September 2008

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MONTH YEAR: Lead Article: 1 ¾ pages [2nd page about 45 lines]
Lead Article Title: Trust Planning Through Economic TurmoilSummary: The markets are in turmoil. Daily Dow movements make Cedar Point roller coasters look tame. The remake of the movie “Fast and Furious” will star a number of leading bankers. Lending sources have dried up for many. Tax, business, economic, investment matters are increasingly uncertain. How does this affect your planning? The bottom line is that you need to reevaluate all aspects of your planning with consideration to the current environment, while at the same time continuing to maintain planning basics. This article will provide an overview of some of the points you might consider. Given that ugly news is coming at Warp Speed, some of the comments below may not even be relevant once this newsletter hits your desk. Beam me up Scottie!

Insurance and Insurance Trusts (ILIT)

Even in rosy financial environments it is advisable every couple of years to review the financial status of the insurance company, obtain an in-force illustration and so on. Whether you’ve done this in the last year or two, the current turmoil should motivate you to do a review now. Don’t assume your insurance company is safe, AIG changed all that. Query how that changes the fiduciary responsibility of trustees? If the policy is a variable policy, how badly have the underlying mutual funds been hammered? What does that do to future plans and the viability of the policy? If the variable policy is held inside a trust, what about the impact on the need for future gifts? What if the grantor has made other plans for her annual gifts? Just because your brother in law asked you to be a trustee doesn’t mean you can ignore your responsibilities as trustee! Action Steps: Review and document the current status of the insurance company. If new insurance is purchased diversify – use a different carrier. Reevaluate whether the lower rate from a less secure insurer is a bargain or a problem waiting to happen. Obtain an in-force illustration and review steps you might take to shore up the policy. If you’re a trustee, meet with counsel and review the benefits or obligations to communicate these matters with trust beneficiaries.

Insurance may need to be evaluated from another perspective. If your other income sources have been reduced, can you reduce or even delay insurance premiums for a couple of years until your financial situation turns around? Recent market shockwaves may have altered the fundamental reasons you purchased the insurance (to pay estate tax on your now defunct mortgage lending business). Re-evaluate what your needs are. You may want to freeze what had been an aggressive gift plan so that your insurance needs may increase. Perhaps you are now convinced that economic developments will force Congress to strengthen the estate tax, not repeal it. Perhaps increasing insurance in spite of economic conditions is the right move for you. Action Steps: Reevaluate all insurance decisions.

Securities GRATs

Grantor Retained Annuity Trusts come in many flavors. A common flavor has been a short term, typically two year GRAT designed to capture upside (not downside!) market volatility. The annuity paid to the grantor would be set high enough so that the GRAT would have a nominal value for gift tax purposes (the so-called post-Walton zeroed out GRAT). The result of this approach is that a substantial portion of the assets of the GRAT (your principal plus the 7520 mandated return) would be paid back to you as the grantor setting up the GRAT. Any market returns (do you remember what that means?) above the mandated federal interest rate, would inure to the benefit of your heirs (or a trust for them under the GRAT). This would result in your having to re-GRAT the large distribution you receive in each year of the GRAT to a new GRAT. This is why the technique of using repetitive short term GRATs is referred to as “rolling” or “cascading” GRATs. Whoops, instead of earning more than the mandated interest rate, your GRAT is worth 20% less than what you initially transferred to it. Most likely your GRAT will bust. All the assets will be distributed to you with nothing left for the heirs. What do you do? When life hands you a lemon, make lemonade! When the final GRAT assets are repaid to you, the trustees should sign a short acknowledgement that the GRAT has been terminated with a final payment to you (so that there is a record in the files of what happened should a question arise in future years). Next, continue your plan. Set up a new GRAT and re-gift the assets to the new GRAT. This was your plan when you undertook the rolling GRAT plan, no need to change now. If in fact the markets have been sufficiently hammered, this may be the ideal time to contribute depressed assets to a new GRAT. Stick with the discipline. If the asset class contributed to the GRAT rises within two years, you’ll have made GRAT lemonade.

Real Estate and Business Note Sale Transactions

A common estate planning technique is to sell assets to a trust. This type of transaction can take many forms. The sale can be to a irrevocable grantor (taxed to you as grantor) trust (IDIT) for a note, for a self-cancelling installment note (SCIN), for a private annuity, etc. Similarly, many clients gift interests in assets to GRATs. A key to these transactions achieving their goals is that the assets will generate sufficient cash flow for the trust to pay the note, or the GRAT to make its periodic annuity payment. If economic developments have cast doubt on the trust being able to make payments out of cash flow, don’t miss any payments. Don’t miss a payment as it may provide a basis for the IRS to challenge the validity of the entire transaction. Audits have focused more attention on compliance with the formalities of maintaining the transaction. Issuing a note back to you to meet a GRAT payment won’t fly. While it might be feasible to secure third party lending by the trust, this is likely to be complex in normal times, and perhaps impossible under current market conditions. The result will be that you may have to distribute back part of the equity of the underlying real estate, business interests, etc. This will require an appraisal. Watch out for discount whipsaw! If you realized a 35% discount on the 45% LLC interest you sold to the IDIT, or gave to the GRAT, will a higher discount apply to the 2% LLC interest that is distributed back to you? Again, while it is a cost, it doesn’t necessarily disrupt your plan. Most of these transactions contemplated re-distribution of equity interests anyhow. Action Step: Review cash flow and payment options now, not when they become due.

