PLANNING WITH FAMILY LIMITED PARTNERSHIPS/FAMILY LLCS, PART 1 & PART

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1 PLANNING WITH FAMILY LIMITED PARTNERSHIPS/FAMILY LLCS, PART 1 & PART 2 First Run Broadcast: October 15 &16, 2013 Live Replay: January 15 & 16, :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) Family Limited Partnerships and Family LLCs are among the most effective planning tools for transferring family businesses from generation to generation while reducing federal estate and gift taxes. Among the many keys to successfully using FLPs is transferring control and obtaining a correspondingly steep discount on the valuation of the company. But the IRS frequently and aggressively challenges the use of FLPs and their valuations, which have made their use fraught with more risk. Led by two of the nation s foremost experts on FLPs/FLLCs, this program will provide you with a practical guide to sophisticated planning techniques using these vehicles, structuring and drafting tips, a real world assessment of the risks involved, and recent trends in audits of FLPs. Day 1 January 15, 2014: Sophisticated planning with FLP and FLLCs Selling FLP/FLLCs and solutions for clients who want to retain control Use, risks and traps of defined value formula clause Planning for challenges by IRS under Section 2036 Trends in FLP audits Day 2 January 16, 2014: FLP planning to reduce GST Post-mortem planning, including note-freeze partnerships Issues on exiting/terminating FLPs Best practices on advising clients on formation of FLP/FLLCs Speakers: S. Stacy Eastland is managing director of Goldman Sachs & Co. and widely recognized as one of the nation s leading authorities on estate planning for family businesses. He advises clients and their advisers on strategic wealth management plans, combining a variety of federal income tax, estate planning and gifting techniques. Prior to joining Goldman Sachs, Mr. Eastland was a senior partner in the law firm of Baker Botts, LLP, in Houston. He is a member of the International Academy of Estate and Trust Law and a Fellow of the American College of Trust and Estate Counsel. He received his B.S., with honors, from Washington and Lee University and his J.D., with honors, from the University of Texas School of Law. Stephen T. Dyer is a partner in the Houston office of Baker Botts, LLP, where his practice emphasizes the design, implementation, and defense of advanced gift and estate tax savings and business succession strategies, particularly for family-owned businesses. He also represents fiduciaries and beneficiaries in estate and trust administration. Before joining Baker Botts, LLP

2 Mr. Dyer was an investment banker doing mergers and acquisitions work for Wasserstein Perella & Co., Inc., one of the nation s leading investment banking boutiques. Mr. Dyer received his B.B.A. with honors, his MBA, and his J.D. with honors from The University of Texas.

3 PROFESSIONAL EDUCATION BROADCAST NETWORK Speaker Contact Information PLANNING WITH FAMILY LIMITED PARTNERSHIPS/FAMILY LLCS, PART 1 & PART 2 S. Stacy Eastland Goldman Sachs Group, Inc. - Houston (o) (713) stacy.eastland@gs.com Stephen T. Dyer Baker Botts, LLP Houston (713) stephen.dyer@bakerbotts.com

4 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 Planning with Family Limited Partnerships/Family LLCs, Part 1 Teleseminar January 15, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 PAYMENT METHOD: NO REFUNDS AFTER January 8, 2014 Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

5 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 Planning with Family Limited Partnerships/Family LLCs, Part 2 Teleseminar January 16, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 PAYMENT METHOD: NO REFUNDS AFTER January 9, 2014 Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

6 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: January 15, 2014 Seminar Title: Planning with Family Limited Partnerships/Family LLCs, Part 1 Location: Credits: Teleseminar 1.0 MCLE General Credit 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.

7 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: January 16, 2014 Seminar Title: Planning with Family Limited Partnerships/Family LLCs, Part 2 Location: Credits: Teleseminar 1.0 MCLE General Credit 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.

8 THE ART OF MAKING A GIFT OR A SALE OF A FAMILY LIMITED PARTNERSHIP INTEREST THAT LIMITS ADDITIONAL GIFT TAX LIABILITY S. Stacy Eastland Houston, Texas SSE01VU

9 Goldman Sachs does not provide legal, tax or accounting advice. Any statement contained in this communication (including any attachments) concerning U.S. tax matters was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code, and was written to support the promotion or marketing of the transaction(s) or matter(s) addressed. Clients of Goldman Sachs should obtain their own independent tax advice based on their particular circumstances. SSE01VU

10 Table of Contents I. THE PRIMARY IMPORTANCE OF GOALS-BASED PLANNING FOR THE SUCCESSFUL SUCCESSION OF THE FAMILY WEALTH IRRESPECTIVE OF THE STATUS OF THE TAX LAW...1 A. The Importance of First Determining a Client s Goals That Determine the Estate Plan s Essential Strategies The Prevalence of Tax Driven Wealth Preservation Focus and Four Suggested Rules to Change the Priority of That Focus Estate Plans Developed Around the Stewardship Purpose of the Family Wealth Organizational Pattern of a Purpose-Based Estate Plan: Compatibility of Strategies and Legal Structures with the Stated Purpose of the Family Wealth....3 II. III. A FREQUENTLY MENTIONED GOAL WITH RESPECT TO A TAXPAYER WHO WISHES TO MAKE A SUBSTANTIAL GIFT OR SALE TO FAMILY MEMBERS: THE DESIRE TO LIMIT ANY ADDITIONAL DONOR GIFT TAX LIABILITY...3 THE ADVANTAGES AND CONSIDERATIONS OF A DONOR FINANCED NET GIFT TO A GRANTOR TRUST FOR A DONOR WHO WISHES TO AVOID PAYING ANY ADDITIONAL GIFT TAX ON A TRANSFER...6 A. What is the Technique?...6 B. Advantages of the Technique Tax Advantages of Creating a Grantor Trust and a Net Gift Sale to a Grantor Trust Net Gift Takes Advantage of the Tax-exclusive Nature of the Gift Tax Significant Synergies Exist With the Combination of the Net Gift Transfer to a Grantor Trust, and Using Low Interest Donor Financing to Pay for the Gift Tax The Near Term Death of the Grantor of a Grantor Trust Generally Does Not Affect the Technique Like the Death of a Grantor of a GRAT The Appreciation of the Assets of the Trust Above the Interest of the Note Used to Finance the Gift Taxes Associated With a Net Gift to a Grantor Trust Will Not Be Taxable in the Grantor/Seller s Estate SSE01VU i

