Protecting Your Client's Assets From Lawsuits Using Entities

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

shenkman martinHelping clients to protect their assets from lawsuits, malpractice claims, divorce, and other risks is a vital part of any estate plan. With the waning importance of estate taxes to the process, practitioners can give increased attention to this type of planning. Every practitioner should be able to provide some level of planning service in this regard. However, recognizing the limitations of knowledge and those issues for which a specialist might be advisable to involve will be prudent. Even practitioners with limited knowledge in this area can provide valuable service being the catalyst for this type of planning. Also, being independent of the client, the client’s business and risks, will assure the practitioner the objectivity clients cannot have for their own issues. Bringing a “new eye” of an outside professional alone will often enable practitioners to identify a range of issues for the client to address. Planning can range from the simple (you have to keep independent records for a business) to the much more complex (how might you structure a self-settled asset protection trust to minimize the risks involved). There is much ground in between. The following checklist might be a helpful starting point. But in all instances, use common business sense, general accounting knowledge, an understanding of the client’s business endeavors, and objectivity to identify issues and planning opportunities. Asset protection planning should be undertaken in a broad context looking at every aspect of a client’s business, investments, insurance, estate planning and more. This checklist focuses only on the use of entities in this context.

Operate Safely

Is the client operating their business, investment and personal affairs in a safe and rational matter? Many clients become so focused on growing a business that they neglect a myriad of common sense “safe” practices. Has the client reviewed resources made available from business and industry trade organizations on safe practices (have you reviewed articles and materials available from the AICPA on minimizing liability risk? Have you kept current with new ethics pronouncements and cases?). There is a wealth of literature that can provide practical planning ideas for every business.

Operate Under Entity Solution

Is the particular business endeavor operated in an entity format to minimize liability exposure in the event of a suit or claim? While larger businesses are typically operated in entity format (S corporation, LLC, etc.) surprisingly many are not. Many clients buy investment real estate, rent that real estate to a tenant and do not realize that the potential liability associated with that common investment. Instead of owning the property jointly, it should be held in a limited liability company. Don’t assume that clients have addressed this obvious planning step.

Entity Format Provides Limited Liability

Not every entity will provide limited liability for the client/equity owner. A general partnership provides no liability protection. The use of a limited partnership usually provides liability protection for the limited partners but not for the general partnership. If a client has used a limited partnership entity to own a business or real estate investment and serves as the general partner there will be no protection. It may be feasible to restructure the general partner so that it is an entity owned by the client to address this limitation.

Governing Documents Support Intended Result

A properly structured entity may still not achieve the intended results. For example, an LLC may have been formed to hold a real estate investment. Ideally the governing legal documents should have been prepared with an objective to provide and enhance liability protection. While the governing documentation could provide the liability protection desired for the client, if the certificate forming the LLC, or the operating agreement governing the LLC were improperly drafted, it could undermine that objective. An operating agreement that grants each member the right to force the liquidation of his or her interest in the entity, might negate the asset protection permitting a creditor to insist that the same rights be enforced in favor of the creditor. Why might this occur? It might be nothing more than inadvertence. Perhaps the attorney preparing the documents used a form from another transaction that was not appropriate to the instant transaction. Perhaps it was intentionally negotiated for reasons unrelated to liability protection. Practitioners should actively work with the client’s legal counsel to provide this type of technical review.

Entity Should be Formed in a Favorable State

The legal entity used to insulate the client’s business or investment should be formed in a state whose laws are favorable to asset protection goals. If the entity has been formed in the client’s home state, or perhaps a different state where the real estate, business or other asset held by the entity is located, inquire of the client’s legal counsel whether consideration was given to forming the entity in a state with more protective laws. Many attorneys automatically form entities in the state where they practice and the client resides with no consideration to the potential benefits of using a more favorable state. If the client’s counsel is not able to address this it might be necessary to consult with an attorney with greater specialization. If the client entity was formed in a state whose laws are not as favorable to asset protection as might be desired it may be feasible to form a new entity in a better jurisdiction and transfer the existing entity to the new entity or merge the existing entity into the new entity.

Segregate Assets in Different Entities

Remember what mom said about asset protection planning? Mom always advised never to, “keep all your eggs in one basket.” That was sage advice. If a client has five retail stores each store should be a separate entity. That might facilitate achieving some insulation of liability under each store lease (depending on the terms of the lease and guarantees, etc.). If each store/entity signs its own lease it might be feasible that if there is a problem for one store’s lease the other operations are not affected. Similarly, it may be feasible to limit liability from one store from the others concerning premises liability. So if a customer is injured on store number 2’s premises perhaps the value of Stores 1, 3, 4 and 5 may remain protected. If a client has a manufacturing facility the building might be held in a separate LLC and leased to the operating entity. That segregation of operations may create some demarcation between the different risk levels (e.g., the widget manufacturing operation might have a much higher risk of suit then the mere ownership and rental of the facility). If a client has a fleet of trucks to deliver the widgets manufactured, those might be owned in a separate shipping entity given the potential risk of accident or injury from shipping and operating heavy vehicles. In most situations clients focus on growing their business and direct insufficient attention to entity structural matters. Practitioners are likely to find that all operations might be conducted in a single enterprise. At that point it may be possible to split a corporation into several corporations to achieve better asset protection planning. If this can be brought within the ambit of IRC Sec. 355 it may be done on a tax-free basis. State law may also contain a specific statute permitting corporate divisions. For LLCs the state law may not provide a clear-cut mechanism but the client’s corporate counsel might be able to structure the division.

Intercompany Transactions Should be Documented

Loans are often the culprit of a claimant “piercing the corporate veil.” That legal phrase means that a claimant is able to demonstrate that the client so disregarded the legal form and formalities of the corporation that the client should not be able to “hide” behind the “veil” of the corporation and protect his or her personal assets from the reach of a business creditor or claimant. If a client routinely withdraws money from a corporation without any documentation or formalities being adhered to, the claimant might assert that the client has so disregarded the corporate entity, and used corporate funds for personal use, that the corporation should not protect the client’s home and personal investments from attack.

Practitioners that complete business entity returns (e.g., 1065, 1120, 1120S) should insist on copies of all documentation corroborating loans and that interest be paid and proof provided. Doing so might prevent the client from falling into the above morass of having the entity disregarded in a lawsuit. Practitioners should request clients authorize and pay them to maintain proper and complete permanent files for all entities for which returns are prepared. Few clients will understand the importance of this until practitioners educate them. The above planning should be much broader than merely loans and corporations. An LLC might also be pierced. Loans are but one related party transaction that should be addressed. If a client or family member is employed by an entity, steps to corroborate the arm’s length nature of the compensation and perquisites paid could be important to backstopping the proper operation of the entity. If the client’s business is divided into several different entities as discussed above the payments for rent and all related party transactions should be reasonable and should have corroborating legal documentation/agreements supporting them.


