Planning for Non-Liquid Estates

Consumer

Estate Basics

Planning Fundamentals for Illiquid Assets

Synopsis. 1
Introduction to planning for illiquid assets. 1
Real estate. 1
Art, jewelry and collectibles. 1
Business interests. 1
Professional practices (including solo practitioners).2
Concentrated stock positions. 2
Implications of illiquidity. 2
Cash flow sources to address illiquidity. 2
Loans. 2
Business/real estate ongoing operations.3
Key person insurance. 3
Insurance outside the business (e.g., ILIT).3
Sale of assets. 3
Succession Planning for Illiquid assets. 3
Buy sell agreements. 3
Charitable bail out11
Estate Tax Considerations of illiquid assets. 11
Carry over basis considerations. 12
Will clause for carryover basis. 12
6161 Extension of time to pay estate tax for reasonable cause. 13
Estate tax deferral 6166. 13
Graegin loans. 13
Estate of Cecil Graegin. 15
Income tax considerations of illiquid estate assets. 15
IRC Sec. 303. 15
754 basis adjustment18
Probate Considerations of illiquid assets. 22
Valuation issues. 22
Distributions of property in kind. 22
Prudent Investor Act.24
Drafting considerations to mitigate issues created by illiquid assets.
25
Tax allocation clause.25
Specific bequests. 25
Direction to retain house for minor children. 25
Investment language. 27
Right of first refusal to permit heir to purchase property.28
Tangible personal property. 30
Directed trusts generally. 31
Directed trust bifurcated as to marketable and closely held business
(or other illiquid) assets. 31
Situs considerations. 3
Insurance trusts. 32
Operating agreements and other entity governing documents. 33

Planning Fundamentals for Illiquid Assets

By: Martin M. Shenkman, CPA, MBA, PFS, JD

1. Synopsis.

a. Planning for illiquid assets presents unique and
difficult problems for clients, estates, and even the assets/business involved.
Practitioners advising clients with substantial liquid assets need to identify
the unique problems and provide guidance and solutions to deal with them.

b. This handout will review a broad range of issues and
planning opportunities affecting illiquid assets including both pre- and post
death planning. Addressing liquidity issues in buy sell agreements, governing
documents, insurance planning in a creative and proactive manner can minimize
the difficulties the client’s estate will later face. Post-death planning
includes addressing complex valuation issues, taking advantage of tax
opportunities to defer estate tax payments, and in some cases reduce them.
Fiduciaries will often have to take special steps to protect the trusts and
estates they are responsible for as well as to protect themselves from
beneficiary challenges. These include properly interpreting will and statutory
provisions affecting illiquid assets such as the Prudent Investor Act, tax
allocations, etc.

2. Introduction to planning for illiquid assets

a. Real estate.

i. Factors affecting liquidity.

1. Ownership entity/governing document terms.

2. Type of property.

3. Cash flow if any.

4. Governing documents impact on cash flow certainty.

5. Ability to sell.

6. and so on.

b. Art, jewelry and collectibles.

i. Distributed in kind versus sale.

ii. Time period and costs to effectuate appraisals,
insurance, transport, sale, etc.

c. Business interests.

i. Buy sell agreement terms and funding.

ii. Transfer in kind to heirs/trusts or liquidate.

iii. Governing instrument.

d. Professional practices (including solo
practitioners).

i. Short half-life if not marketed and transitioned
quickly.

ii. Buy out or succession plan if any.

e. Concentrated stock positions.

3. Implications of illiquidity

a. Heirs.

i. Heirs living expenses.

ii. Expectations of heirs.

b. Property, casualty and other insurance issues.

i. Named insured should be updated to reflect personal
representative and trusts.

ii. How long will insurance company cover vacant
property.

c. Operations of a business.

i. Succession plan.

ii. Who will perform. Example, the accountant as executor
of the estate of a real estate developer or physician with no succession plan
in place.

d. Payment of estate taxes.

i. Cash impact.

ii. See below.

e. Other.

