Step Transaction Doctrine

Demystifying Valuation, Economic Damages + Forensic Accounting

A recent case in the federal district court highlights the need to have some time elapse between the date of formation and funding of an FLP or FLLC and the date of gifting of interests in the FLP/FLLC. In Heckerman v U.S., the taxpayers (David and Susan Heckerman) took the following steps in gifting of minority interests in various LLCs to their children.

  • November 28, 2001 – Establishment of trusts for their children.
  • November 28, 2001 – Formation of three LLCs including:
    1. Heckerman Investments, LLC (“INV LLC”)
    2. Heckerman Real Estate LLC (“RE LLC”)
    3. Heckerman Family LLC (“FAM LLC”)
    FAM LLC owned 100% of INV LLC and RE LLC
  • December 28, 2001 – Transferred ownership of $2M Malibu beach house to FAM LLC and from there to RE LLC via Quitclaim Deed. David and Susan owned 100% of FAM LLC at this time.
  • January 11, 2002 – David/Susan transfer $2.85M in mutual funds to INV LLC. David/Susan gift interests in FAM LLC to each of their children’s trusts (1,217.65 units or 24.85% each).

The Heckerman’s contended that they made the gifts of the interests in FAM LLC subsequent to the time of transfer of the mutual funds to INV LLC and filed gift tax returns claiming a 58% discount for lack of marketability for the interests. The IRS determined that the transactions should be treated under either of the following scenarios:

  1. The transfer of the $2.85M of mutual funds is an indirect gift of the $2.85M to each child’s trust based on their percentage share in FAM LLC, or
  2. The transfer of the $2.85M of mutual funds and transfer of FAM LLC units the same day is an integrated transaction intended to pass investments to children in a tax advantaged form, i.e., a step-transaction and therefore an indirect gift of the asset transferred.

The IRS determined that gift tax is due on the indirect gifts and no discounts were allowed. The Heckerman’s paid the tax, filed claims for refund which were denied, and filed suit in the federal district court.

The court explained that the step-transaction doctrine “…collapses ‘formally distinct steps in an integrated transaction’ in order to assess federal tax liability on the basis of a ‘realistic view of the entire transaction.'”

The court held that the gifts were made simultaneously with the asset transfers and therefore, were indirect gifts of the assets. The court also applied the step-transaction explaining that the plan of transferring assets and gifting of interests was pre-arranged to reach an end result of lowering the valuations for gift tax purposes. The court also applied an “interdependence test” and determined that, but for the anticipated discount, the mutual funds would not have been transferred to INV LLC. The court also explained that the Heckermans did not bear any real economic risk that the LLC units would change in value between any alleged time intervening between the funding and the gifting and therefore the step-transaction doctrine applied. Summary judgment was entered for defendant, United States. The taxpayer lost.

While there is no clear-cut rule regarding the amount of time that should elapse between the date of funding and the date of gift, some daylight is definitely advisable.

Steve Koons, CPA/ABV, ASA, CFF