Same old in D.C.
On Monday, November 15, the President will sign into law the approximately $1 trillion Infrastructure Investment and Jobs Act that was finally passed by Congress when the House approved the Senate’s version of the legislation on November 5. According to various reports, an estimated $6 billion of this monumental sum will find its way into Senator Manchin’s West Virginia:
“[Manchin] said $3 billion will go to federal highway programs in the state; nearly $200 million will go to complete Corridor H of the Appalachian Development Highway System, which is known within the state as the Robert C. Byrd Highway System; $190 million for statewide transit; $43 million for state airports and $700 million to rehabilitate abandon [sic] mine lands.”[i]
Meanwhile, the Senator has yet to endorse the Build Back Better bill,[ii] on which the House has not yet voted as it awaits the Congressional Budget Office’s report on the projected economic cost of the legislation.[iii] Query whether he will in its current form considering the House Rules Committee reinserted into the bill certain provisions opposed by Senator Manchin (such as paid family and medical leave and the tax credits for businesses that use union labor to manufacture electric vehicles); the Senator’s vote remains critical to the bill’s success in the Senate, assuming it reaches the upper house of the Congress.[iv]
In the Real World
As our nation’s leaders continue to do anything but lead – they’re too busy thinking about their prospects for re-election in 2022 – the owners of many closely held businesses continue to sell to private equity firms[v] in advance of what they anticipate will be a new surcharge on taxable income, and the expanded application of the existing 3.8 percent surtax on net investment income, both beginning in 2022.[vi]
At the same time, however, the pressure on other business owners for completing transfers by gift, or by sale to a grantor trust, before the year-end seems to have abated. Those provisions of the Build Back Better bill that had called for the immediate reduction of the basic exclusion amount,[vii] the wholesale revision of the grantor trust rules,[viii] and the limitation of valuation discounts, have been removed from the bill and are no longer under consideration.[ix]
Back to “Normal” Gift Planning?
Consequently, many business owners who thought they were in a use-it-or-lose-it, beat-the-clock-type situation with respect to their gift tax exemption[x] have taken a step back to reassess whether they are ready[xi] to make significant year-end transfers for gift and estate tax purposes.
Hopefully, if one of these individuals decides to make such a transfer, they will act prudently to determine the economics of the transaction (including the proper valuation of the asset to be gifted) and they will observe “corporate formalities” to memorialize the steps undertaken to effectuate the transfer as if they were dealing at arm’s length with an unrelated party.
It’s impossible to overstate the importance of treating a purported gift transfer consistently for tax, corporate and other record-keeping purposes.[xii] Any lapse from this principle could cost a taxpayer dearly, as illustrated by the case described below.[xiii]
Taxpayer developed a plan to provide his progeny a bundle of assets consisting of certain rental real properties, and to provide Spouse a separate group of assets.
Pursuant to this plan, Taxpayer created a revocable trust (“Rev Trust”) and named himself trustee thereof.[xiv] Taxpayer also organized a limited liability company (“LLC”) to which he contributed the above-referenced real properties before transferring all of LLC’s membership interests to Rev Trust, which thereby became the sole member of LLC, with Taxpayer as its manager.[xv]
In addition, Taxpayer created an irrevocable trust, Dynasty Trust, and appointed one of his children to act as its trustee. The beneficiaries of Dynasty Trust were Taxpayer’s children and grandchildren – Spouse was not a beneficiary of the trust.
Taxpayer decided to transfer up to 50 percent of LLC’s membership interests to Dynasty Trust.
The Gift Transfers
Acting in his capacity as trustee of Rev Trust,[xvi] Taxpayer executed a document which purported to assign to Spouse that number of units in LLC “so that the fair market value of such [units] as determined for federal gift tax purposes shall be Five Million Two Hundred Forty Nine Thousand One Hundred Eighteen and 42/100ths Dollars ($5,249,118.42)”.[xvii] This amount represented Spouse’s then-available Federal estate and gift tax exemption. Although the document was signed by both Taxpayer and Spouse, it was not dated.
The next day, Spouse executed another document by which she purported to transfer to Dynasty Trust the LLC units that Taxpayer had purportedly assigned to her.[xviii] The trustee of Dynasty Trust and Spouse both executed the document but did not date it.
