Gifting $5 Million Without Using $5 Million Worth of Lifetime Exemptions

A few weeks ago we discussed the concept of using limited liability companies ("LLC's") for gifting purposes. We have been working with clients using such a strategy and this gives us an opportunity to explain how the concept works.

     Among other assets, John and Jane have commercial buildings valued at $10,000,000, which are likely to double in value over the next 10 years. The clients also have two children and six grandchildren, all of whom are adults. They were not opposed to lifetime gifting to remove assets and the future appreciation from their estates, but they wanted to maintain control of the assets.

     We suggested that John and Jane transfer the buildings to an LLC, in exchange for a 2% voting interest in the LLC and a 98% nonvoting interest in the LLC, which they then divided equally between themselves. We then discussed what portion of the interests they wanted to gift to their children and grandchildren. Since one goal was to ensure that John and Jane maintained control of the buildings, they will definitely retain ownership of the voting interests. They also wanted to enjoy some of the annual income generated by the buildings, so they will need to retain a portion of the nonvoting interests. Ultimately, John and Jane chose to gift 50% of the nonvoting interests to their children and grandchildren.

     Since John and Jane gifted nonvoting interests, which do not give the owner of that interest control of the business, the IRS will allow a discount of the value of the interest gifted for gift tax purposes. Thus, even though John and Jane gifted an equivalent of $5,000,000, because of the discount (conservatively at 20%) the deemed gift was only $4,000,000. John and Jane each used their annual exclusion gifts of $14,000 to make gifts to each of the children and grandchildren, for a total of $224,000 ($14,000 x 2 grantors x 8 descendants). The remaining gift of $3,776,000 was divided equally between John and Jane's lifetime exemptions against estate tax and we filed a gift tax return providing the IRS with a record of the transaction.

    As an additional protection against creditors and any potential divorce, we also established irrevocable trusts for each of John and Jane’s children and grandchildren to hold the gifted nonvoting interests. These trusts have flexible provisions regarding the distribution of income and principal to the beneficiaries, while also creating a nest egg for later in their lives. 

     The net result of this strategy is that John and Jane maintain control of the buildings during their lifetime and removed assets presently valued at $5,000,000 from their estates using only a portion of their lifetime exemptions. In addition, the transfer removes all of the appreciation on the gifts from John and Jane's estates, saving approximately $2,000,000 of estate taxes at their deaths (appreciation of $5,000,000 x 40% estate tax). In addition, income earned by the gifted interests is now reported on eight different income tax returns and presumably taxed at lower tax rates.

     In this situation, an estate tax savings was one of the desired results. However, even if clients do not have an estate tax issue, gifts of LLC interests to irrevocable trusts can provide children and grandchildren with an income stream, while protecting the interests from creditors or possible marital issues. This strategy is not without additional cost, as appraisals of both the asset value and the minority discount must be completed by a qualified appraiser. In addition, attention must be paid to the administrative requirements and tax filings of both the LLC and the irrevocable trust. As always, clients should seek the advice of a qualified professional before engaging in the strategy.

Honesty in Estate Planning

     Of all of the reasons to begin the estate planning process, one of the most important for many clients is gain the peace of mind that comes from knowing a plan exists to care for their loved after the client’s death. For some people that means having guardians and trustees who will see to it that their children grow into responsible adults. For others, that plan is as simple as making sure that someone will organize their assets and divide them equally between the beneficiaries. These clients have common situations and it is easy for them to express their concerns for the future. Generally, the client is forthright and open about their desires and therefore we are able to establish a plan to meet those goals.

     For other clients, this process is not as simple. These clients find themselves in a position where they know that their children or other loved ones, for a variety of reasons, are incapable of managing assets for themselves and will need additional assistance. Some of these beneficiaries may have substance abuse problems, others may simply be bad at managing money, and others still may be in relationships that the clients feel are not in the beneficiary's best interest. In all of these circumstances, it is possible to craft an estate plan that addresses the clients concerns, but only if the client is willing to be open and willing to discuss the situation truthfully. 

