Bona Fide Business Exception
A U.S. District Court in Indiana has held a husband and wife’s transfers of membership interests in a limited liability company (LLC) to their children failed to qualify for the exception to the special valuation rules. The couple gave each of their children a 4.76% interest in the LLC over a three year period. The operating agreement of the LLC included restrictions on the transfer of ownership. An undeveloped plot of lake-front property was the primary asset of the LLC.
The IRS issued a deficiency partly because of the failure of the couple to determine the value of the gifts according to the IRC special valuation rules. One of the requirements to be exempt from the special valuation rules is that restrictions on transfers are a bona fide business arrangement. The court held the LLC was not a bona fide business because there was not any plan or actions on the part of the children or parents to improve, expand or develop the property. Nothing distinguished the LLC from an individual owning real estate outright.
Gifting is one way to transfer wealth to the next generation. Gifting can be used to reduce estate tax liability by giving away assets equal to the annual exclusion every year. When the assets being gifted are LLC units or corporate stock, the value of the gift can be discounted because of minority shareholder status and the lack of marketability of the shares. However, as the above case illustrates, these discounts appear to be limited to businesses that are operating for a profit or plan to make a profit; not for an individual transferring non-productive properties.
By: Basi & Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors