• Recent Tax Court Case Provides Guidance on Annual Exclusion
  • December 30, 2003 | Author: D. Michael O'Leary
  • Law Firm: Trenam, Kemker, Scharf, Barkin, Frye, O'Neill & Mullis Professional Association - Tampa Office
  • The annual gift tax exclusion is an important consideration in most family planning situations. The annual exclusion allows an individual to transfer up to $11,000 per year (subject to cost-of-living adjustments) to each of an unlimited number of donees each year. This amount can be doubled to $22,000 per year when the donor is married even though only one spouse is transferring the asset.

    To qualify for the annual exclusion, the gift must be a gift of a "present interest," which means the donee must have the right to currently enjoy the property. In Hackl v. Commissioner (2002), the court held that certain gifts of membership units in a limited liability company (LLC) were not gifts of a present interest and, accordingly, did not qualify for the annual exclusion.

    In the Hackl case, Mr. and Mrs. Hackl, who were married, established an LLC and contributed cash, publicly traded securities and two tree farms to the LLC. The LLC subsequently purchased a third tree farm using cash and securities of the LLC. The tree farms were not expected to be profitable for a number of years. Pursuant to the terms of the operating agreement of the LLC, Mr. Hackl was the sole manager and, as the manager, could determine if distributions should be made, if unit transfers should be allowed, if members could withdraw capital contributions, and if the LLC should be dissolved.

    Mr. and Mrs. Hackl made outright gifts of voting and nonvoting membership interests in the LLC to their eight children and their spouses, and gave nonvoting membership units in the LLC to an irrevocable trust established for their 25 minor grandchildren. Mr. and Mrs. Hackl claimed annual exclusions on the gifts.

    The Tax Court concluded that the gifts did not qualify for the annual exclusion because the gifts failed to confer a substantial present economic benefit on the donees. The court determined that the terms of the operating agreement of the LLC essentially left most of the meaningful economic rights of the membership interests, such as the ability to transfer the membership units, in the hands of Mr. Hackl, as manager.

    In addition, the donees were unlikely to receive income from the membership units because the tree farms were not projected to generate net income during the initial years and Mr. Hackl, as manager, had no requirement to distribute income even if income had been generated.

    Hackl involved some relatively extreme facts that caused the Court to rule against the Hackl family, and we do not believe that the case diminishes the benefits of using family limited partnerships or LLCs to reduce a person's estate tax liability. However, this case does raise significant issues that must be taken into account when a donor is making gifts of interests in a business entity and annual exclusions are desired.