Real estate has been a great investment. In addition to the potential for appreciation of the property, it may also have the added benefit of producing rental or other income.
Real estate can also have income tax advantages. This can help reduce one’s income tax liability during their peak earning years. Many taxpayers buy real estate for income tax advantages.
They also buy real estate to store value. It’s this feature of real estate that leads to estate planning challenges.
Given that the Federal estate and gift taxes can approach 50 percent of the value of the asset, those with significant real estate holdings have to plan their estates. This often involves making lifetime gifts to transfer an interest in real estate to children or others (which accomplish the same thing but differ from fraudulent transfers made near death to avoid paying the IRS).
The recent Smaldino v. Commissioner, T.C. Memo. 2021-127, case provides an opportunity to consider one of the ways the IRS can unwind these types of tax-motivated estate plans.
Facts & Procedural History
This case involved a husband and father who wanted to provide for his spouse and his children. The children were from a prior marriage.
The husband owned rental properties that he, his wife, and his children managed. His estate exceeded $80 million.
As part of his estate plan, he wanted to provide the real estate to his children and provide other assets to his spouse. He could only transfer up to 50 percent of the property as it was held in an LLC. California law would trigger a revaluation of the real estate in the LLC for property taxes if more was transferred. So the plan was to transfer up to a 50 percent interest in the LLC to his family members.
Given that the unified credit amount was just over $5 million (and that the husband already had used up or had a plan for his unified credit amount), he also wanted to use up the spouse’s unified credit amount to reduce the gift taxes due on the transfer.
To accomplish this, the husband and wife executed the following plan:
- Transfer an interest in the LLC to his spouse (which is gift tax free)
- Have the spouse transfer the interest in the LLC to his irrevocable dynasty trust for the benefit of his children and grandchildren (which could use up the $5 million unified credit amount).
The husband’s son was the trustee of the dynasty trust.
The husband also made a smaller $6 million transfer to the trust. This required that he file a Federal gift tax return to report this smaller transfer.
On audit by the IRS of the gift tax return the husband filed, the IRS asserted that the husband made the larger transfer, not the wife, and therefore, the husband was liable for gift taxes on the full amount of the transfer.
Litigation ensued in the U.S. Tax Court.
About the Federal Gift Tax
The Federal gift tax is set out in Section 2501. It imposes a separate tax on gratuitous transfers of property. The tax is levied on the right to make the transfer.
There are several exclusions, including the:
- Section 2503(b) annual exclusion of up to $15,000 per donee
- Section 2503(c) transfer to a minors trust
- Section 2523(a) transfer to a spouse
- Section 2505 unified credit amount
The Section 2505 unified credit amount is technically not an exclusion. It is a tax credit that functions like an exclusion. The amount of the credit has varied over time. It was just over $5 million during the 2013 year at issue in this case.
The gift tax is paid by the donor of the property. For gifts made by those who are married, half of the gift by one spouse can be deemed to have been made by the other spouse if timely consent is granted by the spouses.
The Form Matters; Substance Does Too
This brings us back to this case. The wife purported to use up her $5 million unified credit. The IRS argued that the transfer was between the husband and the husband’s dynasty trust.
The IRS based its argument on the judicial doctrine referred to as substance over form. This judicial doctrine allows the courts to recast transactions to comport with the economic realities of the transaction.
The court focused on the language of the LLC operating agreements. It noted that the Class B shares in the LLC, in which the wife was transferred and which were in turn transferred to the children, were not full membership interests.
The LLC operating agreement said that these interests were not full membership interests. They were economic interests and they lacked voting rights. The LLC operating agreement also did not include the transfer to the spouse as a permitted transfer.
The LLC operating agreement was not updated to reflect that the wife owned an interest (even if temporarily) and the LLC’s income tax returns did not reflect her ownership either.
Given these circumstances and the express intent to use up the wife’s unified credit amount, the court agreed with the IRS. It did not really have to get to the substance over form argument as the form was not correct. But the court did signify that the substance over form doctrine applied. Either way, it imposed gift taxes on the husband for the full value of the transfers.
The type of marital transfer described in this case can be accomplished in several different ways. Given the very high rate of tax imposed on gift transfers, this type of tax planning can go a long way to reducing the gift taxes due.
Those who follow this method of making a gift might consider documenting the transfers and the reasons for the transfers consistent with the substance over form cases. This may include examining the reasons for the transfer and allowing more than one day between the steps in the transfers, as in this case.
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