When the Tax Cuts and Jobs Act[1] was introduced on November 2, 2017, perhaps the single most important issue on the minds of many closely held business owners was the future of the estate tax: was it going to be repealed as had been promised? A closely related question – and perhaps of equal significance to these owners’ tax advisers – was whether an owner’s assets would receive a so-called “stepped-up” basis in the hands of those persons to whom the assets passed upon the owner’s death?

When the smoke cleared (only seven weeks later), the estate tax remained in place, but its reach was seriously limited, at least temporarily. Moreover, the stepped-up basis rule continued to benefit the beneficiaries of a decedent’s estate.

To better understand the change wrought by the Act – and to appreciate what it left intact – we begin with an overview of the federal transfer taxes.

The Estate and Gift Tax

The Code imposes a gift tax on certain lifetime transfers, an estate tax on certain transfers at death, and a generation-skipping transfer (“GST”) tax when such transfers are made to a “skip person.”

Estate Tax

The Code imposes a tax on the transfer of the taxable estate of a decedent who is a citizen or resident of the U.S. The taxable estate is determined by deducting from the value of the decedent’s gross estate any deductions provided for in the Code. After applying tax rates to determine a tentative amount of estate tax, certain credits are subtracted to determine estate tax liability.

Estate Tax

A decedent’s gross estate includes, to the extent provided for in other sections of the Code, the date-of-death value of all of a decedent’s property, real or personal, tangible or intangible, wherever situated. In the case of a business owner, the principal asset of his gross estate may be his interest in a closely held business. In general, the value of the property for this purpose is the fair market value of the property as of the date of the decedent’s death.

A decedent’s taxable estate is determined by subtracting from the value of his gross estate any deductions provided for in the Code. Among these deductions is one for certain transfers to a surviving spouse, the effect of which is to remove the assets transferred to the surviving spouse from the decedent’s estate tax base.

After accounting for any allowable deductions, a gross amount of estate tax is computed, using a top marginal tax rate of 40%.

In order to ensure that a decedent only gets one run up through the rate brackets for all lifetime gifts and transfers at death, his taxable estate is combined with the value of the “adjusted taxable gifts” made by the decedent during his life, before applying tax rates to determine a tentative total amount of tax. The portion of the tentative tax attributable to lifetime gifts is then subtracted from the total tentative tax to determine the gross estate tax.

The estate tax liability is then determined by subtracting any allowable credits from the gross estate tax. The most significant credit allowed for estate tax purposes is the unified credit.

The unified credit is available with respect to a taxpayer’s taxable transfers by gift and at death. The credit offsets the tax up to a specified cumulative amount of lifetime and testamentary transfers (the “exemption amount”). For 2017, the inflation-indexed exemption amount was set at $5.49 million; prior to the Act, it was set to increase to $5.6 million in 2018.

Any portion of an individual taxpayer’s exemption amount that is used during his lifetime to offset taxable gifts reduces the exemption amount that remains available at his death to offset the taxable value of his estate. In other words, the unified credit available at death is reduced by the amount of unified credit used to offset gift tax incurred on gifts made during the decedent’s life.

In the case of a married decedent, an election is available under which any exemption amount that was not used by the decedent may be used by the decedent’s surviving spouse (the so-called “portability election”) during her life or at her death.

The estate tax generally is due within nine months of a decedent’s death. However, in recognition of the illiquid nature of most closely held businesses, the Code generally allows the executor of a deceased business owner’s estate to elect to pay the estate tax attributable to an interest in a closely held business in up to ten installments. An estate is eligible for payment of the estate tax in installments if the value of the decedent’s interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate (i.e., the gross estate less certain deductions).

If the election is made, the estate may defer payment of principal and pay only interest for the first five years[2], followed by up to 10 annual installments of principal and interest. This provision effectively extends the time for paying estate tax by 14 years from the original due date of the estate tax.

Gift Tax

The Code imposes a tax for each calendar year on the transfer of property by gift during such year by any individual. The amount of taxable gifts for a calendar year is determined by subtracting from the total amount of gifts made during the year: (1) the gift tax annual exclusion; and (2) allowable deductions.

The gift tax for a taxable year is determined by: (1) computing a tentative tax on the combined amount of all taxable gifts for such year and all prior calendar years using the common gift tax and estate tax rate (up to 40 percent); (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of unified credit not consumed by prior-year gifts.

The amount of a taxpayer’s taxable gifts for the year is determined by subtracting from the total amount of the taxpayer’s gifts for the year the gift tax annual exclusion amount and any available deductions.

Donors of lifetime gifts are provided an annual exclusion of $15,000 per donee in 2018 (indexed for inflation from the 1997 annual exclusion amount of $10,000) for gifts of “present interests” in property. Married couples can gift up to $30,000 per donee per year without consuming any of their unified credit.

GST Tax

The GST tax is a separate tax that can apply in addition to either the gift tax or the estate tax. The tax rate and exemption amount for GST tax purposes are set by reference to the estate tax rules. The GST tax is imposed using the highest estate tax rate (40%). Tax is imposed on cumulative generation-skipping transfers in excess of the generation-skipping transfer tax exemption amount in effect for the year of the transfer. The generation-skipping transfer tax exemption for a given year is equal to the estate tax exemption amount in effect for that year ($5.49 million in 2017).

Basis in property received at death

A bequest, or other transfer at death, of appreciated (or loss) property is not an income tax realization event for the transferor-decedent or his estate, but the Code nevertheless provides special rules for determining a recipient’s income tax basis in assets received from a decedent.

Property acquired from a decedent or his estate generally takes a stepped-up basis in the hands of the recipient. “Stepped-up basis” means that the basis of property acquired from a decedent’s estate generally is the fair market value on the date of the decedent’s death. Providing a fair market value basis eliminates the recognition of income on any appreciation in value of the property that occurred prior to the decedent’s death (by stepping-up its basis).[3]

In the case of a closely held business, depending upon the nature of the business entity (for example, a partnership or a corporation) and of its assets, the income tax savings resulting from the basis step-up may be realized as reduced gain on the sale of the decedent’s interest in the business, or as a reduced income tax liability from the operation of the business (for example, in the form of increased depreciation or amortization deductions).

The Act

To the disappointment of many, the Act did not repeal the federal estate tax.

However, the Act greatly increased the federal estate tax, gift tax, and GST tax exemption amount – for decedents dying, and for gifts made, after December 31, 2017 and before January 1, 2026 – and it preserved portability.

The “basic exemption amount” was increased from $5 million (as of 2010) to $10 million; as indicated above, this amount is indexed for inflation occurring after 2011, and was set at $5.6 million for 2018 prior to the Act.

As a result of the Act, this exemption amount was doubled to $11.2 million per person beginning in 2018 – basically, $22.4 million per married couple – and will be adjusted annually for inflation through 2025.

To put this into perspective, over 109,000 estate tax returns were filed in 2001, of which approximately 50,000 were taxable. Compare this with 2016, when approximately 11,000 returns were filed, of which approximately 5,000 were taxable. The decline appears to be due primarily to the increase in the filing threshold (based on the exemption amount) from $675,000 in 2001 to $5.45 million in 2016.[4] An increase from $5.49 million in 2017 to $11.2 million in 2018 should have a similar effect.

In addition, and notwithstanding the increased exemption amount, the Act retained the stepped-up basis rule for determining the income tax basis of assets acquired from a decedent. As a result, property acquired from a decedent’s estate generally will continue to take a stepped-up basis.

Implications

As stated immediately above, the owners of many closely held businesses will not be subject to the federal estate tax – at least not through 2025[5] – thanks to the greatly increased exemption amount and to continued portability.

Thus, a deceased owner’s taxable (not gross) estate in 2018 – even if we only account for conservative valuations of his business interests and for reasonable estate administration expenses – may be as great as $22.4 million (assuming portability) without incurring any federal estate tax.

Moreover, this amount ignores the benefits of fairly conservative gift planning including, for example, the long-term impact of regular annual exclusion gifting (and gift-splitting between spouses), the effect of transfers made for partial consideration (as in a QPRT), or for full and adequate consideration (as in zeroed-out GRATs and installment sales), as well as the benefit of properly-structured life insurance that is not includible in the decedent’s estate.

With these tools, otherwise taxable estates[6], that potentially may be much larger than the new exemption amount, may be brought within its coverage.

The increased exemption amount will also allow many owners to secure a basis step-up for their assets upon their death without incurring additional estate tax, by allowing these owners to retain assets.

Of course, some states, like New York, will continue to impose an estate tax on estates that will not be subject to the federal estate tax.[7] In those cases, the higher federal exemption amount, coupled with the absence of a New York gift tax, provides an opportunity for many taxpayers to reduce their New York taxable estate without any federal estate or gift tax consequences, other than the loss of a basis step-up. The latter may be significant enough, however, that the taxpayer may decide to bear the 16% New York estate tax on his taxable estate rather than lose the income tax savings.[8]

Planning

In light of the foregoing, taxpayers should, at the very least, review their existing estate plan and the documents that will implement it – “for man also knoweth not his time.”[9]

For example, wills or revocable trusts that provide for a mandatory credit shelter or bypass trust may have to be revised, depending upon the expected size of the estate, lest the increased exemption amount defeat one’s testamentary plan.

A more flexible instrument may be warranted – perhaps one that relies upon a disclaimer by a surviving spouse – especially given the December 31, 2025 expiration date for the increased exemption amount, and the “scheduled” reversion in 2026 to the pre-2018 exemption level (albeit adjusted for inflation).

The buy-out provisions of shareholder, partnership and operating agreements should also be reviewed in light of what may be a reduced need for liquidity following the death of an owner. For example, should such a buy-out be mandatory?[10]

Some taxpayers, with larger estates, may want to take advantage of the increased exemption amount before it expires in 2026 so as to remove assets, and the income and appreciation thereon, from their estates.[11] This applies for both estate and GST tax purposes; a trust for the benefit of skip persons may be funded now using the temporarily increased GST exemption amount.

Of course, gifting comes at a cost: the loss of stepped-up basis upon the death of the taxpayer.

Conversely, some taxpayers may want to consider bringing certain appreciated assets (for example, assets that they may have previously gifted to a family member) back into their estates in order to attain the benefit of a basis step-up.

Those taxpayers who decide to take advantage of the increased exemption amount by making lifetime gifts should consider how they may best leverage it.

Some New York taxpayers – who may otherwise have to reduce their gross estates in order to reduce their NY estate tax burden – may want to consider changing their domicile so as to avoid the New York estate tax entirely while holding on to their assets (that would be sheltered by the increased exemption amount) and thereby securing the step-up in basis upon their passing.

There may also be other planning options to consider, some of which have been considered in earlier posts to this blog. For example, ESBTs may now include nonresident aliens as potential current beneficiaries without causing the S corporation to lose its “S” election.

As always, tax savings, estate planning, and gifting strategies have to be considered in light of what the taxpayer is comfortable giving up. In the case of a closely held business owner, any loss of control may be untenable, as may the reduction of cash flow that is attributable to his ownership interest.

