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

Window Closing on Discounts for Intra-family Gifts

We've been quiet for a couple of weeks, something we intend to avoid in the future, however today's blog addresses the Proposed Regulations announced yesterday by the Treasury Department and the IRS with respect to the ability to claim a discounted valuation for Intra-family gifts. If you or your clients are considering transferring partial ownership of a family business on to children it may be beneficial to do so sooner, rather than later.

In previous blogs we discussed the strategy of using a Family Limited Partnership or Family L.L.C. to transfer interests in either family owned businesses or other types of assets, such as real estate, to children while allowing parents to retaining control of the entity during their lifetime. A major benefit of such transfers is the ability of the parent to claim a significant discount in the valuation of the transferred assets for the purposes of Gift Tax liability. On Tuesday August 2, 2016, the Treasury Department and the Internal Revenue Service announced Proposed Regulations that address this strategy and, if put into effect as written, will significantly reduce the ability of family business owners to take advantage of this strategy.

Under current regulations, it is possible for a parent to transfer interests in a family business to the other family members while retaining operational control of those businesses. The transferred interest does not contain voting rights and specifically indicates that the family member does not have the right to sell or otherwise alienate the interest. The lack of control over the operation of the business and inability to sell the interest reduces the value of the interest and allows for a discount in the value for purposes of gifting. This discount allows the client to transfer a greater value of assets to their loved ones at a lesser cost for gift tax purposes. When it has challenged transfers of this nature in court, the IRS has consistently argued against the size of the discounts. 

The Proposed Regulations generally provide that if a parent transfers an interest in a corporation that the parent controls to any other member of the family any "applicable restriction" shall be disregarded in valuing the transferred interest. The Internal Revenue Code defines “applicable restriction” as “any restriction that effectively limits the ability of the entity to liquidate, but which, after the transfer, either in whole or in part, will lapse or may be removed by the transferor or any member of the transferor’s family, either alone or collectively.” In plain English, the Proposed Regulation provides that if a parent transfers an interest in a family owned business to their child with the restriction that the child cannot alienate their interest in the business without the parent’s permission, that restriction is ignored for purposes of valuing the transferred interest. The removal of such restrictions from consideration in valuing the interests transferred will have a significant impact on the strategy of transferring interests in family owned businesses.

While the Proposed Regulations will significantly limit the valuation discount available to clients when making transfers of family-owned businesses, it does not entirely eliminate the benefits of such transfers. Until these regulations go into effect and are tested in real-world situations, it is unclear what level of discount the IRS will argue is reasonable with respect to other restrictions placed on interests transferred to children that do not relate to the child's ability to alienate the interest. Additionally the strategy of transferring minority or non-controlling interests in family businesses to children is still very beneficial, especially when those business interests contain assets that are likely to appreciate significantly in coming years. Such transfers are also still relevant in the context of succession planning for family businesses, as an equity interest in the family business is often necessary to ensure that future generations are fully invested in the operation of that business before they are given control of the company.

There is still an opportunity to take advantage of the valuation discount, but the window for doing so may be closing. Before these Proposed Regulations can go into effect they must first go through a 90-day public comment period, after which there may be changes, but even if there are no changes, portions of the regulations will not take effect until 30 days after the government issues a final version of the regulations.

The strategy of using a Family L.L.C. to obtain a discount in the valuation of assets transferred to children is a complex legal strategy that business owners should not attempt without consulting an attorney and accountant who are familiar with the process. Avoiding significant issues with the IRS in implementing this strategy requires sound valuations of the business and working with advisors familiar with the process of justifying such valuations. If you have additional questions, concerns, or interest in discussing whether this strategy may be appropriate for your circumstances, or the circumstances of one of your clients, we encourage you to contact us quickly, as the time available to take advantage of this strategy is very limited.

Alan and Matt

Using an LLC in your Estate Plan

While trusts of various kinds are important in estate planning, other entities, standing alone or used in conjunction with trusts, are useful in achieving estate planning goals. One such entity is a Limited Liability Company.

