Planning for 2704 Proposed Regs: Be Wary of the Step Transaction Doctrine

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2704-regulationsBy Martin M. Shenkman, CPA, MBA, PFS, AEP, JD

The Ultimate Estate Planner recently ran a series of teleconferences on the 2704 Proposed Regs and received numerous responses from our attorney community.  Here’s one we wanted to share with you.

Introduction

Practitioners are still grappling with the intricacies and complexities of the Proposed 2704 Regulations. But it is vital to start addressing some of the long existing tax doctrines that might undermine planning for the new Regs. Because of the incredible focus on the Regs themselves, little has been written yet on ancillary considerations. Once such potential trap is the step transaction doctrine which the IRS might use to challenge transactions practitioners complete as discount transfers in the last part of 2016 or early 2017. In fact, for some clients it might be worth a pause in discount planning to expedite equity transfers earlier in the process to possibly mitigate against such a challenge.

Example

Wife owns 100% of the shares of Family Business valued at $25 million. Wife Transfers 50% of the shares to Husband on November 1. On November 2 Husband establishes a non-reciprocal spousal lifetime access trust (SLAT) for Wife and Wife establishes a non-reciprocal SLAT for Husband. On November 3, 2016 each spouse transfers a 35% non-controlling interest in Family Business stock to their respective trust. They value each 35% interest at $5,250,000 [$25 million x 35% x (1-.40)]. There is a risk that the IRS may challenge this plan, on among other issues, a step-transaction theory. The IRS might assert that Wife actually funded both trusts and that there was no economic significance to the transfer from Wife to Husband and from Husband to his SLAT in that the stock merely passed through his hands as part of an overall transfer plan by Wife.

Time and Other Events

Certainly the longer the time span between each step or component of a plan, the more each step in a plan can stand independently on its own. So if you are planning such transactions, make the equity transfers now so that there is an opportunity for more time to pass before other transfers are consummated. If instead practitioners wait until what might be the “normal” sequence of a transaction, there may be inadequate time to militate against a step transaction challenge.

Other factors might negate the application of this doctrine. In particular, are there independent economic events that occur between transfers? A loan negotiated with a third party lender, a dividend declared, a new shareholders agreement negotiated and signed? The more events that occur, the more significant and independent they are, the more the facts might deflect such a challenge.

Case Law

The IRS has often raised the step-transaction doctrine in the context of family partnership transactions wherein taxpayers are endeavoring to use FLP or LLC structures to create discounts.  Send, 433 F. 3d 1044; Shepherd v. Commr. 115 T.C. 376 (2000), aff’d 283 F. 3d 1258 (11th Cir. 2002).  In Pierre II the Court held that the various steps were all part of a single transaction structured as separate steps to reduce gift tax. Pierre II, 999 T.C.M. (CCH) 1436. However, the applicability of the doctrine is far broader.

A number of cases have addressed the application of the step transaction doctrine: Linton v. US, 638 F. Supp. 2d, 1277 (W.D. Wash. 2009); Heckerman v. U.S., No. CO8-0211-JCC, 2009 WL 2240326 (W.D. Wash., July 27, 2009); Pierrre v. Comm’r, 99 T.C.M. (CCH) 1436 (2010).  The Linton court focused on the crafting of a scheme that consisted of a pre-arranged parts of a single plan.  The court found that the interdependence test was met because the taxpayers would not have undertaken one or more of the steps without the other integrating acts. Linton also noted that the existence or nonexistence of real economic risk of a change in asset value during the time period between steps is determinative of whether the step transaction doctrine will apply. Is there a real economic risk during the interim step or steps?

“The step transaction doctrine generally applies in cases where a taxpayer seeks to get from point A to point D and does so stopping in between at points B and C. The whole purpose of the unnecessary stops is to achieve tax consequences different from those which a direct path from A to D would have produced. In such a situation, courts are not bound by the twisted pat taken by the taxpayer, and the intervening stops may be disregarded or rearranged.” Smith v. Commr., 78 T.C. 350, 398 (1982).

