From a tax perspective, partnerships and limited liability companies are, by far, the most flexible of business vehicles. Among other benefits, they have no restrictions as to ownership or as to classes of equity; special allocations and disproportionate distributions may be provided for in the partnership or operating agreement; and there is pass-through tax treatment.

However, once you introduce the element of related partners, the structural and contractual flexibility that is so important to arm’s-length business dealings can turn into a dangerous tool, as one unsuspecting taxpayer recently discovered.

Donor and her sons, A and B, formed Company, a limited liability company. Donor’s capital contribution consisted of real property. Donor, who was the sole member to make a capital contribution, thereafter made gifts of membership interests to her sons. The gifts caused Company to be treated as a partnership for tax purposes.

A Textbook Situation

Things started out well. Under Company’s operating agreement, each member’s capital account was credited with the amount of the member’s capital contribution. (In the case of A and B, they took a proportionate share of Donor’s capital account.) Profits and losses were then allocated to a member’s capital account pro rata based on the member’s ownership interest. A member’s ownership interest was the proportion that a member’s capital account bore to the aggregate positive capital accounts of all members. Distributions were made based on a member’s ownership interest. No member had priority over any other member as to participation in profits, losses and distributions or the return of capital contributions. No member had the right to withdraw a capital contribution.  Textbook.

In the event that an asset was distributed in kind, the asset was deemed to have been sold as of the distribution date, and each member’s capital account adjusted to reflect the member’s share of the deemed gain or loss.  Textbook.

In the event of Company’s dissolution, its assets were to be sold and each member’s capital account adjusted to reflect the member’s share of gain or loss. In the event that an asset was distributed in kind, the asset was deemed to have been sold as of the dissolution date, and each member’s capital account adjusted to reflect the member’s share of the deemed gain or loss. Upon completion of dissolution, the balance of each member’s capital account was then to be distributed to the member.  Textbook.

 The Recap

Later, however, at a time when Donor held an M percent ownership interest, and A and B each held an N percent ownership interest, Company was recapitalized. Specifically, in exchange for the agreement of A and B to manage Company, the operating agreement was amended to provide that, thereafter, all profit and loss, including all gain or loss attributable to Company’s assets, would be allocated equally to A and B. After the recapitalization, Donor’s sole equity interest in Company was the right to distributions based on her capital account balance as it existed immediately prior to the recapitalization.

A recapitalization may be used to accomplish various estate planning goals by shifting ownership interests within a partnership or corporation. For example, it may be used to incentivize younger members of the family to assume greater managerial responsibilities. However, a recapitalization often presents a number of income and gift tax traps.

The Code imposes a tax on the transfer of property by gift by any individual. It provides that the tax shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. Thus, any transaction in which an interest in property is gratuitously passed or conferred on another, regardless of the means or device employed, constitutes a gift subject to gift tax.

According to the IRS, the terms “property,” “transfer,” “gift,” and “indirectly” are used in the broadest and most comprehensive sense; the term “property” reaches every species of right or interest protected by law and having an exchangeable value.

Likewise, the words “transfer by gift” and “whether direct or indirect” are designed to cover most transactions whereby, and to the extent that, property or a property right is donatively passed to or conferred upon another, regardless of how it is accomplished.  For example:

(1) a transfer of property by corporation Y, without consideration, to person X would constitute a gift from the stockholders of corporation Y to X.

(2) A transfer by X to a corporation owned by his children would constitute a gift to X’s children.

It follows, then, that the capitalization or recapitalization of an entity may constitute a gift. IRS regulations provide that donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. The application of the tax is based on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.

IRS regulations provide further that a gift is complete as to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him/her no power to change its disposition, whether for his/her own benefit or for the benefit of another.

Special Rules

The Code provides special valuation rules that apply to determine the existence and 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, whether or not the transfer would otherwise be a taxable gift. In other words, a transfer that would not otherwise be a gift because it was a transfer for full and adequate consideration may still be treated as a gift in certain circumstances.

Under the special valuation rules, a contribution to capital, or a redemption, recapitalization, or other change in the capital structure of a family-controlled corporation or partnership may be treated as a taxable transfer of an interest in such entity if, pursuant to such transaction, a taxpayer holding an “applicable retained interest” in the entity surrenders an equity interest therein that is subordinate to the applicable retained interest and, in exchange, receives property other than another applicable retained interest.

An applicable retained interest is an interest with respect to which there is a distribution right. A subordinate interest is an interest as to which an applicable retained interest is a senior interest. A senior interest is an interest that carries a right to distributions of income or capital that is preferred as to the rights of the transferred interest. The term “property” includes every species of right or interest protected by law and having an exchangeable value.

Here, at all relevant times, Donor and her family controlled Company. Company was recapitalized and Donor surrendered her right to participate in future profit and loss, including future gain or loss attributable to Company’s assets. Both before and after the recapitalization, Donor held an equity interest in Company coupled with a distribution right (an applicable retained interest). Donor’s original interest, which carried a right to distributions based upon an existing capital account balance, was senior to the transferred interests, which carried only a right to distributions based on future profit and gain. In exchange, Donor received property in the form of the agreement of A and B to manage Company—not an applicable retained interest.  Accordingly, the recapitalization constituted a transfer by Donor for purposes of the gift tax.


Even where a transfer of equity in a business appears to reflect arm’s-length consideration – as in the ruling, where the sons received an enhancement to their membership interests in exchange for their agreement to manage the Company – the Code may nevertheless create a taxable gift transfer where the business entity is controlled by the transferor’s and transferee’s family. The members of a family business must be careful of what may appear to be an innocuous exchange of equity. While these may be necessary or desirable from a business perspective, one must consider the associated tax risks in order to appreciate the potential economic cost of the transaction, and to thereby measure the net benefit. As always, it will behoove the family members to first consult with their tax advisers.