This article assumes that any advanced planning client will have a trust-centered estate plan in place involving separate revocable living trusts (RLTs) for each spouse that creates a family (credit-shelter) trust in each with the first $625,000 of each spouse’s assets.
The techniques highlighted herein are designed to plan for larger estates because those estates are still exposed to substantial estate taxes ranging from 37% to 55% of the amount over $625,000 (1998).
Recent changes and developments of interest to estate planners counseling wealthier clients include the following:
1. Estate Tax Relief under TRA 97. TRA 97 provided some relief in the form of increasing the unified credit (or the applicable exemption amount) from $600,000 to $1,000,000 per individual in 2006 as follows:
Year Unified Credit Equivalent
1997 192,800 600,000
1998 202,050 625,000
1999 211,300 650,000
2000 220,550 675,000
2001 220,550 675,000
2002 229,500 700,000
2003 229,500 700,000
2004 287,300 850,000
2005 328,300 950,000
2006 345,800 1,000,000
These "tax relief" measures merely raise the 1996 unified credit amount of $600,000 to $1,000,000 by the year 2006 by a 5.4% inflation factor.
2. Check the box regulations. The Internal Revenue Service finally capitulated in its lengthy battle involving the classification of hybrid entities by adopting the so-called "check-the-box" regulations effective January 1, 1997. Treas. Reg. 301.7701-3 (amended Dec. 17, 1996). The effect of this change is that most new "hybrid" entities may choose whether to be taxed as a corporation or as a partnership by filing IRS Form 8832 (Entity Classification Election). This new rule is particularly useful in giving clients who use a limited liability company ("LLC") the decision to be taxed either as a corporation or as a partnership. Given the flexibility of the Illinois LLC Act, this provides a useful protection against a trap for the unwary.
As applied to the tax planning area, this change eliminates any need to use a natural person as a general partner in a limited partnership.
3. QPRT sales back to donors. The IRS has issued proposed regulations prohibiting the sale of a residence from a Qualified Personal Residence Trust back to the donor. Prop. Reg. 25.2702-5 (c)(9) promulgated April 16, 1996.
4. Minimal CRTs outlawed. TRA 97 provided that a charitable remainder trust must provide a minimum benefit of 10% of the value of the assets transferred to the trust. This effectively prohibits individuals younger than 35 from creating CRTs and reduces the annuity benefit available to most donors.
5. IRS attacks Family Limited Partnerships. During 1997 the IRS continued its attack on FLPs in the form of the issuance of 30 Technical Advice Memoranda (TAMs) advising IRS District Offices in 30 separate cases that FLPs were not entitled to discounts claimed on estate tax returns on a variety of grounds. A review of those TAMs reveals that the IRS selected the most egregious situations involving "bad faith" and deathbed partnerships to launch its attack. In an unusual situation, the first such TAM was in circulation in the tax and estate planning community without an assigned number prior to its official publication as TAM 9730005.
In addition, in January of 1998 the Clinton Administration proposed that Congress adopt legislation prohibiting a discount on valuation of entities formed among members of families unless the entities involved the conduct of an active trade or business.
6. IRS attack on Crummey powers. The Clinton Administration has proposed to Congress that the Crummey decision be legislatively reversed by amending Section 2503 of the Internal Revenue Code.
7. IRS approves designating trusts as beneficiaries. On December 30, 1997 the IRS amended its proposed regulations to allow the designation of a revocable living trust as beneficiary of an IRA without causing problems with the minimum distribution rules under Section 409. Prop. Reg. 1.401(a)(9)-1 D-5 and D-6 proposed December 30, 1997.
Review of Advanced Estate Tax Planning Techniques
Advanced estate tax planning techniques may be discussed in three categories: (1) gifting; (2) freezing the value of the assets; and (3) discounting the value of the assets. Gifting involves a donor giving away property during his or her lifetime so as to utilize the donor’s $10,000 annual gift exclusion. This not only excludes the gifted amount from the donor’s taxable estate but also shifts the future appreciation from the estate. Some donors also intentionally gift more and use a portion, or all, of their unified credit so as to shift appreciation to their donees. TRA 97 has also provided for indexing of this annual exclusion for inflation but remains at $10,000 for 1998.
