Whatever your legacy is after you’re gone, whether the legacy is yours or belongs to your grandfather, I would hope that you want your kids and grandchildren to share in some way that legacy you or your mother or grandmother is leaving you all. But many of you all are not all in concurrence as to how the estate shall be handled, and surely not all in agreement as we end the year of 2014. For those of you in this situation, may I suggest tax planning in steps (STTP pronounced STEP) for the family estate and tax plan? No, tax planning in steps is not a new dance step. STTP is the way to move forward on long range estate planning now in 2014 that avoids IRS attack known as the Step Transaction Doctrine. (STD pronounced STUD) Unfortunately the IRS sees STDs even when there is none, and throws your STTP into dead end brick walls resulting in increased tax pain and injury for all. So if your mom and dad or grandparents have substantial assets and you are looking to at least get started on planning your legacy, stay tuned to TaxView with Chris Moss CPA to learn how to stay clear of IRS STTP to STD conversion audits and allow your legacy to be safely preserved for many generations to come.
You will not find “STD” in the IRS code. The concept of STD is carved from hundreds of Federal tax court cases and is a spin-off from the Substance over Form Doctrine codified by Congress into subsection 7701(o) as part of the Health Care and Education Reconciliation Act of 2010. STD then remains a totally Court made law somewhat guided by Section 7701(o). The IRS generally argues that STD is a series of transactions or “steps” over many months or years, that when taken as a whole, convert a taxpayer's innocent STTP to a sinister STD scheme to avoid taxation.
On the other hand a STTP could be viewed as a legal alternative to STD. So are you a good candidate for STTP? Whether it be a private foundation for the arts to be created for the family, or whether it be the family farm being assembled for succession, or perhaps the vast commercial real estate enterprise you have spent your entire life to build now ready to pass on to the next generation, one thing you don’t want to happen is for the estate tax to be so large after you pass that you have to sell the farm to pay the tax all because there was disagreement within the family as to the specifics of the estate plan. So STTPs are used when you for whatever reason your family cannot logistically complete the estate plan all at once.
Unfortunately, there are some taxpayers out there who fall into a STD through perhaps bad advice from tax advisors. Directly in response to these poorly structured STDs, IRS audits have been converting even legitimate STTPs to STDs and have been winning big in US Tax Court. See US Tax Court Bianca Gross v IRS (2008), US Tax Court Holman v IRS (2008), US Tax Court Pierre v IRS (2010), CGF Industries v IRS (1999).
While the IRS wins most of the STD cases, they do sometimes lose a legitimate STTP case, like in Klauer v IRS (2010). Peter Klauer founded Klauer Manufacturing in Iowa in 1870 and branched out in New Mexico in 1919. More recently Klauer descendants were in discussions with the US Bureau of Land Management, the US Trust for Preservation of Land and various Indian tribes regarding purchase of the Taos Overlook or at least an option to purchase. Over three years from 2001 2002 and 2003 various agreements were executed all independent of the other. Taken separately each land sale was substantially below market value. Klauer’s S Corporation tax return for 2001 2002 and 2003 claimed millions of dollars as land donated on Form 8283 Noncash Charitable Contributions and various K1s were distributed to the stockholders with their proportionate share of the contribution. All the shareholders filed their Form 1040s for 2001 2002 and 2003 with very large charitable deductions. The IRS audited as a whipsaw and disallowed all charity deductions for all three years causing large amounts of taxes owed by the individual shareholders. The Government claimed all three years were one big STD voiding the below market sales and subsequent large charity deductions. Klauer appealed to US Tax Court in Klauer v IRS 2010 claiming each year stood by itself as separate transactions.
The Court agreed with Klauer because it was clear that each year was separately negotiated with distinct separate agreements. Specifically, Judge Chiechi points out that the supposed first step created no binding commitment to take the second step siting Security Industrial Insurance v US 702 F.2d 1234 (5th Circuit 1983). The Court then focuses on whether the Klauer family intended to save taxes by structuring the three years from 2001-2003 a certain way citing King v US 418 F.2d 511 (Fed Cir 1969). Judge Chiechi argues that Klauer’s subjective intent was especially relevant in allowing the Court to see if Klauer directed a series of transactions to an intended purpose solely to save taxes. The Court found facts created in the record as evidence that Klauer’s primary intent from 2001-2003 was not to create a tax savings scheme but to work the Bureau of Land Management, the Land Trust, and various Indian tribes to allow for the preservation of the Taos Overlook, This had been the intent of the Klauer family for many years. While there were huge tax savings for the shareholders the way the sales were structured that result was secondary to the primary purpose of land preservation. Klauer wins IRS loses.
So where do we all go from here? First, now that you know STDs are thinly disguised tax schemes, your goal is to protect your good STTP estate plan with plenty of written evidence proving to an IRS agent years later that your primary goal is and has always been legacy preservation and protection with tax savings merely as a secondary goal. Second, discuss with your tax attorney and estate planner your options in operating a Family Limited Liability Company (FLLC) to keep, protect, preserve and grow your family legacy. You may be also able to minimize taxes as you transfer assets between generations, but saving taxes can never be your primary objective. Your tax attorney can create your FLLC in 2014 as a single member or partner with your husband or wife if married with a basic operating agreement. Finally, the whole concept of a legal and IRS bullet proof STTP is that the family estate plan is fluid with no one step leading to a predetermined second step. So while the STTP path may change direction and save you taxes along the way, your final and primary destination will always be legacy protection and preservation. We look forward to perhaps seeing you on that STTP path as we soon close out 2014. A Merry Christmas to all in 2014 from TaxView with Chris Moss CPA
Stay tuned for our year end TaxView special for 2014.
Chris Moss CPA