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? In short, what happened was that the trust was invalid.
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. In other words, the Tax Court found that the wife effectively acted as the agent for the husband in transferring the assets to the husband’s children.
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 explains 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.
BOOK A CALL with me, Ted Vicknair, Board Certified Estate Planning and Administration Specialist, Board Certified Tax Law Specialist, and CPA to learn more about estate planning, incapacity planning, and asset protection.
If you liked this article, “What Happens If a Trust Is Invalid?” read these additional articles: Can I Avoid Password Problems for My Family in Estate Planning? and Does Louisiana Have an Inheritance Tax? and Is Prince’s Estate Settled Yet? and How Do You Split an Estate in a Blended Family?
Reference: The Dallas Morning News (Dec. 19, 2021) “The Smaldino case: Tax court opinion leads to estate planning angst”