Posted tagged ‘Tax’

Modern Families – Estate Planning for Same-Sex Couples

May 17, 2012

 by David Kovsky

Although President Obama has recently come out in support of recognizing same-sex marriages, the law of the land from a federal tax perspective remains the Defense of Marriage Act (“DOMA”).  Under DOMA, the federal government will only recognize marriage as a union between one man and one woman.

To the chagrin of many same-sex couples, the definition of marriage under DOMA precludes the use of fundamental estate planning mechanisms such as the unlimited transfer of wealth between spouses during life, the deferral of estate taxes until both spouses die and, for 2012, the portability of the estate tax exemption.  In many ways, the tax code is structured to benefit married couples.  Nevertheless, married same-sex couples have some unique planning opportunities available to them specifically because the federal government does not recognize their marriage as valid.

Here are two planning ideas that are only available to unrelated parties but may be very effective wealth transfer strategies for same-sex couples:

1. Grantor Retained Income Trust.  This strategy involves transferring assets that the grantor expects will grow and appreciate over time to a new trust while retaining an income interest for a predetermined period of years.  The value of the gift to the beneficiaries is reduced by the value of the income interest retained by the grantor.  The goal here is to freeze the value of the assets at the time of the transfer while permitting the growth and appreciation to occur outside of the grantor’s estate.  Congress recognized the potential for abusing this type of transaction through the investment in non-income producing assets.  Accordingly, Chapter 14 of the Internal Revenue Code was enacted to provide that among applicable family members, the value of a retained interest for transfers in trust is zero, unless that interest is a “qualified” interest.  One such qualified interest is an annuity (hence the common usage of grantor retained annuity trusts).  Since DOMA does not recognize a marriage between same-sex couples, the limitation to qualified interests that is imposed on these types of trusts among family members is not applicable.  Instead, a lawfully married same-sex couple can utilize this very effective (and often overlooked) estate planning device.

2. Qualified Personal Residence Trust.  This type of trust is designed to transfer the ownership of a residence to the trust beneficiaries following the completion of a term of years during which the grantor is entitled to remain in the residence.  The value of the gift to the trust beneficiaries is reduced by the value of the grantor’s right to remain in the residence.  The concept here is to transfer the residence (including all of the appreciation over the term of years) to the trust beneficiaries at a discounted price.  However, when the beneficiaries receive the residence, they are subject to carry-over basis and may incur a substantial capital gains tax on the subsequent sale of the residence.  Had the grantor died owning the residence, the beneficiaries would receive a step up in basis to the fair market value as of the date of the grantor’s death.  Consequently, the subsequent sale would trigger little or no gain.  One way to ameliorate this planning hurdle would be to purchase the residence back from the trust and have it pass through the grantor’s estate.  However, Treasury Regulations governing the use of qualified personal residence trusts specifically prohibit the grantor from buying the residence back when the trust beneficiaries are members of the grantor’s family.  The same prohibition, however, is not applicable to same-sex couples because in the eyes of the government they are unrelated.  To take advantage of this planning opportunity, the grantor should purchase the residence back from the trust (at no gain or loss, due to the grantor trust rules) prior to the conclusion of the trust term.  The same “value” passes to the trust beneficiaries in the form of cash while the residence will ultimately pass through the grantor’s estate and receive a step-up in basis at his or her death.

With the recognition of same-sex marriage quickly becoming a buzz worthy campaign issue, it is possible that we may see the repeal of DOMA sometime in the next few years.  However, until that happens, it is important to advise same-sex clients to double-down on the government’s definition of marriage as the union of one man and one woman and to take advantage of the unique planning opportunities available to them as “unrelated” parties.

Facebook, Instagram and the Zuckerberg Estate Plan

April 24, 2012

 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.