The IRS has never liked valuation discounts for lack of control and marketability and has attempted to attack gifts of limited liability company (LLC) and family limited partnership (FLP) interests under several theories throughout the years, and with varying success. But recently, the IRS has been successful in using the indirect gift theory and the step-transaction doctrine to disallow valuation discounts in connection with gifts of LLC and FLP interests.
Indirect gift theory
Under Treasury Regulation Sec. 25.2511-1(h)(1), if someone makes a capital contribution to a corporation, it results in an indirect gift of the property to each shareholder of the corporation in proportion to his/her stockholdings. In the context of LLCs and FLPs, an indirect gift may occur if the taxpayer cannot prove that the transfer of assets to the LLC/FLP occurred before the assignment of the LLC/FLP interests to the donees. And when the transfer of assets and gift of interests in the LLC/FLP are made on the same day, it's difficult for the taxpayer (who has the burden of proof) to prove which happened first.
The step-transaction doctrine treats a series of separate steps as a single transaction if such steps are in substance integrated, independent and focused toward a particular result. Applying this doctrine to LLCs and FLPs, if the funding of the entity and the gifts of interests were collapsed into a single transaction, the result is a gift of the entity's underlying assets (as opposed to gifts of membership / partnership interests). As such, there would be no valuation discounts.
In general, cases dealing with the step-transaction doctrine do not provide the magical timeframe needed between the funding of the entity and the gifting of the business interests, but they do reveal two patterns. First, that simultaneous funding and gifting is a clear indication of an integrated transaction that will trigger the step-transaction doctrine. Second, the volatility of the asset is material to the analysis of whether enough time-lapsed between the funding and the gifting. In other words, the taxpayer must show that he/she bore real economic risk that the interests transferred would change in value between the funding and the gifting.
Summary of the cases
In Gross v Comm'r, T.C. Memo 2008-21, the taxpayer's delay of 11 days between funding and gifting was sufficient to combat the step-transaction doctrine, given the particular assets at issue (i.e. volatile marketable securities).
In Holman v Comm'r, 130 T.C. 170, 2008, another case where the underlying assets were marketable securities, a delay of six days avoided the step-transaction doctrine.
In Linton v U.S., 104 AFTR 2d 2009-5176 (W.D. Washington, July 1, 2009), there was no concrete evidence that the funding and gifting did not occur on the same day, despite the taxpayer's argument that nine days lapsed between funding and gifting. Nevertheless, the Court ruled in favor of the government because the assets at issue (cash, municipal bonds and real estate) were not deemed sufficiently volatile that the taxpayer bore any real economic risk during said nine-day period.
In Heckerman v U.S., U.S. Dist. Ct. W.D. Washington, Case No. 008-0211-JOC (July 27, 2009), the taxpayer transferred liquid assets to an LLC and made gifts of the LLC interests to trusts on the same day. The Court ruled that the transfer of the liquid assets was an indirect gift because the taxpayer could not prove any delay occurred between funding and gifting. The Court also ruled that the step-transaction doctrine applied because there was no "real economic risk" involved. However, the IRS did not challenge the valuation discounts in a second transaction involving gifts of LLC interests in real estate where there was a delay of 15 days between funding and gifting.
When dealing with less volatile assets, the difficulty is proving a "real economic risk" exists. But in Heckerman, the IRS chose not to make the indirect gift or step-transaction arguments with respect to a 15-day delay involving an LLC owning real estate, an arguably non-volatile asset. So, we'll have to see how the IRS handles similar transfers in the future.
It will also be interesting to see what other courts do with the indirect gift theory and the step-transaction doctrine. Regardless of those arguments, the bottom line is that the donee ends up holding membership/partnership interests -- with substantial restrictions under the operating/partnership agreements -- and not the entity's underlying assets.
Finally, the Court in Heckerman implied that a non-tax purpose may be sufficient to avoid the application of the step-transaction doctrine. The "non-tax purpose" argument has so far been limited to estate tax cases under IRC Section 2036 (transfers with a retained interest). Now it may become relevant in gift tax cases as well, if the IRS continues to push its step-transaction and indirect gift arguments.
The initial contributions made to an LLC or FLP should be documented both in the operating/partnership agreement and on the entity's books and records. If additional contributions are made, they should increase the percentage interests owned by the contributing member/partner and be credited contemporaneously on that member's/partner's capital account.
In addition, put as much delay as possible between the funding of the LLC or FLP and the gifting of the membership/partnership interests. The less volatile the asset (i.e. real estate and liquid assets), the more delay required. Finally, document the non-tax purposes for the proposed transaction. By following these steps, you should be able to avoid a successful attack by the IRS under either the indirect gift theory and/or the step-transaction doctrine.
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