Valuation and Planning Lessons From Smaldino

The recent Tax Court decision in Smaldino v. Commissioner1 provides important lessons regarding the valuation of gifts of discounted interests in a family limited partnership. In that case, Louis P. Smaldino placed 10 rental properties in Southern California in Smaldino Investments, LLC  (Smaldino Investments) in late 2012. The entity was owned through Louis’ revocable trust. A few months later, in April 2013, he transferred effectively a 49% interest in Smaldino Investments to an irrevocable trust. But there were a few wrinkles to this transfer:

1. Approximately 41 percentage points of the transfer were made indirectly by first transferring this portion to Louis’ wife, Agustina. Agustina then transferred it, the next day, to the irrevocable trust —at least according to the transfer documents.2
2. Smaldino Investments had two classes of interests. The senior voting interest also had the right to receive a guaranteed payment of $10,000 per month. What impact, if any, should that have on the valuation of the gift?

Gift Tax Return and Audit

To prepare their 2013 gift tax returns, the Smaldinos retained an appraiser who valued a 49% interest in the class B units of Smaldino Investments at $6,281,000. This appraisal report was dated Aug. 22, 2013 and set the fair market value (FMV) at the exact sum of the two gifts made effective April 2013 by the two taxpayers.

The Internal Revenue Service audited the gift tax returns and determined in its notice of deficiency that Louis had made the entire 49% gift himself and revalued it at $8.18 million, leaving him with a gift tax deficiency of $1.154 million.

The Indirect Gift

The Tax Court applied heightened scrutiny in this case because the parties were related. It also noted that well-established substance over form principles must apply. The court stated that Louis:

... never effectively transferred any membership interest in the LLC to Mrs. Smaldino and consequently that the Dynasty Trust received its entire 49% of the class B membership interests as a gift from petitioner.3

Simply executing the transfer and assignment documents wasn’t controlling in this case. Here are the main facts that led the court to its conclusion:

1. The operating agreement of Smaldino Investments distinguished between the assignment of economic rights and the transfer of membership interests. It stated that no member was entitled to transfer or assign any part of the member’s interest except to other members or trusts for such members. The transfer to Agustina thus wasn’t permitted.
2. A transfer other than to members or their trusts would have been of an assignee interest. An assignee could become a member only by adopting the terms and provisions of the operating agreement, which Agustina never did.
3. The manager of Smaldino Investments (Louis) never gave consent for the admission of Agustina as a member.
4. The exhibit in the operating agreement identifying the members and their respective membership units was never amended to show Agustina as one of the members.
5. All of the certificates of transfer, as well as the amended operating agreement that was effective April 15 (presumably after the last transfer), were undated, a fact the court found particularly significant when also considering that the amounts equaled the concluded value in the appraisal report dated more than four months later.4
6. Finally, the partnership tax returns of Smaldino Investments never reported any partners for tax year 2013 other than Louis and the irrevocable trust.

Valuation of Guaranteed Payments

With the recharacterization of Agustina’s purported transfer as an actual indirect transfer from Louis, the petitioner owed gift taxes on the transfer. But how much? The most consequential difference in valuation methods between the two parties is the valuation of the guaranteed payments to the class A units.

The taxpayer’s appraiser started with the net asset value of Smaldino Investments of approximately $26.8 million, which led him to an estimated FMV for a 49% class B interest of $13.1 million. From this amount, however, he deducted both: (1) the standard valuation discounts for lack of marketability and control; and (2) a $2.928 million amount for the guaranteed payment due to the class A interest holder.

As part of the transfer activity in April 2013, the company’s operating agreement was also amended to provide for the guaranteed payments. Louis was to receive a guaranteed payment of $10,000 per month starting May 15, 2014. The court found that the company in fact paid or accrued $80,000 in such guaranteed payments during the following eight months (the payments ceased thereafter). Louis’ appraiser treated the guaranteed payment as an annuity of $10,000 per month for 40 years. The value of this cash flow stream was calculated using the risk-free long-term monthly adjusted federal rate (AFR) in effect around the valuation date (2.67%).5

Special Valuation Rules

This case is notable primarily because it appears to be the first one in which a court applied the special valuation rules of Section 2701 to a valuation case. The court notes:

Neither party has otherwise argued the applicability of chapter 14 to this case, and we surmise that petitioner does not mean to suggest that chapter 14 should apply to this case other than to support his favored treatment of guaranteed payments. It is instructive, however, to consider the valuation methodology of chapter 14 more comprehensively. For those situations in which section 2701 applies, the value of the junior interest transferred is generally calculated by subtracting the value of the senior interests (including rights to distribution of income or capital that are preferred to rights of the transferred interest) from the aggregate value of all family-held equity interests and then allocating the remaining value among the transferred interest and other interests of the same or junior classes.6

While noting that neither “party has otherwise argued the applicability of chapter 14 to this case,” the court concluded “consistent with chapter 14, but also with this Court’s decision in McCord v. Commissioner,”7 it’s appropriate here to value the class B units by first subtracting the value of the company manager’s priority claim from its NAV and then applying appropriate discounts to the value of the class B units.8

Two key valuation inputs, then, remained to be decided to arrive at the value of the guaranteed payment: the discount rate (the AFR) and the length of the annuity.

