Since the Tax Court decided Hackl in 2002, estate planners have worried that making gifts of limited partnership interests may entitle the donor to a valuation discount or a gift tax annual exclusion—depending on the terms of the partnership agreement—but not both. See Hackl v. Commissioner, 118 T.C. 279 (2002), affd. 335 F.3d 664 (7th Cir. 2003). Two recent decisions raise more concern for estate planners in this area. See Price v. Commissioner, T.C. Memo 2010-2 (January 4, 2010); Fisher v. United States, 105 AFTR2d 2010-1347 (March 11, 2010).
In Price v. Commissioner, the annual gift tax exclusion was held not to apply to the donors’ transfers of limited partnership units to their children. Following Hackl v. Commissioner, the Tax Court held that the donees possessed a “future interest” in the transferred property under IRC §2503(b), focusing on:
- the inability of the donees to transfer their partnership interests without the written consent of all the partners,
- the inability of the donees to withdraw their capital accounts,
- the fact that there was no time limit on the partnership’s exercise of its right of first refusal, and
- the fact that there was no immediate guaranteed cash flow to the donees.
The taxpayers claimed “substantial discounts” for lack of control and lack of marketability of the transferred partnership interest, stating on their gift tax returns that the investments were “illiquid.” The IRS stipulated that the fair market values of the gifts were correctly reported. The very factors that contributed to the IRS upholding the valuation discounts appear to have resulted in a finding that the donees did not possess a “present interest” under Treas. Regs 25.2503-3(b).
In Fisher v. U.S., the District Court for the Southern District of Indiana ruled against the taxpayers on a summary judgment motion regarding whether the taxpayers’ transfers of LLC units to their seven children qualified as present interests for the gift tax annual exclusion. The District Court held:
- the right to receive distributions upon a sale of a capital asset was contingent upon several factors, one being the general manager’s determination to make a distribution from the LLC (the general manager also being the donor of the LLC units);
- the right to use the land on Lake Michigan held in the LLC was a “possessory benefit,” not a substantial present economic benefit (i.e., the right to use the land did not enable the donees to convert the interest to cash);
- the right of first refusal to the LLC was a contingency that hindered the children from realizing a substantial economic benefit (i.e., the LLC could pay the child with non-negotiable promissory notes payable over a period of time not to exceed 15 years).
It appears from this line of cases that the valuation discount and the annual exclusion may be mutually exclusive when the donor makes gifts of partnership interests to their children. Can a partnership be structured in such a way to enable the donor to take advantage of both valuation discounts and annual exclusions? Perhaps, but it appears to be a very fine line, and attempting to do so may undermine some of the taxpayer’s larger estate planning and corporate governance goals.
For example, if the operating agreement directs the partnership to exercise its right of first refusal by redeeming the donee with cash, the taxpayer will have lost an important factor contributing to the valuation discount, and will have relinquished an important level of corporate control. Similarly, if the operating agreement requires the partnership to make distributions to the limited partners of earnings and profits, or even to make distributions for the payment of income taxes attributable to the limited partners’ interests in the partnership, the valuation discount may be reduced. Furthermore, the distribution requirement may hinder the partnership’s overall investment and business purposes.
Taking a step back from the Price and Fisher decisions, it may be that the number of taxpayers who are simply making annual exclusion gifts of limited partnership interests and claiming a valuation discount is on the decline for the following reasons:
- In an environment of low interest rates and depressed equity values, taxpayers may want to take advantage of estate-freeze opportunities by implementing transfer techniques, such as GRATs, sales to intentionally defective grantor trusts and other leveraged-gifting strategies. The use of one or more of these leveraged-gifting strategies will likely permit the taxpayer to immediately transfer a greater limited partnership ownership interest than otherwise would be available with annual exclusion gifting at potentially its lowest value and subject to considerably favorable interest rates, with little or no gift tax cost. By slowly making incremental annual exclusion gifts over time, the taxpayer may lose the opportunity to leverage the gift through low interest rates and current low values.
- The Administration’s “Green Book” proposal to limit certain valuation discounts on intra-family transfers could also be a reason for taxpayers to accelerate their valuation discount gifting strategies.
- The appraisal needed to support a valuation discount can be costly. For entities holding truly difficult to value assets, such as private equity, it may not be worth the cost associated with appraising the entity if the ultimate estate planning benefit is limited to the relatively small annual exclusion amount. Further, depending on the number of annual exclusion donees available to the taxpayer, the recurring appraisal cost generally required for an annual exclusion gifting program focused on the transfer of limited partnership interests may be overly burdensome.
In light of the Hackl, Price and Fisher decisions, there is reason to be concerned that transferors who make gifts of limited partnership interest to children may not be able to claim both a valuation discount and the gift tax annual exclusion. In any event, there may be better ways to make leveraged gifts in this environment of low interest rates and depressed equity values.