In addition to the foregoing transfers, and again acting as trustee of the Rev Trust, Taxpayer executed a document by which Taxpayer transferred to Dynasty Trust a “sufficient number” of LLC units “so that the fair market value of such [units] as determined for federal gift tax purposes shall be One Million Thirty One Thousand Eight Hundred Eighty One and 58/100ths Dollars ($1,031,881.58)” (the balance of Taxpayer’s exemption amount). This document was signed by both Taxpayer and the trustee of Dynasty Trust but did not indicate the date it was executed.
At the end of the day, Dynasty Trust held 49 percent of LLC’s units that previously had belonged to Taxpayer.[xix]
The LLC operating agreement (“Agreement”)[xx] was never amended to account for any transfer of units to Spouse, though it was amended to show Dynasty Trust as holding units representing a 49 percent ownership interest in LLC and to show Taxpayer, as trustee of the Rev Trust, holding the remaining 51 percent ownership interest (consisting of the remaining nonvoting units as well as all the voting units).
Moreover, when the Agreement was amended one day after the purported transfer to Spouse (to address the issue of compensation to LLC’s manager), the amendment indicated that Taxpayer, as trustee of the Rev Trust, was LLC’s “sole member.” When the amended provision was subsequently restored to the Agreement, the amendment identified Taxpayer and Dynasty Trust as LLC’s Members.
When LLC filed its initial partnership tax return on Form 1065, U.S. Return of Partnership Income, the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., attached to the return identified Taxpayer as a 51 percent member and the Dynasty Trust as a 49 percent member for the whole year. Spouse was not listed as a member for any part of the taxable year.
Gift Tax Returns
Taxpayer’s Federal gift tax return reported a taxable gift to Dynasty Trust of $1,031,882 (an 8.05 percent membership interest in LLC). Taxpayer did not elect to split the gift with Spouse.[xxi]
Significantly, Taxpayer did not report any gift to Spouse.
On her Federal gift tax return, Spouse reported a taxable gift to Dynasty Trust of $5,249,118 (a 40.95 percent membership interest in LLC). Spouse allocated her remaining Federal estate and gift tax exemption against this transfer, resulting in zero reported gift tax due.[xxii] She did not elect to split the gift.
The IRS determined that Taxpayer owed gift tax on the above transfers and issued a notice of deficiency. According to the notice, Taxpayer had made taxable gifts of LLC interests that included not only Taxpayer’s direct transfers to Dynasty Trust but also the LLC interests which the IRS asserted were transferred indirectly through Spouse.[xxiii]
Taxpayer petitioned the U.S. Tax Court for relief.
The Court’s Analysis
The issue for decision was the proper characterization for gift tax purposes of Taxpayer’s purported transfer of LLC interests to Spouse, followed by Spouse’s purported retransfer of these same interests to Dynasty Trust.
The Court started by explaining some basic rules: that the gift tax is imposed on an individual’s “transfer of property by gift,” that it applies “whether the transfer is in trust or otherwise, whether the gift is direct or indirect,” and regardless of the nature of the property; and if an individual transfers an interest in property to their spouse as a gift, the value of such property interest is generally allowable as a deduction in computing the individual donor’s taxable gifts.
The parties agreed, the Court stated, that the total LLC units transferred to Dynasty Trust constituted a 49 percent equity interest in the LLC. However, the Court continued, the parties disagreed about the extent to which these transfers should be characterized as gifts from Taxpayer (rather than Spouse) to Dynasty Trust.
Taxpayer contended that he gave to Dynasty Trust only an 8.05 percent membership interest in LLC. Taxpayer also contended that Dynasty Trust received a 40.95 percent membership interest as a gift from Spouse and not from him.
The IRS asserted that Taxpayer made a taxable gift to Dynasty Trust of a 49 percent membership interest in LLC, including an indirect gift of the 40.95 percent interest that Taxpayer purportedly transferred to Spouse and that Spouse purportedly transferred to Dynasty Trust a day later.
Substance Over Form
Before reviewing the parties’ respective positions, the Court reminded them that the substance of a transaction, rather than the form in which it is cast, determines the tax consequences “unless it appears from an examination of the statute and its purpose that form was intended to govern.” The gift tax provisions of the Code, the Court continued, implicitly embody principles of substance over form by including “indirect” transfers in the definition of a taxable gift.
The Court also reminded the parties that “[h]eightened scrutiny is appropriate in cases, like the one before it, where all the parties to the transaction in question are related” to ensure that the transaction is not something other than what it purports to be.
