A Grantor Trust is a Trust that is ignored for tax purposes. Back when Federal Income Tax Rates were much higher, wealthy individuals would establish many trusts for their descendants to push income in to the lower brackets. The trusts were designed to give the Grantor lots of power over the various trusts. Congress decided to maintain the integrity of the Federal Income Tax System by implementing the Grantor Trust Rules. If a Grantor retains certain powers over a trust, then the trust is ignored for income tax purposes. This, in effect, keeps all of the income of the various trusts that "violate" the Grantor Trust rules combined back on the Grantor's income tax returns at the Grantor's marginal bracket.
Back when income tax rates were much higher, the Grantor Trust rules limited the usefulness of trusts. In fact, a trust that violated the Grantor Trust rules was said to be a defective trust. A trust that did not work. If designed for income tax planning, that is correct, the trusts would no longer meet those goals.
Today, Income Tax Rates are lower. Additionally, to further limit the utility of trusts to dilute the income tax base, the tax brackets for trusts are greatly compressed. That is, a trust hits the highest income tax bracket at only around $11,000 of taxable income. This compression of the brackets makes using trusts to manipulate income tax rates unattractive. The Grantor Trust rules are actually no longer needed, but they remain in the law.
The Grantor Trust rules provide a distinct tax advantage from a gift and estate tax point of view. If a gift is made to a properly drafted trust, that trust will keep the assets of the trust out of the Grantor's taxable estate. At the same time, the trust will be ignored for income tax purposes.
This dual tax status trust is essentially a vehicle to allow you to make a gift to your spouse, children or other beneficiaries that can grow income tax free. Income tax-free compounding is a powerful tool for the transfer of wealth.
Remember the estate tax is scheduled to return on 01/01/11 with a $1 million exemption and a 55% highest rate. The assets in a properly structured Grantor Trust not only grow income tax free during the grantor's life, but also will not be subject to an estate tax hit.
Grantor trusts is one more tool to help you Disinherit Uncle Sam.
Patrick
Wednesday, November 24, 2010
Wednesday, October 20, 2010
Using the Beneficiary Controlled Trust
What is a Beneficiary Controlled Trust?
A Beneficiary Controlled Trust is an estate or gift tax planning technique where parents leave property to their children in a trust rather than outright. As the name implies, the child-beneficiary is the trustee of the trust. Thus, the Beneficiary Controlled Trust.
Why are estate planners and their clients increasingly using Beneficiary Controlled Trusts?
It is easier to explain why, if we first understand that there are essentially two methods to leave property to the typical child, excluding those that are irresponsible, etc., they are:
- Outright to the child
- In a trust for the child where the child is the trustee
What are the factors used in the comparison?
We start by listing the things that a beneficiary can do when the property is left outright and free of trust with how those same things included in a Beneficiary Controlled Trust.
What can an owner of property do with the property?
There is actually a fairly limited number of things, they can do, they are:
- Give the property away
- Leave the property to anyone they want
- Use the property without paying for the use
- Sell the property
- Destroy the property
- Lose the property to a creditor
- Lose the property to a divorcing spouse
Yes, that is exactly correct. Let’s see what the comparison shows:
- Give the property away: The beneficiary-trustee of a Beneficiary Controlled Trust may be given the power to make gifts of the property in the trust to anyone other than the beneficiary or the creditors of the beneficiary. In essence, the Beneficiary Controlled Trust is identical to the outright bequest free of trust. We’ll give this an Equal rating.
- Leave the Property to anyone they want: The beneficiary-trustee may be given the power to leave the property to anyone other than the beneficiary’s estate, creditors of the beneficiary, or the creditors of the beneficiary’s estate. In essence, the Beneficiary Controlled Trust is identical to the outright bequest free of trust. We’ll give this an Equal rating.
- Use the property without paying for the use: The beneficiary-trustee of the Beneficiary Controlled Trust may be authorized to use the property of the trust without paying for the use. In essence, the Beneficiary Controlled Trust is identical to the outright bequest free of trust. We’ll give this an Equal rating.
- Sell the property: The beneficiary-trustee may be given the power to sell the property and reinvest the proceeds. In essence, the Beneficiary Controlled Trust is identical to the outright bequest free of trust. We’ll give this an Equal rating.
- Destroy the property: The beneficiary-trustee may not be given the power to destroy the property. The Beneficiary Controlled Trust provides more property protection than an outright bequest. We’ll give the Trust a Superior Protection rating.
- Lose the property to a creditor: The Beneficiary Controlled Trust may be prepared in such a manner that creditors of the beneficiary-trustee may not attach assets held in the Beneficiary Controlled Trust. The Beneficiary Controlled Trust provides better creditor protection. We’ll give the Trust a Superior Protection rating.
- Lose the property to a divorcing spouse: The Beneficiary Controlled Trust can be prepared such that a divorcing spouse has little or no rights to the Beneficiary Controlled Trust’s property. The Beneficiary Controlled Trust provides better asset protection. We’ll give the Trust a Superior Protection rating.
Now, let’s see how the Beneficiary Controlled Trust did in the item by item comparison:
Give the property away | EQUAL RATING |
Leave the property to anyone they want | EQUAL RATING |
Use the property without paying for the use | EQUAL RATING |
Sell the property | EQUAL RATING |
Destroy the property | SUPERIOR PROTECTION |
Lose the property to a creditor | SUPERIOR PROTECTION |
Lose the property to a divorcing spouse | SUPERIOR PROTECTION |
Since the Beneficiary Controlled Trust is so far superior to outright bequests, why doesn’t everyone use them?
The primary reason is many estate planning practitioners are simply not familiar with the technique. In addition, some clients simply do not want, what they perceive to be, “complicated estate plans.”
Are Beneficiary Controlled Trusts complicated?
