Taxpayers often act as if intra-family transactions are private, informal affairs free from any outside oversight—after all, spouses typically can transfer assets between themselves without gift- and estate-tax consequences.
Warning: The IRS actually pays surprisingly close attention to financial transactions that occur within families. A recent tax court ruling hammers home the importance of not cutting corners when transferring assets within a family.
A California man named Louis Smaldino owned rental properties through a limited liability company (LLC). He claimed to have transferred around 41% of the LLC’s membership interests to his wife, who purportedly gifted those interests the following day to a dynasty trust benefiting Smaldino’s children and grandchildren. But the LLC’s operating agreement was never updated to reflect the wife’s extremely short-term ownership stake…and the document that the couple created to record the asset transfer failed to indicate the date on which it was signed. Tax returns also ignored the wife’s one-day “ownership.”
The courts ruled that Smaldino never legally transferred the LLC membership interest to his wife and, in effect, had gifted the assets to the trust himself. Result: Smaldino was saddled with a gift tax bill in excess of $1 million that he could have avoided if he had simply been more careful with the paperwork and his wife had waited perhaps a few months or more between receiving the assets and transferring them to the trust.
Lesson: If you don’t respect the formality of your intra-family financial dealings and estate-planning tools, you can’t expect the IRS and courts (or creditors) to respect them either. What to do…
Each financial step should be documented, and each relevant document should be properly signed and dated.
If you or your family have a trust or LLC, manage its affairs precisely as the trust or LLC’s documents say they are to be managed.
Before making any major intra-family financial moves, ask your CPA or tax attorney if there’s anything about the move that could raise the IRS’s interest and, if so, what could be done to reduce this risk.