Freezing the value of assets attempts to freeze the value and shift future growth to the intended beneficiaries. Chapter 14 of the Code was directed principally at these techniques. Freezing techniques that remain viable after the enactment of Chapter 14 include grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTS).
Discounting the value of assets usually involves the fractionalizing of asset ownership interests so as to create loss of control, loss of marketability and loss of liquidity to reduce the value of the remaining assets in the estate.
Most advanced planning techniques utilize these three basic concepts in different combinations. The remainder of this article will outline the following advanced planning techniques: qualified personal residence trusts (QPRTs); irrevocable life insurance trusts (ILITs); charitable remainder trusts (CRTs); charitable limited partnerships (CLPs); and family limited partnerships (FLPs).
A qualified principal residence trust is a trust to which the client transfers his or her principal residence (or vacation home) and retains the right to use such residence for a specific time period. Upon the expiration of that time period, the residence is owned by the remainder interest owners, generally the children of the creator of the trust. The requirements of a QPRT are set forth in Section 2702 of the Code and Treas. Reg. 25.2702-5.
Upon creation of the QPRT a gift is made by the creator to the remainder beneficiaries in the amount of the actuarially-determined remainder interest. The creator must file a gift tax return at the creation of the trust and utilize a portion of the unified credit or pay a gift tax. Thus, a QPRT attempts to freeze the value of the asset and to gift a portion of the frozen value.
The downside to the QPRT is that the creator must survive to the end of the designated term or the entire value of the residence at the time of death is included in the creator’s estate.
If the creator survives to the end of the period, the entire value of the residence (including any subsequent appreciation in value) is transferred to the creator’s beneficiaries. If successful, the QPRT allows the creator (1) to transfer value for less than full value and (2) to freeze the value as of the date of the transfer to the trust. However, even a successful QPRT uses a portion of the donor’s lifetime unified credit of $625,000 (in 1998).
The requirement that a creator survive until the end of the designated term raises the issue of what happens upon the expiration of the term. Obviously, donors would prefer that their home not be owned by someone else, even if that someone else were their children. Thus, for several years after the passage of the QPRT legislation, donors arranged to buy the residences from the trust just prior to the end of the specified term. This allowed them to remove cash from their estate at less than full value. As you might suspect, the IRS objected to the practice of having the creator buy the residence from the trust and has adopted regulations prohibiting the buyback by the creator. Prop.Reg. 25.2702-5 (c)(9) [Issued 4-15-96]. In addition, the Clinton Administration proposed in January 1998 to eliminate the QPRT entirely.
As of early 1998, the QPRT remains a viable estate planning technique as long as the donor survives for the term of the QPRT.
Irrevocable Life Insurance Trust
An Irrevocable Life Insurance Trust (ILIT) is a trust used to purchase life insurance on the life of the taxpayer. The taxpayer funds the payment of the premiums for that policy yet does not have the insurance proceeds includable in the taxpayer’s federal taxable estate.
ILITs have been used by estate planners for almost thirty years since the decision in the infamous Crummey v. Commissioner, 397 F.2d 82 (9th Cir, 1968). In Crummey, the taxpayer took advantage of the annual gift tax exclusion by transferring cash to an irrevocable trust created by the taxpayer for the benefit of the taxpayer’s children. Because transfers in trust ordinarily do not qualify for the annual gift tax exclusion of Section 2503 of the Code, the taxpayer gave each of his children the right to withdraw a proportionate share of the contribution to the trust for a period of 30 days after receipt of the notice of the right.
The Ninth Circuit ruled that the transfers to the trust qualified for the annual gift tax exclusion. Although the IRS has acquiesced to the result in that case for many years and has issued revenue rulings to that effect (See Rev. Rul 73-405, 1973-2 CB 321), it attempts to contest the taxpayer whenever it sees an opportunity.