4. Cash flow sources to address illiquidity

a. Loans.

i. Third party loans.

1. Viability and cost.

ii. Related party loans generally.

1. Respect for tax purposes.

2. How set collateral and interest rates.

3. Opposing family members and/or heirs.

iii. Revolving loan from heir or family entity.

1. See sample loan document.

b. Business/real estate ongoing operations.

i. Impact of death of principal.

c. Key person insurance.

i. Adequacy.

ii. Impact of governing documents, e.g. buy sell
agreements.

d. Insurance outside the business (e.g., ILIT).

i. Is it available to infuse liquidity to the estate.

ii. Other constraints.

iii. Different fiduciaries.

e. Sale of assets.

i. Can assets be sold.

ii. Price at which sale can be realized. Perception of
many buyers that estates often must sell at distressed prices.

iii. Time period and costs to sell.

iv. Impact of probate issues.

5. Succession Planning for Illiquid assets

a. Buy sell agreements.

i. Lauder. Estate of Joseph H. Lauder, T.C. Memo
1992-736.

1. Estate sold stock for $4,000/share. IRS claimed value
was $13,000/share. The estate used a formula valuation/price. The IRS claimed
the value was not reasonable, and that there was no justification for it since
no arm’s length bargain for using a book value formula. The IRS stated it was a
significant undervaluation. The IRS argued that the value was much greater at
the signing and that the advisers never tried to ascertain the FMV of the
stock. There was no professional analysis. Then the IRS maintained that the
difference was a gift from the estate to the shareholders. Taxpayer’s counsel
argued that if there was a gift, that it would qualify for the marital
deduction to the extent it inured to the surviving spouse.

2. The children sold some shares to pay estate tax. Why
did a 95 year old woman die with so many assets? She really didn’t it was an $8
billion business so most of the estate value was previously transferred. They
only paid tax of $550 million.

3. Lessons from the Lauder case include:

a. Importance of a qualified full time professional
appraisal.

b. Incorporate appraiser’s methodology into the
documentation.

c. Enforce the terms of the agreement pre-death. The more
times the formula has been used prior to death the more credible that approach
will be at death.

d. Arm’s length bargaining, with different counsel, is
important. Document/corroborate that different “sides” (e.g., parents versus
children, kids in the business versus those not in the business), etc. You want
the appearance and reality of arm’s length bargaining.

e. It is essential to show a professional attempt to find
FMV. In Lauder they taxpayer’s did not use a modicum of effort to do this.

ii. Estate of Marlin Rudolph v. U.S., U.S. D.C. So. Dis.
Indiana, No. 91-151-C, February 5, 1993.

1. Facts. The brothers were in the asphalt and concrete
business. Timing is critical to the ultimate determination of this case. When
the buy sell was drafted the attorney documented the purposes of it. These
included: Continuity – keep the business in the family; Income for
decedent/shareholder’s surviving spouse; separate spouse from the business at
the time of the death from the shareholder; and finally the goal of obtaining
bid-bonds. If you want to bid on a governmental project you need bonds to prove
you can complete the project. You need to show corporate responsibility. The
taxpayers used the corporate buy sell agreement to help corroborate their
responsibility and ability to complete a job they started. The agreement was
included in the packages for the bid-bond applications. This was an important
independent use of the appraisal that affected the final determination of this
case.

2. Discounts. Lack of marketability. Tough times. This
case occurred during the oil crisis in the 1980s. Why would asphalt be in tough
shape? Because asphalt is made from oil products and supplies were difficult to
obtain. A discount for “additional competition” was taken. How can you prove to
the IRS that there is new, additional or different competition? Take the yellow
pages and look by year. Evaluate the map of the area code.

3. The estate won the valuation argument because it did
not discuss tax savings when the buy sell price was set. The only documented
discussions were economic related. The price was set before discovery. Both
parties had cancer and the price was negotiated. There was no imminent danger
to the business because they each were able to have life insurance. The
shareholders were healthy when the buy out price was set. This demonstrated
that it was not intended as an estate tax valuation ploy. The predicted sales
slump in their valuation analysis actually occurred (hindsight).

