How to Protect Your LLC Many family businesses form limited liability companies (LLCs) to cost-effectively transfer ownership interests to the next generation. Families often save on estate and gift taxes by taking advantage of minority discounts the IRS grants because of lack of control and marketability, among other things. LLCs are also effective vehicles for consolidating assets, limiting liability and centralizing control. But a Seventh Circuit tax ruling may affect whether family LLCs qualify for the gift-tax exclusion. Let’s take a look at Hackl v. Commissioner to see what we can learn from it. Future interests The Hackls formed an LLC to acquire real estate and to operate a tree farm. They named Mr. Hackl manager for life, authorized him to name the next manager and empowered him to dissolve the company. They then transferred two tree farms worth about $4.5 million and cash and securities of $7.9 million to the LLC, giving ownership units to their children and grandchildren. Although the LLC’s goal was long-term growth, it made no profits or distributions. The LLC operating agreement contained these restrictions: o Members couldn’t withdraw their capital accounts, compel distributions or sell their interests without the manager’s approval, o Membership or voting rights didn’t attach to interests sold without approval, o No single member could dissolve the LLC, and o The manager had sole discretion to distribute cash to members. The Hackls claimed their donated LLC units constituted present gifts that qualified for the annual gift-tax exclusion. They asserted that the donees had the same rights in the donated units that the Hackls held in the units they kept for themselves. Thus, because they gave up their entire rights in the property, the Hackls contended that the gifts constituted present-interest gifts. The IRS argued that the interests in the units didn’t carry “immediate and unconditional rights to the use, possession, or enjoyment of property or income from the property.” The IRS argued that a transfer without any substantial present economic benefit transfers only a future interest and thus is ineligible for the tax exclusion. The Seventh Circuit agreed that the transfers represented gifts of future interests. Citing the transferability restrictions, the court held that the “operating agreement clearly foreclosed the donees’ ability to realize any substantial present economic benefit.” The court found that the ability to sell shares with no membership or voting rights failed to constitute substantial economic benefit. The restricted shares essentially had no immediate value for the donees, so the transferred interests were taxable. Present value You can shield transfers of LLC interests from gift and estate taxes by carefully drafting the LLC agreement. Our attorneys can review your agreement to ensure ownership interests have the necessary present economic value to qualify for the gift-tax exclusion. Of course, looser restrictions could result in an increase in the interests’ value — in turn increasing your estate and gift taxes. But our attorneys may be able to revise your operating agreement to achieve all LLC goals. Sidebar: Playing it safe To obtain the usual tax benefits for your limited-liability company, ownership interests must carry a present interest or economic benefit. You can tailor your operating agreement to decrease the likelihood that the IRS will deem LLC shares to be future interests. In particular, be sure your operating agreement: o Expressly states that the LLC manager owes fiduciary duties to the LLC and its members, o Imposes mandatory cash-distribution requirements — perhaps requiring the LLC to distribute enough cash annually by a specified date to cover members’ individual income tax obligations on their shares of LLC income, o Requires the manager to give financial statements and copies of the LLC tax returns to members annually, o Defines “cash available for distribution” (which must be distributed at least annually by a specified date) — unless the members agree to retain cash in the LLC, o Requires at least two members’ votes to attain a majority — even if one member controls most of the voting power, o Gives members right-of-first-refusal when another member wants to sell his or her interest to an outsider, instead of requiring selling members to first obtain approval, o Gives a temporary withdrawal right to donees of interests in the LLC, allowing them to withdraw their share of capital from the LLC for a limited time — such as 30 days, and o Gives a temporary sell-back right to donees of interests intended as gifts, allowing them to require the LLC to buy their interests at a given price for a limited time. Contact | Legal Disclaimer