Currently ongoing litigation between taxpayers and the government serves to remind us of some very important concepts when creating a family limited partnership or limited liability company. These entities are commonly used to allow parents to make gifts to children and obtain a significant discount from the value of the underlying assets because those assets are owned by an entity in which the donee is given only a minority interest and has only limited ability to transfer his interest. The parents would typically form the entity, usually a limited partnership or limited liability company, and fund it with the assets they wish to give to their children. After a period of time, they make gifts of interests in the entity to their children, or in some cases may sell interests to their children. The gifts or sales are often made to trusts that have been set up for the children. In either case, an appraisal is obtained which usually ascribes a significant discount to the value of the partnership interest because it is a minority interest which cannot exert control over the partnership and is not easily transferable.

This works well when properly implemented; however, Linton v. United States, (9th Cir. January 21, 2011), provides a good example of how things can go awry. The Lintons met with their attorney on January 22, 2003, and at the same meeting signed all of the documents to transfer assets to a limited liability company that had been formed a couple of months previously, create trusts for their children, and transfer interests in the limited liability company to the trusts as gifts. The documents creating the trust and making the gifts were signed but not dated at the meeting. The attorney later wrote the date “January 22, 2003” on those documents.

The IRS contended upon audit that because everything happened on the same date, the proper characterization was that the Linton’s made gifts of the underlying assets to their children, which were then contributed to the limited liability company. Under that characterization, no discount for minority interest would be available. The attorney testified that he mistakenly dated the trust and gift documents January 22, 2003, and that they should have been dated January 31, 2003. The District Court found his testimony not to be controlling and agreed with the IRS. Everything happened on the same day and the transaction was appropriately treated as a gift of the actual assets that were transferred to the limited liability company.

The Ninth Circuit reversed the decision and sent the case back to the District Court to do some more fact finding in order to be able to determine on what date or dates the various actions were taken. The Ninth Circuit noted the Tax Court's decision in the Holman case in 2008, where the court had to identify whether the subject of the gift was an interest in the entity or the underlying assets. The Holman court concluded that in order for the gift to be of the interest in the entity, the assets would need to be contributed to the entity enough time prior to the gift that their value could have changed by the time the gift was made. The Tax Court did not think that this needed to be a long period and in that case, where the assets were marketable securities, the court found that five days was sufficient.

The taxpayers in Linton may ultimately prevail and obtain their valuation discount, but they are certainly incurring a lot of costs that could have been avoided. If you form a family entity for purposes of making discounted gifts or sales of interests in the entity, you should form the entity and transfer to it the assets that you eventually want to transfer to your children. Attention to detail is very important. You need to be sure that legal title to the assets is registered in the name of the entity, whether the assets are brokerage accounts, individual stocks, real estate, partnership interests, etc. You must have clear records and documentation of the dates on which these transfers occur.

After the assets have been transferred to the entity, the best practice, where feasible, it to wait some identifiable period of time before completing the gifts or sales of interests in the entity. The documents must be accurately dated to reflect the actual dates on which transfers occur. The optimal amount of time you should try to wait depends on the nature of the assets. With marketable securities, the Tax Court has indicated that a period of five days is sufficient although clearly a longer period would be better. Longer periods should be observed with less volatile assets such as real estate. We recognize that circumstances do not always permit such careful delineation of the steps, but where possible, these transactions should now be planned with enough time for the optimal staging.