Recent Tax Court Case Has Important Lessons On How To Do Estate Planning Right!

A recent Tax Court Case, Smaldino V. Commissioner Of Internal Revenue, T.C. Memo. 2021-127, November 10, 2021 has lots of important lessons on how to do an estate plan properly. These lessons are particularly important for those that did planning in a rush in 2020 and 2021 fearing dramatic changes in the tax laws. Even if those harsh changes aren’t enacted (few of them were included in the bill just passed by the House), if you are doing planning, you should heed the lessons provided in Smaldino. If you completed planning in 2020 or 2021 already, review these lessons and be certain you have all your tax ducks in a row. If you missed doing things properly, it is certainly worth trying to clean up your tax act after the fact rather than waiting for an IRS auditor to find your mistakes instead. While the critical mistake in the Smaldino case can’t be fixed after the fact, similar planning oversights might benefit from some after the fact clean up efforts. This article will review the Smaldino case, explain what the taxpayers in that case did wrong, and how you can do planning better. We’ll also discuss what you might do for some of their errors to patch them up after the fact when that is feasible.  This will make the discussion of the case a great case study to illustrate the good, the bad and the ugly of the estate planning process. That makes are story a bit long winded, but hopefully more instructive for you.

Here’s the Story

LLC: Mr. Smaldino owned and operated numerous rental properties. He put 10 of his rental properties into a family limited liability company (LLC), which he owned through a revocable trust. Having rental properties owned in LLCs is a prudent way to minimize personal liability so if a tenant, for example, sues you, they should only be able to reach the LLC assets, not your home and other personal assets. Depending on the value of the properties and how many you have, many folks might be better served by having each property held in a separate LLC to prevent a domino effect. That way if there is a lawsuit against one property, the others hopefully remain untouched. This is kinda like the legal equivalent to the water tight doors between a submarine’s compartments. That isn’t relevant to the Smaldinos’ story, but just a good planning suggestion you might consider. Next, the taxpayer in Smaldino had his LLC interests held in a revocable trust. That is generally good planning to protect your assets from probate and the risks of your future incapacity. 

Dynasty Trust:  Mr. Smaldino transferred about 8% of the LLC class B member interests to an irrevocable trust that was designed to benefit his children and grandchildren (Dynasty Trust). This is pretty common estate planning. Many taxpayers have made gifts to irrevocable trusts for heirs to use their exemption as there was considerable concern by taxpayers that the exemption amounts would be reduced. Although the latest proposal passed by the House doesn’t reduce the exemption at all; setting up such a Dynasty Trust and making gifts could be a good planning move, although a somewhat different plan might be better for you. Mr. Smaldino was in a second marriage so presumably his spouse was not included as a beneficiary. If you’re in a solid marriage using a trust that includes your spouse as a beneficiary might be a wiser move for you as that preserves access to the trust assets after the gift. So, be certain that the type of trust you use, and who are beneficiaries, makes sense for your situation. There are even further steps you can take if you are single, or even if you are married, if you want access to the trust you create yourself. You could have the trust include a loan provision so someone can loan you money from the trust. That provides you, the settlor creating the trust, access to trust assets should you need. If you don’t have a spouse, or if your spouse dies or the two of you divorce, that could be important. Other ways to add more access could include naming you a beneficiary or giving someone the right to add you back as a beneficiary or giving someone the power to direct the trustee to give you trust assets (called a special power of appointment). These latter techniques might be better if you either live in one of the 19 states that permit what are called self-settled trusts, or you create the trust in one of those steps.

Gift to Wife (Maybe!): Mr. Smaldino “purportedly” transferred about 41% of the LLC membership interests to his wife. She “purportedly” gifted those same interests to the Dynasty Trust the next day. When a court describes a taxpayer’s actions as “purported” it’s not a good sign. The Court, suffice it to say, was not impressed with the validity of Mr. Smaldino’s gift to his wife and her claimed gift after that to the Dynasty Trust Mr. Smaldino created. This was all at the heart of the case. The bottom line was the Court recharacterized the claimed gift Mr. Smaldino made to his wife, followed by her gift to the Dynasty Trust, as if Mr. Smaldino himself had made the gift directly to the Dynasty Trust. This bypassed the supposed transfer by Mrs. Smaldino. The result was a rather costly tax bite. As you will see below, Mrs. Smaldino held the interests for maybe a day, transferred the same exact interests she received as a gift to the Dynasty Trust, and the family and their advisers skipped lots of steps that should have been followed to corroborate that they respected the transaction, which the Court felt that they didn’t.