No, they are not. An easy comparison is the Family or Credit Shelter Trust that holds the estate tax free amount for the first spouse to die. An annual tax return is due and accounting and monitoring must be done. However, it seems to me that the benefits provided by the Beneficiary Controlled Trust far outweigh the additional costs after the surviving spouse has died.
Successor Trustee? Tips on Avoiding Potential Liability
To help you avoid personal liability in connection when serving as trustee, follow three rules:
- Document all transactions, including any reasons for making or not making distributions. While you may perceive the risk of getting sued as low, you cannot ignore the possibility. When you are acting as a trustee and are essentially in control of someone else's assets, you can easily become the focus of any anger or frustration that beneficiaries may feel.
- Keep beneficiaries well informed of trust business. Be friendly and cooperative. It is much more difficult to sue someone with whom you have a good relationship. Maintain carefully documented files. Seek advice from experts.
- Consider the dynamics of a lawsuit against a trustee. Judges and juries alike tend to have more sympathy for the party who appears to be “right.” If you have sloppy records (or have none), or if you have not sought help when you came up against something beyond your expertise, or if you have not provided beneficiaries with information that you should have, you will not be given the benefit of the doubt.
Tuesday, October 19, 2010
Inheritance Trust to Protect an Inheritance from Creditors
Many of my clients are deeply concerned about how litigious our society has become and fear that their assets may one day be taken by creditors. As a result, they desire to legally protect their assets from creditors, including the possibility of divorce. If you share these concerns, I want you to be aware of an important technique that can asset protect an inheritance and provide an important piece of your estate plan.
The traditional estate planning process focuses exclusively on passing assets downstream to beneficiaries (i.e., to children and grandchildren), often ignoring a potential inheritance from parents or other family members. However, Americans are living longer and longer and trillions of dollars will change hands in the coming decades. Most of these assets will be transferred in a manner that is not protected from the claims of creditors or former spouses.
The laws of most states, including North Carolina, prohibit so-called "self-settled trusts" - an irrevocable trust you establish for your benefit, yet which purports to protect the trust assets from creditors. Therefore, once you receive an inheritance, it is too late to asset protect it. For potential inheritances, we can, by creating an Inheritance Trust to be the recipient of the inheritance, protect these assets. An Inheritance Trust legally protects the inherited assets yet allows you to access them as necessary. It also may remove a substantial portion of the assets from your potential taxable estate, thereby saving estate taxes at your death.
If you want to know more, please contact me.
Patrick
The traditional estate planning process focuses exclusively on passing assets downstream to beneficiaries (i.e., to children and grandchildren), often ignoring a potential inheritance from parents or other family members. However, Americans are living longer and longer and trillions of dollars will change hands in the coming decades. Most of these assets will be transferred in a manner that is not protected from the claims of creditors or former spouses.
The laws of most states, including North Carolina, prohibit so-called "self-settled trusts" - an irrevocable trust you establish for your benefit, yet which purports to protect the trust assets from creditors. Therefore, once you receive an inheritance, it is too late to asset protect it. For potential inheritances, we can, by creating an Inheritance Trust to be the recipient of the inheritance, protect these assets. An Inheritance Trust legally protects the inherited assets yet allows you to access them as necessary. It also may remove a substantial portion of the assets from your potential taxable estate, thereby saving estate taxes at your death.
If you want to know more, please contact me.
Patrick
Monday, October 18, 2010
Alaska Community Property Trusts
There is a planning strategy that could reduce income taxes for married couples. The Alaska Community Property Trust permits married couples to transfer assets to a spouse at death, totally eliminating capital gains on all appreciated assets owned by the couple.
Married couples who live in the ten Community Property states (Alaska, Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin) and hold their assets as community property receive a full "ste-up" in basis at the death of the first spouse for purposes of determining capital gains tax when the property is later sold. Consequently, residents of community property states benefit from a significant capital gains tax savings by holding appreciated property as community property, an advantage unavailable to the rest of the nation, where only the assets of the deceased spouse would receive a step-up in basis (typically considered 1/2 of joint property).
Alaska, however, specifically allows non-Alaska residents who meet certain criteria to "borrow" the features of Alaska Community Property law and eliminate capital gains on their appreciated assets at the death of the first spouse. It is now possible for you to transfer your appreciated property to a special trust drafted to take advantage of Alaska Community Property Trust features.
Upon the first spousal death, the survivor of beneficiaries can then sell the property paying tax only on the gains above the date of death value. If you read this, and are interested, please contact me.
Note: The rules for basis step up in 2010 are particular to 2010, this post does not address the 2010 issues.
Patrick
Married couples who live in the ten Community Property states (Alaska, Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin) and hold their assets as community property receive a full "ste-up" in basis at the death of the first spouse for purposes of determining capital gains tax when the property is later sold. Consequently, residents of community property states benefit from a significant capital gains tax savings by holding appreciated property as community property, an advantage unavailable to the rest of the nation, where only the assets of the deceased spouse would receive a step-up in basis (typically considered 1/2 of joint property).
Alaska, however, specifically allows non-Alaska residents who meet certain criteria to "borrow" the features of Alaska Community Property law and eliminate capital gains on their appreciated assets at the death of the first spouse. It is now possible for you to transfer your appreciated property to a special trust drafted to take advantage of Alaska Community Property Trust features.
Upon the first spousal death, the survivor of beneficiaries can then sell the property paying tax only on the gains above the date of death value. If you read this, and are interested, please contact me.
Note: The rules for basis step up in 2010 are particular to 2010, this post does not address the 2010 issues.
Patrick
Saturday, October 2, 2010
Business Exit Planning Using Charitable Strategies
Business owners usually have four goals when they leave their businesses: retire from the business; sell to a new owner (family members, employees, or third parties); minimize taxes and maximize profits. For those who are already charitably inclined, business exit planning using charitable tools allows them to add a fifth goal: doing good things for their favorite charity or their community.
