ROLE OF LLCS IN TRUST AND ESTATE PLANNING

Transcription

1 ROLE OF LLCS IN TRUST AND ESTATE PLANNING First Run Broadcast: March 14, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) LLCs can be effective vehicles for achieving client goals in trust and estate planning. They are helpful particularly helpful in the context of transferring family-held businesses, from obtaining valuation discounts to succession planning and transfer of control. As income tax planning becomes more important in traditional trust and estate planning, LLCs also offer substantial opportunities for tax reduction. There are also substantial uses of LLCs in holding and transferring real estate, which often forms the most valuable asset in an estate. This program will provide you with a real world guide to using LLCs in your trust and estate planning practice. Use of LLCs for business succession planning purposes Family LLCs and LPs practical uses and risks of IRS challenge Rising importance of income tax planning opportunities Issues involved in holding real estate Impact of new tax law Valuation discount planning when using LLCs and spotting red flags for IRS challenge Speakers: William Kalish is a partner in the Tampa office of Johnson Pope Bokor Ruppel & Burns, LLP. His practice focuses on advising individual clients and their families on their estate and trust plans, including wills, revocable trusts, irrevocable trusts, charitable trusts, private foundations, and limited partnerships. He also practices in probate administration, asset preservation, business succession planning for family-owned entities, and the division of business interests in the context of divorce. He is a Fellow of the American College of Tax Counsel, formerly served as chair of Administrative Practice Committee of the ABA Tax Section, and has served as an Adjunct Professor of Law at Stetson Law School teaching estate planning. Mr. Kalish received his B.A. from the University of Pittsburg and his J.D. with honors from George Washington University Law School. Jeffrey M. Gad is a partner in the Tampa, Florida office of Johnson Pope Bokor Ruppel & Burns, LLP, where his practice emphasizes representing individuals emphasizing a broad range of probate, business and taxation related issues. His practice integrates the personal and estate tax planning concerns of individuals with tax and business planning for their closely-held businesses. He has extensive experience in all aspects of probate and trust administration, including the preparation of estate tax returns. Mr. Gad earned his B.S.B.A. from the University of Florida, his J.D., magna cum laude, from Nova Southeastern University, Shepard Broad Law Center, and his LLM from New York University School of Law.

2 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Role of LLCs in Trust & Estate Planning Teleseminar March 14, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER March 7, 2018 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

3 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: March 14, 2018 Seminar Title: Location: Credits: Program Minutes: Role of LLCs in Trust & Estate Planning Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

4 Family Business Succession Planning, the New Tax Act, and Asset Protection Daniel L. Daniels Wiggin and Dana

5 Introduction General Challenges Estate tax uncertainty Planning must be done on short time frame Business is valuable, but often illiquid, asset Business owners can be challenging clients Creating a Succession Plan Which: Passes the business to intended owners Doesn t adversely affect the business Doesn t treat anyone unfairly 2

6 Same Family Business Succession Statistics - 90% of U.S. businesses are family firms - Represent 64% of Gross Domestic Product - Only one-third make the successful transition to the second generation - Only 15% make it to the third generation - Recent studies indicate 25% will transfer control over the next 5 years (40% over 10 years) - 71% have not completed business succession plans - 93% have little income diversification outside the business - 80% want business to stay in family 3

7 Family Dynamics - Family dynamics issues more important than proper estate tax planning to future success of business. - Choice of successor manager - Active vs. inactive family members - Separating management structures from ownership structures - Intergenerational communications - Providing equally for children - Cash flow concerns of senior generation - Conflict Management and Dispute Resolution - Role of professional facilitators 4

8 Fact Pattern Family Information Client and Spouse, age 65 Client has three children, A, B and C A active in business; B and C are not A is married, but not happily B and C are both married with children 5

9 Fact Pattern Business Information Client is 90% owner of XYZ Inc., an S corporation A, B and C each own 3.33% XYZ s primary business is commercial real estate Company book value is $20 million Company owns $2 million of insurance on Client s life Company leases its headquarters building and premises from Client 6

10 Fact Pattern Other Assets Client owns headquarters building valued at $1 million Client and spouse jointly own principal residence worth $3 million and vacation residence worth $1 million Client has IRA worth $2 million Client and spouse have joint brokerage account worth $3 million Client owns life insurance policy of $2 million 7