Intent Is Important: Mrs. Smaldino testified that before the purported transfer in question she had already made “a commitment, promise” to her husband and family that she would transfer the LLC units to the Dynasty Trust. When asked on direct examination whether she could have changed her mind if she had wanted to, she responded: “No, because I believe in fairness.” Her testimony undermined the position the family presented to the IRS. Taxpayers should understand the transactions they engage in, as well as the substance and form of the transaction. Mrs. Smaldino’s testifying she had no intent to hold the equity interest contradicted the purported substance of the transaction of her accepting ownership of the interests. Too often taxpayers become impatient with planning, don’t want to devote the time or effort to understanding the transaction (“Let the lawyer handle it”), or want to minimize professional fees and thus avoid the meetings or memorandum necessary to their better understanding the transactions. Taxpayers don’t need to understand every technicality but must understand the big picture. Had Mrs. Smaldino understood the plan better perhaps her responses would have been different.

Gift Tax Return: When you make a taxable gift you need to file Form 709, a gift tax return, and report the gifts you made to the IRS. While you don’t have to report many gifts to a spouse, perhaps, as in the Smaldino case, you might opt to do so. Needless to say, Mr. Smaldino did not report the gift to his wife on his gift tax return. So, his transfer to her and the documentation (or lack thereof) formally respecting that transfer was not reported either.

Some other Factoids: Mr. Smaldino was certified public accountant (CPA) and even worked as a CPA. Mrs. Smaldino had a master’s degree in economics, so she too should have had some understanding of the shortcomings of the “plan” they pursued. Also, the family’s real estate portfolio was worth about $80 million. Two points. As a CPA, Mr. Smaldino should have well-understood the need for legal and tax formalities and Mrs. Smaldino should have understood the business/economic shortcomings of the plan. Also, with wealth of the level involved in this case, the family can and should have had a collaborative team of top-notch advisers that worked together to assure that their estate plan was properly planned, drafted and implemented. If you don’t have the business acumen or experience to understand some of the formalities involved in your plan, no problem. Just hire good professionals. Even if your estate is much smaller than that in the Smaldino case, taking shortcuts and forgoing formalities is never a winning strategy. When he was 69, a health scare motivated Mr. Smaldino to get his estate planning in order. In fact, the Court noted that the LLC was formed in 2003 but it remained inactive until late 2012. The Smaldino’s started the process and perhaps got busy with “life” and only may have revisited planning when health concerns became pressing. No one should wait for a health emergency (or other external event) to begin planning. Pretty much everyone needs a plan that works for their wealth level and other circumstances. Waiting is not only a bad idea, but that might have been some of the reason that the Smaldino’s planning was rushed. Similarly, those folks that waited until mid-2021 to plan for possible tax law changes were not doubt rushed through the process thereby making the planning more stressful and less likely to succeed. Learn the lesson and make planning for not just your estate, but all your financial and legal matters, a habit to pursue in increments on a regular basis.

Lessons to Learn

Understanding what the Smaldino’s did wrong, and how you can do better planning, is important. It’s also practical, not necessarily costly, and makes good common sense. On a few points we’ll suggest how your advisers might try to help you fix up shortcomings in your planning, although doing it right from the get-go is safest.