11 6. Flexibility Advantages of a Financed Net Gift to a Grantor Trust a. Flexibility Could Be Achieved By Naming a Spouse as a Beneficiary of the Grantor Trust and Giving a Grantor s Spouse a Special Power of Appointment b. Flexibility Could Also Be Achieved By Converting the Note to a Note With a Different Interest Rate, a Private Annuity, Purchasing Assets Owned By the Trust and/or Renouncing the Powers That Make the Trust a Grantor Trust C. Considerations of the Technique If There is an Adjustment in the Future Gift Tax Liability Owed By the Donee Grantor Trust, the IRS and the Courts May Not Allow That Additional Gift Tax Liability to Be Used in Reducing the Gift in the Net Gift Tax Calculation State Income Tax Considerations The IRS Could Be Successful in Applying the Step Transaction Doctrine to the Technique If the Assets Decrease in Value, There Will Be a Wasted Gift Opportunity That May Not Be Recoverable There May be Capital Gains Consequences With Respect to the Notes Receivables That May Exist at Death IV. THE USE OF FORMULA DEFINED VALUE ALLOCATION ASSIGNMENTS TO FAMILY MEMBERS WITH RESIDUAL GIFTS TO TAX SHELTERED RECIPIENTS TO LIMIT ADDITIONAL GIFT TAX LIABILITY...17 A. Introduction B. Formula Defined Value Allocation Assignments Involving a Residual Gift to a Charity C. Formula Defined Value Allocation Assignments Involving a Residual Gift to a Marital Deduction Trust D. Formula Defined Value Allocation Assignments Involving a Residual Gift to a GRAT V. DEFINED VALUE DOLLAR ASSIGNMENT BY THE DONOR THAT MAY RESULT IN A REVERSION TO THE DONOR IF AN ERROR IS MADE IN THE INITIAL ASSUMED DOLLAR VALUE OF THE TRANSFER...33 SSE01VU ii

12 A. Defined Value Dollar Assignment By the Donor and the Donee Does Not File a Parallel Formula Disclaimer B. Defined Value Dollar Assignments Involving Both a Defined Dollar Assignment By the Donor and a Parallel Formula Qualified Disclaimer By the Donee VI. THE ADVANTAGES AND CONSIDERATIONS OF A DONOR CONTRIBUTING ASSETS TO A GRAT, INCLUDING THE ADVANTAGE AND CONSIDERATIONS OF CONTRIBUTING LEVERAGED SINGLE MEMBER FLLC INTERESTS TO A GRAT...37 A. Transfers to a GRAT Without Using a Single Member FLLC What is a GRAT? Advantages of the Technique a. Valuation Advantage of a GRAT b. Ability of Grantor to Pay For Income Taxes Associated With GRAT Gift Tax-free and Substitute Assets of the GRAT Income Tax-free c. Synergy With Other Techniques d. Comparatively Low Hurdle Rate e. High Leverage f. Non-recourse Risk to Remaindermen Considerations of the Technique a. Part or all of the Assets Could be Taxable in the Grantor s Estate if the Grantor Does Not Survive the Term of the GRAT b. If a GRAT is Not Administered Properly the Retained Interest By the Grantor May Not Be Deemed to Be a Qualified Interest c. GST Planning is Difficult With This Technique d. The Technique Will Be Unsuccessful Unless the GRAT Assets Grow More Than the IRC Sec Rate SSE01VU iii

13 B. The Advantages and Considerations of a Transferor First Contributing Financial Assets to a FLP and Then Contributing the FLP Interests and the Transferor s Alternative Investments (Private Equity) to a Single Member FLLC and Then Contributing Non-Managing Member Interests in That FLLC to a GRAT Advantages of the Technique a. The Transfer of the Non-Managing Member Interests in Holdco, FLLC b. Valuation Advantage of a GRAT c. Ability of Grantor to Pay For Income Taxes Associated With GRAT Gift Tax-free and Substitute Assets of the GRAT Income Tax-free d. Synergy With Other Techniques e. Comparatively Low Hurdle Rate f. High Leverage g. Non-recourse Risk to Remaindermen h. Consumption and Flexibility Advantage of Remainder Trust For the Benefit of a Spouse Who Has a Limited Power of Appointment Considerations of the Technique a. Part or All of the FLLC Interests Could Be Taxable in the Grantor s Estate if the Grantor Does Not Survive the Term of the GRAT b. If a GRAT is Not Administered Properly the Retained Interest By the Grantor May Not Be Deemed to Be a Qualified Interest c. GST Planning is Difficult With This Technqiue d. The Technique Will Be Unsuccessful Unless the GRAT Assets Grow More Than the IRC Sec Rate C. The Advantages and Considerations of a Transferor First Contributing Financial Assets to a FLP and Then Contributing and Selling (in Consideration of a Note) the FLP Interest and the Private Equity Investments to a Single Member FLLC and Then Contributing Non-Managing Member Interests in That FLLC to a GRAT SSE01VU iv