     For clients with more complex situations, we find that problems often arise due to the clients desire to keep their private lives private. No one enjoys admitting that everything is not perfect, and often clients who need more complex planning will not open up about their concerns, despite our best efforts, until well into the planning process. While this delay is understandable, it is important to remember that attorneys and financial planners can only provide good advice if our clients give us access to all of the pertinent information. 

     There are many tools and techniques which we can use to help a client create a plan that will care for their loved ones’ needs, but only when the client communicates those problems. We cannot talk about options for long-term trusts designed to provide for a loved one's needs without directly providing that person with access to assets if we do not know that a son has spendthrift issues. We cannot prepare documents that take into account the need for substance abuse counseling and testing before making distributions if we are unaware that these issues exist. We cannot prepare documents that address the disparate needs of different children, who may not have good relationships with one another, if we are unaware of these family dynamics.

     For clients in these unique situations there are two pieces of good news. 

1. Your privacy is secure. The things that you discuss with your attorney are privileged and will not be shared with anyone else. We are aware that these are difficult issues and want to help you address them. Therefore, you can open up and discuss your concerns about loved ones without worrying that this information will ever reach their ears. 
2. This is not the first time we have dealt with your situation. While each client’s circumstance is unique, any given client is unlikely to be the only one with these types of concerns, and it is unlikely that their story is something we have never heard before.

     Clients come in all varieties, with all manner of concerns, but regardless of those things they all want to create a plan that protects their loved ones and our goal is to help reach that goal while maintaining their privacy.

      It is important to remember that when you come to an attorney, the advice you receive is only as good as the information you provide the attorney. Like any other professional who provides counsel and advice, an attorney is limited to what the client chooses to share. Therefore, it is important that clients come prepared to discuss all of their concerns in order for them to receive the best representation. When consulting any new professional, take the time to get to know the person and make sure that you can be comfortable sharing all of your concerns with them, so that they can provide you with the level of care that your deserve.

Funding: the Next Step in Estate Planning

     When clients finish signing their estate plans, they often have a look of relief on their faces. They realize, after putting off planning for many years, they now have a plan that will make things much easier for their loved ones if something unexpected happens to them. Of course, signing the documents is not the end of the estate planning process. In order to minimize probate delays, unnecessary costs, and gain the maximum benefit from a Living Trust, clients must take the time to fund their assets to the Trust.
     Clients should retitle major assets, such as real estate and business entities, to ownership by the Trust. This allows the client to retain complete control of the asset during their lifetime and ensure that the successor Trustee can easily administer the property within the Trust, in total privacy, after death. Real estate transfers should include residences, vacation homes, vacant land, and commercial buildings. Business interests should include stock in corporations, and ownership interests in limited liability companies and partnerships.
     It is equally as important to transfer broker, bank, and privately managed investment accounts to the Trust. Again, there is no loss of control during the client’s lifetime and the assets will escape probate costs, time delays and publicity.
     For other assets, clients will need to update their beneficiary designations. For life insurance policies, the primary beneficiary of the policy should be the changed to the name of the Trust. This allows the successor Trustee to immediately access the proceeds for the beneficiaries benefit without worrying what happens if beneficiaries get large sums of money without restrictions, or if a beneficiary dies and there are no alternate beneficiaries. Depending on the terms of the trust, clients may also want to name the trust as a contingent beneficiary on their retirement accounts.
     While you are in the organizing mood, you may also want to give attention to the following:

• Notify those you have named to make decisions under your Power of Attorney and Patient Advocate Designation, and provide them with a copy of those documents.
• Make a list of assets, including account numbers and passwords, and keep copies of statements, deeds and business ownership documents in a specific place.
• Consider having children over the age of 18 execute a Power of Attorney and Patient Advocate Designation so you will be able to make decisions for them should they get into an accident or suffer a debilitating illness.
• If you are traveling and leaving minor children with grandparents or others, provide the caregivers with an Authorization for Medical Decisions, so they can give guidance to medical personnel in the event of an emergency.

     These steps can provide you with peace of mind, knowing that things are in place the event of an emergency. Remember to keeps all of these things up to date, then store them somewhere safe, presuming they will not be needed for many years.

The Importance of Personal Property

Today's blog examines an often overlooked part of estate planning. Clients often presume that their children will simply sort out personal property, without considering the potential pitfalls of leaving such decisions up to others. Including a Personal Property Memorandum as part of an estate plan is an excellent way to limit those issues. 