Respect Your Entities and Trusts or Others Won’t Either

It is fundamental for much of legal and tax planning that if you want the rest of the world to treat something you set up as real, you had better do so too. Perhaps the classic example is you set up a corporation or limited liability company to operate your business out of. A purpose of doing so is to insulate personal assets from business creditors. Yet if you ignore the formalities and reality of the entity, e.g., by commingling personal and business funds, using business assets personally (e.g., having your spouse’s personal use car owned by the business), and so forth, the courts and IRS will be loath to respect the entity you disregarded. This is such a common issue that the phrase “piercing the corporate veil” is used to describe the legal theory of breaking through an entity form to reach your personal assets as if the entity did not exist. Well, the Smaldino’s didn’t do well on respecting the formalities of their entity in regard to the gift Mr. Smaldino tried to claim he made his wife.

Adhering to the formalities of the operating agreement restrictions would not have taken much effort. Mr. Smaldino as trustee of the Dynasty Trust and as manager of the LLC could have given written consent for the admission of Mrs. Smaldino as a member in disregard of the operating agreement’s restrictions. But instead, the day after Mr. Smaldino purportedly transferred the LLC member interests to Mrs. Smaldino, he executed an amendment to the LLC operating agreement (providing for guaranteed payments to himself) which identified the Dynasty Trust as the LLC’s “Sole Member.”

The lessons of this particular piece of the saga are pretty simple, but quite important. Adhere to the legal requirements for a gift, and any other estate planning transaction. Document what you have complied so a third party (IRS, court, bank, etc.) can be shown that you did things the right way. If you engaged in estate planning in the past, confirm that all formalities like the one in Smaldino, or others that might apply to your situation, have been addressed. If not, consult your attorney and see if they can be addressed now. While that isn’t ideal, and might not help, perhaps it might.

More on Smaldino’s Legal Documents

The Court in Smaldino listed the legal documents that the Smaldino’s proffered in the case. The documents seemed to be a bit light, and also raised further issues. More lessons to learn.

Date Signed: The legal document used to transfer the LLC interests from Mr. Smaldino to Mrs. Smaldino said that it was “Effective: April 14, 2013” but it did not indicate the date it was actually signed. There is nothing inherently wrong with indicating a date a document should be effective (as long as the effective date is not contradictory to the facts). However, legal documents should indicate the date they were actually signed even if there is a different effective date.

Actual Dates Were A Critical Issue: The problem with dates of legal documents in the Smaldino case was significant. The effective date of Mrs. Smaldino’s gifts to the Dynasty Trust was a mere one day after the transfer of the interests in the LLC to her by Mr. Smaldino.

Dates Were A Worse Issue in Smaldino: The Court felt that the taxpayers were playing games with the dates of the documents. The Court noted that the appraisal report that valued the LLC was dated August 22, 2013. That was over four months after the transfers of the LLC interests supposedly took place. “On the basis of all the evidence in the record we find it more likely than not that the undated certificates of assignment and associated operating agreement amendment were executed no earlier than August 22, 2013.” The fact that key documents did not reflect dates that they were signed lead the Court to suspect that they were really signed much later when the family got the appraisal they needed to consummate the transfer. Worse yet, in the Smaldino situation, if the documents were actually signed long after the supposed gift to Mrs. Smaldino, she could not have had any opportunity to exercise her ownership over the interests Mr. Smaldino gave her. Because, by the time the family signed the legal documents, the effective dates already had the Dynasty Trust owning the LLC interests.  The Court noted that as “a practical matter there was never a time when Mrs. Smaldino would have been able to effectively exercise any ownership rights with respect to any LLC membership interests.”

Value Transferred: The value of LLC interests that Mr. Smaldino transferred to Mrs. Smaldino were about equal to her then available Federal estate and gift tax exemption. That was then the same amount which Mrs. Smaldino purportedly transferred to the trust as her gift. It would have perhaps been preferable to not consummate the transaction with similar amounts/interest. It may have been wiser for Mr. Smaldino to have transferred a larger LLC interest to Mrs. Smaldino so that his gift to her and her gift to the trust were not identical.