Tools for Business Exit Planning Involving Charitable Giving
Three tools involving charities are typically used in business exit planning: charitable remainder trusts, gift annuities and charitable lead trusts.
A charitable remainder trust (CRT) is a tax-exempt trust. It is primarily an income tax planning tool with some estate and gift tax benefits. With a CRT, the appreciation in assets can be realized without immediate gain recognition tax-free, a stream of payments created for the donor and a deferred benefit provided to a charity. An income tax deduction, gift tax deduction or estate tax deduction is based on the remainder value that passes or is projected to pass to charity at the end of the trust term. Certain private foundation rules apply, which can be problematic.
A gift annuity is essentially a bargain sale in which the consideration paid by the charity is in the form of annuity payments. Code Section 72 specifies how the income is categorized; i.e., how much is return of principal and how much is ordinary income. Code Section 1011 specifies how gains are recognized, for example if the gift annuity is funded by contribution of appreciated assets. Code Section 415 limits payments to one or two persons. Private foundation rules do not apply to gift annuities.
A charitable lead trust (CLT) is the opposite of a charitable remainder trust in that the income stream is paid to charity with the remainder going to private individuals. A CLT is primarily an estate or gift tax tool. If it is set up as a grantor trust, it can also provide some income tax benefits. Unlike a CRT, a CLT is not a tax-exempt trust. Some private foundation rules apply to CLTs.
Business Succession Pitfalls
When trying to do charitable planning in conjunction with business exit planning, there are three potential pitfalls: having the transaction treated as a prearranged sale, the unrelated business taxable income (UBTI) rules, and the rule against self-dealing, which is one of the private foundation rules.
Prearranged Sales
Most business owners want a high degree of control, especially when it comes to selling their business. Often they will want to negotiate the sale, execute a binding sale contract, and then transfer the property subject to the sale obligation. That will not work because it violates the prearranged sale rule. Violating that rule means that the IRS will treat the donation as but one step in a unified transaction. Revenue Ruling 78-197 provides:
Under Rev. Rul. 78-197, the key then is whether the charity (or the Trustee of the CRT or CLT) is obligated to sell the donated property to the buyer that the donor has identified.
If the donor violates the prearranged sale rule, the sale proceeds will be income to the donor and the donor will not avoid recognizing the capital gains on the sale.
Planning Tip: The donor can identify and let potential buyers know that the business is for sale and even negotiate a sale price as long as the charity or Trustee is not obligated to go through with that sale.
Unrelated Business Taxable Income (UBTI)
All tax-exempt organizations and charitable trusts are subject to tax on UBTI. UBTI is income from a trade or business that is owned and regularly carried on by a charity or charitable trust that is not substantially related to the tax-exempt function of the charity.
Exceptions include dividends, interest, annuities, royalties, certain rents from real and personal property and capital gains - unless they are derived from debt-financed property.
Income from debt-financed property is UBTI regardless of whether the organization is actually engaged in a trade or business. Debt-financed property is any property held to produce income and with respect to which there is acquisition indebtedness. Acquisition indebtedness generally means indebtedness incurred when acquiring or improving the property.
A charity has acquisition indebtedness when it acquires property (by a gift or purchase) that is subject to debt or borrows against the property to make improvements. Property is considered "debt-financed" even when the charity or trust acquires the property "subject to" the debt.
There are, however, a couple of exceptions:
The Income Tax Impact of UBTI
A charity, including one with gift annuities, must pay tax on all of the UBTI it receives.
For CRTs, any UBTI is confiscated through a 100% excise tax. (The rule used to be different - that if a CRT received any UBTI in a year, all of its income for that year was treated as UBTI.)
For CLTs, when it makes a distribution of the unitrust or annuity amount to the charity, it takes a 100% deduction. However, if the CLT has UBTI, this deduction drops to 50% if paid to a public charity and to 0% if paid to a private foundation.
Self-Dealing
Code Section 4941 lists six specific acts of self-dealing for a private foundation:
Disqualified persons (also defined in Section 4941) are the donor; the trustee; family members (which include the grantor's spouse, ancestors, children, grandchildren, great-grandchildren and the spouses of these individuals); and controlled business organizations (those in which 35% or more of the ownership interest is controlled by disqualified persons).
The tax code makes the private foundation self-dealing rules applicable to CRTs and CLTs. This essentially prohibits all transactions between a CRT or CLT and the donor (and the donor's family) and any business in which the donor and his family have a 35% or greater ownership interest.
Planning Tip: Charities are not disqualified persons, so the remainder charity could purchase something from the trust and that would not cause a self-dealing problem.
Planning Tip: Self-dealing does not apply to transactions involving gift annuities that are maintained only by public charities. This makes gift annuities an important planning tool in business succession planning.
Conclusion
Incorporating charitable planning tools in business exit planning provides unique opportunities for the business owner who is already interested in charitable giving, as well as providing excellent opportunities for the professional advisors to work together.
Tools for Business Exit Planning Involving Charitable Giving
Three tools involving charities are typically used in business exit planning: charitable remainder trusts, gift annuities and charitable lead trusts.
A charitable remainder trust (CRT) is a tax-exempt trust. It is primarily an income tax planning tool with some estate and gift tax benefits. With a CRT, the appreciation in assets can be realized without immediate gain recognition tax-free, a stream of payments created for the donor and a deferred benefit provided to a charity. An income tax deduction, gift tax deduction or estate tax deduction is based on the remainder value that passes or is projected to pass to charity at the end of the trust term. Certain private foundation rules apply, which can be problematic.
A gift annuity is essentially a bargain sale in which the consideration paid by the charity is in the form of annuity payments. Code Section 72 specifies how the income is categorized; i.e., how much is return of principal and how much is ordinary income. Code Section 1011 specifies how gains are recognized, for example if the gift annuity is funded by contribution of appreciated assets. Code Section 415 limits payments to one or two persons. Private foundation rules do not apply to gift annuities.
