As most of you know (I hope!) currently the estate tax in 2010 for decedents dying in 2010 is not effective, and the gift tax rate has been reduced from 45% to 35% in 2010. To prevent individuals from making incomplete gifts to certain trusts, which avoids the gift tax and takes advantage of lower income tax rates in a trust, Code Sec. 2511(c) applies only in 2010 and broadens the scope of transfers subject to the gift tax. It provides that unless trusts are treated as wholly owned by donors or their spouses (in which case the income is taxed at the grantor’s tax rates), transfers in trust will be treated as gifts of the entire interest in the property, thus making such a transfer subject to gift tax. Some commentators were concerned that this section could be construed to mean that ALL transfers to wholly owned grantor trusts would never be treated as gifts, thus avoiding the gift tax and the estate tax (because the asset was not includable in the estate of the decedent) in 2010.

In Notice 2010-19, the IRS clarified that Sec. 2511(c) does not change the Code’s provisions or the substantive law relating to the gift tax. Rather, it is an addition to the substantive law applicable to transfers made during 2010. Thus, the gift tax provisions in effect prior to 2010 still apply to all transfers in trust in determining whether such transfers are subject to the gift tax. Sec. 2511(c) was enacted with the provisions repealing the estate tax for 2010. If Congress eliminates the estate tax repeal, it is likely that it will also eliminate Sec. 2511(c). Further, if you really don’t want to learn this section, it is eliminated in 2011!

While planning for large estates, gifting is a major planning technique. In the case of LLCs and Family Limited Partnerships (“FLP”) the strategy is to make gifts of these interests at discounted values and take advantage of the one million dollar gift tax exclusion and the annual exclusion. Unfortunately, it is not always easy. In Fisher v. United States, Docket # 1:08-cv-0908-LJM-TAB, the U.S. District Court for the Southern District of Indiana held that gifts of LLC interests to the donors’ children were future interests in property that did not qualify for the annual gift tax exclusion.

In reaching its decision, the court determined that provisions in the Operating Agreement placing exclusive discretion over distributions in the hands of the General Manager alone and placing restrictions on the transferability of the membership interests, including a right of first refusal by the LLC, prevented the children from having the right to a “substantial present economic benefit” as required under Hackl. Hackl v. Commissioner, 335 F.3d 664, 667 (7th Cir. 2003). Additionally, the court held that the children’s right to use, possess, and enjoy the primary asset of the LLC, a parcel of beachfront property, was insufficient on its own to meet the Hackl requirement. Carefully review your LLC and FLP agreements to determine whether gifts would qualify for the annual exclusion. Consider “put” rights and rights of first refusal or even a Crummey-like notice that the donee has the ability to sell to anyone within thirty days. Gift tax exclusions may be lost for transfers of LLC or partnership interests if distributions are subject to the exclusive control of one member’s discretion and if significant restrictions are placed on their transferability.

As discussed above, gifting of FLP interests are a common strategy to reduce the size of the estate. Unfortunately, if the transferor holds too many “strings” then, despite the gift, the FLP interests will be includable in the estate of the transferor. Section 2036 of the Code provides if there are strings then inclusion will occur unless the transfer was a bona fide sale for full and adequate consideration. In a recent case, the Tax Court held that stock transferred to an FLP was a bona fide sale for full and adequate consideration and did not have to be included in the transferor’s gross estate under Code Sec. 2036. Estate of Samuel P. Black, Jr., (2009) 133 TC No. 15.

The court found that the transfer to the FLP was a bona fide sale because it was done for the legitimate non-tax purpose of keeping the stock in the family. Additionally, the court found that full and adequate consideration was given for the stock because the FLP partners received partnership interests proportionate to the value of the stock transferred. Once the court determined that there was full and adequate consideration, the court did not have to go to the second prong of retained interest analysis. To avoid inclusion in their taxable estates, clients transferring assets to an FLP should make sure a legitimate non-tax purpose can be identified and that full consideration, such as a proportionate interest in the FLP, is given in exchange.