     One aspect of estate planning frequently overlooked by clients is the distribution of their tangible personal property. "Tangible personal property" includes all of the clients possessions that do not otherwise have a title or ownership designation. As part of our estate planning we use an Assignment to designate the Living Trust as the owner of all of these items. We also provide the client with the ability to leave a list of specific gift of tangible personal property.This Personal Property Memorandum may be changed at any time, without amending the Trust, and is read as part of the Trust after the client’s death. Unfortunately, when we bring this to the client’s attention, they often give it short shrift, indicating that they do not have anything of value or that they believe their children will not care about the personal property.

     Treating tangible personal property as an afterthought or unimportant is a common source of discord in the administration of a client’s estate or trust. Clients fail to account for the their loved ones attaching significant emotional value to items that lack significant monetary value. As an example, children may fight over which of them inherits their mother’s KitchenAid mixer because one of them has a strong emotional attachment to the mixture as a reminder of all the times he and his mother baked together for the holidays, while the client’s daughter simply would like a mixer for her own home. It never occurs to either sibling to explain to the other why they place such a high value on their mother’s mixer, thus resulting in misunderstandings and hurt feelings.

     Whenever our clients indicate that they feel their tangible personal property is not significant in their estate planning we encourage them to take time to sit down with their loved ones and discuss which items may hold emotional significance. This conversation, as much as any other conversation, can alleviate surprises and problems after the client’s death. In addition, it allows the client and their loved ones to begin a discussion about what will happen after the client’s death without focusing on difficult matters to discuss, such as illness and the money. Not only do clients gain a better understanding of what their children value, they also have the ability to limit any unnecessary conflict that otherwise might have arisen after their death.

     Tangible personal property often carries the most emotional significance to a client’s loved ones after their death. For a client concerned about maintaining familial harmony and ensuring the smooth administration of their estate, taking time to prepare a personal property memorandum can significantly reduce the chance of problems after their death. 

     It is important to remember that while the personal property memorandum is a common tool in estate planning is not universally included in every document. Different documents will treat the memorandum differently, some give it different priority from the other terms of the trust, and some trusts omit this option entirely. Clients should consult an experienced professional to determine under what terms they can make use of a memorandum in their planning.

Keeping Family Vacation Homes in the Family

A warm day like yesterday often triggers thoughts of summer and good times at the family cottage. With these thoughts in mind, clients often wonder how to structure the transfer of ownership of a family vacation home to their children and grandchildren either during lifetime or at death.

     Gifting or bequeathing a family vacation home is not an easy matter and requires significant planning in order to treat all family members fairly. Clients need to balance their desire to make a well-intentioned gift with the possible unintended burden on beneficiaries, which may cause strife among loved ones. Additionally, the transfer of such high-value assets brings with it potential estate and gift tax implications. While a client certainly must consider tax issues and the possibility of an increase in property taxes because of the transfer, we will leave these for another time and focus primarily on the family issues. 

     While a parent may hope that common ownership of a vacation home will keep their family together, it is entirely possible that not all of their children have the same warm memories of summers at the lake. In addition, those children’s spouses and children may have different ideas on how to spend family vacations. Add to all of this the fact that many adult children have moved away to pursue their careers (or avoid sometimes harsh Michigan winters) and may not be able to enjoy the use of a vacation home. It is important to discuss these issues with all of the family members to determine which children are interested in owning a part of the "family cottage".

     While there is not enough time to discuss all of the issues, important points to consider when transferring the vacation home include:

• What will the ownership structure be? This could include ownership jointly, as tenants-in-common, by a trust, or by an LLC?
• Who will manage the property? Family dynamics are important - not all of the family members may want to get involved in the day-to-day decisions.
• How will use of the vacation home be determined?  A plan should be in place for fairly selecting weeks of use for each of the family members.
• How are repairs and improvements, including cost, dealt with? Some family members may always be looking to upgrade the facilities while others may be happy to keep things simple and inexpensive.
• Should there be rules about allowing guests to use the cottage, especially without a family member present?  Allowing many non-family guests to use the cottage can cause considerable wear and tear on it and create friction among family members.
• Is there a procedure for allowing a family member to sell or gift the ownership interest?  Either during lifetime or at death, family members often desire to transfer their interest to a spouse, or children. If not planned for, this can result in a significant fractionating of a family member's interest and increasing the total number of "owners" for purposes of use and expenses. It might also result in pieces of the vacation home being owned outside the intended family.

