Wandry v. Commissioner: Defined Formula Transfers Provide Significant Planning Opportunity in 2012

Posted May 1, 2012 by Ashley Alderman
Categories: Business Planning, Estate Planning, Estate Tax, Gift Taxes, Tax, Wealth Planning

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 By Ashley Alderman

As we continue to emphasize, 2012 is the year to make transfers to family members.  The current gift tax exclusion amount is $5.12 million, which will be reduced to only $1 million as of January 1, 2013, unless Congress acts.  Therefore, most wealthy clients should use their $5.12  million exclusion amount to the greatest extent possible by the end of the year.

Many clients, however, may not have the liquidity to make transfers of $5.12 million in cash.   Instead, these clients may have family-held business interests or other business interests that could be transferred to younger generations.  The inherent problem with the transfer of business interests is the valuation of those interests.  If the IRS audits the gift tax return and adjusts the valuation of the business interests, the client may have created an unintended gift tax liability.  For example, suppose that the client transfers 500 membership units in the family LLC worth $5.12 million therefore fully utilizing the exclusion amount.  Following the IRS audit, however, the value of each membership unit is increased.  Now, the client has transferred 500 units worth $6 million and caused an unintended gift tax liability because the gift now exceeds the client’s available exclusion amount.

Fortunately, on March 26, 2012, the Tax Court issued an opinion in the case Wandry v. Commissioner, T.C. Memo 2012-88 that may provide significant assistance to taxpayers interested in these types of transfers.  In Wandry, the taxpayers made gifts of “a sufficient number of [membership units of the LLC] so that the fair market value of such Units for federal gift tax purposes” was a stated amount to their children and grandchildren.  In the assignment documents, the taxpayers acknowledged that the gift could be “subject to challenge by the Internal Revenue Service,” and that if a final determination was made by the IRS or a court of law that was different from the taxpayer’s appraisal, “the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person” equaled the stated amounts.   By making this defined value formula gift, the taxpayers intended to limit the value of the property transferred, thus eliminating the possibility of incurring unintended gift tax liability.   The Tax Court rejected several objections by the IRS to this type of formula gift and upheld the transfer.

Prior cases have upheld similar formula clauses when the excess value (if determined by audit or court) was transferred to a charity.  In those cases, no additional gift tax was incurred because the excess value received a charitable deduction.

Wandry, however, is the first case to address this formula transfer when a charity was not available as a back-stop.   Therefore, Wandry provides a significant planning opportunity for clients who have not fully utilized their $5.12 million exclusion amount.   Now, pursuant to Wandry,  using the example above, a client could make a gift of the number of units in the family LLC worth $5.12 million.  At the time of the gift, pursuant to an independent appraisal, the client may anticipate that this gift will equal 500 units, but if the IRS audits the return and a final determination results in the increase in the value of each unit, it might actually be that only 425 Units are transferred by the client, pursuant to the gift worth $5.12 million.   Rather than transferring a set number of membership units and adjusting the value later, Wandry allows the client to transfer a set value and adjust the number of units transferred later.

Because of the nuances in the Wandry case, a client should seek professional assistance before making these types of transfers to ensure that the transfer complies with the Tax Court’s opinion in Wandry.  If done correctly, however, the client will now be able to fully utilize his $5.12 million exclusion amount in 2012 without incurring any gift tax liability.

Facebook, Instagram and the Zuckerberg Estate Plan

Posted April 24, 2012 by David Kovsky
Categories: Estate Planning, Gift Taxes, Tax, Trusts

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 by David Kovsky

Forbes Magazine ran an article on March 7, 2012, explaining how Mark Zuckerberg transferred approximately $37 million, tax free, to unknown beneficiaries.  The author of the article speculates that the ultimate beneficiaries are Mr. Zuckerberg’s unborn children.  When this article ran, it generated a fair amount of buzz in the estate planning world.  Now, with the lightning quick acquisition of Instagram for a cool $1 billion barely in the rearview mirror, it is worth resuscitating the discussion of estate planning for young entrepreneurs.