14 1. What is the Technique? Advantages of the Technique a. If Leverage is Used in Creating the FLLC that is Contributed to the GRAT, Much More Wealth is Transferred to the Remainderman of the GRAT b. The Technique Has Many of the Same Advantages as the Sale to the Grantor Trust c. Valuation Advantage of a GRAT d. Ability of Grantor to Pay For Income Taxes Associated With GRAT Gift Tax-free and Substitute Assets of the GRAT Income Tax-free e. Synergy With Other Techniques f. Comparatively Low Hurdle Rate g. High Leverage h. Non-recourse Risk to Remaindermen i. The Atkinson Worry About Paying a GRAT Annuity With a Hard-to-Value Asset May Be Eliminated Considerations of the Technique a. Part or All of the FLLC Interests Could Be Taxable in the Grantor s Estate if the Grantor Does Not Survive the Term of the GRAT b. It is More Complex Than the Other GRAT Techniques D. The Advantages and Considerations of Allocating Both the Grantor s GST and Gift Tax Exemptions to a GRAT That Owns a Leveraged FLLC With the Annuity Being Defined as That Fixed Percentage That Produces a Transfer That is Equal to the Allocated Gift Tax Exemption The GRAT Annuity Defined to Use the Exemption Technique (Hypothetical Technique 3) and Does it Satisfy the ETIP Rules For Generation-Skipping Tax Purposes? Advantages Other Than the Possible Generation-Skipping Advantage of Allocating the Gift Tax and GST Exemptions Up-Front to a GRAT SSE01VU v

15 a. If Leverage is Used in Creating the FLLC That is Contributed to the GRAT, Much More Wealth is Transferred to the Remainderman of the GRAT b. Valuation Advantage of a GRAT c. Ability of Grantor to Pay For Income Taxes Association With the GRAT Gift Tax Free and Substitute Assets of the GRAT Income Tax Free d. Synergy With Other Techniques e. Comparatively Low Hurdle Rate f. A Much Smaller Part of the FLLC Interest Will Be Taxed on the Grantor s Estate if the Grantor Does Not Survive the Term of the GRAT in Comparison to the Contribution of a Non-Leveraged FLLC to a GRAT, or a Leveraged FLLC to a GRAT Without the Allocation of the Gift Tax Exemption g. The Atkinson Worry About Paying a GRAT Annuity With a Hard-to-Value Asset May Be Eliminated Considerations of the Technique a. There is Risk That the Allocated Gift Tax and GST Exemptions Will Be Lost b. It is Important That Each Step of the Transaction Be Independent and Be Able to Stand On its Own c. There May Exist Better Techniques For Transferring the Remainder Interest to a Generation-Skipping Trust That Do Not Use the Grantor s GST Exemption VII. THE USE OF DONOR SALES TO THIRD PARTY CREATED TRUSTS IN WHICH THE DONOR IS A BENEFICIARY AND HAS A SPECIAL POWER OF APPOINTMENT IN ORDER TO LIMIT ANY ADDITIONAL GIFT TAX LIABILITIES...63 A. The Advantages and Considerations of a Transferor Selling Assets to a Trust That Names the Transferor as a Beneficiary, Gives the Transferor a Special Power of Appointment, and Under Which the Transferor s Spouse is Considered the Income Tax Owner ( Spousal Grantor Trust ) What is the Technique? Advantages of the Technique SSE01VU vi

16 a. There Will Be No Capital Gains Consequence on the Original Sale of the Assets to the Trust b. The Technique, With Respect to a Sale to the Trust in Which the Seller Has a Power of Appointment, Has the Potential of Mitigating Gift Tax Surprises c. It Has the Advantage of Allowing the Transferor to Be a Beneficiary of the Trust and Have a Power of Appointment Over the Trust d. Appreciation Will Be Out of the Transferor s Estate Considerations of the Technique a. There May Need to Be Substantive Equity in the Trust From Prior Gifts (is 10% Equity Enough?) Before the Sale is Made b. Federal Income Tax Considerations c. State Income Tax Considerations d. Necessary to File Gift Tax Returns e. The Family Could Lose The Benefits of Using the Gift Tax Exemption, if the Trust Assets Depreciate f. The IRS Could Be Successful in Applying the Step Transaction Doctrine to the Technique g. Reciprocal Trust Doctrine Considerations h. If it is Possible For a Current Creditor, or Any Future Creditor, of the Assigning Spouse/Beneficiary to Reach Part of the Assets of the Trust For a Period of Time That Does Not End Before the Assigning Spouse/Beneficiary s Death, By Either Voluntary or Involuntary Assignment By the Assigning Spouse/Beneficiary, Then That Part of the Trust May Be Included in the Assigning Spouse/Beneficiary s Estate Under IRC Secs or i. If it is Possible For a Current or Future Creditor of an Assigning Spouse/Beneficiary to Reach Part of the Assets of a Self-settled Trust, Then That Part of the Trust May Not Constitute a Complete Gift For Gift Tax Purposes SSE01VU vii

17 B. The Advantages and Considerations of a Transferor Selling Assets to a Third Party Created Trust That is Not a Qualified Subchapter S Trust ( QSST ), That Names the Transferor as a Beneficiary, Gives the Transferor a Special Power of Appointment, and Under Which the Transferor is Considered the Income Tax Owner ( Beneficiary Grantor Trust ) What is the Technique? Advantages of the Technique Considerations of the Technique a. Guarantee Fee Transfer Tax Issue b. Additional Transfer Tax Issues c. Income Tax Issues A Beneficiary Grantor Trust Makes an Investment That Has Substantial Value Without a Sale By the Transferor Beneficiary to the Beneficiary Grantor Trust a. Additional Advantages of This Technique b. Considerations of the Technique A Beneficiary Grantor Trust Purchases the Remainder Interest in a GRAT a. What is the Technique?...87 b. Advantages of the Technique c. Considerations of the Technique SSE01VU viii

