2025 Planning Should Begin Before the End of 2024: The Step Transaction Doctrine Can Undermine Last-Minute Plans

Originally published on The CPA Journal

Planning for 2025 is becoming a hotter topic as the scheduled halving of the transfer tax exemption draws closer. But while many are focusing on the end of 2025 as the critical deadline, the end of 2024 warrants greater attention. The first reason on the minds of many is that, for nonreciprocal spousal lifetime access trusts (SLAT), it may be preferable to create one in 2024 and a second in 2025. Having more time between the creation of the two trusts may help differentiate them from a reciprocal trust doctrine attack. Planners tend to feel more secure when each trust has a different tax year; this makes year-end 2024 an important deadline for pre-2026 planning.

While avoiding the reciprocal trust doctrine has attracted much attention (perhaps disproportionately so), it is not the only relevant tax consideration. The step-transaction doctrine deserves attention, especially before the end of 2024. A step-transaction challenge could undermine steps taken to plan an estate before 2026 to secure exemption. The step-transaction doctrine might be applied by the IRS to collapse what otherwise might be separate steps of a plan into fewer steps and arrive at a different result than intended. The key point is that action may be advisable before the end of 2024 to infuse more time, and a separate income tax year, between the retitling of assets from one spouse to another (and other restructuring steps). Individuals should take a longer-term and broader view of pre-2026 planning to potentially deflect a step transaction challenge. This article will focus on how advisors can address the step-transaction doctrine in formulating client planning. Although action before the end of 2024 may be advisable, the following considerations will also be relevant in 2025.

An Example that Might Violate the Step-Transaction Doctrine

The following example illustrates the potential application of the step-transaction doctrine.

Wife is a surgeon and wants to both protect her assets from a malpractice claim and move them out of her estate before the gift and generation-skipping transfer (GST) tax exemption is halved in 2026. Husband is a schoolteacher and has few assets in his name. Neither spouse is concerned about the liability risks faced by Husband, and they have a large excess personal liability (umbrella) policy in place to address common risks. Wife gifts $10 million of securities outright to Husband. The following week, Husband creates a trust to benefit Wife and all of their descendants and transfers the same $10 million of assets into it. The step-transaction doctrine could be applied to this “plan” and unravel it. Wife could be treated as if she, not Husband, made the gift to the trust; that may place those assets back into her estate and make them reachable by her claimants in a malpractice suit. Such a plan would be for naught; even worse, because if Wife gifted her entire exemption to a trust for heirs, the $10 million gift attributed to her under the step-transaction doctrine could create a $10 million taxable gift.

Planners should consider that the courts are not bound by the twisted path taken by taxpayers, and the intervening stops may be disregarded or rearranged [see Smith v. Comm’r., 78 T.C. 350, 398 (1982)].

Modifications to Avoid Violating the Step-Transaction Doctrine

The following example illustrates how planning may reduce the risk of the application of the step-transaction doctrine.

Assume the same facts as above. Wife gifts $6 million of cash and $4 million of marketable securities outright to Husband in mid-2024. The following month, Husband meets with his financial advisor, creates and signs a new investment policy statement changing the investment goals and asset allocation; Husband uses some of the funds for personal purchases. Both of these acts show Husband exerting control over the assets that are now his. Husband then creates a family LLC to hold most, but not all, of the assets he was gifted, and he and the children contribute to that LLC’s capital. Late in 2024, Husband creates a trust to benefit Wife and all of their descendants, and transfers modest amounts of assets that he had held long term to create an initial funding. Wife makes a gift of $18,100 to a child and files a gift tax return reporting that gift; she also reports the marital gift to Husband, even though it is not required. The purpose of reporting the gift is to demonstrate her intent to consummate the gift and put it on record. Husband files a gift tax return reporting his creation and initial funding of the SLAT. Husband has his financial planner create new forecasts and determine through that analysis an amount that Husband might reasonably gift to the new trust. In November 2025, Husband makes a gift of $9.5 million in assets, including most of the LLC formed in 2024, some of the securities that he then holds (reallocated holdings that originated from the gift he received) into the 2024 trust.

