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Trust Income Tax Planning Post-ATRA

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

By: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD | Income tax planning for trusts has been profoundly affected by the dramatic changes the American Taxpayer Relief Act of 2012 (“ATRA”) has had on the tax system. Income tax rates are higher. The federal estate tax, which had been an issue for many clients, now affects only a super-wealthy few. These changes have significant impact on how every practitioner completing a Form 1041, or even a 1040 for clients receiving K-1s from trusts should plan. Even if your clients face a state estate tax, the cost is significantly less than the combined state and federal estate tax that they had once faced. Trusts are subjected to an income tax regime very similar to that faced by individuals, but with a special deduction for distributions of distributable net income (“DNI”). Another hallmark of trust taxation is that trust income is subject to a compressed tax rate structure so that the maximum trust income tax bracket is reached at only about $12,000 of income. The Medicare Surtax which became effective in 2013 has added to the compressed income tax burden that trusts face. The following checklist will help you in the process:

General Trust Planning Tips to Reduce the Surtax

Planning for the Medicare Surtax under IRC Sec. 1411 has been the “talk of the town” since it first became effective in 2013.  Practitioners planning for and preparing Trust Forms 1041 must be especially alert for planning opportunities to reduce the Surtax. This is especially important if the beneficiaries might sue trustees if the trust incurs Surtax that could have been avoided.

- Reduce trust income below the threshold amount if the trust is close to the level at which the Surtax applies. This is most simply accomplished by making distributions to beneficiaries that push income out of the trust to the beneficiary via the distributable net income (“DNI”) deduction to the trust.

- Trustee fees can be used to adjust how much NII is distributed. In regular income tax world trustee fees can generally be allocated against just certain types of income included in DNI (such as interest income) if that is more highly taxed and reported that way on the K-1. Specially allocating trustee fees will also impact the amount of NII that is deemed to be distributed. If you can do this in the income tax world it should affect the NII Surtax world in a similar manner. Note that in the regular income tax world some portion of expenses must be allocated to non-taxable income, e.g. muni-bonds, and lose the deduction to that extent.  After making the trustee fee allocation for general income tax purposes and determining how much of each type of income is distributed under the regular DNI rules, a deduction for trustee fees is then allowed in determining the amount of undistributed NII that is subject to the Surtax, but the trustee fees must be allocated proportionately among NII and non-NII items.

Many clients and trustees will not be comfortable simply distributing funds to beneficiaries to save income tax. Consider the use of LLCs and FLPs to hold trust distributions to provide some measure of control.   Flow through entities can pass income to “beneficiaries” without the need for actual distributions like a trust.

- Common advice is to convert NII to non-NII, but trustees have a fiduciary duty to invest trust assets. Investments must conform to the Prudent Investment Act unless the legal documents permit variation, but even variation must be undertaken with caution.

- Make interest tax exempt by investing in municipal bonds and move investment assets into life insurance which is protected by a tax favored envelope, but again, being mindful of the Prudent Investor Act.

Grantor Charitable Lead Trust

Unlike their more popular cousins, charitable remainder trusts (“CRTs”); charitable lead trusts (“CLTs”) are taxable. Practitioners should be alert for a fundamental change in the tax status of many newly formed CLTs. With higher income tax rates and substantial recent appreciation in the stock market there should be increasing interest in the use of grantor charitable lead trusts (“CLTs”). CLTs, while generally structured as non-grantor trusts, can be structured as a grantor trust so that the donor may benefit from a current income tax charitable contribution deduction. The deduction would be the present value of the qualified annuity or unitrust interest to be paid to the charitable beneficiary. IRC Sec. 170(f)(2)(B). In the remaining years of the CLT the grantor will be taxed on all of the income of the CLT. Thus, the value of the current contribution deduction must outweigh the income taxes that will be due in those future years.

A CLT can be characterized as a grantor trust to achieve this result in the following ways:

- A reversionary interest with value greater than 5% of the value of the trust assets at the time assets are transferred to the trust is held by the grantor’s spouse, the CLT will be characterized as a grantor trust. IRC Sec. 672(e).

- The grantor has a reversionary interest with value greater than 5% of the value of the trust assets at the time assets are transferred to the trust.  IRC Sec. 673.

- The grantor retains a power to substitute assets, for assets of an equivalent value, in a non-fiduciary capacity.  IRC Sec. 675(4)(C).

Use CRTs to Defer and Perhaps Avoid the Medicare Tax

CRTs, as tax-exempt trusts, are not subject to the Medicare tax. However, when the CRT makes distributions to current non-charitable beneficiaries, e.g. the client/grantor, some portion of a distribution may be characterized as NII and subject to the Medicare tax.  While the CRT itself is exempt from income tax, the annuity or unitrust distributions made to individual beneficiaries are subject to regular income tax and Medicare tax. Under the final regulations, net investment income is classified and distributed using the four existing classes into which CRT income must be divided under IRC Sec. 664. These classifications capture the historic categorization of income earned.  Generally, the most costly categories of taxable income are deemed distributed first. NII would similarly be identified as a sub-component of each such class of income. The NII of the CRTs beneficiary attributable to the beneficiary’s annuity or unitrust distribution will be deemed to include an amount equal to the lesser of: (1) the total amount of distributions for the year and (2) the current and accumulated NII of the CRT. Prop. Reg. Sec. 1.1441-3(c)(2)(i).   If there is more than one beneficiary the NII is apportioned among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that year.

