By: Tamara Pow
Your gift or sale of an LLC interest to a family member may be disallowed for tax purposes.
If you are gifting or selling a limited liability company (“LLC”) interest to a family member, you must keep in mind the requirements of Internal Revenue Code Section 704(e). IRC (section sign) 704(e) provides that a gift or sale to a spouse, ancestor or lineal descent (or trust for their benefit) must meet certain requirements. If not, the donee will not be considered a member of the LLC for tax purposes, the gift will not be a completed gift for estate planning purposes, and the donee’s distributive share of LLC items will be subject to reallocation.
Your LLC interest gift must satisfy five conditions to qualify the donee as a member for tax purposes:
- Capital must be a material income producing factor for the LLC. In other words, the LLC’s income must be based on a business that requires substantial capital, such as inventories or equipment, and not a pure service based business resulting in commissions or fees.
- The donee must own a capital interest. You can’t simply gift an interest in profits. If the LLC were to distribute its assets, the LLC operating agreement must provide for the donee to receive a share of the assets on dissolution or if the donee withdraws from the LLC.
- If the donor provides services to the LLC, she must be reasonably compensated.
- The donor and donee’s share of LLC income should be relative to each of their capital interests in the LLC.
- The transfer (whether by gift or sale) must not be a sham. This is a facts and circumstances test that is based on several factors.
The factors that the IRS considers when determining whether or not the transfer is a sham center around whether or not the donee actually got control over the LLC membership interest. The treasury regulations tell us that the donor has too much control if she retained a unilateral right to withhold LLC distributions (other than for reasonable needs of the LLC business), she retained control over the essential assets of the building (e.g. by leasing them to the LLC), she retains more-than-usual management powers, there is a limitation on the donee’s right to sell or liquidate, or the donee is a minor. On the other hand, the donee has enough control if he has substantial participation in the management of the business of the LLC, he receives distributions of all or most of his distributive share of LLC income for his sole use and benefit, and he is really treated as a member for things like bank account control, filing tax returns, and in the LLC operating agreement.
Making a gift of an LLC interest is a transaction that involves expertise in both estate planning and LLC membership interests. To prevent unintended and potentially expensive estate consequences due to incomplete gifts, make sure your LLC attorney is coordinating with your estate planning attorney to ensure compliance with IRC Section 704(e).
Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including formations, operations, transfers, conversions and dissolutions of both family LLCs and non-family LLCs. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her in advising owners of limited liability companies and other business entities.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.