The IRS argued that the doctrine of substance over form demanded that the Court disregard Taxpayer’s purported transfer of LLC interests to Spouse, as well as her purported retransfer of these same interests to Dynasty Trust a day later, because these actions were “part of a prearranged plan between all parties involved to effectuate the transfer of the ownership of the LLC” from Taxpayer to Dynasty Trust. The IRS urged the Court to treat the two purported transfers as an indirect gift from Taxpayer to Dynasty Trust.[xxiv]
Taxpayer did not expressly dispute that the transactions in question were part of a prearranged plan to transfer ownership of 49 percent of LLC’s membership interests to Dynasty Trust while using Spouse’s estate and gift tax exemption.
Spouse testified that before the purported transfer in question she had already made “a commitment, promise” to Taxpayer that she would transfer the LLC units to Dynasty Trust. When asked on direct examination whether she could have changed her mind if she had wanted to, Spouse responded that she would not.
Nevertheless, Taxpayer urged the Court to respect the purported transfer of the LLC membership interests to Spouse because, he said, it was “sanctioned” by the marital deduction, which generally exempts interspousal transfers from gift tax. “The legislative policies informing the marital deduction,” Taxpayer argued, “negate the substance over form doctrine” as the IRS sought to apply it.[xxv]
Consequently, Taxpayer urged the Court to reject the IRS’s recharacterization of the purported interspousal transfer of the LLC interests as an indirect gift from petitioner to the Dynasty Trust.
The Court’s Opinion
The Court rejected Taxpayer’s position, stating that the marital deduction applies only if the donor “transfers * * * an interest in property” to their spouse. Unfortunately for Taxpayer, the Court concluded that Taxpayer’s actions were ineffective to transfer membership interests in LLC to Spouse. Thus, the marital deduction was inapplicable.
Instead, the Court concluded that, in substance, Dynasty Trust received all its membership interests directly and indirectly from Taxpayer.
As a threshold matter, the Court observed that Taxpayer’s execution of an assignment document to Spouse, although a factor to be considered, was not controlling; rather, the “circumstances surrounding the writing must show that the writing was meant to be effective.”
In accordance with these principles, the Court stated that “courts have often recognized that the tax consequences of a transaction involving a nominee or straw party must be determined with regard to the true beneficial interests involved.”
The Court observed that LLC’s Agreement distinguished the assignment of economic rights from the transfer of membership interests. The Agreement stated that “[n]o member” shall be entitled to transfer or assign any part of the member’s ownership “except as expressly provided.” The Agreement provided for transfers of membership interests, without prior board approval, to trusts created for the benefit of Taxpayer’s descendants (e.g., Dynasty Trust). Taxpayer’s purported transfer to Spouse was not among the permitted types of transfers.
Moreover, even if one accepted that Spouse became an Assignee, nothing in the record suggested that Spouse ever executed any instrument that, under the terms of the Agreement, would have bestowed upon her anything more than an Assignee’s interest in LLC as a result of the purported transfer in question.
Nor did the record suggest that Taxpayer, in his dual roles as trustee of the Rev Trust and as manager of LLC, consented to the admission of Spouse as a Member in disregard of the Agreement’s restrictions. To the contrary, the record showed that a day after Taxpayer purportedly transferred LLC membership interests to Spouse, Taxpayer executed an amendment to the Agreement which identified the Rev Trust as LLC’s “sole member.”
The Agreement was never amended to show that Spouse held any membership interest. Instead, the Agreement was amended only to show that Dynasty Trust held a 49 percent membership interest in LLC and to show Taxpayer, as trustee of the Rev Trust, holding the remaining 51 percent interest.[xxvi]
Finally, LLC’s partnership tax return for the year of the gift reported that the only members were Taxpayer with a 51 percent interest (ostensibly by virtue of his role as trustee of the Rev Trust) and Dynasty Trust with a 49 percent interest. The return did not report Spouse as being a member at any time.
On the basis of the foregoing, the Court concluded that Taxpayer never effectively transferred any membership interest in LLC to Spouse and consequently that Dynasty Trust received its entire 49 percent interest from Taxpayer.
Accordingly, the Court sustained the IRS’s determination that Taxpayer made a taxable gift to Dynasty Trust of a 49 percent membership interest in LLC.