For example, if a client gifts appreciated property to a CRT which is subsequently sold by the CRT, there is no immediate imposition of regular income tax or Medicare tax under IRC Sec. 1411 tax on the capital gain which is NII.  The full amount of the sale proceeds can be reinvested in the trust. The deferral of the recognition of NII by having made the gift to the CRT which sells the assets instead of the individual donor may effect not just a deferral but an avoidance of the Medicare tax. For example, if the gain were realized in one year by the client much of the gain could be subject to the Medicare tax. It is possible for some clients that the spreading of that gain out over many years as part of the CRT tier system may result in the realization of that NII in sufficiently small quantities that the client’s MAGI remains under the threshold amount necessary to trigger the Medicare tax in future years. This same result may reduce the bracket in which income is realized as well.

Divorce Considerations

Most clients remain concerned as to whether trust assets are reachable in a divorce. Whether a trust is reachable in a divorce proceeding will depend on state law, as well as on a number of trust characteristics. A “discretionary” trust gives the trustee the power to determine if, when, and how much to distribute from the trust. This can be more difficult to reach through in a divorce. If, on the other hand, a trust is deemed a “support” trust, which directs the trustee to make distributions to support the beneficiary, it may be reachable. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” Supports trusts may have to rely on a spendthrift provision for any protection from claimants. Thus, a support trust might be easier to reach in a matrimonial action. While these generalities provide useful constructs, reality is much more complex because many trusts are actually a blend of the two principals, and all of this is compounded by the differences in state law, and how the trust is administered. A court might be influenced to see a trust that makes those regular distributions of trust income as somehow being more readily available, than a trust that has not made distributions. Practitioners rendering tax planning advice that suggests distributions should be mindful of these important ancillary consequences.

State Tax Compliance

State income tax planning for trusts will remain a critical component of planning and as the importance of estate tax planning wanes, state tax considerations will become relatively more important. Planning the initial situs of a trust, which state laws will govern, and which state or states can tax trust income, could have a material impact on the economic effect of the trust. If a trust is formed in a less than optimal jurisdiction, it may be possible to use the process of decanting (merging or transferring an existing trust into a new trust with more desirable provisions), or other techniques, to modify existing trusts to achieve better results.

Practitioners must bear in mind that as they recommend distributions from trusts to flow out DNI to lower bracket beneficiaries, those beneficiaries may be liable for state income tax on the distributions that could exceed the income tax that the trust might pay. For example, the trust may be based in a state that does not assess income tax on the trust. A distribution may reduce the trust’s federal income tax burden, but it could subject the beneficiaries to a high incremental state income tax.

Where a trust is administered may have important implications to the application (or avoidance) of state income taxation. In a recent case a New Jersey resident created a testamentary trust. In 2006 the sole trustee resided in New York and the trust was administered outside New Jersey. The trustee filed and paid New Jersey tax on S corporation income attributable to income from New Jersey, but not on S corporation income attributable to non-New Jersey sources. The fact that the tax return showed a New Jersey address was not deemed significant by the Court. The court held that since the trust was not administered in New Jersey, the Trustee was a New York resident and therefore could only be taxed on New Jersey source income. Residuary Trust A. v. Director, 27 NJ Tax 68 (2013). Thus, in guiding clients as to state income tax compliance and tax planning practitioners need to consider not only where the trust is administered, but the potential for changing that place of administration to improve state income tax consequences.

Multiple Fiduciaries

The increasing complexities of trusts using various fiduciaries will complicate these decisions and planning to avoid state income tax. Some trusts may have an institutional general trustee, an individual co-trustee, a trust investment adviser, a trust protector, a person authorized to make loans for less than adequate security, the grantor or another person the right to swap assets (see below), or other mechanisms to achieve grantor trust status. A trust protector may hold broad powers to modify the terms or operations of the trust. Practitioners should be cautious in determining tax status and other filing positions to ascertain whether one or more of these fiduciaries (or “quasi-fiduciaries”) has taken actions that might affect the tax status or other attributes of the trust.

Swap Powers

An approach to ensure that clients die with the lowest-basis assets is to include a swap power in trust agreements. The swap power causes the trust to be a grantor trust and permits the holder, typically but not always, the grantor, to swap trust assets for assets of equivalent value, e.g., cash. If a client has made transfers to a grantor trust, he or she may be able to exchange or swap cash for appreciated assets held in the trust, thereby bringing those assets into their estate for a step-up. To make this swap power viable, consider drafting standby purchase instruments. Also endeavor to have lines of credit and other cash resources secured well in advance. This power, while interesting in theory, creates a number of practical issues. How can it be exercised? While one commentator quipped in humor that clients should be called weekly to assure that they are still well enough to exercise the power, when should it be exercised? At minimum, annual planning meetings should address this power.

Irrevocable Trusts Generally

Existing irrevocable trusts should be reviewed to ascertain what, if any, purpose they serve, or can be made to serve, in the new tax environment. Practitioners should not merely prepare returns for trusts because they were prepared in prior years without ascertaining whether the trust is still viable and if viable, still appropriate. If the trust no longer serves optimal planning purposes it may be feasible to merge (decant) the trust into a new trust better crafted to meet current circumstances. This can provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:

- Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.

- Under state statute. A growing number of states permit decanting pursuant to state statute.

- Under state common law.

Decanting may enable a trustee to extend the term of an existing trust, although generation skipping transfer tax issues must be addressed; correct scrivener errors; add a spendthrift provision to protect trust corpus from potential claims of a beneficiary’s creditors; change trustee provisions; change governing law and situs to a state that is more favorable to achieving trust objectives; convert a non-grantor trust to a grantor trust, or vice versa; or qualify a trust as a special needs trust under applicable state law if the successor trust lacked these provisions.

Caution must be exercised in decanting a trust that is GST exempt or grandfathered to avoid tainting that benefit.

Irrevocable Life Insurance Trusts (“ILITs”)

Many ILITs were created to hold life insurance to pay an estate tax that may no longer be relevant to the client. Repurposing existing ILITs if the insurance is no longer needed for its initial purpose, or if the trust no longer optimally serves the client’s purposes, may be productive. For, example, a trust owning insurance might be modified by any of the following approaches:

- The insurance may be cashed in and the proceeds distributed to current beneficiaries and the trust terminated.

