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Practice Management Tips on Serving as Monitor for Aging Clients

  • Written by Martin M. Shenkman, CPA, MBA, PFS, AEP, JD

mug martin shenkmanCPA practices, large and small, should retool to capitalize on new services the aging population will demand. The nature of services must change because CPAs, as the trusted adviser, will have a far more important role in protecting aging clients. While peak financial decision-making ability occurs at age 50, from age 60 onward there is a gradual decline in financial decision-making quality. By the time a client reaches his or her 80s and 90s there has likely been significant impact. Of even greater concern is that while a client’s abilities decline, the client’s confidence in his or her decision-making ability remains the same.1 The services and practice management changes might firms consider include:

√ Monitoring Services Generally

• Few firms focus much attention on providing and marketing financial monitoring services to clients, but all should.

• Elder financial abuse is a burgeoning threat to aging or infirm clients. Practitioners can identify clients that are aging or have health challenges. Often practitioners will simply know of these issues, and if not medical expense, age and other data in a Form 1040 might provide ample clues. But the reality of the data suggested in the introduction is that many clients will face these issues. Thus, the better approach is to offer services to all clients as they age so the odds of anyone becoming the next elder abuse statistic will be curtailed.

• Practitioners are already well skilled in reviewing accounts and identifying potential issues. These skills simply need to be packaged as a service to offer aging clients before financial disasters occur:

√ Firm Practice Decisions

• Determine how monitoring services will be provided, by whom and at what billing rates.

• Which departments will address these services? Some firms have high net worth family office departments which provide bill paying and similar services as really a luxury purchase. These services can be incredibly helpful to a wide array of new clients and can also open up new practice development opportunities.

• Can or should aging partners, instead of being subjected to mandatory retirement policies, be provided leeway to generate these services from the aging clients they have served for decades? Often long time family CPAs are the person of choice for many clients to serve as a trust protector or in other capacities. In those capacities it may be feasible to have the firm assist in providing the monitoring or other services useful to carrying out those duties.

• Should the firm hire a care manager to provide dollarization of care plan costs for aging clients or subcontract this work out to third parties? This input might be essential to financial planning for aging clients. Also, care managers can provide a valuable add on service to aging clients that might create benefits to the clients by integrating into the monitoring services.

√ Engagement

• Prepare new form engagement letters that clearly delineate what services will be provided, that there is no guarantee of detecting fraud, elder financial abuse or other anomalies, obtaining authority to discuss financial matters with a list of approved persons and authorization to consult with and disclose information to other key advisers (e.g., estate planning attorney, trust officer, etc.). As the array of monitoring services increases the options to be included in form engagement letters should grow.

• Determine who should retain you to provide the services. In some instances it may not be the client but the agent under the client’s durable power of attorney, a successor trustee under the client’s revocable trust, etc. There may even have to be multiple fiduciaries and the client each retaining the practitioner.

√ Automation and Bill Paying

• Review how the client’s financial accounts might be consolidated or simplified to make monitoring easier.

• Arrange for automatic receipt of electronic statements from financial institutions on a monthly basis. Be certain that this is authorized in the engagement letter and obtain whatever documentation each financial firm will require.

• Discuss with the client the advantages of electronic bill paying which you will monitor. Few clients realize the exposure a mailbox of bills and checks can create. While many clients might feel secure receiving and depositing checks each step in that process creates exposure that automation can avoid.

• Assist clients who are able and interested in automating their checkbook and other basic financial functions. Many older clients will simply not have the interest or ability. Guide these clients to the benefits of having the firm’s staff write up books electronically every quarter (or monthly if appropriate).

• Many clients as they age struggle to pay recurring billing. It can often be a simple matter for a practitioner to take over preparing bills, arranging for automatic bill pay of recurring bills. Ideally, setting up a continuum of services that is enhanced as clients age, will give the clients the least cost but most protective result. It will be far easier to take over bill paying for a client for whom you have maintained quarterly electronic records.

• Generate reports to the client of these activities so clients who fear losing control over their finances can be reassured they will actually have more control.

• Simplify and enlarge reports as vision issues for a particular client require, the reports sent to the client. Many clients struggle with vision issues to read and handle bills. Substituting that dilemma for a large print, simple format, report will often be incredibly appreciated.

√ Use Your Monitor Role to Guide the Client to Create Checks and Balances

• Arrange, and obtain approval in writing from the client, to submit copies of the periodic reports to another person. That other person might well include an agent under the client’s durable power of attorney (which authorizes that agent to act on behalf of the client if and when the client cannot do so).

• Build in checks and balances by having an independent family member other than the agent receive reports.

• Assess whether the client has subscribed to third party credit monitoring agencies, and if not whether such a service should be used. Obtaining periodic credit reports for the client may be an inexpensive and useful safeguard regardless of whether the client uses a third party service.

• Create procedures for a review of the bills submitted and the general financial data to which you are given access. For example, if new charges are being incurred perhaps they could be highlighted by a staff member calling the client to confirm and/or in a cover letter to the report. If account activity changes significantly from historic norms that might be a clue to elder financial abuse. The most common and easy to identify is a family member, home health aide or other close person taking an aging client to an ATM on too regular a basis.

√ Formalizing the Monitor Role

• Evaluate whether there is an advantage to the practitioner providing monitoring services in a more formal capacity.

• Should you or your firm be formally designated as a monitor in the client’s durable power of attorney and/or revocable trust? While this may not be necessary to the services you provide, it may assure that an agent or trustee seeking to do financial harm to the client might not terminate your involvement at the earliest opportunity.