     While continuing family ownership of vacation property is a laudable goal, much thought should be put into the process to make sure that the intended result of family harmony does not actually result in disharmony. As with any other tax or gift planning strategy is important to understand each client individual circumstances and consult with their professionals to ensure that the planning will not have unforeseen consequences.

Using LLCs to Expand Lifetime Gifting

So far, our discussion regarding the use of gifting an estate plan has revolved primarily around cash gifts, it is important to understand that gifts can consist of any type of property, including interests in real estate and business entities. A family owned Limited Liability Company is an excellent tool for transferring a variety of assets from one generation to the next, often at a reduced value, while allowing parents to retain control of the assets during their lifetime.

     While the use of cash gifts provides clients with a tool for reducing their potential estate tax liability, clients may be able to gain greater benefits through by using a Limited Liability Company (LLC) in their estate planning. The client can establish an LLC with two classes of Membership Interest, voting and nonvoting, and can retain control over assets by keeping the voting interests and gifting the nonvoting interests to beneficiaries..

     To make use of this gifting strategy, clients first establish a LLC (or modify an existing LLC) with a 1% Voting Member Interest and a 99% Nonvoting Member Interest. This allows the owner of the 1% Voting Member Interest to control the company regardless of who owns the 99% Nonvoting Member Interest. Clients then transfer ownership of other assets, such as real estate or business interests, to the LLC. Now the client is able to make gifts of the Nonvoting Member Interest, without giving up control of the assets. This allows clients to begin transferring highly appreciating assets during their lifetime, reducing any potential estate tax liability because the appreciation of the assets is now out of the Estate, and providing a potential source of income to their loved ones. Clients can transfer these  Nonvoting Member Interests in the LLC using either their lifetime estate exemption and/or their annual gift tax exemption, further reducing potential tax liability. These nonvoting member interests can be given to adult children as well as minor children and grandchildren, with trust holding the interest for these minors. These trusts can then be used to provide funds for education for the minors as income is distributed from the LLCs

     Another benefit of including an LLC in an estate plan is the potential to receive a valuation discount when making gifts of Nonvoting Member Interests. The IRS recognizes that a member interest in an LLC which does not allow the owner control over the company and which restricts the owner's ability to sell or transfer the member interest has less value than an unrestricted interest. Thus, a properly structured LLC may allow clients to transfer larger portions of the Nonvoting Member Interest as part of an annual gifting plan. While using an LLC in this manner is a well-established practice, it is important to acknowledge that without proper appraisals and planning, and such transfers may be subject to IRS scrutiny.

     In order to comply with the law and IRS regulations is important to manage and operate the family-owned LLC as a separate entity, and not just an extension of the client’s own affairs. The LLC should not contain all of the client assets, especially not the client’s residence, because the IRS argues that the LLC is necessary to maintain the client’s lifestyle and therefore, under estate tax rules, the IRS may deem the LLC's assets part of the client’s estate.

     For many clients the use of an LLC as part of their estate planning is an excellent strategy to increase the value of annual gifting. It is also an excellent tool for transferring ownership of family-run businesses to the next generation while ensuring that the clients retain control of the business operation. It is important to remember that this is a complex planning technique that clients should not attempt without consulting qualified professionals for assistance in reviewing the tax and legal implications.

The Changing Role of the Irrevocable Life Insurance Trust

Today we look at an advance trust, the Irrevocable Life Insurance Trust, whose role in the the estate planning process continues to evolve in response to changes in the tax code.

     With the Estate Tax Exemption now over $5,000,000 for an individual and $10,000,000 for a married couple, the Irrevocable Life Insurance Trust (ILIT), a once common tool for offsetting estate tax liability, is used less often. While the benefits of an ILIT as a tool to offset the estate tax liability have decreased for the majority of individuals, there are other situations where an ILIT can still be a very useful tool in estate planning.