- The insurance may be retained and the trust modified or decanted to better meet current needs.

- Many ILITs simply hold life insurance and a nominal bank account, but the trust provisions may permit a much more robust trust that can serve as a spousal lifetime access trust to receive and hold additional gifts in order to save state estate taxes or for other purposes.

663(b) 65-Day Election

Under this election, an amount paid or credited to a beneficiary within the first 65 days of a tax year can be treated as if paid or credited during the estate or trust’s prior tax year. This election might facilitate shifting income to a lower bracket taxpayer, shifting income to avoid an underpayment of estimated taxes, or facilitating taking advantage of a net operating loss. The election is made by checking the required box on Form 1041 for the estate or trust. Treas. Reg. Sec. 1.663(b)-2(a). This election is generally only applicable to complex trusts. This is because simple trusts are required to distribute income annually and should generally not have the result necessary to make an election. In light of the new Medicare tax on passive net investment income of estates (and trusts) the fiduciary may wish to use flexibility in the governing instrument as to distributions, and the varying tax brackets of the estate and the various beneficiaries to make a distribution within 65 days of the close of the tax year to reduce the estate’s Medicare tax on net investment income (“NII”).


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

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LLC and FLP: A Swiss Army Knife of Planning Options

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

By: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD | LLCs are ubiquitous in tax and business planning for clients. They have become the default answer to questions like “how to I organize my new business,” or “I’m buying a rental property, how should I do it.” However, LLCs are an incredibly flexible planning tool, a veritable Swiss Army Knife of planning options, that can be molded to meet a wide range of planning goals. The checklist below discusses many common, and not-so-common, planning applications of LLCs. Some of the applications of LLCs are obvious to practitioners, yet many clients still fail to heed the common advice as to how and when to use them. Although these situations are well known, they’ve been added to this checklist to encourage practitioners to proactively address them with clients. Finally, while the changes made by the American Taxpayer Relief Act of 2012 to the estate tax may have been permanent (whatever that word means in Washington) there are seemingly always changes in the law and tax environment that affect planning. The changes that have occurred in recent years make it imperative that every client with FLP/LLC have a check-up meeting. Some of these points are noted as well.

Consolidation LLCs

It is common for client families to accumulate various investment accounts. Whereas in the past the use of FLPs and LLCs to hold investment assets was largely focused on securing estate tax discounts, these discounts may not be important to most clients. However, the other significant benefits from this application of FLPs/LLCs remains a valuable planning tool for many. Practitioners should consider:

- Consolidating many family accounts into a single investment entity may enhance investment opportunities and be used to lower overall investment management fees.

- A properly structured and operated FLP/LLC can provide family members important asset protection benefits. A multi-member entity will afford partners/members charging order protection in the event of a personal lawsuit. This could be instrumental in protecting what might otherwise be fully exposed and easily reached investment assets.

- If the parent or another specified person serves as general partner or manager of the investment entity it may negate arguments in a matrimonial case that the a child actively invested assets somehow transforming them into marital assets.

Practitioners reviewing Forms 1040 Schedule B should be alert for large investment income that is owned individually when a family entity could instead afford significant benefits.

Home Ownership

While the use of an LLC to own rental properties is common, there are some special circumstances when a client might wish to use a special adaption of an LLC to own a home. This might be appropriate in at least one unusual circumstance.  The clients are very concerned about asset protection and the state where the residence is located does not afford any homestead or tenants by the entirety (husband and wife as owners) protection for a home. In these instances having a multi-member LLC own the home may address that issue. The home might be owned for example, 40% husband, 40% wife, 20% family trust. In many instances the cost of this type of structure, or the negative implications to home sale exclusion or mortgage interest will negate the planning. However, in some instances this might be the ideal tool.

Vacation Home Ownership

The client owns a vacation home in a state that has an estate tax so that owning property directly or in a living trust might leave that property subject to a state estate tax. However, if the property is owned by an LLC, and the client is domiciled in a state that does not have a state estate tax (or if it does, for which the client will not be liable), the LLC may also achieve the client’s tax planning goals and avoid ancillary probate as well.

When these “off-label” applications of LLCs to own homes are used, be certain that the attorney modified the legal documentation accordingly since typical commercial operating agreement provisions might make little sense in this context.

Home Based Business

Organizing a home-based business as an LLC is an obvious and common tool every practitioner is familiar with. The problem is that too many clients ignore practitioners’ advice to form an LLC for a “small” home based business worrying about the cost of creating the entity. The size of a home-based business has no correlation to the potential liabilities it can create.  Anytime a practitioner files a Form 1040 with a Schedule C or E that includes a home based business or rental property that is not in an entity format (LLC or otherwise) consider sending a standard letter (or even email) cautioning the client that they should form an entity and that regardless of the profitability or revenue of the business or property, liability may exist.

Single Member LLCs

While it may be obvious to every practitioner that a single member disregarded LLC does not afford the asset protection that a multiple member LLC does, many clients ignore practitioners advice to use a multiple member LLC worrying about the cost of the annual Form 1065. Again, this is a common mistake that puts many clients at risk. If a client is sued the interests in a 100% LLC are fully reachable by a claimant of the client. However, if the LLC is a true multiple-member entity then the client’s interests may be attached generally by a claimant. The claimant, however, may not be able to force the liquidation of the entity to seize on the interests involved. As such, the client has greater protection from suits. Anytime a practitioner files a Form 1040 with a Schedule C or E that includes a single member disregarded LLC consider sending a standard letter (or even email) cautioning the client that they should reform the LLC as a multiple member entity to provide better protection.

