Strategic Timing in Gifting LLC and FLP Interests to Family Members

Understanding the Indirect Gift Theory

According to Treasury Regulation Sec. 25.2511-1(h)(1), a capital contribution to a corporation can result in an indirect gift of property to each shareholder, proportional to their holdings. In the realm of LLCs and FLPs, this means that if a taxpayer cannot demonstrate that the transfer of assets into the entity occurred before the gifting of interests to the donees, the IRS may argue that an indirect gift has taken place. This is particularly challenging when both actions occur on the same day, as the taxpayer bears the burden of proof to establish the sequence of events.

The Step-Transaction Doctrine in Action

The step-transaction doctrine is a legal principle that combines a series of individual steps into a single transaction if they are substantively interconnected and aimed at a specific outcome. When applied to LLCs and FLPs, if the funding of the entity and the gifting of interests are treated as a single transaction, the IRS may argue that the underlying assets were gifted directly, eliminating the possibility of valuation discounts.

While case law does not provide a definitive timeframe between funding an entity and gifting business interests, patterns have emerged. Simultaneous funding and gifting often indicate an integrated transaction, which can trigger the step-transaction doctrine. Additionally, the volatility of the asset plays a role in determining whether sufficient time has elapsed between funding and gifting to establish that the taxpayer faced real economic risk.

Case Law Insights

Several cases illustrate how courts have applied these doctrines:

• In Gross v. Commissioner (T.C. Memo 2008-21), an 11-day gap between funding and gifting was enough to avoid the step-transaction doctrine, given the volatile nature of the marketable securities involved.
• Holman v. Commissioner (130 T.C. 170, 2008) saw a 6-day delay successfully sidestep the doctrine with similar assets.
• Conversely, in Linton v. U.S. (104 AFTR 2d 2009-5176), the court ruled against the taxpayer due to insufficient evidence of a time gap between funding and gifting, coupled with the non-volatile nature of the assets (cash, municipal bonds, and real estate).
• Heckerman v. U.S. (U.S. Dist. Ct. W.D. Washington, Case No. 008-0211-JOC) involved a same-day transfer of liquid assets and gifting of LLC interests, which the court deemed an indirect gift. However, the IRS did not challenge valuation discounts in a subsequent transaction involving a 15-day delay and real estate assets.

Proactive Measures and Best Practices

To defend against IRS challenges under the indirect gift theory or the step-transaction doctrine, consider the following best practices:

• Document initial contributions to an LLC or FLP in the Operating/Partnership Agreement and on the entity's financial records.
• If additional contributions are made, they should be reflected in the contributing member's or partner's capital account contemporaneously.
• Allow as much time as possible between funding the entity and gifting interests, especially with less volatile assets like real estate.
• Document the non-tax purposes of the transaction to strengthen the defense against the step-transaction doctrine.

By adhering to these guidelines, taxpayers can better position themselves to defend against IRS scrutiny. It's also worth noting that the IRS's approach to similar transfers may evolve, and the relevance of the "non-tax purpose" argument could expand beyond estate tax cases to gift tax scenarios.

For further reading on the indirect gift theory and step-transaction doctrine, the IRS provides guidance on gift taxes and legal references for tax professionals.

Please note that this article is for informational purposes only and is not intended as legal or tax advice. Taxpayers should consult their own legal and tax advisors for advice specific to their situation.

This article does not provide penalty protection and is based on general tax rules.