18 THE ART OF MAKING A GIFT OR A SALE OF A FAMILY LIMITED PARTNERSHIP INTEREST THAT LIMITS ADDITIONAL GIFT TAX LIABILITY I. THE PRIMARY IMPORTANCE OF GOALS-BASED PLANNING FOR THE SUCCESSFUL SUCCESSION OF THE FAMILY WEALTH IRRESPECTIVE OF THE STATUS OF THE TAX LAW A. The Importance of First Determining a Client s Goals That Determine the Estate Plan s Essential Strategies. 1. The Prevalence of Tax Driven Wealth Preservation Focus and Four Suggested Rules to Change the Priority of That Focus. In assisting a client with achieving their goals the state of the tax law and how that affects the plan should not be the tail that wags the dog. Certain tax-planning advisors assume that a combination of wealth preservation and tax reduction is the purpose of every estate and succession plan. All tax advisors from time to time have been guilty of that assumption. 1 Whenever owners and tax advisors gather to formulate a plan, inevitably their conversations focus extensively on tax issues. Something about the topic of tax planning, the prevalence of tax advisory literature, tax advisors' professional degrees and titles, how the meetings originate, and the expectations of the gathered parties combine to dictate this focus. 2 Tax planner s habitual patterns of engaging in planning conversations that evolve into tax reduction conversations have resulted in the evolution of a conventional style of planning that can be referred to as tax driven wealth preservation planning. This planning style begins with advisors gathering relevant facts and recommending optimum legal structures. In most instances, the defining characteristics of the selected strategies and legal structures are their tax reduction and control retention characteristics. A danger in tax driven wealth preservation planning is its subtle power to enable money (and its conservation) to become the defining objective. Through the years I have developed four personal rules for determining a client s goals and concerns with respect to the family s capital (as defined below): (1) try to ask open ended questions that give the client the opportunity to articulate his or her goals and concerns; (2) listen; (3) listen, and (4) listen. 1 I would like to thank Mike Allen of Allen Lottmann, P.C., in Tyler, Texas. Around 20 years ago Mike articulated these concepts to me. I have been a better advisor since. 2 L. Paul Hood, Jr., From the School of Hard Knocks: Thoughts on the Initial Estate Planning Interview, 27 ACTEC Law Journal 297 (2002). SSE01VU 1

19 2. Estate Plans Developed Around the Stewardship Purpose of the Family Wealth. It is enlightening to contrast conventional tax driven wealth preservation plans with plans which have been formulated for clients who were initially asked (perhaps through the vehicle of many open-ended questions): "What is the purpose (or stewardship mission) of your family wealth?" A family s wealth, or capital, is more than its financial capital. A family s social capital and stewardship capital are also very important and interact with the family s financial capital. When planning conversations begin with open-ended questions to determine the purpose or mission of the family s capital, a different succession plan may emerge, and the priority of tax reduction can be expected to decline in status from the defining principle to an important collateral objective. At an introductory stage, a dialogue about purpose or stewardship mission questions might evolve like this: Question 1: Question 2: Question 3: Question 4: Question 5: Question 6: Question 7: Question 8: Question 9: Do you want to save taxes? Answer: Yes. Do you want to protect your wealth? Answer: Yes. Do you want to preserve the same level of consumption? Answer: Yes. Do you want to empower your children (or favorite charitable causes)? Answer: Yes. Do you want to give your children (or charitable entities you create) options? Answer: Yes. Do you want to give your children (or charitable entities you create) incentives? Answer: Yes. Do you want to maintain control of investment decisions with respect to your wealth? Answer: Yes. Do you want to maintain your flexibility (control) to change your mind about how and whom should have future stewardship of your wealth? Answer: Yes. Which of these is most important? Typical Answer: (pause) That is the first time we have been asked that question. We'll need to think about it. Members of my tax planning fraternity routinely start with good questions. But we sometimes tend to stop asking them too quickly (often after question #3), and we seldom ask question 9. SSE01VU 2

20 Questions of stewardship mission or the purpose of the family wealth are not raised lightly. They are the most important questions in the succession planning process. Their answers should govern every design decision. 3. Organizational Pattern of a Purpose-Based Estate Plan: A hierarchical organizational pattern for a purpose-based estate plan is: Purpose The declared principles for the family s capital which determine the plan's essential characteristics (having priority over) Strategies The alternative game plans for implementing the essential characteristics (having priority over) Legal Structures The legal documents which embody and implement the essential characteristics 4. Compatibility of Strategies and Legal Structures with the Stated Purpose of the Family Wealth. When an estate succession plan is organized around declared principles, the strategies and legal structures used to accomplish conventional tax planning are retained, but they are modified as necessary to make them compatible with the declared principles. II. A FREQUENTLY MENTIONED GOAL WITH RESPECT TO A TAXPAYER WHO WISHES TO MAKE A SUBSTANTIAL GIFT OR SALE TO FAMILY MEMBERS: THE DESIRE TO LIMIT ANY ADDITIONAL DONOR GIFT TAX LIABILITY Many clients in planning for the stewardship of their assets wish to make transfers during their lifetime to trusts for the benefit of family members. The nontax advantages of lifetime transfers include the present ability to provide for the education, health, support and maintenance needs for the client s family members. Even for clients who have a strong desire to give back to their community, a non-tax stewardship case can be made for providing resources to family SSE01VU 3