Legal Docs Alone Don’t Win the Day: Having proper legal documentation is critical for taxpayers to enhance their likelihood of their plan succeeding, but it may not suffice to win the case. Mr. Smaldino did in fact sign a certificate of assignment transferring interests in the LLC to Mrs. Smaldino. The Court said that this was “a factor to be considered, [but it] is not controlling.” The courts don’t consider legal papers as controlling for tax purposes when the objective economic realities are to contrary to the content of those documents. Kerr v. Commissioner, 113 T.C. 449, 464 (1999). The circumstances surrounding the writing must show that the writing was meant to be effective.  Linton v. United States, 630 F.3d 1211, 1218-1219 (9th Cir. 2011). In Smaldino, the facts belied the legal document, the assignment Mrs. Smaldino held the LLC interests for merely a day, never signed an operating agreement, never received a distribution, was not listed as an owner on the LLC income tax return and acknowledged that she had no intent of retaining the interests. The courts have often recognized that the tax consequences of a transaction involving a nominee or straw party must be determined with regard to the true beneficial interests involved. Transactions which do not vary, control or change the flow of economic benefits, are to be dismissed from consideration. Snyder v. Commissioner, 66 T.C. 785, 791 (1976). In Smaldino, there was no economic consequence to Mrs. Smaldino holding interests in the LLC for one day before regifting them to the ultimate donee that Mr. Smaldino wished to receive them. That lack of economic reality, coupled by all the missed formalities, made Mrs. Smaldino no more than a “straw person” passing the interests on as Mr. Smaldino wished.  

What Might Have Been Done Better: The Smaldinos could have planned the transfers better.

·      It would have been preferable to have more time pass between the date of the gift to her and the date she made a gift. Some commentators recommend a minimum of 30 days, some say 60+, many agree the more time the better. Apart from the Smaldino’s planning, in 2020 and 2021 many taxpayers feared imminent, even retroactive, tax changes. So, waiting was an anathema to getting planning done before unknown effective dates of new rules (which may never happen). Will that environment change how a court might view transactions done close in time? Perhaps not, but at least there are objective external circumstances to point to as the reason for compressed planning.

·      It would have been preferable perhaps to have transferred more LLC interests given to Mrs. Smaldino so that there would not be an identical amount of what was given to her and what she gave to the Dynasty Trust.

·      During the period Mrs. Smaldino held the LLC interests, there might have been a distribution to confirm the reality of her ownership.

·      Perhaps other actions may have occurred during the period of her ownership, e.g., her voting in accordance with the governing document on an important matter.

·      Also, it appears that there was no amended and restated operating agreement signed while she was owner. When a new person owns part of an entity that new person should sign the governing legal documentation agreeing to be bound by them. That should have been done to evidence the reality of her ownership interest. Similarly, when she later transferred interests to the trust yet another amended and restated operating agreement might have been signed reflecting the trust as owner (and perhaps continuing to reflect Mrs. Smaldino as an owner of some interests to confirm that there was no identify of the gift to her and the later transfer she made).

·      If you completed planning and did not have the opportunity to have your corporate attorney create amended and restated governing documents (operating agreement for an LLC, shareholders’ agreement for a corporation or partnership agreement for a partnership) have that done now. The documents can be signed currently (never back date legal documents) but made effective as of the date of the transfers. While that is not ideal, it might still show respect for entity formalities and attention to legal form, albeit after the fact. From the “better late then never” camp, it may be worth a try.

Tax Returns Should Reflect the Transaction

The LLC filed its initial partnership tax return on Form 1065, U.S. Return of Partnership Income. On the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., attached to this Form 1065, the LLC listed Mr. Smaldino as a 51% partner, and the Dynasty Trust as a 49% partner for the whole year. Mrs. Smaldino was not listed as a partner for any part of the tax year. Thus, the income tax returns did not reflect the partial year ownership (1 day) for Mrs. Smaldino which was contradictory to the position the taxpayers’ tried to argue.

It is imperative that all tax reporting (income and gift), legal documents (assignments, operating agreements, etc.), economics (e.g., distributions), third party documents (trust records) be consistent with the position taken.

Mr. Smaldino on his Federal gift tax return reported his direct taxable gift to the Dynasty Trust  but he did not report any gift to Mrs. Smaldino. While it may not be required to report inter-spousal gifts, it may be advisable to do so to fully reflect the transactions involved.

