The Family Cabin LLC Needs a Minor Makeover

By Earl H. Cohen, Attorney at Law

Many of our clients with cabins or second homes expect to retain the property in the family for one or more additional generations. The problem has been that the property is illiquid but will still be subject to estate tax and capital gains tax on sale. The planning strategy we have generally employed to avoid taxation in several successive generations, has been the use of a family limited liability company (FLLC) or a family limited liability limited partnership (FLP), to own the property. Mom and Dad would make annual gifts to children and/or grandchildren, of a percentage interest in the company (FLLC or FLP) based upon a value equivalent to, or less than, the gift tax annual exclusion. This strategy has allowed the transfer of the family property over a period of time without incurring gift tax or use of the gift tax lifetime exemption. Generally speaking, the FLLC or FLP interests in the company have not included rights to vote or rights to demand distribution and, as a result, the have lacked marketability since there are few if any buyers for such a batch of limited rights. This suited our clients well since it allowed use of a discount as to the value of the annual gift for lack of both marketability and lack of control.

However, recently several cases have been decided in which the tax court sided with the IRS in denying a married couple's annual gift tax exclusions on transfers of FLP units to their children because the partnership interests were considered gifts of a future interest. In Walter M. Price v. Comm. the taxpayer owned a closely-held company which he planned to sell. Prior to the sale, he transferred shares of the stock to a newly formed family limited partnership. When the stock of the closely held company was sold, the partnership received its share of the proceeds and invested those proceeds in marketable securities. For the six-year period following formation of the partnership, the taxpayer and his spouse gave interests in the FLP to each of their adult children claiming annual exclusions for the gifts.

The IRS in Price v. Commissioner denied the annual gift tax exclusions because of the restrictions in the FLP document that prevented transfers of the units to third parties and because the FLP document did not require any current income distributions to the limited partners. The IRS relied on earlier Tax Court and Seventh Circuit decisions in Hackl, Sr. v. Commissioner,decided in 2002, and affirmed in 2003. The Court noted that like the Hackl decision, the taxpayers' partnership did not give the donees the immediate ability to use or possess either the transferred property or the income from it. The partners could not transfer their partnership interests, had no unilateral right to withdraw any of their capital accounts and could not show that they would receive an ascertainable portion of the income.

A Federal District Court has also denied annual gift tax exclusions on the transfer of LLC interests to the donor's seven children over a three year period where the children lacked a present interest in the property. In John W. and Janice B. Fischer v. U.S., decided in 2010, the LLC contained a valuable parcel of undeveloped land bordering Lake Michigan. In denying the annual gift tax exclusions, the Court noted that the children/donees could only receive distributions upon approval of the LLC general manager. The right to access and enjoy the beach front property was a nonpecuniary right and, further, was not specifically transferred as part of their LLC unit gifts. The children could only transfer the LLC units to other family members subject to a right of first refusal on the part of the LLC.

What we should take from these recent cases is the following: to assure eligibility for the annual gift tax exclusions, it may be advisable to give each child or other family donee of a limited partnership interest or LLC financial rights, the right to demand income or principal from the partnership as is done with a Crummey withdrawal right from certain irrevocable insurance trusts and to make provision for their current use of the property.

While these cases were heard and decided in other circuits and are not necessarily binding in Minnesota, we believe that it is only a matter of time before the IRS begins looking at other districts in which it will assert these arguments. For those families with existing LLCs or FLPs, now is a good time to be amending the member control agreement or the limited partnership agreement to be better prepared for the issue being raised by the IRS. For more information on these issues and LLCs and FLPs as planning devices, feel free to call Earl H. Cohen at 800-4016-194.