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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney P.C., Washington, D.C.
In Linton v. U.S., 1 , the Ninth Circuit Court of Appeals reversed a grant of summary judgment in favor of the government on the issue of whether gifts of LLC interests were made after the contribution of assets to the LLC, and whether, in any case, the steps of the transaction ought to be collapsed and viewed as a single, integrated transaction under the "step transaction" doctrine.2
In November 2002, William Linton and his wife ("Taxpayers") formed WLFB Investments, LLC, and issued all of the membership interests to William. On January 22, 2003, William gave one-half of the membership interests to his wife and signed a quit claim deed to transfer undeveloped real property to the LLC. He also directed his broker to transfer cash and municipal bonds to the LLC. Also on that date, Taxpayers executed documents creating an irrevocable trust for each of their four children, and each of them assigned an 11.25% LLC interests to each trust, while retaining a 5% LLC interest. The dates of the transfers to the trusts were filled in later by the Taxpayers' attorney, who testified that he had erroneously filled in a transfer date of January 22, rather than the intended date of January 31, 2003.
The LLC agreement restricted the transfer of membership interests to nonfamily members and reserved management functions to the managers (Taxpayers). Taxpayers claimed a 47% valuation discount based on the theory that the limitations on transferability and minority interest status reduced the value of the 11.25% percentage interests in the LLC.
The IRS denied the discount and the Taxpayers paid the gift tax deficiency and sued for a refund.
The government moved for summary judgment based on two theories: First, that the Taxpayers made an indirect gift of the underlying assets to trusts for their children because they could not prove the order of events; and second, that, irrespective of the order of events, there was a single, integrated transaction, the steps of which should be collapsed under the "step transaction" doctrine.
The gift tax under §2511 of the Code applies whether the gift is direct or indirect. Regs. §25.2511-1(h)(1) illustrates a transfer of property by a shareholder to the corporation for less than adequate consideration. The regulation concludes that, generally, such a transfer represents an indirect gift by the shareholder to the other individual shareholders to the extent of their proportionate interests in the donee-corporation. Similarly, under Shepherd v. Comr.,3 if a partner transfers property to a partnership for less than adequate consideration, the transfer generally may be treated, depending on the facts and circumstances surrounding the transfer, as an indirect gift by the transferor to the other partners.4 In both the Shepherd case and in Senda v. Comr.,5 the taxpayers failed to follow the normal formalities of formation and funding of the partnership followed by gifts of partnership interests.
At issue in Linton, was the order of the transactions. If Taxpayers first contributed cash, securities and real property to the LLC and then, after a lapse of time, transferred the LLC interests to trusts for Taxpayers' children, as Taxpayers contended, the gifts would ordinarily be characterized as gifts of LLC interests, and the value of those LLC interests for gift tax purposes might be properly discounted for lack of marketability and/or minority interests. However, if the contributions to the LLC occurred after the transfer of LLC interests to the children's trusts, the gifts would ordinarily be characterized as indirect gifts of the contributed assets and would not be discountable for purposes of the gift tax.
The district court, in granting the IRS's motion for summary judgment, found that the contributions of cash, securities and real property were made to the LLC either simultaneously with or after the gifts of the LLC interests to the children's trusts, thereby constituting indirect gifts to the trusts of pro rata shares of the assets conveyed to the LLC.
The Ninth Circuit, applying Washington state law, found significant ambiguity as to the date on which the gifts of LLC interest were complete because, while all of the documents were signed on January 22, 2003, the documents regarding the gifts of the LLC interests were not dated on January 22, 2003. Additionally, the Ninth Circuit noted that "[t]he mere preparation of a donative document does not effect a present transfer necessary to perfect a gift. Such a writing becomes effective when the donor manifests the intention that the document is to be operative to make a present transfer." Generally, the writing will be deemed effective "when the donor puts the document beyond retrieval" by delivering the document to the donee.
Based on the foregoing, the Ninth Circuit stated that the current record suggested two possibilities. Either: (i) that the trustee's (and, therefore, for legal purposes, the donee's), leaving the meeting on January 22, 2003, with copies of the undated gift documents was a sufficient objective manifestation that the gift documents were intended to be effective immediately; or (ii) the Taxpayers appointed their attorney to be their agent with the power to make the gift documents effective at some later date, that later date occurring whenever the agent dated the gift documents and made some objective manifestation that the gift was effective (such as by sending a copy of the signed documents to the trustee) in March or April of 2003. The Ninth Circuit held that, because the record was subject to contrary inferences as to operative date of the gift, the IRS was not entitled to summary judgment on this pivotal point. Accordingly, the Ninth Circuit remanded the case to the district court for such proceedings as it deems necessary to resolve this question.