4. Note that the life insurance payable to the corporation
was factored into the sales price under the buy sell agreement. No matter how
this is done, it must be addressed.

5. It was not certain whether the formula used
self-adjusted for changes in economic conditions but it appears that it may
have.

6. Lessons from the case: The facts governing discounts
may apply during the current economic turmoil. Discount arguments may apply
today. Be careful to periodically update all buy sell valuations and
agreements.

7. The following factors helped support the taxpayer
victory in this case: The agreement was binding during life or death. It was
not testamentary in nature. Comparable terms and conditions. This is the tough
part of many buy sell agreements. How do you find a comparable paving company?
The IRS and courts will always look at comparability. IRS is aware that a few
accounting tricks here or there can manipulate result. You therefore want
advisers who have worked with similar companies. The court measured
reasonableness of the formula used. The date of signing is the date that is
important. Practitioners need to do a better job documenting the facts at the
date of the signing. How was the state of the corporation, the economy and the
industry at the date of signing?

8. Other lessons to glean from this case include: There
were two deaths within a short time. Consider simultaneous deaths. Give buy
sells the importance and urgency of wills. They should be kept current and
revisited frequently. “Very few” buy sells address multiple events. Time is of
the essence in funding buy sell agreements.

iii. PLR 9315005.

1. Facts: Father and brother-in-law owned business 50/50.
Father, son and brother-in-law entered into a buy sell agreement. If
brother-in-law died son was required to buy as much as possible with proceeds
of life insurance he purchased on the life of the brother in law. If the
proceeds were insufficient then son had an option to buy the rest of the stock,
but if he did not the corporation had to buy it. Brother-in-law committed
suicide during the contestable period for the insurance. So no funds (other
than return of premium) so son purchased only three shares of stock. The estate
lowered the price after the initial purchase and the corporation purchased the
shares at a bargain price, and son purchased the balance of the shares.

2. IRS said by not exercising the corporation’s right to
redeem the father indirectly, because he controlled the corporation, made a
taxable gift to the son. In other words because father did not exercise option
there was a gift.

3. Lessons to learn from this PLR. Be wary of unexercised
options. Inaction (i.e., not exercising options) can create a gift. Never draft
a buy sell to base the obligation to buy on the amount of life insurance
someone owns because that insurance may not be there (e.g., failure to pay
premiums, suicide, false application etc.). There a many reasons the insurance
might fail. The buy sell agreement should provide a safety valve to pay over
time in case the amount of life insurance is insufficient (e.g., installment
provision).

iv. Estate of Gordon B. McLendon v. Comm’r, T.C. Memo.
1993-459, Sept. 30, 1993.

1. This case involved a “big” name in radio broadcasting
who started to purchase radio stations. Then he purchased chain of radio
stations, then television stations. Many medical problems developed. Cancer in
1985. This was followed by an apparent suicide attempt at the end if 1985,
etc.

2. Buy sell provided that son is manager of the FLPs on
his death or disability. The taxpayer set up private annuity to purchase
business interests. The children were to buy his FLP interests for $250,000
plus income for life for their interest in the business.

3. Background on Private annuities. Nothing is included in
the parent/seller’s estate since there is no transmission of wealth on death
because the private annuity payment ends on death. The use of the private
annuity technique in the correct circumstances is an effective tool. You use to
be able to spread out gain over lifetime but cannot do this any longer. So now
sales are structured to grantor trusts. However, if you have an asset with a
high basis (e.g. assets inherited from deceased first spouse) you can do a
private annuity. If party is ill but not in imminent danger of dying you can
use IRS tables and in effect turn the tables against the IRS. There is a
rebuttable presumption if you survive for 18 months after you sign the
agreement that you would have not had a fifty percent or greater likelihood of
dying within a year.