In Mr. Zuckerberg’s case, the article points to his use of a specific type of a trust known as a Grantor Retained Annuity Trust.  Without getting into the mechanical details of this type of planning, the ultimate goal was to transfer the growth and appreciation in value of Facebook stock to the trust beneficiaries (assumed to be Generation 2), free of any wealth transfer tax, while retaining the original value in Mr. Zuckerberg’s estate.  The tremendous growth in value of Facebook over a short period of time made this an excellent vehicle for Mr. Zuckerberg.  Likewise, with historically low IRS interest rates (a Grantor Retained Annuity Trust must pay an interest factor to the Grantor), this is a great tool for more modest clients who expect a sale or strong appreciation within a defined period of years.

For young entrepreneurs who may not see an exit or rapid growth on the horizon, there are other techniques that should be considered.  To keep the planning straightforward, some of these clients may benefit from simply gifting a slice of their company to an irrevocable trust (it is important to not “over plan” young clients, so using a small but meaningful portion of a client’s business is advisable).  The trust assets may be held for the benefit of the client’s children.  If the client is married, his or her spouse may be a permissible beneficiary.  Of course, each dollar that is distributed back to the spouse is counterproductive from an estate planning perspective, but it gives the client the flexibility of having an “out valve” in the event the assets are needed at his or her generation.  This planning is especially important for young entrepreneurs whose financial wherewithal is much less certain than that of an elderly client.

For gift tax reporting purposes, the client’s company must be appraised to establish the value of the gift.  The general concept here is to leverage the low (or nominal) value of a client’s startup and allow all of the growth and appreciation to blossom outside of his or her estate.  Since the client will likely assert only a nominal value for the company on his or her gift tax return (and thus utilize very little of his or her gift exemption), pursuing this strategy in 2012 is advantageous.  If the IRS audits the gift tax return and asserts a higher value for the company (even substantially higher), the $5.12 million exemption for 2012 will serve as a cushion protecting the client from a potential gift tax liability.

Startups like Instagram and Facebook were unmitigated homeruns.  While few clients will have Facebook’s level of success, this type of trust and gift planning is a very effective early-stage estate planning strategy for entrepreneurs, with the potential to pay huge dividends in the long run.  If the company does modestly well, the client may save future wealth transfer taxes (at multiple generations).  Moreover, trusts for the ultimate benefit of Generation 2 and Generation 3 may be protected from creditors and divorcing spouses.  As a client begins to have a track record of success, the trust may also be used to facilitate angel investing in other startups (a common side project for many successful young entrepreneurs).  Alternatively, if the company goes belly-up, the client has incurred the legal expense of establishing the trust, but will have a vehicle in place to receive gifts of interests in future companies.

It’s often very difficult to get young clients to focus on estate planning.  At age 24 when the trusts were established, Mr. Zuckerberg should be commended for focusing on estate planning and having the wit to heed the advice of his counsel.

President Obama’s Estate Plan Reminds Us of the Power of the Annual Exclusion

Posted April 17, 2012 by David Kovsky
Categories: Annual Exclusion, Estate Planning, Gift Taxes, Trusts, Wealth Planning

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 by David Kovsky

On April 13, 2012, The Washington Free Beacon ran an article deriding President Obama’s reliance Section 2503(b) of the Internal Revenue Code to transfer $48,000 to his daughters, free of any federal wealth transfer taxes.  Under that section of the Code, each taxpayer may transfer $10,000 to any number of individuals on an annual basis, free of the federal gift tax.  This is the so-called “annual exclusion.”  Section 2503(b) further provides that the annual exclusion will be indexed for inflation.  As such, the amount that may be transferred to each donee in 2012, free of the federal gift tax, is $13,000.”

