IRS wins again on annual exclusion of gifts of partnership interests.

• Author: Johnson, Eric L.

In April 2010, The Tax Adviser reported on the Price case, (1) which reinforced the IRS's position in Hackl. (2) In that case, the taxpayers failed to show that gifts of partnership interests conferred on the donees an unrestricted right to immediately use, possess, or enjoy either the property itself or income from the property. Thus, the transfers in question were not considered present interest gifts, and the taxpayers were not entitled to gift tax annual exclusions. The Fisher case (3) now follows as the most recent IRS victory on this issue. This article reviews what can be learned from Fisher, the challenge that tax practitioners now face in existing arrangements, and responsive measures that might be considered for further gifts of partnership interests.

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Background

Current law allows an individual who wants to make a gift to transfer up to $13,000 per donee, per calendar year, free of gift tax and without the requirement of filing a gift tax return. (4) In order to qualify for this annual exclusion, however, the gift must be of a present interest in property. The Code does not define "present interest," but Treasury regulations provide that a present interest is "an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain)." (5)

Hackl was the first case to specifically deny the premise that the mere transfer of a partnership interest automatically qualifies as a present interest and thus qualifies the transfer for the gift tax annual exclusion. The Tax Court in Hackl interpreted the regulatory definition to require the taxpayer to

establish that the transfer in dispute conferred on the donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such immediate use, possession, or enjoyment be of a nature that substantial economic benefit is derived therefrom. (6) A transfer needs to meet only the use test or the income test to demonstrate a substantial present benefit and thus qualify as a present interest.

In Price, the Tax Court again applied the substantial present economic benefit rationale. The court noted that, similar to Hackl, because the donees received only an assignee interest, they lacked the ability to withdraw their capital accounts, to sell, assign, or transfer their partnership interests to third parties, or to encumber or dispose of the interests without the written consent of all the partners. Further, the partnership's earnings, which were distributable at the general partner's discretion, did not flow consistently or predictably to the partners because in some years no distributions were made. Consequently, the court noted that the donees lacked the ability "presently to access any substantial economic or financial benefit that might be represented by the ownership of units,"(7) and the gift tax annual exclusion was again denied.

Fisher

In each of the years 2000, 2001, and 2002, John and Janice Fisher (the Fishers) transferred a 4.762% membership interest in Good Harbor Partners, LLC (Good Harbor) to each of their seven children, in effect transferring the entire LLC to their children over this three-year period. During the years that the gifts were made, the LLC's principal asset was a parcel of undeveloped land that bordered Lake Michigan.

A few provisions in the Good Harbor operating agreement are worth mentioning:

* The agreement provided for the LLC to be managed by a management committee that would appoint a general manager, and that manager would determine the timing and amount of all distributions. The Fishers constituted the management committee, and Mr. Fisher was appointed as the general manager.

* The Fisher children were allowed to transfer their interests in the LLC if certain conditions were satisfied. The operating agreement defined "interest" as "a Person's share of the Profits and Losses of, and the right to receive distributions from, the Company," and further provided that this was the only interest that the Fisher children could transfer unilaterally.

* Should a transfer to a nonfamily member be contemplated, the LLC had a right of first refusal for a 30-day period, followed by a 40- to 90-day period to set a closing date. At closing, the LLC would pay the prospective transferor with self-amortizing, non-negotiable promissory notes, payable over a period not to exceed 15 years. The right of first refusal could be disregarded if the contemplated transfer was to a family member.

When the Fishers filed their annual gift tax returns, they claimed a gift tax annual exclusion for each transfer. Upon audit, the IRS disputed the value of the transferred interests and disallowed the annual exclusions on the basis that the gifts were not present interests and therefore did not qualify. The total gift tax deficiency assessed over the three-year period was $625,986. Choosing to forgo a direct challenge of Hackl in Tax Court, the Fishers paid the deficiency and filed for refund, asserting, among other things, that the gifts of membership interests were gifts of present interests that qualified for the gift tax annual exclusion. The refund was denied, and the Fishers filed suit in federal district court. The court ruled on cross motions for summary judgment in which the single issue was whether the gifts the Fishers made "to their children were transfers of present interests in property and, therefore, qualified for the gift tax exclusion under 26 U.S.C. S 2503(b)(1)." (8)

The Fishers presented three arguments in support of their claim, all of which the court rejected:

1. The Fisher children had an unrestricted right to receive distributions from the LLC. However, the court noted that the timing and amount of any distributions...