Colorado Estate Planning & Trust Attorney Blog

Divorce Estate Planning Opportunity

2007-03-10T18:59:00.000-08:00

Adding flexibility to estate and tax plans is crucial given the uncertainties in our current estate tax laws and the uncertainties of our market and individual client situations. Creative estate planning attorneys have found a great number of ways to add this type of flexibility given specific client facts and goals. Private Letter Ruling 12572406 provides an example of one way that divorcing spouses can add flexibility to their tax and estate plans using property settlement agreements.

The facts in this particular letter ruling are as follows: Husband and wife signed a property settlement agreement pursuant to their divorce proceeding. The husband was the CEO of a publicly traded company and he owned approximately 24% of the company stock at the time that they entered into the agreement.

The agreement provided that the husband would include a provision in his will for his wife to receive a portion of the shares equal to 24% of the company stock held by the husband. The divorce court approved the property settlement agreement.

An undisclosed number of years later, the husband and wife renegotiated the property settlement agreement to provide that the husband would currently turn over one half of the amount of stock to his wife that the husband had agreed to, with the other one half to be turned over to the wife upon the husband’s demise.

The IRS ruled that this accelerated lifetime payment by the husband to the wife was (1) not taxable income to the husband or wife and (2) not a taxable gift from the husband to the wife.

The IRS reasoned that the accelerated lifetime payment by the husband to the wife was not taxable income to the husband or wife because the transfer was “related to the cessation of marriage.” The IRS reached this conclusion even though it appears that the modification of the property settlement agreement occurred “years after the divorce.”

The IRS reasoned that the accelerated lifetime payment by the husband to the wife was not a taxable gift from the husband to the wife based on the same reasoning.

As in this private letter ruling, taxpayers can add flexibility to their tax and estate plans by entering into financial-motivated property settlement agreements. This type of arrangement could prove invaluable in reducing estate tax liabilities where one ex-spouse’s assets are expected to increase substantially over time prior to that spouses demise.

If the assets do increase in value or the spouse (say as CEO of a company whose stock is subject to the agreement, assuming that no insider trading rules are violated or that the stock is for a privately held company) expects that the asset is about to appreciate substantially in excess of any estate tax exclusion available for the owner, the owner would have the option of making a tax-free lifetime transfer to the ex-spouse (apparently) any time before the death of either spouse.

Given the right facts, this estate tax freeze technique could be much more powerful than other more common estate tax freeze techniques.

Estate Plan Pitfall: Automatic Allocation of GST Exemption

2007-03-04T09:19:00.000-08:00

Many estate planning clients put a lot of time, energy and money into structuring their estate plans in light of the uncertainties in our estate tax laws. These more complicated tax-motivated estate plans can produce additional tax problems for the unwary estate planning attorney and client.

Private Letter Ruling 200709010 addresses the situation where an estate planning client creates an estate plan intending to effectively use their $1 million generation skipping transfer tax exemption, but the client continues to make post-December 31, 2000 transfers to their irrevocable trust which benefits their grandchildren or other “skip persons.”

As the private letter ruling indicates, the transfers to such irrevocable trust are “indirect transfers” that automatically use up the estate planning client’s unused generation skipping transfer tax exclusion amount if the estate planning client does not elect out of the automatic allocation. This election has to be made by the client by filing an “election out” statement to their Form 709 Federal Gift Tax Return for the year in which the gift is completed.

If the estate planning client does not make this automatic allocation election, then the estate planning client may not have a sufficiently large generation skipping transfer tax exemption upon his or her demise, as may be required by the estate planning client’s estate planning documents.

Luckily the IRS, as is the case in this private letter ruling, is generally willing to allow estate planning clients to make this election by submitting a private letter ruling request prior to the IRS discovering the issue.

Clients who intend to take full advantage of their generation skipping transfer tax exemption should contact their estate planning attorney to review their estate plan in light of this issue.

Income Beneficiaries of Older Trusts Should Consider Making Unitrust Election

2007-02-03T16:22:00.000-08:00

In a recent private letter ruling (15529705), the IRS has confirmed that a generation skipping transfer (GST) tax grandfathered trust will not lose its exemption if a court modifies the trust to permit the income beneficiary to receive unitrust payments.

The facts for the ruling are as follows. Taxpayer creates a testamentary trust (a trust in his/her will) that specifies that when the taxpayer dies the trust will pay income to taxpayer’s surviving spouse and upon spouse’s demise the trust will pay all income to the taxpayer’s children and, upon the childrens’ demise, to the childrens’ descendants.

The taxpayer and the taxpayer’s spouse die. The taxpayer’s children now want to petition the court to permit the trust to pay the children unitrust payments, rather than fixed payments. Unitrust payments are payments equal to a percentage of the trust assets (typically between 2% and 5%).

Absent a unitrust payout the trust would continue to pay all income to the trust beneficiaries. Income typically only refers to interest payments and dividends – not capital gains or gains associated with sell of investments. If there is no unitrust provision, the current income beneficiary (as opposed to future income beneficiaries, such as the taxpayer’s children’s descendants in this case) may prefer that the trustee invest primarily in income producing assets.