The rationale behind the annual exclusion is to not mire the taxpayer or the IRS in tracking the aggregate of annual birthday presents, holiday gifts or dinners on “mom and dad.”  Only when the amount rises to the level of what is deemed wealth transfer, will the gift tax be triggered.

Although the article run by The Washington Free Beacon had a political slant, it is also a great reminder of how useful the annual exclusion can be from an estate planning perspective.  Take, for example, the following hypothetical:  Grandmom and Grandpop have three married children and six grandchildren.  By utilizing the annual exclusion, Grandmom and Grandpop can transfer an aggregate of $312,000 of wealth to Generation 2 and Generation 3, without incurring a gift tax or a generation-skipping transfer tax (another federal wealth transfer tax with its own set of annual exclusion rules), every single year.  If these gifts are made in December of year 1 and January of year 2, our hypothetical Grandmom and Grandpop can transfer over $600,000 during a several week period, free of any federal wealth transfer taxes.  Here is breakdown of the transfers in year 1 (which may be replicated in year 2):

Donee:

Grandmom

Grandpop:

Child 1

$13,000

$13,000

Spouse 1

$13,000

$13,000

Child 2

$13,000

$13,000

Spouse 1

$13,000

$13,000

Child 3

$13,000

$13,000

Spouse 3

$13,000

$13,000

Grandchild 1

$13,000

$13,000

Grandchild 2

$13,000

$13,000

Grandchild 3

$13,000

$13,000

Grandchild 4

$13,000

$13,000

Grandchild 5

$13,000

$13,000

Grandchild 6

$13,000

$13,000

TOTAL:

$156,000

$156,000

This type of estate planning could be as simple as writing checks to all of your immediate family.  However, for many clients, these transfers should be made in conjunction with the establishment of a specially designed trust that qualifies for the annual exclusion and assists clients in meeting their goals of providing the children (and grandchildren) with a measure of asset management assistance, creditor protection and future transfer tax savings.

In whatever form it takes, outright transfers or in trust, fully utilizing the annual exclusion is a powerful estate planning tool that is often overlooked.

Tax Court Approves Georgia-Grown FLPs

Posted April 13, 2012 by Rose K. Wilson
Categories: Business Planning, Estate Planning, Estate Tax

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 By Rose Drupiewski

In a recent decision involving a Georgia family and Georgia family limited partnerships, the U.S. Tax Court upheld estate tax benefits claimed by the family.

A family limited partnership (“FLP”) is a form of business created by family members that, in addition to providing important business, asset protection and other non-tax benefits, may reduce a family’s total estate tax liability.  The estate tax benefit arises from the recognition that a partnership interest is less valuable than direct ownership of the partnership’s assets.  Thus, for estate tax purposes, certain valuation discounts may be available when determining the value of a partnership interest.

In attempting to defeat the tax benefits of FLPs, the IRS often relies on section 2036.  If successfully applied, section 2036 ignores the transfer of assets to a partnership, and therefore the decedent’s estate is taxed on the value of the partnership assets as if the decedent had never transferred such assets to the partnership.  In effect, all valuation discounts are ignored that would otherwise be available by virtue of the partnership structure.  Generally, section 2036 will not apply if a partner transfers assets to the partnership in a “bona fide sale for full and adequate consideration.”  A decedent’s estate may demonstrate that a transfer is bona fide if the decedent had valid nontax reasons for forming the partnership.

In Estate of Beatrice Kelly v. Commissioner, T.C. Memo 2012-73, the decedent was an elderly woman from Rabun County, Georgia.  The decedent was diagnosed with Alzheimer’s disease, and her four children were appointed to act as her co-guardians by reason of her mental disability.  Subsequent to their appointment as her co-guardians, the children discovered that the decedent’s will did not divide her estate equally among them, and they sought a way to provide for an equal division of the decedent’s assets.  The decedent owned 27 parcels of real estate, including two rock quarries, a subdivision with rental homes, a post office, and a rural property with public access.  The Tax Court found that the real estate properties raised liability concerns for the decedent, as evidenced by a previous accident occurring at one of the quarries that resulted in personal injuries, and public traffic through the post office, subdivision and rural property.