11 Fact Pattern Current Estate Planning Documents Client and spouse each have wills leaving entire estates to each other, then to the children Planning Objectives Keep the non-active children (B and C) out of the business Pass control of the business to A Treat A, B and C equally financially Pay as little estate taxes as possible Avoid forced sale of business at death Minimize probate Minimize liabilities 8

12 Phase One Planning 9

13 Phase One Planning (Review) Testamentary documents (will and revocable trust) Defensive tax planning Powers of attorney Health care proxies Life insurance (even if temporary) to deal with liquidity issues pending results of Phase Two planning Buy-sell agreement 10

14 PHASE TWO PLANNING The new tax law Choice of entity Asset protection Advanced Lifetime Gift Planning Advanced Testamentary Planning Charitable Strategies 11

15 2017 Tax Act Transfer Tax Provisions Increased estate, gift and generation skipping tax exemptions to $11.2 million, indexed for inflation Only in effect until January 1, 2026 Retains 40 percent rate Retains unlimited marital deduction 12

16 2017 Tax Act Selected Corporate Income Tax Provisions C Corporations Flat corporate income tax rate of 21 percent Corporate AMT repealed Does not sunset 13

17 2017 Tax Act Selected Corporate Income Tax Provisions Pass-Through Entities Deduction equal to 20 percent of qualified business income BUT deduction limited to the greater of: 50 percent of taxpayer s allocable share of W-2 wages for the entity OR 25 percent of taxpayer s allocable share of W-2 wages plus 2.5 percent of depreciable property in service 14

18 2017 Tax Act Selected Corporate Income Tax Provisions Pass-Through Entities (2) Qualified business income is income earned from a trade or business Income from most service businesses doesn t count to the extent it exceeds certain thresholds $315,000 for married couples $157,500 for singles Service businesses include health, law, accounting, consulting, actuarial science, performing arts, athletics, financial services, brokerage services, reputation-based services and investment management Architecture and engineering service business income DOES count Pass through entity provisions expire January 1,

19 ENTITY-LEVEL PLANNING Choice of entity C corporation now receives highly advantageous income tax rate but is highly undesirable at death LLC or LP produces best basis step up flexibility Synthetic basis step up may be available for S corporation inside assets if corporation liquidated after death Consider dividing stock between spouses for Mellinger discount Consider voting-nonvoting recap to allow for transfer of value but not control to inactive children Consider moving real estate out of corporation into LLC for asset protection purposes 16

20 ASSET PROTECTION Exemption Planning Asset Transfer Planning Family Partnership or LLC Planning On- and Off-shore Trusts 17

21 Overview: Sources of Liability Fiduciary positions Example: directors of public companies Contract Example: personal guarantee of business loan Tort Example: professional malpractice Family Example: divorce 18

22 Overview: Two Prongs of Planning Two basic planning concepts: Limitation of Liability Asset Protection 19

23 Limitation of Liability Inside-out protection. Attempt to trap liabilities within an entity. Prototype is parent-subsidiary (or owner-company) structure. 20

24 Limitation of Liability Parent/Owner Subsidiary/ Company 21

25 Asset Protection Outside-in protection Take advantage of exemptions Separate assets from source of liability Hold assets in a protected form No silver bullet Planning is generally a process of discounting settlement of creditors claims 22

26 Exempt Assets Homestead? Life insurance? Primarily retirement assets 401(k) plans Roth IRAs Traditional IRAs 23

27 Separating Assets Separating assets means client must transfer assets. Transfer will be subject to scrutiny and may be voided as fraudulent conveyance. 24

28 Separating Assets: Examples Gift to spouse Simple Often beneficial for general estate planning purposes No tax impact unless spouse is non-u.s. citizen Gift to children Can have estate planning benefits May generate gift tax Gift to trust for spouse and/or children Consider Spousal Estate Reduction Trust Gift to trust for self generally not effective Consider off-shore or special U.S. jurisdictions? 25

29 FLPs and Other Protected Assets Charging order entities. Other illiquid assets. Encumbered assets. 26

30 Charging Orders Creditors cannot force the sale of certain types of entities (partnerships and their LLC relatives). Step into the shoes of the debtorpartner and wait until the management of the partnership decides to make distributions to the partners. 27

31 Charging Orders A charging order is a remedy created by statute which essentially assigns the debtor s interest in a partnership or limited liability company to the creditor. As an assignee, the creditor is not entitled to become a limited partner, and has no ability to dissolve the entity. 28