     An ILIT is designed to own a life insurance policy, normally on the life of the Grantor, without the proceeds from that policy being included in the Grantor’s estate for the purposes of estate taxes. The premiums for the insurance policy are paid by the Trustee, most often with contributions made to the trust by the Grantor using the Annual Gift Tax Exclusion. In order for these contributions to qualify for that exclusion, they must be what the IRS regulations refer to as "present gifts". This means that the recipient of the gift must have the ability to take the gift outright and free of trust if they so choose. The terms of the ILIT require the Trustee to give the trust beneficiaries written notice of a limited window of time during which they may withdraw their gift from the trust. After that time period passes, the gift becomes a trust asset and the Trustee can use it to pay the premiums on the insurance policy owned by the trust. This notice is often referred to as a "Crummey Notice", and is named after a tax case named Crummey vs Commissioner.

     A keen observer might ask what is to keep the ILIT beneficiaries from simply withdrawing their gifts immediately and leaving the Trustee without any assets to pay the policy premiums. The answer to this question lies in the beneficiaries' understanding that not withdrawing this gift from the trust in the short term will result in a larger benefit in the long term. If that logic fails, the Grantor can simply refuse to make gifts subject to the Crummey withdrawal rules, not providing the beneficiaries with the ability to withdraw gifts. The negative of this strategy is that the gifts do not qualify for the annual exclusion.

     An ILIT's benefit is that the proceeds from a life insurance policy owned by the trust is not considered to be in the estate of the grantor and therefore not counted for calculation of estate tax liability. For those couples with estates in excess of the $10,000,000 estate tax exemption this means a pool of assets that can offset the portion of an estate used to pay the tax bill. For those clients who do not have a taxable estate, there are also benefits.

• For clients who own small, or not so small, businesses that they intend to leave or sell only to children active in the business, an ILIT allows them to create a pool of assets that can pass to the children who will not inherit the family business, creating equity among children and minimizing interfamily squabbles after death, without increasing the size of the client’s estate and risking potential estate taxes. 
• An ILIT also can be used to provide assets for the benefit of a second spouse, protecting client's other assets for the benefit of children of a prior marriage 
• If a client has substantial charitable inclinations, an ILIT can be used to provide children or other loved ones with a certain amount of inheritance while leaving the remainder of an estate to the client’s favorite charities, creating a charitable estate tax deduction. 
• As with other trusts,  for those clients who want to make gifts, but retain some control over the gifted assets, an ILIT allows them to provide and additional benefit to their loved ones while retaining control over the circumstances under which those loved ones may receive distributions from the trust.
• The ILIT also can leverage the grantor’s generation skipping transfer (GST) tax exemption because the grantor’s GST tax exemption can be allocated to an ILIT holding a life insurance policy that may substantially increase in value. As a result, numerous generations may benefit from the trust assets free of federal estate and GST tax.

     While the value of using an ILIT has been reduced by the current ever-growing Lifetime Estate Tax Exclusion, there are still circumstances where an ILIT may be useful to clients. Like any other tax and estate planning strategy, it is important to consult with experienced professionals before deciding to make use of the technique in order to ensure that clients do not expose themselves to unintended consequences.

The Benefits of Intra-family Lending

With this blog, we return to the subject of gift planning. Clients like the idea of reducing taxes with gifting, but the problem is they actually have to give away an asset. When the client expresses an interest in gift planning, We ask them "What amount of assets do you have to own to feel comfortable giving away something?" The answer is usually "just a little bit more!”

     A common issue that arises when we discuss gift planning with a client is the desire to assist their children without giving up control of the assets. One strategy used in this situation, which allows clients to provide funds for family members' use while still protecting the client’s own interests, is intra-family lending. 

     An intra-family loan works much like any other loan, parents loan money to a child for a specific amount of time and at a specific interest rate. For example, a client agrees to lend $200,000 to her son to help finance a business purchase. The son signs a promissory note with specific repayment terms and a mortgage on the new business as security for repayment of the loan. This intra-family loan allows the son to purchase a business he could not otherwise afford and begin securing his own financial future. The client, over time, will get an annual interest payment as well as a return of her principal. If the child's business earns more than the principal and required interest, the child benefits from the loan, and the client has effectively transferred wealth to her son that he would not otherwise have had. 

