With the lifetime gift tax exemption at $5 million and the gift tax rate at 35 percent, now's a perfect time for taxpayers to take advantage of wealth transfer opportunities. But these opportunities aren't endless. Absent intervening legislation, the lifetime gift tax exemption will return to $1 million and the highest marginal gift tax rate will increase to 55 percent on Jan. 1, 2013.¹

While this may seem like plenty of time, it isn't, especially for those taxpayers who plan to make gifts of interests in recently funded family business entities (FBE), such as family limited partnerships (FLPs) or limited liability companies (LLCs). These taxpayers must leave time to avoid running afoul of the step-transaction doctrine. This doctrine refers to the Internal Revenue Service's argument that the funding of an FBE and subsequent gifts of discounted interests in the FBE, should be “stepped together” and re-characterized as gifts of the FBE's underlying, non-discountable assets.

Although a trilogy of recent gift tax cases may have relaxed the doctrine to make it more taxpayer friendly, those rulings still require taxpayers to wait an appropriate amount of time between forming and funding an FBE and making gifts of interests in an FBE. Furthermore, the IRS and courts may apply the doctrine to these transactions in unanticipated ways. Advisors assisting clients who anticipate funding an FBE should urge them to act early in 2012 to avoid rushed year-end transactions that might run afoul of the step-transaction doctrine.

History of the Doctrine

Courts have historically applied three tests for determining whether the step-transaction doctrine will operate to collapse a series of steps into a single transaction for tax purposes: (1) the “end result test;”² (2) the “interdependence test;”³ and (3) the “binding commitment test.”⁴ If the elements of any one of the three tests is satisfied, the step-transaction doctrine will apply.⁵ The traditional tests have been applied in valuation discount cases to reach inexplicably divergent results.⁶ Fortunately, a trilogy of recent gift tax cases: Holman v. Commissioner,⁷ Gross v. Comm'r⁸ and Linton v. Comm'r,⁹ hints at a shift away from the unpredictable three-test analysis and seemingly distills the step-transaction doctrine in FBE valuation matters to a single inquiry: Has the FBE held assets contributed by a taxpayer for a period of time that's sufficient to subject the contributed assets to a real risk of a change in value prior to the taxpayer making gifts of interest in the FBE? If the contributed assets have been owned for a sufficient period of time, the funding of the FBE, and subsequent gifts of FBE interests, will be given independent significance and the step-transaction doctrine won't apply.

Strategies Implicating Doctrine

It's not hard to imagine a December filled with phone calls from clients desperate to implement last minute strategies to use their $5 million gift tax exemptions before the clock strikes midnight on Dec. 31, 2012. Some tools in the planner's toolbox will clearly implicate the step-transaction doctrine — particularly if employed in a last gasp effort to leverage expiring exemptions with discounted FBE interests. Step-transaction risks may not always be so obvious, however, and the doctrine may be applied in unanticipated ways to common planning strategies.

Direct gifts or sales of FBE interests

If a client forms and funds an FBE and makes a gift or sells an interest in the FBE at a discount from the value of the contributed assets shortly after funding, the gift or sale transaction may be at risk of a step-transaction challenge. While the courts have simplified the step-transaction inquiry into a determination of whether assets have been held by an FBE for a period sufficient to create real economic risk, they haven't drawn bright-line rules establishing acceptable holding periods. Certainly, the determination of whether assets have been held for a long enough period of time to create a risk of valuation change will depend on the nature of an FBE's assets. In Holman, the Tax Court determined that a mere six days was sufficient to create “a real economic risk of change in value of the partnership” that held publicly traded shares of Dell stock as its only asset. In a footnote, however, the Tax Court noted that:

[t]he real economic risk of a change in value arises from the nature of the Dell stock as a heavily traded, relatively volatile common stock. We might view the impact of a six-day hiatus differently in the case of another type of investment; for example, a preferred stock or a long-term government bond.¹⁰

Similarly, if a taxpayer contributes cash, private equity or real estate to his FBE, it's likely that a significantly greater amount of time would have to pass prior to making gifts or sales of discounted interests in the FBE. Lawyers, accountants and bankers called upon to assist in the determination of an appropriate holding period should seek the advice of professional valuation firms to determine how long is long enough to create a “real economic risk of a change in the value” of any particular asset.