“50 is Peak Age for Financial Decision Making,” Fox Business, September 18, 2015, Serena Elavia.

Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.

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Checklist: Single Membership LLC Creative Planning Applications

  • Written by Martin M. Shenkman, CPA, MBA, PFS, AEP, JD

shenkman martinLimited liability companies (LLCs) are ubiquitous in client planning. The default format for most new business and investment endeavors is to recommend the client use an LLC unless there is some overriding reason to consider another form of entity. The common use of LLCs can mask the incredible array of creative planning applications LLCs can provide to a range of different planning options. The following checklist suggests some of the myriad of possibilities and shows how LLCs are a powerful tool in every practitioner’s planning kit.

√ Business Successtion Plan

If a client has a business or professional practice, a creative use of an LLC structure can provide a simple and efficient means of creating a robust succession plan. Instead of operating the practice or business as a sole proprietorship have the client form a manager-managed LLC. This can all be done using pretty standard documentation for modest cost. The client can be named the initial manager of the manager-managed LLC. Operating agreements for a manager-managed LLC are common documents that should not require significant cost or effort. Third parties, such as banks, are quite familiar with manager-managed LLCs. While your client is well he or she can manage the LLC as manager with no impact on the operation of the entity. However, if your client should become ill or incapacitated, fairly routine provisions for a successor manager can provide a practical and simple succession plan. The client might name a colleague (e.g., if a license is required for the practice involved), or a family member or friend (if licensure is not required) as the successor manager. With little more than using a managermanaged LLC structure and standard operating agreement provisions, the succession plan is in place. If the client is incapacitated the successor can use the operating agreement to obtain signature authority over bank and other accounts and manage the business until the client recovers. Because the manager has a fiduciary obligation to the client as member, the client has some assurance that the manager will have an incentive to operate the business during this transition in a reasonable manner. Since LLCs can have a manager who is not a member this application of an LLC should not create any complications. The LLC, even with the successor manager serving, would remain a disregarded entity for income tax purposes.

√ LLCs Formed In Trust Jurisdiction

A physician client or another client seeking stronger asset protection than his home state may afford may create a trust in a state known for better asset protection laws. Alternatively, a client may create a trust in a state, in Delaware for example, that has favorable tax and other laws to reduce state income taxation or achieve other goals. If the client begins a new business or buys a new investment that will be owned in part by that Delaware trust instead of forming the new LLC in the client’s home state, it might be better to be formed in Delaware (or whatever state the trust is in) to increase the connections to that state and perhaps to thereby strengthen the validity of the trust under that state’s laws.

√ Irrevocable Trust Real Estate Ownership

The use of trusts is growing with the aging population and with the growing transfers of wealth, irrevocable trust use will accelerate. Trends in modern trust drafting include using long term, even perpetual, trusts. Often this is accomplished by having the trust based (situs) in a state with laws quite favorable to trust administration. Physicians and other clients concerned about malpractice and liability concerns increasingly rely on trusts formed in states like Alaska, Nevada and South Dakota to provide better protection. A trust formed in say Alaska, by a client living in, for example, New York, cannot own real estate outside of Alaska. To do so would undermine the application of Alaska law and taint the benefits Alaska law might provide. This is because real estate owned in another state would subject that real estate, and hence the trust, to the laws of that second state, New York in the above example. The solution for many irrevocable trusts is simple. The trust can form a single member disregarded LLC, infuse money for a down payment (or even all of the money), and that disregarded LLC can then purchase the home. This transmutes foreign (e.g., New York) real estate into an intangible asset that can be held by the Alaska (or other trust friendly state) trust.

√ Aging Client and Revocable Trust Ownership of a Home

With clients aging the use of revocable trusts to manage assets in later years and protect clients will burgeon. Many clients should name a trust company or bank as successor trustee or successor co-trustee in order to obtain the independence and professionalism an institutional trustee will offer. For many clients there are simply no family members that have the time, ability and integrity to serve in such capacity. Similar to the use of an LLC in the context of planning for an asset protection trust above, the bank or trust company named might be located in a state other than where the client resides or other than where the client owns a vacation home. This raises similar issues to a bank having to deal with real estate in a state where the bank may not be based. Transferring that personal residence to a single member LLC owned by the client’s revocable trust has no impact on home ownership tax benefits (mortgage interest and property tax deductions or home sale exclusion) but can assure proper supervision if the client should become incapacitated. Caution is in order that even though both the single member LLC and revocable trust are disregarded for income tax purposes the transfer might trigger a due on transfer clause in the client’s mortgage, and might change the status of the house for local property tax purposes (e.g., jeopardizing veteran status or senior citizen status for favorable property tax rates).

√ Liability Protection from Inside

Liability LLCs are commonly used to provide protection from what can be referred to as inside liability. This is liability exposure created by the actual property or asset held. So if a rental property can create liability from a tenant filing a lawsuit holding that rental property in a single member disregarded LLC can provide liability protection from suit by a visitor or tenant. So in many instances clients that own rental real estate, a vacation home, a home based business, or other asset that creates exposure can transfer that business or asset to a single member LLC. Because the LLC is disregarded for income tax purposes there is little additional operational cost or complexity involved. Practitioners, however, need to be mindful of the distinction between “inside” and “outside” liability so as not to misadvise clients. If a physician who is quite concerned about malpractice risks owns a rental property (or her practice office) having that property held in a single member disregarded LLC can provide protection from inside liability, the risk emanating from that property. However, it will provide no protection from risks emanating from outside that property, e.g., malpractice risk. If instead the LLC were a true multi-member entity it may then be afforded what is referred to as “charging order” protection under state LLC law. This means that if a malpractice claimant seized on the physician client’s interests in a multi-member LLC owning the property the claimant can reach the distributions made on the physician/member’s interests in the LLC but cannot become a substitute member (e.g., cannot vote or force the liquidation of the LLC). This is an important measure of protection and practitioners should be alert to the inadvisable use of a single member LLC when a stronger form of protection is warranted.