The children, as co-guardians, sought the advice of an attorney on how to achieve an equal division of the decedent’s assets.  The attorney advised the children that they could achieve this goal by acting on behalf of the decedent to create four separate FLPs, transferring the decedent’s assets to such FLPs, and transferring the partnership interests to themselves prior to the decedent’s death, such that the decedent’s will would not control the division of such assets.

The Tax Court found that there were valid nontax reasons for formation of the FLPs.  These nontax reasons included effective management of the decedent’s real estate and equal distribution of assets among the children.  As a result, the Tax Court held that the transfer of assets to the FLPs was bona fide and section 2036 did not apply.  The holding of this case is an important reminder that FLPs can provide significant estate tax benefits to families when there are legitimate nontax reasons for forming them.

Fractional Interests in Real Estate: The Unintentional But Effective Partnership

Posted March 14, 2012 by Jeff Waddell
Categories: Asset Protection, Charitable Giving, Estate Planning, Gift Taxes

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 by Jeff Waddell

A gift of a small interest in real estate can have a greater benefit than intended.  So you decided to transfer a one percent interest in the family farm to your daughter last year.  The values were such that the 1% worked out to about $13,000 so you were within your annual exclusion and that was the plan.  You may have done a lot better than you thought from an estate tax perspective.

By creating a fractional interest situation, the farm is now effectively owned by a partnership between you and your daughter.  No third party is going to buy your 99% interest without the ability to obtain her separate 1% interest so effectively you have created a non-marketable interest in real estate.  Additionally, you cannot independently obtain financing on the property or enter into agreements affecting the property without your daughter’s consent. That means you also have a lack of control over the property.  Both of these factors, lack of marketability and lack of control, are recognized discounts which, at present, can be taken for estate and gift tax return purposes.  The amount of the discount depends on a number of factors; but, even with a discount as low as 20%, the effect of your 1% gift can be dramatic, as illustrated below.

Property Value: $1,300,000 prior to gift.  Transfer 1% for $13,000.  Undiscounted remaining value in estate $1,287,000.

Property Value: $1,300,000 prior to gift. Transfer 1% for $13,000. Discount for lack of control and marketability 20%. Remaining value in estate $1,029,600.

Fractional ownership of real estate can be burdensome, but when used effectively can have significant transfer tax benefit as illustrated above.  Consideration of this technique in a fully developed estate and business plan is certainly appropriate for those who have significant real estate holdings.

Do I Need Estate Tax or Asset Protection Planning?

Posted March 2, 2012 by James M. Kane
Categories: Asset Protection, Estate Planning

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 By James M. Kane

A difficulty for clients is how to decide what estate tax / asset protection techniques are realistically suitable or cost-beneficial, compared particularly to the super-wealthy who likely need virtually every technique available.

In other words, a client should gauge whether someone is merely trying to sell them a technique they really don’t need.   This is a legitimate question worthy of serious consideration.

Here are some key points to consider:

(1)    Don’t end up in a situation where the courts have to get involved because you became incapacitated or died without adequate documents in place. Simple examples are dying without a Will, failing to have named guardians for your minor children, ending up with a court-managed guardianship if you later become incapacitated (trusts can help eliminate these threats);

(2)   Keep an eye on your estate tax exposure. The federal tax law exempts a certain portion of your estate from estate tax. This is called the estate exemption amount. (Georgia presently has no death tax).  If your death occurs in 2012 the federal exemption is $5.12 million ($10.24 million combined exemption during 2012 for a married couple). This exemption drops to $1.0 million beginning for deaths in 2013 ($2.0 million combined for a married couple).