Part gift, part sale of interests in an FBE

It's not uncommon for clients to gift interests in an FBE in an amount equal to all or part of their unused lifetime gift-tax exemption and to sell additional interests in the FBE to the same individuals to whom they made these gifts. If a taxpayer makes gifts of interests in an FBE at the same time he sells interests in the same FBE to the same person, the IRS may attempt to apply the step-transaction doctrine to collapse the gift and sale into a single transaction for purposes of determining the aggregate percentage interest received by the donee. If the aggregated percentage interest received by a single donee confers management rights that make it easier for the donee to sell his interest, liquidate the FBE or cause the FBE to make distributions to its owners, applicable valuation discounts may be reduced to reflect the increased liquidity of the donee's aggregated interest. If, for example, a taxpayer gives his son a 40 percent interest in the taxpayer's FBE on the same day that he sells his son a 40 percent interest in the FBE, and the FBE's organizational documents provide that a vote of 80 percent of the owners can remove and replace managers, valuation discounts associated with the transferred interests will be reduced.¹¹

Contribution of FBE interests to a grantor retained annuity trust (GRAT)

GRAT contributions might not immediately call to mind step-transaction concerns. However, if a taxpayer contributes interests in a recently funded FBE to his GRAT on a discounted basis, and the trustee of the GRAT satisfies annuity obligations with non-discounted assets (like cash), the IRS may apply the step-transaction doctrine to eliminate the discounts on the contributed FBE interests. In a recent gift tax audit, the IRS made exactly this argument. The taxpayer formed and funded an LLC with cash and marketable securities in exchange for a 99 percent non-voting interest in the LLC. The day after funding her LLC, the taxpayer contributed her non-voting LLC interest to a two-year, zeroed-out GRAT. The taxpayer filed a gift tax return reporting the nominal gift to the GRAT and included a valuation of the LLC interest reflecting a 35 percent discount. The managing member of the LLC liquidated investments just prior to each annuity payment and made pro rata cash distributions to the members, which the trustee of the GRAT used to pay the taxpayer her annual annuity. The IRS took the position at audit that the step-transaction doctrine applied to recharacterize the contribution to the GRAT as a contribution of non-discounted cash and securities resulting in an underpayment of the taxpayer's annual annuity and an overdistribution to the remainder beneficiary.

Suppose, for example, that the taxpayer had contributed cash and securities worth $1 million to her LLC in exchange for a 99 percent non-voting interest in the LLC, which she contributed to her GRAT the following day. The taxpayer valued her non-voting LLC interest at a 35 percent discount from the value of the cash and securities she had contributed to the LLC, resulting in a $650,000 contribution to the GRAT. The trustee of the GRAT would have to make annual annuity payments to the taxpayer of approximately $335,000 to zero-out a two-year $650,000 GRAT. Assuming no growth in the value of the LLC's assets, the taxpayer would receive cash annuity payments totaling $670,000 and the remainder beneficiary would receive interests in an LLC owning assets worth $330,000. Had the LLC interests been contributed on a non-discounted basis, the GRAT would have been required to make annuity payments, which would have exhausted the GRAT, and the remainder beneficiary wouldn't have received anything from the GRAT.

The GRAT agreement requires that in the event of an incorrect determination of the fair market value (FMV) of the contributed property, the trustee must pay the taxpayer the difference between the correctly determined annuity payments and the actual annuity payments within a reasonable period after the FMV is finally determined for federal gift tax purposes.¹² By the time a final value had been determined for gift tax purposes, however, the trustee of the GRAT had long since distributed the LLC interests to the remainder beneficiary, and the remainder beneficiary had long since liquidated the LLC and spent his money. If the taxpayer doesn't demand repayment from the remainder beneficiary within a reasonable time after a final determination establishes the overdistribution, she will be deemed to have made a gift to the remainder beneficiary in the year she fails to demand repayment. Taxpayers settling GRATs in a year when the gift tax exemption is $5 million, but reaching a “final determination of value for federal gift tax purposes” in a year when the exemption is $1 million, may end up paying an unanticipated gift tax.

Gift Tax Case Trilogy

The three recent gift tax cases effecting a simplification of the step-transaction doctrine in discounted FBE cases, Holman, Gross and, most recently, the U.S. Court of Appeals for the Ninth Circuit's decision in Linton, were all taxpayer victories. In Holman, Tom and Kim Holman contributed shares of Dell stock to Holman Limited Partnership just six days prior to making gifts of limited partnership interests to trusts settled for the benefit of their children. The Tax Court determined that the step-transaction doctrine wouldn't apply because the Holmans bore a “real economic risk of a change in value of the partnership for the six days that separated”¹³ the funding of the partnership and the gifts of partnership interests to the children. The Tax Court determined that it was inappropriate to disregard the passage of time and treat the formation and funding of the partnership and subsequent gifts as occurring simultaneously under the step-transaction doctrine. The Tax Court acknowledged the three traditional step-transaction tests, but analyzed only the “interdependence test” to determine that the passage of time was sufficient to give independent significance to the funding of the partnership and the subsequent gifts of interests in the partnership.