Moreover, there are non-tax reasons for structuring the disposition of one’s estate that may far outweigh any tax savings that may result from a different disposition. Tails, dogs, wagging – you know the idiom.


*  At least until 2026 – keep reading.  With apologies to St. Paul. 1 Corinthians, 15:55.

[1] Pub. L. 115-97 (the “Act”); signed into law on December 22, 2017.

[2] The interest rate applicable to the amount of estate tax attributable to the taxable value of the closely held business in excess of $1 million (adjusted for inflation) is equal to 45 percent of the rate applicable to underpayments of tax (i.e., 45 percent of the Federal short-term rate plus three percentage points). This interest is not deductible for estate or income tax purposes.

[3] It also eliminates the tax benefit from any unrealized loss (by stepping-down its basis to fair market value).

[4] http://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax

[5] This provision expires after 2025. Assuming the provision survives beyond 2020 (the next presidential election), query whether the exemption amount will be scaled back. Has the proverbial cat been let out of the proverbial bag?

[6] Including individuals who had already exhausted their pre-2018 exemption amount.

[7] The NY estate tax exemption amount for 2018 is $5.25 million.

[8] In the case of a NYC decedent, for example, the tax savings to be considered would include the federal capital gains tax of 20%, the federal surtax on net investment income of 3.8%, the NY State income tax of 8.82%, and the NYC income tax of 3.876%. Of course, the likelihood of an asset’s being sold after death also has to be considered.

[9] Ecclesiastes, 9:12. As morbid as it may sound, planning for an elderly or ill taxpayer is different from planning for a younger or healthier individual – it is especially so now given the 2026 expiration of the increased exemption amount.

[10] Of course, there may be overriding business reasons for such a buy-out.

[11] If the exemption amount were to return to its pre-2018 levels in 2026, query how the IRS will account for any pre-2026 gifts that were covered by the increased exemption amount. The Act directs the IRS to issue regulations addressing this point.

An Unreasonable Burden?

One of the reasons often given in support of the elimination of the estate tax is the economic burden it imposes upon the closely-held business; specifically, the requirement that the 40% federal estate tax be satisfied within nine months of the death of the business owner. The imposition of a state “death tax,” such as New York’s 16% tax, only exacerbates the problem.

Under these circumstances, or so the argument goes, a decedent’s estate would be forced to sell the business in what proponents of estate tax repeal describe as a “forced sale,” thus depriving the decedent’s family of an opportunity to continue the business, and resulting in the loss of the value created by the decedent over a lifetime of hard work.

Truth be told, where the decedent’s business represents the most valuable, and perhaps most illiquid, asset in the decedent’s estate, how else is the estate to raise the funds needed to pay the estate tax in such a short period of time?

Plan Ahead

Thankfully, many business owners begin to address this issue while they are still alive. Because the first step in calculating the estate tax is determining the value of the gross estate, a business owner who is able (for example, under the terms of a shareholders’ or operating agreement) and willing can make gifts of interests in the business to family members or to trusts for their benefit, thereby removing the appreciation in the value of those interests from his gross estate.

Although the reduction of one’s gross estate goes a long way in managing the estate tax burden, it has its limits – planning for deductions is necessary, especially for transfers to a spouse who may or may not be involved in the business, but who will require the revenue from the business. However, depending upon the value of the business, this approach will only defer the payment of the tax.

Insurance

In recognition of the foregoing limits, business owners will often acquire insurance on their lives, hopefully in an irrevocable life insurance trust. These funds may be used to purchase the decedent’s business interest, and the terms of the trust would then provide for the disposition of the interest.

In other situations, the business itself, or the decedent’s fellow partners or shareholders, may acquire life insurance on the decedent; pursuant to the terms of a shareholders’, partnership, or other buyout agreement, the owner/beneficiary of the policy would use the insurance proceeds to acquire the decedent’s business interest from his estate.

Where life insurance is not acquired, or the insurance acquired is insufficient, or where the insured is, for whatever reason, not insurable, the decedent’s estate may nevertheless have other options available to it.

Installment Payments

Under one statutory provision, which was enacted for the express purpose of helping to preserve closely-held businesses, the estate of a deceased owner may elect to pay the estate tax attributable to the value of the decedent’s interest in the closely-held business over a period of ten years. Furthermore, these payments are due beginning five years after the estate tax return is filed (with only interest payable until the fifth year). In this way, the profits from the business itself may assist the estate is satisfying the tax liability.

In order to qualify for this benefit, the value of the decedent’s interest in the closely-held business must exceed 35% of the decedent’s adjusted gross estate (which may restrain a lifetime gifting program), and the decedent must have owned at least a 20% interest in the business.  In addition, the business entity must be carrying on an active trade or business (as opposed to a passive or portfolio investment-type activity).

However, the estate is not in the clear just yet; for example, if any portion of the interest in the closely-held business is sold, or if money is withdrawn from the business, and the aggregate value of such transactions equals or exceeds 50% of the value of the business, then the extension of time for payment of the estate tax ceases to apply, and the IRS may demand payment of the unpaid portion of the estate tax.

The logic behind this acceleration rule is fairly obvious.  If the interest is sold, and the estate thereby becomes liquid, then the justification for installment payments – to preserve the interest in the closely-held business – no longer exists.

“Graegin Loans”

In other circumstances – for example, where the estate does not qualify for installment reporting, or where it prefers to pay the tax upfront – the estate may be able to borrow the necessary funds from the decedent’s business (which may have to borrow the funds from an institutional lender). Provided this borrowing represents a bona fide indebtedness between the business and the estate, and provided the interest to be paid by the estate in respect of the loan can be ascertained with reasonable certainty (for example, the loan terms provide that it may not be prepaid as to principal or interest), the estate will be able to deduct the total amount of interest payable under the loan – for purposes of determining the estate tax liability – as an administration expense incurred to prevent the financial loss that may otherwise occur as a result of a forced sale of the business in order to pay the estate tax.

Is the Loan “Necessary”?

A recent decision by the Court of Appeals for the Eleventh Circuit considered the interest deduction claimed by Decedent’s estate in connection with a loan from a controlled LLC.

At his death, Decedent owned 46.9% of Company’s voting stock and 51.5% of its nonvoting stock. His children owned most of the remaining stock, either directly or through trusts, while other family members and trusts held the remaining shares.

The Decedent’s Revocable Trust held a 50.50% interest in LLC on the date of his death, 46.94% of which was a voting interest and 51.59% of which was a nonvoting interest. The Revocable Trust comprised the majority of the assets of Decedent’s Estate, with the Trust’s interest in LLC being its primary asset. LLC was flush with liquid assets at the time of Decedent’s death.

The Loan

The Estate’s remaining liquid assets, however, were insufficient to pay its tax liability. The fiduciaries of the Estate declined to direct a distribution of the Revocable Trust’s interest in LLC to pay the estate tax liability, believing that immediate payment would hinder LLC’s plans to invest in operating businesses.

As a result, the trustees instead obtained a large loan from LLC in exchange for a promissory note bearing a market interest rate, though no payment was due for 18 years, at which point principal and interest were scheduled to be repaid in 14 annual installments. Prepayments were not permitted under the terms of the loan, and the projected interest payments were determined with reasonable certainty.

Because the Revocable Trust’s primary asset was its interest in LLC, it anticipated that the loan would be repaid with distributions from LLC, which had significant liquid assets at the time of the loan.

IRS Challenges the Estate Tax Return

When the Estate filed its estate tax return, it claimed a large deduction, as an administrative expense, for the interest payable on the loan.

The IRS determined a significant estate tax deficiency, in large part due to its determination that the interest payments were not properly deductible.

The U.S. Tax Court agreed, holding that Estate was not allowed to deduct the projected interest expense on the loan from LLC to the Revocable Trust. In reaching this holding, the Tax Court concluded that the loan was not necessary to the administration of the estate because, at the time the loan was made, LLC had substantial liquid assets and the Revocable Trust had a sufficient voting interest in LLC to force a pro rata distribution by the LLC in the amount of the debt. The Tax Court also rejected the Estate’s argument that the loan was preferable because a distribution would have depleted the LLC of cash that could have been used to purchase additional businesses; the Court noted that the loan also depleted the LLC of cash.

Additionally, the Tax Court observed that the loan would ultimately be repaid using the Revocable Trust’s distributions from LLC, such that it merely delayed the use of such distributions to pay the Estate’s tax liability. Further, it stated that the loan repayments were due many years after Decedent’s death, which hindered the proper settlement of the Estate.

The Estate appealed this decision to the Eleventh Circuit.

Administration Expense?

An estate is permitted to deduct expenses that are actually and necessarily incurred in the administration of a decedent’s estate. Expenditures that are not essential to the proper settlement of the estate, but that are incurred for the individual benefit of the decedent’s heirs, may not be taken as deductions. Expenses incurred to prevent financial loss to an estate resulting from forced sales of its assets to pay estate taxes are deductible administration expenses. Conversely, interest payments are not a deductible expense if the estate would have been able to pay the debt using the liquid assets of one of its entities, but instead elected to obtain a loan that will eventually be repaid using those same liquid assets.

The Court began by noting that an estate’s interest payments on a loan may be a necessary expense where the estate would have otherwise been forced to sell its assets at a loss to pay the estate’s debts. The Court described the case of an estate that held a substantial number of shares of voting stock of a closely-held corporation, but lacked sufficient liquidity to pay its tax liability; as a result, the estate obtained a loan from a third party rather than selling its voting stock. The interest payment in that case was necessarily incurred and properly deducted as an administrative expense, the court stated, because the estate consisted of largely illiquid assets and, had it not obtained the loan, it would have been forced to sell its assets on unfavorable terms to pay the taxes.

The Court observed, however, that an interest deduction is properly denied if the estate can pay its tax liability using the liquid assets of an entity, but elects instead to obtain a loan from the entity and then repays the loan using those same liquid assets.

The court then determined that the “loan structure, in effect, constituted an indirect use of [the decedent’s] stock to pay the debts . . . and accomplished nothing more than a direct use of that stock for the same purpose would have accomplished, except for the substantial estate tax savings.” It observed that those cases that permitted the interest deduction involved loans that were necessary to avoid the sale of illiquid assets, and did not involve the sale of the lender’s stock or assets to pay the borrower. Finally, because the petitioner was a majority partner in the limited partnership, “he was on the both sides of the transaction, in effect paying interest to himself,” resulting in the payments having no effect on his net worth aside from the tax savings.

Interest payments are not necessary expenses, the Court stated, where: (1) the entity from which the estate obtained the loan has sufficient liquid assets that the estate can use to pay the tax liability in the first instance; and (2) the estate lacked other assets such that it would be required to eventually resort to those liquid assets to repay the loan.

The Estate’s Liquidity

If the Estate had been forced to sell its interest in LLC, it would have been required to do so at a loss. Tax Court decisions are clear that interest payments on loans constitute a necessary expense if the estate’s only other option is a forced sale of assets at a loss. Therefore, if the Estate’s only option had been to redeem the Revocable Trust’s interest in the LLC, then the loan would have been necessary and the interest payments on the loan would be a necessary expense. However, because the Revocable Trust had voting control over LLC, and because LLC had substantial liquid assets, the Revocable Trust could have ordered a pro rata distribution to obtain these funds and pay its tax liability.