A charitable lead trust (CLT) is the opposite of a charitable remainder trust in that the income stream is paid to charity with the remainder going to private individuals. A CLT is primarily an estate or gift tax tool. If it is set up as a grantor trust, it can also provide some income tax benefits. Unlike a CRT, a CLT is not a tax-exempt trust. Some private foundation rules apply to CLTs.
Business Succession Pitfalls
When trying to do charitable planning in conjunction with business exit planning, there are three potential pitfalls: having the transaction treated as a prearranged sale, the unrelated business taxable income (UBTI) rules, and the rule against self-dealing, which is one of the private foundation rules.
Prearranged Sales
Most business owners want a high degree of control, especially when it comes to selling their business. Often they will want to negotiate the sale, execute a binding sale contract, and then transfer the property subject to the sale obligation. That will not work because it violates the prearranged sale rule. Violating that rule means that the IRS will treat the donation as but one step in a unified transaction. Revenue Ruling 78-197 provides:
- [The IRS] will treat proceeds of a redemption of stock...as income to the donor only if the donee (charity) is legally bound or compelled by the corporation to surrender the shares for redemption.
Under Rev. Rul. 78-197, the key then is whether the charity (or the Trustee of the CRT or CLT) is obligated to sell the donated property to the buyer that the donor has identified.
If the donor violates the prearranged sale rule, the sale proceeds will be income to the donor and the donor will not avoid recognizing the capital gains on the sale.
Planning Tip: The donor can identify and let potential buyers know that the business is for sale and even negotiate a sale price as long as the charity or Trustee is not obligated to go through with that sale.
Unrelated Business Taxable Income (UBTI)
All tax-exempt organizations and charitable trusts are subject to tax on UBTI. UBTI is income from a trade or business that is owned and regularly carried on by a charity or charitable trust that is not substantially related to the tax-exempt function of the charity.
Exceptions include dividends, interest, annuities, royalties, certain rents from real and personal property and capital gains - unless they are derived from debt-financed property.
Income from debt-financed property is UBTI regardless of whether the organization is actually engaged in a trade or business. Debt-financed property is any property held to produce income and with respect to which there is acquisition indebtedness. Acquisition indebtedness generally means indebtedness incurred when acquiring or improving the property.
A charity has acquisition indebtedness when it acquires property (by a gift or purchase) that is subject to debt or borrows against the property to make improvements. Property is considered "debt-financed" even when the charity or trust acquires the property "subject to" the debt.
There are, however, a couple of exceptions:
- An organization will not recognize UBTI solely because the property is debt-financed property for 10 years after receipt if the transfer occurs because of the donor's death.
- Lifetime gifts are not considered "debt financed" if three conditions are met: the organization does not assume the debt, the donor had owned the property for more than five years at the time of the contribution, and the debt had existed on the property for more than five years at the time of the contribution.
The Income Tax Impact of UBTI
A charity, including one with gift annuities, must pay tax on all of the UBTI it receives.
For CRTs, any UBTI is confiscated through a 100% excise tax. (The rule used to be different - that if a CRT received any UBTI in a year, all of its income for that year was treated as UBTI.)
For CLTs, when it makes a distribution of the unitrust or annuity amount to the charity, it takes a 100% deduction. However, if the CLT has UBTI, this deduction drops to 50% if paid to a public charity and to 0% if paid to a private foundation.
Self-Dealing
Code Section 4941 lists six specific acts of self-dealing for a private foundation:
- The sale, exchange or leasing of property between a disqualified person and the foundation, regardless of the size of the transaction;
- Loans of money or any other extension of credit between a disqualified person and the foundation;
- The furnishings of goods, services or facilities between a disqualified person and the foundation;
- The payment of compensation or reimbursement of expenses by the foundation to a disqualified person;
- The transfer of income or an asset from the foundation to a disqualified person for the disqualified person's use or benefit; and
- An agreement by the foundation to pay a government official, other than an agreement to employ the official for any period after the termination of his government service, if the official terminates his government service within a 90-day period.
Disqualified persons (also defined in Section 4941) are the donor; the trustee; family members (which include the grantor's spouse, ancestors, children, grandchildren, great-grandchildren and the spouses of these individuals); and controlled business organizations (those in which 35% or more of the ownership interest is controlled by disqualified persons).
The tax code makes the private foundation self-dealing rules applicable to CRTs and CLTs. This essentially prohibits all transactions between a CRT or CLT and the donor (and the donor's family) and any business in which the donor and his family have a 35% or greater ownership interest.
Planning Tip: Charities are not disqualified persons, so the remainder charity could purchase something from the trust and that would not cause a self-dealing problem.
Planning Tip: Self-dealing does not apply to transactions involving gift annuities that are maintained only by public charities. This makes gift annuities an important planning tool in business succession planning.
Conclusion
Incorporating charitable planning tools in business exit planning provides unique opportunities for the business owner who is already interested in charitable giving, as well as providing excellent opportunities for the professional advisors to work together.
Wednesday, September 22, 2010
My son has married a woman with two children and they have just had one of their own. If I leave assets to my grandchildren, will my son’s stepchildren be included?
No, unless....
Step-relations are not “descendants” for purposes of North Carolina inheritance law. Unless your son legally adopts them or you specifically include them in your definition of descendants in your estate planning documents they will not inherit. This is not true for half-relatives. In North Carolina a half is generally as good as a whole. For example, if you die intestate (without a will) and you leave a full sibling and a half-sibling, they will share your estate.
Step-relations are not “descendants” for purposes of North Carolina inheritance law. Unless your son legally adopts them or you specifically include them in your definition of descendants in your estate planning documents they will not inherit. This is not true for half-relatives. In North Carolina a half is generally as good as a whole. For example, if you die intestate (without a will) and you leave a full sibling and a half-sibling, they will share your estate.
