Recapitalization of L.L.C. Interests and Issuance of Profit Interests Held to be Gifts in Estate Freeze

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Code §2701 is a provision which renders the transfer of a partnership or membership interest to a family member a gift. The tax typically applies in an “estate freeze” scenario, where one generation attempts to transfer assets which appreciate in value to another generation, thereby removing it from their estate for estate tax purposes. In its latest Chief Counsel Advice (“C.C.A.”), the I.R.S. held that a recapitalization of a limited liability company (“L.L.C.”) triggers a gift under Code §2701 in a case where a mother retained a right of distribution but transferred the gain or loss attributable to the L.L.C.’s assets to her sons. The I.R.S. held that the interest retained by the transferor (a distribution right on the existing capital account balance) was a senior interest, whereas the transferred interest held by the sons (the right to future gain of the L.L.C.’s assets) was found to be a subordinate interest. What is notable and most troubling here is that the interests transferred to the sons are so-called “profits interests,” issued for future services to be rendered to the L.L.C.

IN GENERAL

Code §2701 imposes special gift tax valuation rules when partnership or membership interests are transferred to family members. Family members covered under Code §2701 include the spouse of the transferor, any lineal descendant of the transferor or the transferor's spouse, and the spouse of any such descendant. In general, Code §2701 devalues interests of senior family members in order to increase the value of interests transferred to junior family members. Code §2701 generally applies to situations where the transferor retains a senior interest and transfers a subordinate interest to the transferee – such as when a parent keeps preferred shares and transfers common shares to family members.