√ Family Vacation Home

Vacation homes are a common asset. It is also common for parents to wish to bequeath a vacation home to children and other heirs. Ownership of a vacation home by several or more siblings presents a number of issues. There can be some liability exposure when owning any real estate. This exposure can be limited to the children by having the vacation home owned by an LLC. See the discussion above concerning inside liability as it applies to this type of application. Often the children have moved out of the home state where they grew up and where the vacation home is located, or the vacation home is in a different state (e.g., near a lake, ocean or in the mountains). That could subject each child to ancillary probate (probate in a state where the property is located in addition to probate in the state where the child is domiciled). If the vacation home is instead held in a family LLC that issue can be avoided. Leaving aside tax and legal considerations, governance can often be a significant issue for family vacation homes. Who should make decisions concerning the property? Should the mortgage be refinanced? The roof replaced? Who gets to use the property over Christmas week (or perhaps Fourth of July week depending on the location and nature of the property)? One or a combination of approaches utilizing simple LLC structures can be employed to address governance concerns. The LLC can be formed as a manager-managed LLC and one heir, or even an independent family member (an older and wiser uncle who does not use the property) might be named manager. Alternatively, the children might in appropriate circumstances elect a manager each year based on provisions in the operating agreement. A second approach (and they need to be mutually exclusive) is for the operating agreement to incorporate rules and regulations as to the use and maintenance of the vacation home. For example, to accommodate everyone’s differing desires the operating agreement could mandate that the vacation property is strictly a no-smoking property and that anyone that wishes to smoke must do so outdoors. Another common issue is usage. A lottery system could be incorporated into the operating agreement where each child is given 365 points a year and the children can bid their points to use the home for given weeks. Another common alternative is to incorporate a rotational use in the operating agreement (e.g., child A gets use of the vacation home over spring break every third year, and so forth). While these examples might sound petty these and other similar issues have created incredibly family conflict, and addressing them with some specificity in an operating agreement has often proven a simple and inexpensive solution.

√ Disregarded LLC For Estate Freeze Transactions

A client seeking to freeze the value of an asset, e.g. a family business, might sell some of the equity in that business to a grantor trust (an intentionally defective irrevocable trust). As a grantor trust, no gain should be recognized on the sale for income tax purposes, but the transaction, if respected, could remove the value of that equity from the client’s estate. The IRS has become more aggressive in auditing and challenging these sales to grantor trusts. Another approach to freeze transactions might involve the client selling assets to an LLC that is a multi-member disregarded entity. The LLC could be owned by the client and one or more grantor trusts. It’s worth noting that sale transactions might be consummated to an LLC instead of a trust. Interests in this disregarded buying LLC can thereafter be gifted to a grantor retained annuity trust (GRAT) thereby freezing the reduced value. Some commentators believe that this type of transactions might be less risky from a gift tax planning perspective. This might be because a GRAT has an automatic adjustment mechanism if the IRS disagrees with the taxpayer’s valuation of the assets transferred, i.e. interests in the disregarded buying LLC above. This adjustment mechanism is contained in the Chapter 14 regulations.

√ Charities May Benefit from Single Member LLCs

A charity may be able to form a single member disregarded LLC to insulate the main charity from the liability risks associated with the assets or activities isolated in the single member LLC. The entirety of the charity and the LLC will all have to comply with the requirements for being a tax-exempt charity. IRS Notice 2012-52 and PLR 200150027. A client may donate an asset, e.g., real estate to a single member disregarded LLC created by a charity to receive the donation, and still obtain the same income tax charitable contribution deduction.

√ LLC Gifts and Discounts

If a client intends to make a gift of LLC interest to his or her children, it is preferable that the LLC have multiple members as of the date of the gift rather than gift gifts of what was prior to the gift a single member LLC. The risk of gifts of interests in a single member LLC that only becomes a multiple member LLC following the gift is that the discounts might be disregarded. Pierre v. Commissioner - T.C. Memo. 2010-106, May 13, 2010. In the new tax world of $5 million inflation adjusted discounts most clients will not benefit from discounts. Perhaps if there is no desire for discounts the additional steps of creating a multi-member LLC prior to consummating the gifts may not be necessary.

√ Use an LLC to Make Real Estate Intangible

Common planning is to have a client that owns real estate in a state that has an estate tax in an LLC so that the real estate will be an intangible property interest not subject to estate tax in that state. Unfortunately, this approach may not always succeed. New York State issued an Advisory Opinion (TSB-A-15(1)M May 29, 2015 holding that a single member LLC holding real estate will be ignored and the underlying property taxed. There are limits on the creative applications of single member LLCs.

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S Corporation Planning

  • Written by Martin M. Shenkman, CPA, MBA, PFS, AEP, JD

The income tax is the new estate tax. With a federal estate tax exemption at over $5 million and increasing by an inflation index in future years, few clients will be subject to an estate tax. That doesn’t mean that income tax and estate planning for clients with S corporations is passé. It is just different. The 2 million plus S corporations all need succession plans. How those shares are passed on to heirs, or whether instead they should be sold, is an important planning opportunity for accountants to assist clients.