4. Obtain a physician letter stating likelihood of
surviving two years (not 18 months). Another clever approach is to apply for
life insurance. If you get approved it will demonstrate survivability beyond
one year period. There are also life expectancy reporting companies you can
hire to perform an analysis. If two year survival is likely but client is in
poor health private annuities make sense.

5. In this case Mr. McClendon was “circling the drain.”
Therefore, the IRS argued that the difference between what was paid and what
should have been paid was a gift. Gift within one year was likely. Court held
Mr. McClendon’s actual life expectancy, not the 7520 tables, had to be used
since there was a 50% or greater probability that he would die within one
year.

6. A savings clauses may be void as against public policy.
Some practitioners puts these in his private annuities anyhow, others avoid
them intentionally in this context.

7. Lessons from this case include: Death bed private
annuities are problematic. See Rev. Rul. 96-3 and 96-12. Poor health, but
likely to live more than 2 years is viable. McClendon wanted to have his cake
and eat it too. Economic control and benefit of assets inside FLP increased in
value. He could have removed it from his estate but he retained controls over
it causing estate tax inclusion. You cannot base annuity payments solely on the
income of the property transferred or the IRS will argue that this was a
retained income interest.

v. PLR 9349002.

1. If the corporation owns an insurance policy and you
give the insured the right to buy the policy back, if the insured retains the
option to buy the policy back, this is an incident of ownership over as policy
on the insured’s own life.

2. The woman who ran the corporation had an inactive right
to buy back the policy on her own life. Provisions in the buy sell agreement
provided that if certain things happened she would have the right to buy the
policy back. At the time of her death these conditions were not met, so the
right was inactive. Still, the IRS attempted to include the policy in her
estate in its entirety.

3. Lesson. Any meaningful chance of insured buying policy
back could trigger an IRS attack.

vi. PLR 9347016.

1. The corporation in this Ruling owned a life insurance
policy on all three of its shareholders. They wanted to implement a cross
purchase buy sell. The sons paid their father the amount equal to policies cash
value. Policy on dad’s life was the transferred to the sons as co-owners. There
was a co-ownership is a problem. If two sons are co-owners of policy and may
become co-owners with a divorced spouse, or co-owners with children. This is a
complicated and unwieldy situation. You probably never want co-ownership of a
life insurance contract.

2. Using the cash value of the policy as the measurement
of the value of property was not adequate. Difference between cash value and
real value of the policies is a gift. The real value of life insurance policy
is a very difficult question today in light of secondary markets, etc.
Certainly the minimum value is likely to be argued to be the interpolated
terminal reserve plus unearned premium. Eventually the IRS will look at life
settlement values for policies since there is a market for life insurance.
Thus, the value of many life insurance policies will be found to be greater
than the interpolated terminal reserve plus unamortized premium. At this point
the IRS has not taken this position. It may.

3. The transfer for value rules were not triggered only
because of a safe harbor. If partners, even if not transferred inside the
partnership, so long as transferred to a partner or the partnership the safe
harbor applies. However, don’t assume that you can form a partnership for no
reason other than to avoid the transfer for value rules as its only purpose and
win. If the partnership has no valid business purpose the anti-abuse
regulations will cause the disregard of the partnership for this purpose. What
if the parties each purchase an interest in a public partnership (e.g.,
co-shareholders purchase interests in public limited partnership)? This sounds
like an IRC Section 101 safe-harbor, but it is not the intent of the law and
the conclusion is not certain.

vii. Estate of George C. Blount.

1. This case involved IRC Section 2703. October 8, 1990 is
a key date for buy sell agreements. From this date onward, if a buy sell does
not meet the requirements of Chapter 14, the IRS will disregard the terms and
conditions that depress the value if 2703 applies (i.e., is violated). These
restrictions will be ignored and IRS and courts will then be free to determine
a value even if the parties are bound by the terms of the now disregarded (for
tax purposes) buy sell agreement.

