Despite frequent IRS challenges, family limited partnerships and limited liability companies remain effective structures for facilitating the transfer of business interests to family members, protecting assets from creditors’ claims, and reducing gift and estate taxes.

Estate and gift tax benefits are produced by valuation discounts applied to restricted minority interests transferred to family members. So it’s important to consider valuation issues early in the business planning process.

The terms of a limited partnership agreement or LLC operating agreement can have a dramatic impact on the value of FLP or LLC interests. In general, the more restrictions placed on these interests — in terms of the ability to exercise control over business affairs or to sell or transfer the interests — the greater the valuation discounts.

In a recent, controversial case, however, restrictions placed on interests in a family LLC produced unintended consequences. In Hackl v. Commissioner (118 T.C. No. 14, 3/27/02), the Tax Court ruled that gifts of interests in an LLC were gifts of future interests and therefore didn’t qualify for the annual gift tax exclusion.

The Hackls formed the LLC to acquire real estate and operate a tree farm. Their objective was long-term growth, and no short-term profit or cash flow was expected. They made gifts of LLC units to their children and grandchildren.

The court based its conclusion on the considerable authority retained by Mr. Hackl as managing member of the LLC (including the power to name his successor by will), as well as on restrictions contained in the LLC’s operating agreement. Those restrictions, the court said, "foreclosed the ability of the donees presently to access any substantial economic or financial benefit that might be represented by the ownership units." The restrictions included the following:

• LLC members couldn’t withdraw their capital accounts, compel distributions, or transfer their interests to third parties without the consent of the managing member.
  
  
• A member desiring to withdraw could offer the units for sale only to the company, and the managing member had the exclusive authority to accept or reject the offer and negotiate terms.

What Hackl Means for Estate and Business Planning
Although some experts believe the Tax Court’s decision in Hackl was wrong and would be reversed on appeal, it’s important to consider the case in drafting FLP agreements and LLC operating agreements, particularly if an objective is to qualify gifts as present interests for annual exclusion purposes. It may be possible to establish a present interest by including certain provisions in the agreement, such as a right of first refusal or a temporary put option at fair market value.