Disability Planning
15% to 25% of clients between the ages of around 25 to 65 will experience a disability. What plans does the client have in place to deal with this risk on both a personal and corporate level? Is there a written salary continuation payment provision in the shareholders’ agreement? If the client has a personal disability income replacement policy that has a six-month waiting period before payment, perhaps the client can negotiate with the other shareholders some type of salary continuation, e.g., 100% of salary for the first 30 days of disability, and 50% of salary for the next 90 days, to bridge that gap. If no shareholder currently has any health problems all may be willing to agree to some type of provision that might benefit them as well as other shareholders. What about a buyout provision? Life insurance is often inexpensive, simple and commonly addressed in a buyout, but what about paying for disability? Too often few if any plans are made. While disability buy out insurance can and should be considered, the cost is often more than clients are willing to bear. If that is the case, then practitioners should endeavor to work out other arrangements (e.g., 10% down and the balance over 5 years in quarterly installments, based on 75% of the death buyout value to make the cash flow needs less burdensome).

Succession Planning
If the client dies, the focus for many decades had been minimizing estate tax while passing on interests to children or other heirs. With so few clients facing a federal estate tax all succession plans should be revisited. For example, it has been common for closely held S corporation shareholders to agree on a buyout value to avoid a battle of the appraisers. This amount is often memorialized in a certificate of stated value. The shareholders agreement or buyout agreement might refer to that document. What value does it reflect and when was it last updated? Practitioners will find many of these valuations were created years ago when the client’s focus was colored by their concern over estate taxes. Those values, and that perspective, may no longer be practical.

A Better Succession Plan
Most family business succession plans focus on the senior generation gifting interests in the business to the next generation. A series of recent cases present a framework for what might be a better form of planning for many clients. Don’t have the parents gift the business, have the children start and grow a new business. This can avoid liabilities associated with the parents’ business as well as gift tax worries. The key case in this area is Bross Trucking Inc. v. Commr. TC Memo 2014-17. In Bross, the father owned and operated a trucking company but ran into regulatory issues. To avoid that issue, his three sons started their own trucking business using some of equipment used in the father’s business, and some of the same suppliers and customers. The father was not involved in the new business started by the sons. The IRS said the transaction entailed a distribution of goodwill by Bross Trucking to the father. The likely extension of this argument was the father then gave a gift of goodwill to his three sons that should have been subject to the gift tax. The Tax Court held the IRS was not correct because the goodwill involved actually belonged to the father individually, not to the corporation. Important to this conclusion was there was never an employment agreement or non-compete agreement that bound the father’s actions to the corporation. Practitioners should be alert to business transitions to younger generations. When appropriate consider a similar strategy of having the children form their own business and build their own relationships. As long as the senior generation is not involved there may be no gift transfer. This might provide a gift tax-free succession strategy. Another case that favorably held on a similar strategy was Estate of Adell v. Commr. TC memo 2014-155. For an IRS victory on this issue see Cavallaro v. Comr. TC Memo 2014-189. These cases together can give practitioners a useful roadmap in guiding clients in this planning. Might there be even a better variant of this planning? There is for many clients, yes. Have the new ventures started in an irrevocable trust so it is outside of the children’s estates and potentially more difficult to reach by an ex-spouse.

Family Compensation Reporting

Practitioners know to be alert for compensation arrangements that might be characterized as a second class of stock thereby disqualifying an S corporation from meeting the one class of stock requirement. There is another issue that might be relevant to consider as well in the family context. Is your client making a gift if too large a salary is paid to a child in the family business? How must practitioners disclose such a payment? While generally a gift tax return has to be filed to toll the statute of limitations for a gift, there is an exception for salaries paid to family members in the ordinary course of business. The gift tax regulations require the filing of a gift tax return to meet the adequate disclosure requirement on Form 709 or a statement attached to the return. However, if there is a transfer to a family member in the ordinary course of business it is adequately disclosed if reported for income tax return purpose, the statute of limitations will be tolled for gift tax purposes. So, for example, if a child in a family business receives a year-end bonus and it is reported on the income tax return, that will be deemed adequate disclosure for gift tax purpose (as to IRS characterizing the bonus as a gift) without the filing of a gift tax return.

Watch Tax Trap of Wrong Trusts Holding S Stock

There are a number of different types of trusts that can own S corporation stock. Even if the estate tax does not apply to your clients, your clients may worry about the 50% divorce rate decimating a family business. The answer, even without estate tax worries, is to have the client gift/bequeath S corporation interests into trusts for the next generations. Since only certain types of trusts can qualify to hold S corporation stock without jeopardizing the qualification for S corporation status, practitioners need to be alert that those trusts are properly structured. This will become a more common problem. With the new high estate tax exemptions more estate planning will likely be completed by general practice attorneys or business attorneys, instead of estate planning specialists. As this trend continues, accountants will have to be alert to avoid an inadvertent termination of S corporation status:

• Qualified Subchapter S Trust (QSST) is perhaps the most well known of all trusts that hold stock in an S corporation. To qualify as a QSST all trust accounting income of the trust must be distributed currently to a single individual shareholder. During the current income beneficiary’s lifetime distributions of principal of the trust can only be made to that current beneficiary. The beneficiary must make the QSST election by filing a signed election statement with the IRS within 2 ½ months of becoming a shareholder. IRC Sec. 1361(d)(2)(D). If assets other than S corporation stock are held in the same trust they are not subject to the QSST rules and can be treated separately.