Discounts and Valuations

Discounts are a cornerstone of many estate planning leveraging techniques. A discount is simply illustrated as follows: 30% of a $100 business is worth less than $30 because the minority interests is hard to market and has no control. Has recent market turmoil legitimately increased the discounts on certain transactions?

What about valuations? While the decline in the value of marketable assets is pretty obvious, other assets have also taken big valuation hits. To understand the impact, consider an approach of building up a capitalization rate for valuing real estate assets in today’s environment: [Corporate bond rate + Premium for lower liquidity of target asset as compared to bonds generally + Premium for greater management difficulty of real estate + Premium for unique difficulties of assets in question (location, difficulty to liquidate) + Premium for additional management burdens of residential real estate, vacancy and credit risks of tenants in the actual properties involved + Premium to reflect unique factors in 2008 = Total Capitalization Rate.] Credit risks may be far greater than they have been in years. Unique factors certainly exist in the current market. Action Step: Now may be an opportune time to structure gifts. Higher discounts might be justified. Asset values may be depressed. Interest rates remain low. Estate taxes are unlikely to be repealed. Stop hiding under the bed. Move your planning forward.

Conclusion

Market turmoil is never pleasant. Taking the ostrich approach could torpedo your planning. Instead of fretting about what you can’t control, take charge of the planning that you can. This article has illustrated only a few of the myriad of ways recent developments may have impacted your trusts.

Checklist: Second Article 2 lines less than One Page [about 54 lines]:
Checklist Article Title: Business Contraction

Summary: With economic problems growing, you might be inclined to contract your business or professional practice. Unfortunately, there are a myriad of issues and problems with this seemingly simple task. This checklist reviews only a few of the many concerns you’ll face. (See Practical Planner April 2007 for a discussion of an employee’s perspective on reviewing a termination agreement).

◙ Can you Fire a Partner.
When business was humming, marginal partners may have been profitable. Now they may not even be tolerable. Can you fire a partner? While a severe measure, it may become necessary. Since there may be no right under state law to remove a partner, the provisions of the partnership agreement are essential to consider. So start by reviewing all governing documents (employment agreement, shareholders’ agreement, etc.). What do the agreements provide for? Is there a mechanism to force a buyout or termination? Has the situation eroded to a point where application of a “for cause” provision can be justified? Be mindful that remaining partners owe a fiduciary duty to the targeted partners. What are the demographics of the particular partner you’re seeking to terminate? Evaluate the risk that a terminated partner may claim age discrimination. Terminated partners might also sue on the basis that the remaining partners violated their fiduciary or contractual obligations due the terminated partner. Evaluate all the potential risks, disruption to the practice, and the costs of severance and termination into your analysis. Perhaps creating a contract or non-equity partner status may be a preferable compromise to both parties to reduce the likelihood of suits and costs that offset the hoped-for savings.

◙ Defer Making a New Partner.
Your medical practice hired a new associate 2 years ago under an employment agreement that gave you an opportunity to “date” until both sides made a decision as to partnership. Your practice focuses on high end elective procedures so that the economic downturn is having an impact on your revenues, and you fear it will worsen. If the associate is a good fit, perhaps you can delay partnership another year to keep the practice profitable for existing senior partners. Before making this move carefully determine who told what to the new associate. If the managing partner of your practice promised the associate that she’d be a partner “for sure”, she might have a successful claim against you for the deferral. Bottom Line: This doesn’t mean that deferral isn’t a possible course of action, just that you have to be mindful of the risks inherent in the process.

◙ Terminated Employee/Partner Non-Compete.
Will the non-compete clauses in the partnership or employment agreement protect your business? The law governing non-compete agreements is constantly evolving, and varies by state, caution is always in order. In a recent California case, for example, Edwards v. Arthur Andersen, LLP, S147190 (Cal. Aug. 7 2008), the court upheld a California statute limiting non-compete agreements. In this case the employee signed a non-compete when he began employment as a tax accountant in which he agreed that for 18-months after termination he would not perform similar services for any clients of his employer and that for 12 months after termination he would not solicit any of the employer’s clients. The court found that the noncompetition agreement was invalid because it restricted the employee’s ability to practice his profession in violation of the statute. Bottom Line: Review any restrictions before taking action. If a former employee/partner will be able to compete, especially at a lower cost in hard economic times, is termination the best option? Be certain all future agreements contain enforceable provisions, include severability clauses that endeavor to save the rest of the agreement (and other restrictions) in the event the non-compete (or any other clause) is deemed too broad to be valid.