In Gross, Barbara Gross funded her FLP with shares of stock in publicly traded companies 11 days prior to making gifts of limited partnership interests to her daughters. The Tax Court reviewed its decision in Holman, decided only four months earlier, and determined that it wouldn't apply the step-transaction doctrine to a substantially similar set of facts. The Tax Court didn't apply any of the three traditional step-transaction tests. Rather, it merely relied on Holman to determine that the passage of time was sufficient to create real economic risk and avoid application of the step-transaction doctrine.

Finally, in Linton, the most recent of the three cases, William and Stacy Linton executed all of the following documents on the same day, Jan. 22, 2003:

• A deed conveying a parcel of real property from William to WLFB Investments, LLC (WLFB);
• An assignment of a 50 percent interest in WLFB from William to Stacy;
• An assignment of assets directing certain financial institutions to transfer cash and securities to WLFB;
• Four trusts, one for the benefit of each of their children; and
• Gift documents assigning 11.25 percent interests in WLFB to each of the four children's trusts.

The Lintons executed the gift documents on Jan. 22, 2003, but didn't date them. Several weeks after the execution of the documents, the Lintons' attorney dated all undated documents “Jan. 22, 2003,” the same day that assets were contributed to WLFB. The Lintons' attorney later testified that he erroneously dated the gift documents Jan. 22, 2003 and that he should have dated such documents nine days later on Jan. 31, 2003. The district court granted the government's motion for summary judgment, finding that the Lintons either made “indirect gifts”¹⁴ of cash, securities and real property to their children, because the court couldn't establish whether their contributions to WLFB occurred before or after their gifts to their children's trusts, or they made indirect gifts to their children's trusts under the step-transaction doctrine.¹⁵ In reaching its decision, the district court concluded that the series of transactions satisfied all three of the step-transaction tests: (1) the end result test; (2) the interdependence test; and (3) the binding commitment test.

The Ninth Circuit reversed the district court and determined that none of the three step-transaction tests applied. Although the Ninth Circuit analyzed the traditional step-transaction tests, the court persuasively suggested that the step-transaction test should be reduced to a simple determination of whether a sufficient amount of time passed between the date assets were contributed to WLFB and the date the Lintons made gifts of interests:

The waiting period would subject the gifted assets to some risk of changed valuation before they were transferred through the LLC to the children's trusts. That risk would make the two transactions distinct for tax purposes.¹⁶

The Ninth Court determined that the passage of time test was “in essence, a working out of the step-transaction doctrine in a particular set of circumstances.”¹⁷

Structuring Transactions

Although the reformulated step-transaction doctrine reduces the relevant inquiry in FBE cases to a “passage of time-economic risk” analysis, the IRS and the courts will consider a number of factors in connection with matters that implicate the step-transaction doctrine or the closely related concept of indirect gifts.¹⁸ To avoid application of the step-transaction doctrine, taxpayers and advisors should consider the following steps in matters involving transfers of discounted interests in FBEs:

1. Document contributions to the FBE

   Taxpayers should clearly document the sequence of contributions to an FBE and subsequent gifts of interests in the FBE by crediting such contributions to the donor partner's capital account.¹⁹ Additional entries should be made to the FBE books following a gift of an interest to reflect a transfer of capital from the donor partner's capital account to the donee partner's capital account. The partnership agreement or LLC operating agreement must provide for contributed capital to be credited solely to a donor partner's capital account, as opposed to being contributed to all partners' capital accounts pro rata;²⁰

2. Issue contemporaneous membership certificates

   Partnerships and LLCs haven't historically issued certificates of ownership analogous to stock certificates in corporations. More recently, the better practice may be to order minute books and issue certificates at the time a partner makes a capital contribution to establish the sequence of contributions and subsequent gifts;

3. Allow for an appropriate passage of time prior to making the gift

   Allow an FBE to hold contributed assets for a period of time sufficient to create a real economic risk of a change in value before making gifts of interests in the FBE. Consult a valuation professional to determine an appropriate holding period;

