On November 10, 2021, the Tax Court issued a Memorandum Opinion in the case of Smaldino v. Commissioner (T.C. Memo. 2021-127). The primary issues presented in Smaldino were whether (1) the proper characterization for gift tax purposes of petitioner’s purported transfer of LLC class B member interests to Mrs. Smaldino followed by her purported retransfer of these same interests to the Dynasty Trust and (2) the fair market value of the LLC class B member interests that petitioner transferred, directly or indirectly, to the Dynasty Trust.
Executive Summary of Smaldino v. Commissioner
After practicing for a time as a certified public accountant and serving as the treasurer of a computer company, the petitioner Louis “Jumbo” Smaldino, purchased his father’s liquor store business, which he then operated for over 35 years. He eventually expanded his business holdings to include apartment buildings, which he managed as a sole proprietor. By 2008 he had sold all his liquor stores, and his only remaining business was owning and managing what ultimately became an $80 million portfolio of real estate.
Jumbo placed 10 of these properties in Smaldino Investments, LLC, which he owned through a revocable trust. In 2013 he transferred about 8% of the LLC class B member interests to the Smaldino 2012 Dynasty Trust, an irrevocable trust that he had created a few months earlier for the benefit of his children and grandchildren. Around the same time, Jumbo purportedly transferred about 41% of the LLC class B member interests to his wife, Agustina Smaldino, who purportedly retransferred them to the Dynasty Trust the next day.
On Jumbo’s 2013 gift tax return, he reported as a taxable gift only the approximately 8% of the LLC class B membership interests he had transferred directly to the Dynasty Trust. The IRS, however, determined that Jumbo had made a taxable gift to the Dynasty Trust of 49% of the class B membership interests, including the approximately 41% interest that assertedly had passed from Jumbo to the Dynasty Trust indirectly through Mrs. Smaldino. After revaluing the LLC interests, the IRS determined that Jumbo had a whopping $1,154,000 gift tax deficiency for 2013.
Jumbo has been married to Mrs. Smaldino since 2006. She has a master’s degree in economics and since about 1995, she has worked almost continuously all up in Jumbo’s businesses—first in his liquor-stores, after a three-year interval, in his property-management business. After a “health scare,” Jumbo put some estate planning in place.
Jumbo wanted to pass his business to his children (6) and grandchildren (10) and to give many of his remaining assets to Mrs. Smaldino. Similarly, she wanted Jumbo’s progeny to have the property-management business.
The Parties’ Contentions
The parties in Smaldino v. Commissioner agreed that the total LLC units transferred to the Dynasty Trust as of April 2013, constituted a 49% class B member interest in the LLC. The parties disagreed about the extent to which these transfers should be characterized as gifts from petitioner to the Dynasty Trust and the value of the transferred interests for gift tax purposes.
Jumbo contended that he gave to the Dynasty Trust only an 8.05% LLC class B member interest. He contended that the Dynasty Trust received the 40.95% LLC class B member interest as a gift from Mrs. Smaldino and not from him. He further contended that his 2013 gift tax return correctly reported the value of the 8.05% gift interest as $1,031,882, according to his expert’s appraisal, which opined that the fair market value of a 49% class B member interest in the LLC as of April 15, 2013, was $6,281,000.9
The IRS (from behind bulletproof glass) contended that Jumbo made a taxable gift to the Dynasty Trust of a 49% class B member interest in the LLC, including an indirect gift of the 40.95% class B member interest that he purportedly transferred to Mrs. Smaldino and that she purportedly retransferred to the Dynasty Trust a day later. Although the IRS determined in the notice of deficiency that the fair market value of the 49% class B member interest (the subject interest) was $8,180,000, in the Tax Court proceeding the IRS contended, on the basis of its own expert’s report and testimony, that the fair market value of the subject interest was actually $8,421,000.
The Old Substance Over Form Gambit
It is well established that the substance of a transaction, rather than the form in which it is cast, determines the tax consequences unless it appears from an examination of the statute and its purpose that form was intended to govern. IRC § 2511(a) implicitly embodies principles of substance over form by including “indirect” transfers in the definition of a taxable gift. Heightened scrutiny is appropriate in cases, such as this one, where all the parties to the transactions in question are related.
The IRS argued that the transfers were “part of a prearranged plan between all parties involved to effectuate the transfer of the ownership of the LLC” from Jumbo to the Dynasty Trust. In support of its position, the IRS relied on a line of cases in which the courts have employed substance over form principles to recharacterize multistep property transfers among related parties as indirect gifts between the persons who were determined to be, in substance, the actual donors and donees.
Jumbo countered that those cases are not controlling because none involved an interspousal transfer like the one at issue here. Jumbo did not expressly dispute, however, that the transactions in question were part of a prearranged plan to transfer ownership of 49% of the LLC class B member interests to the Dynasty Trust while using Mrs. Smaldino’s estate and gift tax exemption.