◙ Get a Release/Termination Agreement.
If you’re terminating an employee or partner, it has become common practice to make a severance payment to obtain a release of claims to hopefully avoid the issues outlined above. But releases are not a guarantee against a lawsuit. Give the employee reasonable time to review the release. The release should be understandable (if you cannot read it without crib notes, it won’t past muster). Use captions, define technical terms, etc. Some claims can only be waived if they are expressly noted in the release or termination agreement, such as the waiver of age based claims under the EEOC or the Older Workers Benefit Protection Act (OWBPA). Some claims cannot be waived in a termination agreement with an employee, such as claims under the Fair Labor Standards Act (FLSA) so that these should be excluded. Some advisers even advocate that the right to pursue these claims be affirmatively stated in the agreement.

Conclusion.

Economic challenges will force many businesses to restructure to survive. Before proceeding with any step, carefully evaluate all the practical, business, legal and other ancillary issues.

Recent Developments Article 1/3 Page [about 18 lines]:

◙ Taxation of Payments Received by Former Employee. Apropos to the checklist article is a recent ruling on tax consequences of structuring a settlement with a terminated employee. A former employee entered into a settlement with her employer relating to mental anguish and emotional distress from a claimed hostile work environment. The IRS held that the economic benefit and constrictive receipt doctrines would not apply to cause the employee to report income prior to her actual receipt of cash. PLR 200836019. The Settlement Agreement and Release which the employer and employee entered into required a payment of a lump sum initially, and periodic payments for other claims. The agreements preclude the employee for accelerating, deferring or otherwise changing the payment sequence. The employee cannot elect to receive the commuted value of the periodic payments. The employer could enter into a non-qualified assignment with a company that will make the payments. No assets were set aside to secure these payments. The employee is not deemed to have received any property when the employer pays the assignment company funds. Because of the restrictions on the employee she cannot be deemed to constructively receive the funds, there is no current taxation.
◙ Malpractice Coverage . All professionals need it (except for those streakers who think going bare is smart). An attorney was recently sued for malpractice. Then the nightmare of all professionals took place. The insurer denied coverage. The insurer claimed that the attorney had an awareness of the claim in 2003, so that coverage under a 2004 policy was not required. The attorney should have notified the insurer in 2003 when he first became aware of the issue. Ackerman v Westport Insurance Corp., Dist. Ct. (Linares, USDJ), 9/8/08. Deteriorating economic conditions, deals falling apart, and more, are all likely to trigger more claims. All professionals should be wary of the lessons of this case and report any possible issues at the first appearance of a potential claim.

Potpourri ½ Page:

◙ Readers’ Comments:

Qualified Joint Venture – May 2008 Recent Developments discussed CCA 200816030. For a husband and wife to make the election under Code Section 761(f) to avoid filing a partnership tax return, they must be conducting a “trade or business”. The IRS has indicated that the spouses must own the business as co-owners and not in the name of a state law entity. [Thanks to Todd Wieseneck, Esq.]

Appraisals – August 2008 Lead article “Appraisals: Key to Planning” mentioned that the factors noted in Revenue Rulings 59-60 and 68-609 should be considered. Of the two, 59-60 remains the primary source. According to one expert the capitalized excess earnings method of 68-609 is not commonly used. [Thanks to Kenneth Arlein].

◙ Rental Real Estate Clean Ups: It appears that environmental issues are not the only clean up many property owners have to worry about. The government has estimated that 53% of individuals owning rental properties inappropriately report their tax results, to the tune of an aggregate $12.4 billion understatement. That’s not chickenfeed. Expect tougher tax audits of real estate rental activities. If you’re being loose with your compliance clean up your act before Uncle Sam begins what will likely be a crack down. GAO-08-956. See the full report at http://www.gao.gov/new.items/d08956.pdf.

◙ Declining Insurance Rates: Good News: Life insurance rates are declining, in part due to increased mortality. With the stock market meltdown, one source of savings might be to review your insurance coverage and see if you can identify any opportunities for cost savings. Bad News: For those of you who got snookered (whether by a broker or your own greed) into buying an insurance policy with the intent to sell it in a couple of years, the deal just got worse (apart from other clamp-downs on such policies). Increased life expectancy means buyers will pay less for those policies! Evaluate your options with an independent insurance consultant.

Back Page Announcements:

Publications:

Seminars: CPE Seminar No. 8: “Depreciation Planning: Component Depreciation; Sec. 179; Special Rules”. David Grant of J.H. Cohn & Co., LP, and Ron Gold, ASA.

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