The tax law in most cases – combined with proper planning — allows a married couple to delay the day of reckoning for paying the estate tax until the surviving spouse’s death, regardless of the size of the couple’s estates. However, even with this postponement, the above exemptions for each spouse may require a level of estate planning in order to coordinate and make sure both exemptions are (or can be) fully used.

(3)   Asset protection is more subjective than items (1) and (2) above.  Whether you need asset protection depends on your exposure (particularly your occupation) and whether you will sleep better knowing you have in place techniques that better protect you and your family from lawsuits, judgments, creditors, and in some cases bankruptcy.  Thus, in this subjective situation an important cost-benefit factor is how much peace and repose you will experience if you put into place asset protection techniques for insulating you and your family from these types of potential threats and claims.

In reviewing whether items (2) and (3) above may warrant further action, my view is that the portion of assets a client expects to hold for the long-term, exceeding what the client likely will  spend during lifetime for food, shelter, necessities, school, vacations, medical, etc., should at least fall under consideration for potential estate tax and asset protection planning.

By contrast, for younger clients who are spending most of their income currently on raising young children, and so forth, the need for complex estate tax and asset protection planning may not be as important.  In these situations, if one spouse dies with young children the likelihood is much greater that most of the assets will be ultimately spent-down for the care of the surviving spouse and for the children while they continue to grow up and attend school, etc.   The assets ultimately may not be large enough when the surviving spouse dies to trigger estate tax exposure.  In this situation the planning might need to be minimal so as to prevent the courts from having to get involved in dealing with a spouse’s death or incapacity (such as dying with no Will).   Asset protection can also be minimal and directed at making sure a surviving spouse does not remarry and divert the assets to another spouse or children from someone else’s marriage (again, trusts can help eliminate these threats).

Intentionally Defective Budget Proposal: President Obama’s Attack on Grantor Trusts

Posted February 21, 2012 by Erica Opitz
Categories: Estate Planning, Gift Taxes, Tax

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 By Erica Opitz

On February 13, 2012, President Obama proposed the budget for 2013.  The budget proposal has been reported to be dead on arrival.  Notably, however, President Obama’s budget proposal went after intentionally defective grantor trusts, which is not a proposal that we have seen previously.  If this were to pass, the results would wreak havoc on a top estate planning tool. With the sun setting of the current estate tax code provisions at the end of this year, it is possible that President Obama’s grantor trust proposal will be used as a bargaining chip and could potentially reappear in future legislation.

Under the proposal, the legislation would only be effective for transfers on or after the date of enactment.  As a result, transfers to a grantor trust prior to enactment would remain outside of the grantor’s estate.  For this reason, it is important to take advantage of the grantor trust while the benefits remain available.

Current Law:

In an intentionally defective grantor trust, the grantor retains certain rights and powers over the property held by the trust.  For income tax purposes, a grantor trust is not a separate entity from the grantor, and as a result, the grantor pays all income taxes on the trust earnings.  Under the current regime, the assets placed in the grantor trust are held outside of the grantor’s estate.  The transfer of property into the trust is treated as a completed gift for estate and gift tax purposes.  As a result, future appreciation on the assets placed in the trust is not subject to estate or gift tax.  Furthermore, a sale from the grantor to the grantor trust is ignored for income tax purposes.

Proposed Law:

President Obama’s budget proposal would include the assets of the grantor trust in the grantor’s gross estate.  Additionally, any distributions from a grantor trust would be subject to gift tax as would the assets of the trust if the grantor ceased to be the owner of the trust.  President Obama’s proposal would apply income tax to a sale from the grantor to the grantor trust if the sale would be subject to capital gains tax if the sale was made by someone other than the grantor.  The Department of Treasury’s green book states the reasoning behind the proposal.  “Taxpayers should be required to take consistent positions in dealing with the Internal Revenue Service.  The basis of property acquired from a decedent generally is the fair market value of the property on the decedent’s date of death.”