In your first year of practice as an attorney, there are certain rules you often pick up. More often than not, these “rules” are based on mistakes or omissions you make in drafting documents.
One of the most fundamental lessons I learned as a first-year associate was to always consider any existing buy-sell agreement when transferring an equity interest in an entity. This lesson was so profound that I overlawyer any assignment or transfer document I draft, especially for estate planning purposes. I am a bit obsessive about having directors, managers, general partners, and/or other equity owners’ consent to a transfer and waive any purchase options, rights of first refusal, or voidable transfers.
It is against this backdrop that I was intrigued by the recent Tax Court Memorandum Opinion in Smaldino v. Commissioner, TCM 5437-18. Not only has this case been the subject of many “I-told-you-so” types of articles of late, it has also been a source of anxiety for many attorneys (and possibly clients) who flew by the seats of their pants in the past.
As with any case of this type and magnitude, there are important lessons, but there are also several bad facts. And, anybody who has reviewed the most significant estate and gift Tax Court opinions of the last few years (many of which have dealt with Code Section 2036, and many of which have focused either on family limited partnerships, split-dollar arrangements, and/or formula transfer clauses) recognizes that these bad facts often pop up when people try to do deathbed planning in a hurry.
Such was the case for Mr. Smaldino, a CPA-turned-real estate investor who had a health scare in 2013 which led him to execute in a multi-step gifting transaction in that same year. He survived the health scare, but unfortunately this meant a drawn-out gift tax battle. As is common for many real estate owners, Mr. Smaldino consolidated his ownership of rentals into an LLC and then gifted a 49% nonvoting interest from his revocable trust to a dynasty trust created for his children in 2012.
The problem, however, was that he did not have enough gift tax applicable credit to completely shelter this gift from gift tax. So, he decided to use some of his wife’s applicable credit, by “gifting” her a nonvoting interest on April 14, 2013, which she then “gifted” to the aforementioned dynasty trust on April 15, 2013. I say “gifted” in quotes, because as we will see the IRS successfully argued that these intermediate steps did not occur. The result was a recharacterization of this transaction as a gift of the entire 49% nonvoting interest by Mr. Smaldino to the dynasty trust. As you can guess, this caused a gift tax deficiency.
Bad Facts
Now, before we get into the myriad of bad facts, it is important to note that this case was different than many similar cases we see. Why? Because both Mr. and Mrs. Smaldino were alive, and available to give testimony. It may be that this very testimony sunk them. Mrs. Smaldino testified that she felt as if she could not change her mind after receiving Mr, Smaldino’s initial “gift” of an LLC interest. In other words, she stated that she made a promise to her husband that she would transfer the interest to the dynasty trust, and that her belief in fairness would have prevented her from holding on to the interests.
Which brings us to the ultimate question – did she ever, even for one day, own the interests? Ultimately, the Tax Court concluded she did not.
On paper, this appeared to be a substance-over-form argument, where the IRS and Tax Court disregarded the intermediate steps of Mr. Smaldino making a gift to Mrs. Smaldino. But, there is something even more malignant floating in the background which was only indirectly acknowledged – you can only gift what you own. And, Mrs. Smaldino never actually owned the LLC interests that she purported to gift. So, while this was (surprisingly) a case of first impression when it comes to substance-over-form with interspousal gifts, its value as such may be overshadowed by the missteps which led to the end result.
What were these missteps? On the paperwork that actually counts, Mrs. Smaldino was never actually an owner of the LLC interest.
Now, the gifting structure in this case is one that is often considered between spouses. Many practitioners pause because of the possibility of a substance-over-form or step transaction argument. Thus, the focus is often on the temporal aspect – how much of a cooling period must separate the spousal gift, and the gift to the next generation? This is often an offshoot of parallel arguments, such as reciprocal trusts and sales to grantor trusts, which invoke such temporal issues.
But, from a policy perspective, the counterargument asserted by Mr. Smaldino was that substance-over-form should not apply to gifts involving spouses. Instead, Mr. Smaldino asserted that the Tax Court should interpret Code Section 2523(a) (providing a gift tax marital deduction for direct transfers to spouses) to mean that spouses are treated as one joint gifting unit.
The Tax Court somewhat agreed, but found that in order to arrive at this result there must be an actual transfer of an interest to a spouse. The Tax Court concluded that there was no such actual transfer. It appears there were two fatal errors here:
· Governance Document Failures: The LLC documents contained buy-sell language restricting transfers to a spouse, which could have been procedurally waived, but this procedure was not followed.
· Tax Reporting Failures: Mr. Smaldino didn’t actually report a spousal gift on his gift tax return, or claim a marital deduction relating thereto, so there was no reported gift to Mrs. Smaldino to begin with.
These are not just bad facts in isolation – the follow-up paperwork (which may have been backdated) supported the conclusion that Mrs. Smaldino never actually owned an interest in the LLC.
You Can Only Transfer What You Own
If you are familiar with buy-sell provisions within (or external to) LLC operating agreements, then you have probably seen the distinction between a member and a mere economic interest owner. A recipient of an interest (assuming the transfer is not void from inception) only owns an economic interest unless, and until, admitted as a member. In other words, that owner cannot vote or participate in the LLC.