Practitioners should recommend that clients authorize them to expand the scope of involvement and services for all client entities for which they prepare returns to help guide clients to use those entities to achieve the liability protection for which they were formed.

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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Charitable Tax Planning Consulting

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

shenkman martinCharitable Planning Should Address Personal Goals

Charitable giving is too often focused on tax benefits or legal decisions. Practitioners can help clients refocus on “people” decisions. This is especially important for testamentary bequests since so few clients will face an estate tax that few will realize any estate tax benefit from chartable planning. Only 3-4,000 decedents/year will pay a federal estate tax. For the vast majority of clients estate planning will refocus on non-estate tax factors, including income tax minimization and human aspects of planning. However, even lifetime gifts can provide important personal as well as income tax planning benefits.

Help Clients Plan Donations to Enhance Personal Objectives

There are many ways, depending on the client’s particular interest and goals, who is affected, and with what, to tailor a donation to meet client personal objectives. A key step in many cases is to structure a donor agreement between the donor and the charity in advance of the charitable gift. Consider the following:

• Specify how the donation will be used.

• For long term gifts (e.g., a fund that will continue for decades, or an agreement to donate a set amount each year for many years) what investment management or other fees might the charity charge the fund? Will the charity allocate a portion of the initial gift or each year’s withdrawals to general charitable administrative expenses? Can that fee be negotiated so that more of the donation is applied to the objectives the client is hoping to achieve?

• Reach an agreement as to how a gift/bequest will be named, what prominence will be given, how it will be displayed, what happens if the facility moves. Should the client/donor’s name be on a plaque inside the building, prominently on the outside of the building? What is agreeable?

• What happens if the purpose of the gift is no longer relevant?

• Address other issues to assure client’s objectives are met.

Example of Donation Coordinated with Personal Goals.

Example: For prostate cancer the overall 5-year relative survival for 2003-2009 from 18 SEER geographic areas was 99.2%. The median age at diagnosis for cancer of the prostate was 66 years of age. Purchasing a charitable gift annuity that will benefit the American Cancer Society and provide an annuity for life, for these older clients, may be a simple and ideal planning step to address cash flow needs in retirement, charitable intent and more for this group of clients.

For pancreatic cancer the overall 5-year relative survival for 2003-2009 from 18 SEER geographic areas was only 6.0%. For a client diagnosed with pancreatic cancer, creating a QTIP trust with a remainder to the American Cancer Society may provide the personal goal of ultimately benefiting the American Cancer Society, but assuring no matter what, maximum protection for a surviving spouse.

Simple Bequest

A very common charitable gift is a bequest under the client’s will. Even though there may be no estate tax benefit, bequests will remain common as many clients for personal reason wish to make a last bequest to charity. These gifts can also be used to create a powerful message for heirs.  Estate planning is not only about the transmission of wealth, but about the transmission of values. A simple bequest to a charity in a will can demonstrate commitment, values and more. A personal letter of instruction can help.


Example: Dear children, I wanted to explain to you that after my father’s miraculous struggle with pancreatic cancer, I have made a bequest in my will to the Charity Name to fund research that will hopefully [describe objective]. I also hope by this bequest to encourage you to each find ways to give back to charity to demonstrate gratitude.

Example: Add phrase to the testamentary bequest, “I have made this bequest to charity to demonstrate the importance to my heirs of making a contribution back to society,” or whatever drives home the client’s point.

Charitable Gift Annuities Help Meet Personal Goals and Charitable Goals

A gift annuity is a contract between the donor and his or her favorite charity in which the client gives the charity a one-time payment and receives a contractual commitment for a periodic payment, an annuity, for life. The amount of the annuity is determined at inception, without modification (worries) about investment performance/volatility. If your client, or a loved one, is facing the challenges of aging generally, or a specific health challenge, committing some component of his/her investments and expenses to a charitable gift annuity can put some of their finances on auto-pilot, can provide certainty and simplicity.

Example: Client was diagnosed with breast cancer and her physician has recommended a treatment plan to include surgery followed by chemo-therapy. While the overall 5-year relative survival for 2003-2009 from 18 SEER geographic areas was 89.2%, the challenges for a number of years will be significant. The difficulty dealing with financial matters has increased. Sufficient gift annuities are purchased so that the monthly payment covers her recurring expenses. Funds are deposited automatically into her bank account and mortgage, utilities and tax bills are all on auto-pay. On your client’s death the American Cancer Society will receive the funds that remain for its charitable purposes.

Charitable Remainder Trust

A charitable remainder trust (CRT) can be more advantageous post ATRA. The new Medicare tax on passive income that became effective 1/1/13 does not apply to charitable remainder trusts (CRTs). Instead as payments are made to your client/donor they are taxable subject to the CRT tier system.  Using CRTs might shift net investment income (“NII”) to the trust and thereby defer the new 3.8% Medicare tax, generate an income tax deduction of some benefit, and defer the new higher capital gains tax. Better tax results might, however, be achieved. The CRT can defer income over many future years and thereby facilitate keeping the client’s marginal taxable income below the threshold for application of the NII tax. Therefore, making a gift to a CRT could effectively avoid any application of the NII tax to the client. While interest rates are quite low it is difficult for clients who are not sufficiently old to meet the requirements for a CRT. However, as interest rates rise CRTs will continue to grow in popularity to address client charitable goals, the desire for regular cash flow in retirement, and to minimize higher income and capital gain taxes.

Evaluate Existing CRTs for New Donation Opportunities

Your client may have created a CRT in the past and may no longer need the cash flow from the annuity provided, or perhaps the client would like to benefit the named charitable beneficiary now. The client can terminate the CRT so that the charity will receive the current value of its remainder interest. If a CRT is terminated early, the client, as the non-charitable beneficiary, will report capital gain based on the value of the assets distributed to him or her as a taxable exchange under IRC Sec. 1001. PLR 200314021 and 200733014.  When a CRT is terminated early the client would be treated as selling his or her interest in the CRT to the charity as remainder beneficiary. Practitioners should coordinate such a termination, if feasible, in a tax year when the client is in a lower tax bracket.

CRT as a Retirement Plan

The most common CRT is structured as an annuity trust called a “CRAT.” If the initial gift to the CRT was $200,000 and the payout rate was 5% then the CRT would pay $10,000/year to the donor/annuitant for its term. A charitable remainder trust can also be structured as a unitrust called a “CRUT.” If $200,000 were given to a CRT paying 5% it too would payout $10,000 in the first year. If the value of the assets increased to $220,000 by the second year the payout would be based on the payout rate of 5% of the then value of the assets or $11,000. Thus, a CRUT can provide an inflation hedge on its payments to the client/donor. This can be incredibly important in planning a CRT for cash flow for a long duration. Additional variations on the CRT theme can further help practitioners tailor charitable planning to not only achieve the income tax benefits a CRT can afford, but to better achieve client economic goals. If a CRUT is created it can be specified that the unitrust payments will only be made from income; NI-CRUT “net income-only arrangement.” Using this type of CRUT the client/donor, as income beneficiary, will only receive the actual trust income if the income is less than the fixed percentage payment required. This NI-CRUT technique can be applied in a manner to facilitate a CRT being used to provide a result analogous to a “retirement plan.” IRC Sec. 664(d)(3)(A); Treas. Reg. § 1.664-3(a)(1)(i)(b)(1). One additional step might be advantageous in structuring a CRT to achieve retirement plan-like results. A NIM-CRUT is a spin on the NI-CRUT.  The “M” is for “make-up.”

