When people discuss establishing an LLC or FLP because they have signed a lease for a gas well, it brings to mind a lesson learned from chocolate cake. Aside from the heavenly aroma of the cake, or the investment of time and money spent to make or buy the cake, the only real value is in eating it. Everyone eats their chocolate cake differently—Some like to savor every bite, eating it slowly. Others like to eat big bites and wash it down with milk or coffee. Another person may eat the cake first and save the icing for their last bite. However a person chooses to experience their piece of chocolate cake, this fact remains —at the end of the day, no matter what manner the cake is eaten, the piece of cake os still gone. In order to enjoy its benefits, it must be consumed.
So how does eating chocolate cake illustrate a valuable lesson as it relates to gas leases? You cannot have all the control in running a Family Limited Partnership (FLP) or a Limited Liability Company (LLC) that owns a gas lease and still aviod federal estate/gift tax. Basically, as good as it sounds to transfer the value of a gas lease out of your estate while still maintaining control over the operation, you cannot have your cake and eat it too.
The Internal Revenue Service enacted Internal Revenue Code § 2036 to stop taxpayers from having their cake and eating it too. Basically, if a taxpayer transfers an asset and retains any benefit for himself or herself or retains the ability to determine who benefits from the asset, that asset is includable in the taxpayer’s federal taxable estate.
For example, if a taxpayer establishes an LLC, and the only asset owned by that LLC is a gas lease, and every year the taxpayer transfers a small ownership interest in the LLC to his three children until eventually he reduces his ownership interest in the LLC to 49% (and, therefore, does not have control over the LLC through his ownership percentage), but the taxpayer stipulates in the operating agreement of the LLC that he is the manager of the LLC, and the LLC is a manager-managed LLC, there is an issue. Because the LLC is a manager-managed LLC, the operating agreement provides that the manager makes all decisions regarding the LLC. The taxpayer is trying to have his cake and eat it too. He wants to transfer the value of the LLC to his children gradually, using the annual exclusion so federal gift tax is not implicated, but he also wants to maintain control over the LLC by naming himself the manager of the LLC. The IRS would determine that the taxpayer transferred an asset but retained control under § 2036, so the IRS would include 100% of the value of the LLC (based on the fair market value of the LLC on the taxpayer’s date of death) when calculating the value of the taxpayer’s federal estate.
The control issue with a business entity is problematic even if the operating agreement doesn’t name the taxpayer as the manager and the LLC is not manager-managed. Tax courts have concluded that there is a control issue with FLPs or LLCs even when there is only an implied agreement that the taxpayer will benefit from the LLC or FLP.
For example, if a taxpayer transfers 51% ownership of the LLC to his son, and the LLC operating agreement provides that the LLC is member-managed not manager-managed, but there is an unspoken agreement between the taxpayer and his son that the taxpayer makes all decisions relating to the LLC, or the taxpayer still receives a benefit from the LLC (for example, the LLC pays some of the taxpayer’s personal expenses), then the taxpayer has made a transfer and retained control of the LLC. Again, the IRS would determine that the taxpayer transferred an asset but retained control under § 2036 so the value of the entire LLC would be included as part of the taxpayer’s federal estate for valuation purposes.
So a very real concern rests in the fact that people are rushing to transfer their gas leases into an FLP or LLC without realizing that these business entities may not be the best option for transferring a gas lease to future generations.There may be a much more effective tool to accomplish this goal. Please make sure you are not trying to have your cake and eat it too; otherwise, your family may just end up with a big chocolaty mess on their hands, and in the end, they won’t be happy.