The problem with this is that investing a substantial portion of the trust assets in interest/dividend bearing investments will, as the argument goes, diminish the value of the trust assets over time because investments which have typically under performed capital gain assets, such as stocks.
In other words, the trustee may be able to maximize the value of the trust assets if he or she can invest a larger portion of the trust assets in stocks, grow the trust assets for the future beneficiaries.

Unitrust payments eliminate this conflict of interest between current income beneficiaries (such as the taxpayer’s children) and the future income beneficiaries (such as the taxpayer’s children’s descendants).

If the trust document does not provide for unitrust payments (or provide the trustee with the discretion to opt to start paying unitrust payments), the current income beneficiary (with the consent of the future income beneficiaries) must ask a court to alter the trust so that such payments can be made. This type of court intervention is very common, as the unitrust concept is relatively new compared to the age of a majority of trusts that exist today.

The problem addressed in this letter ruling arises when a trust was created before September 1985, the date that the generation skipping transfer (GST) tax was enacted. The GST tax only impacts trusts created after this date. Trusts created (and that were irrevocable) before this date are grandfathered or exempt from the GST tax.

So the question answered by this letter ruling is whether a GST tax exempt trust would lose its exemption if the court changed the trust to provide for unitrust payments. The IRS said that it would not.

Given this ruling, beneficiaries of older trusts should contact their estate planning attorneys to review whether they should modify their trusts to provide for unitrust payments.

GST Tax May Apply to Certain Transfers from Irrevocable Trusts

2006-12-14T11:37:00.000-08:00

Taxpayers who created certain irrevocable trusts prior to 1985 may want to reconsider passing those assets to their grandchildren.

Last month the IRS convinced the US Tax Court to rule that these pre-1986 trusts cannot be used to pass wealth from the grandparent to grandchild without subjecting the transfer to the generation skipping transfer tax (GST tax) – which is currently a 46% tax.

This is only applicable to trusts that provide a grandparent to direct that the assets pass to the grandchildren via a general power of appointment. A general power is the power to give the property to anyone, including oneself (compare that to a limited power, which can be granted to anyone but oneself).

This US Tax Court ruling is in direct contradiction to the law in North Dakota, South Dakota, Nebraska, Minnesota, Iowa, Missouri, Arkansas, California, Nevada, Arizona, Idaho, Oregon, Washington, and Montana. So if you live in Wisconsin, Illinois or Indiana; you have one of these trusts; and you intend to exercise your power of appointment in favor of your grandchildren, you should review the trust with your estate planner.

Deducting Investment Advisor Fees Paid by Trusts

2006-10-20T19:01:00.000-07:00

There has been a split in the various circuit courts of appeals regarding the deductibility of investment advisor fees paid by trusts. The Second Circuit Court of Appeals, in William Rudkin Testamentary Trust v. Commissioner of Internal Revenue, recently held that investment advisor fees paid by trusts are limited by the Section 67 two percent floor imposed on miscellaneous Schedule A itemized deductions. Previously the Sixth Circuit Court of Appeals ruled that the two percent floor did not apply to investment advisor fees paid by trusts and the Federal Circuit and the Fourth Circuit Courts of Appeals ruled that the two percent floor did apply to investment advisor fees paid by trusts. The result: the federal deduction for investment advisor fees paid by trusts is not subject to the two percent floor in Michigan, Kentucky, Ohio, or Tennessee, but they are in New York, Vermont, Connecticut, Virginia, West Virginia, Maryland, North Carolina, South Carolina, and the District of Columbia.

Selling a Business: The Charitable Way

2006-10-03T09:15:00.000-07:00

As more baby boomers begin to retire and sell their businesses, there will be an increasing demand for alternative exit strategies that achieve the owner's personal financial goals. This article discusses one structure for selling a business that establishes a stable income stream and a charitable deduction for the owner.

For purposes of discussion, assume that our baby boomers have owned and operated a moderately successful dry cleaning business for over twenty years and now they are looking to sell the business. Our baby boomers do not think that the business can remain an ongoing enterprise because (1) the business revenues would not support the debt payments someone would have to pay on a loan to purchase the business and (2) there is now a new dry cleaner business in the same shopping complex that has a better and more accessible location.

Our baby boomer's dry cleaning business owns two assets, namely the business real estate and the laundry equipment. It has one full time employee who has been with the company since it started, who is also considering retirement. The dry cleaning business has been operated as a Subchapter S corporation since its inception.

Our baby boomer's goals are to: sell the business assets for as much as possible to provide for their retirement years (i.e., retain as much as possible on an after tax basis) and set aside a portion of that money to support breast cancer research (their daughter lost her life to breast cancer at an early age).

We will discuss two concepts for this example: the Subchapter S corporation and the Charitable Remainder Unitrust.

The S corporation is a flow through entity in that gain or loss is calculated at the corporate level, the gain or loss flows through to the owner's individual owners, and the owner's account for their share of the S corporation gain or loss on their own federal income tax returns. Unlike a regular C corporation, taxes are not imposed at the corporate and shareholder level; with S corporations taxes are only imposed at the shareholder level.

