Step Transaction Doctrine

Jeffrey S. Glaser

People often don’t appreciate the need to fully and properly document intra-family transfers of assets, until it is too late. When documenting a transaction, shortcuts are at the taxpayer’s peril.  One taxpayer, after being slapped with a $1.1 million gift tax deficiency, undoubtedly wishes he could go back in time to pay the additional costs involved with “dotting all the i’s and crossing all the t’s.”

The Tax Court in Smaldino v. Commissioner applied the “step transaction doctrine” to transfers between spouses.  This case is unusual not just because the step transaction doctrine is somewhat rare in the world of gift and estate tax, but because it was applied to transfers between spouses, and raises the question: Is Smaldino a harbinger for attacks on gifts between spouses?

The facts in Smaldino are not unusual, but they are critical.  Husband (H) owned 100% of an LLC, which owned significant real estate investments.  H, who was married to Wife (W), had children by a prior marriage.  H wanted to make gifts of his LLC to a Trust that H created for his children, but wanted W to be the person making the gift to the Trust.  So, on Day 1, H made a gift to W by transferring LLC interests to W and then one day later, W made a gift to Trust by transferring the same LLC interests to the Trust.

Under the tax code, spouses are allowed to make unlimited gifts to one another, free of tax. Unfortunately, the paperwork documenting the two transfers and related circumstances that would ordinarily memorialize the transfers was so deficient, the Tax Court concluded that H never transferred the LLC interests to W.  As a result, the two transfers were effectively collapsed and the “substance over form” or “step transaction doctrine” was applied, meaning H and not W made the gift of the LLC interests to the Trust.  Because H did not have enough gift tax exemption to shelter the collapsed transfer, H must pay $1.1 million of gift tax.

If H and W could go back in time, they would want to change the following:

  • The LLC Operating Agreement did not permit transfers of LLC interests to a member’s spouse, without prior written consent from the LLC Board. H never signed such a consent. Before H transferred the LLC interest to W, H as sole board member should have signed a separate document consenting to the transfer.
  • Owners of the LLC are shown in an exhibit attached to the Operating Agreement. The exhibit was never amended to reflect W was a member. When H transferred the LLC interest to W, the exhibit should have been amended to reflect that W was a member, even for just 1 day.
  • Each LLC member must agree to the terms of the Operating Agreement.  W never agreed to the terms of the Operating Agreement. She should have signed a document indicating she agreed to be bound by the Operating Agreement.
  • Exacerbating matters, the Operating Agreement was amended by H as the “sole member” on the same day that W was purportedly an owner (the amendment concerned changes to a guaranteed payment provision).
  • The documents transferring the LLC interests first from H to W, and then by W to Trust, were never dated. They were simply “effective” on a specified date, meaning nothing indicates when the documents were signed. This led the Tax Court to conclude the documents were signed long after the “effective” date, when neither H nor W were owners.  The transfer documents should have been signed and dated at the time of the transfer.
  • The tax return for the LLC for the year when the transfers occurred did not show that W was an owner during the year. Every owner of the LLC – even if for only 1 day - should have been reflected on the LLC tax return.

Lesson to learn:  Treat a transaction between family members as though they were entering an arms-length transaction.  Clients may consider the extra paperwork as unnecessary, excessive, and expensive, but buttoning down all the proper documentation should be viewed as reasonable precautions to create an insurance policy so that, if and when the audit notice arrives, the clients are put in position to have the transaction respected.

Jeffrey S. Glaser