E-MAIL FROM FINANCIAL PLANNER OUTLINING LLC DISCOUNT GIFTING STRATEGY LEADS TO APPLICATION OF STEP TRANSACTION DOCTRINE09 / 08 / 2009
Heckerman v. United States, Case No. 2:08-cv-00211 (W.D.Wash. 2009)
A Federal court has found that when a couple attempted to make same day transfers of cash to a family LLC they had created, by then turning right around and gifting minority interests in the LLCs to trusts set up for their minor children, this would be properly treated as an indirect gift, directly to the children.
The couple transferred cash to the LLC on January 11, 2002, but could not prove that they then gifted the LLC units to the children subsequent to January 11, 2002. In other words, the "same day" nature of the transaction created significant problems. The court was not persuaded with arguments made at court that the assignment documents were signed later, especially when the "effective as of" date was January 11, 2002, and it became apparent that they treated them as such, on gift tax returns. The couple could not establish that their capital accounts were increased by the amount of their contributions to the LLC, because no contemporaneous capital accounts were maintained reflecting the account as an asset of the LLC at the time of transfer. The fact that the accounts were set up at the time when the tax returns were filed was insufficient.
Alternatively, the court was satisfied that the step transaction doctrine also applied because the couple clearly had a subjective intent to convey property to their children while minimizing their tax liability, pursuant to which they crafted with the help of their attorneys and advisors, a scheme consisting of "pre-arranged" parts of a single transaction (i.e., he and his wife wanted to fund the LLCs in such a way that would not trigger a gift tax). An October 9, 2001 e-mail from the couple's financial advisor explained the basic features of the gifting strategy:
"....when you place your funds into the LLC, no gift is being made (and therefore, no utilization of your unified credit). At that time, effectively you own 100% of an entity that now owns the $4 million of assets you have contributed. The gift for IRS purposes is made when you gift ownership in the LLC to the kids or their trusts. For examle, say you put $4,000,000 into the LLC. Immediately after, you own 100% of the LLC. You may then choose to gift 25% of the ownership of the LLC (not a gift of the assets the LLC holds) to each of the kids. Since we are using the LLC (and the resultant discounts), even though the combined 50% of the assets is $2,000,000, for gift taxes the IRS only considers the gift to be of $1,350,000. This gift of the LLC ownership is where you and your spouse's $675,000 exemptions are used. To get the remaining ownership of the LLC to your kids or their trusts, you will make gifts of LLC ownership equal to $20,000 (again grossed up for the discounts) to each child every year."
The court noted that in two other Tax Court cases, involving gifts of FLP units, Holman v. IRS, 130 T.C. 12 (2008) and Gross v. IRS, 96 TCM at 187, 6 days and 11 days, respectively, passed between the transfer of securities at issue and the gifting of the partnership interests, and there were findings of fact that the taxpayers actually bore a real economic risk that the value of the units could change during that time, given the volatile natue of the underlying securities.