For anyone who missed it, Dan Duncan, a Houston, Texas, oil billionaire passed away earlier this year. Because he died in 2010, with no federal estate tax in place, his entire $9 billion estate will pass tax free. Had he died in 2009, his estate would have owed Uncle Sam approximately $4 billion. Of course, had Mr. Duncan been a resident of Washington State, an estate tax would be due on all assets valued over $2 million.
I’m frequently asked: “How much can I give away tax free?” In 2010 you can give up to $13,000 in cash or property to any one person completely gift tax free. If you are married, you and your spouse can double that tax free gift to $26,000 per recipient. So if you have two children and four grandchildren a married couple could give a total of $156,000 ($26,000 to each of the six individuals). You may also pay for a person’s educational expenses or medical bills in the same year in addition to the direct gifts of $13,000 per person. Therefore, you could pay your grandchild’s college tuition and give him or her $13,000 ($26,000 if you are married) in 2010 without incurring any gift tax. One word of caution regarding tuition and medical – you must pay the institution or provider directly. Do not write the check to the individual and have them pay the school or hospital.
For individuals with substantial estates this can be an effective strategy to help your family members while reducing the value of your estate. You can therefore minimize your estate tax burden and still enjoy helping out your family.
There are a couple of things to keep in mind with gifting programs. First is that you are not entitled to get any of that money back. If you ultimately need those gifted funds, the recipient, if he or she still has the money, is under no legal obligation to help you out. The moral: be sure your gifting will not impoverish you. Second, if you have reason to believe you may need to qualify for Medicaid in the future, the state will look at all gifts within the five year period of time prior to applying for Medicaid. If there are gifts during this five year period, you may be ineligible to receive Medicaid for a period of time.
On January 1, 2010, the federal estate tax was repealed. Currently, there is no federal estate tax. So, what does this mean for people in the State of Washington? It means several things. First, it means that if you die today, you may not owe any estate tax to the federal government; second, there is still an estate tax in Washington State that may apply; and, third your heirs may have to pay a substantial capital gains tax on property that is sold. Let’s look at each of these issues.
Federal Estate Tax
I say you may not owe federal estate tax because toward the end of 2009, Congress made a lot of noise about how they would simply bring the estate tax back in early 2010 and have it applied retroactively to January 1. So in actuality, if you die today and Congress creates a retroactive tax in May, you could still owe federal estate taxes.
If, however, Congress does nothing on the estate tax issue in 2010, the estate tax is automatically set to come roaring back in 2011. At that point, the estate tax exemption will be $1,000,000 per person as opposed to the $3,500,000 exemption in 2009. This means a lot more estates will owe taxes in 2011 than in 2009.
Washington State Estate Tax
Regardless of what happens with the federal estate tax, Washington still has its own estate tax. Here, the estate tax exemption is $2 million per person. So anyone with an estate in excess of that amount would owe estate tax to Washington State. Proper planning can minimize or even eliminate this tax in certain situations.
Capital Gains Tax
There is another wrinkle with estate tax repeal. This year, without the estate tax, you can only receive an increased tax basis on $1,300,000 worth of your property. What does that mean? Well, under the old estate tax laws, when a person died the tax basis in his or her property would increase from the amount paid for the item to the market value of the item at the time of death. But this is not the case in 2010. Now only $1.3 million of your property will qualify (with an additional $3 million exemption for property passing from one spouse to the other). If you have property worth more than that, a capital gain will be incurred on the sale of the asset, and that gain will be based on the original cost of the item.
Here’s an example under both the old and new systems: mom has $1.3 million in her retirement account; mom bought her house in 1980 for $50,000. Mom dies in 2009 and the house was worth $350,000. The tax basis increased from $50,000 to $350,000 and her heirs would owe no capital gains tax on the sale of the house in addition to having no estate tax to either the federal or Washington State governments.
Now let’s say mom died on January 1, 2010. If mom’s retirement account eats up her $1.3 million capital gain “exemption” then capital gain will be due on the sale of the house. The tax will be based on $300,000, the difference between the $50,000 original tax basis and $350,000, the current value of the property.
What will happen to the capital gains tax issue if the estate tax is reinstated retroactively? Presumably, it will go away. Confused? To deal with this mess I (with tongue in cheek) told one client earlier this week – “Don’t die in 2010!”
