GTH Estate Planning Blog

Lars has seen a lot in his three decades as a CPA. One thing he's learned is that in taxes, investments, and estate planning, the most dangerous clients aren't the ones who need a lot of guidance, but rather the ones who don't need any. The ones who know it all. It tends to run in certain occupations.

Take the subject of tax-saving gifts, for instance. There are a lot of untruths and one big favorable set of truths, more so now with the new law. Here are some of the assertions he hears:

"I can only give $10,000 a year." This is the annual gift tax exclusion (actually $14,000 now), the amount one person can give any other person each year without using any lifetime gift tax exemption. But it's not really the limit. One still doesn't pay any tax as one uses the lifetime exemption (now $5,250,000 for each giver).

"OK, but I don't want to use my lifetime exemption. I want to save it for my estate." Well, it would save it not to make gifts, but once you have given away those stocks or that real estate, all future income and appreciation on the gift occurs out of your taxable estate. So it pays to use it as one can afford to.

Our CPA friend Lars and his rich Uncle Nils are having one of their regular dinners at the oddly named restaurant Guy. Nils has heard that the State of Washington's legislature, desperate for funds, is talking about doubling the already-high estate tax rate for its residents. He's thinking about moving.

Nils has been on the internet and describes some of his findings to Lars. A minority of states impose an estate tax. Washington's tax starts at 10% on estates over $2 million, and goes up to 19% for larger amounts. It's one of the highest in the nation.

Nils knows a couple of guys who have already declared other states their home now. Some states are better than others. California has an income tax that significantly undermines the benefit of moving, unless one manages to do it just before one dies. Nevada is better, with neither an income tax nor an estate tax, but few people seem to be talking about moving there.

Lars is a tax guy. This has been a good skill for him. He likes it, kind of a math-like career foundation that makes him useful, earns him a good living, and has forced him (he recognizes) to develop people skills in order for things to go well. He's gotten more interested in estate planning and estate taxes in recent years, but income taxes have been his bread and butter for most of his career.

What Congress did at the beginning of January is an interesting combination of income taxes and estate planning stuff. It's mostly good for those who are wealthy or want to get there. There is still a favorable tax rate for capital gains (generally a maximum of 20%, compared with 39.6% on ordinary income), and the lower rate was also maintained for qualifying dividends. Of course there is policy justification for taxing dividends at lower rates; theoretically at least the corporation's income has already been taxed. But it's still a good deal for those who have stocks, like Lars. His portfolio will grow a little faster over time as a result.

Our friend Lars and his wife Kyra have a Living Trust with a bypass trust arrangement. This means that the share of the first spouse to die, is to be held in trust for the lifetime benefit of the surviving spouse. One of the benefits of this trust is that it would preserve the estate tax exemption of the first estate. There is a new conventional wisdom that bypass trusts aren't needed now that we have portability, by which the surviving spouse inherits the unused portion of the deceased spouse's exemption whether there is a trust or not.

Lars isn't buying this new thinking. If his estate goes outright to Kyra, she inherits his now $5,250,000 unused exemption to add to her own, but can lose it if she remarries. So a possible result is preserving no exemption of the first estate. If instead a $5,250,000 trust is established and grows in value to $10,000,000 during the surviving spouse's lifetime, the first estate gets that much exemption.

Our CPA friend Lars is on one of his crunchy early Sunday walks on the rocky beach. It's light by 7 now. Kyra is sleeping in. Lars can't, or at least would rather walk and think.

CPAs do more income tax work than estate work, but as he and his clients have matured and become more wealthy, he's taken a special interest in gift and estate taxes, and other aspects of estate planning. This morning he's trying to psych out the meaning of the recent Federal tax law changes for him and his practice.

One thing that has happened, at least in Lars's State of Washington, is that state estate taxes have become more important. The main reason is pretty obvious: the State exemption (in Washington) is $2 million per estate; the Federal is now $5,250,000. For a married couple those numbers are doubled, if there is proper planning. At these levels, Lars's rich Uncle Nils still has to worry about the Federal estate tax, but he's in a small minority. Lars and many of his clients fall between $4 million and $10 million, where only the State estate tax is a concern.

Saturday, December 22nd. Lars is at his CPA office, making sure details are worked out for a few clients making year-end gifts. Nobody knows what Congress will do with the estate and gift tax laws in 2013. The gift tax exemption might drop from $5 million per giver to $1 million, but Lars doesn't think that's probable.

