The 12th Annual Estate Planning Forum Focused on Planning With S Corporations and Partnerships By Loraine M. DiSalvo, Morgan & DiSalvo, P.C.

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1 The 12th Annual Estate Planning Forum Focused on Planning With S Corporations and Partnerships By Loraine M. DiSalvo, Morgan & DiSalvo, P.C. On November 3, 2015, the Estate Planning and Probate Section joined with the Tax Law Section of the Atlanta Bar Association and Diversified Trust Company for the 12th Annual Atlanta Estate Planning Forum. The event featured a panel discussion of the many issues and opportunities presented when conducting estate planning involving S corporations and partnerships. Moderator Steven B. Gorin of Thompson Coburn, LLP (sgorin@thompsoncoburn.com or ) (pictured to the left) joined panelists William C. Lankford, Jr., CPA of Moore Stephens Tiller, LLC (blankford@mstiller.com or ), Brook H. Lester, CPA, JD of Diversified Trust Company (blester@diversifiedtrust.com or ), and William A. Turner, JD, LLM of Cohen Pollock Merlin & Small, PC (tturner@cpmas.com or ) for an information-packed discussion. This article can touch on only a very few highlights. Many wealthy clients hold assets in business entities. Two commonly used entity types are S corporations and partnerships, which are attractive to many business owner clients because they can provide limited liability for the entity owners while providing pass through entity status for income tax purposes and avoiding the double income taxation that applies to C corporations and their shareholders. However, due in part to the income tax treatment that applies to S corporations and partnerships, owning these entities can make estate planning more complicated. Partnership interests can create problems when held in an estate or trust because the partnership s owners are taxed on their distributive shares of the partnership s income for the year, even if no actual distributions to the partners are made. This can mean that the estate or trust has taxable income but has not received any distributions of cash with which to pay the taxes on that income. This issue also exists for individual partners, of course, and the common solution is for the partnership to make annual distributions to the partners, generally in an amount designed to allow them to pay the income taxes on their distributive shares for that year. However, these annual distributions will normally be made to the partners who own interests at the distribution date, while the distributive share amount for the year is allocated among each owner of the partnership interest in proportion to the periods during the year for which they owned it. If a partnership interest was transferred during the year, such as from an individual partner to his estate at his death, or from his estate to a trust created under his Will, the partner that actually receives the entire distribution may not be the partner who is actually being taxed on the bulk of the distributive share. Conversely, the former partner will be taxed on a portion of the distributive share, but will receive no distribution from the partnership to help pay those taxes. If a partnership interest is to be distributed to a specific beneficiary, it can still cause other beneficiaries to end up taxed on portions of the distributive share income generated by that partnership. This is because the distributive share that the estate or trust receives from the partnership is considered to be part of the estate or trust s distributable net income ( DNI ) for the year. The DNI of the estate or trust is then allocated among the beneficiaries of the estate and trust based on the separate shares that could be funded with the estate or trust s income, and the fact that a specific income-generating asset is distributed to a specific beneficiary does not mean that all of the related income is taxed only to that beneficiary. So, all beneficiaries of an estate or trust can end up being taxed on a proportionate share of 1

2 the distributive share income generated by a partnership interest held by the estate or trust, even if that interest is eventually distributed only to one of those beneficiaries. Mr. Gorin pointed out that planners who are drafting sale and other agreements relating to a partnership or S corporation need to consider the potential for mismatched tax burdens and cash flows. It may not always be possible to get current owners to consent to having distributions made to former owners at the time such distributions are needed, although if the current owners will consent then such distributions may be possible. A better option could be to have the partnership s operating agreement or corporation s bylaws provide for tax payment distributions to be made to the owners of record at the time when the related income was earned, instead of to the owners of record at the time the distribution is made. However, he noted that this solution does not help address the issue if the original owner of the interest or stock died (as opposed to an estate or trust that merely distributed the interest or stock to a different owner). Mr. Gorin also noted that, with corporations, some states do not allow distributions to be made using a record date too far before the actual distribution. He noted that his home state of Missouri does not allow the record date for a distribution to be more than 70 days before the actual distribution date. Mr. Turner confirmed for attendees that Georgia does not have any such restriction. Mr. Lankford added a note that, if the owners of the partnership or corporation are located in different states, they may need disproportionate distributions to reflect their different tax burdens and potential withholding requirements. It would generally be best if the entity s own structure addresses these issues. If it does not, it may be possible to address the mismatch between tax burden and cash distributions through language in a trust (Mr. Gorin s materials provided a sample). In