The charitable remainder unitrust (CRUT) is an irrevocable trust. The trust qualifies for tax exempt status. The trust splits the interest in the trust property between the income beneficiary and the remainder beneficiary. The business owners are the income beneficiary and they are paid a set amount (generally between 5% and 50% of the trust assets) on set intervals (usually monthly, quarterly or annually). The owners can select whether they want to receive their income stream for one or both of their lives.

The breast cancer charity, as selected by the business owners and named in the trust, is the remainder beneficiary and they will receive the trust assets outright upon the owner's demise.

The typical CRUT entitles the creator to a charitable deduction, in the year that the CRUT was created, equal to the present value of the remainder that will pass to the charity in the future. The CRUT creator can then use this charitable deduction to reduce their federal income tax obligations (there are some limitations, which may cause the creator to carry over part of the charitable deduction to offset taxes in future tax years).

With these two concepts explained, you might be thinking that our baby boomers would just transfer ownership of their S corporation to a CRUT. Unfortunately S corporations are not able to hold S corporation stock without compromising the corporation's S status. This does not prevent our baby boomers from having the business contribute the business assets to the CRUT.

But our boomers are tax savvy (or they have savvy tax advisors), so they know that there are a number of other limitations that may prevent them from achieving their goals. They consider the following three factors:

First, they know that the charitable deduction that they will receive will be severely limited if they contribute the laundry equipment to the CRUT, because the deduction for this type of contribution is limited to the businesses taxable basis in the assets (which is the purchase price less the depreciation deductions that have been taken on the property).

Second, our boomers also know that they cannot contribute substantially all of the business assets to the CRUT or they will not be entitled to the charitable deduction.

Third, our boomers understand that the CRUT will lose its tax exempt status if it receives any unrelated business income. Therefore if the boomer's CRUT rents the property until it is sold, the lease payments would cause the CRUT to lose its exempt status.

Fourth, our boomers understand that there are self-dealing rules which may prevent them from serving as trustee of any CRUT if they continue to use or benefit from the CRUT property.

So here is what our boomers decide to do: First, they have their employee enter into a lease to lease the business real estate from the laundry business. The lease is for a fixed payment and terminate upon the sale of the property. This will prevent any rental payments from passing to the CRUT, causing the CRUT to lose its tax exempt status. Second, they establish a CRUT with their attorney as the trustee (to avoid the self dealing rules) and they transfer ownership of the real property (but not the laundry equipment, to avoid the "substantially all" of the business assets charitable deduction limitation) and a small amount of cash to the CRUT (the cash is used to pay the employee the lease payments -- payment in lieu of a severance payment). Third, they have the business sell the laundry equipment and the CRUT sell the business real estate to third parties.

The result is that the S corporation receives the proceeds for the sale of the laundry equipment, the CRUT receives the proceeds from the sale of the business real estate (the CRUT does not have to pay tax on the gain realized on the sale due to its tax exempt status), and the S corporation is entitled to a charitable deduction for the present value of the amount contributed to the CRUT. The income and charitable deduction flow through the S corporation to out boomer's personal tax return.

The CRUT is now able to invest the proceeds in a diversified portfolio (that is managed by their own financial planner) that will (hopefully) provide a lifetime income stream sufficient to provide for our boomer's retirement years. The CRUT will continue to make regular payments to the S corporation which will pass through to our boomers – which reduces the S corporation to being merely an entity that the boomers pass their investment income through and that provides some asset protection against future creditor's claims. When our boomers eventually pass away, the charity that the boomers selected will receive the CRUT assets.

While the mechanics of this type of transaction can be tricky in the first couple of years, the complexity is greatly reduced in subsequent years. Best of all, the boomers were able to realize most if not all of their financial goals.

Asset Protection: Spendthrift Trusts

2006-10-02T12:30:00.000-07:00

Trusts can be structured to provide superior asset protection against creditor claims.

Spendthrift trust provisions prevent creditors of the trust beneficiary from reaching the trust assets as long as the assets are held in the trust. This type of provision may or may not be upheld, depending on who created the trust and what the other provisions of the trust are.

Generally trusts can be divided into to categories based on who established the trust: namely, self-settled trusts and non-self-settled trusts. Self-settled spendthrift trusts are irrevocable trusts that contain a spendthrift provision that are created by one person for their own benefit. There are very few states that extend asset protection to self settled trusts (Colorado does extend protection to self-settled trusts). The thought is that it violates public policy for an individual to be able to place his or her assets in trust for his or herself and thereby exempt those assets from their own creditors.

On the other hand non-self-settled spendthrift trusts are irrevocable trusts created by someone other than the trust beneficiary for the benefit of the trust beneficiary. Almost all jurisdictions provide full protection to assets held in non-self-settled spendthrift trusts.

There are a number of trust provisions that may compromise the protections provided by self-settled spendthrift trusts (in the states that afford asset protection to these trusts) and for non-self-settled spendthrift trusts. The general rule is that if the trust beneficiary has the power to get at the trust assets, then the trust beneficiaries creditors have the power to get at the trust assets.

Thus, a valid non-self-settled spendthrift trust may be compromised if the trust beneficiary is also the trustee and the trustee is the party that has the power to make trust distributions. In this case the trust beneficiary has the ability to get at the trust assets via their serving as trustee. By not being the trustee, individuals can create sprinkle/spray, discretionary, and shifting/suspension trusts to ensure that the trust beneficiary, and his or her creditors, cannot get at the trust assets.