According to the Court, a loan is not unnecessary merely because the estate had access to a related entity’s liquid assets and could have used those assets to pay its tax liability. Instead, a loan is unnecessary if the estate lacks any other assets with which to repay the loan, and inevitably will be required to use those same assets to repay it. Stated differently, where the estate merely delays using the assets to repay the loan rather than immediately using the assets to pay the tax liability, the loan is an “indirect use” of the assets and is not necessary.

The loan in the present case was an “indirect use” of funds and was not necessary. Aside from the Revocable Trust and the Trust’s interest in LLC, the Estate lacked sufficient funds to repay the loan. The Estate’s Loan repayment schedule was designed to enable the Trust to repay the loan out of its distributions from LLC. Accordingly, the Revocable Trust’s distributions from LLC would be used to satisfy the Estate’s tax obligations regardless of whether the Estate paid its tax liability immediately or obtained a loan and then repaid the tax liability gradually. Further, LLC would be paying disbursements to the Revocable Trust only to have those payments returned in the form of principal and interest payments on the loan. The same entity is on both sides of the transaction, resulting in LLC “in effect paying interest to” itself.

Thus, the loan had no net economic benefit aside from the tax deduction. This further demonstrated that the loan was not necessary.

Decisions, Decisions

It will behoove the future fiduciaries and beneficiaries of a taxpayer’s estate – not to mention the taxpayer himself – to consider how the estate tax on the taxpayer’s estate will be paid. As is the case with gift and estate planning, there is likely no single “silver bullet” solution; rather, different strategies may be combined to produce a payment plan that will be optimal for the decedent’s estate given the nature of his business and other assets, and the cash flow they generate.

If a loan is to be considered, then in addition to the substantive issues described above, the interested parties will have to weigh the economic benefit of preserving the estate’s assets against the economic cost of taking and servicing a loan.

Last week, we reviewed the various U.S. federal income tax consequences that may be visited upon a foreign person who owns and operates U.S. real property (“USRP”). Today we will consider the U.S. federal gift and estate tax consequences of which a foreign individual must be aware when investing in USRP.

Gift Tax

As you probably know, the gift tax is imposed upon the transfer of property by an individual, to or for the benefit of another individual, for less than full and adequate consideration. The typical scenario involves an outright transfer to a family member, or a transfer to an irrevocable trust for the benefit of a family member.

For a U.S. person – meaning a citizen or an alien individual who is domiciled in the U.S. – who makes a gift, the Code currently affords an annual exclusion of $14,000 per donee, plus a combined lifetime/testamentary exemption of $5.49 million, plus an unlimited marital deduction provided the donor’s spouse is a U.S. citizen.  (Note that “domicile” for gift and estate tax purposes is not necessarily the same as “residency” for U.S. income tax purposes; domicile is a more subjective concept: what jurisdiction does the foreign individual consider to be his “permanent home”?)

In the case of a non-U.S. person who is also a non-domiciliary, the Code provides the same $14,000 annual exclusion as above, as well as an annual $149,000 exclusion for gifts to a non-U.S. citizen spouse (not an unlimited marital deduction). There is no other exclusion. The marginal gift tax rate is 40% for taxable gifts over $1 million.

U.S.-Situs Property

In order for the U.S. gift tax to apply to a transfer of property by a non-domiciliary, the property transferred must be located in the U.S. Thus, a gift transfer of USRP is taxable.

Importantly, however, a transfer of intangible property, including shares of stock in a USC, including a U.S. real property holding corporation (USRPHC), is not subject to the gift tax.

As a result, a gift transfer by a foreign individual (“FI”) of shares of USRPHC stock (or of cash to fund a corporation’s acquisition of USRP) to an irrevocable foreign trust for the benefit of the FI’s family is not subject to U.S. gift tax. It is imperative that the foreign donor respect the separate identity of the corporation the stock of which stock is being gifted: the corporation should have its own accounts, act in its own name, hold board meetings, etc. – it may even be advisable that the FI not use the corporation’s USRP without paying a fair market rental rate for such use; otherwise, the IRS may be able to ignore the corporate form and treat the transfer of the stock as a transfer of the underlying USRP.

Similarly, though it is not entirely free from doubt, a transfer of an interest in a partnership that owns USRP should not be subject to gift tax, provided the partnership is not engaged in a U.S. trade or business (USTB).

Estate Tax

We all have to go sometime. It’s the morbid truth. Even wealthy foreigners.

The U.S. estate tax is imposed on the FMV of the U.S. assets of a foreign decedent. This includes the foreigner’s direct interest in USRP.

It also includes the FMV of USRP in a foreign trust if the FI gifted the USRP into the trust and retained an interest in the income from, or in the use of, the trust’s property.

Where the USRP is subject to a nonrecourse debt, the amount of such debt may be applied to reduce the FMV of the property for estate tax purposes. In order to claim a reduction for any recourse debt encumbering the property, the estate of the FI must disclose his/her worldwide assets and claim only a proportionate part of the debt as a deduction, the assumption being that the FI’s worldwide assets are available to satisfy the recourse debt.

The FI’s U.S. gross estate also includes his shares of stock in a U.S. corporation (“USC”), including a USRPHC.

The state of the tax law as to the situs of a partnership interest is not entirely clear, though there is authority for the proposition that U.S. property includes an interest in a partnership that is engaged in a USTB.

The gross estate does not include shares of stock in a foreign corporation (“FC”), however, even if its only asset is USRP, and even if the FC has elected to be treated as a USC for purposes of FIRPTA (see above). Again, it is imperative that the FI have respected the corporate form: it should have its own accounts, act in its own name, etc. (see last week’s post); otherwise, the IRS may be able to ignore the corporate form, treat the FC as a sham, and include the value of the underlying USRP in the FI’s estate.

The FI’s estate does not include an interest in USRP that is held in a foreign trust, provided the FI did not retain (expressly or implicitly) any beneficial interest in, or control over, the trust.

Unlike the estate of a U.S. citizen or domiciliary, the estate of a FI will not have the benefit of the $5.49 million exemption. Rather, there is only a $60,000 exemption amount (though some treaties may provide for a greater amount provided the FI’s estate discloses its worldwide assets). The 40% rate kicks in when the U.S. taxable estate exceeds $1 million in value.

Additionally, there is no unlimited marital deduction unless the FI’s surviving spouse is a U.S. citizen. If the spouse is not a U.S. citizen, a qualified domestic trust (“QDOT”), with a U.S. trustee, will allow an unlimited marital deduction, and the resulting tax deferral benefit, though it is less than ideal for planning purposes. For example, every time principal is distributed to the surviving spouse, the U.S. trustee must report the distribution, and must withhold and transmit the applicable estate tax.

Finally, let’s not forget that any property that is included in the U.S. estate of a FI receives a basis step-up, thereby removing the depreciation in basis during the life of the decedent, and the appreciation in value of the property, from the reach of the U.S. income tax.

Takeaway

Last week’s post explained that the role of the U.S. tax adviser is to educate the foreign client as to basic U.S. tax considerations before the foreigner acquires USRP; to confer with the foreigner’s non-U.S. tax advisers as to the treatment of the investment under foreign tax law; and to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals. The many relevant, and oftentimes competing, factors that we have discussed over the last couple of weeks must be identified and weighed, the various options must be formulated and presented to the foreign client, the client must understand the advantages and disadvantages of the options available, and then the best option under the circumstances must be selected.

Last week’s post explored the federal income tax consequences to a taxpayer who failed to timely file an election for the classification of his wholly-owned business entity.

Today’s post considers how one taxpayer sought to utilize the IRS’s business entity classification rules to reduce his estate’s exposure for NY estate tax. Individuals who are not domiciled in NY (“nonresidents”), but who operate a NY business, should familiarize themselves with NY’s response to the taxpayer’s proposed plan.

Situs of an LLC Interest
NY had previously ruled in an advisory opinion that a membership interest in a single-member LLC (“SMLLC”) that owned NY real property, and that was disregarded for federal income tax purposes, would be treated as real property – not as an intangible – for NY estate tax purposes.

The opinion also held that when a SMLLC makes an election to be treated as an association (taxable as a corporation) pursuant to the IRS’s “check-the-box” rules, the membership interest in the SMLLC would be treated as intangible property.

It concluded that the election that is in place on the date of the single member’s death is the election that will be used to determine whether the interest in the SMLLC is treated as real property or as intangible property for purposes of NY’s estate tax.

A recent NY advisory opinion addressed Taxpayer’s question whether a membership interest in a SMLLC would be treated as intangible property for NY estate tax purposes where the SMLLC initially elects to be disregarded for income tax purposes but, immediately upon the single member’s death, retroactively elects to be treated as an association taxable as a corporation.

Electing to Change Tax Status – and Situs?
Taxpayer represented that he was currently a NY resident, but that he planned to move to another state. At that time, Taxpayer would transfer his NY real property into a SMLLC, of which he would be the sole member. This SMLLC would not elect to be treated as an association for federal income tax purposes. Thus, it would be treated as a disregarded entity, and Taxpayer would continue to be treated as the owner of the real property.

Taxpayer also represented that he intended to remain the sole owner of the LLC for the remainder of his life, and to continue to have the SMLLC treated as a disregarded entity until his death. This would enable Taxpayer to claim on his personal income tax return the income and deductions associated with the real property.

Upon his death, Taxpayer’s Last Will and Testament would direct his executor to elect that the SMLLC be taxed as an association, and as an S-corporation, for income tax purposes. These elections would have retroactive effect to at least one day prior to the date of Taxpayer’s death.

Before we consider NY’s response to Taxpayer’s proposal, let’s first review the application of NY’s estate tax to nonresident decedents, as well as the IRS’s entity classification rules, the interplay of which is key to NY’s opinion.

The NY Estate Tax
NY imposes an estate tax on the transfer by the estate of a nonresident decedent of real property located in NY.

However, where the real property is held by a corporation or partnership, an interest in such entity has been held to constitute intangible property.

The NY Constitution prohibits the imposition of an estate tax on a nonresident’s intangible property, even if such property is located in NY. For example, securities and other intangible personal property within the state, that are not used in carrying on any business within the state by the owner, are considered to be located at the domicile of the owner for purposes of taxation.

NY’s tax law likewise provides that the NY taxable estate of a nonresident decedent does not include the value of any intangible personal property otherwise includible in the decedent’s gross estate.

The Entity Classification (“check-the-box”) Rules
Pursuant to the IRS’s entity classification rules, an entity that has a single owner, such as a SMLLC, is disregarded as an entity separate from its owner unless it elects to be classified as an association taxable as a corporation.

In other words, where no election is filed, the default classification of the SMLLC is that of a disregarded entity, one that is not deemed to be an entity separate from its owner. The SMLLC will retain this default classification until it makes an election to change its classification.

If the SMLLC is disregarded for tax purposes, its assets and activities are treated in the same manner as those of a sole proprietorship, branch, or division of the owner – the sole member is treated as the direct owner of the LLC’s assets, and is treated as conducting the LLC’s activities himself, for tax purposes.

