Planning to Address Highly Appreciating Assets

While not applicable to all clients, it is important to recognize that clients in unique financial situations create unique planning opportunities. One more common situation is a client who wishes to limit their possible Gift/Estate Tax liability while retaining control and income from assets that are likely to continue appreciating over the years. Commonly this includes real estate and family owned companies. 

Carl and Debbie opened a dry cleaner in a strip mall many years ago. Since then, they bought the strip mall containing their store, then the gas station on the corner, and then many other pieces of commercial property. They continue to own that original dry cleaners, and many of their children and now grandchildren have worked there to ensure they understood the value of hard work. In addition to growing the assets of the family owned businesses, Carl and Debbie ensured that their family members got good educations and where possible went into careers that bolster the growth of the family business. While still active in some aspects of the family business, Carl and Debbie now are ready to begin stepping back and giving more responsibility to others, but they are not quite ready to relinquish control of the company. Nor are they prepared to reduce the income to which they have become accustomed.

Carl and Debbie have been cautious clients for many years, making sure to limit their liability through judicious use of LLCs for each of their businesses, creating a tree of holding companies that protect them in the event that a tenant or customer should decide to create legal problems at a particular property. A company known as C&D Holdings, LLC (C&D), ultimately owns all of these different entities and Carl and Debbie each own 50% of the Membership Interests (like stock for an LLC) in C&D. Further breaking down the Membership Interest of C&D, the LLC has Voting and Non-Voting Membership Interests, meaning that the owner of the Voting Interests has control of the decision making for the company and the owners of Non-Voting Membership Interests do not get a say in the operations but do have value. C&D has 4% Voting and 96% Non-Voting Membership Interests, with Carl and Debbie owning an equal share of each.

Carl and Debbie are aware that the value of C&D is likely to continue to increase over the coming years, even as they become less active in its operation. Additionally, they want all of their family (five children, twelve grandchildren, and three great-grandchildren) to benefit from their success, even those family members are not directly involved in the operation of C&D. Carl and Debbie also know that they are not ready to retire from the operation of the business, nor have they fully prepared the family members who are active in the operation of C&D for that situation. The generally increasing value of the company, coupled with the desire to continue to receive income from the business creates a situation where it is beneficial to Carl and Debbie to begin gifting part of their Non-Voting Membership Interests in C&D while retaining the Voting Membership Interests.  This allows the value of the company to appreciate in the hands of Carl and Debbie’s heirs and limits the future Estate Tax liability created at their deaths. While these gifts will have an impact on Carl and Debbie’s Gift Tax liability, it is possible to limit that impact through further planning. 

The rules regarding Gift Tax liability are somewhat complex and we addressed them in an earlier blog, so we will let you refresh yourself on those as you choose. For Carl and Debbie’s purposes it is important to know that their goal is to pass as much value to their children using as little of the lifetime exemption as possible. Discounts in the value of C&D’s Membership Interest stem from limitations what the recipients of a gift may do with that property. A major limitation on the gifts is the recipients’ inability to sell their newly received Membership Interest in C&D. The terms of C&D’s Operating Agreement limit the sale of Membership interest to only Carl, Debbie, or their descendants and require the approval of the owners of the Voting Membership Interests to approve any sale. Additionally, the value of the Non-Voting Membership interests is further limited because those Membership Interests do not give the new owners any say in the management of C&D.

These limitations, combined with a valuation of C&D by a qualified appraiser, create a situation where the value of the Membership Interests that Carl and Debbie gift to their family members can be discounted for gift tax purposes reducing the value of the gifts required to be reported. This discount allows them to transfer more of C&D to their family (where it will continue to grow in value) without using up all of the Gift Tax Exclusion. In addition to this discount, Carl and Debbie are also able to take advantage of their ability to each make gifts up to the annual exclusion ($15,000.00 for 2018) without using any of their lifetime exclusion. This has allowed them to each make annual gifts of their Non-voting Membership Interests to their children, grandchildren, and now great-grandchildren over the course of many years. It is important to note that as family members receive the Non-voting Membership Interests, they will share in any income distributions from C&D.

The result of this extensive, complicated, and intricate planning is a process by which Carl and Debbie are transferring ownership but not control of their family business to the next generations. As Carl and Debbie step back from operations, they will be able to transfer the Voting Membership Interests to their children (or grandchildren) who will succeed them at the helm of the business, leaving those individuals with the fiduciary duty to act in the family’s best interest while running the business. 

As always, the strategies discussed in this blog are complex and require a significant invest to implement properly. Improper use of these strategies can be very expensive both due to the tax implications but also with the ability to properly operate a business. Do not attempt these strategies without working with experience professionals. 

Matt and Al