a state that has adopted the Uniform Principal and Income Act ( UPIA ), it may also be possible to make corrections. Mr. Turner noted that Georgia has kinda adopted the UPIA, but he did not provide an opinion on the extent to which Georgia s version of the UPIA might allow mismatches to be corrected. Another potential problem that can exist when an estate or trust owns stock in an S corporation is the potential for mismatches between the outside basis that the estate or trust has in the stock and the S corporation s inside basis in its assets. The potential mismatch can get worse if the S corporation is in one state and owns an appreciated asset in another state. Mr. Gorin gave an example in which A purchases S corporation stock for $100,000. The S corporation owns land in which it has a $0 basis due to depreciation. A takes an outside basis of $100,000, but the S corporation s basis in the land remains $0, because the sale of the stock from its original owner to A does not affect the inside basis of the S corporation s assets. At A s death, her stock is worth $1,000,000, which gives A s estate a new outside basis of $1,000,000 in the stock. However, the S corporation s inside basis in the land remains $0, because there is no change in the inside basis of an S corporation at the death of a shareholder. If the S corporation then sells the land for $1,000,000, it will have $1,000,000 of gain (likely as ordinary income), which will then be taxed to A s estate. A s estate will then increase its basis in the S corporation stock by the $1,000,000 of gain it was taxed on, producing a new outside basis for A s estate of $2,000,000. If the corporation then liquidates and distributes its $1,000,000 of cash to A s estate, the estate will have a $1,000,000 loss ($2,000,000 outside basis less $1,000,000 received in the liquidation= $1,000,000 loss). This example illustrates the timing mismatch that can result from the difference between the shareholder s outside basis and the corporation s inside basis. To illustrate the additional complications that can be produced if the corporation and its appreciated land are located in different states, Mr. Gorin continued with the example in the scenario described in the preceding paragraph. Let s assume that the corporation is a Missouri corporation, but the $0 basis 2

3 land is in Illinois. In this case, Illinois will tax the $1,000,000 gain realized by the corporation on the sale of the land, because income generated by the sale of Illinois land is considered Illinois source income taxable by Illinois. A s estate will pay these taxes to Illinois. However, when the corporation subsequently liquidates and distributes its $1,000,000 in cash to A s estate, the loss realized by the estate on the liquidation will be a Missouri source loss, because the corporation is in Missouri. The tax imposed by Illinois will likely not be fully offset by the loss s effect on Missouri income taxes. Mr. Gorin noted that, if A s estate sells its stock to another corporation, I.R.C. 338(h)(1) allows the stock sale to be treated for income tax purposes as if the corporation sold all of its assets and then immediately liquidated. However, Section 338(h)(1) does not fully alleviate the negative result when the corporation and an appreciated asset are located in different states. Partnerships have the ability to make an election under I.R.C. 754; if this election is properly made, it allows for the partnership to take a new inside basis in its assets if an interest in the partnership is transferred as a result of the death of the owner or in a sale or exchange. The transfer does not have to be a taxable transfer; and even a distribution from an estate to a beneficiary will be considered a transfer for these purposes. The new basis is actually provided by I.R.C The outside basis in the partnership interest is determined under the normal rules. However, the partnership is allowed to adjust the inside basis of its assets to reflect their values at the date of the transfer. The inside basis adjustment is not a full adjustment; instead, only the portion of each asset that is proportional to the interest held by the transferring (or deceased) partner is adjusted. If the partnership has already made a Section 754 election before the transfer takes place, then it does not need to make another one, because a Section 754 election, once made, applies unless and until the Treasury gives permission for it to be revoked. However, if the partnership has not previously made a Section 754 election, it has to be done on the partnership s income tax return for the year in which the transfer or death took place. This can be an extremely short deadline, and if the deadline is missed, there is no available, easy relief. The panel noted that Treas. Reg (a)(2)(vi) may provide an option for relief, but seeking that relief requires a private letter ruling request, with the corresponding expense, and the requirements for relief under this section are stringent. Although estate planners often refer to a basis step up occurring at death, the basis rules can actually apply to create a basis step down in situations where the asset s fair market value at the date of the owner s death is less than the owner s basis. Partnership interests can be particularly hard hit by basis step downs, for two reasons. One reason is that a built in loss of more than $250,000 triggers an adjustment of the partnership s inside basis at the death of a partner or another sale or exchange of a partnership interest, even if no Section 754 election is made or in place (for this purpose, the total unrealized loss on all partnership assets is considered, and unrealized gains can offset the unrealized losses). The second reason is that valuation discounts that reduce the value of the partnership interest for estate tax purposes also reduce the outside basis that the new owner will receive in that interest. Mr. Gorin presented the example of a partnership that holds an asset that has an inside basis of $10,000,000 in assets worth $9,700,000, so that there is a $300,000 built in loss. A is the owner of a 90% limited partner interest. A s outside basis in her partnership interest is $9,000,000. A dies. After valuation discounts, the value of A s 90% interest is determined to be $6,000,000 for estate tax purposes. This means that A s estate s new outside basis in the partnership interest is $6,000,000, a loss of $3,000,000 due to the basis step down. In addition, the partnership must adjust its inside basis to reflect the built in loss it had with regard to its assets. The panel offered a few options for addressing this issue. If a partnership that holds assets with a large built in loss is no longer needed, they suggested that liquidating it before an owner dies should be considered. If the partnership is needed, they 3