     While the annual interest payment and opportunity to run their own business are clear benefits to the client and her son, the benefits of an intra-family loan, as opposed to a bank loan, also include:

1. The parents' ability to set an interest rate far lower than any interest rate available through a bank. While the Internal Revenue Service regulations require that the interest rate of the loan equal a minimum rate set by the IRS each month, the current annual rate is just 2.19% for loans with a duration of more than nine years and significantly lower for shorter loans. If the parents desire, they can charge an interest rate greater than minimum rate but lower than current bank savings rates, increasing the parent’s benefit and still give a benefit to the child.
2. The parents give the child the opportunity to have access to an eventual inheritance much earlier, with much less risk. The parents can also assess the child's abilities to handle the money and perhaps modify the distribution provisions of their estate plan. 
3. In the event parents want to provide their child with an additional benefit, they can use their Annual Gift Tax Exemption to provide their children with the funds to reduce the principal of the loan, without the worry that the child will frivolously waste such gifts.

     To protect the client and avoid potential problems, it is important that clients document any intra-family loan's amount, term, interest rate, and repayment schedule in a formal written contract. This is important not only to ensure a return of the parent's money, but also for protecting the client against an IRS claim that the transaction was a gift, not a bona fide loan.  Courts have held that the existence of a written document evidencing the debt, the charging of a specific interest rate, the existence of a set repayment day, and proof of actual repayment of the loan are all criteria that favor the position of a transfer was a bona fide loan.

     Intra-family lending is a very useful technique for clients who want to provide gifts to their children, while retaining control of their own assets. As with all tax related strategies, clients should seek the advice of a qualified professional before engaging in an intra-family loan. Proper planning can provide benefits to both the borrower and the lender.

Private Information, Security, and your Estate Plan

Locating and gaining access to a loved one's assets during an emergency or after their death can be one of the biggest challenges. Today's blog addresses how clients can provide their loved ones with access to this information without risking identity theft. 

     We often mention, to our clients, and in this blog, the importance of maintaining a record of important information. This list can include the location of accounts, login information and passwords for online accounts, contact information for planners and advisors, and other sensitive personal information to avoid creating problems for loved ones attempting to administer the client’s affairs in the event of an emergency or their death. However, we rarely discuss how the client can safely maintain a collection of information, which, in the wrong hands, can lead to significant financial hardship. We recommend a combination of high-tech and low-tech solutions to maintain security while also making information accessible in the event of an emergency.

     First, we provide our clients with a worksheet designed to assist them in documenting much of the important information someone would need to administer their affairs in the event of their death or an emergency. On this worksheet, we recommend that our clients provide their loved ones and designees with important, but not private, information. This includes the names and contact information for planners and advisors, a list of utility providers, nonfinancial online accounts (including social media and shopping sites), and a list of known creditors. This is the information loved ones will need in order to handle the client’s day-to-day affairs. We encourage our clients to inform their loved ones of the location of this information so that it is easily accessible in the event of an emergency. 

     Second, with respect to information that in the wrong hands creates a risk of identity theft or loss of assets, including specific account information, passwords for online access to financial accounts, and private personal information, we encourage our clients to prepare a secure document containing this information, the location of which the client guards more closely. While the increased security makes accessing this information more difficult, it primarily impacts information that a loved one would only need if it became necessary to manage the client’s affairs in the long term.

     There are increasingly complex ways to protect private information, while still making it available in the event of an emergency. The simplest, but least secure, way is for the client to prepare a written list of the information and provide their designee with the location of that list. Using technology to increase security, the client can prepare a document containing the information, save that document to a flash drive and store the flash drive in a location known to their designee. For even more security, the client may use an online password management service, designed to provide a high degree of protection for all of their online accounts and private information. Using this method, the client will store the important information using the service and provide their designee with the secure password needed to access client’s information.

     Regardless of the method employed to secure all of this information, the underlying important concept we are attempting to convey is the importance of client preparation for emergencies. By taking the time to prepare lists like the ones we have discussed in this blog will allow clients to minimize the stress and inconvenience to their loved ones in the event of an emergency.