Wednesday, September 1, 2010
Transferring Business Interests to Family Members: Sale of Non-Voting Stock Interests to Grantor Dynasty Trusts
Most of us have at least one client who has a family-owned or closely held business interest as a major part of their estate. Typically, that client has done nothing to plan for the succession of the business. That kind of planning can be challenging because of the complex tax issues and the human element (egos, relationships, etc.) involved. On the other hand, it can be most rewarding, and it offers excellent opportunities to create a deeper relationship with an existing client and build a relationship with the next generation. It also offers the opportunity to create ongoing professional relationships with other key advisors, as we must work together to achieve the best results for our mutual client.
Below, we will examine a case study of how clients can benefit from selling non-voting stock in a closely held business to a specific type of "grantor" dynasty trust.
Our Case Study
The Facts: Harry the husband, age 62, is married to Wilma the wife, age 58. This is a second marriage for both of them. They have no prenuptial agreement and no estate plan. Steve, who is Harry's son, is actively involved in Harry's business. Wilma's daughter Dottie is unemployed and not involved in Harry's business, which Wilma and Dottie resent. Harry and Wilma have one joint child, Mark, who is a minor and is also not involved in Harry's business. Neither Harry nor Wilma has used any of their $1,000,000 lifetime gift tax exemption.
Harry owns 100% of a business that is an S-corporation. It is very successful and has a current fair market value of $10 million. It also has significant cash flow and high growth potential. Harry's desire (which Steve shares) is for Steve to own and continue the business after Harry retires or dies.
There are significant other assets in the estate, including their home and other investments. Some are owned jointly by Harry and Wilma, and some are owned solely by Harry.
Under the probate laws of the state in which they live, if Harry dies intestate Wilma will receive half interest in each of Harry's assets and Steve and Mark will each receive a one quarter interest in each of them. As a result, Wilma, as Mark's guardian, will end up controlling 75% of the business while Steve will only control 25%. In addition, assuming Harry does not die in 2010, there will be a potentially huge estate tax liability. This is not what Harry wants to happen.
Harry's Goals and Objectives: After meeting with his team of advisors, Harry has defined his goals and objectives as:
To meet Harry's goals and objectives, here is the plan his advisors recommend and why:
Phase 1: Reorganize and Recapitalize the S-Corporation
In a tax-free reorganization, convert the S-corporation to a limited liability company taxed as an S-corporation with voting and non-voting common units.
Harry owns all of the 1,000 outstanding shares of the company. They are all voting shares. After the reorganization and issue of voting and non-voting membership units, Harry still owns 100% of the business, only now it is 10 LLC membership units (1%) that are voting and 990 (99%) that are non-voting. Why reorganization of the S-corporation into an LLC is part of the plan will be explained later.
Phase 2: Create Dynasty Trusts
Establish an irrevocable trust for each child that is designed so that its income is taxable to Harry and make initial contributions to the trust.
Harry creates three irrevocable grantor trusts, one for each child, in a jurisdiction that permits perpetual private trusts. The trusts are all "grantor" trusts for income tax purposes, but not for estate and gift tax purposes. These are known as Irrevocable Deemed Owned Trusts (IDOTs). Some call them Intentionally Defective Grantor Trusts (IDGTs).
Planning Tip: It is possible (and an excellent idea) to design the IDOTs so that their income being taxed to Harry can be stopped if that becomes desirable later.
Harry makes a $600,000 cash gift to the trust established for Steve. This is a taxable gift that must be reported on a Federal gift tax return (IRS Form 709). However, no gift tax will be due because $600,000 of Harry's $1 million lifetime gift tax exclusion will be used to shelter the gift from taxation.
Harry will also allocate $600,000 of his generation skipping transfer tax exclusion to Steve's trust. Steve's trust will therefore have a zero inclusion ratio (i.e., have a 0% tax rate) for generation skipping transfer tax purposes.
Planning Tip: In 2010, because the generation skipping transfer tax is suspended, this allocation cannot be made. Therefore, consider making late GST exemption allocations in 2011 when the GST returns, if Congress amends the tax code to permit doing so. Alternatively, delay implementing Phase 2 until 2011.
When Harry and Wilma make gifts to the trusts for Dottie and Mark, they do the same kind of allocations.
This trust structure provides a huge benefit to their descendants because the trusts' assets will never be included in their descendants' estates for estate tax purposes.
Phase 3: Sell Non-Voting Membership Units to Steve's Trust for an Installment Note
To give Steve ultimate ownership of Harry's business, start by selling all of the non-voting membership units to the dynasty trust for Steve.
To make a private sale or gift between family members of something valuable that does not have a known value, the IRS requires that a qualified valuation expert determine its fair market value. When what is sold or given away is an interest in a business, there are two steps to the valuation. First, the balance sheet assets owned by the business (real estate, specialized equipment, inventory, etc.) are valued. Then a business evaluation is performed to determine whether and to what extent the value of the assets underlying an interest in the business needs to be adjusted for lack of control over the business and lack of marketability of the membership interests.
The reason that the S-corporation was reorganized into an LLC taxed as an S-corporation is that limitations on the transferability of a business interest are disregarded in the valuation if they are greater than the default provisions of the state law that govern the business. The default provision for corporations is that there is no limitation on transferability. On the other hand, some states' default provision on LLC membership transfer is that all members must consent.
When the adjustments for lack of control and lack of liquidity are made to non-voting interests in an LLC, it is not uncommon that their cumulative effect is to depress the fair market value by a significant amount. In this case, we assume that the non-voting units' value will be depressed 40% because of lack of control and lack of marketability. Thus, the non-voting units will have a value of $6,000 per unit, making the total value of the 990 non-voting units $5,940,000.
Voting units will have a premium value to reflect the control value. In this example, the voting units have an appraised value of $12,000 per unit, making the total value of the 10 voting units equal to $120,000.
The fair market value of the entire company, sold as a unit, is still $10 million, but the value of the parts does not add up to $10 million! That it is only $5,940,000 + $120,000 = $6,060,000.