21 members who can then use part of their future capital, as opposed to the client s private foundation capital, to make future gifts to their community. Of course, there may also be tax reasons for making lifetime transfers instead of testamentary transfers. Some simple examples may illustrate the possible gift tax advantage of a lifetime transfer of an asset, instead of a testamentary transfer that results in an estate tax. The factors, from a tax perspective, that need to be considered are the amount of the gift tax, the lost investment opportunity with respect to the cash used to pay the gift tax, the estate tax on the transferred asset, the estate tax on the investment assets not used in paying the lifetime gift tax, and the future contingent capital gains tax on the transferred asset. Example 1: Cal Cheapertax Wants to Understand the Tax Math of Transferring an Asset That May Double During His Lifetime to His Children Cal Cheapertax asks his attorney, Sam Spreadsheet, whether it is cheaper, on an after-tax basis, to give certain shares of Growing, Inc. stock to his children now, or to bequeath those shares to them when he dies? The shares to be given have a current value of $100. Cal asks Sam to assume he will pay the taxes associated with the gift or bequest from other shares of Growing, Inc. stock. Call tells Sam to assume the stock will double during his lifetime. Cal asks Sam if it makes a difference if the stock has a full basis or a zero basis. The results of Sam s analysis follow (see the calculations in Schedule 1 attached to this paper): Table 1a Full Basis Stock is Transferred 10-Year Future Values - Post Death Cheapertax Children IRS/Capital Gains Taxes IRS Gift Taxes IRS Lost Investment Opportunity Cost Due to Paying Gift Taxes IRS/Estate Taxes (@ 40%) Total No Further Planning; Bequest of Growing Inc. Stock at Death $168 $0 $0 $0 $112 $280 Cal Cheapertax Gives Growing, Inc. Stock (Full Basis) to His Children and Pays the Gift Tax Associated with the Gift $175 $25 $40 $40 $0 $280 SSE01VU 4

22 Table 1b 0 Basis Stock is Transferred 10-Year Future Values - Post Death Cheapertax Children IRS/ Capital Gains Taxes IRS Gift Taxes IRS Lost Investment Opportunity Cost Due to Paying Gift Taxes IRS/Estate Taxes (@ 40%) Total No Further Planning; Bequest of Growing Inc. Stock at Death $168 $0 $0 $0 $112 $280 Cal Cheapertax Gives Growing, Inc. Stock ($0 Basis) to His Children and Pays the Gift Tax Associated with the Gift $160 $40 $40 $40 $0 $280 In table 1b, the increase in potential capital gains tax from $25 to $40 makes the gift less favorable than a bequest at death. This assumes that the capital gains tax is actually paid, which will be true only if and when Cal s children sell the shares they receive. Disregarding capital gains tax, both gifts make the children better off by $32 ($200 vs. $168) as of Cal s death. The tables assume no state death tax. At present, 18 states and the District of Columbia have state death taxes. In such a state, the gift may result in a larger benefit to Cal s children than shown in the tables. Only 2 of the 18 states have a state gift tax; in those states the gift tax could reduce or eliminate the additional benefit. As the above tables demonstrate, under certain circumstances from a transfer tax perspective, it may be more profitable to transfer an asset during the client s lifetime. Frequently hard to value assets may be attractive to either give or sell to family members. That is either because the inherent investment control the asset may give the donor (e.g., a gift of a non-managing interest in a family holding company, such as a family limited partnership (FLP)) or there is a significant chance for appreciation (e.g., a private equity interest in a closely held oil and gas venture). A clear disadvantage of giving or selling a hard to value asset is the uncertainty of the amount of gift tax that may be owed if the IRS takes the position that the asset is undervalued. The purpose of this paper is to explore the advantages and considerations of five different methods to limit a donor s gift tax liability with a gift, or sale, of a hard to value asset (e.g., a limited partnership interest): (i) the use of donor financed net gifts to a grantor trust; (ii) the use of formula defined value allocation assignments with a residual gift to a tax sheltered recipient; (iii) defined value dollar assignments with, or without, a parallel formula disclaimer by the donee; (iv) the use of grantor retained annuity trusts ( GRAT ) and the transfer of leveraged single member limited liability member interests to GRATs; and (v) the use of sales to third party created trusts in which the donor is a current beneficiary and has a special power of appointment. SSE01VU 5

23 III. THE ADVANTAGES AND CONSIDERATIONS OF A DONOR FINANCED NET GIFT TO A GRANTOR TRUST FOR A DONOR WHO WISHES TO AVOID PAYING ANY ADDITIONAL GIFT TAX ON A TRANSFER A. What is the Technique? If a donor wishes to ensure that the donor will not have to pay any additional gift tax with respect to a gift or sale to a grantor trust, the donor may be able to accomplish that goal contractually with the donee trust. In that manner, the risk of an additional gift tax is with the donee, instead of the donor. Many times a donor is psychologically more comfortable with the risk of a gift tax audit, and the cost of any additional gift tax accruing as a result of a gift tax audit, residing with the person or trust who is received the reward the donee. The contract is commonly referred to as a net gift. The tax advantages of the technique will be explored below. A net gift is a gift in which both the donor and the donee expressly agree that the donee will pay the gift tax, as finally determined for gift tax purposes, and that agreement is a condition of the transfer. The taxable gift is the amount of the property transferred less the amount of gift tax the donee will have to pay. Revenue Ruling gives the formula to determine the amount of the net gift: Tentative Tax 1 + Rate of Tax The contract between the donor and donee should also make it clear that the donee also assumes the gift tax liability for gift tax on a future valuation increase. Consideration should also be given to the donor and donee agreeing that the donee will also be liable for any estate tax that would be due under IRC Sec. 2035(b) if the donor dies within three years of the gift. There is some authority that the actuarial probability of that occurring is also deductible in computing the taxable gift. 4 When a net gift is made to an individual, the donee s payment of the gift tax is treated as consideration for the transfer. If the gift tax exceeds the donor s basis in the transferred asset, the donor will realize a capital gain. 5 If the transfer instead is made to a grantor trust, as is discussed below, there will not be any immediate income tax consequences to the part sale, part gift, even if the basis of the transferred asset is lower than the gift tax to be paid. When the donee grantor trust must pay the gift tax, the trustee may wish to borrow from the donor sufficient funds to pay the tax. In today s low interest environment, the loan could be structured at a very low interest rate without any further gift tax consequences. See IRC Secs and C.B. 310 (1975). 4 See McCord v. Commissioner, 461 F.3d 614 (5 th Cir. 2006). 5 Diedrich v. Commissioner, 457 US 191 (1982). 6 For an excellent discussion of the technique, see David A. Handler, Financed Net Gifts Compared to Sales to Grantor Trusts 44 th Annual Heckerling Institute on Estate Planning, Chapter 17 (2010). SSE01VU 6