• Electing Small Business Trust (ESBT) can provide a more flexible option for a trust to be an S corporation shareholder. A sprinkle or spray trust with multiple beneficiaries, like many bypass trusts, may retain S corporation stock as an ESBT. All of the “potential beneficiaries” must, however, be individuals, estates or qualified charitable organizations. None of the interests of the trust in the S corporation stock could have been acquired by purchase. The trust itself must make the ESBT election by filing a statement with the IRS within 2 ½ months of becoming an S corporation shareholder. The trust must pay income tax on the S portion of any income at the highest applicable income tax rate. There is no offsetting deduction for income distributed to beneficiaries. Thus, the new 3.8% Medicaid tax on passive investment income may be incurred on top of the highest marginal tax rate with no opportunity to distribute to beneficiaries to mitigate it. As with the QSST above if the trust owns other assets, non-S corporation income is not subject to the harsh ESBT rules.

• Grantor trusts have become common vehicles for holding S corporation stock, especially with the substantial transfers following the 2010 tax act. A grantor trust is a trust treated as wholly owned by an individual under the provisions of Code Section 678. While generally this individual is the settlor or trustor establishing the trust, this is not always the case. Some trust drafting techniques will intentionally result in a person other than the settlor being taxed as the grantor for income tax purposes. Occasionally this occurs inadvertently, so practitioners must be careful to review trusts to assure the appropriate status is determined, and the correct grantor is identified. Following death of the grantor the status of the trust as a grantor trust will end. The trust may continue for the two-year period noted above for estates to hold S corporation stock. That period may be extended if the formerly grantor trust was a revocable living trust that can make the election under Code Section 645 to be taxed as part of the estate. Following these periods, whichever apply, the trust must meet other criteria to continue to hold S corporation stock.

• Voting trust can be used to control the vote of stock in a closely held S corporation while the beneficial owners of the stock, each of whom qualifies as an S corporation shareholder, continue to benefit as owners from their economic interests in the stock. IRC Sec. 1361(c)(2)(A)(iv).

S Corporation Income and Death of Shareholder
When an S corporation shareholder dies, the corporate income is generally prorated between the decedent and the successor shareholder (e.g. a complex trust that occurs after a grantor trust loses grantor trust status following the settlor’s death) on a daily basis before and after death. Income allocated to the period before death is included on the decedent’s final income tax return. IRC Section 1377(a)(1); Reg. Section 1.1377-1(a). Income allocated to the period after death is included on the successors’ income tax returns. Alternatively, an S corporation may elect the interim closing of the books method. This divides the corporation’s taxable year into two separate years, the first of which ends at the close of the day the shareholder died. IRC Section 1377(a)(2); Reg. Section 1377-1(b)(1).

Estates and Testamentary Trusts Generally
When a client dies owning S corporation stock the stock is usually transferred to the estate and often from the estate to various testamentary (formed on death) trusts. Practitioners should monitor all of these transfers to be certain they don’t jeopardize S corporation status:

• During the period an estate holds the S corporation stock in the estate there should generally be no issue of S status as an estate is an S corporation shareholder. IRC Sec. 1361(b)(1)(B).

• If the administration of the estate is extended unreasonably the IRS can argue that the estate has been terminated and S status could be in jeopardy.

• Testamentary trusts, funded on a client’s death, will have to qualify to hold S corporation stock for two years without meeting any other special S corporation requirements. IRC Sec 1361(c)(2)(A)(iii). After the second anniversary of the date the S corporation stock is transferred to a testamentary trust, the trust will have to meet general S corporation trust requirements, e.g., QSST or ESBT.

√ Common Estate Planning Trusts that Might Own S Corporations:

• Maritial trusts, such as a qualified terminable interest property (QTIP) will meet the requirements of either a QSST or ESBT. While QSST status has generally been elected for a high-income trust and family ESBT status might make the touchstone for material participation the trustee instead of the beneficiary thereby facilitating avoiding the 3.8% surtax.

• Credit Shelter Trusts, also known as “bypass trusts” or “applicable exclusion trusts” can be structured in many different ways so no conclusion should be drawn as to whether or not it will qualify as any particular type of S corporation trust without first reviewing the terms of the trust. Some bypass trusts are designed so that one beneficiary must receive current income and hence qualify as a QSST. Many, perhaps most, bypass trusts have multiple current beneficiaries and will have to elect to be taxed as an ESBT to qualify to hold S corporation stock. There is another application of QSST status and bypass trusts that can present an interesting planning opportunity. Assume that a bypass trust does not own S corporation stock. It may be feasible for the trust and other family members to create an S corporation. The bypass trust, and other family members, would contribute assets to a new S corporation. The bypass trust can then make a QSST election which would make it a grantor trust as to the beneficiary. This grantor trust status might provide additional income tax and other benefits.

• Grantor Retained Annuity Trusts (GRATs) are grantor trusts during the annuity term and can therefore hold S corporation stock during that period. Following the termination of the annuity term some GRATs distribute assets to children outright. In such cases if the children qualify as S corporation shareholders S corporation status will not be jeopardized. However, many perhaps most GRATs name trusts to hold the remainder interests. Some of these trusts are designed to continue to be grantor trusts as to the settlor of the GRAT. Those will continue to qualify to hold S corporation stock. If the remainder trust is not a grantor trust then the QSST and ESBT provisions have to be reviewed to ascertain if the truest can meet either of them.

• Dynastic Trusts are often, but not always, designed to be grantor trusts. If it is not a grantor trusts then QSST and ESBT provisions will have to be reviewed to ascertain if the trust can qualify.

• Self-Settled or Domestic Asset Protection Trusts are trusts formed in a state, typically Alaska, Delaware, Nevada or South Dakota, which permit the person establishing the trust can be a discretionary beneficiary. These trusts are grantor trusts during the settlor’s lifetime and can hold S corporation stock.

