Chapter 14 Trusts and Closely-held Business Strategies

Trusts and Closely-held Business Strategies as Estate Planning Tools • What is the role of estate planning? • To minimize transfer taxes at death and in life. • What are common estate planning tools? • Trusts for use with minors, to make charitable contributions and as estate freeze mechanisms. • Family limited partnerships and closely-held corporations.

Powers of Appointment • A power of appointment is a power granted to another to determine who will own, enjoy, or the use the property that is the subject of the power, now or in the future. • A general power of appointment is one that the holder may exercise in favor of himself, his creditors, his estate or the creditors of his estate. • The property is includible in the holder’s estate. • Income from the property is taxed to the holder. • An exercise of the power in favor of another is a taxable gift. • The lapse of a general power of appointment can result in a taxable gift if the value of the property subject to the power exceeds greater of (1) $5,000 or (2) 5% of the aggregate value of the property. • A limited power of appointment gives the holder the power to appoint the property to anyone but himself, his creditors, his estate or creditors of his estate. • No gift or estate tax consequences result • A limited power of appointment exercisable in favor of the power holder does not result in inclusion in the holder’s estate if the exercise is limited by an ascertainable standard.

Revocable and Irrevocable Trusts • A revocable trust is one that may be altered, amended, revoked or terminated by the grantor at any time upon appropriate notice. • The grantor has the unilateral power to take back everything he transferred to the trust, with the following tax consequences: • The income from the trust property is taxed to the grantor. • No completed gift occurs when the trust is created. • The value of the trust property is includible in the grantor’s estate. • An irrevocable trust is one where the grantor relinquishes complete dominion and control of the trust property. • How is an irrevocable trust commonly set-up? • With an income interest to one beneficiary for life and a remainder interest to another beneficiary. • The grantor thus makes two gifts – an income interest (a present interest) and a remainder interest (a future interest). • Both must be valued for the gift tax return. How are they valued? • The present value of the remainder interest is determined by locating the appropriate factor in IRS provided tables based on the age of the life interest holder and 120% of the AFR at the time of gift. The actuarial factor is applied to the fair market value of the property transferred to trust to calculate the value of the remainder interest. The value of the income interest is determined by subtracting the present value of the future interest from the whole.

Irrevocable Transfers with a Retained Life Estate: General Tax Consequences • What is the tax consequence if the grantor makes an irrevocable transfer of property to a trust but retains an income interest (or the right to control who enjoys the income) from the trust property? • Answer: Code Sec. 2036 calls back into the grantor’s estate trust property over which the grantor retained a right (extinguished only at death) to enjoy the income from the trust. • The creation of a trust with a grantor retained income interest results in a completed gift of the remainder interest; however, the property is also included in the gross estate of the grantor. • Code Sec. 2072 values the income interest to the grantor at $0 if the remainder interest passes to an applicable family member of the grantor at his death. • An applicable family member is a spouse, ancestor, descendant, sibling, or spouse of any of these.

Insurance Trusts • Life insurance proceeds are included in the decedent’s estate if (1) payable to the estate or payable to another, such as a trust, for the use or benefit of the estate, (2) the grantor retained incidents of ownership in the policy, or (3) the policy was transferred to another within 3 years of the decedent’s death. • How may this result be avoided? • An irrevocable life insurance trust is a vehicle often used to remove life insurance proceeds from the gross taxable estate of the decedent. • The trust owns the policy, holds all incidents of ownership, pays the premiums, and receives the proceeds for the benefit of the trust beneficiaries on the grantor’s death. • Premiums are often paid from annual contributions made by the grantor. • The contributions qualify for the annual exclusion if the terms of the trust provide the beneficiaries with the opportunity to demand withdrawal of the gifted amounts by exercising a Crummey withdrawal power.

Trusts for the Benefit of Minors – Code Sec. 2503(c) • A Code Sec. 2503(c) trust is an irrevocable trust set up for the benefit of a minor. • Contributions to such a trust may qualify for the annual donee exclusion although no income is currently required to be paid to or for the benefit of the minor. • The following three conditions must be met: • The income and principal may be used on the minor’s behalf before he or she reaches 21 years of age. • Any amounts not so expended must be paid to the beneficiary upon reaching 21. • If the minor dies prior to reaching 21 the undistributed trust property must be paid to his or her estate or a beneficiary designated by the minor pursuant to a general power of appointment.

Trusts and Charitable Contributions • Query: Should charitable contributions be made during the donor’s lifetime or at death considering they are excluded from the transfer tax base in either case? • Answer: In general, it is best to make significant charitable contribution during the donor’s life time to take advantage of the income tax deduction (not available at death). • A disadvantage to life-time transfers is that the donor loses control and use of the property, if needed. • Trusts can be used to give the grantor a current income tax deduction and use or enjoyment of the property. • Two types of charitable trusts are commonly used - charitable remainder trusts and charitable lead trusts.