24 Consider the following example: Example 2: Leslie Lessgifttax Enters Into a Net Gift Transaction With a Grantor Trust and Loans to the Donee Trust an Amount Equal to the Gift Tax That is Due Leslie Lessgifttax does not wish to pay any gift tax with respect to a proposed gift to a trust for the benefit of her family. Leslie does not have any remaining gift tax exemption. Leslie also does not want her future cash flow reduced in order to pay any future income taxes on the properties associated with the proposed gift. Leslie s attorney, Casey Comparesalot, proposes that Leslie make a net gift to a grantor trust. Casey also proposes that Leslie finance the trustee s payment of the gift tax with a nine-year loan to the trustee. The interest and principal of the loan will be paid by the trustee in a manner whereby Leslie, on a net basis, never has any negative cash flow because of her payment of income taxes of the trust under the grantor trust rules. That is, the loan repayments of principal and interest will at least equal the income taxes Leslie has to pay. Once the loan is paid, the grantor trust will be converted to a non-grantor complex trust. Leslie and Casey assume Leslie will gift roughly one-half of her assets ($20,000,000) to the trust. Casey s idea is illustrated below: 1 $10,000,000 Net Gift 2 $126,700 in Cash to Pay Trust Income Taxes in First Year 2 $126,700 1-Year Note, 1.22% Interest Leslie Lessgifttax 3 $2,857,143 in Cash Grantor Trust Pays Trust Income Taxes Until $2,721,574 Note is Repaid 3 $2,721,574 9-Year Note, 1.22% Interest in Year 2 Pays Gift Taxes of $2,857,143 in Year 2 3 IRS Leslie assumes her assets will annually earn 7% pre-tax during the 10 years with 2/7 of the return being taxed at ordinary rates and 5/7 at long term capital gains rates (with a 30% annual turnover). Leslie and Casey assume the AFR interest rate on the nine-year note will be 1.22%. In addition to income taxes, Leslie assumes she will annually spend $200,000 a year before inflation (which she assumes will be 3% a year). SSE01VU 7

25 Leslie commissions Casey to compare his idea (Scenario #1 below) to a net gift to a non-grantor, complex trust without donor financed loans (Scenario #2 below) and to an outright gift to a non-grantor complex trust in which Leslie pays the gift tax (Scenario #3 below). Leslie is also curious as to what the simulated gift tax rate and gift would have to be to a non-grantor trust, assuming Leslie pays the gift tax, to equal the result for her donees under Scenario #1 (this comparison is Scenario #4 below). The results after 10 years, based on the above assumptions, before Leslie s death, are below (see Schedule 2 attached to this paper): Table 2a Results in 10 Years Before Leslie s Death 10-Year Future Values - Pre-Death Scenario #1: Net Gift of $10mm to a Grantor Trust (that Becomes a Complex Trust Once Notes are Paid); Loans to Leslie Lessgiftax for Trust Income Taxes (year 1); Loan to Trust for Gift Tax Amount (year 2) Scenario #2: Net Gift of $10mm to a Non- Grantor (Complex) Trust without Donor Financed Loans Leslie Lessgifttax Lessgifttax Children Consumption Consumption Investment Opportunity Cost IRS Income Taxes IRS Gift Taxes IRS Income Taxes and Gift Taxes Opportunity Cost $10,381,800 $15,645,025 $2,292,776 $823,399 $3,976,895 $2,857,143 $3,365,990 $13,719,427 $12,307,397 $2,292,776 $823,399 $3,976,895 $2,857,143 $3,365,990 Scenario #3: Outright Gift of $10mm to a Non-Grantor (Complex) Trust and Donor Pays Gift Tax $9,010,745 $15,645,025 $2,292,776 $823,399 $3,821,010 $3,767,255 $3,982,818 Scenario #4: Simulated Gift ($9.4mm) and Gift Tax to Equal the Results for the Donor and Donee in Scenario #1 for a Gift to a Non-Grantor (Complex) Trust; Donor Pays Gift Tax $10,381,799 $15,645,025 $2,292,776 $823,399 $3,976,895 $2,857,143 $3,365,990 The best result for Leslie s donee, after income taxes and gift taxes and the investment opportunity cost of paying those taxes is either Scenario #1 or Scenario #3. However, under Scenario #1, before Leslie s death, Leslie will have more assets available to her than Scenario #3 (Leslie will have 15.22% more assets under Scenario #1). The results after 10 years, based on the above assumptions, after Leslie s death, are below (see Schedule 2): SSE01VU 8