Be Careful Out There
Taxpayer should not have incurred a gift tax liability. He properly sought to shift assets to his Spouse on a “tax-free” basis, which she could then transfer to Dynasty Trust using almost all of her exemption amount.
Unfortunately, and for some reason that was not disclosed in the Court’s opinion, Taxpayer rushed to complete the transfers described above. Thus, Spouse was never able to exercise dominion and control over the LLC interests purportedly transferred to her; stated differently, the first part of Taxpayer’s plan (the “gift” to Spouse) was not allowed to grow relatively “old and cold,” to borrow a phrase from the world of corporate tax, before Spouse’s transfer to Dynasty Trust.
Perhaps as importantly, at least based upon the Court’s opinion, was the Taxpayer’s income tax and gift tax reporting with respect to LLC and the transfer of the membership interests, both of which were inconsistent with Taxpayer’s claim that Spouse had become a member of LLC.
As always, the taxpayer and their tax advisers need to ensure that there is economic reality to every transaction they undertake, that they memorialize the transaction contemporaneously with carrying it out, and that they report it consistently with its economic consequences for tax purposes.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] “Manchin Sees his Power Grow,” by Alexander Bolton, The Hill (November 9, 2021).
Senator Byrd, after whom the highway system is named, was one of the most influential individuals ever to serve in Congress. (Three terms in the House, followed by over 50 years in the Senate. Way too long.)
Did you know that the residents of West Virginia have the highest dependence on government benefit payments in the country?
[ii] I’ll never get used to that much alliteration. H.R. 5376, Build Back Better Act, Rules Committee Print 117-18.
[iii] We still don’t know when the CBO’s score will be issued. Although many believe it will be this week (beginning November 15) and that the House will vote on the bill before Thanksgiving, the CBO has stated its report could be delivered as late as the week of Thanksgiving.
Speaking of which, the Congress is scheduled to take a one-week Thanksgiving break, returning to the Capitol on November 29. That week is probably the earliest that the Senate would consider a House-passed version of the bill.
What if the two Chambers pass different versions? When will a conference committee meet to iron out those differences?
Doesn’t the continuing resolution for funding the federal government expire on December 3?
Doesn’t the temporary suspension of the federal debt cap expire at around the same time? Didn’t Senate Minority Leader McConnell say the Democrats will have to use the reconciliation process to raise the debt cap?
Time to cancel those Congressional vacation plans? You bet.
[iv] A couple of reminders: it was a group of moderate Democrats in the House who requested the CBO’s score of the bill, and it seems the Dems can’t agree on how to relax the SALT cap (though the folks from New York, California and New Jersey have some strong opinions).
[v] Hell, I received a draft LOI late last week. I’ve dreaded the holidays for four decades, but this may be the worst. Anyone know the lyrics to “Casey’s Last Ride” by Kris Kristofferson, performed by John Denver?
[vii] IRC Sec. 2010.
[viii] To eliminate inconsistencies between the income taxation of grantor trusts and the estate/gift tax regime.
If the Dems somehow increase their majority in Congress after the mid-term elections in 2022 – this seems doubtful at the moment – they will certainly revisit the estate tax. Regardless, they are also likely to reintroduce some version of the “anti-abuse” valuation regulations proposed in 2016 and later withdrawn by the Trump Administration.
[x] Currently at $11.7 million per U.S. individual. It is scheduled to return to pre-2018 levels after 2025.
Last week, coincidentally, shortly after the Bureau of Labor Statistics announced that inflation was up 6.2 percent from a year ago (the largest increase since late 1990), the IRS released Rev. Proc. 2021-45 with the inflation adjustments for 2022. Among these: the annual gift exclusion was increased from $15,000 to $16,000, and the unified gift/estate tax exclusion amount was increased from $11.7 million to $12.06 million (an increase of $360,000).
[xi] It’s often the tax tail wagging the non-tax dog, or something like that. (Query whether such a dog would be chasing its tail or running away from it.) Many taxpayers are so averse to not taking advantage of every available tax benefit – like giving away assets to capture the benefit of their gift tax exemption amount – that they ignore the economic costs of doing so, like finding themselves dependent upon the trusts to which they have made such “irrevocable” transfers. Moreover, think about inclusion of the gifted assets in such a donor’s gross estate under IRC Sec. 2036.