The step-transaction doctrine should be less likely to be applied to this revised plan. By starting the planning in 2024, letting significant time pass between Wife making a gift to Husband and Husband making a gift to a trust that also benefits Wife, the risk of a step transaction challenge should be lowered because of this time frame. Waiting to make gifts or retitle assets to 2025 will limit what can be done. This plan is feasible in part because of the extra time afforded by beginning the planning in 2024, enabling Husband to take several economically significant steps to demonstrate control over the funds gifted to him.

This revised planning scenario may provide better arguments that Husband’s funding of the trust he created was his own independent transfer:

• -Husband treated the funds Wife gave him as his own. He reallocated the investments, withdrew and used funds from the gifted money, and contributed a portion to a new LLC.
• -Husband hired his own investment advisor to advise him on the funds and the nature of the funds changed from a largely cash gift to an investment portfolio.
• -The amount Wife gave the husband did not correlate to the amount Husband gave the trust he created.
• -Husband did not merely re-gift the funds Wife gave—he had an independent analysis completed to arrive at the amount he could give.
• -More than a year passed from Wife’s gift to Husband and Husband’s transfers to the trust.
• -Husband’s gift was in a separate tax year from Wife’s gift.

Smaldino Case Unraveled a Plan Based on a Step-Transaction Doctrine

The Tax Court unraveled an estate plan based on the step-transaction doctrine (and also based on the taxpayers ignoring formalities of their own plan). In Smaldino v. Comm’r. (T.C. Memo. 2021-127, November 10, 2021) the husband purported to gift his second wife interests in a family limited liability company (LLC). The next day, the wife purportedly transferred the identical asset by gift to a trust for the husband’s children from a prior marriage. The court found that it was really the husband that made the transfer to the trust; the wife was merely a straw-person to facilitate the transfer and never really owned the interests involved. The circularity of the transaction was problematic and created bad optics. The taxpayers also did not adhere to several formalities that called the planning into question. No K-1 was issued to the wife for the day she held the LLC interest. The prerequisites to transfer in the existing operating agreement (manager approval) were not complied with. No new operating agreement was signed by the wife reflecting her as an owner. Planners should encourage clients to address all the appropriate formalities to support their plan. Although those are not the only factors to deflect a step-transaction challenge, they can, together with the timing and exercise of control and independent economic events, make the client’s planning safer.

There Are No Bright Line Rules

Taxpayers and advisors like bright line rules. It would be great to know that if, say, more than 30 days pass between steps that the step-transaction doctrine would be avoided, but there really are no bright line rules. This is why the more time that passes between any actions, the more steps and economic control that can be exercised by the donee spouse, the better.

Note that it is not only a donee spouse that is affected by the risk of a step-transaction challenge. If joint or community assets are divided, the spouse/holder of the now separate post-division/transmuted property may also be challenged and might consider taking similar steps.

Worse Plans Have Been Made

Many plans have facts that are far less compelling than the second illustration above, but have successfully defeated an IRS challenge. For example, in 2020 and 2021 when advisors and taxpayers suspected imminent, significant, and detrimental estate tax law changes, many taxpayers implemented plans, such as nonreciprocal SLATs, and funded them with little or no time elapsing between the components of the plan. Those plans, and their tight timing, were motivated by the fear government could change the tax laws any day, such that the risks of minimal time between planning actions might, in the client’s view, have been outweighed by the perceived risks of not completing planning before a change in the tax laws became effective.

Avoid Completing Multiple Steps on the Same Day

The IRS has raised the step-transaction doctrine in the context of family partnership and similar transactions wherein taxpayers were endeavoring to use an entity, such as an FLP or LLC structure, to create discounts [see Senda, 433 F. 3d 1044; Shepherd v. Comm’r, 115 T.C. 376 (2000), aff’d 283 F. 3d 1258 (11th Cir. 2002)]. But these same concepts could be readily applied in many estate planning structures, so planners should be cautious and advise clients of potential step-transaction risks. One such risk, which will occur with greater frequency as the end of 2024 approaches and even more so before the end of 2025, is the pressure to complete various actions in a single day. This pressure occurs not only before year-end, when parties want transactions completed because of tax deadlines, but also due to the desire of clients to reduce costs and minimize billing time. This can lead to pressure to complete various steps in a single day. 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 [999 T.C.M. (CCH) 1436; see also Heckerman v. U.S., No. CO8-0211-JCC, 2009 WL 2240326 (W.D. Wash., July 27, 2009)]. For example, assets may be titled jointly to a couple. The assets may need to be divided between each spouse, contributed to a new entity, and then transferred to various trusts. Although sometimes there is no choice but to complete these multiple steps on the same day, this is not ideal. If multiple steps are implemented on a single day that require a particular sequence to succeed, consider whether the documentation should indicate the time signed in addition to the date signed to corroborate the appropriate sequence.