Sprinkle or spray trusts provide the trustee (who, presumably, is not the trust beneficiary) with the ability allocate trust distributions amongst a class of beneficiaries. For example, the spray trust beneficiary may opt to make a distribution to one trust beneficiary and not to make distributions to another trust beneficiary.

Discretionary trusts provide the trustee (again, who is presumably not the trust beneficiary) with the ability to decide if any trust distributions are to be made to any trust beneficiary. For example, a discretionary trust may provide that the trustee may or may not make distributions to any one or more beneficiaries. If that trust beneficiary turns out to have creditor issues, the trustee can simply opt not to make distributions to that trust beneficiary.

Shifting trusts provide that upon the occurrence or nonoccurrence of a certain event or lapse or passing of time the right to trust distributions inure to different trust beneficiaries. For example, a shifting trust may provide that a trust beneficiaries distributions will go to a second trust beneficiary so long as the first trust beneficiary is married and has not executed a valid pre/post marital agreement.

Similarly suspension trusts provide that upon the occurrence or nonoccurrence of a certain event or lapse or passing of time trust distributions halt. For example, the suspension trust may provide that trust distributions will cease immediately if a civil lawsuit is filed against the trust beneficiary.

In each of these examples the idea is to put the trust assets outside of the trust beneficiaries reach, which in turn puts the trust assets outside of the trust beneficiaries creditors reach as well. Giving up control over the trust assets is the trade off for creating these types of trusts. This can be a great loss in the event that the trustee opts not to make distributions as the person who created the trust would have liked.

There are a number of ways to deal with this loss of control issue, such as using co-trustees, independent trustees, and/or trust protectors. A co-trustee is one individual or institution that shares the power as trustee with a second (or more) individual or institution. The idea is that, as spelled out in the trust and/or in state law, one co-trustee is not authorized to act without the consent of the other co-trustee or co-trustees.

The independent trustee is a person or institution spelled out in the trust document that is given certain limited powers or functions. For example, the independent trustee's powers may be limited to vetoing any distributions proposed by the regular trustee.

The trust protector has an even more limited power or function in that their only role is to fire and hire trustees should they so choose. In this case the trust protector can fire a trustee prior to the trustee making distributions to a trust beneficiary who has creditor issues.

In many cases naming family members to serve as the co-trustee, independent trustee, and/or the trust protector helps ensure that the trust creator's wishes will be carried out. Of course, naming these individuals creates other problems, such as what happens when the named party cannot or will not serve as the person who created the trust intended?

In these cases trusts generally provide that the trust beneficiaries can name subsequent parties (other than themselves) or that the named party has to designate a successor upon taking over the duties outlined in the trust.

If this isn't complicated enough, a number of tax factors that may preclude certain individuals from serving in these capacities or having the power to name or replace these individuals. The trust is an effective asset protection vehicle and, in most cases, these complexities are manageable.

Employment Taxes, LLCs, and Asset Protection

2006-09-30T12:26:00.000-07:00

The Limited Liability Company (LLC) is a flexible legal entity that allows taxpayers to elect how they want to account for their state and federal tax liabilities. Unfortunately many taxpayers do not understand issues surrounding whether they should use the LLC and in what form to achieve their tax and asset protection goals. This article will briefly discuss one issue in this analysis, namely employment or payroll tax liabilities.

The IRS regards a single member LLC (i.e, a LLC owned by one individual or entity) as not being a separate taxable entity distinct from the owner, unless the owner opts to have the LLC treated as a corporation for tax purposes. As a disregarded entity the sole owner of the LLC can simply account for the profits and losses of the LLC on the taxpayer's personal tax returns (on the taxpayer's Schedule C).

It is the sole owner of a single member LLC that is personally responsible for employment taxes related to the LLC's employees. The IRS has the ability to impose a lien or levy or seize the sole owner's personal assets if the LLC's employment taxes are not paid, but the IRS cannot levy or seize the LLC's assets to satisfy this type of liability. This is true regardless of whether the sole owner elected to use his or her name and social security number for the LLC tax reporting or if the sole owner elected to use the LLC name and a separate taxpayer identification number for the LLC tax reporting.

The result for the multi-member LLC (i.e., a LLC owned by more than one individual or entity) may be different depending on the applicable state law. If the state law provides that members of LLC's are not liable for LLC debts then the IRS's recourse with regard to the LLC's unpaid employment taxes lies with the LLC and not with the member owner.

For the most part businesses are started with the aim of making a profit. The thought of incurring a loss is often not planned for in the business formation or start up process. As such, this type of employment tax issue typically does not arise until after the LLC is facing financial difficulties. In these cases the LLC may be unable to meet its state and federal employment tax obligations. If the LLC employment taxes are not timely remitted, the question is whether the state and federal government may collect the employment tax liability from the LLC or the LLC owner or owners.

This issue is most important for LLC's that employ a number of employees and/or that employ highly paid service employees. In these cases the LLC owners with little or no assets and no expectation of having significant assets or whose only significant assets are those used in their trade or business (e.g., a mechanic whose only assets are his or her tools) may prefer that the IRS pursue him or her individually for the LLC's employment tax obligations. On the other hand, the financially well off LLC owner may prefer that the IRS only be able to pursue the LLC for the LLC's employment tax liabilities.