In this phase, Harry sells his 990 non-voting units to the dynasty trust for Steve using a 20-year installment note, payable annually. The note is for $5,940,000 (the fair market value of the 990 non-voting units) and is at a rate of 4.26% (which is slightly above the current long-term AFR rate). Based on the value and terms of the note, the trust will pay Harry $447,197 every year for 20 years. This is a legitimate arms-length business transaction because Steve's dynasty trust is a creditworthy borrower since its assets ($600,000 initial gift + $5,940,000 in LLC units) exceed the value of what it has bought by more than 10%.
Planning Tip: There is no "bright line" test for what is a commercially reasonable loan-to-value ratio. Many practitioners use 10%, but some are more comfortable at 20%.
Planning Tip: Make sure the installment note is handled just like an installment sale to a non-family member or to a bank. Have a signed pledge or security agreement, pay any tax required, do any filings required. Make sure you have a documented paper trail.
The Outcome
Company Ownership and Control
After Phase 3 is completed, Harry owns 10 voting units, which gives him 100% control of the business and 1% of the equity. The dynasty trust for Steve owns 990 non-voting units, which gives it no control over the business and 99% of the equity. The dynasty trust also has $600,000 in cash that Harry gifted to it as seed capital.
Income Tax Reporting
Harry is deemed to be the "owner" of the dynasty trust for Steve for purposes of reporting its income. As long as that is so, the dynasty trust for Steve does not have to file a Form 1041 fiduciary income tax return. Instead, an information return is filed, with the dynasty trust income tax information reported to Harry as the trust's deemed owner, for reporting on his personal Form 1040 income tax return.
Income Tax Effect of Sale of Membership Units
Harry's sale of LLC units to the dynasty trust for Steve is a "non-recognition" event. Because Harry is the deemed owner of the trust for income tax purposes, it is treated as a sale by Harry to himself. Thus no gain is recognized on the sale of the stock and no interest income is recognized on the installment note payments. Of course, the trust does not receive a deduction for interest payments made either.
"Pass Through" Dynasty Trust Income
Income from the LLC will be allocated to the unit holders based on their unit ownership percentages. Let's assume the business has $500,000 in net income. Harry owns 10 voting units, which is equal to 1% of the equity. Therefore, Harry will be allocated $5,000 in K-1 income. The dynasty trust for Steve owns 990 non-voting units, which is equal to 99% of the equity. Therefore it will be allocated $495,000 in K-1 income.
Because the dynasty trusts are structured as grantor trusts for income tax purposes, Harry must pay the income tax attributable to all of their income, including the S-corporation income that is allocated to the trust for Steve. But that is what he was doing before the sale of his non-voting units to Steve's trust, so he is paying the same income tax before and after the sale of the units. Harry's payment of the trusts' income tax is not an additional gift to the trusts, which means that every year Harry is transferring, gift tax free, additional estate assets to the trusts for the children.
How the Dynasty Trust Makes the Required Note Payments
We assume for this case study that the LLC will have $500,000 per year of cash flow to distribute to its unit holders. That will provide Steve's dynasty a cash distribution of $495,000 ($500,000 x 99% = $495,000). Thus at the end of year one it will have $1,095,000 in cash ($495,000 from the LLC and the $600,000 that was gifted to it as seed capital). The trustee can thus easily make the $447,197 note payment to Harry.
Planning Tip: If the company does not generate enough income to pay the note, take the same approach as if a borrower can't repay a bank loan. Options would include deferring payment until such time as the business recovers or renegotiating the term or interest rate of the note.
Results After Year One
At the end of the first year, the note has been reduced to $5,745,847 and the dynasty trust has a cash balance of $647,803. The trustee of the dynasty trust could use this cash to:
Planning Tip: A higher income tax rate would mean less income, but there may be other sources of income. For example, Harry is still in control of his company, and he may receive a salary as well as compensation as a Director on its Board.
Planning Tip: Harry may be able to reduce his salary from the LLC if he does not need the cash flow. This would save payroll tax and would give the business more cash flow. However, make sure he receives enough in salary to continue to qualify for group health insurance coverage.
When Harry Dies
If Harry has either consumed or gifted the net after the tax note payments that he receives from Steve's dynasty trust, only the unpaid balance of the note will be included in his taxable estate; there is no asset "build-up" inside his estate as the company grows.
The dynasty trust for Steve is GST "exempt" so that following Harry's death its assets will never be subject to estate, gift or GST taxation (unless the Congress changes the rules).
So are the dynasty trusts established for Dottie and Mark, so the life insurance proceeds received by them on Harry's death are also GST "exempt," providing a legacy for them and their descendants.
Harry could leave the 10 voting units (1%) to Steve in trust, too.
This arrangement would leave Steve's trusts owning 100% of the business and the other children's GST exempt trust shares owning cash.
Harry's wife Wilma will continue to receive the remaining note payments for her support.
Estate Tax Results
Using this technique, all of Harry's goals and objectives were met. His son Steve would receive the business without having to buy him out, yet Harry could control the timing of the business transfer. He was able to provide for his other children and his wife. In addition, Harry saved substantial estate taxes.
This technique also presents excellent opportunities for strengthening professional relationships, as it requires a team of advisors to work together to achieve these goals. Remember to collaborate as needed. Also remember to present the information to your clients and their advisors in a way that is easily understood and therefore less threatening. In order for your clients to be motivated to act, they must understand what you are recommending and the benefits to them.
Below, we will examine a case study of how clients can benefit from selling non-voting stock in a closely held business to a specific type of "grantor" dynasty trust.