32 On- and Off-shore Asset Protection Trusts Have your cake and eat it too? Transfers to self-settled trust allow transferor to divest self of title, but still have beneficial interest. Self-settled trusts not recognized at common law. Statute of Elizabeth. Restatement (Second) of Trusts, 156. Greenwich Trust Co. v. Tyson, 129 Conn. 211 (1942). Some jurisdictions have changed this by statute. 29

33 On-shore Asset Protection Trusts Several US states now permit self-settled trusts to some degree: Alaska, Delaware, South Dakota. Untested problems with these protections. Full Faith and Credit Clause of Const. 30

34 APPLYING CREDITOR PROTECTION CONCEPTS TO CHARLIE AND SALLY S SITUATION Be sure to respect the form of the entity Segregate separate parcels into separate entities Consider Master LLC with subsidiary for each parcel Consider spendthrift trust for Abby 31

35 LIFETIME GIFTING FUNDAMENTALS Gifts valued at time of gift Avoid tax on future growth and income Defer tax on applicable exclusion amount Valuation opportunities Property without clear value Discounted gift tax value Choice of property to gift Should be likely to appreciate Avoid tax on gift tax Beware: loss of basis step-up at death 2018 Wiggin and Dana 32

36 Lifetime Gift Strategies Outright Gifts To spouse to create discounts applicable exclusion amount Annual exclusion Taxable gifts Spousal Lifetime Access Trust Grantor Retained Annuity Trust Preferred/Common Recap Gifts Caveat: Recapitalization must comply with section 2701 Opportunity Shifting 2018 Wiggin and Dana 33

37 A Zeroed Out GRAT Grantor transfers $1 million to a GRAT when IRS assumed interest rate = 1.4% Grantor receives $119,000 annually for 9 years After 9 years, remaining GRAT funds pass to children Value of taxable gift is near $ Wiggin and Dana 34

38 Savings Dependent On Investment Performance Average Return for 9 years Amount Passing Tax-Free to Children After 9 Years 1.4% $0 4% $164,000 6% $322,000 8% $513, Wiggin and Dana 35

39 Property Suitable for a GRAT Growth stocks Commercial real estate Closely held business LLCs and LPs Gift tax risk of undervaluation can be minimized 2018 Wiggin and Dana 36

40 GRAT Risks What if grantor dies before termination of GRAT? At worst, property is taxable in grantor s estate Nothing gained, but nothing lost What if trust investment performance is less than IRS assumed rate of return? Again, nothing gained, but nothing lost 2018 Wiggin and Dana 37

41 Sale to an Intentionally Defective Irrevocable Trust (IDIT Sale) Grantor Sells Property to Irrevocable Grantor Trust Grantor Receives Promissory Note From Trust Note Terms Interest Only at Applicable Section 1274 Rate Balloon Payment of Principal at End of Note Term Grantor s Interest in Property Frozen at Face Value of Note Plus Annual Interest Payments Objective: Outperform Required Interest Rate On Note Under Section Wiggin and Dana 38

42 IDIT Sale Example Grantor Sells Property Worth $1,000,000 to Seeded Irrevocable Grantor Trust Grantor Receives 9-Year Promissory Note From Trust Note Terms Interest Only at Applicable Section 1274 Rate (1.20% for this example) Balloon Payment of Principal at End of Note Term 2018 Wiggin and Dana 39

43 Amount to Children Depends on Investment Performance Average Return for 9 years Amount Passing Tax-Free to Children After 9 Years 1.2% $ 0 1.4% $ 19,000 4% $296,000 6% $552,000 8% $849, Wiggin and Dana 40

44 IDIT Sale Risks No Safe Harbor Under Code No Automatic Revaluation of Note Upon Audit Will formula work to avoid Proctor? Possible Application of Sections 2036 and 2702 Statute of Limitations Possible Gain Recognition At Grantor s Death 2018 Wiggin and Dana 41

45 Self-Canceling Installment Note (SCIN) By its terms note is extinguished on Client s death Note must take possibility of death into account in form of risk premium Increased interest rate or increased principal amount No safe harbor for valuation; IRS will look at client s actual health status. Note is excluded from Client s estate Client s estate recognizes unrealized gain at death 42

46 SCIN Example Client sells $1,000,000 asset to A in return for selfcanceling note Interest only for 9 years; balloon principal at end of year 9 Note interest rate includes risk premium so that rate increases from 4.82% to 6.98% Or increase principal face amount to $1,181,000 Client receives payments of $69,800 per year Balloon payment of $1,000,000 at end of year 9 43

