Wimmer v. Commissioner
Estate of George H. Wimmer v. Commissioner, T.C. Memo 2012-157
Summary of Key Issues
- The issue is whether annual gifts of limited partnership interests made from 1996 – 2000 qualify for the Federal Gift Tax annual exclusion under Section 2503(b) of the IRS Tax Code of 1986.
- The focus is solely on the distinction between a present interest gift (which is subject to the annual gift tax exclusion) and a future interest gift (which is not subject to the annual gift tax exclusion). There is no discussion of valuation discounts, such as a minority interest or marketability discount, which may have been applicable in in this case.
- The Court concluded that the limited partners who were recipients of the gifts received a substantial present economic benefit sufficient to render the gifts of limited partnership interests as present interest gifts, and accordingly qualify for the annual gift tax exclusion under Section 2503(b).
- Notably, the issue of the present interest gifts depended on i) the partnership generating income; ii) some portion of that income flowing steadily to the donees; and iii) the donees portion of the income being readily ascertained.
In 1996 and 1997, the Wimmers formed the George H. Wimmer Family Partnership, L.P. (the “Partnership”). The Partnership’s primary purpose was to invest in property, including stock, bonds, notes securities and other personal property and real estate on a profitable basis and to share profits, losses benefits and risks with the partners. The partners intended the Partnership to: increase family wealth, control the division of family assets, restrict nonfamily rights to acquire such family assets and, by using the annual gift tax exclusion, transfer property to younger generations without fractionalizing family assets.
The Partnership was funded with publicly traded and dividend-paying stock. The Partnership never held assets other than the publicly traded stock and the dividends received therefrom.
Gifts of limited partnership interest were made each year from 1996 to 2000. The estate bears the burden of proving that the gifts qualify for the annual exclusion.
The Partnership agreement generally restricts transfer of partnership interests and limits the instances in which a transferee may become a substitute limited partner. The transfer of limited partnership interests requires, among other things, the prior written consent of the general partners and 70% of the limited partners. Upon satisfaction of the transfer requirements, the transferee will not become a substitute limited partner unless the transferring limited partner has given the transferee that right and the transferee: 1) accepts and assumes all terms and provisions of the partnership agreement; 2) provides, in the case of an assignee who is a trustee, a complete copy of the applicable trust instrument authorizing the trustee to act as a partner in the partnership; 3) executes such other documents as the general partners may reasonably require; and 4) is accepted as a substitute limited partner by unanimous written consent of the general partners and the limited partners.
The Partnership received stock on a quarterly basis, and made distributions to limited partners in 1996, 1997 and 1998 for payment of Federal income tax. Beginning in February 1999 the Partnership continuously distributed all dividends, net of partnership expenses to the partners. Dividends were distributed when received and in proportion to partnership interests. In addition to dividend distributions, limited partners had access to capital account withdrawals and used such withdrawals for, among other things, paying down their residential mortgages.
The term “future interest” includes “reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.” (Sec. 25-2503-3(a), Gift Tax Regs.)
The term “present interest” is “An unrestricted right to immediate use, possession, or enjoyment of property or the income from property.” (Sec. 25-2503-3(b), Gift TaxRegs.)
The conflict between the “present interest” perspective which allows the annual gift tax exclusion and the “future interest” perspective which does not allow the annual gift tax exclusion has confounded estate planners since at least the Tax Court decision in the Estate of Hackl in 2002 (Hackl v. Commissioner, 118 T.C. No 14. Filed March 27, 2002) Similarly, in the case of Price v. Commissioner in January 2010, the transfer of certain limited partnership interests did not qualify for the annual gift tax exclusion. Most recently, in the case of Fisher v. U.S. in March 2010, the Court concluded that the transfer of membership interests in the Fisher’s Limited Liability Company from the Fishers to the Fisher children were transfers of future interests and, therefore, not subject to the gift tax exclusion under Section 2503(b)(1).
Let’s review these three cases in context with the Court’s perspective on what constitutes a present interest in property, and how that is reflected in the case of Wimmer v. Commissioner.
Hackl v. Commissioner
We reviewed the Hackl decision in our newsletter Value AddedTM in 2002. Upon establishing a tree farm as an LLC, Hackl and his wife began to transfer ownership units to family members. On their tax returns, the Hackls treated these gifts as eligible for the annual exclusion. The IRS contested this classification, claiming that the transfers did not provide a present interest to the donees. To contain said interest, the gift must convey “substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or income from the property.”
