Gifts of an ownership interest in a business not eligible for the annual exclusion.

In Hackl, 118 TC No. 14 (2002), the Tax Court ruled that direct gifts of immediate vested ownership interests in a limited liability company (LLC) were not gifts of present interests entitled to an annual gift tax exclusion, because the donees did not receive rights to a substantial present economic benefit. Hackl could compel taxpayers to restructure gifts of family businesses to qualify for the annual exclusion.

Sec. 2501 imposes a tax on gifts of property. Sec. 2511 specifies that the tax applies whether the gift is direct or indirect. Sec. 2503(b)(1) allows each donor to exclude the first $10,000 per year to each donee for gifts of present interests. Regs. Sec. 25.2503-3(b) defines a present interest as an unrestricted right to the immediate use, possession or enjoyment of property or the income therefrom. Kegs. Sec. 25.2503-3(a) states that future interests, which may be vested or contingent, are limited to use, possession or enjoyment at some future time. Sec. 2503(b)(2) indexes the annual exclusion for inflation in $1,000 increments; the 2002 exclusion is $11,000.

Most case law has involved indirect gifts, such as gifts in trust or gifts to an entity with preexisting owners. In both situations, the gifts are indirect gifts of the underlying property to trust beneficiaries or an entity's owners. Citing Fondren, 324 US 18 (1945), the Tax Court pointed out that the case law has established that to qualify as a present interest, an indirect gift must give the donee "a substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or income from the property." The court examines all facts and circumstances to determine if a gift is of a present interest.

Case law has also established that if the use, possession or enjoyment is postponed due to a future uncertain event (such as the discretion of a trustee or joint action of entity owners), the gift is of a future interest. For income interests to be considered present interests, indirect gifts involving trusts require the donor to show that the trust will receive income and that some ascertainable portion will flow steadily to the beneficiary. In addition, if the beneficiary has the right to demand immediate possession and enjoyment of corpus or income, the beneficiary has a present interest whether or not the right is exercised and whether or not the beneficiary has a vested interest in the trust corpus or income (Estate of Cristofani, 97TC 74 (1991)).

In 1995, Hackl, a retired executive, purchased over 11,000 acres of land to use as tree farms. He contributed the tree farms, plus $8 million in cash and securities, to Treeco, LLC. Treeco actively engaged in tree farming and planted millions of trees. Its business purpose was long-term income and appreciation, not immediate income. Treeco (and its successor, Treesource LLC) did not expect to make distributions to members for several years and generated no profits through April 2001.

Hackl and his wife owned all of Treeco's voting and nonvoting units. They executed an operating agreement, which named Hackl as manager, to govern Treeco. The manager could distribute to the members (i.e., the owners) any cash remaining after paying operating expenses and debts, plus funding a working capital reserve. Members could not receive distributions, withdraw their capital contributions, sell their ownership interests or withdraw from Treeco without the manager's approval. Voting members could remove Hackl as manager by a majority vote and change the operating agreement by an 80% majority vote.

In late 1995, the Hackls gifted 500 voting and 700 nonvoting units (valued at $10.43 per unit) to each of their eight children and their children's spouses. In 1996, they made similar gifts to the same parties. Treeco was later merged into Treesource, LLC, and the Hackls continued to make gifts of the units.

By January 1998, the children and their spouses owned 51% of Treesource's voting stock. The Hackls claimed the Sec. 2503(b) annual exclusion for the gifts, arguing that they were present-interest gifts, because the gifted units had rights identical to the units the Hackls retained. Also, they claimed that the case law for indirect gifts was inapplicable to direct gifts, because rights enjoyed by the donee members were not postponed. The Service disallowed the annual exclusions, arguing that the restrictions in the operating agreement prevented the donees from having immediate and unconditional rights to the use, possession or enjoyment of the property or income therefrom.

The Tax Court adopted the IRS's position and ruled that the gifts were not gifts of present interests. The court pointed out that the form of the gift is irrelevant to whether the donee receives a substantial present economic benefit. If the Hackls had gifted the LLC units prior to contributing the tree farms to the LLC, the contribution of the tree farms would be an indirect gift to the donees. Therefore, prior case law involving indirect gifts had to be applied.

Applying that case law, the Tax Court Found that the operating agreement prevented the donees from presently receiving any economic benefit from the units. A contingency (the manager's approval) prevented individual members from receiving value for their units. Also, in addition to being noncontingent, rights to a present economic benefit must be exercised independently. This condition was not satisfied, as removal of the manager required joint majority action.

Turning to income, the court ruled that Treeco and Treesource did not satisfy the requirement that the entity have income, because they generated no income. Also, even if they had income, the manager's discretion over distributions would make the gifts future, not present, interests. Finally, the court noted that the value of the gifted units was irrelevant to the present-interest issue. The facts and circumstances indicated that the donees could not access that value until the future.

Hackl requires donors of business interests to comply with its interpretation of present interests to receive the Sec. 2503(b) annual exclusion. Clearly, voting rights are not a substantial present economic benefit. If distributions are not regularly made to owners, donees must have a presently exercisable right either to demand a distribution or to unilaterally sell or otherwise receive value for their ownership interests. These rights should be in an amount at least equal to the annual exclusion. Hackl may be appealed, but it is a well-reasoned opinion and therefore reversal is unlikely.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI (NOT AFFILIATED WITH BAKER TILLY INTERNATIONAL)