Time and Economic Consequences of Each Step in a Plan

In a key case, the Tax Court found that holding stock for a mere six days, in one step along the planning path, was enough time for the tax plan to succeed (Holman v. Comm’r, 130 TC No. 12, 5/27/08). The parents transferred stock to a family limited partnership (FLP). Approximately six days later, they gifted part of the partnership interests to a trust and argued that the value of the FLP interests should be discounted from the value of the underlying stock’s value. The IRS challenged the plan using the step-transaction doctrine, arguing that the parents really made direct gifts of the stock to their children’s trusts. This argument was based on the FLP not being real, rather just being a way station (or step) on the path from the parents to the trust so that not only would the FLP be ignored, but the discounts in value the parents claimed would be as well. The gifts would be considered indirect gifts of the stock (no discount), instead of gifts of limited partnership interests (discounted). The IRS reasoned that the step-transaction doctrine provides that if a series of steps in a transaction are so integrated and interdependent, economic reality may be better reflected by collapsing the various steps into a single step. The court, in a resounding victory for the taxpayers, determined that during the six-day period that the FLP held the stock created an economic risk that the value could change because publicly traded stock is volatile. Thus, the discounts on limited partnership interests were respected.

Although few tax experts would recommend a six-day holding period, the lessons of Holman are important to consider when changing ownership or title to assets, restructuring assets into entities, and transmuting community property before gifting it. Certainly, the longer time between steps, the better. But as the court reasoned in Holman, there also should be an economic consequence to each step. In Holman, it was the risk of loss of the value of the underlying assets. What might the economic consequences be on each step of the transaction? Consider the revised planning example illustrated above in this context.

Avoid Interdependent Steps

In Smaldino, there were no consequences to the wife/donee’s purported holding of the LLC interests she received as a gift. Her “ownership” was merely a step along the way of a transfer to a trust for the benefit of her husband’s children from a prior marriage. Unlike Holman, there was no economic risk of the underlying real estate values in Smaldino changing in a short period of time, in contrast to the marketable security in Holman. In addition, the one-day holding period was so short as to not be meaningful. In Smaldino, the taxpayers could have endeavored to infuse economic consequences to the wife’s holding the interests for longer, and through distributions, renegotiating a lease, or perhaps other steps.

The court in Linton v. U.S. found that the taxpayers crafted a scheme that consisted of pre-arranged parts of a single tax plan [638 F. Supp. 2d, 1277 (W.D. Wash. 2009)]. The court found those steps were interdependent. The court did not believe that the taxpayers would have undertaken the initial steps in the plan without the later and integrated acts. It did not find real economic risks of a change in asset values during the time between steps.

Three Factors That Might Affect Applicability of the Step-Transaction Doctrine

If the steps in the plan have to “lien,” or rely on each other to stand, they may be deemed interdependent. Would the parties do step 3 if steps 2 and 5 were not also done? If the answer is no, then there might be a step-transaction issue. This can be referred to as a “mutual interdependence test.” To analyze a plan from this lens, consider each step and try to determine whether specific steps are meaningless unless all the other steps happen. Consider whether the IRS can show that the various steps are really pre-arranged parts of a single plan that are intended from the beginning to achieve a particular end result. This factor is sometimes called the “end result test.”

Although there is no bright line rule as to what is required for steps to stand independently, there should be legal documentation completed for each phase. For example, a client who was to purchase an interest in an LLC would likely have not only a purchase document and assignment of LLC membership interests, but also a signed operating agreement. Legal counsel probably would advise against a client investing in an entity without a governing document. Yet, in some transactions if there are interim steps some practitioners might not bother with that interim governing document. That might be a mistake; the court in Smaldino thought so.

