Monthly Archives: February 2011

Ideal Time for Business Succession Planning

This article appeared in the February 21, 2011 edition of Northern Nevada Business Weekly:

One of the chief concerns of family business owners is how to pass the business to the next generation and/or key employees.  Although various provisions of the federal estate tax laws are intended to ease the tax burden on the transition of small businesses upon an owner’s death, these provisions are very limited in their scope and benefit.  However, the recently enacted Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”) provides business owners with some meaningful tax-free opportunities to move their businesses to the next generation.

As widely publicized, the Act extends the Bush-era individual income, capital-gains and dividend tax cuts for all taxpayers for two years (2011 and 2012).  Most people also know that the Act temporarily increased the federal estate tax exclusion (i.e., the amount that may be passed to heirs free of federal estate tax) from $1 million to $5 million and reduces the federal estate tax rate to a single tax bracket of 35%.  For the first time ever the Act also provides for “portability” of the estate tax exclusion between spouses.  Portability means that any unused portion of a person’s estate tax exemption is transferable to his or her surviving spouse to be used upon the surviving spouse’s death.  So, if one spouse died in 2011 or 2012 and did not use any of his or her gift or estate tax exclusion, the surviving spouse will have an available estate tax exclusion of $10 million, and only the value of assets in excess of that sum would be subject to the 35% federal estate tax.

Obviously, a business owner who dies in the next two years will be able to pass substantially more of his or her business to his or her heirs than would have been possible without the act.  However, unless the business owner dies in the next two years (which is hopefully not the case) the Act’s changes to the estate tax laws really won’t help very much.  As seen in 2010, Congress may or may not extend, modify, or otherwise alter these new laws.  If nothing is done, we will revert to the rules that would have been applicable in 2011 without the Act, i.e., a $1 million federal estate tax exclusion and a maximum estate tax rate of 55%.

The Act’s biggest benefit to business owners, however, is a 500% increase in the federal lifetime gift tax exclusion.  Since 2001 the lifetime gift tax exclusion has remained at $1 million.  Under the terms of the Act, the gift tax exception increases dramatically to $5 million and the gift tax rate is reduced to 35% for transfers in excess of $5 million.  Like the estate tax exclusion, the gift tax exclusion is an exclusion from federal transfer taxes for assets transferred to other persons except that it relates to transfers made while you are alive rather than at death.  The federal gift tax and estate tax exclusions are unified such that any gifts made during your lifetime which use a portion of your gift tax exclusion will also reduce dollar for dollar the amount of your estate tax exclusion available upon your death.

What does all of this mean for business owners?  During this brief, two-year window you have an unprecedented opportunity to pass up to $5 million (or up to $10 million for a married couple) in business interests or other assets to the next generation or generations.  The combination of this previously undreamed-of gift-tax exclusion, depressed asset and real property values, and rock-bottom interest rates has created a once-in-a-lifetime opportunity to transfer very large blocks of your business interests wealth to your children, grandchildren and beyond free of any federal gift and estate taxes.  There has not been a better time to make gifts in several decades.

Importantly, the Act does not disturb some very advantageous estate planning tools.  Valuation discounts for minority interests and illiquid assets (such as closely-held business interests) are still available and are often used with various estate planning techniques to leverage a person’s gift and estate tax exclusions to make tax-free transfers of substantially more assets than would otherwise be possible.  While it had been rumored that the new tax law might limit these valuation discounts, the Act is silent on this subject.  As a result, valuation discounts continue (at least for now) to be an effective estate planning tool, especially for business owners.  For example, assume Father and Mother own a business, including equipment, materials, and real property worth $10 million.  Father and Mother would like to transfer the business to their three children who all participate in the business.  By gifting equal 33% interests in the business to the three children, Father and Mother can take valuation discounts due to the lack of control and lack of marketability associated with those 33% interests.  After the transfers, none of the children will have a controlling interest in the company and there is no ready market or stock exchange available for them to quickly convert the business interests to cash.  Therefore, Father and Mother may be able to discount the value of the gifted business interests as much as 30% to 40%.

Assuming a 30% discount in our example, Father and Mother would utilize $7 million of their combined $10 million gift tax exclusions.  The remaining $3 million in gift tax exclusions could be utilized to transfer other assets to their children or lower generations .  Not only would Father and Mother avoid taxation resulting from the transfer of their business, but also they would maximize the amount of assets transferred by discounting the asset values.  The transfer also allows any future appreciation in the value of the business to inure directly to the benefit of the children outside of Father’s and Mother’s estates.

Some of you have already exhausted your $1 million lifetime gift-tax exclusion.  The Act provides a limited time period to make additional gifts.  You have another $4 million to gift for the next two years.  Some of you have sold business interests to irrevocable trusts for your children, in return for a low interest promissory note payable (which is still a very useful planning method).  Generally, the purpose of these transactions is to take advantage of valuation discounts and to “freeze” the value of the business interest in your estate by replacing the business interest with a very low interest promissory note.  If the business interest has not performed well or if you simply want to be free of the hassle of the ongoing note payments, then the additional $4 million of lifetime gift tax exclusion presents an opportunity to forgive the promissory note and thereby conclude the transaction and relieve your heirs of the burden of making the note payments.

Please keep in mind that other advanced planning techniques are available to leverage your lifetime exclusions to pass even more assets to your descendants or beneficiaries.  Prior legislative proposals would have instituted a minimum ten-year term for an estate planning technique known as a “Grantor Retained Annuity Trust” (“GRAT”), which would have greatly reduced the planning opportunities associated with this type of trust.  However, the Act did not address GRATs.  With a GRAT, the business owner receives fixed annuity payments for a specific term.  At the end of the term, any remaining trust property is transferred to the younger generation free of estate and gift taxes. Short-term GRATs (e.g. two years) are viable, at least in the immediate future.  GRATs can be particularly effective when interest rates are low, and with the current rates at historic lows GRATs are a very common planning tool at this time.