In its article Amid Debate, Business Owners Struggle with Estate-Tax Strategies, the Wall Street Journal reported that the federal estate tax is a significant concern for family business owners even though few actually wind up paying the tax. Family Businesses in Washington State should be even more concerned because the estate tax exemption in here is $2 million and not $3.5 million as with the federal estate tax exemption. However, one reason so few family business owners pay estate tax is most likely due to the use of various estate planning techniques. These techniques can include annual gifts, trusts, intra-family transactions, life insurance and even a properly drafted Will. But early planning is essential. The estate planning process can draw out for years given the many complexities facing a family business. These complexities include, among many others: selecting and grooming a successor, family dynamics and squabbles, excess cash flow to fund life insurance policies, the desire to have children earn the business rather than simply inherit it by birthright and many more. Since it’s almost certain the estate tax isn’t going away, neither will these issues for family businesses.
At some point most of us will have to step up and help our parents with their affairs. A recent Forbes article discusses how difficult it can be if your parents already have some memory loss or dementia when you first enquire about their situation. Since they may not be able to communicate with you effectively, it may take months to ascertain their financial situation because you won’t know what assets they have or where they are located. As the article mentions, a better way to go is to talk with your parents before it becomes necessary. Help get them organized. This task will also help you to find out what bank accounts, insurance policies and sources of income your parents have. And if your parents’ affairs are more complex, it will be even more important to know what’s happening in their financial lives. As with anything, if you prepare early and stay on top of things, you’ll be well served when you do have to help out.
Recently, a number of cases have come out addressing when a gift of an LLC interest is really a gift of an underlying asset owned by the LLC. Two of these cases were decided right here in Federal District Court in Washington: Heckerman v. U.S., U.S. Dist. Ct., W.D. Washington, Cause No. C08-0211-JCC (July 27, 2009) and Linton v. U.S., U.S. Dist. Ct. W.D. Washington, Cause No. C08-227Z (July 1, 2009).
To summarize the cases very briefly, families in each case formed an LLC and the senior generation contributed various assets to the respective LLCs. On the same day the LLC contributions were made, gifts of LLC interests were made to trusts for their respective children. Each family claimed a valuation discount of the LLC interests for gift tax purposes. The IRS applied the indirect gift and step transaction doctrines to attempt to eliminate the discounts. In effect, the IRS said the parents made a gift of an actual asset and not an LLC interest. Valuation discounts apply to the latter. The IRS was successful in both cases.
The primary basis for denying the valuation discounts was the indirect gift doctrine. Application of this doctrine can frustrate a valuation discount if there is insufficient evidence to conclude what occurred first, funding the LLC or making gifts. In each case, with funding and gifting occurring on the same day, the necessary evidence was absent. An additional basis was the step transaction doctrine where a series of separate ‘steps’ are seen in substance as integrated, interdependent, and focused toward a particular result. There are three different tests used to determine if the step transaction doctrine applies in a given transaction: the “binding commitment test” where there is a binding commitment to undertake several different acts that, when viewed as a whole, are really one transaction; the “end result test” where one gleans an overriding transaction based on achieving an end result, such as tax savings; and the “interdependence test” where one act is ultimately fruitless without additional acts.
Can these problems be addressed with proper planning and drafting? Ultimately, the answer is somewhat unclear. What seems obvious is to set up an LLC or partnership first, then subsequently fund it with the assets desired. Other case law also indicates that when contributing property to the LLC the value of the asset should be attributable to the contributor’s capital account only. At a later point in time, seemingly the more elapsed time the better, a person would make gifts of the LLC interests. Presumably, if you are gifting to a trust, as is often the case, setting up the trust subsequent to the creation and funding of the LLC would seem prudent. Conducting affairs in this manner should automatically avoid the indirect gift doctrine and, assuming proper drafting, the “binding commitment test.” It should also go a long way to avoiding the “interdependence test,” however, given that the “end result test” can be apparently be satisfied by evidence of the “subjective intent” of the parties, it is unclear how one would plan to avoid this part of the step transaction doctrine. Stay tuned for further developments.
In PLR 200937028, the IRS concluded that property held in an irrevocable grantor trust that was not included in the grantor’s estate at death does not receive a step-up in basis. Most individuals who own property in their own name at death receive a step-up in the tax basis of that property. For example, if you paid $200,000 for your home in 1995 and you die today with the house valued at $500,000 the tax basis increases to today’s value. Therefore, capital gain on the sale or future sale of the asset is either eliminated or minimized. However, if you transfer an asset to an irrevocable trust, even a grantor trust where the trust income is still taxed to the grantor, the asset is out of your estate and not eligible for a step-up in tax basis upon death. The beneficial trade off is that with the asset outside your estate, it is not included for estate tax purposes.
