- Consumer
Golf Talk – Back 9
Summary:
So last month we gave you exiting tidbits for each of
the front nine. To assure you have
talking points for the rest of the course, here’s some for the back nine.
Hole #10
Start the back 9 with a cool acronym “BDIT” a Beneficiary
Defective Inheritor’s Trust. The BDIT is creation of Las Vegas estate planning
maven Richard Oshins, Esq. of Oshins & Associates. Your golf buddies have
all set up self-settled grantor dynasty trusts and you wanna one up them. The
BDIT is the answer. Have mom (anyone other than you or your spouse) set up a
dynasty trust to benefit you. If you never make a gift to the trust, many of
the estate tax rules that can operate to pull a trust’s assets back into your
estate arguably won’t apply. For example, if your golf buds give assets to their
dynasty trusts but retain the right to enjoy those assets (e.g., the income
from a rental property, or the right to live in a beach house), those assets
will be included in their estates. But with your BDIT, since you don’t transfer
assets to the BDIT you don’t face the sasme risks. But if mom sets up the
trust, how can it be a grantor trust to you? Characterization as a grantor
trust assures all income is taxed to you and that you can sell assets to the
trust without triggering capital gains.
The mechanism to accomplish this feat is having your BDIT include an annual
demand or Crummey power for you to withdraw gifts mom makes to the trust. If you can vest all of the principal of
the trust in yourself, you’ll be treated as the owner of the trust for income
tax purposes so long as the trust is not a grantor trust as to mom. So if mom gives
$13,000 annual gifts to the trust each year and you don’t exercise the Crummey
power to withdraw those gifts, the trust will be a grantor trust as to you. Because
you didn’t set up the BDIT, you can be given more control over the trust then your
golf buds can over their plain vanilla dynasty trusts with less tax and asset
protection risk.
Hole #11
UTMA, Uniform Transfer to Minors
Act, accounts use to be standard operating procedure for kids savings. But they
ain’t fun since at the age of majority Junior can spend the money on a beer instead
of tuition. What can you do? One approach is to have the UTMA invest in a
family partnership or LLC so that when Junior attains the age of majority he’ll
have to convince the local beer depot to take FLP interests as payment. Many
financial institutions object to encumbering Junior’s money more than the UTMA
account would. Solution – Give Junior the right to cash in his FLP interest
within 30 days of attaining the age of majority! For you Code Section geeks
this is similar to the 2503(c) trust right to withdraw at age 21.
Sample Provision: Whereas, it is
the express desire of the parties, notwithstanding anything in this Agreement
or applicable partnership law to the contrary, that if any partner is a minor
for whom custodial funds were transferred or invested in this Partnership. Then
in such event as the minor attaining the age of majority (determined by the
laws of the State) such Partner may upon notice given at any time within Sixty
(60) days of the date of attaining the age of majority that all of his or her
partnership interests attributable to said custodial funds must be liquidated
and the fair value therefore be distributed to said partner. If this right is
not exercised within said period this right shall lapse.
Hole #12
Lots of trusts are structured as directed trusts where a
person or board of investment advisers direct the trustees how to invest and
the trustee is absolved of most or all liability for investment decisions
(depending on state law and the trust terms). Many such trusts could benefit
from the Doublemint gum approach to trust investment advisers. Many investment
advisers are selected to hold family business or real estate assets that an
institutional trustee might not be adept at. However, at some time even a trust
largely comprised of a closely held business interest may become liquid (e.g. a
sale of the business). Does the same investment adviser have the expertise to
invest in marketable securities that knew say real estate or widgets? Unlikely.
The dual approach can provide a better investment result. Finally, what if
funds from one property or business are to be reinvested? Have an independent
fiduciary, e.g., the investment adviser, authorized to allocate liquid assets
from the marketable to the business/real estate component of the trust.
Sample Provision: At the
direction of the Investment Adviser, if any, or if none, the Trust Protector,
or if none, the Individual Trustee, assets which are readily marketable shall
be made available for investments in assets which are not readily marketable or
which are closely held or family businesses or Personal Use Assets. The express intent of this provision is
to ensure that the Institutional Trustee, or the investment adviser who has the
investment authority over marketable securities, not hinder or delay making
those securities available to the Investment Adviser for investment or use in
family business interests or other non-marketable investments under the
direction of the Investment Adviser or a delegate of the Investment Adviser.