Given this dichotomy it may make sense for single member LLC owners to convert their single member LLCs into multi-member LLCs or to elect to have the LLC be taxed as a corporation once the LLC has achieved some measure of financial success. Of course, the business owner must also consider other tax factors, such as the trust fund recovery penalty and the role of self-employment taxes.

Asset Protection Steps Cannot Include Fraudulent Trasnfers

2006-09-27T08:00:00.000-07:00

Asset protection planning is best done in advance of any claims or the person becoming insolvent. Planning opportunities after that point may constitute violations of the state and/or federal fraudulent transfer act. Leverage Leasing Co. v. Smith provides a good example of this concept.

Leverage Leasing Co. refinanced a $200,000 loan to Kenneth and Carol Smith. Prior to this refinancing loan the Smith's personal residence was titled in Carol's name only. At the request of Leverage Leasing Co. Carol quitclaimed or transferred her interest into a joint tenancy with her husband. The Smiths then pledged their interest in their home as collateral for Leverage Leasing Co.'s loan. A couple of years later Kenneth transferred his ownership in the residence to Carol. Kenneth did not get anything in return for this transfer.

It appears that the Smiths probably defaulted on their loan with Leverage Leasing Co. or Leverage Leasing Co. found out about the transfer. Either way, Leverage Leasing Co. brought suit to ask the court to set aside the transfer from Kenneth to Carol as a fraudulent transfer.

The trial court found that this transfer from Kenneth to Carol was not a fraudulent transfer. On appeal, the Colorado Court of Appeals disagreed.

Creditors have the option of using the federal or state fraudulent transfer statutes. In this case Leverage Leasing Co. opted to use the Colorado Fraudulent Transfer Act. In general this Act provides that fraudulent transfers are those made without an exchange of “a reasonably equivalent value” and those made by insolvent debtors.

The transfer from Kenneth to Carol failed both of these tests in that Kenneth received nothing in return for the transfer and he made the transfer when he was insolvent.

Had Kenneth or Carol consulted with an attorney, they might have been advised to (1) make the transfer at a time when Kenneth was not insolvent and (2) to ensure that Kenneth received some quid pro quo for the transfer.

Estate Tax Valuation vs. Income Tax Valuation

2006-09-26T11:55:00.000-07:00

The question in Janis v. Commissioner is whether a taxpayer can claim that property has a low value for estate tax purposes and then turn around and claim that the property has a high value for income tax purposes. The Ninth Circuit said "no," but the answer could have been different under slightly different facts.

Conrad and Maria Janis inherited a gallery of artwork from Conrad’s father. The artwork consisted of over 500 pieces of art by famous artists, such as Piet Mondrian, Jean Arp, and Grandma Moses. Several years prior to his demise Conrad’s father had transferred the gallery of artwork to a trust for the benefit of himself and his two sons – one of whom is Conrad. The father and the two sons were named as the trustee and the sons were named as the executors of their father’s last will and testament.

After the father’s demise, Conrad and his brother, as executors and trustees of the trust, hired Sotheby’s to value the art collection. Sotheby’s valued the collection without applying any discounts. Conrad filed fiduciary trust tax returns listing the artwork at a discounted value of $12 million. This discounted value caused the art gallery to report a net operating loss each year, minimizing the amount of taxes it owed.

The IRS Art Advisory Panel determined that the undiscounted value of the collection was $36 million and the discounted value was $14 million.

Conrad, as co-executor and trustee, consented to the IRS’s adjustment and to its discounted valuation of the estate’s artwork. Conrad signed a Form 890 Waiver of Restrictions on Assessment and Collection of Deficiency and Acceptance of Overassessment. The IRS time period for assessing the estate tax return had already expired before this time.

Immediately after signing the Form 890 Conrad filed amended fiduciary income tax returns for the trust claiming the undiscounted value of $36 million for the artwork. This increased valuation created an even larger net operating loss for the gallery.

The trust was terminated shortly thereafter and its assets were distributed to a partnership created by Conrad and his brother. The net operating losses for the trust were rolled over into the partnership. These losses allowed Conrad and his brother to reduce their federal income tax on their personal tax returns.

The IRS reviewed the brothers’ individual and trust tax returns and determined that the brothers should have used the $14 million discounted value that was calculated by the IRS for their father’s estate tax liability on the trust tax returns, which would limit the net operating losses that flowed through to the brothers’ personal tax returns.

The court applied the "duty of consistency" in holding that the brothers must use the estate tax value for the artwork for the trust and their personal tax returns. The "duty of consistency" only applies where (1) a taxpayer has made a representation, (2) the Commissioner has relied on the representation, and (3) the taxpayer has attempted to recharacterize the representation after the statute of limitations has run in such a way as to harm the Commissioner.

The taxpayer argued that if any "representation" was made it was made by the estate, not by Conrad. The court did not buy this argument because Conrad was the beneficiary and co-executor of the estate. Thus, the idea is that Conrad was an interested party with regard to the valuation. It would have been interesting if Conrad had not been the co-executor or trustee, but merely a trust beneficiary. In that case it would have been even harder for the court to argue that Conrad "represented" that the value of the artwork on his father’s estate tax return was $14 million and not $36 million.