4 suggested that it consider periodically selling built in loss assets to realize the losses, perhaps on an annual basis. If an owner has already died, and if the circumstances surrounding the partnership can support the argument, they suggested that perhaps the estate could argue that I.R.C causes the assets held by the partnership to be included directly in the decedent s estate, avoiding the valuation discount issue. Another potential problem when engaging in estate planning with S corporation stock is that only certain types of trusts can qualify to hold S corporation stock without causing the loss of the S election. In general, a grantor trust can hold S corporation stock, but a non-grantor trust must generally qualify as either a qualified subchapter S trust ( QSST ) or an electing small business trust ( ESBT ) in order to be a qualified shareholder. One problem that can come up with regard to irrevocable trusts is that the trust s status as a grantor trust may change, either at the grantor s death or during their lifetime. The panel gave the example of an irrevocable trust in which the grantor s spouse is a beneficiary. If the grantor and their spouse divorce, but the spouse continues to be entitled to income distributions from the trust, I.R.C. 682 may cause a portion of the trust to cease to be a wholly grantor trust, by taxing the income that the spouse is entitled to receive to the spouse. Mr. Gorin pointed out that, if the S corporation itself does not have bylaws or shareholder agreements in place to deal with this possibility, the trust may cease to qualify as an S corporation shareholder. He also pointed out that very few, if any, S corporations will have such provisions in place. The next best option, he said, is to have the trust make the election to become an ESBT. This election must be made no later than 2 months and 15 days after the separation of the grantor and the grantor s spouse becomes effective. In order to avoid the need to rush in these cases, Mr. Gorin suggested that planners can have their irrevocable grantor trusts make an ESBT election at the time the trusts are created. As long as the trust is still treated as a wholly grantor trust under the grantor trust rules, those rules will override the ESBT treatment under I.R.C. 641(c). He said that the downside of making an ESBT election up front is that the trust will be taxed less favorably on its S corporation income for 2 years after the grantor s death if the trust is still a grantor trust at that time. Someone asked Mr. Gorin whether the application of other grantor trust rules to the irrevocable trust was enough to protect the trust s status as a wholly grantor trust against Section 682; he said no, not if there were any actual distributions to the divorced or legally separated spouse, because in that case Section 682 will override all of the grantor trust rules. Mr. Turner noted that, if there are no actual distributions to the divorced or legally separated spouse, the trust s wholly grantor status would not be affected. Mr. Gorin confirmed that was correct, but added that it was not always possible to avoid actual distributions to the spouse. Mr. Lester stated that he also advises his clients to make the ESBT election for their grantor trusts if the trusts hold S corporation stock. He said he has seen too many problems caused by the failure to make the ESBT election in a timely manner once they became necessary. This led to an interesting discussion of spouses and irrevocable trusts. Mr. Gorin noted that Missouri law automatically removes a divorced spouse not only from the other spouse s Will but also from all trusts created by the other spouse. However, Georgia law does not affect trusts, treating a divorced former spouse as having predeceased the other spouse only for Will purposes. Mr. Lester noted that many of the trust agreements he sees simply define the grantor s spouse as being whoever the grantor is actually married to at any given time, instead of only the spouse to whom the grantor was married at the time the trust was created. Mr. Turner then agreed with a comment from an audience member, who argued that, in many situation where the estate planning attorney works with both members of a married couple as clients, conflict of interest issues will prevent the attorney from using a generic definition of spouse in one spouse s irrevocable trust, and from using an automatic kick-out provision in an irrevocable trust. 4