[xii] For example, anyone who has represented a closely held business knows that stock certificates are often not issued and that stock ledgers are kept in a corporate book but are not to be written on. Then there is the question of shareholder and director minutes or, rather, the complete absence thereof.
[xiii] Smaldino v. Commissioner, T.C. Memo 2021-127 (Nov. 10, 2021).
[xiv] There are non-tax reasons for establishing and “funding” a revocable trust.
[xv] Thus, LLC was initially a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.
[xvi] Any transfer from a revocable trust to someone other than the grantor of the trust (who has reserved the right to revoke the trust) is treated as a transfer from the grantor. The House Ways and Means version of the Build Back Better bill sought to extend this principle to all grantor trusts, not only those that are revocable by the grantor.
[xvii] Each of the transfer documents described the transferred LLC interests not in terms of percentage interests but rather in terms of a defined value, i.e., a “sufficient number” of nonvoting units in the LLC “so that the fair market value of such nonvoting units as determined for federal gift tax purposes shall be” a specified dollar amount. Think Wandry, T.C. Memo. 2012-88.
Taxpayers are not required to file gift tax returns for transfers between spouses.
[xviii] It is not uncommon for a wealthier spouse to gift assets to their spouse to enable the latter to utilize their federal gift/estate tax exemption. Of course, the introduction of portability between a deceased spouse and their surviving spouse, beginning in 2011, has reduced somewhat the need for such interspousal transfers of assets. That said, if the goal is to make lifetime gifts that exhaust both spouses’ exemption amounts, one spouse may have to transfer some assets to the other spouse.
[xix] More precisely, the Dynasty Trust ended up with 49% of the aggregated 1,000 class A voting units and class B nonvoting units, or 49.49% of just the class B nonvoting units.
[xx] The Agreement distinguished a “Member” from an “Assignee” – a Member had both an economic interest in LLC and the right to participate in LLC’s affairs; an “Assignee” had an economic interest in LLC, but lacked other rights accorded to Members, including the right to vote or participate in management.
The Agreement further stated that a Member could not transfer their LLC interest except as provided in the Agreement, and that an Assignee could not be admitted as a Member except as provided in the Agreement.
An Assignee of a Membership Interest could be admitted as a Member only if the Assignee agreed in writing to be bound by the Agreement and paid any reasonable expenses incurred by LLC in connection with such Assignee’s admission.
Notwithstanding the foregoing, an Assignee would automatically be admitted as a Member if the Assignee was a trust for the benefit of Taxpayer or his children, grandchildren, and other descendants (for example, Dynasty Trust).
In the case of a transfer in violation of the Agreement, the transferee would be only an Assignee; they would be allocated a share of LLC income and would receive a distribution when entitled thereto under the Agreement.
[xxi] The gift-splitting election of IRC Sec. 2513 allows married couples to treat gifts to third parties as though made one-half by each spouse even where only spouse owned and transferred the subject property. The election is made annually and covers all gift transfers made during the year.
Because Taxpayer had relatively little of his exemption amount remaining, any gift-splitting with Spouse would not have protected Taxpayer from tax liability. Thus, Taxpayer had to rely upon Spouse’s utilizing her own exemption amount.
[xxii] The opinion says nothing about the generation skipping transfer tax. It’s probably safe to say that Spouse’s exemption amount was allocated automatically to Dynasty Trust and that Spouse did not elect out of such automatic allocation. See IRC Sec. 2632(c).
[xxiii] A 49% (= 8.05% + 40.95%) membership interest in total.
[xxiv] In support of its position, the IRS relied upon a line of cases in which the courts employed substance over form principles to recharacterize multistep property transfers among related parties as indirect gifts between the persons who were determined to be, in substance, the actual donors and donees.
[xxv] Taxpayer’s gift tax return did not claim any marital deduction inasmuch as Taxpayer did not report any gift to Spouse.
[xxvi] The Court observed that the certificates of assignment from Taxpayer to Spouse, and from Taxpayer to LLC and from Spouse to LLC, were undated. On the basis of all the evidence in the record, the Court found it more likely than not that the undated certificates of assignment and associated operating agreement amendment were executed after the stated effective dates of the purported transfers of LLC membership interests to both Spouse and Dynasty Trust, as a practical matter there was never a time when Spouse would have been able to effectively exercise any ownership rights with respect to any LLC membership interests. Moreover, the Court did not believe that Taxpayer ever intended for Spouse to do so.