While this case involved estate tax discounts associated with artwork, the same situation often arises with regard to estate tax discounts for real estate or ownership of small business interests. In each of these cases the game is to try to claim a lower valuation for estate tax purposes and a higher value when the property is later sold for federal income tax purposes. In many cases taxpayers plan on holding the assets for a period of time following the death of the owner so that they can claim that the disparity in the value of the asset for estate tax and income tax purposes resulted from appreciation in the assets that occurred after the owner’s demise.

Of course what beneficiaries are giving up in these scenarios is the stepped up tax basis in the inherited property, which results in a higher federal income tax liability upon the subsequent sale of the property. In most cases it is more beneficial for taxpayers to take the lower estate tax valuation regardless of the lower tax basis and ride out the waiting period because the federal estate tax rates are higher than the federal income tax rates. This is especially true given that the full step up in tax basis is set to be eliminated in coming years.

Perhaps the lesson to be taken from this case is that if the taxpayer is faced with this dilemma, they should remove themselves from the estate administration process so that they are not the taxpayer who is making the "representation" as to the lower estate tax value. Then once the time for assessing additional taxes has expired for the estate tax, the taxpayer can make a "representation" using the higher value for federal income tax purposes.

Rental Real Estate & the Passive Activity Rules

2006-09-24T20:46:00.000-07:00

More and more Americans are investing in real estate due to the appreciation of real estate markets in the past few decades. The real estate tax rules are complex. This complexity causes a number of taxpayers to not realize the full tax benefits associated with their real estate investments. This article will briefly address the passive activity limitation rules as they relate to rental real estate investments and it will point out some basic planning opportunities.

In general the passive activity limitation rules prevent taxpayers from using losses from passive activities to offset income from active activities. Losses from unused passive activities can be carried forward to future tax years or deducted in full upon the taxable disposition of the loss asset.

Active activities include income from a trade or business, wages, and interest and dividends. Passive activities include trade and businesses in which the taxpayer does not materially participate and rental real estate activities. The passive activity rules do not apply to rental activities performed by a real estate professional and certain short term rental activities.

With this said, there is an exception that allows a taxpayer to use up to $25,000 of passive rental real estate losses to offset active income. To qualify for this $25,000 exception the taxpayer must be an active participant, which is different than the more stringent "material participant" requirement (discussed below), and the taxpayer must have recognized less than $100,000 from all sources during the year (technically it is $100,000 of Adjusted Gross Income (AGI), which is income less certain above the line deductions, less certain types of income). The $25,000 exception is phased out for taxpayers whose AGI is over the $100,000 threshold and it is completely phased out when AGI reaches $150,000.

To be an active participant one only has to participate in the activities associated with the property, such as making management decisions, approving new tenants, approving repairs or writing checks. For most weekend or small real estate investors this exception will allow them to use all of their passive real estate losses to offset some of their active income. If the taxpayer's AGI is over this amount, then their passive losses from rental real estate activities may be limited if they do not "materially participate" in the rental activity.

Taxpayers are deemed to have materially participated in a real estate activity if:

They participated in the activity for more than 500 hours during the year,
Their participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
They participated in the activity for more than 100 hours during the tax year, and they participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
The activity is a significant participation activity, and they participated in all significant participation activities for more than 500 hours (A significant participation activity is any trade or business activity in which a taxpayer participated for more than 100 hours during the year and in which they did not materially participate under any of the material participation tests, other than this test).
They materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
The activity is a personal service activity in which they materially participated for any 3 (whether or not consecutive) preceding tax years (An activity is a personal service activity if it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor).
Based on all the facts and circumstances, they participated in the activity on a regular, continuous, and substantial basis during the year.

Participation in an activity includes almost any activity, including the taxpayers spouses efforts. It does not include efforts that the taxpayer expends as an investor or a limited partner in the activity.

Taxpayers have structured their real estate investments in a number of different ways to achieve their desired tax results, especially where real estate investments that are intended to be held for rental purposes are expected to generate losses in excess of $25,000 for many years and/or the taxpayer's AGI is too much to qualify for the $25,000 exception to the passive activity rules.

The trick to understanding and planning for these rules is determining whether the taxpayer has or expects to have other passive income or losses. If the taxpayer has other passive income and a passive loss from the rental investment, the taxpayer may want the passive loss from the rental activities to remain passive. That way the taxpayer can use the rental loss to offset the other passive income. On the other hand, if the taxpayer has only passive losses the taxpayer may want to consider other alternatives for their rental real estate losses.

This is where transferring ownership of the rental property to a Subchapter S corporation and entering into a lease back arrangement might be helpful. S corporations are flow through entities and they are not subject to the passive activity rules; however, the owners of the S corporation is individually subject to the passive activity rules. The S corporation is simply a legal entity, such as a regular C corporation or Limited Liability Company, for which the taxpayer has made a S corporation election with the IRS.

Generally contributing rental real estate to a S corporation results in no negative tax consequences. The taxpayer takes a tax basis in the S corporation stock equal to the amount of the rental property contributed (less certain deductions) to the S corporation and the S corporation takes a tax basis in the rental real estate equal to the taxpayers basis in the S corporation stock.