Child Funds

In many cases a child accumulates significant assets from gifts. These assets might then prove a temptation to the child to inappropriately or even dangerously use the funds. Large funds might be a temptation for a young client’s significant other or other predators or creditors. Ideally, gifts and other transfers should be made in trust for any minor beneficiary. Too often, however, clients ignore the advice of their professionals, or don’t realize the significant amount the funds will grow. After the fact the only trust structure that may be feasible is a self-settled trust. This would require that the client establish a trust in a jurisdiction permitting self-settled trusts (e.g. Delaware). This technique is complex, costly and embodies risks that many clients are not willing to assume. A simple family LLC might offer a practical and low cost option. Consolidate these assets into a family partnership or LLC. This may be an ideal tool to provide a measure of control and protection for these funds with the complexity and cost of a self-settled trust. If the child is a minority owner of the entity the manager or GP can provide brakes on distributions, asset protection, distance from a gold-digging spouse/significant other, etc.

Charity and LLCs

LLCs have not been used to a great degree by charities to insulate them from liability risks of donations. That may change. The change may open up greater possibility to help clients structure more complex charitable gifts. A charity may want to form a single member LLC that it owns and controls so that the activities conducted by the LLC do not subject the charity to liability, such as from accepting a donation of rental real estate. The IRS in 2012-52, confirmed that so long as all other requirements of IRC § 170 are met, the IRS will treat a contribution to the disregarded single member LLC as a tax-deductible contribution to the charity itself for income tax purposes. This option can provide a creative use of LLCs to facilitate client charitable planning especially for clients owning business or real estate interests. Practitioners should be certain that the charity discloses in the acknowledgment of the donation that the single member LLC is wholly owned by the charity and treated by the charity as a disregarded entity.

Charitable FLPs

While some uses of charitable partnerships have been abusive, there are planning opportunities that might be viable if properly implemented. The use of this technique is perhaps most readily explained by example. A client could create a family limited partnership (FLP).  The client will own 100% of the entity that is a 1% general partner (GP). Initially, the client could own the 99% limited partnership (LP) interests (although a spouse and/or adult child could also own LP interests).  The client contributes appreciated assets to the FLP.  Thereafter, the client/donor would contribute some or all of the LP interest to a public charity (the self-dealing restrictions applicable to private foundations make them inadvisable to use).   The client should realize an income tax charitable contribution deduction for the contribution of the LP interests at the appropriate discounted fair market value. This amount should be determined by a qualified appraisal. Treas. Reg. §1.170A-13.  The FLP may then sell appreciated assets and capital gains should flow through to the then owners: i.e. perhaps up to 99% to the tax exempt charity, and 1% to the GP. If this sale was pre-arranged it would not past muster.  Eventually, the charity may be willing to sell the LP interests for their fair market value to a family trust, such as a family dynasty trust.  Even if the assets are not sold, and there is no capital gains minimization (which may eliminate a risk that some practitioners are uncomfortable with), the client could transfer value to a charity and obtain a contribution deduction, and also transfer value to the family dynasty trust leveraged for gift and generation skipping tax exemption purposes.

LLCs May Need to Supplement Asset Protection Trusts

Domestic asset protection trusts (“DAPT”) have been subject to a number of unfavorable cases. In re Huber, 2013 WL 2154218 (Bankr. W.D. WA, May 17, 2013), Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, May 26, 2011 and Rush Univ. Med. Center v. Sessions, ____ N.E. 2d ____, 2012 IL 112906, 2012 WL 4127261 (Ill, Sept. 20, 2012) to name a few. Other types of irrevocable trusts that might be intended for asset protection may also face challenges for other reasons. So, if asset protection is a concern of your client, and the client has existing irrevocable trusts, layering LLCs onto the irrevocable trust plan may provide a backstop to the protection hopefully afforded by the trusts. Assuring that the documentation for these LLCs, if they already exist, is current may be an important planning step. There are a host of other asset protection considerations for existing client LLCs, and opportunities to creatively use an LLC to achieve asset protection benefits.

Many LLCs Need Service Calls

Whether or not it’s been 5,000 miles since your client’s LLC “oil change”, many LLCs are overdue for a service call. There have been a number of significant legal changes that make it advisable for every client to review their LLC operating agreement (the legal document governing the operations of the entity) and other aspects of their LLC structure and planning. While CPAs are not going to review the legal aspects of this, the tax aspects are vital. But as with so many planning areas, if the CPA doesn’t lead the client to the lawyer the work will never be addressed and the client will remain unprotected.

The Revised Uniform Limited Liability Company Act (“LLC Act”) was adopted into law in a number of states including Iowa, Idaho, Utah, Wyoming, Nebraska, New Jersey, California, and the District of Columbia. For LLCs in these jurisdictions the changes in the law could have an important impact and it may be advisable to take action. Every client in these states should meet with their attorney and review their documents.  Some of the comments below are based on the New Jersey law changes, but the key point is that any client who has not reviewed their LLC documents in recent years should do so:

- Creditor’s Rights

The LLC Act permits a creditor of a member (e.g., a physician member’s malpractice claimant) to foreclose on the LLC membership interest. This can undermine LLC protection in a significant manner. Forming new LLCs in states with more favorable laws might make sense. While cumbersome, it may be feasible to convert or reform an existing New Jersey (or other state with similar laws) LLC in a better jurisdiction. For clients worried about lawsuits this is vital to address.

- Written Agreement

The LLC Act permits an LLC operating agreement (the legal document that governs the management and operation of the LLC) to be in writing, oral or even implied based on how the LLC operates. This might make it more important to have annual review meetings, written consents and appropriate amendments of written operating agreements to minimize any unintended implication that another arrangement superseded or modified the existing operating agreement.