The Court ruled that the unusual restrictions in the operating agreement prevented the gifts from conferring a present interest. Specifically, the agreement granted the manager (A.J. Hackl) the authority to 1) appoint his own successor, 2) prevent withdrawal of capital contributions, 3) negotiate terms of resale of interests, and, most important, 4) prohibit any alienation or transfer of member interests. The Court focused not on the features of the interest gift, but on the underlying limitations of the interests being gifted. The Court employed a three-part test to determine whether the income qualified to be characterized as a present interest: receipt of income, steady flow to beneficiaries, and determination of the value of that flow. Because the LLC did not make distributions in the first years of operation, the Court ruled that the donees received no enjoyment of income from the property.
Our analytical perspective in 2002, which remains unchanged today, highlighted a concern regarding the definition of a present interest. The Court insists that, unless donees are receiving income distributions right now, their holdings contain no economic benefit today. Carried to its logical conclusion, this position says that only a portfolio of investment-grade fixed income securities has economic value at any given point in time. Further, in defining present interest, we believe that economic benefit entails more than immediate distributions. In the case of Hackl, the tree farm was highly likely to turn a profit in the long-term. Using the income approach, appraisers take the quantity of that future income and convert it to a present value. An income stream tomorrow counts for an economic benefit today. In short, present interest should also entail growth in value—the benefits from the appreciation of an underlying asset’s worth during the holding period. Unless this concept is real, a portfolio of non-dividend growth stocks carries no value.
Price v. Commissioner
In Price v. Commissioner(T.C. Memo 2010-2), the Court found that the petitioners had failed to show that the gifts of partnership interests conferred on the donees an unrestricted and noncontingent right to immediately use, possess, or enjoy either the property itself or income from the property. Accordingly, the Court held that the petitioners were not entitled to exclusions under Section 2503 (b) for their gifts of partnership interests.
The Court focused on the following key elements of the facts and circumstances for this case:
- The partnership agreement expressly prohibits partners from selling, assigning, or transferring their partnership interests to third parties or from otherwise encumbering or disposing of their partnership interests without the written consent of all partners.
- Under the partnership agreement, the donees have no unilateral right to withdraw their capital accounts.
- Because of the operation of the partnership agreement, it appeared that the donees are not properly characterized as limited partners in the partnership. The Agreement states: Any assignment made to anyone, not already a partner, shall be effective only to give the assignee the right to receive the share of profits to which his assignor would be otherwise entitled and shall not give the assignee the right to become a substituted limited partner.
- A right of first refusal in an option-to-purchase provision of the partnership agreement did not help, since it was subject to a complicated valuation process but without providing any time limit for exercising the purchase option with respect to a voluntary transfer.
- The petitioner alluded to the possibility that the donees could sell their partnership interests to the general partner. However, the Court countered by saying that if the possibility of a donor’s agreeing to buy back a gift sufficed to establish a present interest in the donee, little would remain of the present interest requirement and its statutory purpose would be subverted if not entirely defeated.
- Finally, the record failed to establish that any ascertainable portion of the income would flow steadily to the donees.
Fisher v. U.S.
In Fisher v. U.S. (105 A.F.T.R.2d 2010-1347 (S.D. Indiana) (March 11, 2010)), the Court ruled on a single issue: whether the gifts made by the Fishers to their children were transfers of present interests in property and, therefore, qualified for the gift tax exclusion under 26 U.S.C. Section 2503(b). The Fishers paid the gift tax deficiency claimed by the IRS and sought a refund of the deficiency.
The Fishers transferred 4.762% membership interests in Good Harbor Partners, LLC (“Good Harbor”) to each of their seven children in 2000, 2001 and 2002. From the date of Good Harbor’s formation through 2002, the company’s principal asset was a parcel of undeveloped land that borders Lake Michigan.
The court considered three arguments made by the Fishers in support of their assertion that the transfers of interests in Good Harbor to the Fisher children were “present interests in property.”
- The Fishers argued that upon transfer the Fisher children possessed the unrestricted right to receive distributions of Good Harbor’s Capital Proceeds. However, under the Operating Agreement, any potential distribution of Good Harbor’s Capital Proceeds to the Fisher children was subject to a number of contingencies, all within the discretion of the General Manager.
- The Fishers argued that upon transfer, the Fisher children possessed the unrestricted right to possess, use, and enjoy Good Harbor’s primary asset, the Lake Michigan beachfront property. However, there is no indication from Good Harbor’s Operating Agreement that this right was transferred to the Fisher children when they became Members. It is a right to a non-pecuniary benefit.
