By: Lou Harrison and Natalie Perry
In the recent U.S. Tax Court Smaldino v. Commissioner, T.C. Memo. 2021-127, November 10, 2021, Mr. Smaldino and his wife each made gifts of discounted interests in a family limited liability company. This type of estate planning is very common and often recommended to clients. When done properly, it can be quite effective in shifting assets, often at a discounted value, as well as the future appreciation to the next generation of beneficiaries. Smaldino provides good reminders of the importance of adhering to the formalities and steps to be taken during the planning process which are sometimes be overlooked.
The case turned on two important questions. First, the Court analyzed the proper characterization for gift tax purposes of the taxpayer’s transfer of the LLC class B member interests to the taxpayer’s wife. Second, the Court addressed the transfer the taxpayer’s wife made of her class B interests to the Dynasty Trust. The timing of these two events which occurred over two days was a key factor in the case and provides an important lesson to be learned from the Court’s holding.
Mr. Smaldino owned several parcels rental real estate which he transferred to a family LLC. Mr. Smaldino then transferred approximately 8% of his class B interests in the LLC to a Dynasty Trust for the benefit of his children and grandchildren. Around the same time, he also transferred 41% of his class B member interests to his wife. One day after her receipt of the class B interest, Mrs. Smaldino transferred the 41% received from her husband to the Dynasty Trust.
Immediately after the gifts were made, Mr. Smaldino amended the operating agreement for the LLC to provide for guaranteed payments to himself. This amendment listed the Smaldino Family Trust as the “sole member” even though a 49% interest in the LLC had been transferred to the Dynasty Trust.
Upon review of the gift tax return filed by the Smaldino’s, and the underlying documentation of the transaction, the Tax Court applied the substance over form doctrine to combine the two separate gifts by each spouse and treated both gifts to the Dynasty Trust as if they had been made by Mr. Smaldino (instead of the 8% he transferred). On the basis of this finding, the Tax Court agreed with the IRS and upheld the gift tax deficiency for 2013.
Tax Court’s Citation of Louis S. Harrison’s Article
In considering the value of the guaranteed payment retained by Mr. Smaldino and its impact on the value of the class B interests transferred for gift tax purposes, the Court referred to an article written by Louis S. Harrison titled “Special Valuation Rules Can Save Transfer Taxes”, 11 J. Partnership Tax’n 239, 247 n.29 (1994).
Substance over Form Doctrine
The substance of a transaction, rather than the form in which it is cast, determines the tax consequences. When we engage in estate planning, especially when gifting by both spouses is contemplated, we must evaluate the proposed planning under this framework.
The courts have relied on the substance over form doctrine to recharacterize multistep property transfers among related parties as indirect gifts by the persons who were determined to be, in substance, the actual donors and donees. In the Smaldino case, the Tax Court relied on the doctrine of substance over form to disregard Mr. Smaldino’s transfer of the class B interests to Mrs. Smaldino and her subsequent transfer of the same class B interests to the Dynasty Trust a day later. In reaching this conclusion, the Tax Court determined that the Smaldino’s transfers of the interests were part of a prearranged plan between all the family members involved to effectuate the transfer of the ownership of the LLC from Mr. Smaldino to the Dynasty Trust.
A very important aspect of this case, one which the Tax Court relied on heavily, was the Smaldino’s failure to follow the formalities necessary to effectuate the gifting. In particular, the Tax Court questioned the dating and effective dates on the documents, creating uncertainty as to whether the transaction was done in August, or in April as the documents indicated. This questioning of the dating led the way to further questioning of noncompliance with the formalities. The operating agreement for the family LLC was not updated to comport with gifting to the Dynasty Trust. Further, the assets gifted to Mrs. Smaldino remained in her name were re-gifted so quickly that her ownership was disregarded by the Tax Court. When estate planning transactions such as the planning engaged in by the Smaldino’s are later subject to review by the IRS, the taxpayer must be able to demonstrate that the transaction was properly documented. For example, all parties must sign the appropriate documents in a timely manner and all ownership transfers and any impact on the interests held or the underlying rights of those interest holders must be reflected in the governing documents.
Related Party Transactions
The IRS and the Tax Court frequently scrutinize related party transactions much more closely than arm’s length transactions. Estate planning transactions invariably involve family members or trusts for the same or related family members. The reviewing agencies will look at whether there was real and meaningful economic impact during the time period any person or entity held interests that were later transferred. Accordingly, as planners we must use greater caution and care to ensure that the substance of the transaction will withstand such scrutiny.
The holding in Smaldino serves as an important reminder to use caution when engaging in estate and gift tax planning which involves among related parties. The Tax Court does not provide specific guidance on how to successfully implement this type of planning. When engaging in planning of this type, it is important to follow the formalities of the specific transaction as well as and to consider the overall economic impact on the parties as discussed in Smaldino.