The Tax Court’s decision in Albert J. and Christine M. Hackl v. Commissioner1 has provoked a lively discussion about how to achieve discounts to net asset value and still qualify for the annual exclusion. We challenge the notion that obtaining deep discounts requires a host of restrictive provisions in the operating agreements. We also propose a broader definition of economic interest that includes the growth in value of underlying assets.
A.J. Hackl established a tree farm for the purpose of long-term growth (no pun intended). As he expected, it incurred losses in the first few years of operation. However, according to forestry consultants, Hackl managed the farm in a manner that would generate a steady income stream in the future.
Upon establishing the 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.”2
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 on the interests being gifted. The Court employed a three-part test to determine whether income qualified for 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.
Some believe that the abnormally restrictive operating agreement produced the Hackl result. If they are correct, then Hackl is an aberration that will have little effect on the construction of LLC agreements.
The reaction to Hackl presents the discount and the annual exclusion as an either/or proposition—i.e., the restrictions that produce deep discounts will deprive the recipients of the present interest required for annual exclusion. One observer concludes that estate planners must decide either to gift large interests at heavy discounts based on highly restrictive agreements or to dribble out value with annual exclusion gifts based on much less restrictive agreements.3
The other valuation issue concerns 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.
Mercer Capital has certain strong beliefs on both of these issues. 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.
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. The valuation community should put pressure on the narrow definition of present interest through solutions that explicitly incorporate growth in value into its appraisals.
A widely advocated solution grants the equivalent of a Crummey power to owners of membership interests. This power is like a temporary put, allowing the holders to sell their interests back to the company in exchange for cash.4 A similar arrangement (really the same transaction, in reverse) would involve the transfer, to defective grantor trusts, of gifts of cash used to purchase discounted interests.5 This solution responds to the Court’s statement that “an ability on the part of a donee unilaterally to withdraw his or her capital account might weigh in favor of finding a present interest.”6
However, the Crummey power or any similar provision invites other questions. Members (or willing sellers) would not gift interests to individuals who intend to turn right around and sell them back for cash. Furthermore, individuals would hesitate to use the provision for fear that they would not receive future interest gifts.
From the valuation perspective, Crummey-like powers carry dubious merit compared to an agreement with more traditional provisions. For example, what is the price of withdrawal from the capital account? Would managers consent to fair market value, or tack on a premium or discount? The ability to obtain immediate cash requires generous liquidity assumptions. If these assumptions are realistic, then the ownership interests do not warrant a marketability discount. Therefore, the LLC is exchanging one economically reliable discount in a straightforward arrangement for a murky discount in a heavily restricted agreement.
We ponder a simpler approach. Agreements should rely on traditional approaches to achieve discounts, namely the right of first refusal (ROFR) and applicable state law.7 The ROFR, by allowing members to preempt the sale of interests to outside buyers, balances the competing concerns. Owners retain a necessary level of control without those extraneous restrictions, and members who want to exit the company may do so at fair market value.
Also, agreements should take advantage of existing state laws. This recommendation applies especially to those restrictions on the transfer of interests by members and the withholding of distributions by managers. The Service has ruled that a gift conveys no present interest when the manager can both unilaterally withhold distributions and prohibit the members from withdrawing or transferring their interests. Going beyond the established legal provisions risks disqualification for annual exclusion.
Therefore, the ROFR and state laws are sufficient to support minority and marketability discounts. LLCs need not load up their operating agreements with superfluous restrictions, lest they compromise the favorable tax treatment of such gifts. If such restrictions are necessary for other reasons, then we suggest that the attorney advise the appraiser to ignore them for tax purposes.
As for the (re)definition of present interest, we recommend a technology that, in computing discounts, explicitly considers all economic factors, including both distributions and growth in value. Our quantitative marketability discount model (QMDM) accomplishes this objective. It does not depend on averages computed from benchmark studies. Rather, the QMDM relies on characteristics endogenous to the entity being valued—such as holding period and growth in value. In particular, the QMDM forces members to think specifically about the timing and amount of distributions, fuzzy issues in the Hackl agreement.8 With the QMDM, the discounts match the economic assumptions related to distributions and payouts.
1 Albert J. and Christine M. Hackl v. Commissioner, 118 T.C. No.14. Filed March 27, 2002.
2 Hackl decision, p. 17.
3 Ron Aucutt in Steve Leimberg’s Estate Planning Email Newsletter, Archive Message #403.
4 Owen Fiore and Erwin Wilms, “Pass-Through Entities and Valuation Discounts,” Trusts & Estates (May 2002), pp. 8, 10, 52.
5 Andrew Katzenstein and David Schwartz, “Tax Court Limits Annual Gift Tax Exclusion for Gratuitous Transfers of LLC Interests,” Journal of Taxation (2002). Sample article online.
6 Hackl decision, p. 30.
7 See also James M. McCarten, Esq., “FLPs, The Gift Tax Annual Exclusion, and the Size of the Minority Interest Discount,” ACTEC 16th Annual Southern Regional Meeting (April 2002).
8 Hackl decision, p. 33.
Reprinted from Mercer Capital’s Value Added, Volume 14, No. 3, 2002.