Hole #13
When a partnership, or an LLC taxed
as an partnership, must close its taxable year (e.g., on the termination of a
partner/member during the year), the economic results of the partnership must
be allocated for that partner to the time period prior to the closing of the
FLP/LLC books, and to the period after the closing. There are two methods which
can be used to make this allocation: (1) the interim closing of the FLP/LLC
books; or (2) the pro-ration method. Treas. Reg. Sec. 1.706-1(c)(2)(ii); See, Richardson
v. Comr.,
693 F.2d 1189 (5th Cir. 1982). If the executor has discretion to choose the
assets to fund a bequest under the will, which is common, these rules and that
discretion, will impact the estate’s tax results. If a pecuniary bypass trust
(i.e., funded with a dollar figure not a portion of the estate) is funded with
the interests in an partnership/LLC, the tax year of the partnership/LLC close
and the bypass trust would be allocated the pro rata portion of the gain for
the portion of the year in which it holds the interests in the partnership/LLC.
If the executor uses the discretion granted under the will to distribute the
deceased partner’s interests in the partnership/LLC under the residuary clause of
the will to a residuary trust, instead of to the pecuniary bypass trust
(assuming that the will was so constructed), the tax year of the partnership/LLC
may not close as a result of the estate funding the residuary trust. As a
result, all income from the date of death forward would inure to the residuary
trust (since there would be no closing or allocation). If this discretion is combined with an
interim closing of the books method, in contrast to the proration method, the
executor has flexibility to determine which amount of gain to trap in the
estate versus what gain (or other tax consequence) will be reported on the
income tax return of one of the distributee testamentary trusts.
These general rules need to be
applied to common estate and probate-related situations. The results are not
certain as to how every estate/probate event impacts the requirement to close
the tax year of an FLP/LLC owned in part by a decedent, estate or trust. For
example, Code Sec. 761(e) provides that the distribution of an interest in a
partnership will generally be treated as an exchange for purposes of
determining whether Code Sec. 743(b) basis adjustment rules will apply. The IRS
has held that the distribution of a lower tier partnership by an upper tier
partnership constituted such an exchange, thereby permitting a Code Sec. 743(b)
adjustment, even though no gain was recognized on the distribution. The Regulations indicate that a
distribution by an estate is not an exchange (Reg. §1.706-1(c)(3)(vi), Example
(3)). The IRS has indicated that a
distribution by a trust may be an exchange under Code Sec. 706, thus permitting
a basis adjustment under Code Sec. 743(b) (Rev. Rul. 72-352, 1972-2 CB 395).
Congressional committee reports appear to indicate intent to exclude
distributions by an estate or trust triggered by the death of a member from the
exchange provisions of Code Sec. 761(e) (S. Rep. No. 99-313, at 924 (1986)).
Hole #14
If you buttoned up your FLP so tight to justify discounts you
may undermined the annual gift exclusion for FLP interests. This is because a
gift has to be of a “present interest” to qualify for the $13,000 annual
exclusion and if the donee/partner cannot realize any current economic benefit because
of all the restrictions, it may not qualify. See, Hackl V. Commr. 118 TC 14
(2002), aff’d, 335 F.3d 664 (7th Cir. 2003). Consider adding a right of first
refusal, or provision analogous to a “Crummey” demand power, to the transfer
restrictions or distribution clauses of the partnership agreement. If there is
no present contemplation of annual gift transfers, this issue may be better not
to be addressed in the Operating Agreement as such a provision may detract from
the general discounts.
Hole #15
Recession brought lower asset values so many estates are
choosing to value assets not at the date of death, but 6 months later on the
alternate valuation date (AVD). But this election is not simple and can trigger
family disputes if it benefits one heir at the expense of others. Most if not all
wills and other documents are silent as to how to address this potentially
volcanic dilemma. Example: An estate is comprised of a family business valued
as of the date of death at $7M, securities valued at $10M and a house valued at
$4M. The business on the date of
death constitutes $7M/($7M + $10M + $4M) 33% of the estate, insufficient to
qualify for estate tax deferral under Code Section 6166. At the AVD 6 months
later the business value has declined to $6M, the securities to $4M and the
house increased to $5M. The value of the business is now $6M/($6M + $4M +$5M)
40% of the estate, sufficient to qualify for estate tax deferral under IRC Sec.
6166. Thus, use of the AVD can have the added benefit of enabling the estate to
qualify for additional estate tax benefits. The use of the AVD benefited the
children receiving the business and securities, but penalized the child
receiving the house. How can an executor make the election in such a situation?
How can the executor avoid making the election? What’s good for the goose may not be good for the gander!