If the parties have contractual or other obligations to complete all steps in a plan, it might be viewed as a fait accompli once the first step is taken that all remaining steps would follow. The IRS might be more successful challenging such a plan if all of the various steps occurred in close time proximity to each other [Penrod v. Comm’r, 88 T.C. 1415 (1987)]. This is thus referred to by some as the “binding commitment test.”

The Penrod test is why advisors should encourage clients to plan now and take steps as early in 2024 as feasible. If taxpayers wish to use the exemption before the end of 2025, having steps spread out over time, and ideally in different tax years, could help break the Penrod close proximity test. As 2025 approaches, there will be less time and perhaps more risk of an IRS step-transaction challenge succeeding.

Step-Transaction Planning Suggestions

The best time to address the risks of a step transaction challenge is at the planning stage. Planners should consider the following:

• -The longer the time span between each phase of a plan, the more likely that each planning step can stand independently. Time alone should not be the sole factor considered. Other factors might help negate the application of the step-transaction doctrine. This broader approach is also important because there is no bright line rule on timing.
• -Ideally, there should be economic implications to each step of the plan. Under Holman, merely holding marketable securities may entail sufficient economic risk. But additional steps might be feasible, perhaps those suggested in the example above. If interests in an LLC are transferred, a distribution might be made from the entity while that recipient holds the interests. If assets are transferred directly from one spouse to the other, contributing those assets in part to an entity might be viewed as having economic implications, especially if there are other equity owners or if control may be diminished.
• -To the extent feasible, each step in the plan should be able to serve as the final step. There should ideally be no requirement, or even need, to proceed to later steps. This might be problematic in that planning, often documented in memoranda, may look at the potential entirety of all steps. Although advisors might be tempted not to document the steps under consideration, defensive practices may demand that practitioners document the steps and the attendant risks of the plan, one of which may be a step transaction challenge.
• -The recipient of a transfer should exercise control, to the extent feasible, over the asset received; that may entail economic consequences. In the earlier example, it was suggested that a donee spouse revise the asset allocation, sign a new investment policy statement, or spend some of the funds. There is no authority to confirm the relevance of these suggestions; the point is to encourage or suggest that clients take steps that show both control and have economic consequences.
• -Carefully adhere to all the legal formalities the plan would seem to suggest. For example, if interests in an LLC are transferred from one person to another, then to another entity, and finally to a trust, then the LLC could have a new operating agreement that is amended and restated and signed at each transfer, confirming the new owner after that particular step. Similar steps could be taken for an S corporation with an amended and restated shareholders’ agreement. In addition, consider new bylaws or changing officers and directors to reflect new owners.

Carefully adhere to all the tax formalities suggested by the plan. Again, assume that interests in an entity, such as an LLC, are transferred from one person to another, then to another entity, and finally to a trust. The LLC, assuming that it is taxed as a partnership for income tax purposes, should issue a K-1 to each owner properly reflecting the number of days each owned an interest in that LLC during the year [see Sorensen v. Comm’r, Tax Ct. Dkt. Nos. 24797-18, 24798-18, 20284-19, 20285-19 (decision entered Aug. 22, 2022)].

How Can CPAs Backstop Planning?

In most complex plans, there are dozens if not scores of steps and documents. These are often crafted by counsel, sometimes without a CPA’s involvement. But CPAs can provide a valuable second look at all planning when later compliance steps are addressed. Whatever planning is done, it will have to be reflected on income and likely gift tax returns. CPAs should review the overall structure of the plan and the documents involved to be certain that each step in a plan is documented, and that the phases in the plan flow logically. If anything appears to be missing or unaddressed, this should be raised with client’s counsel who should then address it.

Before filing an income tax return, CPAs should have a permanent file with relevant documentation. When preparing a gift tax return, endeavoring to meet the adequate disclosure regulations should include identifying documentation for all phases of the transaction. CPAs need not act as a lawyer; rather, they serve as independent “eyes” to identify missing issues and documents. As missing items are inevitably identified, when counsel prepares them, they should have an effective date appropriate to the transactions involved, as well as the date of actual signature. Although corporate counsel may commonly have documents signed with merely an effective date, Smaldino made clear that the date of actual signature should be reflected as well.