Argument: Court Should Ignore Substance in Favor of Form in this Case
Jumbo, nevertheless, urged that the Tax Court should respect his purported transfer of the LLC member interests to Mrs. Smaldino. He argued that it was sanctioned by IRC § 2523(a), which generally exempts interspousal transfers from gift tax. Jumbo cited the legislative history of IRC § 2523(a), and he also suggested that the legislative policies informing IRC § 2523(a) negated the substance over form doctrine as the IRS sought to apply it in this case. Consequently, Jumbo urged the Tax Court to reject the IRS’s recharacterization of the purported interspousal transfer of the LLC member interests as an indirect gift from petitioner to the Dynasty Trust.
Unfortunately for Jumbo, the Tax Court found that “pursuant to its terms,” IRC § 2523(a) applies only if the donor transfers an interest in property to his or her spouse. The Tax Court concluded that Jumbo’s actions were ineffective to transfer membership interests in the LLC to Mrs. Smaldino. Consequently, IRC § 2523(a) was inapplicable, and the Tax Court agreed with the IRS that in substance the Dynasty Trust received all its membership interests from Jumbo.
General Valuation Principles
After a long discussion of the mechanics of the transfers to the Dynasty Trust, the Tax Court entered the world of valuation.
Shameless Plug: For a much more detailed (and much more entertaining discussion of valuation), I highly suggest that you check out my article “Valuing a Complex Legacy: Lessons in Valuation From Estate of Jackson,” which was published by Bloomberg Tax.
As you know, a gift of property is valued as of the date of the transfer. If property is transferred for less than adequate and full consideration, then the excess of the value of the property transferred over the consideration received is generally deemed a gift. A gift is measured by the value of the property passing from the donor, rather than by the property received by the donee or upon the measure of enrichment to the donee.
Typically, the Tax Court considers information available on or close to the valuation date and facts that were reasonably known on the valuation date. For gift tax purposes, the value of the transferred property is generally the “price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
The determination of property value for gift tax purposes is an issue of fact, and all relevant factors must be considered. For gift tax purposes, transfers of interests in a single-member LLC are valued as transfers of interests in the LLC rather than as transfers of proportionate shares of the underlying assets.
The Tax Court was as skeptical of expert opinions as a carnivore unwittingly biting into a Tofurky sandwich. The Tax Court evaluates expert opinions in the light of all the evidence in the record and may accept or reject the expert testimony, in whole or in part, according to its own judgment. The persuasiveness of an expert’s opinion depends largely upon the disclosed facts on which it is based. The Tax Court may be selective in its use of any part of an expert’s opinion.
Ultimately, the Tax Court was persuaded to a greater extent by the IRS’s expert, though the court did adjust the IRS’s figure from $8.4 to $7.8 million.
- Just guessing on the nom de guerre. ↑
- One has to imagine that this is Tax Court code for “attempted mob hit.” ↑
- Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 265-267 (1958); Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945); Stewart v. Commissioner, 714 F.2d 977, 988 (9th Cir. 1983), aff’g T.C. Memo. 1982-209. ↑
- Sather v. Commissioner, 251 F.3d 1168, 1174 (8th Cir. 2001), aff’g in part, rev’g in part T.C. Memo. 1999-309. ↑
- See Brown v. United States, 329 F.3d 664, 673 (9th Cir. 2003); Kuney v. Frank, 308 F.2d 719, 721 (9th Cir. 1962) (noting that “[t]ransactions between persons in a close family group, whether or not involving partnership interests, afford much opportunity for deception and should be subject to close scrutiny” (quoting H.R. Rept. No. 82-586, at 33 (1951), 1951-2 C.B. 357, 381)); Estate of Bongard v. Commissioner, 124 T.C. 95, 119 (2005) (holding a “transaction between family members is subjected to heightened scrutiny to ensure that it is not a sham or disguised gift”). ↑
- See, e.g., Heyen v. United States, 945 F.2d 359 (10th Cir. 1991); Estate of Bies v. Commissioner, T.C. Memo. 2000-338; Estate of Cidulka v. Commissioner, T.C. Memo. 1996-149. ↑
- IRC § 2512(a). ↑
- See IRC § 2512(b). ↑
- See Treas. Reg. § 25.2511-2(a). ↑
- Estate of Gilford v. Commissioner, 88 T.C. 38, 52-53 (1987). ↑
- United States v. Cartwright, 411 U.S. 546, 551 (1973) (quoting Treas. Reg. § 20.2031-1(b)); see Treas. Reg. § 25.2512-1. ↑
- See Anderson v. Commissioner, 250 F.2d 242, 249 (5th Cir. 1957), aff’g in part and remanding T.C. Memo. 1956-178; LeFrak v. Commissioner, T.C. Memo. 1993-526. ↑
- See Pierre v. Commissioner, 133 T.C. 24 (2009), supplemented by T.C. Memo. 2010-106. ↑
- Admittedly not my best simile. ↑
- See Helvering v. Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Estate of Mellinger v. Commissioner, 112 T.C. 26, 39 (1999). ↑
- Estate of Davis v. Commissioner, 110 T.C. 530, 538 (1998). ↑
- Id. ↑