Tuesday, January 18, 2022
I recently concluded a five-part series on what I viewed as the “Top Ten” agricultural law and agricultural tax developments of 2021. There were many “happenings” in ag law and tax in 2021 which meant that there were still some significant developments that didn’t make the “Top Ten.” In today’s post I start discussing some of those. This will also be a multi-part series, and the developments are in no particular order.
The “Almost Top 10” of 2021, the first article in a series – it’s the topic of today’s post.
Bankruptcy Trustee Cannot Retain Fee
In re Doll, No. 21-cv-00731-RBJ, 2021 U.S. Dist. LEXIS 232612 (D. Colo. Dec. 6, 2021)
The debtor filed Chapter 13 in late 2017, and failed to get the bankruptcy court to confirm his plan. The debtor made $29,900 in plan payments to the standing trustee. From that amount, the debtor’s counsel received $19,800 and $7503.30 was paid to the state for property taxes. The trustee paid the balance of $2,596.70 to himself in partial satisfaction of the statutory 10 percent fee. The debtor sought the return of the amount the trustee paid himself based on 11 U.S.C. §1326 and its difference to the comparative Chapter 12 provision of 11 U.S.C. §1326(a)(1). The debtor pointed out that a trustee is allowed to retain fees when a debtor’s Chapter 12 plan is not confirmed, but not in a Chapter 13. The bankruptcy court allowed the standing trustee to be compensated and the debtor appealed.
The district court agreed with the debtor, noting that 11 U.S.C. §1326(a)(2) provides, “if a plan is not confirmed, the trustee shall return any such payments not previously paid out and not yet due and owing to creditors.” The district court reasoned that if the payments must be returned, the fees collected from such payments must be returned. That language, the district court noted, was in contrast to the Chapter 12 language providing that “if a plan is not confirmed, the trustee shall return any such payments to the debtor, after deducting…the percentage fee fixed for such standing trustee.” The court reversed the reversed the bankruptcy court and remanded the case with instructions for the bankruptcy court to order the trustee to return the fee.
Note: While the district court expressed concern that a standing trustee may not be compensated for his efforts in situations such as this, the district court found the issue to be one for the Congress to address.
LLC Gifts Recharacterized
Smaldino v. Comr., T.C. Memo. 2021-127
Estate planning is a complicated process, and it gets more complicated as assets increase in number and value. If a family business is involved, the complexity is increased further. In this case, the Tax Court pointed out how important it is to carefully do estate planning correctly. At its core, the case involved a gift by a husband to his wife and then to an irrevocable trust. Because the plan wasn’t implemented and/or administered properly, the IRS recast the transaction and the court agreed, with severe tax consequences.
Facts of the case. The couple had a real estate portfolio of nearly $80 million including numerous rental properties that they owned and operated. They agreed that the real estate should pass to the husband’s children and grandchildren from his prior marriage. To accomplish that goal, he put 10 of the real estate properties into a family limited liability company (LLC) that he formed in 2003 (and for which he was designated as the manager) but which remained inactive until late 2012 when he had a health scare that finally motivated him to get his affairs in order. The LLC, in turn, was placed into a revocable trust of which he was the trustee. In 2013, he transferred approximately eight percent of class B member interests in the LLC to an irrevocable trust (dynasty trust) that he had created a few months earlier for the benefit of his children and grandchildren. He named his son as trustee.
At about the same time as the transfer to the dynasty trust, the petitioner transferred approximately 41 percent of the LLC membership interests to his wife (in an amount that roughly matched her then available federal estate and gift tax exemption), who then in turn transferred the same interests to the dynasty trust the next day. As a result, the dynasty trust owned 49 percent of the LLC. Simultaneously, the petitioner amended the LLC operating agreement to provide for guaranteed payments to himself and identified the dynasty trust as the LLC’s sole member. On his 2013 gift tax return, the petitioner reported only his direct transfer of LLC interests to the dynasty trust and not those of his wife. A valuation report dated four months after the transfers to the dynasty trust stated that the 49 percent interest in the LLC had a value of $6,281,000. The federal estate and gift tax exemption was $5,250,000 in 2013. The IRS asserted that the petitioner had underreported the 2013 taxable gifts by not reporting the wife’s gift to the dynasty trust, and asserted a gift tax deficiency of $1,154,000.