Example: Assume your client has a non-income producing asset, such as raw land, that she wants to donate to charity. The CRT will not produce income until the charity sells the property. In a NIM-CRUT, if the income in any year is less than the unitrust amount for that year, the shortfall is made up in future years in which trust income exceeds the unitrust amount.  It is as if the payments due to the client/donor are accrued and will be paid in a future year. The maximum payout in later years is the sum of the CRUT amount due to the client/donor in each of the prior years, plus the amount necessary to make up for any shortfalls in prior lean years. A NIM-CRUT may be the ideal CRT for a client/donor planning for retirement because it addresses the risks to cash flow of future inflation.

Charitable Lead Trust and Personal Goals

Charitable lead trusts (“CLTs”) are the opposite of CRTs with the charity receiving the payments from the trust during the trust term and the designated heirs, typically a client/donor’s children, receiving the remainder interest. While CLTs have typically been used to minimize gift or estate taxes (A CLT is not income tax exempt like a CRT)) the technique can be adapted to meet personal goals. Assume that a client has an adult child with a health challenge that will limit the child’s work expectancy. The client could establish a CLT which concludes at the ill child’s anticipated retirement date. The back end of the CLT would be a trust for that particular child which would name trustees and include dispositive provisions which were consistent with the financial concerns facing that child.

Example: Daughter is a single mother with two children. At age 40 she was diagnosed with cervical cancer. The overall 5-year relative survival for 2003-2009 for Localized (confined to primary site) cancer of the cervix is over 90%. While the prognosis is positive, Daughter is very worried about supporting her children, in the event the outcome is negative. Parents establish a 15 year CLUT for $1 million. The CLUT pays out 6% for the 15 year period which the Daughter will direct to meet various charitable projects supporting cancer research. The payment to the charity for 15 years will reduce the gift tax value of the transfer from $1 million to $397,213. If the invested funds earn 7.5% over the 15 year period Daughter’s children will receive a nest egg of $1.2 million when the CLT ends. The CLT plan empowers Daughter to be proactive to fight cancer while giving her assurance of her children’s security.

QTIP and Charitable Remainder

If a client’s spouse faces the challenges of aging or illness the well spouse could create an estate plan that provides protection for that spouse and an eventual charitable bequest. The client could establish inter-vivos (while alive) marital trust (“QTIP”) to protect ill spouse. A QTIP trust can protect the ill spouse by providing professional management of the assets in the trust, trustees who can his pay bills and handle other matters for spouse if/when necessary, protection from lawsuits and claims, and other benefits. The QTIP trustees can invade the principal of the trust and use it to pay any or all of it for the care of the spouse. No estate tax will be due on the well-spouse/transferor’s death. Following the death of surviving spouse, whatever assets remain in the QTIP trust can be contributed to charity, since the charity can be named as the remainder beneficiary of this trust.

Bequest of Closely Held Business with Hedge Against IRS Challenge of Valuation

This technique involves a charity to backstop a defined value clause on the sale of assets to a grantor trust. President Obama has repeatedly proposed eliminating this technique by causing estate inclusion. The use of a defined value mechanism may dissuade the IRS from challenging the value of closely held business, real estate or other hard to value interest transferred, especially if the excess is paid over to a charity. A prospective donor may structure a substantial sale to a defective grantor dynasty trust (intentionally defective irrevocable trust (IDIT)), or even just a gift using the current $5.25 million (2013) gift exemption if concerned about possible valuation challenges in the event of an audit of hard to value assets, e.g. a closely held business. Transfer documents limit sale (gift) to the IDIT to a dollar value of the assets sold, keyed into the intended purchase price using the defined value clause. The excess of the gift as valued by the IRS on audit, over the defined value of the gift (the intended gift amount) passes as a result of the defined value clause to charity. While IRS incentives to audit would be adversely effected, the charity’s interests should be protected by the state AG’s involvement and fiduciary duties of the executor. The IRS has argued the rationale of the landmark decision in Commissioner of Internal Revenue v. Procter, 4th Circuit 1944. Procter held that mechanisms that render an audit ineffectual will not work if they create a condition subsequent. This creates a public policy problem since to enforce it renders the issue moot. McCord v. Commissioner of Internal Revenue, 120 TC 358 (2003), rev'd and rem'd, 461 F3d 614 (5th Cir. 2006). Taxpayers transferred partnership interests to children and charities using a formula clause that transferred approximately $6.9 M to children and trusts for children, $134,000 value of partnership interests to one charity, and the balance to a second charity. Donees (children and two charities) were required to determine the value of the partnership interests, and to allocate the gift among themselves, based on the price at which the assigned partnership interest would change hands as of the date of this assignment between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant acts. The donees entered into a settlement agreement allocating the gift based on an independent appraisal. Some suggest that the case implies that no charitable beneficiary is necessary, but is relying on the desired approach. In the Estate of Christiansen the Tax Court upheld a valuation adjustment clause structured as a form of disclaimer. The decedent's will bequeathed her net estate to her daughter. If any assets were disclaimed, 25% would pass to a charitable foundation and 75 percent to a twenty-year charitable lead annuity trust (CLAT). The daughter was a remainder beneficiary of the charitable lead annuity trust. The daughter disclaimed a fractional share of the estate, equal to the excess of the estate over $6.35 million. The Tax Court found that the disclaimer passing to the lead trust was not a qualified disclaimer, because Christine had not disclaimed her interest in the lead trust. The court stated that revaluation clauses that depend for their effectiveness on a condition subsequent are ineffective. The Tax Court also rejected the IRS argument that the disclaimer's adjustment clause was void on public policy grounds, because it would discourage the IRS from auditing estate tax returns. Estate of Christiansen v. Commissioner of Internal Revenue, 130 TC 1 (2008). Wandry v. Commissioner, T.C. Memo. 2012-88. In Christiansen, Petter and McCord the defined value clauses used all had a charitable component. The Wandry Court explained that in these cases, “This factor contributed to our conclusion, but it was not determinative.” In Wandry even though there was no charity involved the Court ruled in favor of the taxpayer, noting that the documents clearly indicated that the gift was of a fixed dollar amount and not of a percentage interest in the LLC. While some practitioners suggest that you no longer need a charity or a pay-over mechanism in a defined value clause, many practitioners prefer that approach.