In terms of planning beyond the Act’s two-year horizon, we feel that the only prudent thing to do at this time is to assume that the Act will expire.  Therefore prompt action to take advantage of these planning opportunities is clearly advisable.

By Don L. Ross, Esq. and Jason C. Morris, Esq.

Deductibility of Legal Fees for Estate Planning

**UPDATE: Tax Cuts and Jobs Act (TCJA) enacted on December 22, 2017, provided, “[n]otwithstanding subsection (a) [subjecting certain miscellaneous itemized deductions to the 2 percent floor], no miscellaneous itemized deductions shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.”**

Section 212 of the Internal Revenue Code (the “Code”) provides that a deduction is available for all the ordinary and necessary expenses paid or incurred during the taxable year:

1. for the production or collection of income;

2. for the management, conservation, or maintenance of property held for the production of income; or

3. in connection with the determination, collection, or refund of any tax.

Section 212 is limited by the two percent (2%) floor under § 67 of the Code. Section 67 provides an individual’s “miscellaneous itemized deductions” may only be deducted to the extent that the aggregate of the deductions exceed two (2%) percent of adjusted gross income. IRC §67(a).  Because of the itemized deductions floor, most clients will not benefit from a deduction for legal expenses incurred in estate planning.

The Tax Court has considered numerous cases to determine whether legal fees incurred in estate planning are deductible.  One of the first cases to allow a deduction for estate planning fees, Bagley v. Commissioner, found that the law firm provided deductible legal services under §212(2).  The law firm consulted the clients with regard to tax-favorable investments, loans to the corporation owned by the client family, and the review and creation of estate plans for the family members.

In Merians v. Commissioner, the court allowed a §212(3) deduction for legal fees allocated to tax advice.  The court narrowly construed their decision to a deduction for only the portion of services which it considered tax advice.  The attorney did not maintain accurate time entry or billing records reflecting the amount of time spent on tax-related aspects of his representation.

The Tax Court has disallowed deductions for legal fees paid for estate planning and general business guidance when the taxpayer does not have any evidence of how the fees relate to the §212 categories.  The mere preparation of a will or testamentary trust will not be deductible.  However, an argument can be made that the creation of a revocable living trust is a tax-motivated transaction for the management and conservation of property.  Similarly, the taxpayer could argue the fees were incurred in connection with the determination (minimization) of the taxpayer’s future tax liability. Therefore, the fees should be deductible under §§212(2) and 212(3).


Divorce Forfeiture Provisions in a Will or Trust

A forfeiture provision may be drafted such that a couple must remain married in order for both spouses to receive distributions or withdrawals from the estate. Such a provision would not be invalid because the provision does not encourage divorce or disrupt the family relations. None of the Restatements of Law, which are legal treatises, prohibit forfeiture provisions upon divorce. In fact, some states allow reasonable restrictions upon remarriage of a surviving spouse.

Certain provisions in a will or trust may be held invalid on the basis that they would disrupt family relations. For example, a provision which provides for the payment of money to a beneficiary if he divorces or separates from a spouse may be invalid. Similarly, a provision which prohibits distributions to a beneficiary if he does not divorce or separate from a spouse may be invalid. Also, a provision cannot deny a bequest until a beneficiary’s spouse dies or the beneficiary divorces his spouse. Likewise, a trust or will provision must not prohibit marriage altogether or severely limit a beneficiary’s choice of spouse.

A dispositive instrument, will or trust, may provide for a beneficiary in the event of a divorce or death. A special disposition to an unmarried beneficiary may be available to relieve pressure upon the beneficiary to remain in or enter a marriage. Wills and trusts can be custom drafted to fit many varied situations. Whenever possible, the construction of a trust instrument will be favored that upholds the validity of the trust and renders the instrument effective.  Despite judicial inclination to uphold trusts, provisions violating public policy will be held invalid.

“Inception” Lacks a Trust

In the recent Hollywood hit movie, Inception, Leonardo DiCaprio plays a corporate espionage thief who extracts information from subjects while they are dreaming. DiCaprio and his crew of thieves are hired to plant an idea in the mind of an heir to the world’s most powerful energy company. The spies seek to coax the heir into believing his father wants him to break-up the father’s vast energy empire. The flaw in Inception is that the dying patriarch of the energy giant sets forth his wishes in a last will and testament. The average business owner or an energy titan owner would not hold business interests outside of a trust or set forth his dispositive wishes in a will.

A trust serves many valuable functions; it is not just for business owners (or, the wealthy). A few reasons why you should consider putting your assets in a trust:

  • Provide Financial Management of your Property – You may act as trustee at first and later decide you no longer wish to do so. A trustee or successor trustee you’ve selected can take over the day-to-day property management.
  • Provide Property Management if you can’t manage your affairs – If you become too ill or disabled to manage your property, your trustee or successor trustee will do this for you. With no trust in place, you would need a guardianship (or, conservatorship outside of Nevada). You can avoid the trouble and expense of setting up such arrangements if you have a living trust.
  • Avoid Probate – Property in your revocable living trust doesn’t go through probate after your death. However, if you fail to title property in the name of the trust, those assets will have to pass through probate.
  • Quick Distribution to Beneficiaries – This is another advantage of avoiding probate. The probate process delays property distribution. With a trust, your trustee can distribute property to your beneficiaries sooner.

A trust does not eliminate the need for a will. You may have property that never gets transferred to your trust. A will can act as a backstop to transfer any property to your trust. However, if you happen to own the world’s largest energy company, you should definitely have a trust.

by: Jason Morris, Esq.