Are you an entrepreneur with family business? Have you thought about your children and grandchildren being more involved in your business? Perhaps a Family Limited Liability Company (Family LLC) is just what you need. Properly structured for your unique situation, the Family LLC is a 21st century way to hand down the family business for generations to come in a safe, protected and orderly business structure. But if you set up your Family LLC be aware you face dangerous IRS tax mines hidden in IRS Code Section 2036(a) that could explode your tax plan into an IRS audit focusing on when a gift is not a gift (GINAG) and when a transfer is not a transfer (TINAT). Indeed, you may experience unexpected increases in estate tax so high the children might have to sell the farm just to pay the tax. So if you don’t want GINAG or TINAT, or just want to learn more about them, stay with us here on TaxView with Chris Moss CPA to fully understand how to avoid GINAG, TINAT, and Section 2036(a) so you can save and preserve your assets for your children for many generations to come.
Section 2036(a) prohibits you transferring property out of your estate that are “testamentary “in nature. The US Supreme Court in Grace V US, 395 US 316 (1969) has defined “testamentary” as those transfers which leave you in significant control over the property transferred. For example you still control the business you just transferred to your children.Section 2036(a) does not apply to transfers that are bona-fide sales for adequate and full consideration. Furthermore, the bona fide sale exception is satisfied where the record establishes you had a legitimate and significant nontax reason for creating your Family LLC, and your children received membership interests proportionate to the value of the property transferred. Turner v IRS 2011 at page 33. Therefore, all transfers and gifts to adult or minor children in a Family Limited Liability Company must be perfectly executed to comply with Section 2036(a). See Bigelow v IRS, 503 F.3d 955 (2007)Affirming Bigelow v IRS T.C. Memo. 2005-65; also see Rector v IRS 2007.
Our first US Tax Court case is True v IRS 2001. Dave and Jean True made direct gifts in their family business to some or all of their children every year form 1955-1993 at the maximum annual exclusion each year. True did not use a Family LLC. Instead of using an LLC Operating Agreement, True created restrictive buy-sell agreements for all of the family. This Agreements gave Dave True total control over all family business. Dave True died on June 4, 1994 with many various trusts in place with True still maintaining control over all businesses. An Estate Tax return was filed on March 3, 1995 with the Estate valued less the value of all the gifts given to all the children over all the years. The estate was audited by the IRS in 1998. Do you all see the GINAG and TINAT coming?
Sure enough the IRS determined that the whole purposes of the gifts to the True children and related buy-sell agreements was to avoid estate tax. The Government sent the True family a bill for over $75 Million plus $30 Million in penalties adding back all those gifts as a violation of Section 2036(a). This is major GINAG. Why? True was giving everything away without a business structure to back up his estate plan making the primary motive to avoid estate tax. As the Court notes on page 108 of this over 300 page Opinion, Dave True had “control” over the whole operation which made for good GINAG in that he had a “life estate” in the business operations. In my view if True had set up a Family Limited Liability Company with normal restrictions placed in a family Operating Agreement allowing the family under unanimous consent provisions to control the assets, GINAG and TINAT would have been avoided, and assets would have been preserved and protected from Section 2036(a). Unfortunately for the True children, IRS wins True loses.
Our next case is Hurford v IRS 2008. Thelma Hurford was a very wealth widow. On advice of legal counsel she formed a Family Limited Partnership which allowed her to transfer assets, including farms and ranches into a single entity. Hurford gave a 25% interest to each of her children. But Hurford still maintained control over everything. GINAG is written all over this. Hurford even remained the sole signatory on many of the accounts. Hurford died on February 19, 2001. The estate tax return was filed on September 26, 2001. The IRS audited the return on November 18, 2004 claiming Hurford owed over $20 Million for estate and gift tax. Hurford appealed to US Tax Court in Hurford v IRS 2008.
Judge Holmes and the Government proposed GINAG for the whole estate plan calling it nothing more than a transparently thin substitute for a will. The Court agreed with the Government finding that Hurford retained an impermissible interest in the assets she had tried to transfer to her children in total violation of Section 2036(a). Further the Court noted that Thelma commingled her own funds with the partnerships until shortly before she died, and that there was no meaningful economic activity where the partnership furthers family investment goals or where the partners work together to jointly manage family investments. You guessed it IRS wins Hurford loses.
Our last case: Stone vs IRS 2003. Mr. and Mrs. Stone founded multiple business ventures. They were also beneficiaries of various trusts. Perhaps due to or because of all this wealth, the family and 4 children Eugene, Rivers, Rosalie and Mary and other parties sued each other in the early 1990s over these trusts. After settlement of all the litigation, Stone formed 5 family limited partnerships in 1996 for his wife and 4 adult children. The partnership agreements provided unanimous consent of all partners to sell, transfer or encumber property and the children worked in the businesses owned by the partnerships. Mr. Stone died as a South Carolina resident on June 5, 1997 at age 89. Mrs. Stone died on October 16, 1998 at age 86. An estate tax return was filed for both Mr. and Mrs. Stone and the IRS eventually audited. The Government sent Mr. Stone a bill for $8 Million and Mrs. Stone a bill for $1.5 Million claiming the transfers to the partnerships violated Section 2036(a). Stones appealed to US Tax Court Stone v IRS 2003.
Judge Chiechi notes that the Stones retained enough assets in their estate to maintain their life style. The Court found that transfers were motivated primarily by investment and business concerns relating to the management of certain of the respective assets of Mr. and Mrs. Stone during their lives and thereafter. The Court concludes that the partnerships had economic substance and operated as joint enterprises for profit through which the children actively participated in the management and development of the assets and therefore the transfers were bona fide sales for adequate and full consideration in money or money’s worth under section 2036(a). Stone wins IRS Loses. Also see Mirowski v IRS US Tax Court 2008
So what does this all mean for us? If you have a business or perhaps multiple businesses and your tax attorney has suggested a Family Limited Liability Company which will own all of these businesses make sure the operating agreements protect you from Section 2036(a) and GINAG and TINAT. Based on the US Tax Court case law, retain some assets for yourself to maintain your lifestyle and perhaps transfer everything else to the LLC. Regarding adult children who are willing to participate in the family business see to it that they are signatures on the bank accounts and make sure there are unanimous consent requirements for all important decisions. Any gifts to minor children through the annual tax free gift exclusion require an absolute legitimate bullet proof non tax purpose in forming the LLC. Finally consult a tax attorney to create your unique business plan. Avoid GINAG and TINA. Most importantly avoid violation of Section 2036(a). You will be ready for any IRS audit coming your way and your assets will be part of your family legacy to your children and your children’s children for many years to come.
Thanks for joining me on TaxView with Chris Moss CPA.
Chris Moss CPA