12 April 2022

Lessons Learned from Smaldino v. Commissioner: Give Yourself Time to Plan

A recent tax court case, Smaldino v. Commissioner, T.C. Memo. 2021-127, serves as a stern reminder that wealth transfers can’t be by document only—a transaction is much more vulnerable to attack and to be characterized resulting in additional tax when it lacks economic substance.

Federal Estate and Gift Tax Basics:

Federal estate and gift taxes are often grouped together and referred to as wealth transfer taxes.  If an individual owns property, that property is generally included as part of his or her taxable estate for federal estate tax purposes.  If a transfer of wealth is made during life, it is subject to gift tax.  If a transfer of wealth is made at death, it is subject to estate tax.

Each year, individuals are permitted to transfer property during life up to an “annual exclusion” amount.  Annual exclusion gifts are not subject to gift tax and do not reduce the available unified credit, described below.  During 2022, qualifying gifts of $16,000 may be made to as many different people as the donor would like without incurring gift tax.  Subject to changes in the law, gifts at or below the annual exclusion amount may be made each year to several different people without incurring gift tax liability or reducing the available unified credit.  That is why you will often hear tax advisors reciting “$16,000 per person, per year”—at least until the amount is changed due to inflation.

In addition to the annual exclusion, federal tax law provides that each individual is entitled to a “unified credit” against gift and estate taxes, allowing each person to pass substantial wealth to beneficiaries during life or at death before wealth transfer taxes are imposed.  The unified credit amount for 2022 is $12,060,000.  An individual may also make gifts to his or her spouse free of gift and estate tax, as long as the spouse is a U.S. citizen.

To maximize the value transferred using the annual exclusion and the unified credit, estate planners often employ sophisticated estate planning strategies which allow for a discount to the value of the assets being transferred, or to otherwise leverage the transfers.  The case discussed below utilized the transfer of interests in an LLC which owned real estate.  As a general rule, wealth transfers may be leveraged using tools such as an LLC with a carefully drafted operating agreement.  Provisions may be added to the operating agreement to support discounts to gifted LLC interests to reflect lack of control and lack of marketability.  These discounts ultimately lead to a larger interest being gifted at a given tax cost, meaning that more wealth is transferred to the beneficiaries instead of incurring tax.  If done correctly, this can lead to a significant reduction in wealth transfer tax.

The Facts of the Smaldino Case:

Louis Smaldino owned a large and lucrative real estate portfolio in California worth approximately $80 million.  As a result, his total estate was well in excess of the estate tax exemption, which at the time of the transfers was $5,250,000, making his estate likely to be subject to substantial estate tax at his death.  Mr. Smaldino had 6 children and 10 grandchildren from a previous marriage, and had remarried.  He wanted his children and grandchildren to inherit his real estate holdings and wanted his wife to inherit other property.

Mr. Smaldino funded his real estate holdings into a single-member LLC.  He also established the Smaldino 2012 Dynasty Trust to receive the LLC interests which represented his real estate portfolio.

After a health scare, Mr. Smaldino was compelled to make gifts for tax reasons, to mitigate estate taxes which would be imposed on his estate.  Because his wife had not utilized her unified credit against estate and gift taxes, the Smaldinos agreed to a series of transfers to utilize Mrs. Smaldino’s available estate tax exemption to transfer additional wealth to Mr. Smaldino’s descendants by using his remaining exemption and Mrs. Smaldino’s exemption.

Mr. Smaldino first transferred a 41% interest in the LLC to his wife, dated effective April 14, 2013.  On documents dated effective April 15, 2013 (the day after receiving the LLC interest from her husband), Mrs. Smaldino transferred that same 41% LLC interest to the Smaldino 2012 Dynasty Trust previously established by Mr. Smaldino and benefiting his descendants.  Mr. Smaldino also transferred an additional 8% interest in the LLC from his revocable trust directly to the Dynasty Trust, dated effective April 15, 2013.  Because of these transfers, the LLC went from being wholly-owned by Mr. Smaldino to being owned 51% by Mr. Smaldino and 49% by the Smaldino 2012 Dynasty Trust.

The following year, when Mr. Smaldino filed his gift tax return, he did not disclose the 41% interest in the LLC he gifted to his wife.  However, he did report his 8% gift of LLC membership interests to the Dynasty Trust.

