Understanding Serious Mistakes and Planning Implications in the Smaldino Tax Court Case
“Understanding Serious Mistakes and Estate Planning Implications in the Smaldino Tax Court Case,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Travis Hayes, ACTEC Fellow from Naples, Florida. Many spouses make gifts of hard-to-value assets and business interests in order to use a spouse’s unused lifetime gift tax exemption. In Smaldino, the wife had unused lifetime gift tax exemption that the couple wanted to use to make gifts of interest in an LLC which held hard-to-value rental properties. In order to accomplish this, the husband transferred business interests to the wife, prior to the gift to an irrevocable trust. The Smaldino ruling from the tax court enumerates concerns regarding that type of transfer.
Today, ACTEC Fellows Steve Akers of Dallas, Texas and Lou Harrison of Chicago, Illinois will be discussing the Smaldino ruling and the estate planning implications of the tax court decision. Welcome to Steve and Lou.
The Facts and Holding of the Smaldino Case
Stephen Akers: Thank you, Travis. Smaldino v. Commissioner, T.C. Memo. 2021-127, is a very, very interesting case. In this case, the husband wanted to transfer up to 50% of his interest in an LLC. So, he was going to transfer 49%. His wife had $5.25 million of gift exemption amount — that was the amount at that time that they did it. Well, he didn’t know how many units were worth $5.25 million, so he didn’t know how many units to transfer to his wife so that then she could make a gift using her gift exclusion amount.
And so, they went out and hired an appraiser. Apparently, they came to the conclusion in April they wanted to do this. They hired an appraiser; the appraiser got the work finished in August telling them what the value was per unit and so then they knew and ended up transferring 41% of the units — Husband transferred to Wife. Now, he did it purporting to use a Wandry sort of transfer: transferring that number of units as determined for federal gift tax purposes to equal about $5.25 million. (Joanne Wandry v. Commissioner, T.C. Memo. 2012-88)
The parties concluded later and conceded that they really didn’t treat this as a Wandry transfer and so they just treated it as a 41% transfer to the wife. And they did that in August, signed a document effective April 14th. It wasn’t dated but it was just effective April 14th. Wife signed a document the next day, effective the next day – April 15th, transferring the 41% interest to a dynasty trust for the children. Husband also signed a document effective April 15th assigning the remaining 8% so 49% total went to the dynasty trust. The husband also, effective that same date, signed an amendment to the operating agreement making some changes.
The court concluded that those documents that were signed, undated documents that were effective April 14th and 15th, actually must have been signed in August after they got the appraisal because the numbers that they used exactly equaled the appraisal amount of the 49% interest. So, they were actually signed in August. The husband filed a gift tax return reporting his 8% gift, but did not report the gift at all to the wife. They did not make the split gift election — so the husband made a gift and then the wife made a gift. There were just terrible formalities in this situation.
The primary factor in the case was that the wife admitted at trial that she made that transfer effective the next day because she had made a commitment/promise to her husband and the family that she would transfer the LLC units to the dynasty trust. And when asked on the stand if she could have changed her mind, she responded, “No, because I believe in fairness.” So, she testified that she actually had committed to make that subsequent transfer.
The wife was never formally admitted as a member of the LLC. An amendment, this amendment that the husband signed, said that he was the sole member when, effectively, the transfer had been made to the wife the prior day. Exhibit A to the operating agreement never showed the wife as an owner. The court said that all this happened before the fact and that she never really had the ability to exercise any ownership rights. The income tax return never reported any income to the wife. As a result of all that, the court concluded that there was never an effective transfer of the units to the wife.
Now, I think the court could have reason, even if it found that the units had been effectively transferred to the wife, that indirectly the husband made this transfer to the dynasty trust directly. So, those are the facts and the holding of the case. Now, some very interesting planning implications come from that. Lou?
Estate Planning Implications of the Ruling
Louis Harrison: So, Steve, I would not dismiss this case as many have as a “bad facts” case. I think there is more afoot here. Number one is that the tax court really didn’t like the optics of what was going on in this case and did not like the optics of the transactional documents, what I would call, and “the stench of the transaction.” And, once the tax court concluded that they did not find these taxpayers particularly trustworthy, or the planning particularly trustworthy, they trotted out the old chestnut of the “sham transaction principle” in order to invalidate the wife’s transfer. Essentially, to treat that as if it was made by the husband.
The sham transaction principle, in particular, that they trotted out this time was the substance over form, mainly, followed by the step transaction. So, when the tax court does not like a transaction, since they have nothing in the Code or Regulations necessarily to invalidate it, they use the sham transaction concept. And they did that to invalidate that second transfer from the wife to the gifting trust.
