Smaldino V. Commissioner: Gift Transfer Of LLC Member Interests Results In Large Tax Liability

A US Tax Court decision earlier this month determined that an interspousal transfer of company interests to a trust was a gift tax liability despite being an indirect transfer. The Court upheld the Commissioner’s determination that the petitioner, Mr. Smaldino, owed an additional $1.54 million tax liability as a result of his failure to report the interests as a gift on his 2013 tax return.

Backstory: Indirect Company Interest Transfers Not Filed As a Gift

Mr. Smaldino owned and operated multiple rental properties in California. Ten of these properties were placed into an LLC called Smaldino Investments, which was owned through a revocable trust. In 2013, Mr. Smaldino transferred around 8% of the LLC’s class B member interests to the Smaldino 2012 Dynasty Trust, which was a newly created irrevocable trust stated to be for the benefit of Mr. Smaldino’s children and grandchildren. Subsequently, Mr. Smaldino transferred 41% of the LLC’s class B member interests to his wife, Angusta Smaldino, who re-transferred those same interests to Dynasty Trust the following day.

When Mr. Smaldino filed his tax return that year, he reported only the 8% member interest transfers as taxable gifts. However, upon an audit, the IRS indicated that the 41% interests that were transferred to his wife and then re-transferred to Dynasty Trust were also considered to be a taxable gift, even though they had been transferred to Dynasty Trust indirectly. The IRS indicated that Mr. Smaldino had a gift tax deficiency on his tax filing and owed on the 41% member interests that had been indirectly transferred.

U.S. Tax Court Ruling On The Indirect Interest Transfers

In court, there were multiple issues for decision. The court sought to determine how the LLC class B member interests that were transferred to Mrs. Smaldino and then re-transferred to Dynasty Trust should be characterized. Secondly, there was a question about the fair market value of the total class B member interests that had been transferred, whether directly or indirectly, to Dynasty Trust, so that an accurate tax value could be assigned if needed.

Mr. Smaldino argued that the precedents set by other legal cases were not controlling over the situation because none of them included an interspousal transfer. However, he did not explicitly deny that the transactions had an intended purpose of being a prearranged plan to transfer 49% of the LLC class B member interests to Dynasty Trust while utilizing his wife’s estate and gift tax exemption and admitted that he had done so in order to divide the interests among five of his children. When asked under oath, Mrs. Smaldino testified that she had already committed and promised, prior to the transfer to her ownership, to transfer the same LLC interests to Dynasty Trust.

Mr. Smaldino urged the court to respect the interspousal transfer as exempt from the gift tax, citing section 2523(a) and indicating that husband and wife are treated as one economic unit when it comes to tax purposes. Ultimately, the Court determined that the LLC class B member interests did not qualify under section 2523(a) because the section refers specifically to property and is therefore inapplicable. Additionally, Mr. Smaldino had not claimed a marital deduction on his tax return. Therefore, in substance, all of the membership interests in Dynasty Trust were a gift from Mr. Smaldino and required to be taxed as such.

Case Conclusion

The value of the total 49% class B member interests were valued at $7,820,008, resulting in a tax deficit of $1,540,000 to be paid by Mr. Smaldino.

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