This was the case here.
Mrs. Smaldino could only receive an economic interest as an assignee under the buy-sell language. Yet, she purported to transfer an actual membership interest to the dynasty trust. This may not have been a problem if she had first become a member, but she did not – at no point did she meet the requirements or procedure to become a substitute member. You can only gift what you own, and it is questionable whether she actually owned anything of substance as an assignee.
Even if the Tax Court had honored the interspousal gift to begin with, the failure to observe these formalities would be fatal. Now, an interest as an assignee would be worth less than an interest as a member for gift tax purposes, which perhaps could have entitled Mrs. Smaldino to a larger discount on her gift to the dynasty trust, but I doubt the Tax Court would have allowed such a loophole. No argument was made under Code Sections 2701 or 2704 relating to this alternate theory, but that could have been the outcome if the spousal gift was indeed honored. So, let’s not guess.
Instead, as a starting point, this disparity between the interspousal gift and the actual dynasty trust gift could have been fixed with paperwork admitting Mrs. Smaldino as an LLC member. This did not happen, and the Tax Court refused to imply such consent by virtue of the marital relationship. (As an aside, to do so would have been bad law to begin with – buy-sell agreements are often designed with the goal of preventing a spouse from becoming an equity owner).
But, if this were not enough, Mr. Smaldino decided to double-down. You see, he executed an amended operating agreement effective April 15, 2013 (the supposed date of spousal transfer to the dynasty trust) showing only his revocable trust, and the dynasty trust, as members, and not reflecting Mrs. Smaldino as an interest owner or assignee at all.
This is where the Tax Court called into doubt the effective date of all paperwork, as the assignments and amended operating agreement were not actually dated at the time of signature. (It is not known whether these documents contained a typewritten “effective date” within the body of the documents, or whether mere testimony established these purported effective dates). The Tax Court implied that the documents were, in a sense, self-serving, as they appeared to have been prepared on or around August 22, 2013 in conjunction with the appraisal. This cast further doubt on whether Mrs. Smaldino was ever even an assignee or economic interest owner.
(As an aside, the primary context of this issue of self-serving paperwork related to the addition of a guaranteed payment to Mr. Smaldino in the amended operating agreement, the effect of which was in dispute for discounting purposes).
Finally, to add insult to injury, the interspousal gift was not actually reported on Mr. Smaldino’s gift tax return. Instead, he reported only his direct gift to the dynasty trust. Mrs. Smaldino reported her gift to the dynasty trust (of an interest which she magically appeared to obtain notwithstanding gift tax reporting to the contrary) on her own gift tax return. Further, the partnership return for the LLC (Form 1065) did not actually report Mrs. Smaldino as holding a membership interest during the year.
Takeaways
While the many analyses of this case have focused on the need to follow entity-level formalities, there are deeper points to consider. Not only do you need to follow these formalities, but you need to do so correctly. And, you need to follow the formalities in a way that is concurrent with the purported effective date of the gift, instead of covering yourself after the fact with self-serving paperwork.
Substance-over-form is important, but the problem here was that there was no form for the IRS to disregard to begin with. Other than an assignment document, there was nothing to show that Mrs. Smaldino ever actually owned an interest in the LLC. Even the tax reporting did not reflect this.
Now, as with any case, there are unanswered questions here. The Smaldinos could have considered a gift-splitting election, which would have generated some gift tax liability for Mr. Smaldino, but not as much as he paid in this case (notwithstanding the legal fees of defending the deficiency). Of course, there are two deadlines here which appear to foreclose this as alternate remedy – one being that the consent to gift-splitting must be signed by April 15, and the other being that no such consent can be signed after a notice of deficiency in gift tax has been sent.
Since the Smaldinos were California residents, and had been married since 2006, one must also wonder whether the outcome would have been different had Mrs. Smaldino actually been the biological parent of Mr. Smaldino’s children (they were her stepchildren). It is also likely that the LLC interest was not community property, otherwise the outcome could have been similar to that of the gift-splitting election. Nonetheless, instead of guessing, it might be a good idea in a second marriage to consider that the need for following the formalities is greatly enhanced. This could be further exacerbated, for example, by the terms of a marital agreement if one exists.
Nonetheless, the following are some suggested practices for an interspousal gift in the wake of Smaldino:
· Minutes or written consent of the managers and/or members, waiving transfer restrictions and admitting the donee spouse as a member;
· Updated schedules of ownership reflecting the donee spouse as a member;
· The donee spouse’s consent to be bound by the terms of the operating agreement;
· Gift tax returns reporting the gift to the donee spouse; and
· Partnership returns reporting the spouse as a member of the LLC.
While not addressed in the opinion, the following practices could also be helpful:
· A cooling period, perhaps spanning into the following calendar year, between the gift to the donee spouse and the gift from the donee spouse; and
· Documented proof of membership benefits (cash distributions, participation in voting/consent, receipt of LLC financials, etc.) to the donee spouse during this cooling period.