5 Mr. Gorin and the panelists also held an extensive discussion of capital gains and the determination of DNI for trust income tax purposes in non-grantor trusts. In general, capital gain received by a trust from the sale of a capital asset does not become part of the trust s DNI, except under certain circumstances. Mr. Gorin noted that you should be careful when looking at a trust s gain to determine whether gain is actually from a capital asset for DNI purposes, especially where the trust holds interests in any business entity. Capital assets do not include assets that are used in a trade or business and generate gain under I.R.C One rule of thumb is that if an asset is depreciable, it is not a capital asset. If the asset that generated the gain is a capital asset, the next step is to determine whether the capital gain was part of an actual or deemed distribution, or whether it was included in the trust s fiduciary accounting income. Capital gain is considered to be part of an actual or deemed distribution only if the trustee documents that a specific distribution is being made from the capital gain income; internal trustee documentation can be critical here. A note to the beneficiary that a distribution includes capital gain may also be helpful. Another way to include capital gains as part of DNI is available when the trustee plans to make recurring distributions of specific amounts ( budgeted distributions), and makes an irrevocable election to include capital gain as part of the corpus used to make such distributions the first time that the distribution amount exceeds the amount of the distribution and corpus is used to make up the shortfall. Once this kind of election has been made, all future budgeted distributions will include a portion of capital gain, which means that the trustee loses the option to have some capital gains allocated to income and others to corpus. One potential way to avoid being deemed to have elected to include capital gain in budgeted distributions is to specifically refer to the inclusion of capital gain in actual distributions. Shari Martin, a colleague of Mr. Lester s at Diversified Trust Company, added from the audience that estate planners should attempt to give the trustee as much flexibility as possible in making trust distributions, and should be very careful when crafting distribution standards if the trustee is intended to be able to consider income tax mitigation as a reason for a distribution to a beneficiary; if the standards don t allow for such distributions, she said, they cannot be made, even if desirable. An audience member asked about options for capital gains received by a unitrust. Mr. Gorin noted that unitrust distributions are considered to be budgeted distributions and thus only allow the trustee one chance at deciding whether or not to include capital gains in distributions. He stated that he preferred to allow the trustee a power to allocate capital gains to either income or corpus as they are received, rather than using unitrusts, with the requirement that the trustee s allocation decisions do not affect some beneficiaries unfairly. For trusts that have made an election to have capital gain included in budgeted distributions and want to be able to avoid that treatment for future distributions, having the trust form a partnership was offered as a solution. If a partnership makes distributions that are not considered to be distributions in partial or complete liquidation of the partnership, those distributions constitute trust accounting income, even if the partnership s income itself includes capital gains. This can offer the trustee the opportunity to allocate some, all, or none of any capital gains received from the partnership as distributions to the trust s DNI. However, Mr. Gorin noted that the partnership has to actually make distributions; the partnership s distributive share alone does not affect the allocation of capital gains. In addition, if the partnership distributes less than the full distributive share, some ordinary income can be trapped inside the trust, because distributions from the partnership carry out a proportionate share of each category of income received by the partnership. This can result in capital gain being allocated to DNI but ordinary income continuing to be taxed at higher trust rates. Mr. Gorin suggests that the trustee should be the general partner of any partnership created by the trust, so that the trustee can avoid fiduciary duty violations and keep management of the assets in the same hands. Mr. Gorin also 5

6 suggested that one way to avoid trapping partnership income inside the trust while continuing to protect the trust assets might be to have the trust make a distribution of an interest in the partnership itself to a beneficiary. He noted that this should generally be used only with reasonably well-behaved and stable beneficiaries, but that in the right situation it could allow trust income, including capital gain, to be carried out as DNI and ensure that the beneficiary is taxed directly on future distributive shares, while still allowing the trustee to control the amount and timing of distributions. Mr. Lester asked Mr. Gorin how often he has actually used this technique. Mr. Gorin said rarely, and added that this technique is useful mainly in situations where capital gains are otherwise being carried out by budgeted distributions, and not in trusts that are not deemed to have elected to include capital gains in such distributions or are not making budgeted distributions. Other topics covered by Mr. Gorin and the panelists included a fairly detailed discussion of QSSTs and ESBTs, their uses and their pitfalls. The discussions were much too extensive to include in this article in any depth. The materials provided at the Forum came in the form of a detailed, 27-page outline. Additionally, Mr. Gorin invited attendees to submit their addresses to receive the full written materials on which the outline was based. He has also extended this invitation to readers of The Mortmain. As of early February 2016, Mr. Gorin stated that these materials were now over 960 pages long (not counting the table of contents, which would push the total to over 1,000 pages). This extremely comprehensive resource is being provided for free by Mr. Gorin, and this author urges readers with an interest in the topic who weren t able to attend the Forum or who haven t already requested a copy from Mr. Gorin to him at sgorin@thompsoncoburn.com and ask to have a copy sent to them. The Section thanks Mr. Gorin, Mr. Lankford, Mr. Lester, and Mr. Turner for sharing their time and expertise with us. The author of this summary, Loraine M. DiSalvo, can be contacted at (678) or ldisalvo@morgandisalvo.com 6