- Statement of Authority

The LLC Act permits an LLC to file a document, referred to as a “statement of authority,” with the State Treasurer specifying individuals or entities whom have (or don’t have) the authority to execute agreements transferring LLC real estate, or entering into any other transactions on behalf of the LLC. This might be useful to certain LLCs, perhaps those with independent parties who want to assure who can or cannot bind the LLC legally. In the family context, the use of this mechanism should be considered in a tax context as well. For example, might naming a person to hold authority to sell real estate affect the characterization of the LLC for purposes of the passive income or loss rules under IRC Sec. 469, or the Medicare Surtax Rules under IRC Sec. 1411? Might naming a parent who made gifts of LLC interests to hold authority to sell real estate or a business of the LLC be argued by the IRS as a retained right that could cause estate inclusion under IRS Sec. 2036? While this mechanism might provide a useful simplification for real estate and business transactions, its use should first be reviewed in the broad context of your overall planning.

- Fiduciary Duties

Under the LLC Act, the Operating Agreement cannot eliminate or restrict a member or manager’s fiduciary duties unless it is not manifestly unreasonable. If an existing operating agreement has restrictions that may run afoul of this criterium, amendment may be appropriate. Also, those members or managers that are affected may wish to reassess their level of involvement if a change is warranted. Caution should be exercised in family LLCs in that restricting fiduciary responsibilities could have tax ramifications. For example, if a parent made gifts of LLC interests and the operating agreement restricts the parent’s fiduciary responsibilities as a manager or member the IRS may argue that the restrictions permit excessive control by the donor/parent and may therefore support an argument of estate inclusion. The operating agreement may include a mechanism by which a particular transaction that would otherwise violate the duty of loyalty may be approved by a disinterested and independent person, after full disclosure of all material facts. This may be a concept that is worthwhile to integrate into some LLC arrangements.

- Indemnification

Under prior LLC law the LLC operating agreement could alter or eliminate the indemnification for a manager or member. The LLC Act provides that the Operating Agreement may eliminate or limit a member or manager’s liability to the LLC and members for money damages, except for: (1) breach of the duty of loyalty; (2) an unentitled financial benefit received by the member or manager; (3) an improper distribution; (4) intentional infliction of harm on the LLC or a member; or (5) an intentional violation of criminal law. It is advisable to review the indemnification and related provisions to assure that the standards of the LLC Act are acceptable, and if not whether the operating agreement should be modified to address these matters. It may be advisable to review your liability, errors and omissions and other insurance coverage to confirm what is in fact addressed in your policy.

- Resigning Member Rights

Under the LLC Act, a resigning member of an LLC is no longer entitled to the “fair value” for his LLC interest as of the date of resignation. Instead, a resigning member disassociates himself as a member and will only have rights as an economic interest holder (i.e., he will retain an equity interest but forfeits his voting interest).

- Oppressed Member Rights

The Revised LLC Act allows a member of an LLC to apply for an order from the Court dissolving the LLC, or appointing a custodian to manage the LLC, because the LLC’s activities are either unlawful or the LLC manager or controlling members are acting illegally, fraudulently or oppressively to the other member. The right might be of particular concern where key employees or other third parties have minority interests in family businesses organized as LLCs. In family investment LLCs, which have become a common planning vehicle, might this permit an antagonistic family member to unwind the family entity?

- Distributions

The Revised LLC Act provides that unless the members of the LLC agree otherwise, any distributions to members, before the dissolution and winding up of the LLC, are to be made to members in equal shares. If the LLC is owned by family members, it is important to have an operating agreement specify the ownership and distribution percentages. If, for example, a parent made gifts of most of his or her LLC interests and distributions were still made equally by a member, that might cause an estate inclusion issue for the parent. In some instances the default law may be desirable to provide a position to argue that the LLC interests are included in the parent’s estate to obtain a basis step-up.


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

 

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Probate Planning Steps to Take Now

  • Written by Martin M. Shenkman

Planning for uncertain times is the key issue on the table for advisors and clients today. Instead of focusing on what you can’t assure clients about, focus on proactive steps you can take to help clients deal with estates of decedents who died in 2010.

Carryover Basis Rules

If a client died in 2010, you have to deal with the carryover basis rules of Code Section 1022 enacted with the 2001 Tax Act and guide the executor. The basis of assets from a decedent is the lower of the decedent’s adjusted basis, or the fair value of the asset on death. This is adjusted for the special basis of $1.3 million on property passing to anyone and the $3 million for property passing out-right to a spouse, or in a trust that meets the requirements of Qualified Spousal Property.

Be proactive: get appraisals of all assets to demonstrate fair market value; corroborate the decedent’s income tax basis. Prepare a worksheet allocating the basis adjustment. The worksheet will be somewhat analogous to worksheets you have prepared in the past to allocation of 754 basis adjustments.

Don’t wait for forms to be released or for detailed instructions; move now. Returns will be due April 15, 2011, and the allocation of basis adjustments will have to be reported May 15, 2011. If Congress gives 2010 estates the option of using carryover basis or 2009 rules, you’ll still need calculations to confirm the decision. The answer may not be obvious because of the complexity and myriad of factors to consider: capital gains rates may rise, some assets cannot be stepped up, the $1.3 million basis step-up might eliminate capital gains with no tax, etc.

Funding

Beneficiaries are pressuring executors for distributions. With the law so unclear, suggest executors find sources (e.g., heirs, family business, insurance trust) to loan funds to the estate so that the estate can make some distributions to beneficiaries. To raise cash, guide the executor to also consider borrowing funds on margin, mortgages, commercial loans, etc. in order to avoid selling assets and solidifying unknown tax consequences

Investment Plans

Executors and trustees of revocable trusts still have the responsibility to invest prudently, and this must be addressed. Review with the estate’s legal counsel the provisions of the will or trust and applicable state law. Help guide fiduciary in preparing an investment plan in coordination with whoever is managing the estate/trust assets.