Our Case Study
The Facts: Harry the husband, age 62, is married to Wilma the wife, age 58. This is a second marriage for both of them. They have no prenuptial agreement and no estate plan. Steve, who is Harry's son, is actively involved in Harry's business. Wilma's daughter Dottie is unemployed and not involved in Harry's business, which Wilma and Dottie resent. Harry and Wilma have one joint child, Mark, who is a minor and is also not involved in Harry's business. Neither Harry nor Wilma has used any of their $1,000,000 lifetime gift tax exemption.
Harry owns 100% of a business that is an S-corporation. It is very successful and has a current fair market value of $10 million. It also has significant cash flow and high growth potential. Harry's desire (which Steve shares) is for Steve to own and continue the business after Harry retires or dies.
There are significant other assets in the estate, including their home and other investments. Some are owned jointly by Harry and Wilma, and some are owned solely by Harry.
Under the probate laws of the state in which they live, if Harry dies intestate Wilma will receive half interest in each of Harry's assets and Steve and Mark will each receive a one quarter interest in each of them. As a result, Wilma, as Mark's guardian, will end up controlling 75% of the business while Steve will only control 25%. In addition, assuming Harry does not die in 2010, there will be a potentially huge estate tax liability. This is not what Harry wants to happen.
Harry's Goals and Objectives: After meeting with his team of advisors, Harry has defined his goals and objectives as:
- To have a comprehensive plan that will ensure ownership of the business will pass to his son Steve. (Steve also wants the security of knowing the business will one day become his.)
- To be in control of the timing of the transfer of the business.
- To treat his stepdaughter and his younger son fairly.
- To have enough cash flow for now and to provide for Wilma if he dies first.
- To save estate taxes.
To meet Harry's goals and objectives, here is the plan his advisors recommend and why:
Phase 1: Reorganize and Recapitalize the S-Corporation
In a tax-free reorganization, convert the S-corporation to a limited liability company taxed as an S-corporation with voting and non-voting common units.
Harry owns all of the 1,000 outstanding shares of the company. They are all voting shares. After the reorganization and issue of voting and non-voting membership units, Harry still owns 100% of the business, only now it is 10 LLC membership units (1%) that are voting and 990 (99%) that are non-voting. Why reorganization of the S-corporation into an LLC is part of the plan will be explained later.
Phase 2: Create Dynasty Trusts
Establish an irrevocable trust for each child that is designed so that its income is taxable to Harry and make initial contributions to the trust.
Harry creates three irrevocable grantor trusts, one for each child, in a jurisdiction that permits perpetual private trusts. The trusts are all "grantor" trusts for income tax purposes, but not for estate and gift tax purposes. These are known as Irrevocable Deemed Owned Trusts (IDOTs). Some call them Intentionally Defective Grantor Trusts (IDGTs).
Planning Tip: It is possible (and an excellent idea) to design the IDOTs so that their income being taxed to Harry can be stopped if that becomes desirable later.
Harry makes a $600,000 cash gift to the trust established for Steve. This is a taxable gift that must be reported on a Federal gift tax return (IRS Form 709). However, no gift tax will be due because $600,000 of Harry's $1 million lifetime gift tax exclusion will be used to shelter the gift from taxation.
Harry will also allocate $600,000 of his generation skipping transfer tax exclusion to Steve's trust. Steve's trust will therefore have a zero inclusion ratio (i.e., have a 0% tax rate) for generation skipping transfer tax purposes.
Planning Tip: In 2010, because the generation skipping transfer tax is suspended, this allocation cannot be made. Therefore, consider making late GST exemption allocations in 2011 when the GST returns, if Congress amends the tax code to permit doing so. Alternatively, delay implementing Phase 2 until 2011.
When Harry and Wilma make gifts to the trusts for Dottie and Mark, they do the same kind of allocations.
This trust structure provides a huge benefit to their descendants because the trusts' assets will never be included in their descendants' estates for estate tax purposes.
Phase 3: Sell Non-Voting Membership Units to Steve's Trust for an Installment Note
To give Steve ultimate ownership of Harry's business, start by selling all of the non-voting membership units to the dynasty trust for Steve.
To make a private sale or gift between family members of something valuable that does not have a known value, the IRS requires that a qualified valuation expert determine its fair market value. When what is sold or given away is an interest in a business, there are two steps to the valuation. First, the balance sheet assets owned by the business (real estate, specialized equipment, inventory, etc.) are valued. Then a business evaluation is performed to determine whether and to what extent the value of the assets underlying an interest in the business needs to be adjusted for lack of control over the business and lack of marketability of the membership interests.
The reason that the S-corporation was reorganized into an LLC taxed as an S-corporation is that limitations on the transferability of a business interest are disregarded in the valuation if they are greater than the default provisions of the state law that govern the business. The default provision for corporations is that there is no limitation on transferability. On the other hand, some states' default provision on LLC membership transfer is that all members must consent.
When the adjustments for lack of control and lack of liquidity are made to non-voting interests in an LLC, it is not uncommon that their cumulative effect is to depress the fair market value by a significant amount. In this case, we assume that the non-voting units' value will be depressed 40% because of lack of control and lack of marketability. Thus, the non-voting units will have a value of $6,000 per unit, making the total value of the 990 non-voting units $5,940,000.
Voting units will have a premium value to reflect the control value. In this example, the voting units have an appraised value of $12,000 per unit, making the total value of the 10 voting units equal to $120,000.
The fair market value of the entire company, sold as a unit, is still $10 million, but the value of the parts does not add up to $10 million! That it is only $5,940,000 + $120,000 = $6,060,000.
In this phase, Harry sells his 990 non-voting units to the dynasty trust for Steve using a 20-year installment note, payable annually. The note is for $5,940,000 (the fair market value of the 990 non-voting units) and is at a rate of 4.26% (which is slightly above the current long-term AFR rate). Based on the value and terms of the note, the trust will pay Harry $447,197 every year for 20 years. This is a legitimate arms-length business transaction because Steve's dynasty trust is a creditworthy borrower since its assets ($600,000 initial gift + $5,940,000 in LLC units) exceed the value of what it has bought by more than 10%.