As might be expected tax planners "stretch the envelope" when insurance premiums are more than can be protected by the available annual gift tax exclusions. In two recent court cases, the IRS attempted to attack the use of ILITs where the taxpayer sought to take advantage of extra gift tax annual exclusions by giving withdrawal rights to contingent remainderman. In Cristofani v. Commissioner, 97 T.C. 74 (1991), a donor gave each of his 4 children and 16 grandchildren the right to withdraw $10,000 within 30 days of the contribution. The IRS argued that there must have been a "pre-arranged" agreement for the grandchildren not to have exercised their right to withdraw because the grandchildren would only receive the insurance proceeds if their parent did not survive. The Tax Court disagreed with the IRS and held that there was no evidence of a pre-arrangement. The IRS also lost on this issue in Kohlsaat v. Commissioner, TCM 1997-212 (1997).
In January 1998, the Clinton Administration proposed to Congress that the Crummey decision be reversed legislatively by amending Section 2503 of the Code.
A review of recent cases, private letter rulings and official pronouncements of the IRS in the form of Actions on Decisions make clear that the IRS is not challenging the use of withdrawal rights to fund ILITs in situations where the individuals who are given the withdrawal rights are vested remainder beneficiaries. The IRS has, however, indicated that it will continue to contest the use of withdrawal rights given to contingent remainder beneficiaries on the grounds that their refusal to exercise those withdrawal rights must have been because of a prearranged understanding among the parties. Notwithstanding the IRS’ hostility to the ILITs in practice, ILITs remain a very viable planning tool particularly in the usual situation where withdrawal rights are given only to persons who will eventually receive some benefit when the insurance proceeds are paid. Naturally a prudent planner will make sure that the required notice of contribution and withdrawal rights be documented each year.
In furtherance of Congress’ support of charitable giving, an individual may create a Charitable Remainder Trust (CRT) by gifting cash or property to a trustee and receiving a qualified annuity from the trust for his or her life (and spouse’s life) and/or a term of years. At the end of the annuity period, the entire value of the trust is transferred to the charity. The donor obtains a current tax deduction in the amount of the actuarially determined value of the remainder gift to the charity. The value is determined by IRS tables. For example a 65 year old who transfers property to a CRT and receives back an annuity for his life at 8% receives a current tax deduction in the amount of 25% of the value of the transfer.
A CRT is most useful in avoiding capital gains that the donor may incur if the donor sold the property. By transferring the property to the CRT, the gain is avoided and the trust has more assets to invest and to pay an annuity to the donor. The effect of a CRT may be shown by the following example:
A owns 10,000 shares of publicly held stock of Company W which currently trades at 96 per share; A purchased the stock for $3.00 per share in 1962. Co W stock pays $.75 dividend per share. A is considering retiring but does not want to pay substantial capital gains. If A were to sell the stock and invest in available investments, the analysis would be as follows:
Sale to Third Party:
Proceeds of sale of stock 960,000
Less: Tax Basis 30,000
Capital Gain 930,000
Times Tax Rate x .20
Capital Gain Tax 186,000
Balance available for investment 774,000
Annual earnings at 8% 61,920
Transfer to CRT 960,000
Less: tax paid on sale -0-
Balance available for investment 960,000
Annuity received at 8% 76,800
PLUS: First years charitable tax deduction 240,000
Many donors also tie a CRT into the creation of a private foundation. Such donors currently may use the fair market value of the property in determining the amount of the charitable contribution to a CRT for a private foundation pursuant to a temporary tax provision that is set to expire on June 30, 1998. The Clinton administration has proposed that such expiration again be extended.
The reduction of the capital gains tax has made CRTs less attractive. In addition, TRA 97 imposed a requirement that the charity receive a remainder interest of at least 10% of the value of the assets transferred thereto. In the end, CRTs remain a viable estate planning opportunity especially for charitably-inclined clients.
