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Saturday, June 09, 2012

ARE DISTRIBUTIONS TO PAY TAXES ENOUGH TO CREATE PRESENT INTEREST GIFTS?

Code §2503(b) allows donors to make gifts free of gift tax and without using up any of their unified credit – presently, $13,000 per year per recipient can be gifted. However, to use Code §2503(b), the gift must be a gift of a “present interest” in property. Treas. Regs. §25.2503-3 defines a “present interest” as “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain).”  A nonqualified “future interest” is one that is “limited to commence in use, possession, or enjoyment at some future date or time.”

In Hackl, 118 T.C. 279, 289 (2002), aff'd, 335 F.3d 664 [92 AFTR 2d 2003-5254] (7th Cir. 2003), the Tax Court held that a gift of an LLC interest that was subject to substantial restrictions on transfer was not a gift of a present interest for this purpose. The Tax Court and the Seventh Circuit Court of Appeals found that such a restricted interest did not have the requisite “right to substantial present economic benefit.”

In a memorandum decision, the Tax Court has now provided for a possible methodology to get around the Hackl restrictions for interests in partnerships and LLC’s. This case involved the transfer of limited partnership interests that also were restricted on transferability and the admittance of transferees as substitute limited partners.

The assets of the partnership were publicly traded stock and dividends received on the stock. The subject transfers were made in 1996, 1997, 1998, 1999, and 2000.  In 1996, 1997, and 1998, the partnership made distributions to all of its partners in amounts sufficient for them to pay their Federal income tax attributable to partnership income passed through to them from the partnership. Beginning in February 1999, the partnership continuously distributed all dividends, net of partnership expenses, to the partners. The partners also had access to capital account withdrawals and used them at times.

The IRS determined the partnership interests were not present interests for purposes of §2503(b) based on Hackl principles. The Tax Court disagreed and ruled that the interests were present interests.

True, the partnership interests were restricted as to transfer, similar to the facts in Hackl. However, the Tax Court noted that use, possession or enjoyment can create a present interest if it relates EITHER to the partnership interest itself, or income from those interests. While a present interest in the partnership interest itself appears foreclosed due to the transfer restrictions, the Tax Court found that a present interest did exist in the income from the partnership interest.

In determining whether rights to income qualify as a present interest, the Tax Court noted that the following three elements must be present: (1) the partnership would generate income, (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.

Elements (1) and (3) were deemed met by reason of the partnership owning publicly traded dividend-paying stock that would generate income (element 1) and that due to its publicly traded nature could be reasonably estimated and ascertained (element 3).

Element (2) was deemed satisfied because one of the partners was a trust and that the general partner was deemed to have a fiduciary duty to distribute enough assets to allow that trust to pay its taxes since it owned no other assets.

Some Comments and Observations

A. The case did not appear to turn on a requirement that the partnership distribute ALL of its income each year, even though such a pattern commenced in 1999 which does muddy the facts a little. The obligation to distribute enough to pay taxes was enough to meet element (2) above for present interest in an income interest.

B. The fiduciary obligation to distribute enough income to pay taxes was based on state law. Rather than rely on the vagaries of state law in each state (which may not directly address the question of an obligation to distribute cash to pay taxes of owners), a direct obligation in the partnership or operating agreement for minimum distributions to pay owner taxes on their share of entity income should bring the same result.

C. The court was heavily influenced by the presence of publicly traded income paying stock to meet the requirements of elements (1) and (3). A partnership that holds nonincome producing property (e.g., investment property held for appreciation), or perhaps even income-producing property that produces income on an irregular or non-ascertainable manner, may not be able to meet these elements.

Thus, the case does provide another method of working around the limitations of Hackl, if minimum distributions to cover taxes are acceptable. However, the case may have limited value for entities with assets that do not regularly produce cash flow or income for distribution to the partners/members.

Estate of George H. Wimmer, TC Memo 2012-157 (6/4/12)

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