A SMLLC may elect to be classified as other than its default classification by filing an entity classification election with the IRS. Specifically, a SMLLC may elect to be classified as an association, and thus treated as a corporation for tax purposes, by making such an entity classification election.

Such an election would be effective on the date specified by the entity on the election form, or on the date the form was filed if no such date is specified on the form. The effective date specified on the form cannot be more than 75 days prior to the date on which the election is filed, or more than 12 months after the date on which the election is filed.

NY’s Opinion
“A membership interest in a SMLLC owning New York real property, which is disregarded for income tax purposes, is not treated as ‘intangible property’ for purposes of New York State estate tax purposes. However, where a SMLLC makes an election to be treated as a corporation pursuant to [the ‘check-the-box’ rules], rather than being treated as a disregarded entity, such ownership interest would be considered intangible property for New York State estate tax purposes.”

The opinion noted that there is no provision in NY law applicable to the estate tax that provides for retroactively changing an entity’s classification, in this case to be treated as an association/corporation, after the death of its sole owner. Consequently, any post-mortem, retroactive classification election would be disregarded and not treated as a valid election for NY estate tax purposes.

Based on the above analysis, the advisory opinion stated that where a SMLLC is disregarded for Federal income tax purposes, the assets and activities of the SMLLC are treated as those of the deceased nonresident sole member without regard to any post-mortem election directed by his Last Will and Testament.

Therefore, under the circumstances described above, the interest in the SMLLC owned by Taxpayer would not be treated, for NY estate tax purposes, as an intangible asset. Instead, the NY real property held by the SMLLC would continue to be treated as real property held by the Taxpayer for NY estate tax purposes, even after the retroactive classification election was filed.

The Right Answer
Although an advisory opinion is limited to the facts set forth therein, and is binding on NY only with respect to the person to whom it is issued, it is pretty clear that NY’s position regarding Taxpayer’s proposed gambit stands on fairly solid ground.

The proposal described above is premised on the fact that Taxpayer has no idea of when he will die. He wants to enjoy the flexibility of operating through a SMLLC during his life and, upon his demise, take advantage of the opportunity afforded by the entity classification rules to make a retroactive change to the LLC’s tax status and, thereby, to change the situs of his membership interest in the LLC.

Although there are several statutorily-approved post-mortem planning opportunities (for example, the 6-month alternate valuation rule), the ability to elect to change the situs of a nonresident decedent’s property for NY estate tax purposes is definitely not one of them.

A nonresident business owner who operates in NY through a SMLLC certainly should not rely upon his executor’s making a post-mortem entity classification election to “remove” his tangible assets from the reach of the NY estate tax.

An S-corporation is a viable alternative, though it is more restrictive than a SMLLC, and the S-corporation election would have to be made while the owner was still alive.

Alternatively, the owner could choose to admit a second member to the LLC – perhaps an S-corporation, wholly-owned by him, that would hold a de minimis membership interest. The LLC would be treated as a partnership for tax purposes, thereby affording the owner the desired flexibility and pass-through treatment. The LLC interest would also be treated as an intangible in the hands of the nonresident owner under the NY estate tax.

Fortunately, Taxpayer sought professional guidance, as well as NY’s opinion, before implementing the proposed gambit. It’s a lesson to be remembered.

“The” Proposed Regulations

They were years in the making – proposed regulations that seek to address what the IRS believes are abuses in the valuation of family-owned business and investment entities. Based upon the volume of commentary generated in response to the proposed rules, it is clear that the IRS has struck the proverbial raw nerve. It is difficult to recall the last time there was this much interest in proposed estate tax and gift tax rules. Almost every tax adviser under the sun has issued a client advisory. Many of these have been quite critical of the proposed rules. All have urged clients to act now, before the rules are finalized, or face the prospect of paying millions of dollars in transfer tax later.

By way of comparison, when the original version of these regulations was proposed in 1991, the year after the enactment of the legislation under which the regulations are being issued, the IRS received only one set of comments from the tax bar before finalizing them in 1992.

I think it’s safe to say that the IRS will be inundated with comments, questions and suggestions this time around. I daresay that, by the time the November 2, 2016 deadline for such comments arrives, the IRS may decide that it has to add an additional day of hearings to the single, currently scheduled day of December 1, 2016.

Given the importance of these proposed regulations, the amount of attention that they have garnered, and the calls-to-action from the estate tax planning bar, today’s post – which will be the first of three posts on the proposed regulations – will try to provide some historical and theoretical context for the regulations. In this case, historical perspective is important not only for purposes of understanding the regulations, but also in appreciating the “valuation options” that remain available. Tomorrow’s post will consider Section 2704 of the Code and the valuation of an interest in a closely-held business, generally. The third and final post will appear next week, and will discuss and comment on the technical aspects of the proposals, themselves.

Planning, In General

In order to better appreciate the effect of the proposed regulations, we need to first consider the traditional goal of estate tax and gift tax (“transfer tax”) planning, which has been to remove valuable, preferably appreciating, assets from a taxpayer’s hands.

In the case of interests in a family-owned business, a related goal has been to structure and/or reduce the taxpayer’s holdings in the business in such a way so as to reduce their value for purposes of the estate tax, to thereby reduce any resulting tax liability and, thus, to maximize the amount passing to the taxpayer’s family.

Over the years, many transfer techniques and vehicles have been developed to assist the taxpayer in accomplishing the goal of removing assets from his estate, though some of these vehicles/techniques have, themselves, been under attack by the IRS. In connection with the transfer of business interests, planners have used, among other things, GRATs, sales to grantor trusts, sales in exchange for private annuities, sales in exchange for self-cancelling installment notes, recapitalizations into voting and non-voting interests, and simple gifts.

Each of these techniques, standing alone, enables the taxpayer to save transfer taxes on the transfer of an interest in a family-owned entity to members of his family, even without significant valuation discounting.

However, if the interest being transferred is valued on a favorable – i.e., significantly discounted – basis, the tax-saving impact of the transfer is multiplied. The taxpayer is effectively given a “head start.”

Saving On Taxes – It’s Not Everything

Although tax savings are obviously an important considerations in any gift/estate tax plan, the assets to be transferred must be “disposable” insofar as the transferor is concerned.

No doubt, many of you have fond memories of the final days of 2012, when many believed that the transfer tax exemption amount would revert to its 2001 levels. Many taxpayers rushed to make gifts as we approached the end of that year, lest they lose their ability to make large gifts free of transfer tax. Many acted without sufficient regard for their own personal needs, or their tolerance for loss of control. All that seemed to matter was that if they didn’t act right away, they would “lose” the ability to make transfers free of gift tax.

Following the “permanent” restoration of the $5 million exemption (indexed to $5.45 million for 2016; likely to approach $5.5 million in 2017), many of these same taxpayers sought to recover the gifted properties or to rescind the gifts. Clearly, many acted only for the transfer tax benefit. Not a good move.

A Cautionary Note

As stated above, many advisers are urging taxpayers to act quickly, before the proposed regulations are finalized, or face the prospect of enormous tax bills. To this I respond: remember 2012. In other words, does the gifting being considered make sense from a personal and business perspective? If not, then stop right there.

Next, I say, keep in mind the increased (and indexed) exemption amount, not to mention the portability of the exemption amount between spouses, which may allow a taxpayer to hold onto property until his demise.

Closely connected to this is the basis step-up, to fair market value, for property that a taxpayer owns at his date of death, and the ability afforded by the step-up to avoid or reduce future income taxes, capital gains taxes, and the surtax on net investment income.

Many individuals who have already implemented a gift program should also keep in mind that reduced valuation discounts may actually benefit them. For example, a GRAT that is forced to distribute interests in a closely-held business may have to distribute fewer equity units of the business to satisfy the trust’s annuity obligation if the units are valued at a greater amount than would result with the application of large discounts.

The Top Tier

Of course, in the case of more affluent taxpayers, gift tax planning retains its luster. For these folks, the proposed regulations, if finalized in their present form, may present a significant challenge.

For those very affluent individuals who have deferred their gift tax planning, it may be advisable to act now, before the regulations are finalized. The goal in acting now will be to secure larger valuation discounts, and lower transfer tax values, for the closely-held business interests to be transferred.

Even as to these taxpayers, however, caution should be exercised. They have been forewarned that the IRS does not have a favorable view of the items identified in the proposed regulations. In fact, many taxpayers have already experienced the IRS’s suspicion of these items; for the most part, the proposed regulations do not introduce new concepts – rather, they embody the IRS’s historical audit and litigation positions. Thus, these taxpayers (and their advisers) can expect a serious challenge by the IRS, and should be prepared for it.

Prospects for Change Before Going Final?

Many advisers believe that the IRS has exceeded its authority in issuing these regulations. They believe that the courts will strike down the proposed rules if finalized in their current form. That may be, but I would not bet on it, nor would I plan for it; if the courts speak at all, it will likely be years from now – the IRS and death wait for no one.

Moreover, I disagree with this assessment of the IRS’s authority. The 1990 enabling legislation granted the IRS significant authority to interpret the statute and to issue regulations. That being said, my guess is that the IRS will be responsive to some of the comments from the tax bar, which may include some tweaking of the effective date for one provision of the proposed rules.

As regards all other items covered by the proposed regulations, the clock is in fact running. The good thing is that the proposed regulations will be effective prospectively only. Of course, we don’t know when they will go final – December 1, 2016 (the scheduled hearing date) is a possibility, as is early 2017. Of course, we also have to await the outcome of the presidential election in November.

Tomorrow’s Post

Before we turn to the proposed regulations, tomorrow’s post will briefly describe some of the factors that are typically considered by the IRS in determining the value of an interest in a closely-held business, including the rules under Section 2704 of the Code.

Appraisal
Is it an art or a science? Is it equal parts of art and science? Is one part weighted more than the other? Do the answers to these questions depend upon the purpose for which the appraisal is being sought? Do they depend upon who is asking the question?

Yes, no, maybe, sometimes.

Not very helpful, right? Yet, the results of an appraisal can have far-reaching economic consequences, especially where the object being valued is a decedent’s interest in a closely held business. For example, the appraisal can affect the taxable income from the operation of the business, or the gain realized on a subsequent sale of the business.

The valuation method and the factors considered can vary greatly depending upon, among other things, the nature of the business interest (a partnership interest or shares of stock in a corporation), the tax status of the business (C or S corporation, partnership or disregarded entity), the nature of the business (service- or capital-intensive), the nature of its assets (depreciable or amortizable), the identity of the other owners (family or unrelated persons), the life-stage of the business (in growth mode, or looking for a liquidity event).

It is often said that “where you stand depends upon where you sit.” This truth is often encountered upon the demise of an owner of a close business, as was reflected in a recent Tax Court (“TC”) decision. [Est. of Giustina v. Commr., T.C. Memo 2016-114]

The Partnership
Decedent owned a 41% limited-partner (“LP”) interest in Partnership, which owned timberland, and earned profits from growing trees, cutting them down, and selling the logs.

The Decedent’s estate and the IRS agreed that if Partnership sold off its timberlands, it would have received almost $143 million. If one included the value of its non-timberland assets, Partnership would have received over $150 million on a sale of its assets.

