All successful closely-held family businesses eventually face the same challenge: how to transition ownership from one generation to the next. A popular, tax advantaged method of transferring ownership is by gifting shares from the current shareholders, for example, Mom and Dad, to their children. Current tax law allows an individual to make tax-free gifts up to $13,000 per donee, per calendar year without the requirement of filing a gift tax return. Shareholders wishing to transfer ownership of family businesses to the next generation often use this gift tax exclusion amount as an annual threshold in a systematic succession plan. Sounds simple, right?

However, recent victories by the IRS clearly indicate that a mere transfer of shares is not sufficient to qualify for the annual exclusion. The partnership's operating agreement and overall operations also affect the gift of partnership interests and more importantly, the availability of the annual gift tax exclusions.

In order to qualify for the annual gift tax exclusion, the gift must be of a present interest in property. The Internal Revenue Code (IRC) does not define "present interest". The Income Tax Regulations (Regs.) provide that a present interest is "an unrestricted right to the immediate use, possession, or enjoyment of property (the "use test") or income from property (the "income test")" [Regs. Section 25.2503-3(b)]. A transfer will qualify as a present interest if it satisfies either the use test or the income test. Conversely, a "future interest" postpones the donee's right to use, possess or enjoy the property. Vesting in the property has been deemed irrelevant as immediate vesting does not necessarily coincide with the donee's ability to use, possess or enjoy the property itself or income from the property.

The Hackl case (118 T.C. 279 (2002), aff'd, 335 F.3d 664 (7th Cir. 2003)) was the IRS's first victory at explicitly denying the premise that a mere transfer of a partnership automatically qualified as a "present interest" and therefore qualified the transfer for the gift tax annual exclusion. For a period of years, A.J. Hackl annually transferred shares in an LLC to his children. He claimed the allowable annual gift tax exclusion on timely filed gift tax returns. Hackl was the managing member of the LLC, controlling all financial decisions. Other shareholders needed his approval to withdraw from the company or to sell their shares. The company never reported any profits and never made any distributions. In disallowing that annual gift tax exclusion the IRS, and subsequently the Tax Court, ruled that Hackl's restrictions on the donee's transferability of shares meant they had little or no immediate economic benefit. In addition, since there were no profits and no distributions, the donee's did not receive any present income interest.

In Price (T.C. Memo. 2010-2), the parents placed the shares of their family business in a partnership and over a period of years gifted each of their children interests in the partnership. The Prices claimed annual exclusions on their gift tax returns. The partnership agreement prevented any partner from withdrawing capital. In addition, the agreement prohibited any partner from transferring or assigning their interests without the written consent of all other partners. The IRS, similar to Hackl, contended that these restrictions on the transfer of partnership interests represented a "future interest" with respect to the ability to immediately use, possess or enjoy the property. The Prices argued that the partners received a present income interest because the partnership made profit distributions in three of the five years over which the partnership interests were gifted. By satisfying the income test, the transfers should qualify as a present interest and the annual gift tax exclusion should be allowed. Similar to the Hackl decision, the Tax Court rejected the Price's arguments, concluding that the restrictions on withdrawing capital and transferring or disposing of their interests lacked the requisite ability to immediately use, possess or enjoy the property. In addition, the Tax Court concluded that the income distributions were at the sole discretion of the general partner (Mr. Price) and were neither consistent nor predictable as represented by the fact there were no distributions in some years.

Finally, in Fisher (No. 1:2008cv00908 (S.D. Ind. 3/11/10)), the parents placed an undeveloped parcel of land along Lake Michigan into a partnership (an LLC). Over a period of 3 years they transferred equal interests to their seven children. Each year, the Fishers filed a gift tax return claiming the applicable annual exclusion. The operating agreement required the LLC to be managed by a management committee (the Fishers) and for the committee to appoint a general manager (Mr. Fisher). The children were allowed to transfer their interests if certain conditions were met. The LLC retained a right of first refusal for any transfer to a non-family member. The LLC retained the right to set the closing date and payment would be in the form of a self-amortizing, non-negotiable promissory note payable over a period up to 15 years. Again, the Tax Court ruled in favor of the IRS. The Court concluded that the sole discretion of the general manager with respect to distributions coupled with the children's lack of free transferability of their interest (except to other family members) did not provide the children with a present interest in the property. Therefore, the annual transfer of partnership interests by the parents to the children did not qualify for the gift tax exclusion.

In all three cases the IRS and the Tax Court looked to the operating agreements and the operations of the entities to support the denial of the annual gift tax exclusion claimed in connection with the ownership transfers. These IRS-friendly decisions make proper planning and review of operating agreements essential steps in the succession planning of any closely-held family business, especially where gifting of interests is contemplated.

If your business is beginning the process of developing its succession plan to the next generation of ownership, please contact your Dermody, Burke & Brown tax advisor to discuss how we can assist you with developing and implementing your plan!

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.