Upon review, the IRS took the position that Mr. Smaldino had gifted not just the 8% he transferred to the Dynasty Trust directly, but also that he had indirectly gifted the 41% interest Mrs. Smaldino transferred to the Dynasty Trust.  Characterizing the transfers in this way, the IRS took the position that Mr. Smaldino was liable for gift tax in excess of $1.5 Million.

Ultimately, when the case was litigated, the court agreed with the IRS.  If Mr. Smaldino was deemed to have made a total gift of 49% of the LLC interests, he exceeded his available unified credit—and thus incurred gift tax liability for the transfers.  As bad as this news was for Mr. Smaldino, we can look to what led to this result and use that knowledge to avoid similar outcomes in other wealth transfers.  As bad as some of the facts look, much of what worked against Mr. Smaldino was likely due to the fact that the transaction may have been rushed due to his health scare.  If the transaction had been completed under more normal circumstances, he may have avoided such an adverse result.

One big and troubling issue in the Smaldino case is that there was a complete lack of substance to Mrs. Smaldino’s day-long ownership in the LLC.  The assignment giving her the interest was dated with an effective date rather than an actual date, so we don’t know when Mrs. Smaldino actually received the LLC interest.  Since the assignment transferring the interest from Mrs. Smaldino to the Dynasty Trust was also dated with an effective date rather than an actual date, we also don’t know when she actually assigned it to the Dynasty Trust.  Mrs. Smaldino also testified at trial that she promised to transfer the LLC interests to the Dynasty Trust once she received them, and that she needed to follow through with this promise.  Mrs. Smaldino was never admitted as a Member of the LLC, and never exercised rights given to Members in the company’s operating agreement.  Membership rights aside, if she were a legitimate assignee of the company, she would still have an economic interest in the company.  However, when the LLC’s tax returns were prepared, Mrs. Smaldino was not listed as being a Member or assignee of the company, even for a day.   She was not allocated any gains, losses, income or other tax attributes to show that she had an economic interest in the company.  There was no evidence that she actually received any benefits or burdens of ownership to correspond with the interests she received in the LLC and subsequently transferred to the Dynasty Trust.

The company’s operating agreement was also amended to reflect the 2013 transfers.  However, the amendment recited only that the company was originally a single member LLC owned by Mr. Smaldino through his trust, and ultimately became a multi-member LLC with Mr. Smaldino’s revocable trust owning 51% and the Dynasty Trust owning 49%.  It completely skipped the gift to Mrs. Smaldino.  Like the other documents, the amendment to the operating agreement was not dated, but was effective as of April 15, 2013.

The court also noted that the appraiser Mr. Smaldino hired to value the interests in the LLC dated his appraisal on August 22, 2013, and that the interests transferred in the assignments corresponded to the dollar amounts cited in the appraisal.  This led the court to believe that the transfer documents were likely completed in August, several months after the “effective date” of the transfers.  If the documents were backdated, Mrs. Smaldino never really had an opportunity to be an owner of the LLC.  The court also concluded that Mr. Smaldino did not intend for Mrs. Smaldino to actually be an owner of the LLC.

With these facts, the court easily sided with the IRS that the Smaldinos had a pre-arranged plan to use Mrs. Smaldino’s exemption to fund the Dynasty Trust, and that the gifts were actually made indirectly by Mr. Smaldino.

It’s easy to come up with a list of things that could have been done differently to make this gifting plan more successful.  If Mrs. Smaldino had been admitted as a Member of the LLC and had participated in a decision or two, perhaps it would have led to a different outcome.  If she had received a distribution from the LLC as an assignee, and had been listed as owning an interest in the LLC during the tax year, perhaps it would have been different.  If she had owned the interests for a period of time much longer than one day, the transaction may have been deemed to have economic substance.  In Holman v. Commissioner, (2008) 130 TC 170 (2008). aff’d, 601 F.3d 763 (8th Cir. 2010), the Court accepted six days as a sufficient period of time between phases of a transaction.  Courts will look to see if there is meaningful substance or if there is a likelihood of a genuine economic impact to occur during the time period in which the individual or entity holds particular interests.  If there is not, it is likely a court will characterize the transaction as a step transaction which lacks economic substance.  The important lesson here is that it’s imperative to always take the steps necessary to maximize the chance of a successful outcome for any estate planning transaction.  Observe the formalities, treat all the components of the transaction as substantive transfers, and if possible, make sure that you start the process early to avoid problems that can arise when work is rushed.

If you have any questions about this client alert or any of the issues it raises related to estate planning or wealth transfers, contact the authors.