Through corporate structures, Partnership had two general partners (“GPs”): LG and JG. It had eight LPs, including Decedent.

The LPs were members of the same family (or trusts for the benefit of members of the family). The partnership agreement provided that an LP interest could be transferred only to another LP (or to a trust for the benefit of an LP), unless the transfer was approved by the GPs. A dissolution provision in the partnership agreement provided that if two-thirds of the LPs agreed (as measured by percentage interest), then Partnership would be dissolved, its assets sold, and the proceeds distributed to the partners.

The Decedent’s estate and the IRS disagreed over the value of the Decedent’s 41% LP interest. In particular, they assigned different weights to the probability that Partnership would sell its business or continue its operation.

Tax Court: Round One
The IRS’s expert gave greater weight to the sale value of Partnership’s assets than did the estate’s expert, and arrived at a fair market value (“FMV”) of $33.5 MM for the 41% LP interest. The TC declined to adopt the findings of either expert.

The TC took the view that the partnership asset values were relevant to the value of the 41% LP interest only to the extent of the probability that Partnership would sell its assets. The TC determined that there was only a 25% chance that Partnership would sell its assets after Decedent’s LP interest was transferred to a hypothetical third party. It reasoned that there was a 25% chance that the hypothetical buyer of the 41% LP interest could convince two-thirds of the partners to either: (1) vote to dissolve Partnership, resulting in the sale of Partnership’s assets and distribution of the proceeds to the partners, or (2) replace the two GPs (who had the authority to sell the assets and make distributions) to achieve the same result. The TC, therefore, gave a 25% weight to the value of the partnership assets rather than the greater weight used by the IRS’s expert.

The TC took the view that the cash-flows were relevant to the value of the 41% LP interest only to the extent of the probability that Partnership would continue its operations. It determined there was a 75% chance that Partnership would continue its operations.

In order to incorporate the cash-flows from continued operations into its valuation, the TC had to determine the present value of the cash-flows. It did this by adjusting the present value calculations of the estate’s expert. It also made certain assumptions about the annual increase in cash-flows and the rate for discounting the cash-flows to present value. This rate was the sum of: a risk-free rate of return equal to the rate of return on Treasury bonds, a risk premium for timber industry companies, a risk premium for small companies, and a risk premium for the unique risk of Partnership.

The TC accepted all of these components of the estate expert’s discount rate with the exception of the risk premium for the “unique risk” of Partnership’s timber business (as opposed to so-called “market risk”), which the TC reduced by 50%.

The TC explained that risk is not preferred by investors – they require a premium to bear it. However, some of the risk associated with an asset can be eliminated, the TC noted, through diversification if the owner of the asset also owns other assets, if the risks of the other assets are not associated with the asset in question, and if the other assets are great enough in value.

In evaluating a potential buyer’s ability to diversify the risks associated with Partnership, the TC assumed that the buyer could be an entity owned by multiple owners who could have diversified the unique risk associated with the 41% LP interest because the entity’s owners could hold other assets outside the entity.

Alternatively, the entity could diversify the risks of holding the 41% LP interest by holding other substantial assets that were unaffected by the Partnership-specific risk.

On the basis of its assumption that an entity with multiple owners could be the hypothetical buyer of the 41% limited-partner interest, the TC believed that a hypothetical buyer would not require a premium for all the Partnership-specific risk associated with owning the LP interest.

The TC concluded that the FMV of the 41% LP interest was $27.5 MM.

Court of Appeals
The estate appealed the TC’s decision, and the Ninth Circuit (the “Circuit”) held that the TC had erred by finding that there was a 25% chance that Partnership would sell its business and dissolve.

The Circuit held that a buyer who intended to dissolve Partnership would not be allowed to become an LP by the GPs, who favored the continued operation of Partnership. The Circuit also found it implausible that the buyer would seek the removal of the GPs who had just granted the buyer admission to Partnership.

Finally, the Circuit found it implausible that enough of the other partners would go along with a plan to dissolve Partnership.

Consequently, the Circuit directed the TC, on remand, to “recalculate the value of the Estate based on the partnership’s value as a going concern.”

The Circuit also held that the TC erred “by failing to adequately explain its basis for cutting in half the Estate’s expert’s proffered company-specific risk premium.”

The Standard
The FMV of an item of property includible in a decedent’s gross estate is its FMV at the time of the decedent’s death. The FMV is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.

In the case of shares of stock of a closely held corporation, the FMV is determined by taking into consideration the company’s net worth, prospective earning power and dividend-paying capacity. Other relevant factors to be considered include the good will of the business; the economic outlook in the particular industry; the company’s position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange.

The weight to be accorded such comparisons, or any other evidentiary factors considered in the determination of a value, depends upon the facts of each case. In addition to the relevant factors described above, consideration must also be given to non-operating assets, to the extent such non-operating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.

Tax Court: Round Two
In response to the Circuit’s direction , the TC based its adjusted valuation of the 41% LP interest entirely on Partnership’s value as a “going concern.” In the TC’s view, the going-concern value was the present value of the cash-flows Partnership would receive if it were to continue its operations.

However, the Circuit opinion, in discussing the possibility that a hypothetical buyer could force the sale of Partnership’s assets, held that the hypothetical buyer must be a buyer to whom a transfer of an LP interest was permitted under the partnership agreement. By the same token, in evaluating the hypothetical buyer’s ability to diversify risk, the TC considered only a buyer whose ownership of an LP interest was permitted by the partnership agreement.

Under the partnership agreement, an LP interest could be transferred only to another LP (or a trust for the benefit of another LP) or a person receiving the approval of the two GPs. Other than Decedent, there were seven LPs. All seven were individuals and trusts. The record did not support the notion that any of the LPs had enough assets to diversify the risks of owning an additional 41% LP interest. The LPs appeared to be family members (or trusts for the benefit of family members) who probably had most of their wealth tied up in the family business in the form of their partner interests in Partnership.

Under the partnership agreement, an LP interest could be transferred to a person other than an LP (or a trust for the benefit of an LP) only if that person was approved by the two GPs. The two GPs were LG and JG (through corporate structures). For 25 years, they had run Partnership as an operating business. The record suggested that these two partners would refuse to permit someone who was not interested in having Partnership continue its business to become an LP. Thus, the TC determined that they would not permit a multiple-owner investment entity to become an LP.

Such an entity would seek to increase the returns on its investments. If such an entity owned the 41% LP interest, it would attempt to have Partnership discontinue its operations and dissolve. More generally, the TC found that no buyer that LG and JG would permit to become an LP would be able to diversify the Partnership-specific risk.

As a result of these findings, the TC determined that a hypothetical buyer of the 41% LP interest would be unable to diversify the unique risks associated with Partnership. Without diversification, the buyer would demand the full risk premium assigned to the interest by the estate’s expert.

Thus, after eliminating any weight attributed to the value of Partnership’s assets, and applying the Partnership-specific risk premium, the TC valued the LP interest at $13.95 million.

Take-away
In applying the hypothetical willing buyer-willing seller standard, the courts have routinely stated that one must not speculate about who might buy a decedent’s stock, how a buyer might desire to work themselves into a major role in the company, what combinations they might form with the decedent’s family members, and whether the buyer would be able to buy more shares from members of the decedent’s family. According to the courts, speculation about what imaginary buyers might do should be ignored because, by engaging in such speculation, one departs from the willing buyer-willing seller test.

On the other hand, courts have recognized that it is appropriate, in applying the hypothetical willing buyer-willing seller test, to consider who owns the remaining shares in the company. In general, and without more (such as litigation among the members of the family), courts have concluded that it is unlikely that a member of the taxpayer’s family would join with an outsider to control the actions of the company, noting that family members have a distinct advantage in forming coalitions, especially where they have a history of dealing with one another.

As was demonstrated by the decision discussed above, the recognition of a family connection among the surviving owners goes not only to the size of the discount that may be applied in valuing a decedent’s minority interest in a business entity, but also to the methodology that that must be applied in determining the value of the business as a whole.

The owners of a closely-held business confront several issues upon the death of any one of them:

  • How will the decedent’s shares be valued?
  • How will the decedent’s estate pay the resulting estate tax?
  • To whom will the decedent’s shares be transferred?
  • How will the acquiring party pay for such shares?

In most cases, the owners of the business will limit the universe of persons to whom the decedent’s shares can pass, for example, by entering into a shareholders’ agreement that requires the business or the surviving owners to purchase the shares from the decedent’s estate.

As to the funding for such a purchase, the owners of the business may decide to acquire life insurance upon the lives of the various shareholders, the proceeds from which would serve two purposes: to fund the purchase price for the shares, and to provide the decedent’s estate with liquidity for purposes of paying the estate tax. tornhundreddollarbill-thumb

A recent Tax Court decision considered one family’s use of split-dollar life insurance arrangements to serve these purposes.

Buy-Sell Arrangement

Decedent and her late husband started a business that eventually grew into a total of eleven companies (“Group”). All companies in the Group were brother-sister corporations with identical ownership.

Decedent established a revocable trust (“Trust”) in 1994, appointed herself as trustee, and contributed all of her stock in each company in the Group to the Trust.

Decedent then established three “dynasty” trusts in 2006: one for the benefit of each of her Sons and that Son’s family (each a “Dynasty Trust”).

Also in 2006, the Trust was amended to permit the trustee to “(i) pay premiums on life insurance policies acquired to fund the buy-sell provisions of the * * * [Group’s] business succession plan, and (ii) make loans, enter into split-dollar life insurance agreements or make other arrangements.”

Additionally, the amendment authorized the trustee of Trust to transfer each “receivable” from the split-dollar life insurance arrangement, when paid by each Dynasty Trust, back to the Dynasty Trust that owed the receivable.

In late 2006, the Dynasty Trusts, the Sons and the Trust entered into a shareholders agreement. The agreement provided that upon the death of any Son, his surviving siblings and their respective Dynasty Trusts would purchase the Group stock held by the deceased sibling.

To provide the Dynasty Trusts with the resources to purchase the Group stock held by or on behalf of a deceased Son, each Dynasty Trust purchased two life insurance policies, one on the life of each other brother.

Split-Dollar Life Insurance Arrangements

To fund the purchase of the policies, each Dynasty Trust and the Trust entered into two split-dollar life insurance arrangements in 2006, to set forth the rights of the respective parties with respect to the policies. The Trust contributed almost $10 million to each Dynasty Trust, which then used that money to pay a lump-sum premium on each policy to maintain that policy for the insured Son’s projected life expectancy.

Under the split-dollar arrangements, upon the death of the insured Son, the Trust would receive a portion of the death benefit from the policy insuring the life of the deceased Son equal to the greater of (i) the cash surrender value (“CSV”) of that policy, or (ii) the aggregate premium payments on that policy (each a “receivable”).

Each Dynasty Trust would receive the balance of the death benefit under the policy it owned on the life of the deceased Son, which would be available to fund the purchase of the stock owned by the deceased Son. If a split-dollar arrangement terminated for any reason during the lifetime of an insured Son, the Trust would have the unqualified right to receive the greater of (i) the total amount of the premiums paid or (ii) the CSV of the policy, and the Dynasty Trust would not receive anything from the policy.