47 SCIN: Amount to Children Depends on Investment Performance Average Return for 10 years Amount Passing Tax-Free to Children After 10 Years 6.98% $0 8% $138,000 10% $451,000 12% $831,000 14% $1,287,000 44

48 Private Annuity Client transfers stock to A in return for A s agreement to pay an annuity for remainder of A s lifetime Advantages to Client Estate freeze at value of annuity payments plus internal interest rate. No gift tax provided that annuity value equals value of transferred stock. Income stream guaranteed for life Advantages to A Cash flow Windfall in the event Client dies early 45

49 Private Annuity (Continued) Disadvantages Regulations on income tax treatment of the annuity. If stock is undervalued, Client will be treated as having made a taxable gift. A price adjustment clause may not be respected. A s payments are indefinite and nondeductible. 46

50 BOOTSTRAP REDEMPTION Client gifts small amount of stock to A Corporation redeems Client s stock, thereby increasing A s ownership percentage Caveat: Since B and C, and key employees own shares as well, their ownership percentages will also be increased 47

51 Selected Charitable Options 48

52 The Typical Charitable Vehicles Private Foundations Charitable Lead Trusts Charitable Remainder Trusts 49

53 Private Family Foundation Default Status - Greatest Donor Control 3 Typical Characteristics: single source of funding make grants rather than operate programs grants and administrative expenses paid from endowment Subject to Chapter 42 Excise Tax Rules unavoidable: tax on net investment income avoidable: self-dealing, failure to distribute income, excess business holdings, jeopardy investments and taxable expenditure 5% Mandatory Annual Distributions 50

54 Charitable Remainder Trust Irrevocable trust Income stream payable to one or more noncharitable beneficiaries For life or for a fixed term Remainder interest payable to charity 51

55 Charitable Remainder Trust Trust pays no income tax Tax-free diversification vehicle Grantor gets estate, gift and income tax deductions Increased cash flow Income deferral (NIMCRUT) Closely held business assets (FLIPCRUT) 52

56 Charitable Lead Trust Charitable remainder trust in reverse Lead Interest - annuity or unitrust to charity Term Remainder interest to grantor or family Income tax deductibility limited to grantor trusts only Income taxation of trust depends on structure Non-grantor trusts taxed as complex trust with 642(c) deduction for payments to charity Grantor trust taxed under traditional rules 53

57 Overview of Tax Issues Private Foundation Excise Taxes Self-dealing and excess business holdings are primary concern Unrelated Business Income Tax ( UBIT ) Prearranged Sale Ascertainability Other Tax Issues 54

58 Entities Subject to Excise Taxes Private Foundations Subject to all taxes Charitable Lead Trusts Subject to taxes on self-dealing, excess business holdings, jeopardy investments and taxable expenditures CLTs are subject to taxes on excess business holdings or jeopardy investments if value of the charitable interest exceeds 60% CLTs are not subject to the minimum distribution tax or the net investment income tax Charitable Remainder Trusts Subject only taxes on self-dealing and taxable expenditures 55

59 Self Dealing Most transactions between a private foundation and a disqualified person are strictly prohibited regardless of whether the transaction is beneficial to the foundation Example: Use of foundation to satisfy charitable pledge Tax rates 10% initial tax 200% tax if act not corrected within prescribed period Indirect self dealing The general redemption exception 56

60 Excess Business Holdings Excess business holdings occur when holdings of foundation plus disqualified persons exceed 20% Increased to 35% if effective control of the business is held by non-disqualified persons Does not apply to business receiving 95% or more of income from passive sources 2% de minimis rule Foundation has five years to dispose of excess business holdings Up to additional five years with permission of IRS Tax rate: 10% of value of holdings Rate increased to 200% if not corrected in timely manner 57

61 Unrelated Business Taxable Income General Rule: Charities Exempt from Federal Income Tax Exception: Charities Taxable on Unrelated Business Taxable Income ( UBTI ) UBTI Defined: Income from an Active Trade or Business Excludes Passive Investments (unless Debt-financed) Example of Debt-financed Passive Income Mortgaged real estate Tax only imposed on debt-financed portion of income and gain Prior to 1/1/2007, A CRT lost its tax exempt status in any year that it had UBTI Post 1/1/2007, no loss of exempt status but rather 100% excise tax on any UBTI 58