What’s really going on and what’s our planning because of Smaldino? There are absolute steps for us to take – not, by the way, a double entendre on the step transaction – to avoid the Smaldino holding. Number one, and this is probably a global for all our planning: let’s not get cute with transactions. Let’s realize that optics will matter if these cases get to the courts.
Practice Recommendation: Document Dating
So, in Smaldino the most important fact is, Steve, what you had mentioned with regard to the dating here. They wanted a transaction effective as of April 14th but, apparently, documentation really wasn’t done until August and I think the tax court basically looked at it and concluded that this was an August transaction that they were trying to predate, as it were, back to April.
So, the number one takeaway here is: please, provide evidence that the transaction that you’re doing on the gifting occurred when you said it occurred. Either date the documents in real-time, in other words when you are signing them, date them, or if you are doing this effective date transaction make sure you have something indicating that the parties had a verbal agreement that was enforceable and that the transaction was essentially done at the time they said it was done, even if some of the documents are done after. So, that’s absolutely the number one takeaway here: don’t be cute and do a transaction 4 months after you said you did it.
Estate Practice Recommendation: Transfers
Second is, make sure that when you’re transferring assets, you really transfer them. So, in Smaldino, the husband transfers a LLC interest to the wife but none of the transaction documents really evidence that the wife had any ownership interest. In particular, the time difference was right on top of each other. Husband transfers it in one day. The wife transfers it the next. And then, as Steve mentioned, there is no evidence that the wife really had any real ownership or any real hold on the asset that was transferred. So alluding to the Holman case, for all our transactions, if we can put some time in between the various pieces of a transaction, that’s exceptionally important.
As well as, please, we have to make sure that we coordinate with the accountants; we coordinate all of the pieces of a transaction so that they match up. In other words, we have to make sure the tax returns, the 1065s in this case, actually reflect the ownership that has been transferred. In this case, the 1065s didn’t match up – did not reflect the actual transfer of ownership. So, we have to coordinate with our accounting colleagues to make sure they’re doing that correctly. We have to make sure the organizational documents, for LLCs – the operating agreements, are amended to reflect that the transfers have actually taken place.
And, we’re going to suggest something from Smaldino that is not completely evident from the case but a step that we all should take as planners. When we get to the finish line of these complicated, sophisticated transactions and we had quite a few, right, last year, we take a deep breath, our clients are happy that we finished, and we move on to the next case.
It’s exceptionally important that a week, two weeks, a month after these transactions are finished, we look at what we have, what we’ve done, and we see if improvements can be made. If there are gaps in the planning that was done, we take a fresh look after the transaction is completed. Not just on the compliance side, but to what we have, and to see if there are any additions that should be made to these transactions. I know we all have good intent to do that. A lot of times we’re not doing that and Smaldino really is another encouragement to do that.
The final piece here, and then I’m going to shift it back to Steve for some concluding remarks. The final piece is you look at Smaldino and we all get concerned with regard to these interspousal transfers to use the other spouse’s credit amount.
We have been doing this for a long time, I think we have been doing it without too much concern and Smaldino is telling us now – look, if one spouse is transferring to the other, be careful with regard to retained interests, concerns, and the effectiveness of that transfer. So, we don’t want to have implied agreements that the other spouse is going to do certain transfers. We certainly don’t want to have express agreements to that effect, and we want to put a time differential between when one spouse transfers it to the other, and the other spouse either takes action or doesn’t take action. So, Steve, do you want to expand on that or other points on Smaldino?
Stephen Akers: Just some last comments I would make is that there is authority out there that this case cited 3 cases. There are various others that have discussed this indirect gift sort of concept. If A makes a transfer to B, with just the clear understanding B’s going to transfer to C, then treat it as a transfer from A to C. And I think all the comments that Lou’s made are good. Don’t have an express agreement by all means. Which apparently they did in the Smaldino case. And then, do everything possible to avoid the implied agreement.
I like your idea of adding some time in between. Maybe, preferably if you could wait until the next tax year; that’s not always possible. Do everything you can to document that the initial recipient is making an independent decision to make the subsequent gift. Maybe even wait long enough so that the first person could actually receive some distributions out of the asset.
This could have even more devasting effects in a SLAT sort of scenario where, for example, the husband is transferring assets to the wife, and then the wife transfers the assets into a trust of which the husband is a beneficiary. In that situation, if the IRS is successful in saying that indirectly the husband made the gift into the SLAT where the husband is a beneficiary, IRC Section 2036 might apply.
So, we would want to be very careful to apply all of these special planning issues just as much as we can to avoid the problem. So, very interesting case and planning implications coming from Smaldino.
Travis Hayes: Thank you, Steve and Lou, for discussing the Smaldino ruling and its implications on estate planning and gift transactions.
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