Additionally, the Dynasty Trusts executed collateral assignments of the policies to the Trust to secure payment of the amounts they each owed to the Trust. Neither the Dynasty Trusts nor the Trust retained the right to borrow against a policy.

Insurance Policies

The life insurance policies acquired by the Dynasty Trusts were universal life insurance policies, a form of permanent life insurance providing the owner with flexibility in making premium payments. Under the policies, the owner could pay premiums in a lump-sum, over a limited number of years, over an extended number of years, or over the life of the insured. The owner could determine the amount of premiums at the inception of the contract, change the amount of the future premium from time to time, stop paying premiums for any other reason, and resume paying premiums at a later date if desired.

 The IRS’s Challenge

From 2006 to 2009, Decedent reported gifts to the Dynasty Trusts as determined using the so-called “economic benefit” regime. The amount of each gift reported was the cost of the current life insurance protection as determined using tables issued by the IRS.

After Decedent’s death in late 2009, her Estate retained an appraiser to value the receivables owing to the Trust and includible in Decedent’s gross estate as of the date of her death.

The IRS issued two notices of deficiency to the Estate. One sought to increase the value of the receivables payable to the Trust, as reported by the Estate. The other notice asserted that the Estate had failed to report almost $30 million of gifts in 2006 — specifically, the total amount of the policy premiums paid by Trust for the split-dollar insurance policies.

Split-Dollar Life Insurance

In general, split-dollar life insurance arrangements are governed by IRS regulations.  These regulations define a “split-dollar life insurance arrangement” as an arrangement between an owner and a non-owner of a life insurance contract in which: (i) either party to the arrangement pays all or a portion of the premiums on the life insurance contract; and (ii) the party paying for the premiums is entitled to recover all or any portion of those premiums, and such recovery is to be made from the proceeds of the life insurance contract.

The split-dollar arrangements at issue were governed by these regulations. Trust paid the premiums on the policies; it was entitled to recover, at a minimum, all of those premiums paid, and this recovery was to be made from, and was secured by, the proceeds of the policies.

The regulations provide two mutually exclusive regimes for taxing split-dollar life insurance arrangements. The determination of which regime applies to a particular arrangement depends on which party owns the life insurance policy subject to the arrangement. Generally, the person named as the owner in the insurance contract is treated as the owner.

Under this general rule, the Dynasty Trusts would be considered the owners of the policies, and the premium payments by Trust would be treated as loans to the Dynasty Trusts.

Deemed Owner

As an exception to the general rule, the regulations include a special ownership rule that provides that if the only economic benefit provided to the donee under the split-dollar arrangement is current life insurance protection, then the donor will be treated as the owner of the life insurance contract, regardless of who actually owns the policy.

On the other hand, if the donee receives any additional economic benefit, other than current life insurance protection, then the donee will be considered the owner, and the loan regime will apply.

Thus, the key question in the case – which determined which party owned, or was deemed to own, a life insurance policy – was whether the lump-sum payment of premiums made on the policies by the Trust generated any additional economic benefit, other than current life insurance protection, to the Dynasty Trusts.

If there was no additional economic benefit to the Dynasty Trusts, then the Trust would be the deemed owner of the policies, and the split-dollar life insurance arrangements would be governed by the economic benefit regime.

Economic Benefit Regime

For a split-dollar arrangement to be taxed under the economic benefit regime, the owner or deemed owner will be treated as providing an annual benefit to the non-owner in an amount equal to the value of the economic benefits provided under the arrangement, reduced by any consideration the non-owner pays for the benefits. The value of the economic benefits provided to the non-owner for a taxable year under the arrangement is equal to the sum of (i) the cost of current life insurance protection, (ii) the amount of cash value to which the non-owner has current access during the year, and (iii) any other economic benefits that are provided to the non-owner.

To determine whether any additional economic benefit was conferred by the Trust to the Dynasty Trusts, the relevant inquiry was whether the Dynasty Trusts had current access to the cash values of their respective policies under the split-dollar arrangements or whether any other economic benefit was provided.

Current Access?

The regulations provide that the non-owner has current access to any portion of the policy cash value to which the non-owner (i) has a current or future right and (ii) that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.

For the Dynasty Trusts to have current access, they must first have had a current or future right to any portion of the policy cash value. The split-dollar arrangements, however, were structured so that upon the termination of the arrangement during the lifetime of the insured, 100% of the CSV would be paid to the Trust. Additionally, upon the death of the insured, the Dynasty Trusts would be entitled to receive only that portion of the death benefit of the policy in excess of the amount payable to the Trust.

Accordingly, the Dynasty Trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regulations.

The IRS argued that the Dynasty Trusts had a right to the cash values of the insurance policies by virtue of the terms of the 2006 amendment to the Trust. Under that amendment, the IRS argued, the Trust’s interest in the cash values of the policies would pass to the Dynasty Trusts or directly to the Sons or their heirs upon Decedent’s death.

However, because the Trust was a revocable trust with respect to Decedent, she retained an absolute right to alter the Trust throughout her lifetime. Accordingly, the Dynasty Trusts did not have a legally enforceable right to the cash values of the policies during the lifetime of the Decedent-grantor. Furthermore, the split-dollar arrangements did not require the Trust to distribute the receivables to the Dynasty Trusts. Rather, Decedent retained the right to receipt of the receivables.

The Court also noted that when the regulations state that “[t]he value of the economic benefits provided to a non-owner for a taxable year under the arrangement equals . . . [t]he amount of policy cash value to which the non-owner has current access. . .,” the regulations are referring to the split-dollar arrangement. The 2006 amendment to the Trust was not part of the split-dollar arrangements between the Trust and the Dynasty Trusts.

Under each split-dollar arrangement, the Court stated, upon the death of the insured-Son, the Trust would be entitled to receive a portion of the death benefit of the policies insuring the life of the deceased equal to the greater of (i) the CSV of the applicable policies or (ii) the aggregate premium payments made with respect to the applicable policies. The Trust obtained the receivables as a result of entering into the split-dollar arrangements. Thus, it was appropriate to execute the 2006 amendment to provide for the disposition of these assets. Importantly, the split-dollar arrangements did not address the disposition of the receivables by the Trust and did not require or permit the receivables be distributed to the Dynasty Trusts. Thus, the Dynasty Trusts did not have a right in the cash values of the policies by virtue of the 2006 amendment.

Other Economic Benefit?

The IRS argued that the circumstances of the split-dollar arrangements at issue prohibited the use of the economic benefit regime. Specifically, it compared the arrangements to certain abusive split-dollar life insurance arrangements under which one party holding a right to current life insurance protection uses inappropriately high current term insurance rates, prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The use of such techniques by any party to understate the value of these other policy benefits distorts the income or gift tax consequences of the arrangement, the IRS claimed, and does not conform to, and is not permitted by the regulations.

The Court found that the split-dollar arrangements between the Trust and the Dynasty Trusts bore no resemblance to the transactions described by the IRS. Decedent, who was 94 at the time she set these arrangements into motion, wanted the Group to remain in her family. To that end, she caused the Trust to pay a lump-sum premium, through the Dynasty Trusts, on the life insurance policies held on the lives of her Sons, the proceeds of which would be used to purchase the stock held by each of her Sons upon his death. Unlike the abusive insurance arrangements described by the IRS, the receivables the Trust obtained in exchange for its advances provided the Trust sole access to the CSV of the policies.

Conclusion

Because the Dynasty Trusts received no additional economic benefit beyond that of current life insurance protection, the Court held that the Trust was the deemed owner of the life insurance contracts by way of the special ownership rule under the regulations. Therefore, the economic benefit regime under the regulations applied to the split-dollar arrangements.

It should be noted that the preamble to the split-dollar regulations included an example that was structured identically to the split-dollar arrangements at issue. The preamble distinguished between a donor (or the donor’s estate) who is entitled to receive an amount equal to the greater of the aggregate premiums paid by the donor or the CSV of the contract and a donor (or the donor’s estate) who is entitled to receive the lesser of those two values.

In the former situation, as in the case above, the donor makes a gift to the donee equal to the cost of the current life insurance protection provided.

Thus, the issue remaining to be resolved in this case is the value of the receivable owing to the donor’s estate, which the IRS asserted was significantly understated.

Depending upon the outcome of this valuation, estate planners may, in the appropriate situation, be able to utilize split-dollar arrangements within a family-owned business to provide funds for a buyout and for the payment of the estate tax.

The owners of closely-held businesses are among the greatest benefactors of charitable organizations in this country. Although their contributions to charity are usually effectuated through the transfer of cash or marketable securities, it is often the case that the only asset available to satisfy an owner’s charitable inclinations is his or her interest in the closely-held business that the owner founded and/or operated.

Of course, the owner, or the owner’s estate (in the case of a testamentary transfer) will realize a tax benefit by virtue of making a charitable transfer, provided the transfer is completed in accordance with various statutory and regulatory requirements. Thus, where the interest in the closely held business is included in the owner’s gross estate, the bequest of such interest to a qualifying organization will generate a charitable contribution deduction for purposes of determining the owner’s estate tax.

Most charitable organizations, however, have no interest in owning equity in a closely-held business because it is not easily convertible into cash, at least not without some advance planning. Thus, many donors “arrange” for the purchase of such equity from the organization.

This strategy presents many challenges and risks, as illustrated in a recent decision.

Mom’s Testamentary Plan

Decedent and some family members owned DPI, a closely-held real property management corporation that managed a combination of commercial and residential rental properties.

DPI was a C corporation. Decedent owned 81%, and Son E owned 19%, of DPI’s voting shares. Decedent also owned 84% of DPI’s nonvoting shares, and her Sons  owned the remaining 16%.

Decedent and her Sons were officers and directors of DPI at the time of Decedent’s death.

During her life, Decedent had created an irrevocable life insurance trust that distributed the insurance proceeds to her children upon her death, and had established Trust and Foundation. Son E was the sole trustee of Trust and Foundation.

Decedent’s will left her entire estate to Trust. Under the terms of Trust, some cash passed to various charitable organizations. The remainder of Decedent’s estate, consisting primarily of DPI stock, was to pass to Foundation.

The Estate Tax Appraisal

The Estate obtained an appraisal to determine the date-of-death fair market value (FMV) of Decedent’s DPI shares. The appraisal explained that it would be used for estate administration purposes.

The appraisal valued the voting stock at $1,824 per share with no discount because the voting shares represented a controlling interest. It valued the nonvoting stock at $1,733 per share, which included a 5% discount to reflect the lack of voting power.

On its estate tax return, the Estate reported no estate tax liability, claiming a charitable contribution deduction for the date-of-death value of Decedent’s DPI shares.

Post-Death Events

Numerous events occurred after Decedent’s death, but before Decedent’s bequeathed property was transferred to Foundation.

S Corp. Election

Seven months after her death, DPI elected S corporation status in order to accomplish long-term corporate tax planning; specifically, the corporation’s board wanted DPI to avoid the built-in gains tax on corporate assets. The board also wanted Foundation, as an owner of shares in an S corporation, to avoid being subject to the unrelated business income tax (“UBIT”).