The election must apply to all estate assets, no partial application is
permitted. Treas. Reg. Sec. 20.2032-1(b)(2). The result is the classic
Shakespearean decision: “To ADV, or not to ADV: that is the question: Whether
’tis nobler in the estate administration to suffer the slings and arrows of
outraged beneficiaries…”.
Hole #16
It remains common for investments to be structured in the
form of a limited partnership (FLP): control, income shifting, gift and estate
discounts (but that window may be closing), etc. If you’re transferring securities to a FLP watch the Code
Section 721 investment rules. Many folk forgot about these because capital
gains kinda disappeared. But with the run up in the equity markets and other
investments these rules could easily ensnare you. If you form an FLP consisting
primarily of securities there generally is no income tax consequence, but if
the FLP is characterized as an “investment company” and you diversify your
previously undiversified securities portfolios by forming that FLP, then all
the gain on all assets contributed to the FLP will be triggered for income tax
purposes. Ouch! To make this even more painful, losses are not triggered, just
gains!
A portfolio is considered
diversified if less than 25% of its assets are invested in any single issuer
and less than 50% are invested in any five or fewer issuers.
Hole #17
If you have or are divorcing, watch
the home sale exclusion rules — the housing market will eventually recover and
you’ll get nailed if you don’t. Most folks cannot imagine appreciating home
values, but if you’re negotiating a divorce agreement don’t ignore it. If your
ex-spouse is granted exclusive use of the residence that use will be credited
to you for purposes of meeting the use and ownership requirements for the
$250,000 home sale exclusion if mandated by a qualifying agreement (divorce
agreement, decree of separate maintenance, and a decree of legal separation).
IRC Sec. 71(b)(2). If not, it will not be credited to you if you’re not
residing in the house. Bottom line: you could loose a big tax bennie.The timing
of each spouse’s use and ownership should be considered to assure the maximum
qualification for the exclusion.
It may be advantageous to delay
the divorce, or the common filing of separate tax returns, to assure that the
full $500,000 exclusion is available.
In the context of a divorce settlement, if the house is transferred to
one spouse, that transferee spouse may treat the house as if he or she had
owned it during the period it was owned by the transferor spouse. I.R.C.
§121(d)(3).
Hole #18
Financial stress is a top factor
triggering divorce. This recession has been plenty stressful financially. It
has also wreaked havoc with investment portfolios like none other since the
depression. If you are in the process of or were recently divorced, review and
revise your investment strategy. Pre-divorce
portfolios are structured on a family basis. Post divorce each spouse may end
up with non-coordinated pieces of the former family portfolio. Diversification
which may have been adequate before, may be undermined by a divorce settlement
that focused on tax basis, accounts within the control of each spouse, and
other non-investment factors. The financial realities of divorce often
necessitate a portfolio geared more toward generating cash to cover
post-divorce living expenses, then growth for the future. An issue to address
in the reallocation process is that the portfolio likely has a carry over cost
basis under Code Sec. 1041 from your ex-spouse, or low basis equities purchased
and held by you.
Example: In some instances
selling covered calls against some of the holdings, with the intention of
having the calls exercised, can produce incremental income to offset some of
the tax liability.
Example: ABC stock is selling at
$48/share. Cost basis is $25/share. If a client sells 1,000 shares the capital
gain is $23,000 which at 15% (ignoring state tax) implies a tax liability of
$3,450. If a $50 call (an option or right to purchase the stock at the $50
strike price) is sold for 1 point, this would generate $1,000. The client would
sell the call, and hope the stock exceeds $50/share prior to the expiration of
the call. If so, the call would be exercised and the client would realize
$51/share, an additional $3,000 above the current value of the shares. That
incremental revenue will offset most of the tax liability. If the stock price
does not exceed $50, the call won’t be exercised, but the client has received
$1,000 towards the tax cost to be incurred on restructuring the portfolio.
Your risk tolerance may change to reflect
post-divorce economic reality, which is often much harsher than before. Intact
families can often accept more risk in their portfolio when comfortable with
their employment situation, and can rely on that cash flow for expenses.
Post-divorce this certainty is often undermined by lower earnings, higher
support or alimony payments, and the increased costs of maintaining separate
homes and lives. Too often clients ignore the changed risk, or take the
opposite approach and become so fearful of this new risk profile that they
assume anything other than a money market account or CD is too risky. Clients
seeking low risk portfolios often build a portfolio based on bonds, etc. They
assume price risk is eliminated when they hold the securities to maturity.
Reality is that the price risk remains because interest rates fluctuate. They
are unknowingly assuming a great deal of risk, but risks of a different type,
namely inflation risk. Even a modest rate of inflation can devastate a fixed
income portfolio over time.