In the past, executors could sell concentrated positions in an estate without capital gains because of the assured step-up in tax basis at death. While many estates might qualify to step-up basis using the $1.3 million and $3 million basis adjustments, the rules are still uncertain, and for some estates these won’t suffice. This means an income tax may be incurred on the sale. Tax costs are a factor which the prudent investor act requires executors to consider in evaluating the appropriate investment options.

Formula Clauses

Many states have enacted laws that provide that formula clauses under a will should be interpreted based on 2009 estate tax rules. An example of this is a will that states: “I give, devise and bequeath the largest amount that will not create a federal estate tax, to the Credit Shelter Trust for my spouse and children ... ”

Executors have to apply and interpret state statutes enacted to deal with formula clauses. These may influence who receives property under a will and therefore, affect the circumstances that have to be considered in evaluating options for allocating the $1.3 million or $3 million basis adjustment. If a trust for a spouse and children receives assets, rather than a trust solely for spouse, the tax status of the beneficiaries (likely holding period and other factors pertinent to deciding on how to allocate basis) may all change.

Allocations

Executors have to begin the process of gathering data and beginning the analysis as to how to allocate the basis adjustments to estate assets as soon as practical. A major problem is that few, if any, wills (or trusts) address these issues. Some documents provide general language about tax elections and executor decisions that may indirectly provide some guidance. Fiduciaries should consider informing beneficiaries and having beneficiaries approve any allocations and decisions.

Caution: CPAs should clarify in their engagement letters who they are representing. Be wary of the minefields of conflict that can occur between the executor and beneficiaries and especially, among the various beneficiaries on these issues. Executors should get receipts and releases (a legal document in which a beneficiary acknowledges the bequest they are receiving and agrees to release the executor from any claims or actions) from the beneficiaries before filing their allocation determinations with the IRS. Worksheets prepared by the estate CPA may be attached to those releases to corroborate the decision process involved in the allocation.

Fair Value

Appraisals for estates will raise new and unexpected issues. The initial issue with many clients will be explaining why an appraisal is even needed if there is no estate tax in 2010. Appraisals are necessary, even if there is no federal (or state) estate tax in order to comply with the carryover basis regime.

Practitioners will need basis data to confirm whether the fair value on death or the taxpayer/decedent’s cost basis is lower. If in fact the fair value exceeds the cost basis, the appraisal of fair value will be essential to ascertain the maximum basis adjustment which can be allocated.

Discounts on partnerships and other family entities may have surprising effects, especially on estates with less appreciation then the maximum adjustments permitted. Discounts, long sought after as the nectar of successful estate planning, will reduce the amount of basis allocation that may be allocated to assets having a negative impact for some estates.

Trust Assets

If a will provides a distribution to trusts for grandchildren, it is unclear that those trusts can be exempt from GST in future years. In 2010, there is no GST tax, so this is not an issue. But, what happens in 2011 when the GST is expected to be reinstated?

In some instances, it might be advisable to distribute the trust assets outright to an adult grandchild (or other skip person) before the end of 2010 to possibly avoid GST implications. While even this position is subject to uncertainty, it may prove to be a preferable option if outright distributions to grandchildren (GST skip persons) in 2010 escape GST, and trusts formed in 2010 are subjected to GST in 2011 and later years.

Estate Planning

What income tax planning should be done for estates in 2010? In past years, the general presumption was to select the estate’s fiscal tax year and plan deductions, income realization and distributions, to defer taxable income to later years. However, 2010 may be a planning anomaly for which it might be advantageous to accelerate income and postpone deductions if there will be higher income tax rates in 2011 and later years.

QTIP Trusts

Most estate planners rely extensively on the use of marital qualified terminable interest property (“QTIP”) trusts in wills and estate plans. Upon the death of the first spouse, significant wealth is often transferred into a QTIP trust to benefit the surviving spouse. But, in 2010, there is no estate tax.

If a QTIP-type trust is still funded, the restrictions under the QTIP rules (which if embodied in the governing document may apply to the trust regardless of the status of the estate tax in 2010) will limit the extent to which the surviving spouse can engage in affirmative estate tax minimization following the death of the first spouse. It may prove advantageous, especially if 2011 brings a $1 million exclusion and 55% rate for surviving spouses to disclaim assets to pass to a QTIP trust from a 2010 deceased spouse so that those assets can pass free of federal estate tax to other heirs.

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Tax Season Checklist

  • Written by Martin M. Shenkman

This is a tough tax season to prepare a checklist for in advance because so much of the law is uncertain. So, here are some planning ideas that will serve you and your clients well but which won’t be eliminated by legislation passed before you read this article:

Interest Income and Expense

Many clients engaged in intra-family loans in 2010. This was done in part because the historic low interest rates made this a tremendously valuable estate and financial planning tool. These loans were also common because of the tremendous economic disruption and efforts by family members to help out other family members that were in economic distress.

Critical to these loans being respected as loans for tax purposes is the proper reporting of loan interest income and expense by both sides of the transaction. If interest is not paid as required, and not reported properly, the IRS will likely recharacterize these loans as gifts.

Practitioners should inquire as to whether clients engaged in these transactions, obtain copies of the signed notes for their permanent files and verify proper reporting.

Insurance Trust Loans

Irrevocable life insurance trusts (ILITs) are almost ubiquitous in the planning arena. 2010, among other anomalies, changed the way many clients had to fund insurance premium payments through their trusts. If the client’s ILIT was planned to be exempt from the generation skipping transfer (GST) tax in 2010, clients probably should not have made gifts to the trust since no GST exemption could be allocated to the trust. (This is true since there was no GST in 2010.)

Therefore, many of these clients would have loaned the money to the trust that the ILIT needed to pay insurance premiums. These loans need to be respected to avoid undermining the GST status of the trust, which means addressing the recommendations for personal loans in the preceding paragraph.