The AFR

In support of his appraiser’s valuation of the guaranteed payment, Louis suggests that the AFR is appropriate because the “guaranteed payment is payable in all circumstances, whether the LLC has cash flow or profit or not.” But this doesn’t get Louis off the hook because the operating agreement, as amended, also required that, if the company had insufficient funds to pay the guaranteed payment, then Louis himself (as the class A member) would make additional capital contributions to enable the company to make the guaranteed payment. The court found that the effect of this provision is that “petitioner bore the risk of the LLC’s inability to make guaranteed payments.”9 The IRS argued that the AFR was too low and that a discount rate consistent with the capitalization rate for the properties held by Smaldino Investments—or 6.75%—was more appropriate. Even though the guaranteed payments represent a senior claim, and such claims typically receive a lower rate of return than the average for the entity, the court held in favor of the IRS.

Length of Annuity

Even if the court had held against the taxpayer on the discount rate, the resulting value of the guaranteed payment is still very large, more than $1.6 million. The court’s opinion doesn’t provide a reason or explanation for how Louis’ appraiser arrived at the 40-year period for his annuity calculation. This may be because apparently, this part of his analysis wasn’t disputed in the first place. As the court noted:

Respondent has not otherwise expressly disputed Mr. Biedenbender’s treatment of the guaranteed payments as an annuity payable for 40 years. We deem respondent to have waived or conceded any argument in this regard.10

The IRS appears to have put too much stock in its argument that the guaranteed payments were merely management fees in disguise. It’s not hard to see why this could have happened:

1. The operating agreement of Smaldino Investments originally had no guaranteed payments, but instead allowed the manager (petitioner) to pay himself a management fee equal to 10% of the company’s annual net cash flow. However, he could decrease this amount in his sole discretion, and no such amounts were actually paid.
2. In the amendment effective April 15, 2013, this provision was deleted and replaced with the guaranteed payment to the class A member. Per the agreement, the $10,000 per month was “intended to constitute a guaranteed payment within the meaning of Code Section 707(c) and shall not be treated as a distribution for the purposes of computing the recipient’s capital account.”11
3. Later, on Dec. 31, 2013, the operating agreement was again amended to delete the guaranteed payment and restore the management compensation, except now at 20% of cash flow.

While the IRS didn’t take this opportunity to expressly dispute the taxpayer’s treatment of the guaranteed payment as a 40-year annuity, the IRS did argue that the elimination of the guaranteed payment after only eight months was reason to disallow this deduction altogether. However, the court held that subsequent events generally “are not considered in fixing fair market value, except to the extent that they were reasonably foreseeable” and that the IRS “has not asserted that the elimination of the provision for guaranteed payments was reasonably foreseeable as of April 15, 2013.” Finally, the IRS also hadn’t “argued that the elimination of the provision for guaranteed payments on December 31, 2013, gave rise to a separate gift from petitioner to the other class B members at that time,” and the court deemed this argument waived.

Finally, the lookback rule of IRC Section 2701(d) might have applied here—and may have resulted in an addition to the gift for guaranteed payments not made after the end of 2013 had the IRS argued that Chapter 14 applied to the case—but the court also deemed this argument waived.12

Planning Implications

The result in Smaldino is a very significant effective “discount” to the valuation of the gifted interests of greater than $1.6 million for annuity payments of no more than $80,000. However, this result is unlikely to hold if such arrangements are challenged in future cases. Many of the court’s findings in favor of the taxpayer in this case came on “open goal” questions in which available arguments for the government were deemed waived. The case does, however, provide a preview of how the court could treat similar valuations of senior interests under
Chapter 14 in the future.

Endnotes

1. Smaldino v. Commissioner, 5437-18 (U.S.T.C. Nov. 10, 2021).

2. Undated transfer documents assigned and transferred to Agustina Smaldino a sufficient number of B units to equal $5,249,118.42, which was almost the exact federal estate and gift tax exemption amount available to her at that time. This transfer was stated as being effective April 14, 2013. This same interest was transferred to the irrevocable trust by another undated document, stated as being effective April 15, 2013. A third, also undated, transfer document transferred $1,031,881.58 worth of units from Louis Smaldino to the same irrevocable trust, also effective April 15, 2013.

3. Smaldino, supranote 1, at p. 26.

4. The court’s opinion doesn’t specify whether the appraiser for the tax returns had been retained prior to April 15, which would have provided the appraiser with a chance to communicate his conclusions informally prior to issuing his formal, written appraisal report. The year 2013 was a busy one for many appraisers—so a 4-month delay between concluding on the value and issuing the report doesn’t seem impossible.

5. Smaldino, supra note 1, at pp. 31-32. The fair market value of a 40-year annuity of 480 monthly payments, discounted to the present at 2.67%, equals $2,928,000.

6. Ibid., at pp. 34-35, citing Treasury Regulations Section 25.2701-3(b)(1)-(3).

7. McCord v. Comm’r, 120 T.C. 358. In McCord, the court also first subtracted the value of the class A limited partners’ priority claims against the partnership’s assets when valuing the class B interest.

8. The court opined on a 36% total valuation discount (the dispute between the parties on the discount was only a little over 2%).

9. Purely going by the language of the operating agreement as cited in the court’s opinion, Louis sounds like he had the better argument here: If Louis had made additional capital contributions to make this guaranteed payment (a relatively unlikely event, in any case, as $120,000 per year would tend to be a small portion of the earnings of this entity), then he would presumably also have received additional capital interests for such contributions. Making such additional capital contributions wouldn’t necessarily have made the class A holder worse off.

10. Smaldino, supra note 1, at p. 18.

11. Ibid., at p. 10.

12. The lookback rule generally adds to the taxable gift or a taxable estate if a qualified payment right is valued at an amount greater than zero in the subtraction method and then, subsequently, the qualified payments due aren’t paid.