26 Table 2b Results in 10 Years After Leslie s Death Lessgifttax Children Consumption Consumption Investment Opportunity Cost IRS Income Taxes IRS Gift Taxes IRS Income Taxes and Gift Taxes Opportunity Cost Estate Taxes (@ 40%) 10-Year Future Values - Post Death Scenario #1: Net Gift of $10mm to a Grantor Trust (that Becomes a Complex Trust Once Notes are Paid); Loans to Leslie Lessgiftax for Trust Income Taxes (year 1); Loan to Trust for Gift Tax Amount (year 2) $23,318,105 $2,292,776 $823,399 $3,976,895 $2,857,143 $3,365,990 $2,708,720 $39,343,027 Total Scenario #2: Net Gift of $10mm to a Non-Grantor (Complex) Trust without Donor Financed Loans $21,983,054 $2,292,776 $823,399 $3,976,895 $2,857,143 $3,365,990 $4,043,771 $39,343,027 Scenario #3: Outright Gift of $10mm to a Non-Grantor (Complex) Trust and Donor Pays Gift Tax $22,495,472 $2,292,776 $823,399 $3,821,010 $3,767,255 $3,982,818 $2,160,298 $39,343,027 Scenario #4: Simulated Gift ($9.4mm) and Gift Tax Rate (30.337%) to Equal the Results for the Donor and Donee in Scenario #1 for a Gift to a Non-Grantor (Complex) Trust; Donor Pays Gift Tax $23,318,105 $2,292,776 $823,399 $3,976,895 $2,857,143 $3,365,990 $2,708,720 $39,343,027 After Leslie s death, Scenario #1 gives the best result for her beneficiaries. Scenario #4 illustrates that Leslie s children and Leslie would have the same result under Scenario #3 as Scenario #1, if the gift tax rate is % (instead of 40%) and the gift is $9,418,138 (instead of $10,000,000). The advantages and considerations of the technique are discussed below. B. Advantages of the Technique. 1. Tax Advantages of Creating a Grantor Trust and a Net Gift Sale to a Grantor Trust. IRC Secs. 671 through 677 contain rules under which the grantor of a trust will be treated as the owner of all or any portion of that trust, referred to as a grantor trust. If a grantor retains certain powers over a trust, it will cause the trust to be treated as a grantor trust. If the grantor is treated as the owner of any portion of a trust, IRC Sec. 671 provides that those items of income, deductions, and credits against the tax of the trust that are attributable to that portion of the trust are to be included in computing the taxable income and credits of the grantor to the extent that such items will be taken into account in computing the taxable income or credits of an individual. An item of income, deduction or credit included under IRC Sec. 671 in computing the taxable income and credits of the grantor is treated as if received or paid directly to the grantor. 7 Thus, if the private investor contributes assets to an intentionally defective grantor trust, the assets will grow (from the point of view of the trust beneficiaries) income-tax free. Furthermore, the IRS now 7 Treas. Reg. Section (c). SSE01VU 9

27 agrees that there is no additional gift tax liability, if the private investor continues to be subject to income taxes on the trust assets and there is no right of reimbursement from the trust. 8 Under Rev. Rul , 9 a grantor is treated as the owner of trust assets for federal income tax purposes to the extent the grantor is treated as the owner of any portion of the trust under IRC Sec In that ruling, it was held that a transfer of trust assets to the grantor in exchange for the grantor s unsecured promissory note is not recognized as a sale for federal income tax purposes. 10 Similarly, if the grantor is treated as the owner of the trust property and transfers property into the trust in exchange for property previously held by the trust, such transfer will not be recognized as a sale, exchange or disposition for federal income tax purposes. 11 Thus, no gain or loss is realized by the grantor or the trust. The basis of the property transferred into the trust is unaffected by the transfer, and neither the grantor or the trust acquires a cost basis in the assets transferred from or to the trust. This should also be true for a part sale/part gift transaction with a grantor trust as embodied in the net gift transaction. It is possible to design a grantor trust that is defective for income tax purposes (e.g., with a retained power to substitute assets of the trust for assets of equivalent value), but is not defective for transfer tax purposes. In comparison to discounting or freezing a client s net worth, over periods of 20 years or more, paying the income taxes of a grantor trust is generally the most effective wealth transfer technique. 2. Net Gift Takes Advantage of the Tax-exclusive Nature of the Gift Tax. A net gift takes advantage of the tax-exclusive nature of the gift tax in comparison to the tax-inclusive nature of the estate tax. The gift tax is assessed only on the net amount received by the donee. The estate tax is assessed on the entire estate including that part of the estate that is used to pay the estate tax. As a result, the effective rate of the gift tax is 28.57% as compared to a 40% effective estate tax rate. 3. Significant Synergies Exist With the Combination of the Net Gift Transfer to a Grantor Trust, and Using Low Interest Donor Financing to Pay for the Gift Tax. Under the facts of Example 2 because of the added benefit of the donor financing at low interest rates and the grantor trust rules, which allow trustee payments of the gift tax financing with pre-income tax dollars, it is as if the statutory gift tax rate had been reduced to % from 8 See Rev. Rul , C.B Rev. Rul , C.B See also, P.L.R (Aug. 14, 1991) (finding that transfer of stock to grantor by trustees of grantor trust in satisfaction of payments due grantor under the terms of the trust does not constitute a sale or exchange of the stock). 11 See P.L.R (Dec.13, 1989). SSE01VU 10

28 40% and the effective gift tax rate had been reduced to 23.28% from 28.57%. See Scenario #4 above and the calculations in Schedule The Near Term Death of the Grantor of a Grantor Trust Generally Does Not Affect the Technique Like the Death of a Grantor of a GRAT. A popular estate planning device that will be discussed in greater detail in this paper is the GRAT. See Section VI A of this paper. The requirements of a successful GRAT are delineated in IRC Sec If a grantor of a GRAT dies before the end of the term of the GRAT, part or all of the trust assets will be taxable in the grantor s estate under IRC Sec The amount that will be included is equal to the annual annuity amount divided by the interest rate determined under IRC Sec See Treas. Reg. Secs (c)(2)(i) and (c)(2)(iii), Example 2. In many instances, unless the annuity amount is relatively small in comparison to the value of the assets of the trust, all of the assets of the trust will be included in the grantor s estate. If the grantor dies shortly after the sale to the grantor trust, all that should be included in the grantor s estate is the remaining principal value of the note, assuming the sale is recognized as a valid sale and the note is recognized as a valid note. The grantor/seller could bequeath that note to his spouse. Over the surviving spouse s lifetime, that surviving spouse could live off of the proceeds of the interest and principal payments of the note, before drawing down on any beneficial interest that surviving spouse would be entitled to under the trust. Thus, there are two lifetimes to utilize to assure the efficacy of the technique: the original grantor s lifetime and his spouse s lifetime. 5. The Appreciation of the Assets of the Trust Above the Interest of the Note Used to Finance the Gift Taxes Associated With a Net Gift to a Grantor Trust Will Not Be Taxable in the Grantor/Seller s Estate. Assuming there is appreciation of the trust assets above the interest carry on any note used to finance the gift taxes, that appreciation will not be subject to estate taxes in either the grantor s estate or the grantor spouse s estate (if the spouse is a beneficiary of the grantor trust). This is a significant transfer tax advantage. In calculations that we have performed in situations in which the joint life expectancies exceed 20 years, this is the second biggest driver of transfer tax savings for a client s family. (The most important driver, mentioned above, for saving transfer taxes is the donor s paying the income taxes of the trust on a gift tax-free basis.) The interest on the note does not have to be any higher than the applicable federal rate in order to ensure there are no gift tax consequences. The applicable federal rate depends upon the length of the term of the note and is equal to the average rate of Treasury securities for that term. See IRC Secs and 1274(d). SSE01VU 11