Tests Used to Analyze Step Transaction Issues

In determining the applicability of the step transaction doctrine one or more of three tests are often considered.

  • Binding commitment test: this test is triggered if there is a binding commitment from the outset to undertake each component or step in a plan. Penrod v. Comm. 88 T.C. 1415 (1987).
  • End result test: If the IRS can demonstrate that the various steps are really pre-arranged parts of a single transaction that are intended from inception to achieve a particular end result.
  • Mutual interdependence test: Each possible step involved is evaluated to ascertain whether steps are meaningless unless all other steps occur. The instant transaction seems to be comprised of steps that can each have independent viability. So while this test might be problematic, it might be feasible to plan to minimize, but not eliminate, the risk of its application.

Example

Wife owns 100% of the shares of Family Business valued at $25 million. Wife transfers 50% of the shares to Husband on October 10, 2016. On October 12 Wife establishes a non-reciprocal spousal lifetime access trust (SLAT) for Husband and contributes marketable securities worth $200,000 and a 35% non-controlling interest in Family Business stock to her SLAT. On October 31, 2016 the Family Business enters into a new lease of material value for equipment used in its operations. On November 1, 2016 Family Business pays a dividend pro-rata to its then current shareholders: Wife $15,000, Wife’s SLAT $35,000 and Husband $50,000.

On November 2 Husband establishes a non-reciprocal spousal lifetime access trust (SLAT) for Wife and funds the trust with contributions of interests in a family real estate LLC valued at $200,000. On December 5, 2016 the shareholders of the Family Business execute an Amended and Restated Shareholders’ Agreement. On December 13, 2016 Husband transfers a 35% non-controlling interest in Family Business stock to the SLAT he created. They value each 35% interest at $5,250,000 [$25 million x 35% x (1-.40)].  While there is no assurance that the intervening actions and additional time between components of the transaction will break a step-transaction challenge they do illustrate steps that might be possible to deflect such a challenge. As 2016 draws to a close the feasibility of spacing transactions, or of intervening events occurring, will be more restricted. This too is another reason practitioners should encourage their clients to move more quickly.

Conclusion

While understanding the possible effective date of the Proposed 2704 Regulations, which discounts might be eliminated, etc. is all vital to planning, practitioners must also consider the wide body of laws and issues that affect all planning and how those issues may need to be addressed in the unique circumstances of planning for the possible reduction or elimination of valuation discounts. A broad planning perspective and attention to ancillary issues is essential to success.

RELATED EDUCATION

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 ABOUT THE AUTHOR

Martin M. ShenkmanMartin “Marty” Shenkman, CPA, MBA, PFS, AEP, JD is an estate planning attorney and Certified Public Accountant from Paramus, New Jersey. He received his Bachelor of Science degree from Wharton School, University of Pennsylvania 1977 with a concentration in accounting and economics. He received a Masters degree in Business Administration from the University of Michigan 1981, with a concentration in tax and finance.

Mr. Shenkman is a widely quoted expert on tax matters and is a regular source for numerous financial and business publications, including The Wall Street Journal, Fortune, Money, The New York Times, and others. He has appeared as a tax expert on numerous television and cable television shows including The Today Show, CNN, NBC Evening News, CNBC, MSNBC, CNN-FN and others. He is a frequent guest on radio talk shows throughout the country and has a regular weekly radio show on Money Matters Financial Network.

Mr. Shenkman is a prolific author, having published thirty-four books and more than seven hundred articles. Mr. Shenkman has served as contributing editor to a host of publications, including: New Jersey Lawyer, The Journal of Real Estate Finance, Real Estate Insight, Commercial Leasing Law & Strategy, The Journal of Accountancy, Real Estate Accounting and Taxation, Shopping Centers Today, and others.

Mr. Shenkman is active in numerous charitable organizations, sitting on many boards and planned giving committees and lectures regularly for these and other organizations.

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