A limited partnership is a powerful estate planning tool that may help a family plan for the future in many ways. Heinz Brisske, in a prior issue of the Brief, described some of the benefits of a limited partnership in the family context. A limited partnership continues to be a useful device to assist family members in diversifying their investments and in teaching the younger generation how to save and invest. It may also result in the savings of significant amounts of federal estate and income taxes.
Before one implements a limited partnership, one must make sure that there is an independent purpose being served by the creation of the limited partnership. The primary problem that the IRS has with FLPs is the lack of an independent business purpose to the partnership.
A limited partnership is a partnership formed under the Uniform Limited Partnership Act of a particular state and is subject to taxation as a partnership under Subchapter K of the Internal Revenue Code. Under that subchapter, a partnership is a so-called "flow-through" entity. This means that the partnership’s items of income and deductions are reported to the individual partners’ tax returns through Schedule K-1 provided by the partnership. Thus, the partnership itself pays no federal income tax.
A limited partnership may allocate income and deductions among the general and limited partners in any way that they agree. The primary restriction placed upon the partnership’s flexibility to make such allocations is that the allocations must have substantial economic effect. By virtue of this ability to allocate to the individual partners, a family partnership may spread income to lower tax bracket members.
Before organizing a limited partnership, an attorney must carefully analyze a multitude of issues regarding the structure of the limited partnership. These issues include choosing who or what entity will serve as general partner. A general partner manages the limited partnership and has unlimited liability for partnership liabilities and losses. In addition, a general partner and the partnership may be bound by the actions of one general partner. After the implementation of the check-the-box regulations there appears to be little reason not to use a corporation as the general partner in limited partnerships.
An important component of limited partnerships is that a limited partner may not have any share in the management of the partnership. In the context of a family limited partnership this means that the general partner or the officers of the corporate general partner (usually the parents or older generation) control the management of the limited partnership. Also, a limited partner is liable for partnership liabilities only to the extent of the limited partner’s investment in the partnership.
A limited partnership is also a powerful tool in tax planning. For starters, limited partnership interests may be gifted to any number of individuals (usually to family members). Thus, many partnerships are created because such ownership of different interests in the partnership may lead to discounts for valuing those interests. The Internal Revenue Service (in Rev. Rul 93-12) and the courts recognize that discounts in valuation are legitimate for lack of control and for lack of marketability for interests even where the remainder of the entity is owned by other family members.
When the interests in a limited partnership are given to family members, one must review Chapter 14 (Sections 2701 through 2704) of the Code in any valuation of those interests. In particular, restrictions on control and withdrawal rights, both of which are significant issues in determining value, are disregarded if those restrictions are more severe than the rule which would be applicable under the particular state’s laws if the partnership agreement contained no provision.
The Illinois Revised Uniform Limited Partnership Act provides that a limited partner may withdraw from the partnership upon the giving of 6 months notice. In addition, the dissolution of a limited partnership must be approved by a two-thirds vote of the partners. If one attempts to make any of such restrictions more severe, thereby increasing the discount, that restriction is ignored for purposes of valuation by virtue of Chapter 14.
One may obtain the "benefits" of more severe restrictions by organizing the limited partnership in a state whose laws adopt a more severe default provision regarding any or all of these issues. Currently, planners who wish to take advantage of larger discounts usually organize the limited partnership in Delaware.
In organizing a limited partnership for family planning purposes one must weigh the tax planning opportunities against the "cost" of such benefits: greater restrictions on transfers, withdrawals and liquidation rights.
Other tax ramifications must be considered. If a business is to be conducted as a limited partnership, this may foreclose other tax planning opportunities particularly in the employee benefit area. A careful planner will consider using a corporation as a general partner to allow the implementation of benefits and the payment of a management fee to the corporate general partner. The corporate general partner may then provide corporate benefits. Finally, one should review whether the corporate general partner should elect S corporation tax treatment.