Redemption

In addition, DPI’s board realized that, pursuant to the Code, Foundation would be required to make annual minimum distributions of at least 5% of the value of its assets. Son E, as trustee of Foundation, was concerned that merely owning Decedent’s bequeathed DPI shares would not provide Foundation sufficient cash-flow necessary to make the requisite annual distribution.  Son E was also concerned that Foundation could be subject to excise tax on the value of any “excess business holdings” in DPI held by Foundation.

As a result, DPI agreed to redeem all of Decedent’s bequeathed voting shares, and approximately 72% of  her bequeathed nonvoting shares, from Trust in exchange for cash and promissory notes.

Son E then obtained local court approval for the redemption, to confirm that the redemption would not be a violation of the “self-dealing” rules.

At the same time as the redemption, pursuant to subscription agreements, Decedent’s Sons purchased additional shares in DPI in order to infuse the corporation with cash to assist in paying off the promissory notes DPI gave the Trust as a result of the redemption transaction.

An appraisal of Decedent’s DPI stock for purposes of the redemption and subscription agreements determined that her DPI voting shares had a FMV of $916 per share, and the nonvoting shares of $870 per share. The appraisal of the voting stock included discounts of 15% for lack of control and 35% for lack of marketability. The appraisal of the nonvoting stock included the lack of control and marketability discounts plus an additional 5% discount for the lack of voting power.

The IRS Challenge

The IRS disputed the amount of the Estate’s charitable contribution, arguing that the amount of the charitable contribution should be determined by the post-death events. The Estate argued that the charitable contribution should not be measured by the value of the property received by Foundation.

Because the IRS found that the value of Estate’s charitable contribution was lower than reported on its Estate Tax Return, the IRS also determined that additional estate tax was due. The Estate challenged the asserted deficiency in the Tax Court.

The Court considered whether the Estate was entitled to a charitable contribution deduction equal to the date-of-death FMV of DPI stock bequeathed to Foundation.

The Estate’s lawyer, who also served as DPI’s and Foundation’s lawyer, hired an appraisal firm to appraise the DPI stock. The appraisal specified that it provided a valuation of a minority interest in DPI as of the date of the redemption agreement. His understanding was that the appraisal would be used as support for the redemption. The appraisal treated DPI as a C corporation. The appraisal valued the DPI shares at $916 per voting share and at $870 per nonvoting share, reflecting discounts for lack of control and lack of marketability.

The date-of-death valuation had not included these discounts.

Foundation Tax Return

On its Form 990-PF, Foundation reported that it had received the following contributions from Trust:

  • Approximately 28% of Decedent’s nonvoting DPI shares;
  • A long-term note receivable; and
  • A short-term note receivable (the notes having been received by the Trust from DPI in the redemption transaction).

Trust Tax Return

On its Form 1041 for the taxable year of the redemption, Trust reported a capital loss for the sale of its shares of DPI voting stock, and a capital loss for the sale of its shares of DPI nonvoting stock (the redemption appraisal having been lower than the date-of-death appraisal from which the Trust’s adjusted basis for the shares was derived).

The Court’s Analysis

In general, the value of a decedent’s gross estate includes the FMV of all property that she owned, or in which she had an interest, at the time of her death. The value of stocks is the FMV per share at that time. “Fair market value” is defined as the price that a willing buyer would pay a willing seller, both persons having reasonable knowledge of all the relevant facts and neither person being under compulsion to buy or sell. The “willing buyer” and “willing seller” are hypothetical persons, rather than specific individuals or entities, and all relevant facts and elements of value as of the valuation date must be considered.

Charitable Deduction

In calculating a decedent’s taxable estate, a charitable deduction is generally allowed for bequests made to charities. The deduction from the gross estate generally is allowed for the value of property included in the decedent’s gross estate and transferred by the decedent at her death to a qualified, charitable organization. In general, the courts have held that the amount of the charitable contribution deduction is based on the amount that passes to the charity.

In the case at hand, the Estate contended that the applicable valuation date for determining the value of the charitable contribution was the date of death.

The Estate also argued that the charitable contribution deduction should not depend upon or be measured by the value received by Foundation. The Estate contended that consideration of post-death events that may alter the valuation of property would not truly reflect the FMV of Decedent’s assets. The Estate further contended that there was neither a plan of redemption nor any other precondition or contingency affecting the value of Decedent’s charitable bequest.

The IRS argued that the value of the charitable contribution should be determined by post-death events. It argued that the Sons thwarted Decedent’s intent to bequeath all of her majority interest in DPI or the equivalent value of the stock to Foundation, contending that the manner in which the two appraisals were solicited, as well as the redemption of Decedent’s controlling interest at a minority interest discount, indicated that the Sons never intended to effect Decedent’s testamentary plan.

The Valuations

The Court acknowledged that, normally, the date-of-death value determines the amount of the charitable contribution deduction, which is based on the value of property transferred to the charitable organization. There are circumstances, however, where the appropriate amount of a charitable contribution deduction does not equal the contributed property’s date-of-death value.

The Court noted that numerous events occurred after Decedent’s death, but before Decedent’s property was transferred to Foundation, that changed the nature and reduced the value of Decedent’s charitable contribution. DPI elected S corporation status. On the same date, DPI agreed to redeem all of Decedent’s voting shares and most of her nonvoting shares from the Trust, in exchange for promissory notes from DPI. Additionally, using the appraisal for the date of the redemption agreement, the Sons signed subscription agreements purchasing additional shares in DPI for $916 per voting share and $870 per nonvoting share.

The Estate contended that the foregoing subsequent events occurred for business purposes and should not affect the amount of Decedent’s charitable contribution.

The subsequent events did appear to have been done for valid business purposes. DPI elected S corporation status in order to avoid the section 1374 built-in gains tax on corporate assets. Additionally, DPI believed that the redemption would allow it to freeze the value of its shares (that would pass to Foundation) into a promissory note, which would mitigate the risk of a decline in stock value. The redemption also made Foundation a preferred creditor of DPI so that, for purposes of cash-flow, it had a priority position over DPI’s shareholders. The Sons purchased additional shares in DPI in order to infuse the corporation with cash to pay off the promissory notes that DPI gave the Trust as a result of the redemption.

The same firm that had completed the date of death appraisal was hired to perform an appraisal of Decedent’s bequeathed shares for purposes of the redemption. This appraisal included a 15% discount for lack of control and a 35% discount for lack of marketability, plus an additional 5% discount for the lack of voting power in the case of the nonvoting stock. The appraisal did not explain why these discounts were included.

Decedent’s bequeathed majority interest in DPI therefore was appraised at a significantly higher value only seven months before the redemption transactions without explanation.

Even though there were valid business reasons for the redemption and subscription transactions, the record did not support a substantial decline in DPI’s per share value. The reported decline in per share value was primarily due to the specific instruction to value Decedent’s interest as a minority interest with a significant discount.

Given that intra-family transactions in a close corporation receive a heightened level of scrutiny, Sons’ roles (especially Son E’s) needed to be examined, the Court said. Son E, as executor of the Estate and President, director, and a shareholder of DPI, instructed DPI’s attorney to inform the appraiser that Decedent’s bequeathed shares should be valued as a minority interest. He was also sole trustee of Trust and of Foundation. Decedent’s majority interest, therefore, was redeemed for a fraction of its value without any independent and outside accountability. The Sons thereby altered Decedent’s testamentary plan by reducing the value of the assets eventually transferred to Foundation without significant restraints.

Accordingly, the Tax Court held that the Estate was not entitled to the full amount of its claimed charitable contribution deduction.

Still A Good Idea

Notwithstanding the Court’s decision, the Decedent and her Sons had the right idea. The family was charitably inclined, and Foundation provided an effective vehicle through which to engage in charitable giving.

The bequest to Foundation would have enabled the Estate to escape estate tax if the Sons had not gotten greedy by “depressing” the value of the DPI shares.

The redemption would have removed the Foundation from the reach of the UBIT and some of the excise taxes (mentioned above) that apply to private foundations.

Importantly, the redemption would have removed from Foundation, and shifted to the Sons, the future appreciation in the value of decedent’s DPI shares.

Finally, if the Foundation and DPI were ever controlled by different persons in the future, the redemption would have removed the potential for shareholder disputes.

It Happens All The Time

A business owner dedicates every waking moment to the growth and well-being of the business. Invariably, the owner is motivated, in no small part, by the desire to provide for his or her family. After years of effort, and maybe some luck, the business succeeds. The owner and his or her spouse are able to accumulate wealth outside the business, or the business is sold for a significant amount.

At that point (belatedly, in my opinion), the owner and his or her spouse usually start to think about estate planning, including the reduction of estate taxes and maximizing the value of the assets that will pass to their family.

Where the estate plan is devised carefully, the owner and his or her spouse recognize that some loss of control over some of their assets may be necessary, and the plan is implemented properly and with sufficient time to “mature,” these goals may be attained. 55

Alas, too many business owners wait until it is too late to adopt and execute an effective estate plan that can also generate tax savings. This week’s post considers a recent example of one such situation.

The Limited Partnership

Decedent and her spouse owned a heating and air conditioning wholesale business and were involved in real estate development. They had accumulated substantial assets by the time the Decedent’s spouse died in 1999. His will directed that his assets be placed in three trusts. The income from two of those trusts was payable to Decedent on a regular basis, and the principal of all three could be used for her benefit. Further, at the time of her spouse’s death, Decedent had substantial assets of her own.

In 2003, Decedent moved to a nursing home, and granted her Son a power of attorney. Son attended to Decedent’s day-to-day financial needs and managed her financial assets using the power of attorney.

A few years later, Son and Decedent’s attorney devised an estate plan for some of her assets. Decedent was not involved in deciding how her assets would be held; she left this up to her Son and her attorney.

Decedent executed a certificate of limited partnership and a limited partnership agreement in November, 2006. The partnership agreement described the Partnership’s purpose in broad terms. However, one stated purpose was to provide “a means for members of the Family to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property is continued by, and closely-held by, members of the [F]amily.” The agreement also provided that limited partners did not have the right or power to participate in the Partnership’s business, affairs, or operations.

On the same day, Decedent executed the articles of organization, and the operating agreement, of LLC, a limited liability company, with Decedent as the sole member. LLC was created for the primary purpose of being the general partner of Partnership.

In December, 2006, Partnership was funded with marketable securities transferred from Decedent’s account. A portion of this contribution was made “on behalf of” LLC. The gross value of Partnership’s assets at that time was almost $6 million. This was the only capital contribution made to Partnership. In consideration for her contribution, Decedent received a 99.9% interest as a limited partner, and LLC received a 0.1% interest as the general partner.

Subsequently, on the same day, Decedent assigned her interest in LLC to her Son in exchange for almost $6,000. The price paid by Son equaled the gross value of 0.1% of Partnership’s assets on that day, without discount. Son’s purchase of Decedent’s interest in LLC (the general partner) eliminated any formal control Decedent may have had over the assets she transferred to Partnership.