2. Facts: Buy sell required about $7.6 million but did not
have the cash to affect this purchase. The taxpayer drew up his own buy sell
agreement that was a page long. He considered the amount of cash and life
insurance and changed the price to $4 million. He did not add lifetime
restrictions because he did not anticipate living that long. One of the
shareholders’ was an ESOP and taxpayer did not even discuss with them his
unilateral change. The taxpayer argued that the proceeds of the life insurance
should be offset for valuation purposes by the obligation to pay for the
shares. In Blount, the $4 million obligation to pay the decedent/shareholder’s
estate should offset the $3 million life insurance. Lower court said that the
$3 million of life insurance is a non-operating asset so that the company value
was the $4 million value plus a dollar for dollar increase for the life
insurance of $3 million.

3. Here are the approximate numbers: $6,750,000
+3,146,134=9,896,134. Problem. The stock is according to the above calculation
worth about $10 million. The estate tax was about $5 million at a 50% tax rate,
on the estate’s interest in the stock. However, the estate was only paid about
$4 million. The tax exceeded amount received by the estate!

4. The agreement must be comparable in terms of price so
value was $6.7 million. 11th circuit reversed and said you don’t have to add
the insurance proceeds. Is the 11th circuit right?

5. Court held that: Decedent’s unilateral ability to
change the agreement alone invoked the IRC 2703 provisions. The taxpayer
modified a pre 1990 grandfathered agreement by substantially modifying it, so
IRC Section 2703 rules now apply. What is a substantial modification? When you
change value, quality or timing of rights. Taxpayer in Blount changed all of
these. The buy sell agreement in Blount was not comparable to other
agreements.

6. Lessons to learn from Blount: IRC Sec. 2703 applies to
buy sells, options, to almost anything you put in writing to depress the
purchase price if changed after October 1990. The agreement must be reasonable
with a determinable price at the time it is signed. The estate must be bound to
sell under the buy sell agreement. The buy sell arrangement cannot be a device
to transfer the stock at a depressed price. It cannot be a testamentary device
to transfer wealth from parent to child, etc. It cannot be a substitute for a
will. The buy sell pricing must represent a bona fide arm’s length business
agreement. A lifetime price cannot be higher than the death-time price.

7. Remember that a higher level of scrutiny applies to all
of these points if the parties to the buy sell are related. There must be a
bona fide business agreement at arm’s length but closer scrutiny is assured
with related parties. The terms of the agreement must be comparable to similar
businesses. Can you demonstrate that non-related parties would have entered
into a similar agreement? It cannot be a d device to transfer the interests at
a reduced value.

8. Problem or warning signs include: The client is old or
in poor health; there were no negotiations of terms with independent lawyers;
the provisions of buy sell agreement were not consistently enforced, e.g.,
different results during lifetime than at death-time; the client won’t obtain
professional advice from a full time professional appraiser in setting a
valuation formula. If significant assets, such as life insurance, are excluded
from the formula, the buy sell is less credible. If there is no periodic review
of the terms of the agreement, the terms will be suspect. (e.g., 8-10 years go
buy since buy sell last updated or reviewed). If the transfers were really
based on family relationships instead of business relationships the agreement
will be more suspect.

b. Charitable bail out.

i. Gift to CRT so gain is partially sheltered and
contribution deduction received pre-death.

ii. Issue 2511(c).

c. Insurance arrangements.

i. Life insurance generally.

ii. Buy sell.

iii. Key person.

6. Estate Tax Considerations of illiquid assets

a. Carry over basis considerations.

i. Wills should also have express language authorizing the
executor to allocate the $1.3 million general basis adjustment and the
additional $3 million spousal basis adjustment. This power perhaps should be
exercised by an independent person, not a beneficiary who would benefit. This
is far from a simple matter to address as the possibilities are endless.

ii. What is the expected holding period for the property?
If property, such as a family cottage, is intended to remain for generations in
the family it is less in need of an allocation to increase basis than are other
assets which are more likely to be sold.

iii. Are other avenues to avoid, defer or minimize the
potential future capital gains tax available and how does their availability
compare to other assets in the estate if the maximum basis adjustment has to be
rationed to the various assets?