Planning Tip: There is no "bright line" test for what is a commercially reasonable loan-to-value ratio. Many practitioners use 10%, but some are more comfortable at 20%.
Planning Tip: Make sure the installment note is handled just like an installment sale to a non-family member or to a bank. Have a signed pledge or security agreement, pay any tax required, do any filings required. Make sure you have a documented paper trail.
The Outcome
Company Ownership and Control
After Phase 3 is completed, Harry owns 10 voting units, which gives him 100% control of the business and 1% of the equity. The dynasty trust for Steve owns 990 non-voting units, which gives it no control over the business and 99% of the equity. The dynasty trust also has $600,000 in cash that Harry gifted to it as seed capital.
Income Tax Reporting
Harry is deemed to be the "owner" of the dynasty trust for Steve for purposes of reporting its income. As long as that is so, the dynasty trust for Steve does not have to file a Form 1041 fiduciary income tax return. Instead, an information return is filed, with the dynasty trust income tax information reported to Harry as the trust's deemed owner, for reporting on his personal Form 1040 income tax return.
Income Tax Effect of Sale of Membership Units
Harry's sale of LLC units to the dynasty trust for Steve is a "non-recognition" event. Because Harry is the deemed owner of the trust for income tax purposes, it is treated as a sale by Harry to himself. Thus no gain is recognized on the sale of the stock and no interest income is recognized on the installment note payments. Of course, the trust does not receive a deduction for interest payments made either.
"Pass Through" Dynasty Trust Income
Income from the LLC will be allocated to the unit holders based on their unit ownership percentages. Let's assume the business has $500,000 in net income. Harry owns 10 voting units, which is equal to 1% of the equity. Therefore, Harry will be allocated $5,000 in K-1 income. The dynasty trust for Steve owns 990 non-voting units, which is equal to 99% of the equity. Therefore it will be allocated $495,000 in K-1 income.
Because the dynasty trusts are structured as grantor trusts for income tax purposes, Harry must pay the income tax attributable to all of their income, including the S-corporation income that is allocated to the trust for Steve. But that is what he was doing before the sale of his non-voting units to Steve's trust, so he is paying the same income tax before and after the sale of the units. Harry's payment of the trusts' income tax is not an additional gift to the trusts, which means that every year Harry is transferring, gift tax free, additional estate assets to the trusts for the children.
How the Dynasty Trust Makes the Required Note Payments
We assume for this case study that the LLC will have $500,000 per year of cash flow to distribute to its unit holders. That will provide Steve's dynasty a cash distribution of $495,000 ($500,000 x 99% = $495,000). Thus at the end of year one it will have $1,095,000 in cash ($495,000 from the LLC and the $600,000 that was gifted to it as seed capital). The trustee can thus easily make the $447,197 note payment to Harry.
Planning Tip: If the company does not generate enough income to pay the note, take the same approach as if a borrower can't repay a bank loan. Options would include deferring payment until such time as the business recovers or renegotiating the term or interest rate of the note.
Results After Year One
At the end of the first year, the note has been reduced to $5,745,847 and the dynasty trust has a cash balance of $647,803. The trustee of the dynasty trust could use this cash to:
- Invest and save. (Income taxes on the earnings would be taxed to Harry.)
- Make distributions to the trust beneficiaries. (Distributions would be gift tax-free.)
- Buy life insurance on Harry's life.
Planning Tip: A higher income tax rate would mean less income, but there may be other sources of income. For example, Harry is still in control of his company, and he may receive a salary as well as compensation as a Director on its Board.
Planning Tip: Harry may be able to reduce his salary from the LLC if he does not need the cash flow. This would save payroll tax and would give the business more cash flow. However, make sure he receives enough in salary to continue to qualify for group health insurance coverage.
When Harry Dies
If Harry has either consumed or gifted the net after the tax note payments that he receives from Steve's dynasty trust, only the unpaid balance of the note will be included in his taxable estate; there is no asset "build-up" inside his estate as the company grows.
The dynasty trust for Steve is GST "exempt" so that following Harry's death its assets will never be subject to estate, gift or GST taxation (unless the Congress changes the rules).
So are the dynasty trusts established for Dottie and Mark, so the life insurance proceeds received by them on Harry's death are also GST "exempt," providing a legacy for them and their descendants.
Harry could leave the 10 voting units (1%) to Steve in trust, too.
This arrangement would leave Steve's trusts owning 100% of the business and the other children's GST exempt trust shares owning cash.
Harry's wife Wilma will continue to receive the remaining note payments for her support.
Estate Tax Results
- Harry has removed $10,600,000 of appreciating assets from his gross estate that, at his death, would be subject to estate tax. Unless the Congress acts quickly, the top rate after the catch-up tax will be 55% in 2011.
- Harry has received an asset (the self-amortizing note) that is based on a discounted asset value, frozen (will not appreciate in value) and depreciating (the note principal will decrease over the 20-year note amortization term).
- If Harry does not accumulate the note payments, then at the end of the note term (20 years), he will have totally removed the $10,600,000 (plus all future appreciation on this amount) from his gross estate without making a taxable gift other than the initial $600,000 seed capital gift.
- The trust assets are in a generation skipping tax-exempt trusts that can include asset protection features. These trust assets are not included in the children's or grandchildren's gross estates at their deaths.
Using this technique, all of Harry's goals and objectives were met. His son Steve would receive the business without having to buy him out, yet Harry could control the timing of the business transfer. He was able to provide for his other children and his wife. In addition, Harry saved substantial estate taxes.
This technique also presents excellent opportunities for strengthening professional relationships, as it requires a team of advisors to work together to achieve these goals. Remember to collaborate as needed. Also remember to present the information to your clients and their advisors in a way that is easily understood and therefore less threatening. In order for your clients to be motivated to act, they must understand what you are recommending and the benefits to them.
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