4. Report transactions consistently

   Prepare valuation reports, gift documents, gift tax returns and partnership returns in a manner that accurately and consistently reflects the dates capital is contributed to an FBE and the dates a taxpayer makes subsequent gifts of FBE interests;

5. Avoid prejudicial correspondence

   In every case in which the IRS has prevailed on a step-transaction theory, taxpayers have sent or received correspondence from advisors undermining their reporting position. In Heckerman, for example, the taxpayer sent an email to his valuation firm stating that his contributions to his LLC were made on the same day that he and his wife made gifts of their interests in their LLCs, despite later taking the position that the gifts took place several days after the capital contributions. The Heckerman's attorney had also prepared a letter indicating that no capital accounts were maintained to reflect the contribution of assets to the LLCs; and

6. Don't convey controlling interests to a single donee

   Review the organizational documents of an FBE prior to making gifts or selling ownership interests to ensure that the interest transferred doesn't confer management rights upon the donee.²¹

Endnotes

1. Economic Growth and Tax Relief Reconciliation Act of 2001, Section 901(a) (as amended by Section 101(a)(i) of the 2010 Act).
2. The end result test combines “into a single transaction separate events, which appear to be component parts of something undertaken to reach a particular result.” True v. United States, 190 F.3d 1165 (10th Cir. 1999), quoting Kornfeld v. Commissioner, 137 F.3d 1231, 1234 (10th Cir. 1998).
3. The interdependence test asks “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.” Linton v. Comm'r, 630 F.3d 1211 (9th Cir. 2011), quoting Associated Wholesale Grocers, Inc. v. U.S., 927 F.2d 1517, 1523 (10th Cir. 1991).
4. 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. Comm'r v. Gordon, 391 U.S. 83, 96 (1968).
5. True, supra note 2 at 1173.
6. Compare the analysis of the district court in Heckerman v. United States, 104 AFTR.2d 2009-5551 (W.D. Wash. 2009) and Linton v. U.S., 638 F. Supp.2d 1277 (W.D. Wash. 2009), finding that all three step-transaction tests applied to gifts of recently funded family business entity (FBE) interests, with the Ninth Circuit's analysis in Linton, supra note 3, holding that none of the three tests result in application of the step-transaction doctrine.
7. Holman v. Comm'r, 130 T.C. 170 (2008), aff'd, 601 F.3d 763 (8th Cir. 2010).
8. Gross v. Comm'r, 96 T.C.M. 187 (2008).
9. Linton, supra note 3.
10. Holman, supra note 7 at *7.
11. Pierre v. Comm'r, T.C. Memo. 2010-106 (2010).
12. The repayment provision is required by Treasury Regulations Sections 25.2702-3(b)(2) and 1.664-2(a)(1)(iii).
13. Holman, supra note 7 at 180.
14. Taxpayers who fund an FBE and make gifts of FBE interests so closely in time that they are unable to establish the sequence of events, may be deemed to have made “indirect gifts” of the FBE's underlying, non-discounted assets. Indirect gift cases are an extension of Treas. Regs. Section 25.2511-1(h)(l), which provides that an individual shareholder in a corporation will be deemed to make a gift to his fellow shareholders to the extent of their proportionate interest in the corporation, when he transfers property to the corporation and doesn't take back additional shares in exchange. Taxpayers similarly have been found to have made indirect gifts in partnership cases, if they couldn't establish the sequence of steps. See Senda v. Comm'r, 443 F.3d 1044 (8th Cir. 2006), aff'ing T.C. Memo. 2004-160; and Shepherd v. Comm'r, 115 T.C. 376 (2000), aff'd, 283 F.3d 1258 (11th Cir. 2002) (a partner's contribution to a partnership were credited to all partners' capital accounts pro rata, rather than solely to the contributing partner).
15. Linton supra note 6 at 1286.
16. Linton, supra note 3 at *9.
17. Ibid.
18. See supra note 14.
19. See Shepherd, supra note 14 (taxpayer's capital contributions credited to all partners' capital accounts pro rata resulting in an indirect gift) and Estate of W.W. Jones II v. Comm'r, 116 T.C. 121 (2011) (taxpayer's contribution of ranchland properly reflected in his capital account prior to same day gift of limited partnership interest to children avoided finding of indirect gift).
20. See Shepherd, supra note 14 and Estate of Jones, ibid.
21. See Pierre, supra note 11.

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Stephen G. Vogelsang is a shareholder with Gunster, in West Palm Beach, Fla.