PLANNING FOR ESTATE LIQUIDITY. ALI-ABA Course of Study Sophisticated Estate Planning Techniques Boston, Massachusetts.

Transcription

1 PLANNING FOR ESTATE LIQUIDITY ALI-ABA Course of Study Sophisticated Estate Planning Techniques Boston, Massachusetts September 9, 2005 I. Introduction and Overview TABLE OF CONTENTS 1,2 II. Liquidity and Related Planning for Partnership Interests Held at Death A. Income Tax Issues when Dissolving an FLP or LLC (Louis A. Mezzullo) B. Sale of Partnership Interest, Section 754 Election and Passive Loss Rules Applicable to Estates and Trusts (Neill G. McBryde) C. Administration, Distribution, and Division of FLP and LLC General Partner (Neill G. McBryde) D. Funding Issues for Owners of Flow-Through Entities Particularly Funding Pecuniary Bequests and Valuation Issues in Funding Marital or Charitable Bequests (Stephen R. Akers) III. Liquidity and Related Planning for S Corporation Stock Held at Death A. Selected Issues when Liquidating an S Corporation after a Shareholder s Death or Redeeming Shares from a Deceased S Corporation Shareholder (Louis A. Mezzullo) B. Treatment of a Grantor Trust Holding S Corporation Stock upon Death of Grantor (Neill G. McBryde) C. Liquidity Issues Relating to Funding Post Death for Owners of Flow-Through Entities Particularly Funding Pecuniary Bequests and Valuation Issues in Funding Marital or Charitable Bequests (Stephen R. Akers) 1 The materials referenced in the Table of Contents have been provided by, and included with the express permission of, the individuals noted. The materials were presented as part of a program at the Annual Meeting of the American College of Trust and Estate Counsel on February 24, 2005 entitled Passing through Death: How to Deal with the Death of an Owner of a Pass-Through Entity. 2 To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. Federal tax advice contained in these materials, including attachments, is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Service. I

2 IV. Additional Liquidity Planning Issues for Pass-Through Entities upon Death of the Owner A. Allocation of Income between Individual and Estate Returns in Year of Death: Estate Fiscal Year Considerations (Stephen R. Akers) B. Extensions for Paying Federal Estate Tax (Stephen R. Akers) C. Estate Tax Administration Expense and Debt Deduction Issues for Owners of C Corporation Stock and Interests in Flow-Through Entities Including Deducting Interest on Amounts Borrowed to Pay Estate Tax (Stephen R. Akers) D. Income Tax Consequences of Termination of Grantor Trust Status (Neill G. McBryde) II

3 I. Introduction and Overview The presentation concerning planning for liquidity is intended to address the problems associated with the ownership of closely held entities when there will be a need to provide liquidity through these entities directly or indirectly at the death of a significant owner of such entities. There are, of course, additional ways to provide liquidity through life insurance and/or the creation of cash pools during lifetime and/or through marketable securities that will receive a basis step up at death and thus could be sold with little or no tax cost. However, in many instances the size of the interest in the entities and their value at death results in estate taxes, administration expenses and other costs at death that are unable to be satisfied except through accessing liquidity inside the particular entities. At that point in time, after the death of the person holding a substantial interest in such entities, there are often competing interests for the use of such funds, for example, to provide for the continued operation of the business, to provide for the well being of the intended beneficiaries of the owner s estate or trust and to satisfy concerns of other shareholders, and there are also often governance concerns. These issues obviously should be addressed prior to death and/or handled with careful precision following death to avoid even further liquidity issues resulting from the unnecessary payment of taxes. The traditional entity of choice for closely held business interests until the last two decades was the C corporation, and then in the 1980 s with the liberalization of the S corporation rules and in the late 1980 s and 1990 s with the emergence of family partnerships and then limited liability companies, special liquidity issues have arisen with pass through entities which were not previously addressed upon the death of an owner with a substantial interest in a C corporation. This presentation will cover a number of the planning opportunities and issues, both tax and nontax, that arise at the death of an owner of an interest in a pass through entity. In normal tax parlance, the pass through entity concept might encompass a number of entities such as REITs that we do not typically see in our estate planning. Similarly, the use of ESOPs as a means of providing liquidity will not be addressed in this presentation. Thus, this presentation will focus principally on interests in limited partnerships and LLCs. Any reference to limited partnerships is intended to include both the limited partnership and the LLC. The stock or limited partnership interests may be held directly by the owner or through the owner s revocable trust at death. In addition, the irrevocable defective grantor trust, is increasingly the vehicle of choice for holding S corporation stock and limited partnership interests as a result of inter vivos gifts or sales. This presentation will not attempt to address the nuances or potential changes that would apply as a result of actual repeal of carryover basis or increased exemptions for estate, gift and GST purposes. Nor will this presentation discuss how we should communicate with our clients to comply with Circular

4 INCOME TAX ISSUES WHEN FORMING AND DISSOLVING AN FLP OR LLC Louis A. Mezzullo McGuireWoods LLP Richmond, Virginia (May 17, 2005) 2

5 INCOME TAX ISSUES WHEN FORMING AND DISSOLVING AN FLP OR LLC TABLE OF CONTENTS I. FORMATION OF THE ENTITY...1 A. Investment Company Issues....1 B. Contributions of Assets Subject To Liabilities....4 C. Disguised Sales...5 II. DISTRIBUTIONS SUBJECT TO GAIN RECOGNITION...5 A. General Rule....5 B. The Gain Provisions...6 C. Disproportionate Distribution to One Member...12 D. Distribution to a Member In Liquidation of Donor/Member s Interest...17 E. Distribution Liquidating A Donee/Member s Interest...21 F. Liquidation After Parents Death...24 G. Avoiding Gain on Distributions...26 Copyright by Louis A. Mezzullo. All rights reserved. 3

6 INCOME TAX ISSUES WHEN FORMING AND DISSOLVING AN FLP OR LLC I. FORMATION OF THE ENTITY A. Investment Company Issues. Louis A. Mezzullo McGuireWoods LLP Richmond, Virginia (May 17, 2005) 1. To avoid recognition of gain on a transfer of appreciated securities or other investments to a partnership or limited liability company (LLC), the transfer must not be treated as a transfer to an investment company as described in I.R.C I.R.C. 721(b). 2. Under I.R.C. 351(e)(1), a transfer of property will be considered to be a transfer to an investment company if the transfer results, directly or indirectly, in diversification of the transferors interests and the transferee is: a. A regulated investment company; b. A real estate investment trust; or c. A corporation, partnership, or LLC if more than 80% of the value of its assets are held for investment and such assets are cash, stocks or securities, whether or not readily marketable, certain other investments listed in I.R.C. 351(e)(1) or regulations thereunder, or interests in regulated investment companies or real estate investment trusts. (1) Included in the list of investments in I.R.C. 351(e)(1) is an interest in an entity if substantially all of the assets of such entity consist (directly or indirectly) of any assets that are otherwise treated as investments. Copyright by Louis A. Mezzullo. All rights reserved. 4