We’ve been waiting for changes to the federal estate tax for some time, however, we really have no idea what the changes will look like. Over the weekend the Wall Street Journal reported the issue is stalled in Congress with seemingly no consensus about what to do. The administration apparently wants to lock in the current exemption level of $3.5 million per person with a 45% tax rate and some Republicans are still looking for a complete repeal. Now there is a newer proposal for a $5 million dollar per person exemption with a 35% tax rate. But with so many members of Congress focused on the health care debate, this issue is decidedly low priority. Another very real possibility is that the Bush tax cuts will run their course as planned. With no action, the estate tax will be repealed for 2010 only, then return with only a $1 million federal exemption per person. Regardless of what happens at the federal level, Washington State appears wedded to its current $2 million per person exemption. If the federal exemption is rolled back to $1 million, I would expect a large number of estate plans will need to be updated.
In a recent ruling, the U.S. Tax Court concluded that transfers of LLC interests were in fact transfers of LLC interests. If this conclusion sounds obvious, it isn’t. In Pierre, the owner of certain assets formed a single member limited liability company, or LLC, contributed those assets to the company, then both gifted and sold portions of the company to trusts for her children – a fairly standard estate planning strategy.
When forming such an entity the IRS allows the selection of several different ways to be taxed. Among the options are for a LLC to be taxed as a corporation or as a “disregarded entity.” Here, the owner opted for the LLC to be taxed as a disregarded entity. That means that “for tax purposes” the entity is viewed not to exist and all tax aspects flow directly to the sole owner of the LLC. For ownership and liability purposes however, the entity very much exists. Under New York law (where the company was located) the owner of an LLC has no interest in the assets held by the LLC, she only had a personal property interest in the entity itself. It is these two conflicting legal concepts on which Pierre turned. The IRS argued, unsuccessfully, that a transfer of an interest in a disregarded entity was actually a transfer of the underlying asset(s) held by the LLC because “for tax purposes” the LLC doesn’t exit. Pierre argued that, under state law, she had no interest in the underlying asset to transfer, only LLC interests and therefore could not transfer the underlying asset(s). A rather divided tax court ultimately agreed with Pierre saying the entity selection rules, otherwise referred to as the “check-the-box” rules, that allow the entity to be “disregarded for tax purposes” did not apply to transfers of an interest in the company. Accordingly, a transfer of a LLC interest is a transfer of an interest in the entity and not a transfer of any specific asset owned by the entity.
There are two questions you should be asking yourself. First, what is the significance of this ruling? Well, if you gift a piece of real property worth one million dollars the gift tax would generally be based on the full one million dollar value. However, when the same asset is owned in a LLC and an interest in the LLC is gifted the tax code allows you to discount the value of the LLC interest transferred. So in this example you might get a 20% discount and only have to pay tax on $800,000 and not one million dollars (this is an oversimplified example). Second, does this ruling apply to Washington state LLC’s? The answer presumably is yes. Washington State’s limited liability company act contains a provision very similar to that of New York where the owner of the LLC has only an interest in the company and not in the assets owned by the company.
Regardless of whether you want to pass your business to your family or sell it to a third party, a thorough plan is vital to the survival of the company after you’re gone. A recent article in the Investors Business Daily outlines some of the various challenges your family may face with the business if you die or are incapacitated. These challenges can include, among other things, ensuring sufficient cash flow, the ability for family members to get money out of the company, maintaining existing employees, and transferring ownership either within the family or through a sale of the company. You should have a plan in place the sets out not only who will own the business when you’re gone, but who will oversee the management and transition of the business. This goes beyond just a simple Will. Such a plan may call for multiple business entities, trusts, a buy-sell agreement if you have partners, a dividend policy, and other mechanisms to get the right people in place to continue the business without interruption. It is often prudent to assemble a team of advisors including an estate planning attorney with an understanding of business succession issues, an accountant and an insurance professional. Most important, however, is to both have a plan and implement it.