If the S corporation owns the rental real estate and the S corporation rents or leases the property back to the S corporation owner, any loss from the rental activity will be deemed to be a passive loss if the owner materially participated in the S corporation business (this is often referred to as the "self-rental rule").

So why would a taxpayer enter into this type of transaction? The answer is that if the S corporation is expected to generate other losses, those losses will flow through to the taxpayer and can be used to offset the taxpayer's other active income. If the taxpayer did not enter into this type of transaction these other S corporation losses may not have been recognized until sometime in the future, as S corporation losses can only be deducted to the extent of the taxpayer's tax basis in the S corporation - which the contribution of the rental property to the corporation increased.

Given the current speculation that there is a "real estate bubble" that is about to "burst," it is important that current rental real estate investors understand these rules and consider whether they can benefit from restructuring their rental real estate holdings.

Estate Planning in Uncertain Times

2005-12-11T07:40:00.000-08:00

With 2006 fast approaching I can't help but pause to think about our estate and gift tax regime. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 changed the rules of the game. Following the enactment of EGTRRA estate planners and tax attorneys went to work defining and clarifying how estate plans should be structured for maximum flexibility in light EGTRRA. Congress has yet to clarify the uncertainties associated with EGTRRA and, as a result, many taxpayers and tax advisors have yet to restructure their estate plans. The importance of restructuring estate plans is increasing as the sunset time EGTRRA draws near, so this post will review some of the basic uncertainties and solutions.

Perhaps the most obvious EGTRRA uncertainties involve the increasing applicable exclusion amount (AEA). The AEA has increased from $120,667 in 1977 to $3,500,000 in 2009. Much of this AEA increase has occurred over the past few years. For example, the AEA increased from $675,000 in 2000 to $2,000,000 in 2006. This large increase over such a short time will be particularly problematic for estate plans consisting of credit-shelter (or A/B) trusts with pecuniary formulas. The pecuniary formula is the mechanism in credit-shelter trusts which allocates the amount that is to go to the marital trust (for the benefit of the surviving spouse) and the family trust (for the benefit of others).

The pecuniary formula accomplishes this by: (1) allocating the surviving spouse the amount necessary to take full advantage of the unlimited marital deduction or (2) allocating the surviving family members an amount equal to the AEA. If there is no estate tax or AEA then in the former case the surviving spouse might not receive anything and in the later case the surviving family members might not receive anything. This situation will be most unfortunate for those individuals who are dependent on the decedent and who are otherwise unable to support themselves - such as surviving spouses and minor children.

This situation can be easily avoided with advance planning. For example, the estate could employ a non-formulary qualified terminal interest (QTIP) property allocation instead of a pecuniary formula. This could involve one-lung QTIP or Clayton QTIP trusts. Alternatively, the estate could cap the amount that passes to the family trust, employ a fractional marital deduction formula, or provide that the only property to pass to a credit-shelter trust would be the property disclaimed by the surviving spouse.

A second set of EGTRRA uncertainties involves the step-up basis changes. For those individuals who pass away after 2010 the tax basis of property from a decedent will be the lesser of the decedent's adjusted basis in the property or the fair market value of the property on the decedent's date of death. With numerous caveats, executors will be able to increase the basis of property by $1,300,000 and an additional $3,000,000 for property passing to a surviving spouse (either outright or in a QTIP arrangement). As discussed above, many estate plans employ a pecuniary formula which could result in the surviving spouse getting little or nothing from the decedent's estate. In those cases the surviving family or other beneficiaries would not be entitled to the additional basis step-up. Using a non-formulary allocation would help ensure that this extra basis step-up is not wasted.

In addition, one of the caveats for the extra basis step-up is that the step-up is not available for property over which the descendent holds a power of appointment. Thus, property held in power of appointment trusts might not qualify for this limited basis increase; whereas, property held in QTIP trusts might qualify for the limited basis increase.

A third set of EGTRRA uncertainties involves the repeal of the state death tax credit. Many states have not decoupled from the federal estate tax system, so those states impose no state estate taxes. On the other hand, a number of states have decoupled and, thus, impose state estate taxes. This raises a number of planning opportunities for locating assets in different states and it also presents a number of obstacles for trusts which employ pecuniary formulas that are tied to the federal estate tax.

These uncertainties have made it more important to consider other estate planning structures, such as: transferring high income or appreciation property to grantor retained annuity trusts, installment sales to defective grantor trusts, transferring property to charitable lead annuity trusts where the remainder interest has only a nominal value, and making inter-family loans and gifts.

It is probably safe to say that most estate plans have not been updated in light of these uncertainties. These are a few of the considerations that taxpayers and estate planners will have to grapple with in the coming years -- regardless of whether the estate tax is repealed or if the AEA is increased. It ought to be an interesting couple of years.

Entrepreneur Rollover Stock Purchase Plans

2005-11-26T17:52:00.000-08:00

Financing a business start-up can be a challenge. Most traditional lenders require that a business be operational for at least a year before they will provide small business loans. Moreover, venture capitalists are quick to reject most start-up proposals and if the venture capitalist is willing to fund the start-up they typically demand a significant ownership stake in the business. This has caused many entrepreneurs to look for alternative means for financing business start-ups. The entrepreneur rollover stock purchase (ERSOP) plan is one such financing alternative.