• Beneficiary Defective Trust (BDT) is intentionally designed to qualify as a grantor trust as to the beneficiary, not the settlor. As such, BDITs can hold S corporation stock and the beneficiary will report his or her share of S corporation income.

• Insurance trusts generally hold few assets other than a bank account and an insurance policy while the settlor/insured is alive. However, many insurance trusts are grantor trusts during this time period. Be careful, however. While many practitioners rely on the fact that the trustee can use trust income to pay life insurance premiums on insurance on the life of the grantor, other commentators have expressed some concern as to whether this assures full grantor trust status. Following the death of the settlor/insured the insurance trust may purchase S corporation stock from the settlor’s estate. But following death the trust cannot be a grantor trust (except perhaps as to the beneficiaries as a result of the Crummey powers) so that the trust may have to qualify at that point as a QSST or ESBT.

Modifying Irrevocable Trusts to Meet S Corporation Requirements
If a trust comes to own S corporation stock, it might lack the requisite QSST or ESBT provisions, or other provisions that might prove helpful. In many cases, even if the trust has the required language, it might be desirable to effect some modification of the trust to facilitate better tax planning or even just trust administration. Practitioners can review the following and other ideas with trust counsel:

• Modification of a trust by fiduciaries, such as a trustee or trust protector, exercising powers granted under the trust agreement might be feasible. These may suffice to change the trust to one that qualifies as a grantor trust or QSST.

• Many trust agreements permit the trustee to subdivide the trust into separate trusts. This might be used to isolate the S corporation stock in one trust that can meet S corporation requirements. Non-S corporation stock can be held in other sub-trusts. This approach might enhance the results of the trust overall.

• The trustee could petition a court to modify a trust to make the trust meet the requirements to hold S corporation stock.

• Decanting is a process by which one trust is poured over into another trust. If the existing trust cannot hold S corporation stock that was transferred to it, the trustee might move the trust to a state like Alaska and use Alaska law to decant the existing problematic trust into a newly created and better designed trust. Approximately 20 states now permit decanting.


Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.

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Checklist: Obama Budget Proposal (Greenbook) - Planning Implications

  • Written by Martin M. Shenkman, CPA, MBA, PFS, AEP, JD

shenkman martinAs the presidential election is less than six months away it seems highly improbable President Obama’s budget proposals will be enacted. That being said, practitioners are well aware the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41 included the new basis consistency and reporting rules under IRC Sections 1014(f) and 6035. This should serve as a reminder that even unlikely legislation may have a tax change appended. Further, the turmoil of the current election process should leave practitioners and clients alike wary of what might be in store. So rather than dismissing President Obama’s proposal as irrelevant practitioners should caution clients as to the possible impact of the proposals and proactive steps that might warrant taking “just in case.” Regardless of the outcome of the election, there appears to have been a change in the “conversation” concerning wealthy taxpayers and many of the provisions may reappear in the future in new proposals. Prudence might suggest taxpayers consider some of these proposed changes in forecasts and projections. Here I explore like-kind exchanges, Roth IRAs and marginal tax rates:

Like-kind or tax deferred code section 1031 exchanges have been a valuable tax deferral technique for wealthy real estate investors and developers for many years. In recent years the technique has taken on a new, different and significant planning role. With the new tax paradigm of estate tax rates closer to income tax rates than ever before, basis step up on death has become a major focus of income and estate tax planning. When planning which assets to retain in the client’s estate to obtain a step up, versus which assets to gift to remove from the client’s estate, the timing of sale is a critical consideration. If, for example, a client has a parcel of real estate that is anticipated to be held for decades, gifting it to remove appreciation from the client’s estate may make sense. The lack of basis step up may be inconsequential on a present value basis. The tax cost in two or more decades is, on a present value basis, likely not to be particularly significant. If the client is uncertain about how long the holding period might be the balance may shift from the prior situation in favor of retaining the asset in the estate for a basis step up. With real estate the planning has assumed a somewhat different analysis. Even if the client is not certain that the particular property will be held for a long period of time, it may be feasible to gift the property at an opportune time when the valuation might be low (e.g., large vacancies depressing current value) and have future appreciation occur outside the estate (e.g., in a grantor trust). If unexpectedly the client (perhaps in his or her role as being an investment trustee of the grantor trust) opts to dispose of the real estate it may be feasible to do so using a tax deferred like kind exchange. Now, however, the planning analysis for real estate investors and developers should contemplate the potential elimination of Code Section 1031 tax deferral. Although the Greenbook proposals recommend a cap on the maximum gain to be deferred in a 1031 like-kind exchange of real estate, if the proposal is sufficiently low it will be insignificant in this estate planning context. The implication of this proposed change is that large real estate investors and developers may be wiser not to assume the availability of a 1031 escape hatch on assets transferred out of their estates. Again, while there may be little likelihood of any legislation in the near term, this proposal seems to recognize that the intent for 1031 when enacted (not to create a tax cost when a taxpayer continues his or her investment, only in a different property) has lost some of its meaning and has with no limit likely favored the wealthiest taxpayers.

There have been many discussions about eliminating stretch IRAs in favor of a mandatory payout over no more than five years. The elimination of stretch IRAs will transform estate planning for inherited IRAs. Again, while practitioners and taxpayers alike may not wish to believe such a provision is likely to be enacted the revenue estimates from this change are significant. Further, if the statistical data as to how long most IRAs remain after the death of the plan holder are considered, the typical IRA is withdrawn rather quickly. It is likely only larger IRAs for wealthier clients that are stretched. The average person’s IRA accounts in 2010 had a total balance of $91,864 and the median value was $25,296. “How Much Do People Really Have In IRAs?” June 6, 2012 • Karen DeMasters. The median value is quite low. The majority of IRA balances are such that the benefits of deferral are not that significant. This may serve to make passage of a restriction on stretch IRAs easier.