iv. CRT Example: I the estate holds raw land that is
likely to be donated to the local church for an expansion project the basis
adjustment is less important as compared to other assets if a charitable
remainder trust could be used.

v. 1031 Exchange Example: If the estate owns a shopping
center and rather than sell it a tax deferred Code Section 1031 exchange is a
likely possibility, then the allocation of basis to the shopping center may be
less advantageous than an allocation to other assets.

vi. Principal Residence: If the decedent’s principal
residence can be sold and exclude gain under the home sale exclusion rules then
to the extent that that exclusion

Synopsis.
- Planning for illiquid assets presents unique and difficult
  problems for clients, estates, and even the assets/business
  involved. Practitioners advising clients with substantial liquid
  assets need to identify the unique problems and provide guidance
  and solutions to deal with them.
- This handout will review a broad range of issues and planning
  opportunities affecting illiquid assets including both pre- and
  post death planning. Addressing liquidity issues in buy sell
  agreements, governing documents, insurance planning in a creative
  and proactive manner can minimize the difficulties the client’s
  estate will later face. Post-death planning includes addressing
  complex valuation issues, taking advantage of tax opportunities to
  defer estate tax payments, and in some cases reduce them.
  Fiduciaries will often have to take special steps to protect the
  trusts and estates they are responsible for as well as to protect
  themselves from beneficiary challenges. These include properly
  interpreting will and statutory provisions affecting illiquid
  assets such as the Prudent Investor Act, tax allocations, etc.
Introduction to planning for illiquid assets
- Real estate.
  - Factors affecting liquidity.
    - Ownership entity/governing document terms
    - Type of property.
    - Cash flow if any.
    - Governing documents impact on cash flow
      certainty.
    - Ability to sell.
    - and so on.
- Art, jewelry and collectibles.
- i. Distributed in kind versus sale.
  
  ii. Time period and costs to effectuate
  appraisals, insurance, transport, sale, etc.
- Business interests.
- i. Buy sell agreement terms and
  funding.
  
  ii. Transfer in kind to heirs/trusts or
  liquidate.
  
  iii. Governing instrument.
- Professional practices (including solo practitioners).
  i. Short half-life if not marketed and
  transitioned quickly.
  
  ii. Buy out or succession plan if any.
  
  e. Concentrated stock positions.
Implications of illiquidity
- Heirs.
  i. Heirs living expenses.
  
  ii. Expectations of heirs.
- Property, casualty and other insurance issues.
  i. Named insured should be updated to
  reflect personal representative and trusts.
  
  ii. How long will insurance company cover
  vacant property.
- Operations of a business.
  i. Succession plan.
  
  ii. Who will perform. Example, the
  accountant as executor of the estate of a real estate developer
  or physician with no succession plan in place.
- Payment of estate taxes.
  i. Cash impact.
  
  ii. See below.
- Other.
Cash flow sources to address illiquidity
- Loans.
  i. Third party loans.
  
  1. Viability and cost.
  
  ii. Related party loans generally.
  
  1. Respect for tax purposes.
  
  2. How set collateral and interest
  rates.
  
  3. Opposing family members and/or
  heirs.
  
  iii. Revolving loan from heir or family
  entity.
  
  1. See sample loan document.
- Business/real estate ongoing operations.
  i. Impact of death of principal.
- Key person insurance.
  i. Adequacy.
  
  ii. Impact of governing documents, e.g.
  buy sell agreements.
- Insurance outside the business (e.g., ILIT).
  i. Is it available to infuse liquidity to
  the estate.
  
  ii. Other constraints.
  
  iii. Different fiduciaries.
- Sale of assets.
  i. Can assets be sold.
  
  ii. Price at which sale can be realized.
  Perception of many buyers that estates often must sell at
  distressed prices.
  
  iii. Time period and costs to sell.
  
  iv. Impact of probate issues.
Succession Planning for Illiquid assets
- Buy sell agreements.
  i. Lauder. Estate of Joseph H. Lauder,
  T.C. Memo 1992-736.