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George F. Bearup, J.D. Senior Legal Trust Advisor

18-Nov-21

Indirect Gifts – Form Over Substance

Take-Away: A recent Tax Court decision demonstrates the risk posed with marital deduction gifts, followed by the gift of the recipient spouse, being classified as an indirect gift.

Background: IRC 2511(a) provides that a gift tax will apply “whether the transfer of property is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. While the gift of assets from one spouse to the other qualifies for the federal gift tax marital deduction [IRC 2523(a)] it may still ultimately be treated as an indirect gift by the donee-spouse acting as agent for the donor-spouse. This outcome was recently reiterated in a Tax Court decision.

Smaldino v Commissioner, U.S. Tax Court, Filed November 10, 2021

Facts: Louis placed 10 real properties in southern California in an LLC. Louis transferred 8% of the LLC class B membership interests to a dynasty trust that he established for the benefit of his children and grandchildren. Louis transferred another 41% of the LLC class B membership interests to his wife Agustina. The next day Agustina transferred all 41% of the class B membership to the dynasty trust. The value of the gift from Louis to Agustina was valued at $5,249,118, slightly below Agustina’s then available unified credit. Louis reported his gift to the dynasty trust with a value of $,031,881. Louis and Agustina elected not to split their gifts to the dynasty trust. Accordingly,  when the dust settled, the dynasty trust wound up owning 49% of the LLC class B membership interests. That 49% valuation was set at $6,281,000 by a certified appraiser.

[This was a second marriage for Louis and Agustina. Only Louis’ children and grandchildren were the beneficiaries of the dynasty trust. Louis transferred substantial non-family business assets to Agustina. Agustina testified that her intent was the Louis children some of whom were involved in the property management LLC, would own and operate the family business. Each of Louis and Agustina filed their own federal gift tax returns reporting these two 2013 taxable gifts.]

Notice of Deficiency: The IRS determined that Louis have a $1,154,000 gift tax deficiency, asserting that Louis make taxable gifts of $8,180,000 comprised of $2,157,071 of LLC units that Louis directly gave to the dynasty trust, and $6,022,929 of LLC interests that Louis made indirectly to the dynasty trust through Agustina.

Dispute: Louis claimed that he gave the dynasty trust only 8.05% LLC class B member interests. Louis further claimed that 40.95% LLC class B member interests were a gift from Agustina, his wife,  and not him. The IRS claimed that Louis made an indirect gift of 40.95% LLC class B units to the dynasty trust, which “Agustina purportedly re-transferred to the dynasty trust a day later.”

Tax Court: The Tax Court found that Louis had made a gift of 49% of the class B membership interests in the LLC to the dynasty trust with a value of $7,820,000. [A large part of the court’s decision was with regard to the valuation of the LLC  and the size of the valuation discounts, which will be skipped in this summary.] To reach its conclusion that an indirect gift by Louis was made to the dynasty trust, the Tax Court judge noted the following:

  • Substance Over Form: The substance of a transaction, rather than the form in which it is cast, determines its tax consequences unless it appears from the terms of the governing statute and its purpose that form was intended to govern. To this end, IRC 2511(a) implicitly embodies principles of substance over form by including indirect transfers in the definition of a taxable gift. “Transactions between persons in a close family group, whether or not involving partnership interests, afford much opportunity for deception and should be subject to close scrutiny… A transaction between family members is subjected to heightened scrutiny to ensure that it is not a sham or disguised gift.”
  • Prearranged Plan: The doctrine of substance over form demands that Louis’ purported transfer of the LLC member interests to Mrs. Smaldino  be disregarded and her purported retransfer of these same LLC interests to the dynasty trust a day later were ‘part of a prearranged plan between all parties involved to effectuate the transfer of the ownership of the LLC from Louis to the dynasty trust. Louis conceded that the two transfers were part of a prearranged plan to transfer 49% of the family business to the dynasty trust for his children and grandchildren’s benefit.
  • Marital Deduction Inapplicable: Louis argued that the legislative policies behind IRC 2523(a), i.e. the unlimited federal gift tax marital deduction, where ‘Congress intended that a husband and wife should be treated as one economic unit fo purposes of estate and gift taxes’ negate the substance over form doctrine advocated by the IRS, and thus the recharacterization of the purported interspousal transfer of LLC units from Louis to Agustina should rejected by the Tax Court. The judge found that IRC 2523(a) was inapplicable. “[H]owever, section 2523(a) applies in the first instance only if the donor ‘transfers an interest in property to his or her spouse.’ Courts recognize that the tax consequences of a transaction involving a nominee or straw party must be determined with regard to the trust beneficial interests involved. “Transactions which do not vary, control, or change the flow of economic benefits are to be dismissed from consideration.” The reality of the transfer and of the donee’s ownership of an interest in a partnership attributed to him or her are to be ascertained from the conduct of the parties with respect to the alleged gift and not by any mechanical or formal test. [Regulation 1.704-1(e)(2)(i).] In short, the judge found that IRC 2523(a) was in applicable to his analysis and that the dynasty trust received all of the LLC membership interest from Louis, effectively ignoring Agustina, or implicitly finding that Agustina was acting as Louis’ agent.
  • Bad Facts: The court found that Agustina, due to the terms of the LLC Operating Agreement, was only an assignee of Louis’ membership interests, i.e. she never become a member of the LLC. None of the LLC records ever reported Agustina as ever being a member of the LLC. In addition,  the LLC’s tax return for 2013 never reflected that Agustina was a member at any time. Nor did Louis, the LLC’s manager, ever formally accept in writing Agustina as a member, thus leaving her in the role of an assignee, not a member.  Consequently, the judge concluded that Louis never effectively transferred any of the LLC interests to Agustina and as a result the dynasty trust received its 49% LLC class B membership interests as a gift only from Louis.

Observations: A couple of observations after reading the 24 page court decision follow:

  • No Split Gift: The court’s decision never said, but it can be presumed, that Louis did not have enough of his own applicable exemption amount to ‘cover’ the anticipated gifts of 49% of the class B LLC units to the dynasty trust. Apparently Agustina did have available her full applicable exemption amount in the year of the gift, which is why Louis transferred the LLC membership interests to her, planning on ‘using’ her applicable exemption amount to shelter the taxable gift. Louis and Agustina could not agree to split the taxable gift(s) to the dynasty trust, since each would be deemed to have gifted 50% of the class B LLC units, which probably would have exposed Louis to having to pay a federal gift tax.
  • Marital Deduction: The court’s decision spent very little time addressing the marital deduction argument raised by Louis, and how the federal policy behind unlimited gift tax marital deduction provision in the Tax Court should ‘trump’ an IRS theory of ‘substance over form’ casting the spouse into the role of an agent for her spouse. I had hoped to read more analysis by the judge before coming to his summary conclusion that IRC 2523(a) was “inapplicable.”
  • Form Over Substance: Once again the old ‘bad facts make bad law’ adage appears to be at work. Ignoring the provisions of the LLC’s Operating Agreement,  ignoring the need to formally make Agustina an LLC member by the LLC’s manager’s acceptance, albeit for only a day or two, hurt Louis’ argument that Agustina had become an economic member of the LLC, and thus she had economic benefits that she could bestow on the dynasty trust with her ‘gift’ of the LLC units. The fact that Agustina never appeared in any of the LLC’s documents, no capital account was ever created for her, and she did not appear on the LLC’s tax returns and filings as an LLC member, supported the judge’s conclusion that Agustina was only a ‘straw person’ who was used only long enough to take advantage of her available applicable exemption amount. From several prior federal court cases, it is clear that a gift, followed the very next day with a gift of the same assets,  always waves a ‘red flag’ in front of the IRS.
  • Next Day Transfer: The failure to put much, if any, ‘time’ between the gift to Agustina, and her subsequent gift to the dynasty trust, was probably the biggest problem. Acting in haste to ‘implement a plan’ can often lead to mistakes, or in this case, the failure to actually make Agustina an actual LLC member who owned something of value to gift on her own. That might be the biggest ‘take-away’ from this ‘substance over form’ decision. Acting too fast, overlooking some of the small, but telling, steps to document true ownership is an invitation for the IRS to assert its substance over form theory to find a taxable gift by the donor. Something spouses always need to keep in the back of their minds.