√  Bequest to Charitable Lead Trust (CLT) to Minimize Audit Risk on Large Estate

Using a testamentary CLT reduces audit incentive if audit adjustment won’t increase tax revenue but rather increase the amount going to charity using a defined value clause Example: “I bequeath $1M of the Family Widget Business to my daughter Jane. If the value as finally determined for federal estate tax purposes exceeds $1M, the excess shall be bequeathed to the Jane 15 year 6% Charitable Lead Trust.” “Lids”: The above concepts are being expanded by some practitioners to use as caps or Charitable “lids” on the value of any type of estate planning transfer.

Charitable Bail Out

The client could donate a portion of his or her business or the real estate to a charitable remainder trust (CRT). When the business is later sold, or the business redeems the equity held by the CRT, the CRT would invest the proceeds, which could pay the client a monthly annuity for life (or for the client’s life and the life of another beneficiary or beneficiaries). This annuity may cover a significant portion or all of your client’s living expenses. As with gift annuities, your client must be cautious about how much you commit to a CRT, because you cannot access the principal in the event of an emergency.  Thus, in certain plans, a portion of the asset may be sold and a portion contributed to a CRT. On your client’s death, the money remaining in the CRT will be given to the charities named. Your client can also reserve the right in the CRT agreement to designate new charities in his or her will.

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S Corp. Planning

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

shenkman martinThe income tax is the new estate tax. With a federal estate tax exemption at $5,430,000 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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Planning Ideas for High Net Worth Clients

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

shenkman martinHigh net worth clients require a different nature of planning than other clients. Practitioners serving these clients need to address a range of sophisticated estate tax minimization steps that are simultaneously designed to minimize income tax impact to these clients. While high net worth does not necessarily imply high income, it often does, so for purposes of this article it will be presumed that it does. While most of the planning points are targeted at the ultra-high net worth client, many are applicable to the merely wealthy client as well.

Review FLP/LLC Agreements

High net worth clients commonly have entities that own investment and business interests. In the event of a death, the ability to step-up the inside basis of the membership interest in an entity is important to preserve. If the governing legal document for the entity does not mandate that the entity will make the election to step-up basis under IRC Sec. 754 your client may not obtain this benefit. The optimal time to negotiate for such a provision to be included in the partnership or operating agreement is before it is necessary. One of the most important and universally overlooked steps is for the client, CPA and attorney (and in some instances other advisers) to periodically review the partnership or operating agreement for an FLP/LLC or the shareholder’s agreement for a family S corporation to see what operational mandates it provides for. CPA practitioners will often maintain accounting records for a client entity, prepare tax filings and provide general planning advice while never reviewing the actual governing legal document. What might be sound tax planning, compliance or business advice might prove contradictory to the terms of a form shareholders’ agreement the family signed a decade ago and no one has looked at since. Why might anyone care? If there is a lawsuit or claim and an effort is made to pierce the entity to reach personal assets of the client, ongoing operation of the entity in direct contradiction of the terms of the governing instrument could be a potent line of attack. If a family member/equity holder divorces it is assured that counsel for the ex-spouse will review the governing agreement with the proverbial “fine-tooth comb” looking for hooks for lines of attack. The only sensible approach, which in most instances will never occur absent the CPA practitioner insisting on it, is to have a meeting to review the operational aspects of the document. What must the client, the CPA, and others do each year to comply with the terms of the governing agreement (or in turn if the governing agreement provisions are no longer reasonable, what steps should be taken to update it). What are some of the many actions that might be governed by a partnership agreement:

• Compensation for equity owners and their family. You may have taken great precaution to corroborate the arm’s-length nature of a salary for a child but if the agreement prohibits or caps compensation there is a problem irrespective of your diligent efforts.

• Related party transactions and payments for them. Some boilerplate prohibits related party payments, some require a super-majority (e.g. 2/3rds approval by partners) for a related party payment. The boilerplate in other agreements merely requires it be arm’s length. You cannot advise a client as to how to operate, plan for income taxes, or support related party transactions, without first understanding what the governing instrument provides for.

• Distributions are typically made whenever the primary client decides they are made. But if the agreement mandates first assuring an “adequate working capital” (or any other prerequisite) then no distribution should be made until the CPA practitioner has helped the client corroborate that those prerequisites have been complied with.

Example: The client has substantial operating business interests and real estate held in a family LLC. 40% of the LLC interests were sold to a dynasty trust in a note sale transaction. 35% of the LLC interest was gifted to a tier of grantor retained annuity trusts (GRATs). The attorney for the family carefully delineated that the client as manager of the family LLC must carry out all functions with due regard to her fiduciary obligations to the LLC and to the members of the LLC. That provision should help deflect an IRS attack that the LLC should be pulled back into the client’s estate under IRC Sec. 2036 by virtue of her being the manager and controlling distributions. The client dies and the IRS audits the estate. The examining agent reviews the operating agreement on the estate tax audit and the pattern of distributions, and identifies that all distributions were made in contradiction of the express terms of the operating agreement. This evidence is presented to demonstrate that the decedent had held unfettered control over distributions by the LLC, that there was an implied agreement between the trustees of the various trusts that controlled 75% of the LLC membership interests and the decedent that she retain unfettered control. The IRS asserts that the entirety of the LLC interests are included in the client’s estate undermining the entire estate plan and resulting in tens of millions of additional estate tax.

Operational Formalities

Wealthy clients frequently use entities and irrevocable trusts in their planning. However, those entities and trusts must observe the requirements mandated by their legal format.

Example: The President or another officer of an S corporation should sign entity legal documents and tax returns using their correct title. Has the client signing entity tax returns properly been designated as having that position? When is the last time that officers and directors were appointed? In addition to these requirements, provisions included in the entities governing documents (e.g., an operating agreement for an LLC) must also be adhered to. For example, if a partnership agreement requires that certain reserves be maintained, are they? If a 2/3rds vote of members is required for a capital improvement, have those votes occurred and been documented? If a trust includes specific investment mandates for trust assets, have they been followed and documented in a trust investment policy statement? Failure to adhere to legal or governing instrument requirements can torpedo the tax, control and asset protection benefits of these entities and trusts. Too often accounting practitioners presume these matters are all issues for the client’s lawyer to address. That is a dangerous misconception. If you are providing compliance services you want to be certain that the appropriate person is signing the returns. If you provide investment or financial planning advice, you don’t want to find that your recommendations were in direct contradiction of the provisions of the governing instrument. Most significant, many clients are unwilling to monitor these issues on a regular basis with their attorneys unless another professional adviser pushes them to do so. CPAs must remain proactively involved in monitoring all of the complex planning structures for wealthy clients.

