Washington Estate Planning Law Blog : Washington Estate Planning Lawyer & Attorney : John Hugg Law Firm : WA Elder Law, Wills, Trusts : Seattle, Woodinville, Bellevue

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 With no action, the estate tax will be repealed for 2010 only, then return with only a $1 million federal exemption per person.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.

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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.
 

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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.

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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.
 

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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.
 

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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:

www.familybusinessmagazine.com/index.html

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