Transferring Real Estate By Gifting LLC Interests

By James N. Graham, MS, JD.

FACTS:  Client owns LLC which owns real estate  Suppose the real estate is worth $5M.  Client wants to transfer it to adult children without incurring gift or estate tax.  Client proposes to gift 2% units (worth about $10,000 each and well below the $13,000/person/year gift tax exclusion limit) to each of his 4 children annually.  Over the course of 5 years, this would result in the tax free transfer of 40% of the value.


DISCUSSION:  Depending upon a careful review of the facts including, most significantly, the LLC operating agreement, this may be a flawed strategy.   IRC section 2503(b) permits an annual gift tax exclusion on the first $13,000 (the statutory $10,000 adjusted for inflation) gifted to a person.  However, "future interests" do not qualify for the exemption.  The IRS has taken the position that the gift of an LLC unit that limits the use, possession or enjoyment to some future date is a future interest which is not eligible for the exemption.  The donor would incur tax or would need to utilize a portion of the donor's unified credit. (Note, as an aside, that one is taxed for giving property, not for receiving it).

In Hackl, Sr. v. Commissioner, 92 AFTR2d 2003-5254, 335 F3d 664 (7th Cir. 1994), the Seventh Circuit Court of Appeals found that the operating agreement of an LLC so limited the donee's ability to realize economic benefit that the units were "future interests."  Although the parents gave their children direct, complete and unrestricted ownership of the units, the operating agreement made the units presently worthless by requiring parent/manager consent for a member to withdraw from the company or to transfer interests or else the donee would lose all voting and membership rights.  In short, the parent/donor retained such control over the units that the units had little present value.  Changes in the LLC operating agreement would have alleviated this tax problem.

This case is instructive for several reasons:  1) The operating agreement, a document internal to the company's operation, is not an insignificant document.  Many people who set up their own LLCs fail to create a proper operating agreement.  Often, if they have an operating agreement at all, they download a multi-purpose form from some website.  This may be entirely inappropriate for the nature of the enterprise.  2) Tax law is often not intuitive or logical.  It might be a reasonable assumption that you could transfer a 10% interest in a $130,000 enterprise using the $13,000 gift tax exclusion, but that is not necessarily correct.  There are other factors deemed relevant by the law in determining whether the exlusion applies. 3) I have seen this exact transfer recommended as an "asset protection" technique by supposedly knowledgeable people.  They even described as an advantage the fact that the donor could retain control over the asset through unit restrictions.  While this is true, it can risk disruption of the entire purpose of structuring the transfer in this fashion.