Or so I seem to hear every time I discuss the need to hire an expert to value business and real estate interests. It’s frequently been my experience that few things bring implementation of a succession plan to a halt faster than having to pay a valuation expert. After all, those guys don’t know anything . . . right? However, in case after case, a detailed, substantiated valuation, bests the IRS almost every time there’s a dispute over asset valuation or the application of minority, lack of control or other discounts. The case of Litchfield v. Commissioner, T.C. Memo 2009-21 which came down earlier this year is no exception.
In Litchfield, the estate owned interests in a real estate company and a securities company. A portion of the interests were owned by Ms. Litchfield outright and a portion of the interests were owned through a QTIP trust. The combined interests added up to a minority stake in each company, permitting the application of a valuation discount. In upholding most of the discounted valuation, the tax court found that the estate’s valuation expert used more precise methods for determining value and had a more thorough knowledge of the companies’ business strategies. This depth of understanding was found to be more convincing than the less rigorous valuation methods used by the IRS. So remember the real benefit of a valuation expert—done properly, your transactions and discounts are more likely to be honored in the face of an IRS challenge.
Will your family members be able to step in and effectively run the family business and settle your affairs, or will your family be lost in a maze of business and personal dealings they didn’t even know existed? A short time ago, Family Business Magazine ran an interesting piece that shows the value of being prepared and the difficulties that stem from not having your ducks in a row. The Mazzaro brothers had to take over the family business in the wake of tragedy. Their parents built up a successful food business. Then one day both mother and father died in a car accident. Both boys dived into the family business. But it took them a year just to unearth the most basic information, such as the names of customer accounts, how much money the company made, charged or billed. They didn’t know if they could even keep the business. Much of the business information was stored in their father’s head.
A solid plan is the best way to address not only retirement and business succession, but the problems arising out of a tragedy. Such a plan is slightly more involved than simply having a Will. Your Will should be the starting point for what happens with the family business. It should state who gets your ownership interest and provide, among other things, that the executor is authorized to continue running the family business during the period between your death and the end of probate. You should also have a Durable Power of Attorney that will function in the event you are incapacitated. In this case, since you are still alive, a Will won’t cover this situation. You need to appoint someone who can vote your shares and handle business matters; and, be sure to give that person clear authority to do what is necessary for the business to function.
Finally, a written contingency plan is vital. You should include information about where everything is located and how to access it. Set out a document that includes: the places where you bank and the account numbers; accounting information; any brokerage firm(s) where you maintain an account; the location of all corporate and other business records; a statement showing the assets of the business; computer login IDs and passwords so the system (and the accounting, customer, payroll and other information) can be accessed; lists of vendors and accounts payable; names and address of your key advisors: attorney, accountant, financial advisor, insurance professional and others. You should also create procedures for producing, selling and delivering your product or service so another person can step in and maintain business flow.
Remember, you don’t need to do everything at once. Pick one thing that you haven’t addressed such as your estate plan, then move on to another task. Soon enough everything will be in place.
When a business has been in the family for more than one generation the number of family member shareholders can grow significantly. The minor children in the newest generation probably have little or no comprehension of business in general, let alone the family business. It can, however, pay dividends to educate the newest generation as early as possible about what the business does, how is works and who’s involved. Learning about these and other aspects of the business can help a child decide if he or she wants to be involved with the business and to understand the impact the business may have on the family and the child in particular. A recent Family Business Magazine article outlined a fun way for kids to learn about the family business. At the annual retreat the family would separate the kids into teams and have various competitions—disassembling and reassembling certain company products, thinking up new products, trivia games and scavenger hunts. Everything revolved around the business, its products, its customers, the family and the family history. This type of “education” can be fun and informative and is likely more effective than trying to have an eight year-old sit through your own version of Business and Economics 101. For more information about family business go to:
Most closely held businesses with multiple owners should have a Buy-Sell Agreement, often called a Shareholder Agreement. Without such an agreement problems can arise. Upon an owner’s death his or her shares in the company will often pass to a surviving spouse. This may or may not be desirable from the surviving business owner’s point of view.
Another situation that can arise is that one shareholder will cease to be active in the business. If his/her shares are not reacquired at that time, you may have to buyout the departed shareholder’s shares years later; and for a greatly inflated price. Not that this is unfair, but most people feel that only the people who actually contribute to the business’ success should reap the benefits.
The Buy-Sell Agreement can address these and many other issues between business owners. The agreement should address some or all of the following:
A thorough Buy-Sell Agreement can alleviate a lot of headaches down the road, especially if the Company is successful. I tend to recommend such an agreement to all of my closely held business clients with multiple owners.
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