The idea behind the ERSOP is to use the entrepreneur's 401(k), IRA, or other qualified plans to fund the start-up. The ERSOP process looks something like this: establish a legal entity; get a taxpayer identification number and checking account for the entity; set up a trust and get a taxpayer identification number and a checking account for the trust; (hopefully) get a determination letter from the IRS specifying that the trust qualifies as an everyday employee stock option purchase plan (ESOP); roll the entrepreneur's retirement accounts over to the trust checking account and then to the entity checking account; the entity transfers entity stock into the trust. At that point the money is in the business checking account and the business stock is in the ESOP.

Most transactions such as this are disseminated via financial planners or via the large accounting firms; however, it appears that very few of those advisors are actively recommending the ERSOP. Instead the ERSOP seems to be being pushed by the professionals who help facilitate the transfer of franchise businesses. There are a number of businesses on the internet that claim to specalize in handling these types of transactions (see, e.g., http://www.ERSOP.com).

The main problem with the ERSOP is that it involves pulling money out of retirement accounts to fund speculative business ventures. This is a particularly risky undertaking given today's diminishing government safety net and increasing government regulation.

Other problems involve violating the self-dealing rules required for ESOPs, volunteering for additional accounting and compliance requirements and costs, limiting future business structuring by creating a near permanent stock ownership arrangement, possibly limiting the entrepreneurs' rights if the business goes under or if the entrepreneur wants to sell the business in the future, and placing the business in a vulnerable position with respect to future changes in the law.

While these drawbacks will probably preclude the use of an ERSOP in most cases, this does not mean that the ERSOP would never be appropriate. A client who is going to start a business using other risky financing methods (such as taking on credit card debt), who is fully advised of the consequences and requirements, and who is fully willing to comply with the requirements and willing to take the risk might be a viable candidate for the ERSOP. The ERSOP may be particularly attractive for clients who have significant wealth that is held outside of their retirement accounts, but it is currently illiquid.

A tight money supply and tougher underwriting mandates from Congress will probably help fuel the popularity of ERSOPs and other alternative financing arrangements in the near future. However, long-term, ERSOPs will probably be legislated out of existence or will continue to be passed up for simpler financing alternatives.

Basic Estate Administration and Taxes: Elections & Timing

2005-11-19T17:58:00.000-08:00

This post is written to remind non-tax attorneys who administer estates of a few basic tax issues that must be considered in administering estates. From a tax perspective, estate administration is all about making elections and timing distributions, income and expenses.

The first group of elections involves selecting tax years. IRC § 441 defines a taxpayers "taxable year" as the taxpayer's annual accounting period that may be a calendar year or a fiscal year. IRC § 441(e) defines a "fiscal year" as any period of 12 months ending other than in the month of December. IRC § 441(d) defines a "calendar year" as a tax year as ending in December. The second election that the estate attorney must consider is whether to elect a "short period." With some exceptions, IRC §§ 443 and 7701(a)(1),(14) provides that a "short period" is a period of less than 12 months. These elections essentially allow the estate attorney to terminate the tax year when it will result in the least amount of tax.

The second group of elections involves timing the receipt of income and flow through and allocation of tax attributes. Most states have adopted some version of the Uniform Principal and Income Act, which allows the fiduciary to elect to elect to allocate capital gains to principal. Similarly, Treas. Reg. § 1.643(a)-3(b)(1) permits the fiduciary to treat certain capital gain receipts as income for trust accounting purposes, IRC § 663(b)(2) permits the fiduciary to elect to treat certain distributions as having been made during the prior year, IRC § 645 permits the fiduciary to treat a revocable trust as part of the estate, IRC § 642(g) permits the fiduciary to elect to deduct administrative expenses, and IRC § 643(g) permits the fiduciary to treat estimated tax payers as made by beneficiaries.

There are a number of other decisions that fiduciaries must make that are not elections per say, but are in essence elections. For example, fiduciaries are often able to time distributions, to make distributions under residuary clauses versus specific distribution clauses in wills, to make in-kind distributions in lieu of specific distributions, and to allocate deductions and expenses to certain beneficiaries or property.

This combination of elections presents fiduciaries administering estates with a number of planning opportunities. For example, the fiduciary may elect a short fiscal year for the first tax year and then have the estate terminate and deductions or other tax attributes flow through to the heirs' tax returns in the second tax year. This is possible because IRC § 642(h) specifically provides that certain carryovers and excess deductions pass through to the beneficiaries if they arise in the year that the estate is terminated. This can be particularly useful where the estate is entitled to significant depreciation or depletion deductions, which would otherwise be lost because the estate had deductions in excess of income. Similarly, in other cases these flexible election rules may permit the fiduciary to time distributions so that the heirs receive distributions and expenses in years where the heirs have other offsetting tax attributes or income.

Of course, tax minimization is often not the main consideration in administering an estate. However, the rules sufficiently flexible and present the fiduciary with a number of tax minimization opportunities. Fiduciaries administering estates should not inadvertently pass up these tax minimization opportunities.