August 31, 2012 The Tax Lawyer

Judicial Expansion of the Future Interest Exception to the Gift Tax Annual Exclusion—Examination of the Legislative History and Policy Basis for the Future Interest Exception

Vol. 65, No. 3 - Spring 2012

William C. Brown

Abstract

    When the Tax Court issued its opinion in Hackl v. Commissioner in 2002, the estate planning community initially stood up and took notice. The case represented a dramatic new line of attack by the Service against one of the best tools in the estate planner’s arsenal—the family limited partnership (FLP). Prior to that time, the Service had principally attacked FLPs with only limited success on the grounds that they constituted transfers with retained interests includable in the donor’s estate under sections 2036(a)(1), 2036(a)(2), and 2038, or as indirect gifts of the underlying assets, without valuation discounts, under substance over form grounds. By and large, the estate planning community had adjusted to these potential attacks by (1) making sure personal assets were not placed in an FLP, (2) advising clients not to use FLP funds to pay personal expenses, (3) meticulously documenting the form of the formation transaction and subsequent transactions with the FLP, (4) retaining sufficient donor assets outside of the FLP to support the donor following the formation of the FLP, (5) not pursuing an FLP strategy for terminally ill donors, and (6) avoiding contemporaneous formation and gifting of FLP units. The Hackl case represented a new threat with which planners needed to deal effectively to assure the maximum benefits available from an FLP planning strategy.

    After the initial reaction to Hackl was digested, practitioners began to examine the case more closely, and many began to marginalize the holding based on its peculiar facts, which could be easily distinguished from those in most FLP situations. Most notably, Hackl involved a limited liability company that principally held tree-farming operations that were not expected to generate income for many years and that had been operating at a loss for several years. As a consequence, the LLC acknowledged that it did not intend to make distributions to members for many years. Since most FLPs do not involve non-income-producing property, many estate planners felt that their FLPs could easily be distinguished from Hackl so as to enable a donor to utilize annual exclusions with respect to gifts of their interests, particularly if distributions were being made—even if those distributions were irregular. Moreover, in the immediate aftermath of Hackl, there were no further cases holding gifts of FLP interests to not qualify for the gift tax annual exclusion, which added to the complacency of the estate planning community in dealing with eligibility of a gift for the annual exclusion under section 2503(b). Hackl came to be viewed by many as an outlier case with little applicability to the standard FLP holding income-producing property.

    The complacency that developed in the estate planning community concerning annual exclusion qualifications on FLP gifts was also a function of the few challenges to annual exclusion claims that arise in a typical estate planning practice. Many gifting plans are structured as only annual exclusion gifts which do not result in the necessity of filing gift tax returns unless spouses elect to split gifts, and as a result many gifting plans do not generate audits.  Planners have often been lulled into a false sense of security because of the absence of gift tax audit challenges with respect to such plans.

    In 2010, all of this changed. First, the Tax Court issued a memorandum opinion in Price v. Commissioner in which the court held that gifts of limited partnership interests in a limited partnership holding commercial real estate and marketable securities were gifts of future interests not qualifying for the gift tax annual exclusion. The court cited substantial similarities in the limited partnership agreement to the operating agreement in Hackl, including (1) a provision which restricted the transfer of units without the consent of all of the limited partners, (2) the grant to the limited partnership and the other limited partners of an option to purchase the interests of a partner from an assignee, and (3) a provision granting the general partner discretion as to whether to distribute profits to the partners. In addition, the Tax Court expressly reaffirmed its specific formulation of the income test of present interest qualification which it had set forth in the Hackl case as a three-part test: (1) the partnership must “generate income at or near the time of the gifts,” (2) some of that income must flow steadily to the donees, and (3) “the portion of income flowing to the donees can be readily ascertained.” This case made it clear that the Tax Court did not regard the decision in Hackl  to be limited to FLPs holding non-income-producing property which generated losses.

    About two months later, in Fisher v. United States, an Indiana federal district court held that transfers of membership interests in an LLC principally holding beachfront real estate bordering Lake Michigan were gifts of future interests not qualifying for the gift tax annual exclusion. In so holding, the court pointed to several LLC operating agreement provisions it deemed pertinent to the present interest question: (1) that the general manager would determine the timing and amount of all distributions to members, (2) that members could only transfer their share of profits and losses and the right to receive distributions, and (3) a right of first refusal to purchase the membership units on a proposed transfer and pay for the units by means of a nonnegotiable promissory note to be paid over a period not to exceed 15 years. The court also quoted the Hackl court’s statement that a present interest “connotes the right to substantial present economic benefit” and found such a benefit lacking. There seems to be little question that the district court’s holding was also influenced significantly by the fact that an appeal from that court would lie with the Seventh Circuit Court of Appeals, which had previously affirmed the Tax Court in Hackl.

    While the FLP in the Fisher case contained non-income-producing property like the LLC in Hackl, in contrast the FLP in Price held only income producing property and hence cannot be distinguished from most FLPs on that basis.

    This Article examines the history and policy reasons behind the present interest requirement for qualifying for the gift tax annual exclusion. It also looks at the development of the formulation of the present interest test in Hackl and Price and the historical application of the present interest test to gifts involving public and closely held business interests. Finally, this Article considers the implications of the application of the Hackl and Price formulation of the present interest requirement to transfers of business interests, whether such an application is consistent with the policy for the present interest requirement of the gift tax annual exclusion, and whether such an approach should be applied to business interests in the absence of further legislative action.

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