the general partners could theoretically withhold enjoyment from the limited partners because of their ability to control distributions, TAM 9131006 and PLR 9415007 each point out that the general partner was under a fiduciary obligation to manage the partnership on behalf of all the partners, including the limited partners. Such a responsibility is similar to the obligation of a corporate board of directors to its shareholders. Also, since the limited partners were free to sell or assign their interests (subject to a right of first refusal), they could shift the economic benefit to others. Thus, the gifts of partnership interests qualified for the annual exclusion.

NOTE: In both private rulings mentioned in the preceding paragraph, the limited partners had the right to transfer their interests, subject to a right of first refusal by the other partners. If the partnership agreement had been structured so that the limited partners had no right of withdrawal, perhaps in an attempt to increase valuation discounts, the gifts might not have been treated as present interest gifts by the IRS. In TAM 9751003 the IRS found that limited partner interests were not present interests in property. The general partner had sole discretion to make distributions to limited partners and the limited partners had no right to withdraw or assign their interests.

In Hackl, the Tax Court denied the annual gift tax exclusion for gifts of family limited liability company (FLLC) interests to the taxpayers’ adult children and their spouses and to a trust set up for the taxpayers’ grandchildren. The Tax Court decided they were gifts of future economic interests, which are ineligible for the annual gift tax exclusion. There were two main reasons for this unfavorable decision. First, the FLLC’s primary assets were tree farming properties that were not expected to produce any positive cash flow for years. Second, the FLLC’s operating agreement (similar to an FLP’s partnership agreement) placed onerous restrictions on the ability of the taxpayers’ children and grandchildren to sell their interests or have them redeemed by the FLLC. As a result, the children and grandchildren could not realistically expect to receive any FLLC cash distributions anytime soon. Nor could they realistically expect to be able to convert their FLLC ownership interests into cash by selling them or having them redeemed. Therefore, the gifts of the FLLC interests were characterized as gifts of future interests. Had the taxpayers set up an FLP under the same circumstances, the tax outcome would have been the same.

Planning Point: In Hackl, the gift tax exclusion probably would have been allowed had the FLLC owned at least some assets that generated current cash distributions for the children and grandchildren. Also, the gift tax exclusion probably would have been allowed had the FLLC’s operating agreement permitted sales or redemptions of the interests under certain conditions. In this case, however, the complete economic stranglehold put on the children and grandchildren resulted in losing the annual gift tax exclusion privilege. Remember, funding an FLP (or FLLC) with income-producing assets and adopting a more liberal partnership agreement (or FLLC operating agreement) in order to preserve the annual gift tax exclusion would have the unwanted side effect of reducing valuation discounts for gifts of FLP (or FLLC) interests. (See the discussion of valuation discounts beginning at paragraph 3003.20.) In other words, taxpayers cannot necessarily qualify for the annual gift tax exclusion and maximize the valuations discounts for minority interest and lack of marketability.

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