A recent Tax Court case, Smaldino v. Commissioner, T.C. Memo. 2021-127 (November 10, 2021) emphasizes the need to ensure that the phases of transactions are completed properly, and certain formalities are observed in order for an estate planning strategy to be successful. It is important to be careful even (and perhaps especially) in the case of emergency planning (i.e., planning because of health scares or impending tax law changes).
In the Smaldino case, rushed planning caused a tax deficiency that may have been avoided with a team of advisors working together to ensure that Mr. and Mrs. Smaldino’s plan was properly implemented.
Mr. and Mrs. Smaldino were married in 2006. Mr. Smaldino had 6 children from a prior marriage and 10 grandchildren. Mr. Smaldino was a CPA turned real estate investor, with a real estate portfolio worth approximately $80 million. Mrs. Smaldino held a master’s degree in economics and had worked in her husband’s business for many years.
In 2003 Mr. Smaldino established Smaldino Investments, LLC, of which Mr. Smaldino was a member, as well as a revocable trust called the Smaldino Family Trust. In 2012 when he was 69, Mr. Smaldino had a health scare and transferred interests in 10 different parcels of real estate into the LLC. The LLC interests were then contributed to the Smaldino Family Trust.
The LLC’s operating agreement distinguished a “Member” from an “Assignee.” Mr. Smaldino was a member of the LLC; Mrs. Smaldino was not a member.
The LLC’s operating agreement differentiated the assignment of economic rights in the LLC from the transfer of membership interests. It stated that “no member” was entitled to transfer or assign any part of the member’s ownership interest “except as expressly provided for in Section 11.5(c).” Section 11.5(c) provided for transfers of membership interests without prior board approval only to (1) other members and (2) to trusts created for the benefit of a member’s descendants.
On December 21, 2012, Mr. Smaldino established the Smaldino 2012 Dynasty Trust for the benefit of his children and grandchildren. On April 14, 2013, Mr. Smaldino transferred approximately 41% of LLC interests to Mrs. Smaldino. Mr. Smaldino’s transfer to Mrs. Smaldino was not among the types of transfers expressly provided for in Section 11.5(c) of the operating agreement. Therefore, Mrs. Smaldino was an assignee of the LLC interests and not a member. The very next day, Mrs. Smaldino gave those same LLC interests to the Smaldino 2012 Dynasty Trust. The transaction was an attempt to use Mrs. Smaldino’s federal estate and gift tax exemption in order to shelter a gift to the Dynasty Trust from federal gift tax. Mrs. Smaldino reported the gift to the Dynasty Trust on a Gift Tax Return and allocated her estate and gift tax exemption to the gift.
However, the Tax Court recharacterized the gift Mr. Smaldino made to his wife followed by her gift to the Dynasty Trust as if Mr. Smaldino himself had made the gift directly to the Dynasty Trust, deeming Mrs. Smaldino as no more than a straw person. Because Mr. Smaldino did not have sufficient exemption remaining to shelter the gift from the tax, the IRS assessed Mr. Smaldino a $1,154,000 gift tax deficiency, which was upheld by the Tax Court.
Some key steps that went wrong in Smaldino:
- Mrs. Smaldino held her LLC interests for only one day before she transferred those interests to the Dynasty Trust. The transaction may have passed muster had she waited longer. Some recommend a minimum of 30 days, others say 60 plus.
- Mr. Smaldino, who controlled the LLC, never amended the LLC documents to reflect that Mrs. Smaldino was the owner of some of the LLC interests. When a donee receives an interest in an LLC or other entity, the governing legal documents should reflect the change in ownership.
- Mrs. Smaldino was never formally recognized by the LLC as a member. The LLC documents made a distinction between an assignee and a member. Mrs. Smaldino was not a member of the LLC and arguably did not have the power to transfer her LLC interests according to the operating agreement.
- Following Mrs. Smaldino’s transfer of interests to the Dynasty Trust, the LLC operating agreement should have been amended to reflect the Smaldino Dynasty Trust as owner
The Smaldino case is a cautionary tale to ensure that the various phases of a plan are carried out in the proper order. If entities such as LLCs and partnerships are involved, corporate and partnership formalities should be observed. Transferors should have the authority under the documents to make any contemplated transfers. Transferees should be determined to be appropriate recipients of assets or interests before the transfers take place.
In the current estate planning climate, where large gifts are being made to spousal lifetime access trusts (SLATs) and other entities, it is extremely important to ensure that the components of a plan occur in the proper order in order to avoid a recharacterization similar to what occurred in Smaldino v. Commissioner. For example, when married couples have mostly jointly held assets and are looking to implement SLATS care and thoughtful planning should be taken.
In connection with rushed planning, we saw this in 2021 when urgency was felt by proposed Legislation that would potentially eliminate many of the benefits of estate planning techniques and the possibility that Congress might make some changes retroactive. This caused some families to want to finish transactions in a rushed manner.
This type of urgency will most likely only increase in the next several years. In 2026, the current estate tax exemption will revert to a much smaller amount. Congress could also decide to take the opportunity and completely change the exemptions as well.
In the Smaldino v. Commissioner rather than rushing into a series of transactions that were not documented properly, perhaps they could have used a Lifetime QTIP trust and achieved the same results. Estate planning attorneys are already familiar with the benefits of a QTIP trust in planning, especially planning for mixed marriages. The QTIP trust qualifies for the unlimited marital exemption to both the gift tax and the estate tax. Mr. Smaldino could have gifted the interests into a Lifetime QTIP trust for Mrs. Smaldino. The trust then could have passed the ownership interests to the Dynasty Trust on the death of Mrs. Smaldino. No gift tax exemption would be used and on Mrs. Smaldino’s death the assets would be included in her estate to use the remaining exemption.
This planning tool may be more and more important as the year end planning crunch hits each year and 2026 approaches. For 2022, the annual gifting exclusion is $16,000 and the lifetime estate and gift tax exemption is $12.06 million. In 2026, the exemption is scheduled to decrease to $6 million dollars.