Just in time for Christmas, the tax court has handed down an opinion that gives us abject lessons in gifting, blended families, entity formalities, trusts and estate planning

That should be a tip-off that the taxpayer did not fare well. 

The Smaldino Case

The case involved gift taxes, specifically on a gift of LLC interests to a dynasty trust. The interests were first funneled from the husband’s trust to his wife, who then transferred them to a dynasty trust set up to benefit some of the husband’s children from a prior marriage.  

Taxpayers are not required to report gifts between spouses. The husband’s gift to his spouse was not reported to the IRS.  She reported her gift to the IRS, but did not have to pay any gift taxes because the reported value did not exceed her lifetime gift tax exemption. Thus, no gift taxes were paid on that transfer of the LLC interests to the trust.  

The IRS was not amused and assessed the husband a $1,154,000 gift tax deficiency. The assessment was upheld by the tax court.  

This case should be required reading for any person who has an interest in an entity or a trust. It emphasizes the importance of following corporate formalities, especially when families are involved.   

The Importance of Corporate Formalities

There were a number of facts in the case that the court found suspect.  

The wife held her LLC interest for only one day before she transferred it to the trust. This was a suspiciously short period of time. The scheme would have been more believable had she waited longer.   

The wife never acted as though she were going to keep the interests.  She testified that before she received the assignment of shares, she had committed to transferring them to the trust. She said she would not have changed her mind about transferring the interest because “I believe in fairness.” 

Corporate formalities mattered a lot to the court. The husband, who controlled the LLC, never amended the LLC documents to reflect that the wife held an interest.  

The wife was never formally recognized by the LLC as a member. The LLC documents made a distinction between an assignee and a member. The husband had executed an assignment of the interests to the wife, but she never took the required steps to become a member of the LLC.   

The court found that some of the corporate documents were just not believable. Some of the corporate documents were undated. Others had an “effective date” but did not reflect the date of signing.  

Despite these circumstances, how could the IRS disregard what the actual documents said? Two reasons.  There is a rather inconvenient doctrine used by the tax court of “substance over form.” It is the substance of a transaction, rather than the form in which it is cast, that determines the tax consequences. The second reason is that a transaction that involves family members is subject to heightened scrutiny to make sure it is not a sham.  

Take this to heart. 

When you structure a transaction, make sure you follow through on the storyline. Intent must be shown through consistent actions.

Read the operating agreement, bylaws or trust agreement and adhere to them scrupulously.

When a transaction is between family members, be very conservative. Indirect transfers can be costly, in more ways than just money.  

For 2021, the annual gifting exclusion is $15,000 and the lifetime estate and gift tax exemption is $11.7 million. For 2022, the numbers are $16,000 and $12.06 million, respectively.

Hammerle Finley Can Help You With Your Estate Planning Needs

If you have questions about your estate planning options, schedule a consultation with an estate planning attorney at Hammerle Finley to discuss what is right for you.

Virginia Hammerle is an attorney with Hammerle Finley Law Firm.  She is entering her 40th year in the practice of law.  She is Board Certified in Civil Trial Law by the Texas Board of Legal specialization. Contact legaltalktexas@hammerle.com to receive her firm’s newsletter.