One of Lars's clients is a newly-widowed woman whose husband had a successful business. She's not old, but she's not young. She has been trying, with Lars's help, to determine whether to make large gifts of company stock or other assets, to her children before year-end. This ain't right that she has to wrestle with this so soon after her husband died, Lars muses. Even if Congress puts something together this last week of the year, the widow has still been burdened with worried uncertainty.

It has been a busier than usual first half of December for our CPA friend Lars, with a number of clients deciding late in the year to take advantage of the $5 million gift tax exemption that might be reduced in 2013. It's the 16th, and he's out taking one of his early Sunday walks along the gravelly beach. He and Kyra came out Saturday evening for a one-night stand, they like to call these short visits. Drizzle this morning but he doesn't notice it; he's preoccupied with broad thoughts about his work. He loves to get his perspective back at the beach.

Yes, a number of clients making large gifts, but not even most of them who could. And among those who are giving big, few are going to the max. Of course the max is $10 million for a couple, and while Lars has more than his share of very successful clients, $10 million is still a lot in his medium-sized city. He had wondered earlier in the year why few were taking advantage. Now with the deadline looming and the Democrats keeping the White House, more were motivated but not the majority.

Duncan arrives on time for today's meeting with his and Lars's mutual client Jack. Retired rich guy Jack, as is his custom, came in way early and has been distractedly paging through magazines and watching the door for Duncan. Lars was informed of Jack's early arrival but knows better than to go out and try meaningless conversation when Jack really just wants to have the meeting.

They wander into the conference room; Lars's office is large enough but too messy. They all know the purpose is to determine year-end tax-saving gifts for Jack and his wife Andrea, who have already turned their business over to two of their kids (no easy task), but still own a lot of real estate including the business facility, and a large portfolio of cash, stocks, and bonds.

Our CPA friend Lars had observed earlier in the year that surprisingly few clients were taking advantage of the $5 million gift tax exemption that is likely to be reduced after 2012. He had even come up with a few theories why. He had forgotten about the simple factor of procrastination. Now that December has arrived, a number of his clients are calling and asking how they can take advantage.

Most of these clients aren't quite sure what the rules are, but they've heard of the chance of an unfavorable change. Lars tells them what he knows, that in 2012 each person may give away $5 million without paying gift tax. If a person has made large gifts before, in excess of the now $13,000-per-recipient annual gift tax exclusion, those other large gifts will count against the $5 million. And any of the $5 million used by gifts, will count against the estate tax exemption. These are the Federal rules; in Lars's State of Washington gifts are entirely tax free: they aren't counted against the now $2 million estate exemption.

Duncan's next main point is that certain lifetime transfers, to children and charities, can be asset protection. Bernie has already done some of this, for example in creating 529 education accounts for his grandchildren. This move actually has protection of two sorts, partly because it is a transfer (the current topic) and partly because the funds have gone into an asset specially treated (the subject just before this).

Bernie could also give liquid assets or real estate LLC interests to his children or grandchildren, or to trusts for them, so long as there were none of the fraudulent conveyances Duncan had described. In Bernie's case there would be estate tax savings as well as asset protection achieved, because the balance of 2012 is an unusually good time to make tax-saving gifts.

We have seen that Uncle Nils has agreed to leave his Washington house and a $2 million trust for wife Sylvia if he predeceases her. We have more recently seen that Nils has decided to go beyond the minimum requirements of his premarital agreement, and increase the amount of the trust. This will be treated favorably in Nils's estate, allowing it to deduct the gifts from the gross estate in computing the amount of tax. The later cost of this is that what she inherits from Nils must be included in Sylvia's estate, but her estate is much smaller than Nils's so the tax consequence may be minimal.

The eventual gift of the house to Sylvia (assuming Nils dies before her) will qualify for the marital deduction because it is outright. She will be the new owner of the home, in her own name.

The trust for her may be deducted from Nils's estate only if it meets certain rules known as the "QTIP" requirements set mainly to assure that Sylvia gets significant benefit from the trust. What are these rules and what choices does Nils have in designing the trust for her?

We have seen that Uncle Nils has all his investment real estate in limited liability companies (LLCs). He even has one LLC with just cash, waiting to be invested in the next project. Why do people use LLCs?

One big reason is limiting liability. If Nils owned his properties outright, just in his own name and not in an entity, any lawsuit coming out of one of them could threaten all his holdings. So if there were a disastrous loss in just one real estate venture, say an injury or an economic meltdown, someone might get a huge judgment against Nils as owner, and seize any of his assets, not limited to the project in which the loss was incurred. And there are serious potential liabilities in owning real estate; see for instance some of the mold cases in recent years. If on the other hand the property is in an LLC, only the holdings of the LLC would be at risk. A limited partnership has a similar effect, at least for those who are limited partners rather than general partners. In Nils's state of Washington, limited partnership law has recently been updated to offer the same protection to all partners as the LLC, its newer cousin.

