What Happens If a Trust Is Invalid?

Lessons about gifting, blended families, entity formalities, trusts and estate planning may all be found in the outcome of a tax case described in The Dallas Morning News’ article “The Smaldino case: Tax court opinion leads to estate planning angst.” The case involves gift taxes, and more particularly, a gift of LLC interest to a dynasty trust. The interest started out in the husband’s trust, transferred to the wife, who then transferred them to a dynasty trust, created to benefit some of the husband’s children from a prior marriage.

You may know that taxpayers are not required to report gifts between spouses. The husband’s gift to his spouse was, therefore, not reported to the IRS. The wife did report her gift to the IRS, but she didn’t need to pay any gift taxes because the reported value didn’t exceed her own lifetime gift tax exemption. Therefore, no gift taxes were due or paid on the transfer of the LLC interest to the trust.

The IRS assessed the husband a $1,154,000 gift tax deficiency, which was subsequently held up by the tax court. What was wrong?

The IRS and the tax court found a number of red flags. For starters, the wife held her LLC interest for only one day, before transferring it to the trust.

In testimony before the court, the wife said she had committed to transferring the shares to the trust even before she received the assignment of the shares. She clearly stated that she would have not changed her mind about transferring the assets, which were to benefit her stepchildren. Her timing was too hasty, however.

The husband, who was in control of the LLC, neglected to amend the LLC documents to reflect his wife’s owning an interest in the LLC. As a result, she was never recognized formally as a member of the LLC. The LLC documents made a clear distinction between the roles and duties of an assignee and a member. He executed the assignment of the interest, but she never became a member of the LLC.

The tax court also found a number of the corporate documents simply unbelievable. Several were undated. Others had an “effective date,” but lacked the date of signing.

One could say the IRS was being picky, but the IRS doesn’t have the ability to disregard documents, for two reasons. One is the doctrine of the tax court known as “substance over form.” The substance of a transaction, rather than the form it is presented in, determines the tax determination. The second is something families need to take seriously: when transactions involve family members, the IRS uses a fine-tooth comb to be sure transactions are legitimate.

When estate planning entities are created and transactions take place, consistency in actions is needed to demonstrate intent. All of the rules and practices must be followed, and when family members are involved, those involved must go above and beyond to avoid any appearance of impropriety.

An estate planning attorney with experience in creating LLCs, transferring interests and procedures required by the IRS, does more than create documents. He or she educates clients and explain how the transactions should be carried out to ensure that proper procedures are being followed. In this case, the mistakes far outweighed any benefits from the transaction.

Reference: The Dallas Morning News (Dec. 19, 2021) “The Smaldino case: Tax court opinion leads to estate planning angst”

Will Inheritance and Gift Tax Exemptions Change in 2021?

The federal estate and gift tax exemption is applied to the sum total of a person’s taxable gifts during life and the assets they leave behind at death. In 2017, Congress doubled the exemption, starting in 2018. That number continues to rise with inflation until 2025, unless the laws are changed. According to the article “Estate and Gift Taxes 2021—2022: Here’s What You Need to Know” from The Wall Street Journal, the 2017 expansion cut the number of taxable estates from about 8,000 to about 3,000 in 2019.

Gift Tax Exemptions. In 2020, the exemption was $11.58 million per individual ($23.16 million per married couple). An inflation adjustment increased this amount to $11.7 million per person and $23.4 million per couple. For 2020 and 2021, the top estate-tax rate is 40%.

That increase is set to end in 2025, but both the Treasury Department and the IRS issued regulations in 2019 allowing the increased exemption to apply to gifts made while this increase is in effect, even if Congress lowers the exemption after those gifts were made.

Capital Gains After Death. Under current law, investments owned at the time of death are not subject to capital gains taxes. This is referred to as a “step-up in basis.” Congress and the Biden administration are now considering reducing or eliminating this benefit as a means of raising revenue.

Annual Gift Tax Exemptions. In 2020 and 2021, the annual gift-tax exclusion is $15,000 for each individual donor, for each individual recipient. You can give anyone up to $15,000 in assets per year and not owe any federal gift taxes. A generous couple with two married children and six grandchildren may give away $300,000 to their ten descendants. The couple could also give $30,000 to as many other people as they want, friends or family members or perfect strangers.

Above the $15,000 per donor, per recipient, gifts are subtracted from the lifetime gift and estate-tax exemption. Annual gifts are not deductible for income tax purposes and they are not considered income for the recipient. If the gift is not cash, the giver’s “cost basis” does carry over to the recipient.

Other Tax-Free Gifts. Another way to make a gift is to pay educational or health expenses for another person. The payment must go directly from the person giving the gift to the college, private school, or medical provider on behalf of another person. Otherwise, it will not have any tax benefit for the person giving the gift.

While a generous gift is always welcome, making a gift that is part of a holistic estate plan benefits you and your recipients. Speak with an experienced estate planning attorney about the role of gifting in your overall estate plan.

Reference: The Wall Street Journal (April 8, 2021) “Estate and Gift Taxes 2021—2022: Here’s What You Need to Know”