T he gift of an LLC interest generally does not result in the recognition of gain or loss by the donor or the donee. A gift is subject to gift tax unless the gift qualifies for the annual gift tax exclusion (Sec. 2503(b)) or reduces the donor’s applicable unified credit amount (Sec. 2505(a)).
However, practitioners should note that if management of the LLC has unfettered discretion to make or withhold distributions, any gift of an interest in the LLC may be treated as a gift of a future interest and thus not qualify for the annual gift tax exclusion (TAM 9751003). In Hackl, 335 F3d 664 (7th Cir. 2003), the court found that where the donor/donee has no distribution right and no right of withdrawal, the gift of an LLC interest is a gift of a future interest not qualifying for the annual gift tax exclusion.
This outcome can be avoided by giving the manager/managing member the authority to accumulate the funds as he or she may deem appropriate based on his or her reasonable business judgment. This problem may also be avoided by requiring cash distributions to pay the taxes created by operations or by providing a right of first refusal on sale of the interest.
If a gift tax is imposed, it is calculated on the fair market value (FMV) of the gifted property less the amount of debt from which the donor is relieved (no debt relief occurs if the interest gifted is in an LLC taxed as a corporation). In the context of a gift of an LLC interest, the FMV involved is that of the donor’s interest in LLC property, and the debt involved is the donor’s share of LLC liabilities. If the debt relief exceeds the donor’s basis in his or her LLC interest, the transfer of the interest is treated in part as a gift and in part as a sale. The debt relief is treated as an amount realized in a deemed sale transaction and the donor must recognize gain (Regs. Sec. 1.1001-2(a)). Gain recognition usually occurs when the member has a negative tax basis capital account. Some of this gain may be ordinary, de-pending on whether the hot asset rules of Sec. 751 apply. (“Hot assets” include partnership unrealized receivables and substantially appreciated inventory (Sec. 751(b)).) Any capital gain on the deemed sale may be short term or long term under the applicable rules.
Example: J is a member in ABC LLC, which is classified as a partnership for federal taxes. His tax basis capital account is $(100,000), and his share of the LLC’s liabilities is $150,000. The FMV of his interest in LLC assets is $200,000. J asks his practitioner about the tax consequences of gifting his LLC interest to his son, R.
According to the analysis in the exhibit on p. 396, J will recognize a gain on the transfer.
A member acquiring an interest by gift generally has a basis equal to the donor’s basis plus, in some instances, a portion of the gift tax paid (Secs. 742 and 1015). The increase is equal to the gift tax paid on the net appreciation of the transferred interest, but the basis may not exceed the interest’s FMV (Sec. 1015(d)(6); Regs. Sec. 1.1015-5(c)). Net appreciation is the amount by which the FMV of the transferred interest immediately before the gift exceeds the donor’s basis. Accordingly, the donee increases the basis by the following amount:
If the donor recognizes gain on the deemed sale transaction in a transfer treated in part as a gift and in part as a sale, as in the above example, the amount of the gain is added to the donor’s basis in his or her interest for purposes of determining the donee’s basis. The donee then has a basis equal to the amount realized (which in the example is the amount of debt relief) in the deemed sale (Regs. Sec. 1.10154(a)(2)). However, if the FMV of an interest is less than the member’s basis at the time of gift, for purposes of determining the donee’s loss on a subsequent disposition, the donee’s basis in the interest is the FMV of the LLC interest at the time of the gift (Sec. 1015(a)).
Observation: There are some unanswered questions about how to value a single-member LLC interest for gift tax purposes. For example, can a discount be taken for the legal restrictions on the transfer of an interest when the form is ignored for federal tax purposes? While no cases have yet arisen in valuing a single-member LLC, the IRS has been very consistent in treating the entity as a separate legal entity, thereby strengthening the argument for claiming a discount upon transferring an interest in a single-member LLC. The authors believe that any discount available would be less than that available in a multimember LLC.
If the donor member recognizes a gain on the deemed sale of an interest in an LLC classified as a partnership and the LLC has made a Sec. 754 election, the LLC should adjust the basis of its assets to reflect the gain.
Any transfer of an interest in an LLC classified as a partnership to a family member is subject to the family partnership rules of Sec. 704(e). Because LLCs can be used to shift income and property appreciation from higher-bracket, older-generation taxpayers to lower-bracket children and grandchildren, these rules are designed to enforce two principles. One is that income produced by capital should be taxed to the true owner of that capital. The other is that income derived from services should be taxed to the person performing the services. If these principles are circumvented, the IRS may reallocate income between members of an LLC or may even determine that one or more of the LLC’s members are not members at all, at least for income tax purposes.
Warning: Gifts of LLC interests to family members are frequently valued at a reduced amount because of discounts for lack of marketability or minority discounts. The IRS is mounting a significant attack on the use of such discounts, including changing how the penalty for estate and gift tax valuation understatements is determined (Sec. 6662). Practitioners should be aware of these attacks when structuring the gift of an LLC interest.
The substitution of an assignee member with full rights to participate in management generally requires the unanimous consent of the nontransferring members under state law. Consequently, an individual receiving a gift of an LLC interest generally has no right to participate in the LLC’s management until such consent is obtained.
A transfer of a deceased member’s interest by bequest does not result in the recognition of income or loss by the beneficiary or the decedent’s estate. The FMV of the decedent’s LLC interest is includible in the decedent’s gross estate and is subject to estate tax. The beneficiary member has a basis in the LLC interest equal to the FMV of the interest at the decedent’s date of death or the alternate valuation date, if elected by the executor (Sec. 1014(a)).
Observation: The Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), includes modified carryover basis rules that will apply to property received from a decedent dying after December 31, 2009 (Sec. 1022). The basis of the property in the hands of the person acquiring the property at the date of the decedent’s death will be the lesser of the decedent’s adjusted basis or the FMV on the decedent’s date of death. The executor can increase the basis of the trans-ferred property by $1.3 million (but cannot increase the basis of property in excess of its FMV). A spousal property basis increase of $3 million is also available, allowing the basis of property transferred to surviving spouses to be increased by as much as $4.3 million. Consequently, a basis step-up will not always be available and no reduction under this rule would be necessary. The provisions of EGTRRA, including the carryover basis provisions, are scheduled to sunset on December 31, 2010.
The LLC can adjust the basis of its assets to reflect the step-up of the LLC interest’s basis to FMV (if any step-up is available) if a Sec. 754 election is made or is in effect. This adjustment is only for the benefit of the beneficiary member. The election permits an increase in the beneficiary’s basis in LLC property as if the member had acquired a direct interest in the LLC’s assets for FMV on the date of the decedent’s death (or alternate valuation date). The adjustment is based on the FMV used for the decedent’s estate tax return.
For transfers of interests (including transfers upon the death of a member), a basis adjustment under Sec. 743 is required if the LLC has a substantial built-in loss immediately after the transfer (unless the LLC is an electing investment partnership or LLC or a securitization partnership or LLC). An LLC has a substantial built-in loss if the LLC’s adjusted basis in LLC property exceeds the FMV of the property by more than $250,000 (Secs. 743(a) and (d)).
A member’s death may dissolve the LLC under applicable state law (unless the articles of organization or operating agreement provide otherwise). However, most states with a dissolution provision allow the LLC to continue if the remaining members unanimously consent (in some states the requirement is for less than unanimous consent) to continue the LLC within 90 days of the termination of the deceased member’s interest (or if the members can continue according to other provisions in the operating agreement). To prevent one or more members from holding the LLC “hostage,” the members should consider adopting a provision allowing continuation with less than unanimous consent if allowed under the applicable statute.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 13th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com ).