Consider the following:
• Create a permanent file for each client trust and entity.
• Each engagement letter and tax return must be signed by the appropriately authorized person. The primary client may be the grantor (settlor) of a trust but have no authority to sign either a tax return or engagement letter.
• Complex trusts for wealthy clients often include an array of fiduciaries and other persons. A trust might have: an institutional general trustee, an investment adviser, trust protector, person authorized to make loans, the grantor may hold swap powers, heirs may hold Crummey powers, etc. In all matters in which practitioners are involved, and all documents obtained for a trust, LLC or other client permanent file, be certain the correct person signed in the correct capacity.
• Consider filing tax returns for all grantor trusts to at a minimum corroborate the existence of the trust.
• Be certain that income taxes, annual report fees and other often nominal expenses are paid from the correct accounts. If a client personally pays a tax return preparation fee for an inexpensive grantor trust return for an irrevocable trust that payment constitutes an indirect gift to the trust for which a gift tax return has to be filed. That modest payment could have GST tax planning implications. Most significant that payment might be raised as an example by a creditor or the IRS (or both!) that the client disregarded the independence of the trust. A few minor infractions like that (the grantor paid a trustee fee for the trust, the wrong fiduciary signed a tax return, and so on) could be proffered as a pattern of disregard in a later divorce case.
• Plan distributions in advance from any trust. Should the payment be a distribution to a beneficiary? Should it instead be a loan (and if so have it properly documented and assure an appropriate interest rate is charged), should it be a tax reimbursement (does the trust instrument permit this?) or some other transaction? What life events are occurring for the client? Is it advisable to take the distribution (or other payment) at a different time so as not to create an impression that the client has unfettered access to the trust to pay for life events. This is the type of argument the IRS (or perhaps counsel for a divorcing spouse) may advance to support that there was an implied agreement between the client and the trustee. Clients too frequently simply write checks or ask for distributions with nary a regard for the implications of that. The client may well be entitled to access funds in an irrevocable trust, but the manner in which he or she does so is critically important to the success of the entire plan.

Asset Protection

Too often planning has focused on tax minimization not overall planning. Wealthy clients obviously have more to lose to a lawsuit, divorce or claim than other clients. In 2015 wealthy clients will be able to transfer $5,430,000 free of estate tax. A married couple will be able to transfer $10,860,000. In prior years a client with $10 million+ of net worth would have been rather likely to pursue estate tax minimization. The use of FLPs, LLCs and irrevocable trusts that typically are used in such planning would have also provided meaningful asset protection benefits. Now, however, a client at this wealth level may not be motivated to pursue any significant estate tax planning since they are under the federal exemption (assuming portability is used). Practitioners need to be alert to guide these clients to pursue asset protection planning regardless of the client’s concern about estate tax planning (but see comments below). Asset protection planning should include a foundation of appropriate property, casualty and liability coverage. Wealthy clients should all have excess liability coverage that provides higher dollar coverage above the liability coverage included in homeowners and automobile policies. Significant non-qualified marketable securities could be held in tiers of LLCs/FLPs and those interests in turn held in irrevocable trusts to provide protection from claims.

Spousal Lifetime Access Trusts

One of the very popular estate and asset protection planning techniques for wealthy clients is for each spouse to create a trust for the benefit of the other spouse and for the couple’s descendants. This can indirectly provide each spouse with access to the funds in the other spouse’s trust.

Example: Husband creates a trust for the benefit of Wife, children and all descendants and his mother (so that there is a different beneficiary in his trust as she will not be included as a beneficiary in Wife’s trust). Wife creates a similar trust for the benefit of Husband, children and all descendants. Husband may receive distributions from Wife’s trust and Wife may receive distribution from Husband’s trust so that the couple as a whole still has access to funds that are arguably outside of both estates and unreachable by either spouse’s creditors. These trusts can be quite robust and serve a range of planning purposes. Each trust might appoint a special trustee to handle life insurance decisions and include a range of life insurance powers. Because the trusts hold other assets (and therefore serve as asset protection trusts) this obviates the need for annual gifts and the burdens of annual Crummey powers. Earnings from the assets in the trust can be used to pay for life insurance premiums. Because all descendants are included as beneficiaries these trusts serve the planning objective of dynastic trusts. These trusts should be structured as grantor trusts so that note sale (see below) and other transactions are feasible. If sufficient wealth is transferred to these trusts the grantor trust burn, growth in assets outside of the estate on gifted (and sold) assets, life insurance proceeds, in aggregate can eliminate over time any federal estate tax burden on a substantial estate while permitting the clients meaningful access to trust assets. To achieve all of these goals in optimal fashion these trusts should be created in a state that permits self-settled trusts and has other trust “friendly” legislation including a very long rule against perpetuities period (how long a trust can last), favorable trust income tax system, courts experienced and favorable to sophisticated trust planning, etc. The four most common jurisdictions used for this type of planning are Alaska, Delaware, Nevada and South Dakota.

Estate Tax Deferral

Given the importance of basis step-up to planning it may be more advantageous for some clients, especially those holding negative basis real estate (see below) to retain certain assets in the taxable estate. This can be the exact opposite of estate planning goals only a few years ago which almost uniformly sought to remove appreciating assets from the client’s estate in order to reduce estate tax. Affirmatively planning to retain business, real estate and perhaps other assets in a client’s estate (and perhaps the corollary reliance on a more robust permanent life insurance plan to address estate tax costs) will increase the reliance on the use of the estate tax deferral provisions under IRC Sec. 6166. Practitioners should proactively endeavor to help clients plan so that their estates can qualify for the benefits of IRC Sec. 6166 estate tax deferral so that the benefits are not inadvertently lost. The following are some of the requirements:
• The executor must elect to defer the payment of estate taxes. As part of the election, the executor must file an agreement with the IRS as described in IRC Sec. 6324A(c).
• In order to qualify for the deferral of estate tax the decedent must have been a U.S. citizen or a resident alien. IRC Sec. 6166(a)(1).
• Only interests in a closely held business may qualify for the deferral of estate tax attributable to their value. An "interest in a closely held business" is defined as:
• A sole proprietorship that operated a trade or business.
• A partner in a partnership carrying a trade or business, if 20% or more of the partnership value is included in the decedent’s gross estate. There must also be less than 45 partners in the partnership.
• Stock in a corporation carrying on a trade or business if 20% or more of the voting stock of the corporation is included in the decedent’s gross estate. There must be less than 45 shareholders regardless of class of stock owned. IRC Sec. 6166(b)(1).
• The interests in closely held or family businesses that qualify must in the aggregate exceed 35% of the decedent’s adjusted gross estate. The value of the active business assets are considered for the 35% rule. Any closely held real estate investments, or business assets, which are passive in nature are excluded from the qualifying value for purposes of the application of the 35% test.

Practitioners helping clients monitor the percentage tests above when qualifying for IRC Sec. 6166 estate tax deferral will be advantageous. Also, steps should be taken to corroborate the active nature of business interests intended to qualify. Finally, estate planning and other transfers that might cause the number of equity holders to exceed the maximum permitted above should be reviewed.