Roth conversions are possible to achieve by high income taxpayers through an indirect route. The high income taxpayer can contribute to a non-deductible traditional IRA. Thereafter, he or she can convert that non-deductible IRA to a Roth IRA. The Greenbook proposal would create a chilling effect on high income taxpayers using this indirect approach to create Roth IRAs but limiting a Roth conversion to only the pre-tax portion of a regular IRA. Too often practitioners view the Roth conversion only from an income tax planning lens. But for many taxpayers Roth conversions can and should be primarily about asset protection. If a client has $1 million in a regular IRA, the tax value of assets actually protected may only be about $600,000. However, if a Roth conversion is completed, the total amount can be protected even though funds outside the IRA are used to pay the income tax on the conversion. Leaving aside income tax considerations, the effect of the conversion is for the taxpayer, perhaps an OB-GYN very concerned about malpractice issues, to convert $400,000 of non-protected assets (cash in the bank account used to pay the tax on conversion) into protected assets (the fully protected $1 million Roth IRA). With this change even a possibility perhaps practitioners should review possible conversion opportunities for clients with significant liability worries rather than defer those conversions.

There are a number of proposals to increase the marginal tax rates on the wealthy and to set a minimum tax level the wealthiest taxpayers pay. Whether referred to as the “Buffet Rule” or as a “Fair Share Tax” there are proposals for a minimum 30% tax on very high income individual taxpayers. The goal is to address high income taxpayers using deductions, capital gain characterization and other techniques to reduce significantly their marginal tax burden. There is also a proposal to increase the maximum capital gains rate to 24.2%. When this is coupled with the 3.8% Medicare surtax on net investment income (the “NIIT”) the aggregate capital gains rate before state capital gains tax is close to 30%. While there may be little that can be done to plan ahead for these types of changes, as no one will realize income early to avoid the possibility of a tax increase, practitioners should consider incorporating higher tax rates when completing financial forecasts for client financial plans or investment projections. Perhaps at minimum sensitivity analysis should be done and financial forecasts regenerated with higher marginal tax rates to demonstrate to wealthier clients the possible impact of future changes before they consummate large gift transactions or take other significant financial steps.

For example, a client paying a modest marginal income tax rate today might believe from a financial forecast they can gift their exemption amounts to dynastic trusts for children and future descendants. Perhaps regenerating that forecast substituting a 30% tax rate rather than a much lower rate that is currently paid might suggest to the client that instead of dynastic trusts for heirs some portion or all of the funds might more safely be given to non-reciprocal spousal lifetime access trusts (SLATs) so that each donor/spouse has access to the trust set up by the other spouses should adverse tax changes make that necessary.

The current proposal, as prior year proposals, includes a return to 2009 estate rates and exemption amounts. The possibility of a return to a $3.5 million exemption suggests that physician and other clients with significant malpractice or liability concerns should evaluate consummating estate and asset protection planning before such a reduction makes it more difficult. For example, gifts to non-reciprocal SLATs or to a domestic asset protection trust (DAPT) or both could be consummated to secure the benefits of the current high exemption. This is important for practitioners to realize. Utilizing the current high exemption is not only about estate tax planning but it is vital to asset protection planning for a much broader range of clients. For estate planning, a reduction from the current 2016 $5,450,000 exemption to a $3,500,000 exemption can mean much more than the dollar value reduction. If the planning for a very wealthy client contemplates a note sale to a grantor trust the leverage in the transaction might mean, depending on the interpretation of the law, a tenfold increase in the assets that can be transferred. Thus, a $1,950,000 reduction in the current exemption could mean a reduction of $19,500,000 of assets sold to a trust and for which the value might be frozen.

There are a host of other provisions contained in the latest Greenbook proposal. While few if any are likely to be enacted before the election, practitioners should nonetheless selectively consider the proposals and guide appropriate clients as to steps that might be prudent.

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Checklist: Tax Planning Challenges

  • Written by Martin M. Shenkman, CPA, MBA, PFS, AEP, JD

shenkman martin Surtax/Kiddie Tax Planning

The 3.8% Surtax may be avoided by distributions to children subject to the Kiddie Tax (persons under age 19 and full-time students under age 24 with unearned income over $2,000 for 2013) will be taxed at the parent’s tax rate. However, each child’s AGI is viewed separately from the parent’s AGI for purposes of testing whether the Medicare tax on passive income applies. IRC Sec. 1411. If the child’s AGI is under $200,000 the child will not be subject to the Medicare tax. For this tip to succeed a separate income tax return must be filed for the child. Do not report the child’s unearned income on the parent’s income tax return. If the child’s unearned income is reported on the parent’s return, the parent’s MAGI will be considered and the Surtax may apply. The challenge with this planning is the risks of putting significant income in a child’s hands to save a 3.8% tax.