Charitable Remainder Trusts and Charitable Lead Trusts • Charitable Remainder Trusts - The grantor transfers property to trust reserving an income interest to himself or herself for life with the remainder to a qualified charity. • CRAT - The grantor’s income interest is determined as a fixed dollar amount payable each year – a charitable remainder annuity trust . • CRUT - The grantor’s income interest is determined as a percentage of the value of the trust re-determined each year – a charitable remainder unitrust. • Tax Consequences: The transfer of the appreciated property to the trust removes it from the grantor’s gross taxable estate resulting in a decrease in the estate tax due, guarantees the grantor an income stream for life esp. during retirement, and provides an income tax deduction for the value of the remainder interest to charity. • Charitable Lead Trusts – The grantor makes an irrevocable transfer of property to a trust granting an income interest for a term of years payable to a qualified charity with the remainder to the grantor’s designated beneficiaries. • The present value of the income interest granted to the charity qualifies for the charitable deduction. • There is a gift of a future interest to the remainderperson.

Estate Freezes • What is an estate tax freeze? • Answer: A tool or mechanism used to freeze the value of an individual’s assets for estate or gift tax purposes at a point in time permitting future appreciation to accrue to beneficiaries, thereby minimizing transfer tax costs. • Estate freeze mechanisms or tools permit the grantor/transferor to transfer future appreciation while often retaining some benefit from the property. • What are two examples of traditional estate freezes? • (1) The owner of a small business recapitalizes issuing two classes of stock - voting preferred and nonvoting common. The owner retains the voting preferred to which most of the current value of the business is attached due to its voting preference. The owner then gradually gifts the common stock interests (holding the benefit of future appreciation), which have little current value because of their subordinate status to his or her children. • (2) Parents transfer their house to an irrevocable trust retaining a life estate with the remainder to the children at death. The value of the remainder interest is valued quite low assuming a relatively high rate of return on the income interest, such as 10%. If the parent survives the 10 year term, the future appreciation inures the benefit of the children without additional transfer tax consequences. • The Congressional response to estate freeze mechanisms was to enact Code Secs. 2701 to 2704.

Installment Sales as a Freeze Strategy • An individual, approaching retirement, could sell business or investment assets, typically to children or other family members, on an installment basis to freeze estate values. • How does the estate freeze work? • If the seller dies before the note is collected in full only the face value of the remaining payments is included in his or her estate, any appreciation subsequent to the sale rests in the hands of the buyer. • No gift tax consequences result if the property was sold at fair market value. • If the seller dies before all payments are collected the beneficiary of the note steps into his shoes and will report income in the same manner as the seller – IRD. • Self-Canceling Installment Note (SCIN) • In some installment sales, especially those between family members, a provision is included which cancels the note on the earlier of payment in full or the death of the seller. • Include a risk premium in the sale’s price to account for the premature death of the seller. • The term of the note must be less than the seller’s remaining life expectancy. • The tax consequences associated with a SCIN: • The value of the note is not included in the seller’s estate as it is extinguished. • The unreported gain is IRD and is included in the estate’s income tax return.

Using Trusts as Estate Freezes • A trust designed with an estate freeze typically grants a life interest in the form of a term of years or annuity to the grantor followed by a gift of the remainder to the grantor’s family members. • They take three basic forms: Grantor Retained Income Trust (GRIT), Grantor Retained Annuity Trust (GRAT) or Grantor Retained Unitrust (GRUT). • Tax savings goals of such a trust: • Because the grantor retains an income interest, only the value of the remainder interest is a taxable gift. • The downside to all three trust strategies is that if the grantor dies prior to termination of the income interest, the value of the all the assets held in trust is includible in the grantor’s estate under Code Sec. 2036(a).

GRITs • A GRIT is usually formed when the grantor transfers business or investment property, retaining an interest in all of the income for a term of years, with the remainder to the grantor’s family members. The value of the life-interest is carved out of the transfer, leaving the remainder interest as the only taxable portion of the transfer. • Code Sec. 2702(b) deems the value of the grantor’s retained income interest to be $0 if the remainder passes to an applicable family member (spouse, ancestor, descendant, sibling, or spouse of any of these) unless the retained income interest in the grantor is a qualified interest. • The result is that the taxable gift is the entire value of the property transferred to trust. • Qualified interests are GRATs and GRUTs. • The GRIT rules do not apply to transfers to unrelated parties or non-applicable family members and the creation of qualified personal residence trusts (QPRTs).