Monitoring Grantor Trust Status

Most sophisticated trusts designed for high net worth clients are structured as grantor trusts. A major incentive for this approach is to permit the settlor/client to continue to pay income taxes on the earnings inside the trust. This results in a continued reduction in the size of the clients estate, due to the so called “tax burn,” while the growth inside the trust which is outside the client’s estate, is enhanced by the benefit of what is effectively for the trust an income tax free environment. Over the years the impact of this tax burn can become “too much of a good thing.” For some clients a crossover point will be reached when the benefit of the tax burn is no longer necessary. This is a particularly sensitive and important issue if a sale of a highly appreciated trust assets (e.g. a family business being purchased by a large public company) is being contemplated.

• Practitioners should review the status of each grantor trust each year with their clients and discuss the future prospects for the trust assets.
• Balance sheets for the client and the trusts should be prepared and reviewed.
• Monitor the inflation adjusted remaining estate tax exemption for the client. For wealthy (but not ultra-high net worth clients) the aggregate impact of: (1) annual inflation adjustments to the exemption; (2) the tax burn from grantor trusts; and (3) the normal course of spending an estate down post-retirement, may obviate the need for the continuation of grantor trust status.
• Compare the above analysis and projections of the future impact of continued grantor trust status to the real need for any new proposed estate planning. The client’s estate planning attorney might recommend further estate planning transfers to reduce the estate when the combination of the factors noted above, and the availability of an already existing life insurance plan, may more than adequately address any tax costs. This is not only a matter of not having a client pursue unnecessary planning, it is also a matter of assuring that appreciating assets that can remain in the estate to receive a step-up in basis in fact do so.
• Bear in mind that the step-up in basis benefits and the annual inflation adjustments to the estate tax exemption are relatively new to the planning picture and have a different impact on planning recommendations than what most planners have traditionally pursued.

If grantor trust status is no longer needed, or a sale of a large appreciated asset might make the impact of grantor trust status too painful to the client, consider turning off grantor trust status. The following might be relevant to that process:
• Review with the client the possibility that if grantor trust status is turned off it may never be turned back on again. Even if the trust instrument permits a light-switch approach (on-off-on) some commentators advise that this should not be done.
• Does the trust have a tax reimbursement clause that might provide a means of tempering the impact of grantor trust status while retaining its benefits in the event it cannot be turned back on? Is the trust formed in a state where this clause will not cause estate inclusion and make trust assets reachable by creditors?
• Consider whether the trusts have the wherewithal to make loans to fund the grantor’s cash flow needs. This might provide a means to address financial concerns while retaining grantor trust status that for the future years might still be advisable.
• What do the terms of the trust instrument provide for? What steps need to be taken, by whom and how, to turn off grantor trust status? What notifications might be appropriate to include on the tax returns affected?

Insurance Trust Traps on Grantor Trust Status

There are several issues that must be evaluated at the planning stage, and if not, at the appropriate future date (e.g. when a discussion occurs about turning off grantor trust status) concerning life insurance trusts. If trust income can be used, directly or indirectly, to benefit the grantor, the grantor will be treated as the owner of the trust. IRC Sec. 677. This includes the application of income to pay premiums on life insurance policies insuring the life of the grantor or the grantor’s spouse. IRC Sec. 677(a); Treas. Reg. Sec. 1.677(a)-1. Specifically, the grantor is deemed the owner of any portion of the trust or the trust income which can be used (without the consent of an adverse party) to pay premiums on life insurance policies. IRC Sec. 677(a)(3). Prior cases, under a predecessor statute, held that the grantor was only taxable on trust income actually used to pay premiums. Rand v. Comr., 40 B.T.A. 233 (1939), acq., 1939-2 C.B. 30, aff’d, 116 F.2nd 929 (8th Cir. 1941), cert. denied, 313 U.S. 594 (1941). The IRS has held that if trust income is used to purchase life insurance even in contradiction of the terms of the trust, the trust will still be characterized as a grantor trust. PLR 8839008. The application of trust income to discharge the grantor’s legal obligation of supporting his or her spouse will also taint the trust as a grantor trust. IRC Sec. 677(b); Treas. Reg. Sec. 1.677(b)-1. If trust income can be used to pay the grantor’s mortgage, the trust will be taxed to the grantor. Rev. Rul. 54-516, 1954-2 C.B. 54. Many practitioners believe that if a trust holds life insurance it is automatically characterized as a fully grantor trust. The ability of a trustee to use trust income to pay insurance premiums on the life of the grantor might be advanced as the basis for this. Other practitioners are concerned that this may characterize the trust as a grantor trust as to income but not assuredly as to principal. Thus, if a trust is desired to be wholly grantor it may be advisable to include an additional power such as a swap power, the right to loan without adequate security, etc. in the trust instrument. If an existing trust does not have those additional powers it may be advisable to consider decanting into a new trust which includes additional grantor trust powers (although the tax issues that modification might raise should be considered). There is potentially another planning implication to life insurance trusts. If the grantor desires to turn off grantor trust status it is not clear according to some trust instruments that the trustee can merely stop using trust income to pay for premiums and thereby achieve an end to grantor trust status. It might be preferable to have a trust protector or other person hold a power to trigger a prohibition against the trustee using trust income to pay for premiums.

Plan Now Before Estate Tax Laws Change

Is permanent really “permanent.” While the 40% rate and $5.43 million inflation adjusted exemption are permanent that term can mean whatever the next vote in Congress decides it means. Any wealth client should aggressively plan to minimize future estate tax costs before the laws are changed adversely. Certainly there remains a possibility that the estate tax might be repealed. But there have been and continue to be proposals to make the estate tax incredibly harsher. GRATs may be restricted, the use of grantor trusts and especially note sale transactions to grantor trusts (perhaps the favored wealth shifting tool for ultra-high net worth clients) prohibited ( by mandating estate inclusion of asset sold to a grantor trust), etc. Act now.

Grantor Retained Annuity Trusts (GRATs)

GRATs are a powerful tool for shifting wealth. For the ultra-high net worth client the estate tax exemptions that seem so incredibly high for the vast majority of merely wealthy Americans are quite inadequate. Note sales to grantor trusts and GRATs that can shift tremendous wealth beyond the level of the exemption amounts are ideal. For the very wealthy client, the (albeit fictitious) convention of requiring a 10% seed gift to support a sale to a grantor trust caps the wealth transfer using a note sale to about $100 million (depending on the practitioner you question, the interpretation of the law, the practitioner’s comfort with using guarantee arrangements, and of course the alignment of the stars on the closing date). For these clients GRATs are a great tool for shifting large additional wealth. The viability of GRATs is potentially in jeopardy because of the proposals to restrict thier use (10 year minimum GRAT term, no more zeroed out GRATs, etc.) and the potential that increases in interest rates in the future will make the technique less advantageous than in the current low interest rate environment. When planning and structuring GRATs consideration should be given to the term of the GRATs used. For many practitioners the two year rolling GRAT format is GRAT heaven. However, if you are concerned that at some point interest rates may rise, and perhaps substantially, it may be advantageous to instead have client’s tiers of GRATs to shift wealth. Longer term GRATs will lock in current low interest rates for the duration of the GRAT. To address mortality risk a longer term GRAT necessarily is subject to tiers of GRATs (i.e., GRATs expiring in different years, or laddered GRATs) and perhaps offsetting life insurance (e.g., a 10 year term policy to backstop the mortality risk of a client dying before a 10 year GRAT matures) might be used.

