One Step Forward: Ninth Circuit Holds that Step Transaction Doctrine Does Not Apply in the Formation of an LLC or FLP

I wrote recently about how useful limited liability companies (LLCs) can be as a planning device for a variety of business transactions.  Another common use for LLCs falls into the estate planning area; namely, the use of LLCs (and also family limited partnerships, or “FLPs”) to transfer assets from one generation to the next free of Federal estate and gift tax.

One very common estate planning technique – particularly where real estate is involved – is to form a family limited liability company (“FLLC”) or an FLP.  The donors then transfer all interest to the asset(s) to the newly-formed entity in exchange for ownership in the entity.  In a subsequent transaction, the donors then gift a percentage of the ownership interests to their children.  These gifts are made free and clear of any gift tax so long as they do not exceed each donor’s Federal gift tax exclusion (currently $13,000 per donee). 

So far, so good, right?  Well, here’s the step that the IRS doesn’t like:  it is an accepted practice to discount the valuation of the interests transferred to the donees based upon several factors stemming from the fact that the interests are minority interests (e.g., lack of control over the entity; inability to transfer the interests due to buy-sell restrictions, etc.)  Thus, a donor can transfer more value through the FLLC/FLP mechanism than if the donor transferred fractional interests in the assets outright to the donees and thus the potential that the donor can effect transfers of 100% of the entity interests to the next generation without having to pay over any amounts to the IRS increases.  It is because of this that the IRS has applied a great deal of scrutiny to these types of transactions over the past decades, in the hopes that a missed step in the process could lead to more money in the IRS’ coffers.

One of the methods the IRS has used to attack FLLCs and FLPs is a doctrine of tax law known as the “step transaction doctrine.”  According to this principle, effect should be given to the substance, rather than the form, of a transaction, by ignoring for tax purposes steps of an integrated transaction that when taken separately are without substance. In short, the tax liability should be determined by viewing the transaction as a whole, disregarding one or more non substantive, intervening transactions taken to achieve the final result. This doctrine expresses the familiar principle that in applying the income tax laws, the substance rather than the form of the transaction is controlling. The U.S. Supreme Court has expressly sanctioned the step transaction doctrine in many cases, noting that interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction.

Courts generally enunciate three basic tests that define the criteria upon which application of the step transaction doctrine applies–the interdependence test, the end result test, and the binding commitment test. The interdependence test requires an inquiry as to whether the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. The end result test examines whether it appears that separate transactions were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result. The binding commitment test examines whether there was a binding commitment to undertake the later step in a series of transactions. Falconwood Corp. v. United States, 422 F.3d 1339 (Fed. Cir. 2005).

The Ninth Circuit Court of Appeals issued a significant ruling in January 2011 in regards to the IRS’ use of the step transaction doctrine in the LLC/FLP context.  The case, Linton v. U.S., involved facts similar to those described above:  the donor formed an LLC and had 100% of the membership interests to him.  Two months later, the donor transferred one-half of the membership interests to his wife.  At the same time, he also executed a quit claim deed transferring  a parcel of real estate to the LLC; he also made an assignment of other assets to the LLC.  The donor then effected gifts of membership interests from him and his wife to their children.  Discounts were used in valuing the interests transferred to the children and an appropriate percentage of membership interests based upon the discounts was transferred to the children. 

The IRS disallowed the discounts and assessed a gift tax deficiency to the donor.  The deficiency was paid and the donors in turn sued the IRS for a refund.  The District Court for the Western District of Washington held for the IRS on the grounds of the timing of the transfers (the gifting documents were mistakenly dated prior to the transfer of the assets to the LLC; it was acknowledged that the donor intended that the gifts be made effective as of a later date).  When the case was appealed to the Ninth Circuit, the IRS relied upon the step transaction doctrine as an alternative basis for its disallowance of the discount.

The Ninth Circuit, as to the effective date of the gifts, remanded that issue to the District Court for further findings as to the donative intent.  However, it is the Court’s holding as to the application of the step transaction doctrine that makes the case important:  the Court held that the step transaction doctrine did not apply to the type of transaction involved in the case. 

The Linton decision, if adopted by other Circuits, could take away one of the IRS’ key weapons in its war on FLLCs and FLPs.  We can only hope.