Late Allocation of GST

So, your client funded trusts in 2010 while interest rates and asset values were low, but could not allocate GST; evaluate whether a late allocation of GST exemption should be made in 2011. If the gift tax return reporting the 2010 gift is not filed in a timely manner, then the GST exemption can still be allocated to protect the transfer of property to the trust. The value of the gifts for purposes of allocating the GST tax exemption will be the value on the date the gift tax return is filed in 2011. IRC Sec. 2642(b)(3).

If your client made a gift transfer to a trust and must make a late allocation of GST exemption to the donee trust in 2011, the client can elect to value the transferred property as of the first day of the month in which the allocation occurs. Reg. 26.2642-2(a)(2). This will be an unusual tax season in that this analysis of late GST allocation may affect far more clients than ever before.

However, many of the laws and issues remain in flux at the time this is written, so practitioners should exercise caution to review recent developments that might affect the late allocation of GST for 2010 gifts.

Title to Assets

In 2010, married clients should have focused on dividing assets they own so that approximately half of the appreciation in their estate was owned by each spouse. This should have been done to capitalize on the carryover basis adjustments permitted while the estate tax was repealed. Many clients have ignored asset title for years once the size of the old federal estate tax exclusion exceeded their net worth ($3.5 million in 2009).

Well, unless Congress has acted before you read this article, the exclusion for 2011 is scheduled to be only $1 million. Even if the amount has been increased, the combination of recession and years of neglecting planning will make it imperative that most clients revisit how their assets are owned, so that whichever spouse dies first a bypass trust can be funded.

When preparing a return and receiving 1099s and other documents indicating ownership, make a follow up note in the file for post-tax season consulting on this issue.

Carryover Basis Returns

These will be due for decedents who died in 2010. The return is new and at the time this article is being written the IRS has withdrawn the draft form they had issued, “Form 8939, Allocation of Increase in Basis for Property Received from a Decedent.” Expect complexity.

The return will allocate the special basis adjustment of $1.3 million available for every decedent on property passing to any beneficiary. For married decedents passing property to a spouse, an additional adjustment of $3 million will be available if the special requirements for Qualified Spousal Property (“QSP”) are met.

Be cautious completing the form as you will need appraisals to determine date of death values, basis information, and the manner in which the adjustment should be allocated if the appreciation in the estate exceeds these amounts.

Roth Conversions

These were popular in 2010. Now you have to make decisions: When should the tax be reported for 2010, or spread over two years? If new tax laws establish the income tax rates for 2011 and later years, you may have more concrete information than the client did when the conversion was consummated.

Clients have until October 15 to recharacterize so perhaps every return that reflects a Roth conversion should be extended. If a client is elderly or infirm, be certain that they have a durable power of attorney that specifically permits recharacterization.

Schedules K-1

Be alert when completing K-1s for partnerships, LLCs and S corporations. Many astute clients made gifts during 2010 to take advantage of depressed asset and business values. While the clients and their estate planners should have involved CPAs in the entire process, too often they don’t.

Practitioners preparing K-1s based on “SALY” (same as last year) could contradict planning. This is an important tax season to be certain that you have up-to-date shareholder, operating or partnership agreements confirming ownership percentages in your entity’s permanent files.

Schedules C and E, One Member LLCs

Many clients have opted to form LLCs for real estate rental properties and small businesses, often using single member LLCs to avoid the cost of filing a Partnership Form 1065. This could be a big mistake, and practitioners should identify clients to warn when completing Schedules C and E.

Single member LLCs provide a measure of asset protection from inside liability (e.g., the tenant on a real estate LLC sues your client, the owner). They do not afford protection from outside liability (e.g. a physician owns a single member LLC and rental property and is sued for malpractice). Adding meaningful additional members may provide important asset protection benefits for your client. (These will vary depending on state law.)

Buy Sell Agreements

Few clients have revised their buy sell agreements during the long recession and tepid recovery. Many are reluctant to incur costs on something they view as non-critical, while they have been struggling to keep their business going through difficult times.

However, many who have buy sell agreements that based on those formulas could have dramatically different results than anticipated. Identify appropriate clients for post-tax season follow up.

Ostriches Must Act

Most clients — not many, most — have ignored critical aspects of estate, tax, financial, insurance and business planning for years as a result of the double whammy of recession and uncertainty about the tax laws. There probably has never been a tax season in memory where practitioners will be able to identify problems that clients will need to address post-tax season. Implement procedures as soon as possible to flag clients and issues for those clients for post-tax season planning.


REVIEW QUESTION

The carryover basis return for decedents who died in 2010 will allocate the special basis adjustment of what amount on property passing to any beneficiary is: $1 million, $1.3 million, $3 million or $3.5 million?

Answer: $1.3 million

$3.5 million is incorrect, because that is the minimum estate amount before federal tax in 2009. $1 million is incorrect, because that is the minimum amount before federal tax for 2011 if Congress fails to act before 12-31-2010.

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Considerations When Selling Your Practice

  • Written by Martin M. Shenkman

The succession, merger or sale of your practice is one of the most significant milestones in your practice's life cycle and perhaps, your professional career. Properly accomplished, it can achieve major personal goals. Improperly structured, it can be financially ruinous.

Characterizing the Transaction

What type of "merger" or "sale" is contemplated? A merger could be your joining with a colleague as your exit strategy in contemplation of retirement. A merger into a larger, dominant practice may be indistinguishable from a sale. If instead, you merge into a similar sized practice, you need to monitor the practice more as the revenue base supporting your payments. The steps to safeguard your payout and the post-transaction use of your name will vary depending on the transaction. The transaction documents cannot be based on the terms used to describe the transaction but rather should reflect the specific aspects of your transaction. Most transactions are a conglomeration of different types of transactions, yet too often, the governing documentation is standard and not reflective of these nuances.

