Estate planners sometimes advise their LLC clients to recapitalize their equity structure for estate planning reasons. The note below from today’s Tax Notes summarizes an IRS ruling that the IRS may treat some of these recapitalizations as gifts.
In a legal memorandum, the IRS concluded that the recapitalization of a limited liability company was a transfer from a donor to her two sons for gift tax purposes under section 2701(e)(5).
The donor and her sons formed the LLC, but only the donor made a capital contribution that consisted of real property. However, the donor later made gifts of membership interests to her sons and their children. The company was later recapitalized, and the sons agreed to manage the company in exchange for an amendment to the LLC operating agreement providing that all future profit and loss, including all gain or loss attributable to the company’s assets, would be allocated equally between the sons. After the recapitalization, the sole equity interest of the donor and her grandchildren in the company was the right to distributions based on their capital account balances as they existed immediately before the recapitalization.
Section 2501 imposes a tax on the transfer of property by gift by any individual. Under section 2511, the tax applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, and tangible or intangible. Section 2701 provides special valuation rules to determine the amount of a gift when an individual transfers an equity interest in a family-controlled corporation or partnership to a member of the individual’s family. Under section 2701(e)(5), a contribution to capital or a redemption, recapitalization, or other change in the capital structure of a corporation or partnership is treated as a transfer of an interest in that entity if the taxpayer or an applicable family member (1) receives an applicable retained interest in the entity in connection with the transaction; or (2) under regulations, otherwise holds, immediately after the transaction, an applicable retained interest in the entity.
The IRS noted that the donor and her family controlled the LLC at all relevant times and that she held an applicable retained interest — an equity interest in the company coupled with a distribution right — both before and after the recapitalization. The IRS said her interest, which carried a right to distributions based on an existing capital account balance, was senior to the transferred interests, which carried only a right to distributions based on future profit and gain. Accordingly, the IRS determined that the recapitalization constituted a transfer by the donor for purposes of section 2701.
Generally, the amount of a gift resulting from any transfer to which section 2701 applies is determined by a subtraction method of valuation. Under this method, the amount of the transfer is determined by subtracting the values of all family-held senior equity interests from the fair market value of all family-held interests in the entity determined immediately before the transfer. Reg. section 25.2701-3(b) provides a four-step method for determining the amount of the gift.