Monitor Defined Value Clause Mechanisms

Many complex gift and sale transactions have been backstopped by the use of various types of defined value mechanisms. These mechanisms might provide that the client has transferred a specified number of shares of stock in a corporation but that the number of shares of stock that were transferred by sale to a grantor trust is capped or defined as a specified dollar figure, say $50 million, and the balance, if any of the stock (i.e., the balance that will be created if the IRS successfully asserted that the value of the stock shares involved exceeded the $50 million appraised value) was transferred effective at the date of the sale to the client’s private foundation. Practitioners should monitor the reporting of these items for all purposes. Perhaps Forms K-1 for the S corporation whose stock was subject to the sale/defined value clause should report the percentage ownership of the particular K-1 with an “*” asterisk and an indication that the actual number of shares depends on the terms of the defined value clause contained in a stock purchase agreement dated [insert date]. Also, when the period for an IRS audit expires, or if there is an adjustment as a result of an IRS audit, the documentation and reporting must all be adjusted. If the existence of the defined value mechanism and its terms are not acknowledged and respected by the client the IRS may assert that in a challenge to the effectiveness of the mechanism. If a distribution is to be made to shareholders while the uncertainty of the defined value mechanism remains active (i.e., before the period for IRS audit has expired) how should that distribution be handled?

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Tax Audit Hot Buttons for Gifts and Estates

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

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  Donee Transferee Liability
When clients make gifts few donees give thought to the tax issues, which is in the donor’s domain. That is not correct; it is clear that the donees can bear a tax cost if the donor does not pay the gift tax due on the transfer. The only issue is how far the donee’s pain can extend. There is a split in the circuit courts on whether donee liability for gift tax is limited to value of gift received (3rd and 8th Circuits), or whether that responsibility includes unlimited liability for interest (5th and 11th circuits). This is important concerning filing adequate disclosure for note sale transactions. The statute of limitations for the donee expires one year after donor’s statute of limitations.

Portability Audit Considerations
Should or must the surviving heirs file to secure portability? This will become a common planning challenge facing practitioners in future years now that portability is permanent. Especially in the context of second or later marriages when different parties may bear the cost and liability of filing, and different parties will benefit from the ported exemption, conflicts will arise. If there is a contractual obligation to file that should govern then the decedent’s heir will have to file and DSUE (deceased spouse unused exclusion) should carryover. If there is no prenuptial or other binding agreement there may still be a fiduciary obligation on the executor to file to secure the exemption. But this possible obligation on the executor (or other fiduciary) is not simple. The executor has a fiduciary duty of impartiality and if an estate tax return is filed to secure portability, that filing will create a tax audit risk based on the valuation of the assets of the deceased spouse reported on that Form 706. Instead, if no Form 706 were filed, the audit exposure would not be triggered. The executor might view the filing of a Form 706 for portability as exposing the estate and other beneficiaries to greater risk of tax audit, the costs and administrative burdens of an audit, etc.

FLP (family limited partnership) audits remain a focus of IRS audit efforts. Following are some of the common considerations:

• Is there a significant and legitimate non-tax reason for creating the entity?

• Is centralized asset management an objective?

• Involvement of the next generation in the management and operations of the partnership can demonstrate a non-tax purpose.

• Protection from creditors or failed marriages can be a valid non-tax motive.

• Preservation of a special investment philosophy has been recognized in a number of cases.

• Partnerships can be used to avoid fractionalization of assets. For example, placing a family ranch or vacation home inside an entity may be used to avoid partition, provide for centralized management and preserve the desired asset.

• FLPs can be used to avoid imprudent expenditures by next generation family members.

• If the senior family member will be a GP (general partner) of FLP (family limited partnership), or manager of LLC, include a business judgment ascertainable standard. The entity can mandate that available cash should be distributed but entity can hold cash reserves determined by general partner though fiduciary obligation and their reasonable business judgment.

There are a number of audit hot button issues that should be avoided:

• Non-prorata distributions can undermine the integrity of the partnership.

• Having the partnership pay personal expenditures with partnership funds can undermine the reality of the partnership.

• Having personal use asset, like the family home, held in a partnership can compromise the reality and independence of the entity.

• Payment of estate tax and expenses when asset transferred to partnership close to death is often argued by the IRS as a factor indicating that the partnership was not real.

• Not maintaining accurate books and records can be negative.

• Having insufficient assets outside of the partnership can be quite negative. If this is identified in advance a partial liquidation of the partner’s interest can shift assets back to possibly rectify this.

This so often seems to be a struggle with clients and a gap in many plans. Great attention is paid to the governing trust instrument and appraisal but the entity documents governing the entity interests transferred are too often not given enough attention. It certainly seems from the above comment that these formalities are on the IRS radar screen. Sometimes transactions are completed with the least entity documentation possible. Perhaps that is not the optimal approach in light of the above comment.

Some of the issues/steps worth considering might include:

• Creating governing entity documents before and after a transfer (e.g., a signed operating agreement before the entity interests are gifted or sold, and again after with the new trust owner signing as a member).

• Obtaining copies of underling documents for the entity, such as a deed for a real estate LLC to confirm it is held in the name of the entity.

• Corroborating the compensation arrangement for family members (e.g.., to deflect a later challenge that under compensation constituted an impermissible transfer by the founder/GRAT settlor to the GRAT).

• Obtaining certificates of good standing for entities whose interests are transferred to identify and correct issues.

• Enhancing nexus to a trust friendly jurisdiction by taking steps in addition to just naming an institutional trustee in that jurisdiction.

• Using arm’s length documents and security arrangements.

• Having annual minutes or even meetings.

Note Sales to Grantor Trusts
One of the big worries about this common estate tax minimization planning technique is the case of Donald Woelbing and Marion Woelbing Estate. This case is still unresolved, but the issues raised by the IRS are worrisome to every practitioner with a client who has engaged in these transactions.  In the Woelbing case the taxpayer sold interest in a profitable company that manufactures lip balm to a trust. The interest sold was valued by the taxpayer at $60 million dollars. The sale was consummated for a note to a grantor trust. The transaction in many respects was structured in a manner in which many advisers would consider reasonable. The trust had assets in excess of 10% of the value of the note. This is an often-quoted (though baseless) convention of the equity in a trust to support a note sale transaction. There was also a guarantee further supporting the validity of the note.

