Many Estate Planning attorneys faced a huge uptick in business beginning mid to late 2020 that seemingly hasn’t ended. Some attorneys heard from brand new clients in a rush to complete Estate Planning because of the global pandemic. Others finally heard from clients for whom planning was half-completed and who had all but disappeared. Still others continued to work with long-standing clients on more sophisticated planning designed to take advantage of the increased exclusion amount that was thought to be ending. Whatever the stage of planning for their clients, it’s indisputable that Trusts and Estates attorneys were busier than ever in 2020 and have stayed that way in 2021. The downside of the increased demand for Estate Planning services is a shrinking supply of time in which to complete those services. Less time causes attorneys and clients to rush which increases the potential for mistakes. Let’s examine a set of facts based upon a recent tax case that highlights the numerous ways that planning can go wrong in a rushed situation.
Assume that Tom was married to Katie and had two children from a prior union, Isabella and Connor. Tom transferred his rental properties to a Limited Liability Company (“LLC”), in which he owned both the 1% voting interest and the 99% non-voting interest. Tom transferred his membership interests in the LLC to his revocable trust. A few months later Tom created a dynasty trust for the benefit of Isabella and Connor. After creating the dynasty trust, Tom made a gift of approximately 41% of his non-voting interest in the LLC to Katie. The next day Katie transferred that interest to the dynasty trust. Concurrently with Katie’s transfer, Tom gifted 8% of his remaining non-voting interest in the LLC to the dynasty trust. The Operating Agreement for the LLC expressly prohibited a transfer of the LLC interests to anyone other than Tom’s descendants or a trust for their benefit. Katie was neither. Although Tom amended the Operating Agreement twice over the course of this transaction, he never amended it to include Katie as a permissible transferee or in any way documented her brief ownership on official LLC documents.
When the LLC filed its initial partnership return, the Schedules K-1 listed Tom as a 51% owner and Tom’s revocable trust as a 49% owner, which underscored the fact that Katie was never an owner. Thus, although Katie “owned” a portion of the LLC for a day, that was not reflected in the partnership return filed with the Internal Revenue Service (“IRS”). Four months after the gifts to the dynasty trust, Tom obtained an appraisal for a 49% non-voting interest in the LLC. Tom and Katie filed gift tax returns evidencing their respective transfers to the dynasty trust. The IRS audited those returns. Ultimately, Tom and Katie ended up in court and lost.
These facts, while dense, help us understand the numerous mistakes made in implementing this plan. Those familiar with the actual case know that the above example highlights only the most glaring issues. First, Tom transferred the LLC interest to Katie, an impermissible beneficiary, in direct contravention of the Operating Agreement for the LLC. Tom could have easily updated the Operating Agreement to include Katie as a permissible transferee when he made other changes, but failed to do that. Further, the LLC’s initial tax return never listed Katie as an owner and should have. The lesson: do not take one position while providing evidence to the contrary to the IRS.
Next, Katie transferred the non-voting interest the day after she received it which often signals a rushed transaction. Katie did not allow any time to elapse between the transfer to her and her transfer to the trust. It seems that she could have waited because Tom waited four months to obtain the appraisal. The lesson: give yourself and your attorney enough time to complete the plan. That does not mean to let it sit indefinitely, but rather let enough time pass between different steps in the transaction.
Finally, the appraiser provided an appraisal for a 49% non-voting interest, rather than a 41% non-voting interest and an 8% non-voting interest which was dated four months after the gifts occurred. The lesson: request appraisals close in time to the gifts and ensure that they reflect the proper gift and date. As this example demonstrates, Tom controlled the transaction from start to finish and could have easily followed the formalities that he established as part of the plan. Instead, Tom and Katie took shortcuts, forewent formalities, and failed to properly execute the plan which ultimately cost them.
To avoid unintended results, respect the formalities set forth in the entities and documents. If you do not, you can assume the IRS will not. Make sure that if an appraisal is necessary, the appraisal is of the exact asset in the transaction and has a date matching that of the transaction. Finally, make sure that the tax returns filed accurately reflect the transaction that occurred and include supporting documents substantiating the positions taken.
If you are considering Estate Planning, contact a qualified Estate Planning attorney sooner, rather than later. If you have not reviewed your plan recently, take a look now. If you were one of the many who rushed to do planning at the end of 2020 or even in 2021, review your plan with your attorney and see if there are areas that could be improved. Rushing through the process increases stress and decreases the likelihood of success. Make sure the plan is well documented and you understand potential areas of exposure and how best to limit that exposure.
Tereina Stidd, J.D., LL.M. (Tax)
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128