A Limited Liability Company (LLC) is a business entity often used instead of a corporation or partnership. It is a hybrid entity that provides the benefit of limiting liability against personal assets for its owners (just like a corporation) as well as the benefits of being taxed for income tax purposes like a partnership.

By establishing an LLC with a "voting interest" component (typically 1%) and a "non-voting interest" component (99%) clients can give away assets, while maintaining substantial control over the administration of those asset during the client’s lifetime. The client (typically a parent) can keep the voting interest and give part or all of the nonvoting interest to children, grandchildren, or other beneficiaries. By retaining the voting interest, the parent maintains control of the operation of the LLC and the assets owned by it, yet is giving away value and future appreciation on the gift portion to others. I liken this to the client sitting in the front seat driving the car and his beneficiaries sitting in the backseat coming along for the ride. By giving away the majority of the non-voting interest during their lifetime (ideally using their Lifetime Gift Tax Exemption), the client reduces the total value of their estate and any potential Estate Tax liability. Another benefit of using the LLC strategy is a potential reduction in the client’s annual income taxes. If the LLC earns annual income, the LLC allocates that income in proportion to the owned interests. Thus instead of the client paying taxes on all of the income, the beneficiaries pay (presumably in a lower bracket) the tax on their share of the income.

The client can transfer any type of asset to the LLC, including cash. Transferring closely held businesses and real estate to an LLC provides additional planning opportunities:

1.    If structured properly, the LLC can take advantage of valuation discounts for minority interests and lack of control. In addition, assets such as real estate and closely held businesses tend to have a range of value rather than a specific value, and the client can take advantage of the lower range of the value in order to make more gifts under the Annual Gift Tax Exclusion or the Lifetime Exemption. It is important, if an LLC desires to take advantage of these valuation discounts, that a valuation expert determines the assets themselves and the valuation discount.

2.   Using an LLC offers the ability for business succession planning and provides a platform for determining who will operate entities in the future.

3.    An LLC provides protection against creditors, both for the client and the succeeding generations.

4.    The LLC offers an ability to plan for estate liquidity by purchasing life insurance in the LLC on the life of the client to eventually purchase the un-gifted client interests at the client's death or simply to replace the "client's wisdom and experience" with cash at death.

Clients can transfer an LLC interest as a gift to an individual or as a gift to a trust set up for the benefit of the individual. This is especially beneficial if a beneficiary has creditor issues, marital issues that may result in divorce, or spendthrift issues and an inability to control spending habits. In addition, gifting an LLC interest to a trust for the benefit of a minor allows for protection well beyond the minor's 18th birthday. The trust can specifically provide for income and principal distributions for the benefit of the minor with the eventual distribution at stated ages or certain events.

While the concept and use of an LLC for estate planning purposes is well-established, it is subject to IRS attack if not properly valued or if not appropriately established:

1.    The LLC must comply with all state law rules for establishing such an entity and must continue to maintain all the required documents. The LLC must be managed and operated as a separate entity and not just another "pocket of the client".

2.    With an LLC, the concept of "if some is good, more is better" is not necessarily a good idea. Clients should not transfer all of their assets to an LLC, because the IRS will argue that the client needs the LLC to maintain their lifestyle and therefore under estate tax rules the assets are deemed to be part of the client’s estate. Based on case law it is an especially bad idea to place the client's residence in the LLC.

3.    When making gifts, valuations are necessary to substantiate the amount of the gift. To the extent the gift is in excess of the $13,000 annual exclusion, a Gift Tax Return is required.

4.    Certain specific provisions must be included in the LLC to protect its integrity, ensure that gifts will be recognized, and allow gifts to be claimed as a "present gift" using the Annual Exclusion.

Use of an LLC for estate planning purposes is an excellent strategy in the right situation. It may be especially appropriate for any clients still interested in making large gifts before December 31, 2012 to take advantage of the $5,120,000.00 lifetime exemption, which may be going away in 2013. However, before taking any steps to include an LLC in an estate plan, clients should carefully review all tax and legal requirements with qualified professionals.