After Decedent’s transfer of her interest in LLC to Son, and still on the same day, she gave 10% of her limited partnership interest in Partnership to the Irrevocable Trust. Decedent executed this Trust on the same day that LLC and Partnership were formed. Following this transfer, Decedent held an 89.9% limited partnership interest in Partnership, which she held until her death.

At all times before Decedent’s death, Partnership’s assets consisted solely of investment assets, such as marketable securities and cash. Decedent held substantial assets that she did not transfer to Partnership.

In 2007, Partnership made a pro rata cash distribution to its partners. This was the only distribution Partnership made during Decedent’s lifetime.

When Decedent died in 2009, the fair market value of all of the assets owned by Partnership, without discount, was just over $4 million. The value of Decedent’s interest in Partnership was reported on her estate’s tax return as approximately $2.43 million as a result of discounts (over 30%) that were applied to her 89.9% limited partnership interest.

The IRS claimed that the assets of the Partnership should have been included in the Decedent’s gross estate, and issued a notice of deficiency in estate tax. Decedent’s Estate petitioned the Tax Court for relief.

 The Law

Estate tax is imposed on the transfer of a decedent’s taxable estate. The taxable estate consists of the value of the gross estate after applicable deductions.

The Code requires the inclusion in a decedent’s gross estate of certain lifetime transfers that were testamentary in nature. Accordingly, a decedent’s gross estate includes the value of all property that the decedent transferred during life, but retained the possession or enjoyment of, or the right to the income from, for the decedent’s life, provided the decedent’s transfer was not a bona fide sale for adequate and full consideration.

An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred. In determining whether an implied agreement exists, the courts consider the facts and circumstances surrounding the transfer and the property’s use after the transfer. The taxpayer, of course, bears the burden of proving that an implied agreement or understanding did not exist at the time of the transfer. This burden is particularly onerous when intra-family arrangements are involved.

The Decedent’s “Retained” Interest?

The Estate denied the existence of an implied or oral agreement that allowed Decedent to retain control of the assets transferred to Partnership. The Estate asserted that after Decedent sold her interest in LLC to her Son, she did not retain possession or enjoyment of, or the right to income from, the assets that were transferred to Partnership. The Estate further contended that Decedent had no right to designate who would possess or enjoy the assets transferred to Partnership or the income from those assets.

The IRS, however, argued that Decedent did retain possession of the property transferred to Partnership and that she retained a right to income from that property. The IRS asserted that the distribution provision of the partnership agreement – which required the distribution of funds in excess of Partnership’s current operating needs – evidenced Decedent’s right to income from the assets transferred to Partnership.

The IRS also argued that there was an implied agreement that Decedent could access the income from the assets transferred to Partnership if necessary. Son’s testimony made it clear that had Decedent required a distribution, one would have been made.

On the basis of these facts and circumstances, the Court believed that there was an implied agreement that Decedent retained the right to “the possession or enjoyment of, or the right to the income from, the property” she transferred to Partnership.

 Bona Fide Sale?

If Decedent’s transfer of the assets to Partnership was a bona fide sale for adequate and full consideration, the special inclusion rule would not apply. In the context of a family limited partnership, the record must establish a legitimate and significant nontax reason for creating the partnership, and that the transferor received partnership interests proportionate to the value of the property transferred. The objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership’s creation. A significant purpose must be an actual motivation, not a theoretical justification.

The Estate argued that three significant nontax business purposes prompted the creation of Partnership: first, to protect the assets from “trial attorney extortion”; second, to protect the assets from the “undue influence of caregivers”; and third, to preserve the assets for the benefit of Decedent’s heirs.

The IRS, however, asserted that the first two “purposes” were merely theoretical justifications, and not legitimate and significant nontax reasons for Partnership’s formation. The Court agreed.

The final proposed justification for the creation of Partnership was to preserve the transferred assets for the benefit of Decedent’s heirs. Though the partnership agreement explained Partnership’s purpose in extremely broad terms, it also stated that it was “formed for the purposes of providing a means for members of the [F]amily to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property is continued by, and closely-held by, members of the [F]amily.” Son also testified that Decedent wanted to make sure that her assets were preserved for the benefit of the family.

The IRS contended that the facts surrounding the creation of Partnership showed that there was no significant nontax reason for its creation. The IRS emphasized that the transfer was not the result of arm’s-length bargaining, that Partnership held only cash and marketable securities, and that the terms of Partnership’s partnership agreement were not followed.

A Litany of Poor Planning

The Court was not convinced, on the basis of these facts and circumstances, that the formation of Partnership was for a legitimate and significant nontax reason. It found the reasons given unconvincing, particularly in the light of the fact that the assets of the Decedent’s spouse were held in trusts and there were no issues with the management of these assets. Further, Decedent was not involved in selecting the structure used to preserve her assets. Her Son testified at trial that Decedent was “fine” with whatever he and the attorney decided on.

Decedent stood on both sides of the transaction. She made the only contribution of capital to Partnership and held, directly or indirectly, a 100% interest in Partnership immediately after its formation. On the same day, Decedent assigned her interest in LLC to Son in exchange for its fair market value. There was no meaningful negotiation or bargaining associated with the formation of Partnership. In fact, the Son testified that during conversations about forming Partnership, Decedent would agree to whatever he and their attorney decided to do. This was not an arm’s-length transaction.

Partnership also failed to maintain books and records other than brokerage statements and ledgers maintained by Son. The partners did not hold formal meetings, and no minutes were kept. Despite the provisions of the partnership agreement, Partnership made only one distribution before Decedent’s death. Other portions of Partnership’s agreement that were also ignored.

Taking all of the facts and circumstances surrounding Partnership’s formation into account, the Court found that Decedent did not have a legitimate and significant nontax reason for transferring assets to Partnership. The Court also observed that Partnership held marketable securities that were not actively managed and were traded only on limited occasions. Despite the purported nontax reasons for Partnership’s formation, the Estate had failed to show that there were significant legitimate reasons.

On the basis of the foregoing, the Court held that the value of the assets Decedent transferred to Partnership should have been included in the value of Decedent’s gross estate.

Don’t Blow It At the End

Not planning properly for the transfer of one’s wealth– whether represented by a business or in the form of investments– is almost as bad as not planning at all. The tax savings are often the same: none. Witness the case above: poor planning and poor execution led to poor results.

That is why it behooves the “immortal” business owner and his or her all-too-mortal spouse to start planning early. That will require some difficult decision-making, first as to whether they should dispose of any of their assets during their lifetimes, and second, as to the disposition of their assets at their deaths. In both cases, they will have to address the questions of “to whom and how” their assets should be transferred. This is a responsibility that should not be abdicated to one’s children, as in the case above. It is a task that should be undertaken sooner rather than later.

 

Make sure you check out Part I before reading below…

The Bigger Picture

In addition to the SCIN-specific issues, the complaint touches on a number of themes of which every estate-planning adviser – and every client – should be aware.

The Facts Matter

An adviser should assume that the IRS will scrutinize the estate plan closely, especially in the case of a large estate or a prominent client.

The adviser should prepare for such an exam contemporaneously with the implementation of the plan, not later. This may be especially important in the case of a client’s premature or unexpected death.

The Technique and Execution Matter

An adviser should recognize that certain techniques, including the use of SCINs, are likely to attract the attention of the IRS.

Whenever a “risky” technique is employed as part of an estate plan, it must be prudently and properly executed if it is to withstand IRS scrutiny.

As a general rule, transfers between family members will be subject to greater scrutiny, and could be challenged as not being bona fide and not being conducted at arm’s-length. Failing to have separate counsel for the parties to the transaction will only exacerbate the matter. The estate plan as a whole could be deemed to be a testamentary device deployed purely to avoid tax liability.

Educate the Client

The client must be presented with alternatives, each of which may accomplish his or her testamentary goals. It is not the adviser’s role to make the necessary “business” decisions.

Assess the Risks

For each alternative, the client must also be informed of the attendant risks, the likelihood of their being realized, and the economic consequences thereof. Without this information, how can the client be expected to make any decision?

According to the complaint, nowhere in DT’s presentation was there a comprehensive list of the relevant and material risks. Rather, it is alleged that DT assured the decedent that its estate plan hedged all risk, maximized the transfer of wealth, and minimized taxes.

One Tool May Not Suffice

In light of the strict scrutiny that a particular decedent’s estate is likely to receive (for example, because of the size of the estate), it may behoove the estate planner to use more conservative and more reliable estate planning techniques.

If more “aggressive” techniques are to be used, the planner should consider not making them the centerpiece of the estate plan. The planner should also consult with subject matter experts, including other legal counsel, doctors, actuaries and others, in connection with the formulation and implementation of such an estate plan.

Too Good to be True

A proposal that purports to eliminate all economic risk to the taxpayer’s estate is the sort of estate plan that the IRS routinely rejects as having no economic substance.

DT’s SCIN-GRAT “circular” transaction eliminated the risk incumbent in the SCIN transactions. Only if the transaction involves an appropriate degree of economic risk will it be found to be a bona fide transfer. Without such risk, the IRS is bound to scrutinize a transaction, like the SCIN, and challenge it as strictly a tax avoidance device.

Substance Over Form

In the case of the decedent’s estate, the IRS concluded that the transfers of stock

in exchange for the SCINs should be viewed as gifts because the SCINs lacked the indicia of genuine debt in that there was no requirement of repayment of principal, there was no reasonable expectation that the debt would be repaid, and DT’s use of the §7520 mortality tables to set the terms of the SCINs was unfounded.

The arrangement was nothing more than a device to transfer the stock to family members at a substantially lower value than the fair market value of the stock.

Although an estate may vigorously maintain that a decedent intended to enforce and collect on a note, it is difficult to support such an assertion without the kind of proof that is demonstrated by the actual receipt of payments.

Know the Law and Apply It

The client will reasonably assume that the adviser is – and the adviser must actually be – intimately familiar with the applicable statutes, regulations, administrative and judicial pronouncements.

In recommending any estate planning technique, the adviser must be able to anticipate the IRS’s reaction and arguments, and he or she must plan for them accordingly.

According to the complaint, the existing authority made clear that the absence of periodic payments of principal in connection with all of the SCINs and, in particular, no requirement of the payment of any risk premium until the end of their term, made them susceptible to being challenged as not being bona fide transactions. DT should have known, it continues, that the IRS generally challenges estate plans that provide purported “win/win” scenarios.

Conflicts?

It is not unusual for an estate planner, acting on behalf of a client’s estate, to defend its planning and the implementation thereof to the IRS. In doing so, however, the planner must walk a very fine line and must be completely transparent with respect to its client.

For example, the complaint alleges that DT’s provision of services to the decedent’s estate subsequent to his death was not only intended to defend its plan to the IRS, but also to conceal the defects in that plan from the executors of the client’s estate.

“How Do We Kosher This Pig?”

A former colleague would sometimes put this question to me when confronted with an IRS examination of a transaction or plan that we had not structured, but that we were retained to defend. Too often, there was little we could do to reverse what had already been done, and it was too late to do what should have been done earlier.

This question also highlighted the importance of planning thoroughly and in advance of engaging in any transaction. The best time to prepare for an audit is before the subject of the audit has even occurred.