GRATs and GRUTs • A GRAT is an irrevocable trust which provides the grantor with a fixed annuity (expressed as a fixed dollar amount or percentage of the value of the trust on formation) for a term of years or the earlier death of the grantor. • The grantor must receive the annuity amount each year in cash or assets of the trust for the term of years or the grantor’s life. • On the grantor’s death the remainder passes to the grantor’s beneficiaries in trust or outright. • The remainder is valued by backing out the present value of the annuity from the fair market value of the trust property. • If the grantor dies before the income term has expired, only the portion of the principal which is necessary to produce the remaining annuity, using the Code Sec. 7520 interest in effect on the valuation date, is included in the grantor’s estate. • A GRUT operates in the same manner as the GRAT, however, the grantor’s income interest is in the form of a unitrust amount. • A unitrust amount is a percentage of the fair market value of the trusts assets recalculated annually.

Minority and Marketability Discount Strategies for Family-Held Businesses • One issue that arises in estate planning is valuing closely-held business interests. • In recent years, taxpayers have won judicial victories permitting a minority discount. • In Hooper, the Tax Court held that the a minority discount should be applied in valuing the decedent’s 1/3rd interest because “minority stock interests in a close corporation are usually worth much less than the proportionate share of the assets to which they attach.” • IRS Strategies Used to Block Minority Discounts • A minority discount should not be allowed when the transferor’s interest represents a swing vote in taking corporate action, thus indirectly controlling corporate activity. • The Service had some success with the step-transaction doctrine when successive small transfers of stock ownership over a short-period of time are collapsed into one transaction, indicating the series of transfers was made solely to benefit from a minority discount. • Lack of Marketability Discounts • A marketability discount is justified when there is no ready market of willing buyers for the stock interest.

The Family Limited Partnership (FLP) as an Estate Planning Tool • What is an FLP? How is it set-up? • An FLP is generally formed by transferring assets (usually business assets) to a partnership in exchange for general and limited partnership interests. • The general partnership interests are held by the donor of the property for control purposes. • Other family members may contribute a small amount of cash in exchange for limited partnership interests. • The general partner (usually parent(s)) then gift limited partnership interests to children taking advantage of the annual exclusion, minority, and lack of marketability discounts. • On the general partner’s death, his or her remaining interest may also be valued using a minority or lack of marketability discounts.

The Family Limited Partnership (FLP) as an Estate Planning Tool (Cont’d) • IRS Attacks on FLPs • When created with a lack of business purpose, the entity itself is ignored for gift and estate purposes and the underlying assets are valued at FMV. • When the partnership form is not respected; the FLP is a sham. • Actions such as co-mingling of partnership and partner assets indicate a lack of business purpose for the FLP. • Using the step-transaction doctrine. • To disqualify transfers under Code Sec. 2036(a). • Code Sec. 2036(a) calls back into the decedent’s gross estate any interest in property which he or she transferred but retained the right, during his or her lifetime, to possess, use or enjoy or to designate who will possess, use or enjoy such property and which was not transferred for full and adequate consideration. • Most challenges under this Section have been based on the theory that the transferor retained an interest in the property, including an implied right to continue to control and enjoy the transferred assets.

Formation of FLP Attacked as Not a Bona-fide Sale • The existence of an FLP has been successfully attacked as not a bona fide sale when the partners, especially limited partners, do not contribute capital in accordance with their partnership interests and/or the partners distributions are not proportionate to their ownership interests. • Query: When will transfers of property to an FLP in exchange for partnership interests constitute a bona fide sale (adequate consideration) such that minority discounts will be allowed? • Answer: The 5th Circuit in Kimbell established a five factor safe-harbor from IRS attack: • Most importantly, the transferor retained sufficient assets outside of the partnership to provide for his or her support. • Personal and partnership assets are not commingled. • Entity formalities are followed and assets are actually contributed to the partnership. • There is a business reason for the formation of the partnership. • Valid non-tax reasons exist for creation of the FLP, such as legal protection from creditors, reducing administrative costs, and centralization of management.

Intentionally Defective Irrevocable Trust (IDIT) • An IDIT is a relatively new, as of yet unchallenged, estate planning technique - Use with caution! • The steps to formation of IDIT include the following: • An irrevocable trust is formed with designated beneficiaries receiving the property on the grantor’s death. • The grantor retains disqualifying powers which cause the transfer to be incomplete and characterized as a grantor trust, with all income taxed to the grantor. • The grantor funds the trust through a taxable gift of a small portion of trust property, such as 10%, of the value that the trust will ultimately hold. • The grantor then sells the remaining trust property at fair market value, usually appreciating property, to the trust in exchange for an installment note bearing interest at the current AFR. • No gain or loss is recognized because the sale is between the grantor and grantor trust (one in the same) nor is the grantor taxed on the interest income received. • Note, with any of these techniques additional tax savings can be achieved with the formation of a closely-held corporation or an FLP by transferring these business interests to a GRAT or IDIT and taking advantage of minority and lack of marketability discounts.

Chapter 14 Trusts and Closely-held Business Strategies