Letter of Intent

Once negotiations become serious, some of the key terms are documented in a letter of intent. Although often informal and nonbinding, this can be an effective way to identify key points of agreement, open issues, future steps and move the transaction forward. If prior agreements were signed governing confidentiality, non-disclosure, etc. they should be coordinated with the subsequent letter of intent. If not, these concepts should be embodied in the letter of intent but excluded from any provision providing that the agreement is nonbinding.

Due Diligence

Be certain significant facets of the practice you are selling to or merging with are addressed. Ascertain the veracity of the representations made during the negotiations and those contained in the contract documents. Ferret out issues that might affect the price, deal terms or even the viability of the deal. Obtain good standing certificates on the entity involved to ensure it is properly formed and obtain copies of all corporate, LLC or partnership documents filed with the Secretary of State. Conduct Internet searches with variations of each person's name and the firm. Have intellectual property counsel confirm the status of logos, trademarks and any fictitious names the practice operates under. Telltale signs of potential issues often turn up in some of these basic steps.

Liabilities

There is no substitute for skepticism. Obtain credit reports, UCC and lien and judgment searches on the principals. If the practice owns real estate obtain a title search. This might identify suits or claims that were missed on other searches. Order searches on the names of the practice and its partners to identify outstanding lawsuits, claims or other issues. Obtain a Dunn and Bradstreet report on the target practice and a state level tax search to ascertain that all required tax filings have been made. These types of credit reports can often be telling as to the real financial status of a purportedly successful practitioner.

Equipment

Leases of personal property or other assets should be identified. Copies of all leases, even for insignificant equipment should be obtained and terminated or assigned as permitted under the agreements. Be alert for loans or other obligations. Sometimes mishandling of small lease obligations might give an important indication of how other business issues have been handled.

Real Estate

Obtain a title report on real estate if you are purchasing real estate as part of the assets of the practice. Ascertain if there are any issues with the property — environmental, use restrictions, liens or judgments. Have the lease reviewed to determine if a change in control provision requires landlord approval that could undermine a key lease or could provide a contentious landlord a door-opener to renegotiate rent. If you're selling, consider having your lease "assigned" to the buyer (or if the buyer is not taking over your lease, to a third party) instead of merely sub-letting it. With an assignment you should be removed from liability, however, you may have better security for a deferred payment purchase price with a sublet to the buyer. The sublet could include a cross default provision in the lease. This provides that if the buyer fails to make a payment under the purchase contract, the sub-lease will automatically be in default.

Representations

A key of the contract documents are the representations of the other parties to the transaction. Be proactive to make certain that they are finely tailored to address specific nuances of the practice you are selling to or merging with. Each item on your due diligence checklist should be addressed. How should the agreement define "material" when it is applied to representations? Modest variation from represented amounts may be insignificant and should not undermine the transaction. But, if significant, they should have consequences. A tailored materiality standard can be defined for different representations.  At what point should a violation of a representation be considered a default? What should the consequence of the default be? How should the purchase or merger agreement define the standard for the level of representation: (i) "absolute"; (ii) "to the best of knowledge"; (iii) "to best of knowledge without duty of inquiry"; (iv) "to the best of knowledge after due inquiry"; etc? These linguistic differences can be significant. Often, if the other party objects to a particular representation, resolutions can be found by lowering the standard of the representation.

Meaningful Security

There are many ways to secure the payment of the purchase price for your practice. But, if it's not paid in full, what recourse will you realistically have as the seller? If you're an older practitioner, or are ill, the typical recourse is for the seller to recover the practice from the defaulting buyer. If the buyer defaults on a note, you should accelerate the balance, applying a higher default interest rate, etc. The value of these remedies will depend on the depth of the pockets supporting them. Contingent payments based on future earnings or revenues may be difficult to protect. A simpler, self executing remedy may be more practical than a complex one requiring layers of proof. Holding documents in escrow pending the seller's achieving certain milestones is helpful. Review and understand the nuances of the escrow agreement so that drafting laxity won't undermine you.

Schedules and Exhibits

Obtain clearer protection by attaching exhibits referred to in the documents rather than having longer representations and other provisions. Another key advantage of using extensive schedules is that it avoids potential ambiguities or issues over which documents the representations referred to. Whether or not the lease is available, indicating that you want a full copy of the executed lease early on avoids complaints later if you keep adding new requests.

Stub Period

If you're doing a simultaneous closing, you still need to address the interim period between contract discussion/signing and the actual closing. Is all your due diligence current? If not, what updating is necessary? This might include requiring each party to update the schedules attached to the contract at signing to reflect data up to the closing. The contract should also clarify what each party's rights are if the differences are significant.

Survival of Representations

Consider what survival terms/periods are acceptable to the parties for each representation and warranty. If you're looking at the transaction as a retirement exit strategy, you should prefer to end the survival periods sooner. Too often, contracts simplistically contain an arbitrary one-year survival period. Tailoring reasonable survival periods for each representation will take a bit longer and make the documentation a bit more complex, but this approach will often help create the reasonable middle ground that can address the legitimate concerns of each party.

Post Closing

Be certain to include adequate reporting and auditing rights to assure post-closing payments can be monitored. The fact that you may be working as a consultant for the practice that is buying your practice or that you are merging into, may give you access to this information, but if that arrangement does not work out or the situation becomes more antagonistic, you need the protection. You should reserve reasonable and complete access to financial statements, contracts, books, records and other relevant business information of the buyer. What time limits should apply? What does the phrase "books, records and other relevant business information" include? Should more specific reports and time periods be used? Audit rights must be addressed in the agreement. Some reasonable rights should be negotiated so that once a year or prior to major events, audits should be permitted. What happens if the buying practice purchases another practice, mergers or is taken over? Be certain that any new debt issued will be subservient to your practice sale debt

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