The district court further determined, in the alternative, that even if Taxpayers established that the cash, securities and real property were contributed to the LLC prior to the gifts of the LLC interests to the children's trusts, Taxpayers made indirect gifts of the transferred assets to their children's trusts under the "step transaction" doctrine. Under that doctrine, the IRS will collapse "formally distinct steps in an integrated transaction" in order to assess taxes based on a "realistic view of the entire transaction." The step transaction doctrine treats multiple transactions as part of a single integrated transaction for tax purposes if the elements of at least one of three tests are satisfied.
The first of the tests, the "end result test," queries whether a series of steps were undertaken to reach a particular result, and, if so, treats the steps as a single transaction. Accordingly, under this test, a court must ask "whether the taxpayer intended to reach a particular result by structuring a series of transactions in a certain way." The Ninth Circuit concluded that, under this test even if the transactions could somehow be merged, Taxpayers would still prevail, because the end result would be that their gifts of LLC interests would be taxed as they contended.
The second test, the "interdependence test" examines "whether on a reasonable interpretation of objective facts the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series." The Ninth Circuit concluded that transferring assets into the LLC was an ordinary and objectively reasonable business activity that made sense with or without any subsequent gift. Accordingly, the Ninth Circuit concluded that the facts did not meet the requirements of the interdependence test.
Finally, the "binding commitment" test asks whether, at the time the first step of a transaction was entered, there was a binding commitment to take the later steps. This test only applies to transactions spanning several years. Since Taxpayers' transactions took place over the course of no more than a few months, and arguably a few weeks, the Ninth Circuit found that the binding commitment test was inapplicable.
Consequently, the Ninth Circuit reversed the district court's grant of summary judgment in favor of the IRS. The Ninth Circuit concluded that issues of material fact existed as to the sequence of transactions by which the gifts were made, and, therefore, remanded the case to the district court for a determination of when the four elements of a gift under Washington state law were simultaneously present, and, in particular, to determine when Taxpayers first objectively manifested their intent to make the gifts effective.
Note that the application of the step transaction doctrine — which is essentially a variation of the judicially developed "substance-over-form" or "economic substance" doctrines — to estate planning techniques is, in and of itself, questionable. During 1994, the Treasury issued regulations (the partnership "anti-abuse" regulations) that authorized the IRS to recharacterize a transaction to disallow the use of the partnership form — i.e., to treat the partnership as an "aggregate" of individual partners, rather than as an "entity" — for federal tax purposes, if the principal purpose of the arrangement was to reduce substantially the present value of the partners' "aggregate federal tax liability" in a manner inconsistent with the partnership income tax provisions. The regulations were later amended to include two examples that purported to apply the anti-abuse regulations to transfer taxes, and specifically to discounts available for family partnership transactions. Early in 1995, however, the IRS announced that the regulations would be amended to clarify that they will apply only to income taxes. Subsequently, in April 1995, an amendment to the regulations was issued providing that the anti-abuse rule applies "solely with respect to taxes under subtitle A" of the Code (income taxes). In addition, the examples involving family partnerships were deleted from the final regulations.
Similarly, when the "economic substance" doctrine was codified in the "Health Care and Education Reconciliation Act of 2010,"6 the Act exempted from its provisions "personal transactions of individuals" - i.e., those entered into "in connection with a trade or business or an activity engaged in for the production income." The economic substance doctrine requires that both a substantial business purpose and a meaningful change in economic position ("apart from federal income tax effects") be present for a transaction to be respected for tax purposes. Because of this language, some have queried whether the provision applies to the avoidance of estate or gift taxes (although it doubtless would be unwise to assume that it doesn't).
Nevertheless, the better course for estate planners in future transactions would be to follow the precise steps suggested in Shepherdand Senda and allocate any contributions to a family partnership or LLC to the capital account of the donor, followed by a later transfer partnership or LLC interests to the donees.
For more information, in BNA's Tax Management Portfolios, see Lischer, 845 T.M., Gifts, and in Tax Practice Series, see ¶6320, Gifts.
2 See also Heckerman v. U.S., 2009-2 USTC ¶60,578 (W.D. Wash. 2009) and Pierre v. Comr., T.C. Memo 2010-106, both of which applied the "step transaction" doctrine to collapse a series of steps resulting in the transfer, by gift, of LLC interests to the transferors' children into a single transaction.
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