The taxpayer died in 2009 and the note was still outstanding at his death, and the gift tax audit was still outstanding. The IRS has argued that the value of the shares transferred was $116 million, not the $60 million the taxpayer claimed. More damaging, the IRS claimed that the transaction was not a sale but rather a transfer to a trust with a retained interest. Further, that retained interest did not qualify as a “qualified retained interest” under Chapter 14 so the transaction should be deemed a transfer of the entire interest, i.e. a gift of $116 million. The value definition mechanism should be disregarded so that the taxpayer’s valuation safety net would be ineffective. The IRS asserted valuation penalties.

While this case is pending, consider what can be done with similar transactions to perhaps shore up the plan:

• Inform clients that the IRS may attack such transactions.

• On new transactions, evaluate the use of GRATs (grantor retained annuity trust) instead of note sales until the issue is resolved. Many commentators do not believe that is necessary and the loss of GST (goods and services tax) benefits by using GRATs rather than note sale to dynastic trusts, is significant. While GRATs are safer, sales to a grantor trust can be more effective.

• You could use a note sale but structure the payments to conform to GRAT annuity payments. This too, while theoretically a possibility, may not be feasible.

• The IRS may argue that decedent interest in the note payments is tantamount to a retained right to income from partnership (or other entity interest transferred in the note sale transaction) because distributions from the partnership were used to pay note payments. Endeavor to structure the transaction so the paper trail of payments from the partnership does not correlate nor equal the note payments as to amounts or timing.

Defined Value Clauses
• These safety mechanisms have grown more popular in estate and gift tax planning. The concept is simple, although the details and implementation can be varied and complex. If the IRS successfully challenges the value of a transfer, the excess amount, instead of creating a taxable gift, is transferred (depending on the manner of mechanism used) to another receptacle, which will minimize or eliminate the gift tax.

• A number of cases have approved the transfer of the excess to charity.  

• Another approach some practitioners have used is a transfer of the excess to a GRAT. This can reduce the value of the excess to near zero and provides an option for a client who is simply too uncomfortable risking the transfer of family business interests or other special assets, to a charity. Other practitioners have raised the question as to whether the use of a GRAT as the defined value receptacle might be against public policy because the annuity payments from the GRAT are made to the grantor. This might be argued to be tantamount to the landmark Procter case, which proscribed returning the excess value to the grantor/transferor. Another concern some commentators raise is whether or not the spillover of the excess value to the GRAT would be tantamount to a deemed contribution when GRATs do not permit additional contributions.  A number of practitioners have and continue to use this technique of having the excess value spillover into a zeroed out GRAT. So many experts believe there is no issue with the GRAT approach. Practitioners might consider informing clients who have used (or will use) this technique of the potential issues.

• Another consideration is for practitioners to review all transactions that used defined value mechanism to be certain the transaction reported consistently with the formula clause used. Most comments concerning consistent with the defined value mechanism have generally focused on gift tax reporting, but is more advisable even if not perhaps necessary? If entity interests are sold to a trust subject to a defined value mechanism should anything be indicated on the Form K-1? Might the K-1 report the percentage interest with an asterisk and an indication that the percentage reported is subject to a defined value mechanism? Should the potential receptacle under the defined value mechanism (e.g., a GRAT or QTIP) indicate on its income tax filings that it has a possibility of an interest in an entity under that mechanism? What about on a QSST (qualified subchapter S trust) or ESBT (electing small business trust) election? Should there be an indication of the potential for shares being held by another entity?

• Under landmark Procter, Commr. v. Procter 142 F.2d 824, case the court did not uphold a defined value mechanism that resulted in the excess value reverting to the donor. One problem the court identified was the fact that the mechanism resulted in no tax after a successful audit. The court determined that the mechanism violated public policy. Is there any advantage to using a mechanism that will trigger some current tax on audit? Consider adjusting whatever mechanism is used have the first $X or Y% of interests remain with the donee/buying trust knowingly triggering some gift and GST tax. Then the remainder resulting from the valuation increase on audit spillover into a private foundation, GRAT, QTIP, etc.

Valuation Issues
These have historically focused on discounts, etc. But in the new tax paradigm for moderate wealth clients who will not be subject to the estate tax, valuing assets as high as possible, short of triggering an estate tax can lead to the opposite planning. Will Congress have to enact valuation overstatement penalties?

Step Transaction  
Practitioners should be alert for step-transaction issues in complex or multi-part plans. If a gift is to be made, e.g., from wife to husband, and thereafter husband will be gifting or selling some or all of those interests to a trust, endeavor to separate the two steps of the transaction into separate tax years. If feasible, the preferable approach would be for independent substantive economic events to occur during the intervening period.

Promissory Notes
Loan transactions are ubiquitous in family and estate planning. When a client dies holding notes practitioners often have those notes appraised for estate planning purposes. In other transactions, clients may have the holder of a note resulting from a family transaction gift the note based on its appraised value. The IRS has challenged value of notes at less than face value. There is a presumption (IRC Sec. 7872) interest rate is a safe harbor.

Another audit issue for notes is whether or not they are real loans (valid indebtedness). Some of the factors to evaluate the validity of a note include:

• Reasonable expectation for repayment of the note.

• The interest rate charged.

• The existence and adherence to a repayment schedule.

• Security for the loan.

• Whether a demand for payment has been made and whether it was respected.

• Books and records of the transaction. How the parties reported.

• Repayment of the loan.

• Solvency of the borrower.

Another audit issue is challenging the refinancing of loans as interest rates decline. Many AFR (applicable federal rate) notes have been refinanced. The IRS has argued that the refinancing of a note at a lower rate is a gift. Some commentators suggest shortening the term of the renegotiated note or providing another modification that could constitute consideration for the change. Consider the fiduciary obligations of the trustee in all these matters, especially if the note prohibited prepayment.

GRAT Audit Issues
Are all provisions required by the Regulations included in the trust agreement?  Are the formalities of the GRAT being complied with? Is the GRAT being operated in accordance with its terms? Consider Atkinson analysis based on CRT. Have annuity payments been properly and timely made? Valuation on initial transfer. Re-valuation provision may help. Was there a disguised gift compared to what grantor received on a substitution? Were in-kind distributions made? Were they properly valued? Consider using a Wandry formula with respect to exercise of power of substitution and paying an annuity in kind. Perhaps this is a result of increasing audits of GRAT annuity payments and/or a desire to shift appreciated assets back into a client/settlor’s estate for basis step up purposes. In contrast in the past it may have been more desirable to use cash in the GRAT to make the annuity payment. At any rate, it seems the use of valuation formulas in GRAT payments in-kind might become the new way to go.

Gift and Income Tax Auditors Speak to Each Other
Cavalera Case. Audit of a company that sold all of its assets. It had merged with a company owned by three sons and company owned by parents. Income tax agent referred to gift tax auditors who audited the return and found a $27 million gift. Practitioners should not assume these referrals to gift tax auditors don’t happen, they do. Consider filing gift tax returns in these issues.


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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