A second reason for LLCs is centralization of management where more than one owner is involved. If Nils owns a property with two or three others, it's important to define who is responsible for overseeing any construction, maintenance, insurance, and other business activity. If three people are just plain co-owners without a partnership or LLC agreement, then management remains undefined. In most of Nils's LLCs, nephew Lars is designated as the Manager and his responsibilities and compensation are described, as is the inability of other owners to interfere with Lars's management. Also important is to name successor Managers, in case something should happen to Lars.

Third, LLCs are convenient arrangements for making gifts. Once he places a property in an LLC, Uncle Nils can, on whatever timetable he chooses, share ownership with other family members. It works much better to give LLC interests than fractional interests in direct real estate ownership, for the reasons given above. With an LLC, the new owners have limited liability, and also limited opportunity to participate in decisions. This wouldn't be the case with shared direct ownership. So Nils can give small LLC interests to greatnieces and greatnephews without jeopardizing nephew Lars's control. And Nils has done that with most of his projects. In reporting the gifts he has followed certain valuation principles that bring us to the big debate, the big deal about family partnerships and family LLCs.

As we learned three weeks ago, our CPA friend Lars has recommended three ways for rich Uncle Nils to take advantage of the $5 million Federal gift tax exemption that might not be available after this year. Nils's home state of Washington doesn't tax gifts at all, so large gifts are particularly useful in reducing that tax.

Lars has suggested a personal residence trust with Nils's California house, a transfer of all Nils's interest in his only underperforming real estate LLC, and some combination of gifts of portions of the two more successfully cash-flowing real estate LLCs.

Nils has been turning these ideas over in his head and has a different notion of what he should do. He's pretty clear on what he will tell Lars when they meet again. First, he does not want to give away his California place. He wants to retain complete control of it because he and Sylvia might possibly make that their primary home some day. They've made good friends down there in the winters and the weather is nice. Another motivation to move there is the Washington estate tax: California has none, at least for now. There's a drawback in that California does have an income tax (Washington does not). It's because of this tradeoff that nephew Lars has half-joked that a rich guy should move south just before he dies.

Nils has taken the suggestion of giving the underperforming LLC and amended it in his head. He wants to merge the cash from his inactive LLC into it, and then give it to relatives. The cash can pay down the debt and so allow the property to produce net cash flow. There is enough cash that the merger will also create a pool for additional investment. So when a good deal comes along, Nils and Lars can take advantage of it in the merged-together entity placed outside Nils's taxable estate. This will use most but not all of Nils's remaining gift tax exemption, but he wants to leave it at that plus a couple other notions he has for saving estate tax.

Before we learn of Uncle Nils's decision on major gifts, let's look at a second case about a "defined value clause." In 2004 Mr. and Mrs. Wandry made gifts of interest in their Colorado limited liability company as follows: $261,000 worth to each child, and $11,000 in value to each grandchild. The gift document stated that a third-party valuation would be obtained to determine the ownership percentages equivalent to these dollar amounts. Gift tax returns were filed reporting the dollar amounts of the transfers.

The IRS audited the returns, objecting for much the same reason as in the McCord case we reviewed last week. As the Tax Court opinion put it, the IRS argued "that the adjustment clause does not save [taxpayers] from the tax imposed by section 2501 because it creates a condition subsequent to completed gifts and is void for Federal tax purposes as contrary to public policy." The gift formula, if successful, shielded the taxpayers from any additional tax consequence by audit; if the family LLC interests were found to be worth more, then the only result would be that a smaller percentage was transferred to children and grandchildren.

We're taking a break from our four-part series on Uncle Nils's using his $5 million gift tax exemption, to look at a couple of important recent cases on the valuation of gifts. In each the IRS tried to revalue the gift to cause a greater gift tax liability.

In the first case, Mr. and Mrs. McCord of Shreveport, Louisiana gave all their remaining family partnership interests to family members and charities. The gift document first transferred specific dollar amounts (in the millions) of family partnership interests to a generation-skipping trust, and the sons of the McCords. The balance of the partnership interests were directed by the same document to two charities. The gifts to family members were subject to gift tax, but the interests going to charity were not.

A valuation of the interests was obtained, and the family and charities then entered into a Confirmation Agreement on the partnership percentages going to each recipient. Gift tax returns were filed and then audited. What was it the IRS didn't like about this arrangement?