- Finally, the Fishers asserted that upon transfer, the Fisher children possessed the unrestricted right to unilaterally transfer their interests to Good Harbor. The Fishers argued that this right is a present interest in the property. However, according to the Operating Agreement, the Fisher children may unilaterally transfer their right to receive distributions from Good Harbor, but only if certain conditions of transfer are satisfied. These conditions include Good Harbor’s right of first refusal, which effectively prevents the Fisher children from transferring their interests in exchange for immediate value, unless the transfer is to a family member – although even an attempted transfer to a family member is not without restrictions.
Based on the facts and arguments presented in the case, the Court concluded that the transfers of interests in Good Harbor from the Fishers to the Fisher children were transfers of future interests in property and, therefore, not subject to the gift tax exclusion under Section 2503(b).
Wimmer v. Commissioner
In this case, the Court continued its focus on the ownership and transfer restrictions included in the Operating Agreement. The Court interpreted the Operating Agreement to conclude that the donees’ rights are limited with respect to the use, possession, or enjoyment of the property. For example, although limited partners may transfer their partnership interests to other partners and related parties, all other transfers are restricted unless certain requirements are met. Therefore, the Court concluded that the donees did not receive unrestricted and noncontingent rights to immediate use, possession, or enjoyment of the limited partnership interests themselves.
Having concluded that the limited partnership interests themselves were not present interests, the Court then considered a three-pronged test to determine if the limited partners’ rights to income satisfy the criteria for a present interest under Section 2503(b). (Recall the regulations referenced above, which characterize a present interest as “An unrestricted right to immediate use, possession, or enjoyment of property or the income from property.”) Accordingly, the Estate of Wimmer needed to prove, on the basis of the surrounding circumstances:
- The Partnership would generate income;
- Some portion of that income would flow steadily to the donees; and,
- That portion of income could be readily ascertained.
With respect to the first prong, the Estate proved that on each date the Partnership made a gift of a limited partnership interest, the partnership expected to generate income. The principal assets consisted of publicly traded, dividend-paying stock.
With respect to the second prong, the fiduciary relationship between the general partners and the trustee of the grandchildren’s trust showed that on the date of each gift, some portion of Partnership income was expected to flow steadily to the limited partners. Indeed, the limited partners not only received annual distributions but also had access to capital account withdrawals to pay down residential mortgages, among other reasons.
Finally, with respect to the third prong, the Court concluded that the portion of the income flowing to the limited partners could be readily ascertained. The Partnership held publicly traded, dividend-paying stock and was thus expected to earn dividend income for each year at issue. And, because the stock was publicly traded, the limited partners could estimate their allocation of quarterly dividends on the basis of the stock’s dividend history and their percentage ownership interests in the Partnership.
Given the facts and circumstances of the case, the Court’s focus on the income from the property was sufficient to conclude that the limited partners received a substantial present economic benefit. This rendered the gifts of limited partnership interests as present interest gifts on the date of each gift, and accordingly the gifts qualified for the annual gift tax exclusion under Section 2503(b).
Here’s What’s Important
- Restrictions on ownership and transferability typically included in Operating Agreements to achieve valuation discounts can preclude the transferred ownership interest from being characterized as a present interest gift – the characterization required to qualify for the Federal Gift Tax annual exclusion.
- The most recent focus on the rights to receive income clearly indicates, from the Court’s perspective, that the entity must: i) generate income; ii) distribute some portion of that income steadily to the ownership interests; and iii) be able to readily ascertain the respective portions of that income.
Our conclusion articulated in 2002, is still appropriate in context with the Court’s adjudication of the cases discussed herein:
With regard to the restrictions in operating agreements, we maintain that analysts have constructed a false dichotomy between discounts and annual exclusion. It is possible to obtain both within the same gift. We would even cast doubt on the idea that unusually heavy restrictions guarantee any additional discounts beyond those contained in typical, “plain vanilla” agreements. The discounts for minority interest and lack of marketability derived from these latter type of agreements are substantial in size and indisputably eligible for annual exclusion. Furthermore, these discounts can be computed with high degrees of accuracy. How does one systematically determine the discount associated with a host of oddball provisions? And why would one, aware of the unfavorable tax consequences, endeavor such a calculation? LLC members gain nothing from restrictions that, in the process of deepening discounts, remove the present interest and disqualify the transfer for annual exclusion. While unusual restrictions may be necessary for the parties, they are not necessary for calculating discounts.