The Tax Court agreed with the IRS, concluding that the wife’s gift to the dynasty trust should be treated as a direct gift by the petitioner for numerous reasons. The Tax Court noted that the wife was not a “permitted transferee” under the LLC operating agreement and, thus, could not have owned the LLC interest. The Tax Court also pointed out that the petitioner had amended the LLC operating agreement on the same day of his transfer of LLC member units to the dynasty trust to reflect himself as the sole member. The Tax Court also pointed out that the transfers of the wife’s LLC member interest were undated – they only had “effective” dates, and that the assignments were likely signed after the valuation report was prepared four months later. This meant that the wife had no real ownership rights in the LLC. In addition, the Tax Court pointed out that the 2013 LLC income tax return did not allocate any income to the wife even though the petitioner claimed that she had an ownership interest for one day. The LLC’s return and associated Schedules K-1 listed the petitioner as a 51 percent partner and the dynasty trust as a 49 percent partner for the entire year. The petitioner’s wife was not listed as a partner for any part of the year.
Take home planning pointers. The case is a good one for learning what not to do when setting up a trust and transferring LLC interests as part of an estate plan. The wife’s holding of the LLC interests for a day (at most) before the transfer to the LLC and then her transferring the exact same interests received as a gift to the dynasty trust is not a good approach. It shows a lack of respect for the transaction. The wife’s testimony at trial that she had no intent to hold the interest contradicted the alleged substance of the transaction. It also shows that she didn’t understand the planning that was being engaged in – that’s the fault of the attorneys involved. Also, the husband‘s failure to report the gift to his wife on a gift tax return was further demonstration that he didn’t respect that transfer. With the amount of wealth involved in the case, a team of professionals should have been engaged, and all formalities of the various transactions should have been closely followed. This includes providing written consent for the wife’s admission as an LLC member; providing the dates that documents were actually signed; not transferring the precise amount to the trust as was initially gifted; and having more time pass between the date of the gift to the wife and her subsequent transfer. There was also no amended and restated LLC operating agreement to reflect her ownership (however brief). Also, tax returns did not properly reflect what the taxpayers were doing.
From a broader perspective, it simply is a bad idea to not do estate planning until health emergencies arise. The same is true for other significant life events. By waiting until estate planning is absolutely necessary, estate planning can be rushed and not be done as thoroughly as it otherwise should be. Estate planning is a process that takes time. The rushed process in the case was probably a factor in the IRS succeeding in its assertion of the “step transaction” doctrine.
There’s also another point from the timing involved in the case that has relevance to estate planning in 2020-2021. While I can’t be positive from reading the court’s opinion, it appears that the estate planning was done in late 2012, at least from the standpoint of document drafting, and then completed in 2013. 2012/2013 was a time when there was concern by many that the federal estate tax exemption would drop from $5 million to $1 million. Thus, many clients were worried about being faced with a “use-it-or-lose-it” situation not unlike the situation in 2021 going into 2022. The point is that this uncertainty in the law surrounding estate planning creates an substantial increase in work for estate planners to accomplish in a short timeframe. That combination can lead to a lack of thoroughness in the estate planning drafting and/or review process. It is possible that this was part of the problem that led to the unfortunate tax result of the case.
Note: Following legal formalities is important, such as creating and signing essential documents. Also, consistency in tax reporting is critical. In addition, thorough estate planning should involve a “team approach.” The attorneys drafting the legal documents and providing legal counsel; tax practitioners that can review the tax consequences of the plan; financial and insurance professionals. The more “eyes” that see an estate plan, the less chance that steps will be overlooked and/or mistakes made.
A key question in the case involved the timing of the transfers to the wife and then to the dynasty trust. How long should she have held those transfers before retransferring them to avoid IRS successfully asserting the step-transaction doctrine? In one case, six days was enough for holding assets as part of an overall estate plan before they were retransferred. See Holman v. Comr., 130 T.C. 170 (2008), aff’d., 601 F.3d 763 (8th Cir. 2010). In any event, the transaction must have economic substance if the transaction is to be respected taxwise.
In the next article, I will look further at other developments of 2021 that weren’t quite significant enough on a national scale to make the 2021 Top Ten list.