62 The Prearranged Sale Problem If Foundation or CRT enters into informal agreement to sell property prior to contribution, then IRS may recharacterize transaction as a sale by grantor personally Causes grantor to be taxed personally on sale Cases and rulings favorable to taxpayer Palmer v. Commissioner Rev. Rul Rauenhorst v. Commissioner Cases favorable to IRS Blake v. Commissioner Ferguson v. Commissioner 59

63 The Ascertainability Problem To qualify for charitable deduction value of bequest must be presently ascertainable as of date of death The Marine case Decedent s will left residuary estate to charity Will gave executor discretion to make preresiduary gifts to various individuals of up to 1% of the estate per individual Estate tax charitable deduction denied because executor s discretion made value of residuary estate unascertainable Note, a beneficiary s power to choose between two different charitable lead trusts did not fail the Marine test PLR

64 Testamentary Charitable Planning Simple Bequest of the Business to a Private Foundation Bequest to Private Foundation Followed by a Redemption Bequest to Private Foundation Coupled with an Option Bequest to a Charitable Lead Trust Coupled 61

65 Simple Bequest to Private Foundation Perceived Benefits Eliminates estate tax on the business at death Preserves owner s control Preserves family control as Trustees of Foundation Tax Issues Typically Make the Simple Bequest Untenable Excess business holdings Self-dealing Indirect self-dealing UBIT S corporation concerns Solution: Get the Business Out of the Foundation How 62

66 The General Redemption Exception Simple sale of business to family member causes self-dealing problem Redemption must be: At fair market value All cash Offered to all owners of same class of stock Structuring the Estate Plan with the Exception in Mind: Prior to death, recapitalize business into separate classes of stock Class A held or bequeathed to family members Class B bequeathed to Foundation Corporation redeems Class B stock from Foundation Beware charitable deduction valuation whipsaw 63

67 Bequest to Foundation Coupled with an Option Alternative to General Redemption Technique Decedent bequeaths business to Foundation subject to option in family to purchase from the estate for fair value Sale will not constitute self-dealing if requirements of Treas. Regs. sec (d)-1(c) are met Sale for fair market value Court approval Completed during reasonable period of estate administration 64

68 Benefits and Risks of Option/Note Benefits Technique Avoids problems presented by simple bequest Unlike general redemption exception, IRS has approved use of a disqualified person s note to fund the purchase price Concerns/Risks Terms of note must be fair Court approval required Payments under note must be timely made Refinancing of note probably constitutes self-dealing All payments on the note inure to benefit of Foundation 65

69 Bequest to CLAT Coupled with an Option Alternative to Foundation/Note Technique Similar Benefits and Risks Additional Benefit: Decedent s Family Receives CLAT Remainder Additional Concerns CLAT payments should be set to correspond to cash flow from business Ascertainability issues if CLAT design set by formula or if multiple CLATs are used Possible generation-skipping tax if CLAT rather than CLUT is used 66

70 Bequest to CLAT Coupled with an Option: Example C owns commercial real estate business with NAV of $100 million Business produces annual cash flow of $8 million Assume 30% valuation discount C bequeaths business to CLAT subject to option in children to purchase from estate for fair market value using promissory note Assume section 7520 rate of 5.4% 67

71 Bequest to CLAT Coupled with an Option: Example (Continued) $70 million CLAT with lead payment of roughly $7.6 million zeroes out with a 13 year term Note structured with interest rate of 5.4% amortizes at annual payment of approximately $7.6 million in 13 years At end of CLAT term Note is fully paid CLAT has minimal remainder interest Children receive business free and clear of note 68

72 Bequest to CLAT Coupled with an Option: Payout rate Term Issues to Consider What if cash flow from business is less than anticipated or Trustee is concerned that planned-for valuation discounts may not materialize? Consider giving Trustee power to choose among CLATs with varying payout rates Draft trust to last for a sufficient term to produce an estate tax charitable deduction equal to the value of the assets passing to the trust Promissory note Set note term equal to term of CLAT Set interest rate at or above section 7520 rate Provide for security 69

73 Bequest to CLAT Coupled with an Option: Issues to Consider CLAT remainder beneficiaries Ensure remainder beneficiaries are identical to payors on the promissory note Consider guarantees/personal liability if necessary to support valuation of note Consider trust structure to defer application of generation-skipping transfer tax and provide management and creditor protection 70

74 Contact Information Daniel L. Daniels, Esq. Wiggin and Dana LLP 30 Milbank Avenue Greenwich, CT