An example may help to clarify the tax implications of a partnership. John and Mary Green operate a shipping business in Prairie, Illinois. They have three children ages 25, 24 and 21. The Greens wish to bring their children into the business and to educate them regarding investments. They have received an appraisal that their business is worth $2,000,000. Having consulted with an estate planning attorney, they have determined that a limited partnership best suits their needs. They decide to establish a corporation to be owned 50% by each of John and Mary, which will be the general partner of their limited partnership. The corporation will own a 1% partnership interest. John and Mary will receive limited partnership interests for the remaining 99% of partnership. During the first year, they will gift partnership interests valued at up to the maximum amount that they may gift as a married couple to each of their children. They have obtained an appraisal that each unit of limited partnership interest is worth $14,000.00. That valuation is based upon the appraiser’s judgement that there is a 30% discount attributable to lack of control and lack of marketability of the units. At the end of the first year, the business is included in the Greens’ taxable estates at approximately $1,358,000 determined as follows:
Value of underlying business $2,000,000
Less: 30% valuation discount 600,000
Value of partnership units 1,400,000
Divided by 100 units 100
Value per unit of L.P. 14,000
Value of partnership units retained by John and Mary at the end of the first year:
General partner 14,000
96 Units of L.P. 1,344,000
Total Value 1,358,000
By using a limited partnership and by beginning a gifting process, John and Mary have reduced their taxable estates by over $600,000. John and Mary may continue to decrease the value of the business in their taxable estates by continuing to gift limited partnership interests each year by using their annual gift tax exclusion. Thus they are able to make annual gifts to decrease their estate without decreasing their cash resources. As a married couple they are able to gift up to $20,000 in value of limited partnership interests to each child or other individual without using up any of their lifetime credit.
The use of a limited partnership in a family setting has significant tax and non-tax benefits.
Charitable Limited Partnerships
One could also use a limited partnership to accomplish the result of a CRT and add flexibility to the planning process by using what I call a "charitable limited partnership" ("CLP"). In a CLP, the donor would set up a corporation and thereafter create a limited partnership between the corporation and the donor. The donor would transfer the assets to the CLP in exchange for units of limited partnership; thereafter, the donor would gift units of limited partnership to a tax-exempt charity (qualifying under Section 501(c)(3) of the Code).
If the limited partnership thereafter sold the assets at a taxable gain, the gain would be reported to the partners in accordance with the partnership gain. If the donor had given all 99 units of limited partnership (each entitled to 1% of the income and losses of the partnership) to the charity, the gain would be reported via K-1s to the charity. The partnership, under the control of the corporate general partner would thereafter be able to invest the full amount (less any taxes payable by the corporate general partner).
Of course, the corporate general partner would be entitled to a management fee. Naturally, the amount of the fee would differ based upon the extent of the services provided by the general partner’s officers, but a fee in the range of 3% to 10% of the assets managed would be expected. This fee would be comparable to the annuity paid to the donor in the context of a CRT. The annuity paid by a CRT is taxable as ordinary income and not subject to payroll taxes. The management fee paid to the corporate general partner would be subject to possible payroll taxes but would be offset by ordinary business deductions and the use of corporate employee fringe benefits and qualified plans. In addition, the corporation could elect S corporation status for any remaining income.
The client needs to review the actual numbers applicable to his or her situation to determine if the flexibility of the CLP is more attractive than the conventional CRT. Applying a CLP to the CRT example from the section above, would result in a much larger current tax deduction while at the same time allowing the charity to receive funds during the life of the donor. For example, if one were to assume that the donor would set up a CLP with a corporate general partner owned entirely by the donor with a 1% share of profits and a management contract providing for an annual management fee of 8%, the donor would receive a charitable contribution deduction of $712,800 ($960,000 x .99 x .75) rather than the $240,000 from the CRT. The charity would also benefit from the added availability of funds from the limited partnership during the partnership’s life.
As these numbers reveal, the CLP provides an attractive alternative to the CRT. Furthermore, the CLP is much more flexible given that it is governed by a partnership agreement as opposed to an irrevocable trust.
Patrick J. Crotty is of counsel to Momkus, Ozog & McCluskey, L.L.C., Downers Grove. He is Vice-Chair of the DCBA’s Tax Committee. He received his Undergraduate Degree in 1975 and his Law Degree in 1978 from Notre Dame.