29 6. Flexibility Advantages of a Financed Net Gift to a Grantor Trust. a. Flexibility Could Be Achieved By Naming a Spouse as a Beneficiary of the Grantor Trust and Giving a Grantor s Spouse a Special Power of Appointment. It is possible for the patriarch or matriarch to name his or her spouse as a beneficiary of a trust and also give that spouse the power to redirect trust assets that are different than the default provisions of the trust instrument. IRC Sec of the Internal Revenue Code provides that a person may be a beneficiary of a trust and have a power of appointment over the trust as long as the beneficiary does not have the right to enjoy the benefits of the trust under a standard that is not ascertainable and does not have the power to appoint the trust assets to either the beneficiary s estate or creditors of the beneficiary s estate. If an independent third party is trustee of the trust, that third party could have significant additional powers over the trust to distribute assets of the trust for the benefit of that spouse. If the spouse is serving as trustee and has distribution powers in that capacity, distributions to the spouse must be for the spouse s health, education, maintenance or support, under an ascertainable standard described in Sec of the Internal Revenue Code and enforceable by a court. If unanticipated consumption problems accrue during a couple s lifetime and if the trust allows distributions to be made to meet those unanticipated consumption needs, that trust can obviously act as a safety valve for those needs. If the trust allows the grantor s spouse to appoint properties in a manner different than the default provisions of the trust, those powers of appointment could also serve as a safety valve to redirect the properties of the trust that is more consistent with the client s future stewardship goals. A collateral benefit of the inherent flexibility of creating trusts that have the safety valve of having a client s spouse as the beneficiary, and giving that spouse a limited special power of appointment, is that the technique encourages the client to create such a trust when the client may be reluctant to do so. b. Flexibility Could Also Be Achieved By Converting the Note to a Note With a Different Interest Rate, a Private Annuity, Purchasing Assets Owned By the Trust and/or Renouncing the Powers That Make the Trust a Grantor Trust. The note retained by the grantor could also be structured and/or converted to meet the grantor s consumption needs, without additional gift taxes, as long as the restructuring is for adequate and full consideration. For instance, the note at a future time could be converted to a private annuity to last the grantor s lifetime. That conversion should be on an income tax free basis since, as noted above, the trust and any consideration received for any sale to the trust are ignored for income tax purposes. The note could also be restructured to pay a different interest rate, as long as the new rate is not lower than the AFR rate nor higher than the fair market value rate. If the grantor cannot afford to pay the trust s income taxes in the future, the trust could be converted to a complex trust that pays its own income taxes. However, converting the trust to a complex trust could have income tax consequences if the then principal balance of the note is SSE01VU 12

30 greater than the basis of the assets that were originally sold. That difference will be subject to capital gains taxes. 12 C. Considerations of the Technique. 1. If There is an Adjustment in the Future Gift Tax Liability Owed By the Donee Grantor Trust, the IRS and the Courts May Not Allow That Additional Gift Tax Liability to Be Used in Reducing the Gift in the Net Gift Tax Calculation. There is a split of authority as to whether future increases in gift tax payable by the donee trust, because of valuation increases of the gift by the IRS on audit, would be eligible for a net gift offset in calculating the amount of gift tax owed. Compare Frank J. Armstrong, Jr. Trust v. United States 13 to McCord v. Commissioner. 14 Arguably, Armstrong is distinguishable from the facts of Example 2 because the donees in Armstrong assumed only the obligation to pay any additional gift tax that would be caused by an audit instead of all of the gift tax liability. The court found in Armstrong that was too speculative and that the obligation was not a true condition on the gift at the time of the transfer. 2. State Income Tax Considerations. Many states that have a state income tax have similar provisions to the federal tax law with respect to grantor trusts, but it is not clear all states would follow the logic of Rev. Rul Thus, there could be state income tax consequences with the sale, whether there are capital gains consequences and/or there could be a mismatch of the interest income and interest deduction associated with any sale. 3. The IRS Could Be Successful in Applying the Step Transaction Doctrine to the Technique. The common law doctrine known as the step transaction doctrine, which is an application of the larger substance over form doctrine, could under certain circumstances be used by the IRS to deny the tax benefit of taking a valuation discount on a net gift to a grantor trust of a family entity such as a FLP or a family limited liability company (FLLC). 15 In applying the step transaction doctrine, the IRS, or court, may not treat the various steps of the transfer as independent. Instead, the steps may be collapsed into a single transaction. 12 See Treas. Reg. Section (e), Ex. 5; Madorin v. Commissioner, 84 T.C. 667 (1985); Rev. Rul , C.B W.D. Va. (Jan. 10, 2001), aff d 277 F.2d 490 (4 th Cir. 2001) F.3d 614 (5 th Cir. 2006), reversing 120 T.C. 358 (2003). 15 See Donald P. DiCarlo, Jr., What Estate Planners Need to Know About the Step Transaction Doctrine, 45 Real Prop. Tr. & Est. L.J. 355 (Summer 2010). SSE01VU 13