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I have an LLC. My son and daughter (both over 18) are the only other members. In December 2019, I transferred to my son a capital interest worth $15,000 as a gift and did the same for my daughter. Both capital interests are unvested and will vest upon my death.

In March 2022, my son discovered, or appreciated more acutely, that this gift had been made and decided that he would like to disclaim it or otherwise reject it, ideally returning the capital interest back to me as though I had never given it to him in the first place. Currently, the gift is valued at about $40,000.

What is the most tax-efficient way for my son to reject or return this gift? The LLC has no liabilities, its assets are liquid, and the LLC operating agreement may be amended arbitrarily if doing so would be helpful.

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Possible Forms Of Transactions

Reformation

Generally speaking, a transaction can only be unwound ("reformed") by mutual agreement without a court order in the same tax year in which it takes place (usually a calendar year in a pass through entity).

One would also have to state a good faith legal basis for a reformation.

Disclaimers

Both state and federal law apply to disclaimers of gifts (i.e. a refusal to accept a gift). Historically, there was often a nine month limitation, but many states have relaxed that rule. Even more important, however, the recipient of a gift may not take any action benefiting from or affirmatively exercising control over the asset received as a gift before it is disclaimed. State law governs the formalities with which the document must be executed and delivered.

Assuming that the LLC has been issuing K-1s for 2019, 2020 and has or is about to do so in 2021 to the recipients of the gifts, either reporting income and paying tax on it, or reporting a net operating loss, simply disclaiming it might not be a smooth process, since signing a tax return acknowledging the gift would probably remove the ability to disclaim. Any vote on any member matter or receipt of any distributions would likewise make a disclaimer impossible.

Rebound gifts

The gift, when made, would take a carryover "outside basis" in the hands of the recipients for capital gains tax purposes (i.e. it would have the same value as in the hands of the donor). Generally this outside basis would subsequently have been modified by allocated profits and losses in 2019, 2020 and 2021 less any distributions. But neither the gift to the recipient, nor a gift back, would trigger capital gains taxation. The distributable share of profit and loss from prior tax years would remain in place, but the gift back could be back dated to year end (either December 31, 2021 or January 1, 2022) by mutual agreement, avoiding income in 2022.

If done in one year, the gift should be reported on IRS Form 709 (a gift tax return) since the gift exceeds the annual exclusion amount, unless it is broken up into multiple years. But, given the liquid assets it should be fairly easy to value (a 3% minority interest/valuation discount would be common for liquid assets) so breaking up the gift into a couple of years to avoid the need for file a IRS Form 709 would be impossible.

Sale And Cash Gift

One could sell the interest back at fair market value, but that would trigger capital gains taxation on the outside basis if there was unrealized gain in liquid assets held by the LLC, which would be undesirable. There would also have to be a rebound gift of the cash sales proceeds.

Liquidation In-Kind And Gift In-Kind*

Liquidating the LLC in kind wouldn't trigger capital gains taxation, nor would making a gift of the assets liquidated in kind back, although if it exceeded the annual exclusion, it would have to be reported on IRS Form 709.

Non-Tax Considerations

The reason for returning the transferred interest could matter and require considerations of non-tax issues.

Is the return to unwind a fraudulent transfer with creditors now seeking to make claims against the donor?

Is the return to assist in better treatment for financial aid purposes, or for qualification for a means tested program like Medicaid?

Is the return to make the financial statement of the donor look better or to meet the solvency requirements of a loan covenant or to qualify as an accredited investor?

Is the return because the child simply due to familial unhappiness and alienation does not want to be receiving gifts?

Is the return because the person receiving the gift has creditors who might claim it?

Is the return seeking to unwind an estate plan done for tax purposes that no longer makes sense?

The non-tax purpose for the transaction almost surely matters and influences which options do and do not make sense.

Unvested LLC Interests Don't Really Make Sense

All of this, however, also hinges on the notion of the membership interests are not vested. Arguably, so long as there is a substantial risk of forfeiture before the interests vest, the gift hasn't happened at all in the first place, no K-1s should have been done, and simply meeting the non-vesting condition would suffice.

But, while unvested employee stock options in corporations aren't that unusual (and are simple to understand, since a stock option conveys no property interest in an entity until exercised, although it is sometimes a property interest of its own as an option that doesn't interact with the entity until exercised), an unvested estate planning or succession gifts of an actual membership interest in an LLC would be very unconventional and is somewhat ill defined in meaning and in tax effect. It isn't obvious that this is really a correct description of the transaction.

Also gifts of unvested interests in entities do not qualify for the annual exclusion from gift taxation as they are not present interests in property, so any such gifts should have been reported on IRS Form 709 in the year that they were made.

While the question is open to tweaking the governing documents, and there might be some permutation of that which would be desirable, it makes the question much more complicated and I will leave that aspect of the question hanging.

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  • These comments and ideas are very helpful. Thanks for the detail, ohwilleke. One thought to mention in response to your final section: Internal Revenue Bulletin 2005-24 (irs.gov/irb/2005-24_IRB) gives useful definitions and examples regarding unvested LLC interests -- see for instance 4.03 and examples (3)-(7) in section 6. Though, as you say, such unvested interests are uncommon in estate planning.
    – SapereAude
    Commented Apr 1, 2022 at 2:07

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