Tax Principles That You Should Be Mindful Of

There are a several general tax principals which applied in the Smaldino case, and which taxpayers (and their advisers) should consider in planning estate transactions.

Substance over Form: The substance of a transaction, rather than the form in which it is cast, determines the tax consequences. This is an important touchstone to evaluate all planning against. The courts have used substance over form principles to recharacterize multistep property transfers among related parties as indirect gifts between the persons who were determined to be, in substance, the actual donors and donees. In the Smaldino case, the doctrine of substance over form demands that we disregard petitioner’s purported transfer of the LLC member interests to Mrs. Smaldino and her purported retransfer of those same interests to the Dynasty Trust a day later because their actions were part of a prearranged plan between all the parties involved to effectuate the transfer of the ownership of the LLC from Mr. Smaldino to the Dynasty Trust.

Related Party Transactions: Heightened scrutiny is appropriate in cases, such as this one, where all the parties to the transactions in question are related. Estate planning transactions are invariably between related parties, so greater caution and care in assuring that the substance of the transaction passes “muster” is important. The courts have viewed family transactions as affording much opportunity for deception and should therefore be subject to close scrutiny

Marital Deduction Doesn’t Supersede Substance Over Form: Mr. Smaldino tried to argue that because the tax law permitted him to make a gift to his wife that gift should be permitted. Code Section 2523(a). The Court basically said no dice as the marital deduction rule does not supersede the substance over form doctrine and under that doctrine Mr. Smaldino’s actions were ineffective to transfer membership interests in the LLC to Mrs. Smaldino. So, the Court sided with the IRS that Mr. Smaldino, in substance, made all the gifts to the Dynasty Trust.

How Long Is Long Enough?

I Smaldino the wife held onto the LLC interests she received as a gift or a mere day and the Court found that was not enough time for the gift to her to be real. No doubt that result was influenced by all the other goof-ups in the planning and documentation. But leaving those other factors aside, how long is long enough to hold on to an asset before retransferring it? Might six days be enough?

In the Holman case, the Court accepted six days as perhaps long enough. Holman, (2008) 130 TC No. 12. In Holman the IRS also argued that the a gift should be viewed as an indirect gift applying the step transaction doctrine. The Holmans formed and funding a partnership with Dell stock then six days later made gifts of the partnership interests. The IRS asserted that the formation and funding of the partnership, and later gifts of partnership interests, should be treated as occurring simultaneously. The IRS reasoned that the transactions (funding and later gift) were interdependent. The brief separation in time between formation and funding and the subsequent  gift served no purpose other than to avoid making an indirect gift of the partnership interests. Treas. Reg. Sec. 25.2511-1(h)(1). But the Court reasoned that the Holmans bore a real economic risk of a change in value of the underlying Dell stock and hence of the partnership for the six days that separated the transfer of Dell shares to the partnership. So, the Court refused to treat the formation and funding of the partnership, and the later gifts as being a single event under the step transaction doctrine. So is one day too short and six days just enough? The reality it depends. Even if the taxpayers succeeded with a mere six days in Holman it is unlikely any tax adviser would recommend such a short time between different steps in a plan (although the fear of imminent and massive tax changes in 2020 and 2021 may have had many taxpayers choose not to let much time pass). But the common theme between Smaldino and Holman is economic substance. The courts want to see that there was real and meaningful economic impact during the time period any person or entity held interests.

Conclusion

While many tax advisers might dismiss the Smaldino case as “bad facts-bad law” that would be a mistake. Many of the oversights in the Smaldino case are common. Instead of dismissing the case, read the case to glean lessons about how to fix up your existing estate planning transactions, and how to do new estate planning better. While there were a lot of bad facts in the Smaldino case, your tax planning ship might get sunk for far fewer infringements. Better to be cautious and confirm your planning is in order, adheres to all legal and tax formalities, and that the underlying economics support the tax objectives you are endeavoring to achieve. With all the pressure of 2020 and now 2021 planning, its probably advisable for everyone to review what was done to be sure that all is in order.