Self-Referential Exception

The self-rental exception for the net investment income tax (NIIT) can be illustrated as follows. A manufacturer has interests in FLP that rents building to her dental practice. The self-rental exception to the IRC Sec. 469 passive loss rules applies and the income in the FLP from the rental to the professional practice is deemed active. This characterization also avoids the NIIT 1411 Surtax. Estate planning may bifurcate ownership tainting the self-rental exception. For example, the dentist may transfer her interests in the FLP owning the practice building to trusts for her children. If those trusts are grantor trusts they will be ignored for income tax purposes and the manufacturer will continue to be treated as subject to the self-rental exception. However, if the grantor trust status of those trusts is turned off (by an action to avoid the settlor/manufacturer continuing to be taxed on the income, the death of the settlor, etc.) the trust will be respected and the identity of ownership of the manufacturer and the rental FLP will be broken. The self-rental exception will no longer apply and the NIIT Surtax will apply. This can be a challenge to continue to avoid the NIIT. What can be done? Shift interests to requalify by having trusts sell interests.

[This article is course content for the Tax Season 2016 CPE quiz, worth 3 CPE credits! Reach the quiz and additional content HERE.]

Gifts Under a Power of Attorney

Powers of attorney, which authorize an agent to act when the client is unable to do so, are an essential estate planning document. Most powers of attorney include a provision authorizing the agent to make gifts almost always up to the annual exclusion amount. In 2015 this amount is $14,000. For clients that face either a state or federal estate tax a gift provision can be quite valuable. Even for clients not subject to any transfer tax concerns a gift provision may be valuable to enable the agent to help support family members the client has helped out. The challenge with a gift provision is how to minimize the risk that the agent will abuse the power to enrich himself or herself. Elder abuse is rampant. Is the potential benefit of such a provision worth the risk? What can be done to protect the client from this risk? The challenge of a tax oriented gift power, is much more difficult than mere tax planning.

Credit Shelter Trusts

Traditional estate planning has often been based on distributing assets on the death of the first spouse to a credit shelter trust. These assets would be available to the surviving spouse but not included in his or her estate. The problem using credit shelter trust is that the assets excluded from the survivor’s estate will not receive a basis step up on the survivor’s death. The simple and inexpensive solution to this is to bequeath assets out right and rely on portability and the inflation adjusted exemption to avoid estate tax on the surviving spouse’s death. The problem is that the option of an outright bequest is certainly simpler, less costly and might result in a better overall tax result. However the challenge to that tax planning is that should the surviving spouse remarry, prove fiscally irresponsible or be sued all of the assets the credit shelter trust could have protected might be lost.

754 Basis Adjustment

The tax focus of estate planning for all estates, taxable or smaller, has shifted to increase income tax basis by having appreciated assets included in the decedent’s estate. When a limited partnership or LLC taxed as a partnership is included in the decedent’s estate a Code Section 754 basis adjustment must be made by the entity in order for the increase in the tax basis to be effective. The challenge with this oft assumed tax result is that the managing member of the LLC or the general partner of the partnership may not be willing to make a 754 election. The challenge to practitioners will be to convince clients that are able to, to negotiate provisions in current partnership and operating agreements to mandate that a 754 election has to be made.

Minimizing State Estate Tax

Many states that have decoupled from the federal estate tax system can present costly estate taxes to a client’s estate. The only state which has a gift tax is Connecticut (although New York effectively has an estate tax as part of his re-coupling with the federal estate tax). Thus, it may be feasible for a client to gift assets thereby removing them from the reach of his or her state estate tax. The challenge for many clients is that while they are desirous of saving state estate tax they are worried and uncomfortable about losing access to their assets. There is a way to have these clients can have their tax cake and eat it too. The gifts can be made to a self-settled irrevocable trust (often referred to as a domestic asset protection trust). The client can be a beneficiary of such a trust, yet the trust can be treated as a completed gift and removed from the client’s estate. The challenge is that this type of planning can be costly and complex. For example, if the client does not reside in one of the 15 states that permit self-settled trusts the client will likely have to name a corporate trustee in one of those states to create nexus to one of those states that permit self-settled trusts. That will require annual trustee fees in addition to other costs. Even if the state estate tax savings can be significant, as the costs of the planning grows it becomes a challenge to get the client comfortable with proceeding.

Surtax S Corporation Planning

QTIP (marital) trusts owning S corporation stock have typically elected Qualified Subchapter S Trust (QSST) treatment. Is a QSST the optimal result for Surtax planning? With a QSST all S corporation income will be reported by the surviving spouse and the surviving spouse will be the touchstone for determining material participation. Will the surviving spouse materially participate? Perhaps an electing small business trust (ESBT) a better result? If an ESBT is elected the trust pays all income tax on s corporation income and the trustee, instead of the surviving spouse, becomes the touchstone for determining material participation. The challenge with this approach is that the maximum tax bracket on all trust income.

Executor Responsibility to Report

As a result of recent law changes, the executor or personal representative must provide information to each beneficiary as to the basis of assets distributed.  New IRC Sec. 6035, “Basis Information To Persons Acquiring Property From Decedent.” How should this be done is quite a challenge. In the past, few executors had sent an estate tax return, Form 706, to any beneficiary. While some executors might be tempted to send a copy of the entire return to each beneficiary to meet whatever disclosure obligation the IRS imposes that level of disclosure may prove a significant mistake. That much information in the hands of each beneficiary might result in the executor being inundated with questions about valuation, dispositions and anything else on the estate tax return. It might prove less problematic to have a schedule prepared for each beneficiary providing details as to the assets bequeathed to that particular beneficiary.  This, however, will create more administrative costs and professional fees which executors might object to when they don’t not perceive a tax savings from the incremental efforts. Executors will be required to report basis information to beneficiaries within 30 days after the due date of the estate tax return, or from the date the return is actually filed. A practical problem with this reporting is that if the executor is given discretion as to how to divide assets among different beneficiaries, that decision may not have been made by the reporting deadline. In the past, it didn’t not matter, now it may.

Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.

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